UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




Form
10-K




(Mark
One)


x
            Annual
      Report under Section 13 or 15(d) of the Securities Exchange Act of
      1934




For the
fiscal year ended December 31, 2008




or




 ̈
            Transition
      Report under Section 13 or 15(d) of the Securities Exchange Act of
      1934




For the
transition period from
                
to




Commission
file no. 000-30523







First
National Bancshares, Inc.


(Exact
name of registrant as specified in its charter)




South
      Carolina
                  
                  58-2466370(State
      or other jurisdiction
                    of
      incorporation or organization)
                  
                  (I.R.S.
      Employer
                    Identification
      No.)215
      N. Pine St.
                    Spartanburg,
      S.C.
                  
                  29302(Address
      of principal executive offices)
                  
                  (Zip
      Code)




864-948-9001


Registrant’s
telephone number, including area code




Securities
registered pursuant to Section 12(b) of the Act:




Title
      of class
                          
                          Name
      of each exchange on which registeredCommon
      Stock $0.01 par value
                          
                          The
      NASDAQ Global
Market




Securities
registered pursuant to Section 12(g) of the Act: None.




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes  ̈No x




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes  ̈No x




Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes xNo  ̈




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. x




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




Large
      accelerated filer o
              Accelerated
      filer o
              Smaller
      reporting company x




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




The
aggregate market value of the common stock held by non-affiliates (shareholders
holding less than 5% of an outstanding class of stock, excluding directors and
executive officers), computed by reference to the price at which the common
stock was last sold was $8,784,232, as of the last business day of the
registrant’s most recent completed second fiscal quarter.




6,296,698
shares of the registrant’s common stock were outstanding as of March 31, 2009
(the latest practicable date).




DOCUMENTS
INCORPORATED BY REFERENCE




None.












IMPORTANT
INFORMATION ABOUT THIS REPORT





In this
report, the words “First National,” “Company,” “we,” “us” and “our” mean First
National Bancshares, Inc., including First National Bank of the South, our
wholly-owned national bank subsidiary.





SPECIAL
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS





This report, including information
included or incorporated by reference in this document, contains statements
which constitute forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements relate to the
financial condition, results of operations, plans, objectives, future
performance, and business of First National. Forward-looking statements are
based on many assumptions and estimates and are not guarantees of future
performance. Our actual results may differ materially from those anticipated in
any forward-looking statements, as they will depend on many factors about which
we are unsure, including many factors which are beyond our control. The words
“may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,”
“project,” “potential,” “continue,” “assume,” “believe,” “intend,” “plan,”
“forecast,” “goal,” and “estimate,” as well as similar expressions, are meant to
identify such forward-looking statements.  Potential risks and
uncertainties that could cause our actual results to differ materially from
those anticipated in our forward-looking statements include, but are not limited
to the following:





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





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





·
            whether
      our lender will exercise the remedies available to it in the event of
      default on the line of credit to our holding
  company;





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





·
            our
      ability to comply with the terms of the consent order between the bank and
      its primary federal regulator within the timeframes
    specified;





·
            adequacy
      of the level of our allowance for loan
losses;





·
            reduced
      earnings due to higher credit losses generally and specifically
      potentially because losses in our residential real estate loan portfolio
      are greater than expected due to economic factors, including declining
      real estate values, increasing interest rates, increasing unemployment, or
      changes in payment behavior or other
factors;





·
            reduced
      earnings due to higher credit losses because our loans are concentrated by
      loan type, industry segment, borrower type, or location of the borrower or
      collateral;





·
            the
      rate of delinquencies and amounts of
chargeoffs;





·
            the
      rates of historical loan growth and the lack of seasoning of our loan
      portfolio;





·
            the
      amount of our real estate-based loans, and the weakness in the commercial
      real estate market;





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





·
            significant
      increases in competitive pressure in the banking and financial services
      industries;





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




2


·
            construction
      delays and cost overruns related to the expansion of our branch
      network;





·
            changes
      in political conditions or the legislative or regulatory
      environment;





·
            general
      economic conditions, either nationally or regionally and especially in our
      primary service areas, becoming less favorable than expected, resulting
      in, among other things, a deterioration in credit
  quality;





·
            changes
      occurring in business conditions and
inflation;





·
            changes
      in technology;





·
            changes
      in deposit flows;





·
            changes
      in monetary and tax policies;





·
            changes
      in accounting principles, policies or
  guidelines;





·
            our
      ability to maintain effective internal control over financial
      reporting;





·
            our
      reliance on secondary funding sources such as Federal Home Loan Bank
      advances, Federal Reserve Bank discount window borrowings, sales of
      securities and loans, federal funds lines of credit from correspondent
      banks and out-of-market time deposits including brokered deposits, to meet
      our liquidity needs;





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





·
            loss
      of consumer confidence and economic disruptions resulting from terrorist
      activities or other military
actions;





·
            changes
      in the securities markets;





·
            reduced
      earnings from not realizing the expected benefits of the acquisition of
      Carolina National (as defined below) or from unexpected difficulties
      integrating the acquisition; and





·
            other
      risks and uncertainties detailed from time to time in our filings with the
      Securities and Exchange Commission.





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





These risks are exacerbated by the
recent developments in national and international financial markets, and we are
unable to predict what effect these uncertain market conditions will have on
us.  During 2008, the capital and credit markets have experienced
extended volatility and disruption.  In recent months, the volatility
and disruption have reached unprecedented levels.  There can be no
assurance that these unprecedented recent developments will not continue to
materially and adversely affect our business, financial condition and results of
operations, as well as our ability to raise capital or other funding for
liquidity and business purposes.


3





PART
I





Item 1. Business.





First
National Bancshares, Inc.





We are a South Carolina corporation
organized in 1999 to serve as the holding company for First National Bank of the
South, a national banking association, which is referred to herein as the
"bank." The bank currently maintains its corporate headquarters and three
full-service branches in Spartanburg, South Carolina, and nine additional
full-service branches in select markets across the state.





Our
assets consist primarily of our investment in the bank and our primary
activities are conducted through the bank. As of December 31, 2008, our
consolidated total assets were $812.7 million, our consolidated total loans were
$709.3 million (including mortgage loans held for sale), our consolidated total
deposits were $646.9 million, and our total shareholders’ equity was
approximately $40.6 million.  In January 2008, we acquired Carolina
National Corporation (“Carolina National”) and its wholly-owned bank subsidiary,
Carolina National Bank and Trust Company.  As of January 31, 2008,
Carolina National’s consolidated total assets were $220.9 million, its
consolidated total loans were $203.3 million, its consolidated total deposits
were $187.3 million, and its total shareholders’ equity was approximately $29.2
million.





Our net income is dependent primarily
on our net interest income, which is the difference between the interest income
earned on loans, investments, and other interest-earning assets and the interest
paid on deposits and other interest-bearing liabilities.  In addition,
our net income also is supported by our noninterest income, derived principally
from service charges and fees on deposit accounts and on the origination, sale
and/or servicing of financial assets such as loans and investments, as well as
the level of noninterest expenses such as salaries, employee benefits, and
occupancy costs.




Our
operations are significantly affected by prevailing economic conditions,
competition, and the monetary, fiscal, and regulatory policies of governmental
agencies. Lending activities are influenced by a number of factors, including
the general credit needs of individuals and small and medium-sized businesses in
our market areas, competition among lenders, the level of interest rates, and
the availability of funds. Deposit flows and costs of funds are influenced by
prevailing market interest rates (primarily the rates paid on competing
investments), account maturities, and the levels of personal income and savings
in our market areas.




As part
of our previous strategic plan for growth and expansion, we executed the
acquisition (the “Merger”) of Carolina National, effective January 31,
2008.  Through the Merger, Carolina National’s wholly owned bank
subsidiary bank, Carolina National Bank and Trust Company, a national banking
association, became a subsidiary of First National and, as of the close of
business on February 18, 2008, was merged with and into our bank
subsidiary.  On May 30, 2008, the core bank data processing system was
successfully converted, bringing closure to the substantial undertaking of
blending the two banks into one cohesive statewide branch network.





First
National Bank of the South





First National Bank of the South is a
national banking association with its principal executive offices in
Spartanburg, South Carolina. The bank is primarily engaged in the business of
accepting deposits insured by the Federal Deposit Insurance Corporation (“FDIC”)
and providing commercial, consumer, and mortgage loans to the general public. We
operate under a traditional community banking model and offer a variety of
services and products to consumers and small businesses.  We commenced
banking operations in March 2000 in Spartanburg, South Carolina, where we
operate our corporate headquarters and three full-service
branches.  In April 2007, we opened our new operations center adjacent
to our corporate headquarters, which resulted in a total of 29,500 square feet
of office space, including our existing corporate headquarters facility which
continues to house a full-service branch.


4





We rely
on our branch network as a vehicle to deliver products and services to the
customers in our markets throughout South Carolina.  While we offer
traditional banking products and services to cater to our customers and generate
noninterest income, we also provide a variety of unique options to complement
our core business features.  Combining uncommon options with standard
features allows us to maximize our appeal to a broad customer base while
capitalizing on noninterest income potential.  We have offered trust
and investment management services since August 2002, through a strategic
alliance with Colonial Trust Company, a South Carolina private trust company
established in 1913 (“Colonial Trust”).    Through a recent
alliance with WorkLife Financial, we are able to offer business expertise in a
variety of areas, such as human resource management, payroll administration,
risk management, and other financial services, to our customers.  In
addition, we earn income through the origination and sale of residential
mortgages.  Each of these distinctive services represents not only an
exceptional opportunity to build and strengthen customer loyalty but also to
enhance our financial position with noninterest income, as we believe they are
less directly impacted by current economic challenges.





Since
2003, we have expanded into three additional markets in the Carolinas, with
twelve full-service branches operating under the name First National Bank of the
South.  In 2004, we opened our first full-service branch in the
coastal region in Mount Pleasant, SC and opened our market headquarters in 2007
in downtown Charleston.  On February 19, 2008, the four Columbia
full-service branches of Carolina National Bank and Trust Company began to
operate as First National Bank of the South.  In July 2008, we opened
our fifth full-service branch in the Columbia market in Lexington, South
Carolina.  We have also expanded our banking operations into York and
Lancaster counties, beginning with a loan production office in Rock Hill that
opened in February 2007.  In December 2007, the Office of the
Comptroller of the Currency (“OCC”) approved the opening of a full-service
branch in the Fort Mill/Tega Cay community in York County.  This new
facility is currently under construction and is projected to open in the second
quarter of 2009.





Our
Business Strategy





We strive to be a community bank that
matters.  We believe that we play a vital role in providing capital,
in the form of loans, to households and small to medium-sized businesses
throughout the state of South Carolina.  We seek to be a financial
resource to our customers by offering them solid financial products and
services, assisting with networking, and making business
referrals.  We believe that being a community bank means that we and
our employees are involved in our communities.  Our decentralized
business strategy focuses on providing superior service through our experienced
bankers who are relationship oriented and committed to their respective
communities.  We are focused on maximizing revenue while tightly
managing risks and controlling costs.  We believe that this strategy
will allow us to experience renewed loan and deposit growth and improved
financial performance as the economy ultimately recovers, positioning us as a
leader in the community banking industry in our state.





Following the first quarter of 2008, we
observed the deterioration in national and regional economic indicators and
declining real estate values as well as slowing real estate sales activity in
our markets.  As a result, we have experienced a significant rise in
loan delinquencies and the level of our problem assets has
increased.  Consequently, our loan loss provision for the year ended
December 31, 2008 increased from $1.4 million for the year ended December 31,
2007 to $20.5 million for the year ended December 31, 2008.  In
response to the changing business climate, we have reduced our asset growth plan
from historic levels and modified our business strategy based on the following
principles:





Improve asset quality by reducing the
amount of our nonperforming assets.





To improve our results of operations,
our primary focus over the next six to twelve months is to significantly reduce
the amount of our nonperforming assets. Nonperforming assets hurt our
profitability because they reduce the balance of earning assets, may require
additional loan loss provisions or write-downs, and require significant devotion
of staff time and financial resources to resolve.  Our level of
nonperforming assets (loans not accruing interest, restructured loans, loans
past due 90 days or more and still accruing interest, and other real estate
owned) had increased to $75.5 million as of December 31, 2008 as compared to
$14.3 million as of December 31, 2007.   We believe that the
increase in the level of our nonperforming assets has occurred largely as a
result of the severe housing downturn and deterioration in the residential real
estate market.





We have moved aggressively to address
this issue by increasing our reserves for losses and directing the efforts of an
entire team of bankers solely to managing the liquidation of nonperforming
assets.  This team is actively pursuing remedies with borrowers,
including foreclosure, and working to hold the borrowers accountable for the
principal and interest owed.  Additionally, we are vigorously
marketing our inventory of foreclosed real estate.


5





It is our goal to remove the majority
of the nonperforming assets from our balance sheet as quickly as
possible.  Accomplishing this goal will be a tremendous undertaking
requiring both time and the considerable effort of our staff, given the current
conditions in the real estate market, but we are committed to devoting
significant resources to these efforts.  We will initiate workout
plans for problem loans that are designed to promptly collect on or rehabilitate
those problem loans in an effort to convert them to earning
assets.  We also intend to sell foreclosed real estate and packages of
nonperforming loans to investors at acceptable levels.  Additional
provisions for loan losses may be required during 2009 to implement these plans
since we will likely be required to accept discounted sales prices below
appraised value to quickly dispose of these assets.





Strengthen our capital
base.





Capital adequacy is an important
indicator of financial stability and performance.  Our goal has been
to maintain  a “well-capitalized” status for the bank  since
failure to meet or exceed this classification affects how regulatory
applications for certain activities, including acquisitions, continuation and
expansion of existing activities, are evaluated and could make our customers and
potential investors less confident in our bank.





The bank’s primary federal regulator,
the OCC, recently completed a safety and soundness examination of the bank,
which included a review of our asset quality.  We have received the
final report from this examination.  On April 27, 2009, the bank
entered into a consent order with the OCC, which contains a requirement that our
bank maintain minimum capital requirements that exceed the minimum regulatory
capital ratios for “well-capitalized” banks.  As a result of the
consent order, the bank is no longer deemed “well-capitalized” regardless of its
capital levels.  Therefore, we will need to raise additional capital,
limit our growth, and/or sell assets to increase our capital ratios within 120
days of the execution of the consent order to meet these standards set forth by
the OCC.





In
addition, the exam report includes a requirement that the bank’s board of
directors develop a written strategic and capital plan covering at least a
three-year period.  The plan must establish objectives for the bank’s
overall risk profile, earnings performance, asset growth, balance sheet
composition, off-balance sheet activities, funding sources, capital adequacy,
reduction in nonperforming assets, product line development and market segments
planned for development and growth.





We anticipate that we will also need
additional capital in order to take the significant write-downs needed to remove
the majority of nonperforming assets from our balance sheet in a relatively
short time frame, given the particularly challenging real estate
market.  In addition, we have recently performed a thorough review of
our loan portfolio including both nonperforming loans and performing
loans.  We have stress tested our borrowers’ ability to repay their
loans and believe that we have identified substantially all of the loans that
could become problem assets in the near future.  We have projected our
estimate of the future possible losses associated with these potential problem
assets which will also require additional capital if these potential losses are
realized.   As a result of the recent downturn in the financial
markets, the availability of many sources of capital (principally to financial
services companies like ours) has become significantly restricted or has become
increasingly costly as compared to the prevailing market rates prior to the
volatility.  We cannot predict when or if the capital markets will
return to more favorable conditions.  We are actively evaluating a
number of capital sources and balance sheet management strategies to ensure that
our projected level of regulatory capital can support our balance sheet and meet
or exceed the minimum requirements set forth in the consent order.





Increase operating earnings.





Management is focused on increasing our
operating earnings by implementing strategies to improve the core profitability
of our franchise.  These strategies change the mix of our earning
assets without growing our balance sheet.  Specifically, we are
reducing the level of nonperforming assets, controlling our operating expenses,
improving our net interest margin and increasing fee income. We do not expect
our balance sheet to grow materially over the next twelve months as we reduce
the amount of our nonperforming assets, which may require us to record
additional provisions for loan losses to accomplish within this
timeframe.  In fact, our balance sheet may shrink as we use cash from
the disposal of nonperforming assets and loan repayments to reduce our wholesale
funding.  We are also reducing the concentration of commercial real
estate loans and construction loans within our loan portfolio and have generally
ceased making new loans to homebuilders.  We are carefully evaluating
all renewing loans in our portfolio to ensure that we are focusing our capital
and resources on our best relationship customers.


6


The benefits of slower balance sheet
growth include more disciplined loan and deposit pricing going forward which
should result in subsequent net interest margin
expansion.  Additionally, we will seek to expand our net interest
margin as our current loans and deposits reprice and renew.  Between
January 1, 2009 and June 30, 2009, we have $276.9 million of time deposits that
will reprice at current market rates, which represents approximately 65% of our
total time deposits at December 31, 2008.  These time deposits had a
weighted average interest rate of 3.57% at December 31, 2008. Additionally, we
have $167.3 million of variable rate loans that are renewing between January 1,
2009 and June 30, 2009 which were initially made at a rate variable with the
Wall Street Journal prime rate.  We will seek to put floors, or
minimum interest rates, in our variable rate loans at
renewal.  Generally, our new and renewing variable rate loans will be
based on the First National prime rate instead of the Wall Street Journal prime
rate.  We believe that indexing our loans on an internal benchmark
will allow us to respond better to the prevailing interest rate
environment.  Furthermore, we will look to cheaper sources of funding
as they become available to us.





Aggressively manage operating costs and
increase fee revenue.





We have always focused on controlling
our operating expenses and managing our overhead to an efficient level. Given
the recent downturn in the economy, we have embarked on an even more aggressive
expense reduction campaign that we believe will save us over $5 million in
annual expenditures compared to our level of operating expenses in
2007.  We believe that we can reach this level of efficiency by the
end of 2009.  To achieve this goal, management has already reduced
salary and benefits expense by eliminating several positions as a result of a
review of employee efficiency, renegotiated vendor contracts, and implemented
several other cost-saving measures to reduce noninterest
expenses.  Reducing our level of nonperforming assets will also lower
our operating costs.





We are streamlining our cost structure
to reflect our projected base of earning assets and eliminate associated
unnecessary infrastructure.  It is our goal to continually identify
other ways to reduce costs through outsourcing and ensuring our operation is
functioning as efficiently as possible. We are committed to maintaining these
cost control measures and believe that this effort will play a major role in
improving our performance. We also believe that our technology allows us to be
efficient in our back-office operations.





To date, our noninterest income sources
have primarily consisted of service charge income, mortgage banking related fees
and commissions and fees from joint ventures to provide financial services to
our customers. We seek to provide a broad range of products and services to
better serve our customers while simultaneously attempting to increase our
fee-based income as a percentage of our gross income (net interest income plus
noninterest income).  Additionally, we will evaluate future
opportunities to increase fee-based income as they arise. We expect that these
efforts will help bolster our noninterest income sources.





Continue to increase local funding
and core deposits.





We have grown rapidly since our
inception, and we have historically funded our asset growth with a combination
of local deposits and wholesale funding, including brokered time deposits and
borrowings from the Federal Home Loan Bank of Atlanta.  We are focused
on increasing the percentage of our balance sheet funded by local depositors and
expanding our collection of core deposits while we reduce the level of wholesale
funding on our balance sheet. Absent a waiver from the FDIC, we are now
restricted on our ability to accept, renew and roll over brokered time deposits
since we executed the consent order with our bank’s regulator on April 27,
2009.  We intend to apply for a waiver in future months to allow us to
accept, renew or roll over brokered deposits.  However, we cannot be
assured that our request for a waiver will be approved.  In addition,
our ability to borrow funds from the Federal Home Loan Bank of Atlanta (“FHLB”)
has been restricted following the FHLB’s quarterly review of our assigned credit
risk rating for the fourth quarter of 2008.





Core deposit balances, generated from
customers throughout our branch network, are generally a stable source of funds
similar to long-term funding, but core deposits such as checking and savings
accounts, are typically much less costly than alternative fixed rate funding. We
believe that this cost advantage makes core deposits a superior funding source,
in addition to providing cross-selling opportunities and fee income
possibilities.  We work to increase our level of core deposits by
actively cross-selling core deposits to our local depositors and
borrowers.  As we grow our core deposits, we believe that our cost of
funds should decrease, thereby increasing our net interest margin in the
future.





Our team of experienced retail bankers
is focused on strengthening our relationships with our retail customers to grow
core deposits.  We hold our retail bankers accountable for sales
production through our targeted officer calling program which includes weekly
sales calls.  Additionally, our customer-focused sales training
emphasizes product knowledge and enhanced customer service
techniques.





We generate local deposits through a
combination of competitive pricing and extensive personal and commercial
relationships in the local market.  Five of our twelve branches are
less than two years old, and we expect those branches to significantly increase
their levels of deposits in the near future, as well as our thirteenth
full-service branch which we expect to open during the second quarter of
2009.  Our strategy is to maintain a healthy mix of deposits that
favors a larger concentration of non-time deposits, such as noninterest-bearing
checking accounts, interest-bearing checking accounts and money market
accounts.


7





Our primary competition in our markets
is larger regional and super-regional banks. We believe that our community
banking philosophy and emphasis on customer service give us an excellent
opportunity to take market share from our competitors. As a result, we intend to
decrease our reliance on non-core funding as our full-service branches grow and
mature. While building a core deposit base takes time, our strategy has
experienced considerable success.  Since opening in 2000, the bank has
climbed to the number three ranking for deposit market share in Spartanburg
County, South Carolina with 12.1% of the deposit
market.    As of the June 30, 2008 FDIC summary of deposits
report, we have the eighth-highest deposit market share of the South
Carolina-based banks.  Our long-term goal is to be in the top five
institutions in deposit market share in each of our markets.





Deliver superior community banking
to our customers.





We effectively compete with our
super-regional competitors by providing superior customer service with localized
decision-making capabilities. We believe that we can continue to deliver our
level of superior customer service while managing through this challenging
period of time.  We emphasize to our employees the importance of
delivering superior customer service and seeking opportunities to strengthen
relationships both with customers and in the communities we serve.





Our
organizational structure, with its designation of regional executives, allows us
to provide local decision-making consistent with our community banking
philosophy. Our regional boards in Charleston, Columbia, and Greenville are
comprised of local business and community leaders who act as ambassadors for us
in their markets and help generate referrals for new business for the
bank.  These board members also provide us with valuable insight on
the financial needs of their communities, which allows us to deliver targeted
financial products to each market.





Merger
with Carolina National





On
January 31, 2008, Carolina National, the holding company for Carolina National
Bank and Trust Company, merged with and into First National.  Through
the Merger, Carolina National’s wholly owned bank subsidiary, Carolina National
Bank and Trust Company, a national banking association, became a subsidiary of
First National and, as of the close of business on February 18, 2008, was merged
with and into our bank subsidiary.  As a result of this acquisition,
we added four full-service branches in the Columbia market to our
operations.  On May 30, 2008, the core bank data processing system was
successfully converted, bringing closure to the substantial undertaking of
blending the two banks into one cohesive branch network.





Columbia’s
central location in the state and convenient access to I-20, I-26, and I-77 make
this area one of the fastest growing areas in South Carolina according to U.S.
Census data. Home to the state capital, the University of South Carolina, and a
variety of service-based and light manufacturing companies, this area provides a
growing and diverse economy. According to SNL Financial (“SNL”), Columbia had an
estimated population of 356,842 residents as of July 1, 2007, and is
projected to grow 7.6% from 2007 to 2012. The South Carolina Department of
Commerce reports that Richland County attracted over $442.0 million in
announced capital investment since 2000. As of June 30, 2008, FDIC-insured
institutions in Richland County and the Columbia metropolitan area had
approximately $9.55 billion and $9.40 billion in deposits,
respectively.





In
connection with the Merger, our balance sheet reflects intangible assets
consisting of core deposit intangibles and purchase accounting adjustments to
reflect the fair valuation of loans, deposits and leases. The core deposit
intangible represents the excess intangible value of acquired deposit customer
relationships as determined by valuation specialists. The core deposit
intangible is being amortized over a ten-year period using the declining balance
line method. Adjustments recorded to the fair market values of loans and
certificates of deposit are being recognized beginning with the effective date
of the Merger, January 31, 2008, over 34 months and 5 months, respectively.
Adjustments to leases are being amortized over the terms of the respective
leases. See further discussion in Note 1- Summary of Significant Accounting
Policies & Activities for additional information on purchase accounting
adjustments and intangible assets associated with the Merger.





We
recorded an after-tax noncash accounting charge of $28.7 million during the
fourth quarter of 2008 as a result of our annual testing of the goodwill
initially recorded in the Merger for impairment, as required by accounting
standards.  The impairment analysis was negatively impacted by the
unprecedented weakness in the financial markets. The first step of the goodwill
impairment analysis involves estimating a hypothetical fair value and comparing
that with the carrying amount or book value of the entity; our initial
comparison suggested that the carrying amount of goodwill exceeded its implied
fair value due to our low stock price, consistent with that of most
publicly-traded financial institutions.  Therefore, we were required
to perform the second step of the analysis to determine the amount of the
impairment.  We prepared a discounted cash flow analysis which
established the estimated fair value of the entity and conducted a full
valuation of the net assets of the entity.  Following these
procedures, we determined that no amount of the net asset value could be
allocated to goodwill and recorded the impairment to the goodwill balance as a
noncash accounting charge to our earnings in 2008.   Our
regulatory capital ratios are not affected by this noncash impairment
charge.


8





Our
Market Areas





To
execute our strategic plan, we have organized our banking operations into four
regions:





•
            Upstate
      Region;





•
            Coastal
      Region;





•
            Northern
      Region; and





•
            Midlands
      Region.





The
Upstate Region serves as the backbone and support center for First National's
expanding branch network. First National's corporate headquarters and home
office are located in Spartanburg, along with three full-service branches.
Within each other region, First National conducts its banking operations in
selected market areas which meet the criteria for its business plan. First
National has appointed an officer to each region to oversee the banking and
business development activities and assist the executive management team in
evaluating market areas within their respective regions for growth and
development opportunities. These regional officers also serve as the liaison to
their region's business community and function as the primary point of contact
for the local regional board members.





Upstate
Region





Our
primary market area includes Spartanburg and Greenville Counties, which are
located in the upstate region of South Carolina between Atlanta and Charlotte on
the I-85 business corridor stretching to the Georgia
border.  According to SNL, as of July 1, 2008, Spartanburg
County's population totaled 277,796 residents. Population growth from 2008 to
2013 for Spartanburg County is projected to be 5.52%.  As of 2008,
estimated median family income for the Spartanburg metropolitan statistical area
was $54,000 versus $52,900 for the state of South Carolina, according to the
U.S. Department of Housing and Urban Development. Greenville County is South
Carolina’s most populous county with 428,744 residents as of July 1, 2008,
according to SNL.  Greenville County’s projected population growth
from 2008 to 2013 is 8.40%.  Greenville is also one of the state’s
wealthiest counties, with an estimated median income of $55,100 in 2008 versus
$52,900 for the state of South Carolina according to U.S. Department of Housing
and Urban Development.





According
to the Upstate Alliance, the Upstate has had over $712 million in capital
investment in the past three years. In addition, the Upstate region announced
more than $2 billion in capital investment and more than 6,000 new jobs for
2008, according to the Upstate Alliance. In 2007, the Greenville-Spartanburg
area of South Carolina was noted as one of Expansion Management’s “Top
Metros for Recruitment and Attraction,” according to Upstate Alliance. We
believe that the Upstate region has a strong economic environment that will
continue to encourage business growth and development and support our business
in the future.





Spartanburg





Spartanburg
serves as the support center for our statewide branch network. We maintain our
corporate headquarters in Spartanburg.  We opened our operations
center adjacent to our corporate headquarters in April 2007.  The
completion of this addition created a total of 29,500 square feet of office
space while continuing to house a full-service branch.





According
to the Economic Futures Group, formerly known as Spartanburg Economic
Development Corporation, more than 80 international firms, representing 18
nations, conduct business in Spartanburg County, including BMW, Milliken,
Michelin, Cryovac and Invista. Spartanburg is also home to many domestic
corporations, including Denny’s, QS/1, Extended Stay America and Advance
America. Spartanburg is currently experiencing numerous business expansions as
well as an influx of new business facilities. BMW's North American assembly
plant in Greer announced a three-year construction project to expand its
operations. This expansion represents $750 million in capital investment and
will create 500 new jobs, according to a press release issued by BMW in early
2008. Other notable companies, including Adidas, Lear Corporation and Coca-Cola,
have announced new or expanded facilities that will create many new jobs in the
Spartanburg area. We believe that Spartanburg has a strong economic environment
that will continue to support the community and provide a sound base for our
business in the future.


9





We
advertise heavily in the Spartanburg market and, through our three full-service
branches in Spartanburg, have positioned ourselves as the leading local
community bank in this market. As of June 30, 2008, we were the third
largest bank in Spartanburg County, with $448.0 million in total deposits, or
12.07% of the approximately $3.7 billion of deposits in the
market.  The following table includes information from the FDIC
website regarding our deposit market share in Spartanburg County relative to top
competitor banks as of June 30, 2008:




Rank
                                
                                Bank
                                
                                Branches
                                
                                TotalDeposits
                                
                                MarketShare1
                                
                                Bank
      of America
                                
                                
                                8
                                
                                $
                                632.2 million
                                
                                
                                17.03
                                %2
                                
                                Wachovia
                                
                                
                                7
                                
                                539.1
      million
                                
                                
                                14.52
                                %3
                                
                                First
      National Bank
                                
                                
                                3
                                
                                448.0
      million
                                
                                
                                12.07
                                %4
                                
                                BB
      & T
                                
                                
                                9
                                
                                404.6
      million
                                
                                
                                10.90
                                %5
                                
                                First
      Citizens
                                
                                
                                11
                                
                                348.8  million
                                
                                
                                9.39
                                %6
                                
                                Suntrust
      Bank
                                
                                
                                11
                                
                                290.8
      million
                                
                                
                                7.83
                                %7
                                
                                First
      South Bank
                                
                                
                                2
                                
                                233.4
      million
                                
                                
                                6.29
                                %8
                                
                                Arthur
      State Bank
                                
                                
                                7
                                
                                182.6
      million
                                
                                
                                4.92
                                %All
      others (10 institutions)
                                
                                
                                21
                                
                                633.3
      million
                                
                                
                                17.05
                                %Total
                                
                                
                                79
                                
                                $
                                3.7 billion
                                
                                
                                100.00
                                %




Greenville





In 2008,
Greenville County announced more than $181 million in new capital investment and
more than 1,500 new jobs, according to the Greenville Area Development
Corporation. Greenville is also home for over 70 international firms, which have
provided over 14,000 jobs, and has been rated first in the nation by Site Selectionmagazine for
both new and expanding international firms. Greenville was named a top five
finalist for “Most Business Friendly and Best Human Resources in Small Cities
for 2007-2008,” according to Foreign Direct Investmentmagazine. In 2007, Greenville was listed as one of “America’s 50 Hottest
Cities” by Expansion
Managementmagazine.





As of
June 30, 2008, with two full-service branches in the Greenville market, we
were the 21st largest
bank in Greenville County, with $37.8 million in total deposits, or 0.37% of the
approximately $10.12 billion of deposits in the market.  The following
table includes information from the FDIC website regarding deposit market share
in Greenville County as of June 30, 2008:





Rank
                            
                            Bank
                            
                            Branches
                            
                            TotalDeposits
                            
                            MarketShare1
                            
                            Carolina
      First Bank
                            
                            
                            13
                            
                            $
                            2.86
      billion
                            
                            
                            28.29
                            %2
                            
                            Wachovia
                            
                            
                            18
                            
                            1.48
      billion
                            
                            
                            14.58
                            %3
                            
                            BB&T
                            
                            
                            19
                            
                            1.16
      billion
                            
                            
                            11.50
                            %4
                            
                            Bank
      of America
                            
                            
                            16
                            
                            973.5
      million
                            
                            
                            9.62
                            %5
                            
                            Southern
      First Bank
                            
                            
                            3
                            
                            467.9
      million
                            
                            
                            4.62
                            %6
                            
                            Suntrust
                            
                            
                            17
                            
                            432.0
      million
                            
                            
                            4.27
                            %7
                            
                            Bank
      of Travelers Rest
                            
                            
                            9
                            
                            392.7
      million
                            
                            
                            3.88
                            %8
                            
                            Palmetto
      Bank
                            
                            
                            11
                            
                            349.7
      million
                            
                            
                            3.46
                            %9
                            
                            First
      Citizens
                            
                            
                            11
                            
                            276.4
      million
                            
                            
                            2.73
                            %10
                            
                            Greer
      State Bank
                            
                            
                            4
                            
                            275.5
      million
                            
                            
                            2.72
                            %All
      others (24 institutions)
                            
                            
                            48
                            
                            1.45
      billion
                            
                            
                            14.33
                            %Total
                            
                            
                            169
                            
                            10.12
      billion
                            
                            
                            100.00
                            %21
                            
                            First
      National Bank
                            
                            
                            2
                            
                            $
                            37.8
      million
                            
                            
                            0.37
                            %





Coastal
Region





The
Coastal Region consists of historic Charleston and its surrounding
counties.  Our full-service branches in Mount Pleasant and on East Bay
Street in downtown Charleston serve the fast-growing Charleston
market.   The downtown location serves as First National's
headquarters for the Charleston market area. According to the FDIC, total
deposits in Charleston were $7.31 billion as of June 30,
2008.


10





As of
July 1, 2008, Charleston County’s estimated population totaled 347,490
residents, and population growth for Charleston County is projected to be 6.39%
from 2008 to 2013, according to SNL. For 2007, the Charleston-North Charleston
Metropolitan Statistical Area (“MSA”) estimated population totaled 630,100
residents and is projected to total 652,380 residents by 2015, according to the
Charleston Regional Development Alliance with data provided by the U.S. Census
Bureau. The Charleston area achieved an employment growth rate of 16.5% from
2000 through 2007, outpacing national employment growth of 6.7% during that same
period, according to the Charleston Regional Development Alliance.





Charleston
is the beneficiary of significant investment and development. According to the
Charleston Regional Development Alliance, Charleston County has attracted over
$5.21 billion in announced capital investment and more than 19,600 new jobs
since its inception in 1995. In 2008, Charleston County announced new capital
investment projects totaling more than $70 million and introducing more than 350
new jobs to the area. In its August 2008 issue, Inc. magazine ranked
Charleston as one of "The Top U.S. Cities for Doing Business," and in April 2007
Charleston was placed in the top 25 for job growth. The Charleston regional
economy has attracted over 70 firms with internationally owned operations,
according to the Center for Business Research. These firms include Bosch,
Berchtold, Maersk Sealand, Rhodia, and Holset Engineering. Domestic firms also
maintain significant operations in the Charleston area, including MeadWestvaco,
Nucor Steel, Alcoa, Arborgen, Blackbaud, and Piggly Wiggly. In addition, as of
July 2008, the U.S. Navy and the Charleston Air Force Base collectively employed
over 20,000 full-time employees, according to the Charleston Metro Chamber of
Commerce.





Charleston
is also a popular travel destination, which helps fuel the local economy. Condé Nast Traveller magazine
has ranked Charleston as one of the country's top 10 domestic travel
destinations for the past 16 years. According to the Charleston Metro
Chamber of Commerce, in 2007 there were over 4.3 million visitors to the
Charleston region with an aggregate regional economic impact of
$3.09 billion.





As of
June 30, 2008, with two full-service branches in the Charleston market, we
were the 20th largest
bank in Charleston County, with $36.6 million in total deposits, or 0.50% of the
approximately $7.31 billion of deposits in the market.  The following
table includes information from the FDIC website regarding deposit market share
in Charleston County as of June 30, 2008:




Rank
                            
                            Bank
                            
                            Branches
                            
                            TotalDeposits
                            
                            MarketShare1
                            
                            Wachovia
                            
                            
                            21
                            
                            $
                            2.01
      billion
                            
                            
                            27.45
                            %2
                            
                            Bank
      of America
                            
                            
                            16
                            
                            1.06
      billion
                            
                            
                            14.46
                            %3
                            
                            First
      FS&LA of Charleston
                            
                            
                            19
                            
                            991.7
      million
                            
                            
                            13.56
                            %4
                            
                            National
      Bank of South Carolina
                            
                            
                            6
                            
                            441.0
      million
                            
                            
                            6.03
                            %5
                            
                            Tidelands
                            
                            
                            3
                            
                            383.5
      million
                            
                            
                            5.24
                            %6
                            
                            Community
      First Bank
                            
                            
                            4
                            
                            352.9
      million
                            
                            
                            4.83
                            %7
                            
                            BB
      & T
                            
                            
                            7
                            
                            336.6
      million
                            
                            
                            4.60
                            %8
                            
                            First
      Citizens
                            
                            
                            15
                            
                            311.6
      million
                            
                            
                            4.26
                            %9
                            
                            Southcoast
      Community Bank
                            
                            
                            7
                            
                            306.7
      million
                            
                            
                            4.19
                            %10
                            
                            Carolina
      First Bank
                            
                            
                            4
                            
                            186.9
      million
                            
                            
                            2.56
                            %All
      others (15 institutions)
                            
                            
                            34
                            
                            936.8
      million
                            
                            
                            12.82
                            %Total
                            
                            
                            136
                            
                            7.31
      billion
                            
                            
                            100.00
                            %20
                            
                            First
      National Bank
                            
                            
                            2
                            
                            $
                            36.6
      million
                            
                            
                            0.50
                            %




Northern
Region





The
opening of our loan production office in February 2007 in Rock Hill marked
our entry into the Northern Region of our franchise.  This region
includes growing York and Lancaster counties and the suburbs south of Charlotte,
North Carolina. In 2001, York County had an estimated population of 199,957
residents and is projected to total 221,763 residents by 2012, according to the
York County Economic Development Board. York County attracted over
$46.3 million in announced capital investment in 2008, according to the
South Carolina Department of Commerce. According to Rock Hill Economic
Development, Rock Hill had an estimated population of 59,620 residents in 2007
and is projected to total 66,683 residents by 2012.


11





According
to the U.S. Department of Housing and Urban Development, York County had one of,
if not, the highest median household incomes in the state at $64,300 estimated
for 2008.  The three largest employers in York County are Wells Fargo
Home Mortgage, Bowater and Duke Power.  York County had
$2.02 billion in deposits as of June 30, 2008, according to the
FDIC.  With its opening already approved by the OCC, construction
should be completed to open our full-service branch in the Tega Cay community of
Fort Mill during the second quarter of 2009, which will also serve as our
Northern region headquarters.





Midlands
Region





As
discussed previously, Columbia’s central location in the state and convenient
access to I-20, I-26, and I-77 makes this area one of the fastest growing areas
in South Carolina according to U.S. Census data.  Home to the state
capital, the University of South Carolina, and a variety of service based and
light manufacturing companies, this area provides a growing and diverse
economy.





As of
June 30, 2008, with four full-service branches in the Midlands market, we
were the 8th largest
bank in Richland County, with $147.4 million in total deposits, or 1.54% of the
approximately $9.6 billion of deposits in the market.  The following
table includes information from the FDIC website regarding deposit market share
in Richland County as of June 30, 2008:





Rank
                              
                              Bank
                              
                              Branches
                              
                              TotalDeposits
                              
                              MarketShare1
                              
                              Wachovia
                              
                              
                              19
                              
                              $
                              2.41
      billion
                              
                              
                              25.27
                              %2
                              
                              Bank
      of America
                              
                              
                              15
                              
                              2.08
      billion
                              
                              
                              21.78
                              %3
                              
                              National
      Bank of South Carolina
                              
                              
                              9
                              
                              2.0
      billion
                              
                              
                              20.60
                              %4
                              
                              BB
      & T
                              
                              
                              9
                              
                              820.8
      million
                              
                              
                              8.59
                              %5
                              
                              First
      Citizens
                              
                              
                              16
                              
                              793.8
      million
                              
                              
                              8.31
                              %6
                              
                              Carolina
      First Bank
                              
                              
                              7
                              
                              434.2
      million
                              
                              
                              4.54
                              %7
                              
                              South
      Carolina B&T
                              
                              
                              4
                              
                              171.3
      million
                              
                              
                              1.79
                              %8
                              
                              First
      National Bank
                              
                              
                              4
                              
                              147.4
      million
                              
                              
                              1.54
                              %9
                              
                              Bankmeridian
                              
                              
                              1
                              
                              144.6
      million
                              
                              
                              1.51
                              %10
                              
                              First
      Community Bank
                              
                              
                              4
                              
                              111.5
      million
                              
                              
                              1.17
                              %All
      others (13 institutions)
                              
                              
                              25
                              
                              467.2
      million
                              
                              
                              4.90
                              %Total
                              
                              
                              113
                              
                              $
                              9.55
      billion
                              
                              
                              100.00
                              %





Lending
Activities





General.  We offer
a variety of lending services, including real estate, commercial, and consumer
loans, including home equity lines of credit, primarily to individuals and
small- to mid-size businesses that are located, or conduct a substantial portion
of their business in the Spartanburg, Greenville, Charleston, Columbia or Rock
Hill markets.  As of December 31, 2008, we had total loans,
including mortgage loans held for sale, of $709.3 million, representing 87.3% of
our total assets.  We emphasize a strong credit culture based on
traditional credit measures and our knowledge of our markets through experienced
relationship managers.





Our credit
risk management function is comprised of our senior credit officer and his
credit department who execute our loan review process.  Through our
credit risk management function, we continuously review our loan portfolio for
credit risk.  This function is independent of the credit approval
process and reports directly to our CEO. It provides regular reports to the
board of directors and its committees on its activities.  Adherence to
underwriting standards is managed through a documented credit approval process
and post-funding review by the credit department.  Based on the volume
and complexity of the problem loans in our portfolio, we adjust the resources
allocated to the process of monitoring and resolution of these
assets.  Compliance with these standards is closely supervised by a
number of procedures, including reviews of exception reports.





Once
problem loans are identified, policies require written plans for resolution and
periodic reporting to credit risk management to review and document
progress.  The Asset Classification Committee meets quarterly to
review items such as credit quality trends, problem credits and updates on
specific credits reviewed.  This committee is composed of executive
management and credit risk management personnel, as well as several
representatives from our board of directors.


12


As a
result of the identification of adverse developments with respect to certain
loans in our loan portfolio, we increased the amount of impaired loans during
the fourth quarter of 2008 to $39.5 million.  As of March 31, 2009,
this amount had increased to $69.1 million. The provision for loan losses
generally, and the loans impaired under the criteria defined in FAS 114,
specifically, reflect the negative impact of the continued deterioration in the
residential real estate market, specifically in the counties in and around
Charleston along the South Carolina coast, and the economy in general. 
Recent reviews by the credit department have specifically focused on our
residential real estate development and construction borrowers.





Our
analysis of impaired loans and their underlying collateral values has revealed
the continued deterioration in the level of property values as well as reduced
borrower ability to make regularly scheduled payments.  Loans in our
residential land development and construction portfolios are secured by
unimproved and improved land, residential lots, and single-family and
multi-family homes.  Generally, current lot sales by the developers
and/or borrowers are taking place at a greatly reduced pace and at reduced
prices.  As home sales volumes have declined, income of residential
developers, contractors and other real estate-dependent borrowers has also been
reduced.  This difficult operating environment, along with the
additional loan carrying time, has caused some borrowers to exhaust payment
sources.  Within the last several months, several of our clients have
reached the point where payment sources have been exhausted which has increased
our level of nonaccrual loans and foreclosed properties.





On
December 31, 2008 and December 31, 2007, $69.1 million and $12.0 million in
loans were on nonaccrual status, respectively.  Foregone interest
income on these nonaccrual loans and other nonaccrual loans charged off during
the twelve-month periods ended December 31, 2008 and 2007, was approximately
$1,139,000 and $139,000, respectively.  There were no loans
contractually past due in excess of 90 days and still accruing interest at
December 31, 2008 and 2007.  There were impaired loans, under the
criteria defined in FAS 114, of $69.1 million and $12.0 million with related
valuation allowances of approximately $8.3 million, net of chargeoffs during
2008 of $4.5 million, and $655,000 at December 31, 2008 and 2007,
respectively.  The amounts presented as of December 31, 2008 reflect
our analysis of the effect of events subsequent to the balance sheet date to the
date of this report.





Our
underwriting standards vary for each type of loan.  While we generally
underwrite the loans in our portfolio in accordance with our internal
underwriting guidelines and regulatory supervisory guidelines, in certain
circumstances we have made loans that exceed either our internal underwriting
guidelines, supervisory guidelines, or both.  We are generally
permitted to hold loans that exceed supervisory guidelines up to 100% of our
capital.  We have made loans that exceed our internal guidelines to a
limited number of our customers who have significant liquid assets, net worth,
and amounts on deposit with the bank.  As of December 31, 2008,
$96.6 million, or approximately 13.6% of our loans and 237.8% of our capital,
had loan-to-value ratios that exceeded regulatory supervisory
guidelines.





We have
focused our lending activities primarily on small- and medium-sized business
owners, commercial real estate developers, and professionals.  We also
strive to maintain a diversified loan portfolio and limit the amount of our
loans to any single customer.  As of December 31, 2008, our 10
largest individual customer loan balances represented approximately $38.4
million, or 5.5% of the loan portfolio, excluding mortgage loans held for
sale.





Real Estate Mortgage
Loans.  Loans secured by real estate mortgages are the principal
component of our loan portfolio.  To increase the likelihood of the
ultimate repayment of the loan, we obtain a security interest in real estate
whenever possible, in addition to other available collateral.  As of
December 31, 2008, loans secured by first or second mortgages on real
estate made up approximately $636.8 million, or 89.8% of our loan portfolio,
excluding mortgage loans held for sale.





Within
the broader category of real estate mortgage loans, the following table
describes the loan categories of one-to-four family residential real estate
loans, multi-family residential real estate loans, home equity loans, commercial
real estate loans, and land loans as of December 31, 2008 (dollars in
thousands):





Type of Real Estate Loan
                    
                    AmountOne-to-four
      residential
                    
                    $
                    103,081Multi-family
      residential
                    
                    
                    9,242HELOC
                    
                    
                    66,842Commercial
      real estate
                    
                    
                    345,114
                    (1)Land
                    
                    
                    112,499Total
                    
                    $
                    636,778
                    (2)





(1)
            Includes
      Small Business Administration (“SBA”)
loans.


(2)
            Total
      real estate loans do not include mortgage loans held for
    sale.


13





Most of
our real estate loans are secured by residential or commercial
property.  Real estate loans are subject to the same general risks as
other loans and are particularly sensitive to fluctuations in the value of real
estate.  Fluctuations in the value of real estate, as well as other
factors arising after a loan has been made, could negatively affect a borrower’s
cash flow, creditworthiness, and ability to repay the loan.





Commercial Real Estate Loans.
As of December 31, 2008, our individual commercial real estate loans ranged
in size from $15,200 to $4.5 million.  The average commercial real
estate loan size was approximately $549,000. These loans generally have terms of
five years or less, although payments may be structured on a longer amortization
basis.  We evaluate each borrower on an individual basis and attempt
to determine the business risks and credit profile of each
borrower.  We attempt to reduce credit risk in the commercial real
estate portfolio by emphasizing loans on owner-occupied properties where the
loan-to-value ratio, established by independent appraisals, does not exceed
80%.  We prepare a credit analysis in addition to a cash flow analysis
to support the loan.  In order to ensure secondary sources of payment
and to support a loan request, we typically review all of the personal financial
statements of the principal owners and require their personal
guarantees.  These commercial real estate loans include various types
of business purpose loans secured by commercial real estate.





Residential Real Estate
Loans.  As of December 31, 2008, our individual
residential real estate loans ranged in size from less than $1,000 to $1.8
million, with an average loan size of approximately
$146,000.  Generally, we limit the loan-to-value ratio on our
residential real estate loans to 80%.  We offer fixed and adjustable
rate residential real estate loans with amortizations up to 20
years.  To limit our risk, we offer fixed rate and variable rate loans
for terms greater than 20 years through a third party, rather than originating
and retaining these loans ourselves.  Generally, we do not originate
traditional long term residential mortgages for our portfolio, but we do issue
traditional first and second mortgage residential real estate loans and home
equity lines of credit.  As of December 31, 2008, included in the
residential real estate loans was $27.8 million, or 34.7% of our residential
loan portfolio, in first and second mortgages on individuals’
homes.





Home Equity Lines of
Credit.  As of December 31, 2008, our individual home
equity lines of credit ranged in size from less than $3,000 to $1.5 million,
with an average balance of approximately $50,000.  Our underwriting
criteria for and the risks associated with home equity loans and lines of credit
are generally the same as those for first mortgage loans.  Home equity
lines of credit typically have terms of 15 years or less.  We
generally limit the extension of credit to 90% of the available equity of each
property, although we may extend up to 100% of the available
equity.  Approximately $66.8 million, or 10.5% of First National’s
real estate loans, are home equity lines of credit.





Wholesale Mortgage Loans Held for
Sale.  Our wholesale mortgage division began operations in
January 2007.  This division offers a wide variety of conforming and
non-conforming loans with fixed and variable rate options, although the trend is
to move towards all loans being conforming or traditional mortgage
loans.  Conforming loans are those that are fully documented and are
in amounts less than $417,000.  The division offers FHA/VA and
construction/permanent products to its customers.  The division’s
customers are located primarily in South Carolina and are primarily other
community banks.





Real Estate Construction and Land
Development Loans.We offer adjustable and fixed rate residential and
commercial construction loans to builders and developers.  As of
December 31, 2008, our commercial construction and development real estate
loans ranged in size from approximately $2,000 to $5.0 million, with an average
loan size of approximately $355,000. As of December 31, 2008, our
individual residential construction and development real estate loans ranged in
size from less than $2,000 to $1.8 million, with an average loan size of
approximately $280,000.  The duration of our construction and
development loans generally is limited to 12 months, although payments may be
structured on a longer amortization basis.  We attempt to reduce the
risk associated with construction and development loans by obtaining personal
guarantees and by keeping the loan-to-value ratio of the completed project at or
below 80%.  Construction and development loans generally carry a
higher degree of risk than long-term financing of existing properties because
repayment depends on the ultimate completion of the project or home and usually
on the sale of the property or permanent financing.  Specific risks
include:





•
            cost
      overruns;





•
            mismanaged
      construction;





•
            inferior
      or improper construction
techniques;





•
            economic
      changes or downturns during
construction;





•
            rising
      interest rates that may prevent sale of the property;
  and





•
            failure
      to sell completed projects in a timely
manner.


14





As of
December 31, 2008, total construction and development loans amounted to
$223.6 million, or 31.5% of our total loan portfolio.  Included in the
$223.6 million were $56.0 million in residential construction loans, or 25.0% of
our construction and development loan portfolio, that were made to residential
construction developers. We are reducing the concentration of real estate
construction and land development loans in our portfolio and have generally
ceased making new loans to homebuilders.





Commercial Business
Loans.Most of our commercial business loans are secured by
first or second mortgages on real estate, as described above.  We also
make some commercial business loans that are not secured by real
estate.  We make loans for commercial purposes in various lines of
business, including retail, service industry, and professional
services.  As of December 31, 2008, our individual commercial
business loans ranged in size from less than $1,000 to $1.3 million, with an
average loan size of approximately $84,000.  As with other categories
of loans, the principal economic risk associated with commercial loans is the
creditworthiness of the borrower.  The risks associated with commercial
loans vary with many economic factors, including the economy in our market
areas.  Commercial loans are generally considered to have greater risk than
first or second mortgages on real estate because commercial loans may be
unsecured, or if they are secured, the value of the collateral may be difficult
to assess and more likely to decrease than real estate.  As of
December 31, 2008, commercial business loans amounted to $48.4 million, or
6.8%, of our total loan portfolio.





Consumer Loans.We
make a variety of loans to individuals for personal and household purposes,
including secured and unsecured installment loans and revolving lines of
credit.  Consumer loans are underwritten based on the borrower’s
income, current debt level, past credit history, and the availability and value
of collateral.  Consumer rates are both fixed and variable, with
negotiable terms.  Our installment loans typically amortize over
periods up to 60 months.  However, we will offer consumer loans with a
single maturity date when a specific source of repayment is
available.  We typically require monthly payments of interest and a
portion of the principal on our revolving loan products.  Consumer
loans are generally considered to have greater risk than first or second
mortgages on real estate because consumer loans may be unsecured, or if they are
secured, the value of the collateral may be difficult to assess and more likely
to decrease in value than real estate.  As of December 31, 2008,
consumer loans amounted to $8.4 million, or 1.2% of our loan
portfolio.





Loan
Approval.Certain credit risks are inherent in making
loans.  These include prepayment risks, risks resulting from
uncertainties in the future value of collateral, risks resulting from changes in
economic and industry conditions, and risks inherent in dealing with individual
borrowers.  We attempt to mitigate repayment risks by adhering to
internal credit policies and procedures.  These policies and
procedures include officer and customer lending limits, a multi-layered approval
process for larger loans, documentation examination, and follow-up procedures
for any exceptions to credit policies.  Our loan approval policies
provide for various levels of officer lending authority and have recently been
reduced by our Board Loan Committee.  All loans/cumulative debt
exceeding $250,000 must be approved by the President, Senior Lending Officer and
Senior Credit Officer.  Loans/cumulative debt exceeding $500,000 must
be approved by our Board Loan Committee, the Board of Directors, with nine
concurring members, can approve loans up to our legal lending
limit.  As a result of the consent order the bank entered into with
the OCC on April 27, 2009, additional procedures will be required before loans
can be approved.  The bank may not, without approval of the Board Loan
Committee, grant, extend, renew, alter or restructure any loan or other
extension of credit until any outstanding credit or collateral exceptions are
resolved.





Credit Administration and Loan
Review.We seek to emphasize a strong credit culture based on
traditional credit measures and our knowledge of our markets through experienced
relationship managers.  We rely heavily on the experience and
knowledge of these individuals as well as our senior credit officer and his
credit department to implement and maintain our credit
culture.  However, despite their efforts, we have experienced a
decline in credit quality over the last eighteen months as economic conditions
in our markets have worsened.  We maintain a continuous internal loan
review system and engage an independent consultant on an annual basis to review
loan files on a test basis to confirm our loan grading.  Each loan
officer is responsible for every loan he or she makes, regardless of whether
other individuals or committees joined in the approval.  This
responsibility continues until the loan is repaid or until the loan is
officially assigned to another officer.  In the past, the compensation
of our lending officers has been dependent in part on the asset quality of their
loan portfolios.  We have adopted an incentive plan under which our
loan officers are eligible to receive cash bonuses for achieving monthly and
annual goals relating to, among other things, loan production and maintenance of
minimum quality levels for the officer’s loan portfolio.  However,
payment of incentives under this plan has been suspended during the current
period of reduced profitability for the bank.





Our
dedication to strong credit quality is reinforced by our internal credit review
process and performance benchmarks in the areas of nonperforming assets,
chargeoffs, past dues, and loan documentation.  We intend to add
additional employees to assist with credit administration and loan review as the
complexity of this area grows.  In addition to our own in-house credit
review function, we currently engage an outside firm to evaluate our loan
portfolio on a quarterly basis for credit quality, a second outside firm for
compliance issues on an annual basis, and a third outside firm to provide advice
and recommendations and respond to specific loan-related inquiries at any
time.  Pursuant to the executed consent order with the OCC, our bank’s
loan review function will be enhanced by quarterly written reporting to the
board of directors on the content of the results of the loan reviews
performed.


15





Special Assets Management
Group.In order to concentrate our efforts on the timely
resolution and disposition of nonperforming and foreclosed assets, we have
formed a special assets management group.  This group’s objective is
the expedient workout/resolution of assigned loans and assets at the highest
present value recovery.  This separate operating unit reports directly
to the senior credit officer with personnel dedicated solely to the assigned
special assets.  When loans are scheduled to be moved to the group,
they are assessed and assigned to the special assets officer best suited to
manage that loan/asset.  The assigned special assets officer then
begins the takeover and review process to determine the recommended action
plan.  These plans are reviewed and approved by the senior credit
officer and submitted for final approval.  In cases where the plan
involves a loan restructure or modification, appropriate risk controls such as
improved requirements for borrower/guarantor financial information, principal
reductions or additional collateral or loan covenants specific to the project or
borrower, may be utilized to preserve or strengthen our position.  The
group also manages the disposition of foreclosed properties from the
pre-foreclosure deed steps to the management, maintenance and marketing efforts
with the objective of disposing of these assets in an expeditious manner at the
highest present value to the bank, pursuant to asset-specific strategies which
give consideration to holding costs.





Lending
Limits.Our lending activities are subject to a variety
of lending limits imposed by federal law.  In general, our bank is
subject to a legal limit on loans to a single borrower equal to 15% of the
bank’s capital and unimpaired surplus.  This limit will increase or
decrease as the bank’s capital increases or decreases.  Based upon the
capitalization of the bank as of December 31, 2008, our legal lending limit
was approximately $10.3 million.  We sell participations in our larger
loans to other financial institutions, which allow us to manage the risk
involved in these loans and to meet the lending needs of our customers requiring
extensions of credit in excess of this limit.





Deposit Services





One of
our principal sources of funds is core deposits (deposits other than time
deposits of $100,000 or more).  As of December 31, 2008,
approximately 76.8% of our total deposits were obtained from within our branch
network.  We also rely on time deposits of $100,000 or more to support
our growth, which are generally obtained through brokers with whom we maintain
ongoing relationships.  Due to the April 27, 2009 execution of the
consent order with the OCC, we are no longer able to accept, renew or roll over
the time deposits obtained through brokers without a waiver from the
FDIC.  There is no assurance that the FDIC will grant us a
waiver.    We do not obtain time deposits of $100,000 or
more through the internet.  As of December 31, 2008, 42.2% of our
total time deposits were deposits of $100,000 or more.




We offer
a full range of deposit services, including checking accounts, commercial
accounts, savings accounts, and other time deposits of various types, ranging
from daily money market accounts to certificates of deposit.  We
regularly review our deposit rates to ensure that we remain competitive in our
markets.





Trust
and Investment Management Services





Since
August 15, 2002, we have offered trust and investment management services
through an alliance with Colonial Trust.  This arrangement allows our
consumer and commercial customers access to a wide variety of services provided
by Colonial Trust, including trust services, professional portfolio management,
estate administration, individual financial and retirement planning, and
corporate retirement planning services.  We receive a residual fee
from Colonial Trust based on a percentage of the aggregate assets under
management generated by referrals from the bank.





Other
Banking Services





We rely
on our branch network as a vehicle to deliver products and services to the
customers in our markets throughout South Carolina.  While we offer
traditional banking products and services to our customers which generate
noninterest income for us, we also provide a variety of unique options to
complement our core business features.  Combining these options with
standard products and services allows us to maximize our appeal to a broad
customer base while capitalizing on noninterest income
potential.  Through our alliance with WorkLife Financial, we are able
to offer business expertise to our customers in a variety of areas, such as
human resource management, payroll administration, risk management, and other
financial services through a fee based arrangement which provides residual
income to us.





In
addition, we earn income through the origination and sale of residential
mortgages.  Each of these distinctive services represents not only an
exceptional opportunity to build and strengthen customer loyalty but also to
enhance our financial position with noninterest income, as we believe they are
less directly impacted by current economic challenges.


16





We offer
other banking services including safe deposit boxes, traveler’s checks, direct
deposit, United States savings bonds, and banking by mail.  We earn
fees for most of these services, including debit and credit card transactions,
sales of checks, and wire transfers.  We provide ATM transactions to
our customers at no charge; however, we receive ATM transaction fees from
transactions performed at our branches by persons who are not customers of the
bank.  We are associated with the Cirrus and Pulse ATM networks, which
are available to our customers free of charge throughout the
country.  Since we outsource our ATM services, we are charged related
transaction fees from our ATM service provider.  We have contracted
with an outside vendor to provide our core data processing services and our ATM
processing.  Given our current size, we believe that outsourcing these
services reduces our overhead by matching the expense in each period to the
transaction volume that occurs during the period, as a significant portion of
the fee charged is directly related to the number of loan and deposit accounts
and the related number of transactions we have during the period.





First
National Online, our internet website www.fnbwecandothat.com, provides our
personal and business customers access to internet banking services, including
electronic bill payment services and cash management services including
account-to-account transfers.  The internet banking services are
provided through a contractual arrangement with an outside vendor.





We offer
our customers insurance services, including life, long term care, and annuities
through vendors associated with the South Carolina Bankers
Association.  Additionally, we provide equipment leasing arrangements
through an outside vendor.




17




SUPERVISION
AND REGULATION





Both the
company and the bank are subject to extensive state and federal banking laws and
regulations that impose specific requirements or restrictions on and provide for
general regulatory oversight of virtually all aspects of our
operations.  These laws and regulations are generally intended to
protect depositors, not shareholders.  The following summary is
qualified by reference to the statutory and regulatory provisions
discussed.  Changes in applicable laws or regulations may have a
material effect on our business and prospects.  Our operations may be
affected by legislative changes and the policies of various regulatory
authorities.  We cannot predict the effect that fiscal or monetary
policies, economic control, or new federal or state legislation may have on our
business and earnings in the future.





The
following discussion is not intended to be a complete list of all the activities
regulated by the banking laws or of the impact of such laws and regulations on
our operations.  It is intended only to briefly summarize some
material provisions.





First
National Bancshares, Inc.





We own
100% of the outstanding capital stock of the bank, and therefore we are
considered to be a bank holding company under the federal Bank Holding Company
Act of 1956 (the “Bank Holding Company Act”).  As a result, we are
primarily subject to the supervision, examination and reporting requirements of
the Board of Governors of the Federal Reserve (the “Federal Reserve”) under the
Bank Holding Company Act and its regulations promulgated there
under.  Moreover, as a bank holding company of a bank located in South
Carolina, we also are subject to the South Carolina Banking and Branching
Efficiency Act.





Permitted
Activities.Under the Bank Holding Company Act, a bank holding company is
generally permitted to engage in, or acquire direct or indirect control of more
than 5% of the voting shares of any company engaged in, the following
activities:





•
            banking
      or managing or controlling banks;





•
            furnishing
      services to or performing services for our subsidiaries;
    and





•
            any
      activity that the Federal Reserve determines to be so closely related to
      banking as to be a proper incident to the business of
    banking.





Activities
that the Federal Reserve has found to be so closely related to banking as to be
a proper incident to the business of banking include:





•
            factoring
      accounts receivable;





•
            making,
      acquiring, brokering or servicing loans and usual related
      activities;





•
            leasing
      personal or real property;





•
            operating
      a non-bank depository institution, such as a savings
      association;





•
            trust
      company functions;





•
            financial
      and investment advisory activities;





•
            conducting
      discount securities brokerage
activities;





•
            underwriting
      and dealing in government obligations and money market
      instruments;





•
            providing
      specified management consulting and counseling
  activities;





•
            performing
      selected data processing services and support
  services;





•
            acting
      as agent or broker in selling credit life insurance and other types of
      insurance in connection with credit transactions;
  and





•
            performing
      selected insurance underwriting
activities.


18





As a bank
holding company, we had elected to be treated as a “financial holding company,”
which allows us to engage in a broader array of activities.  In sum, a
financial holding company can engage in activities that are financial in nature
or incidental or complementary to financial activities, including insurance
underwriting, sales and brokerage activities, providing financial and investment
advisory services, underwriting services and limited merchant banking
activities.  In order to maintain our  financial holding
company status, each insured depository institution we control would have to be
well-capitalized, well managed and have at least a satisfactory rating under the
CRA (discussed below).  Our bank’s regulatory classification no longer
qualifies as well-capitalized after our execution of the consent order with the
OCC on April 27, 2009. Therefore, by notice of a letter dated April 30, 2009, to
the Federal Reserve, we are decertified as a financial holding company. The
Federal Reserve has the authority to order a bank holding company or its
subsidiaries to terminate any of these activities or to terminate its ownership
or control of any subsidiary when it has reasonable cause to believe that the
bank holding company’s continued ownership, activity or control constitutes a
serious risk to the financial safety, soundness or stability of it or any of its
bank subsidiaries.  However, none of the activities of our holding company
will be affected by our decertifying.





Change in
Control.  In addition, and subject to certain exceptions, the
Bank Holding Company Act and the Change in Bank Control Act, together with
regulations promulgated there under, require Federal Reserve approval prior to
any person or company acquiring “control” of a bank holding
company.  Control is conclusively presumed to exist if an individual
or company acquires 25% or more of any class of voting securities of a bank
holding company.  Following the relaxing of these restrictions by the
Federal Reserve in September 2008, control will be rebuttably presumed to exist
if a person acquires more than 33% of the total equity of a bank or bank holding
company, of which it may own, control or have the power to vote not more than
15% of any class of voting securities.





Source of
Strength.  In accordance with Federal Reserve Board policy, we
are expected to act as a source of financial strength to the bank and to commit
resources to support the bank in circumstances in which we might not otherwise
do so.  If the bank were to become “undercapitalized” (see below
“First National Bank of the South—Prompt Corrective Action”), we would be
required to provide a guarantee of the bank’s plan to return to capital
adequacy.  Additionally, under the Bank Holding Company Act, the
Federal Reserve Board may require a bank holding company to terminate any
activity or relinquish control of a non-bank subsidiary, other than a non-bank
subsidiary of a bank, upon the Federal Reserve’s determination that such
activity or control constitutes a serious risk to the financial soundness or
stability of any depository institution subsidiary of a bank holding
company.  Federal bank regulatory authorities have additional
discretion to require a bank holding company to divest itself of any bank or
non-bank subsidiaries if the agency determines that divestiture may aid the
depository institution’s financial condition.  Further, any loans by a
bank holding company to a subsidiary bank are subordinate in right of payment to
deposits and certain other indebtedness of the subsidiary bank.  In
the event of a bank holding company’s bankruptcy, any commitment by the bank
holding company to a federal bank regulatory agency to maintain the capital of a
subsidiary bank at a certain level would be assumed by the bankruptcy trustee
and entitled to priority payment.





Capital
Requirements.  The Federal Reserve Board imposes certain
capital requirements on the bank holding company under the Bank Holding Company
Act, including a minimum leverage ratio and minimum ratios of “certain” capital
to risk-weighted assets.  These requirements are essentially the same
as those that apply to the bank and are described below under “First National
Bank of the South—Capital Regulations.”  Subject to our capital
requirements and certain other restrictions, we are able to borrow money to make
a capital contribution to the bank, and these loans may be repaid from dividends
paid from the bank to the company.  Our ability to pay dividends
depends on the bank’s ability to pay dividends to us, which is subject to
regulatory restrictions as described below in “First National Bank of the
South—Dividends.”  We are also able to raise capital for contribution
to the bank by issuing securities without having to receive regulatory approval,
subject to compliance with federal and state securities laws.





South Carolina
State Regulation.  As a South Carolina bank holding company
under the South Carolina Banking and Branching Efficiency Act, we are subject to
limitations on sale or merger and to regulation by the South Carolina Board of
Financial Institutions (the “S.C. Board”).  We are not required to
obtain the approval of the S.C. Board prior to acquiring the capital stock of a
national bank, but we must notify them at least 15 days prior to doing
so.  We must receive the S.C. Board’s approval prior to engaging in
the acquisition of a South Carolina state chartered bank or another South
Carolina bank holding company.




19




First
National Bank of the South





The bank
operates as a national banking association incorporated under the laws of the
United States and subject to examination by the OCC.  Deposits in the
bank are insured by the FDIC up to a maximum amount, which is currently $100,000
for each non-retirement depositor and $250,000 for certain retirement-account
depositors.  However, the FDIC has temporarily increased the coverage
up to $250,000 for each non-retirement depositor through December 31, 2009, and
the bank is participating in the FDIC’s Transaction Account Guarantee Program
(discussed below in greater detail) which fully insures certain noninterest
bearing transaction accounts. The OCC and the FDIC regulate or monitor virtually
all areas of the bank’s operations, including:





•
            security
      devices and procedures;





•
            adequacy
      of capitalization and loss
reserves;





•
            loans;





•
            investments;





•
            borrowings;





•
            deposits;





•
            mergers;





•
            issuances
      of securities;





•
            payment
      of dividends;





•
            interest
      rates payable on deposits;





•
            interest
      rates or fees chargeable on loans;





•
            establishment
      of branches;





•
            corporate
      reorganizations;





•
            maintenance
      of books and records; and





•
            adequacy
      of staff training to carry on safe lending and deposit gathering
      practices.





The OCC
requires that the bank maintain specified capital ratios of capital to assets
and imposes limitations on the bank’s aggregate investment in real estate, bank
premises, and furniture and fixtures.  Two categories of regulatory
capital are used in calculating these ratios—Tier 1 capital and total
capital.  Tier 1 capital generally includes common equity, retained
earnings, a limited amount of qualifying preferred stock, and qualifying
minority interests in consolidated subsidiaries, reduced by goodwill and certain
other intangible assets, such as core deposit intangibles, and certain other
assets.  Total capital generally consists of Tier 1 capital plus Tier
2 capital, which includes the allowance for loan losses, preferred stock that
did not qualify as Tier 1 capital, certain types of subordinated debt and a
limited amount of other items.





The bank
is required to calculate three ratios: the ratio of Tier 1 capital to
risk-weighted assets, the ratio of total capital to risk-weighted assets, and
the “leverage ratio,” which is the ratio of Tier 1 capital to assets on a
non-risk-adjusted basis. For the two ratios of capital to risk-weighted assets,
certain assets, such as cash and U.S. Treasury securities, have a zero risk
weighting. Others, such as commercial and consumer loans, have a 100% risk
weighting. Some assets, notably purchase-money loans secured by first-liens on
residential real property, are risk-weighted at 50%. Risk-weighted assets also
include amounts that represent the potential funding of off-balance sheet
obligations such as loan commitments and letters of credit. These potential
assets are assigned to risk categories in the same manner as funded assets. The
total assets in each category are multiplied by the appropriate risk weighting
to determine risk-adjusted assets for the capital calculations.


20





The
minimum capital ratios for both bank holding companies and banks are generally
8% for total capital, 4% for Tier 1 capital and 4% for leverage. To be eligible
to be classified as “well-capitalized,” a bank must generally maintain a total
capital ratio of 10% or more, a Tier 1 capital ratio of 6% or more, and a
leverage ratio of 5% or more unless the bank is subject to an enforcement action
or specific directive to maintain higher capital ratios.  Certain
implications of the regulatory capital classification system and our bank’s
current capital condition are discussed in greater detail below.





Prompt Corrective
Action.  The Federal Deposit Insurance Corporation Improvement
Act of 1991 (“FDICIA”) established “prompt corrective action” regulations in
which every FDIC insured institution is placed in one of five regulatory
categories, depending primarily on its regulatory capital levels. The OCC and
the other federal banking regulators are permitted to take increasingly severe
action as a bank’s capital position or financial condition
declines  as described below. Regulators are also empowered to place
in receivership or require the sale of a bank to another depository institution
when a bank’s leverage ratio reaches two percent. Better capitalized
institutions are generally subject to less onerous regulation and supervision
than banks with lesser amounts of capital.  The prompt corrective
action regulations set forth five capital categories, each with specific
regulatory consequences. The categories are:





•
            Well-Capitalized—The
      institution exceeds the required minimum level for each relevant capital
      measure.  A well- capitalized institution is one (i) having
      a total capital ratio of 10% or greater, (ii) having a tier 1 capital
      ratio of 6% or greater, (iii) having a leverage capital ratio of 5%
      or greater and (iv) that is not subject to any order or written
      directive to meet and maintain a specific capital level for any capital
      measure.





•
            Adequately
      Capitalized—The institution meets the required minimum level for each
      relevant capital measure.  No capital distribution may be made
      that would result in the institution becoming undercapitalized. An
      adequately capitalized institution is one (i) having a total capital
      ratio of 8% or greater, (ii) having a tier 1 capital ratio of 4% or
      greater and (iii) having a leverage capital ratio of 4% or greater or
      a leverage capital ratio of 3% or greater if the institution is rated
      composite 1 under the CAMELS (Capital, Assets, Management, Earnings,
      Liquidity and Sensitivity to Market Risk) rating
  system.





•
            Undercapitalized—The
      institution fails to meet the required minimum level for any relevant
      capital measure.  An undercapitalized institution is one
      (i) having a total capital ratio of less than 8% or (ii) having
      a tier 1 capital ratio of less than 4% or (iii) having a leverage
      capital ratio of less than 4%, or if the institution is rated a composite
      1 under the CAMEL rating system, a leverage capital ratio of less than
      3%.





•
            Significantly
      Undercapitalized—The institution is significantly below the required
      minimum level for any relevant capital measure.  A significantly
      undercapitalized institution is one (i) having a total capital ratio
      of less than 6% or (ii) having a tier 1 capital ratio of less than 3%
      or (iii) having a leverage capital ratio of less than
    3%.





•
            Critically
      Undercapitalized—The institution fails to meet a critical capital level
      set by the appropriate federal banking agency.  A critically
      undercapitalized institution is one having a ratio of tangible equity to
      total assets that is equal to or less than
2%.





If the
OCC determines, after notice and an opportunity for hearing, that the bank is in
an unsafe or unsound condition, the regulator is authorized to reclassify the
bank to the next lower capital category (other than critically undercapitalized)
and require the submission of a plan to correct the unsafe or unsound
condition.





Our bank
is required to maintain higher capital levels due to minimum requirements
included in the formal enforcement action it executed with the OCC on April 27,
2009.  As a result, the bank is currently deemed to be adequately
capitalized.  See Capital Resources for more details on the bank’s
current capital condition and Consent Order for more details on the minimum
capital requirements set forth in the consent order.





Because
the bank is not considered well-capitalized, it cannot accept brokered deposits
without prior FDIC approval and, if approval is granted, cannot offer an
effective yield in excess of 75 basis points on interests paid on deposits of
comparable size and maturity in such institution’s normal market area for
deposits accepted from within its normal market area, or national rate paid on
deposits of comparable size and maturity for deposits accepted outside the
bank’s normal market area.  There is no assurance that the FDIC will
grant us the approval when requested.


21





Moreover,
if the bank becomes less than adequately capitalized, it must adopt a capital
restoration plan acceptable to the OCC that is subject to a limited performance
guarantee by the corporation.  The bank also would become subject to
increased regulatory oversight, and is increasingly restricted in the scope of
its permissible activities.  Each company having control over an
undercapitalized institution also must provide a limited guarantee that the
institution will comply with its capital restoration plan.  Except
under limited circumstances consistent with an accepted capital restoration
plan, an undercapitalized institution may not grow.  An
undercapitalized institution may not acquire another institution, establish
additional branch offices or engage in any new line of business unless
determined by the appropriate Federal banking agency to be consistent with an
accepted capital restoration plan, or unless it is determined that the proposed
action will further the purpose of prompt corrective action.  The
appropriate federal banking agency may take any action authorized for a
significantly undercapitalized institution if an undercapitalized institution
fails to submit an acceptable capital restoration plan or fails in any material
respect to implement a plan accepted by the agency.  A critically
undercapitalized institution is subject to having a receiver or conservator
appointed to manage its affairs and for loss of its charter to conduct banking
activities.





An
insured depository institution may not pay a management fee to a bank holding
company controlling that institution or any other person having control of the
institution if, after making the payment, the institution, would be
undercapitalized.  In addition, an institution cannot make a capital
distribution, such as a dividend or other distribution that is in substance a
distribution of capital to the owners of the institution if following such a
distribution the institution would be undercapitalized.  Thus, if
payment of such a management fee or the making of such would cause the bank to
become undercapitalized, it could not pay a management fee or dividend to our
holding company.





Standards for
Safety and Soundness. The FDIA also requires the
federal banking regulatory agencies to prescribe, by regulation or guideline,
operational and managerial standards for all insured depository institutions
relating to: (i) internal controls, information systems and internal audit
systems; (ii) loan documentation; (iii) credit underwriting;
(iv) interest rate risk exposure; and (v) asset growth. The agencies
also must prescribe standards for asset quality, earnings, and stock valuation,
as well as standards for compensation, fees and benefits. The federal banking
agencies have adopted regulations and Interagency Guidelines Prescribing
Standards for Safety and Soundness to implement these required standards. The
guidelines set forth the safety and soundness standards that the federal banking
agencies use to identify and address problems at insured depository institutions
before capital becomes impaired. Under the regulations, if the OCC determines
that the bank fails to meet any standards prescribed by the guidelines, the
agency may require the bank to submit to the agency an acceptable plan to
achieve compliance with the standard, as required by the OCC. The final
regulations establish deadlines for the submission and review of such safety and
soundness compliance plans.





Regulatory
Examination. The OCC also requires the bank to
prepare annual reports on the bank’s financial condition and to conduct an
annual audit of its financial affairs in compliance with its minimum standards
and procedures.




All
insured institutions must undergo regular on-site examinations by their
appropriate banking agency. The cost of examinations of insured depository
institutions and any affiliates may be assessed by the appropriate federal
banking agency against each institution or affiliate as it deems necessary or
appropriate. Insured institutions are required to submit annual reports to the
FDIC, their federal regulatory agency, and state supervisor when applicable. The
FDIC has developed a method for insured depository institutions to provide
supplemental disclosure of the estimated fair market value of assets and
liabilities, to the extent feasible and practicable, in any balance sheet,
financial statement, report of condition or any other report of any insured
depository institution. The federal banking regulatory agencies to prescribe, by
regulation, standards for all insured depository institutions and depository
institution holding companies relating, among other things, to the
following:




•       internal controls;




•       information systems and audit
systems;




•       loan documentation;




•       credit
underwriting;




•       interest rate risk exposure;
and




•        asset
quality.





Recent
Legislative and Regulatory Initiatives to Address Financial and Economic
Crises.The Congress, Treasury Department and the federal
banking regulators, including the FDIC, have taken broad action since early
September 2008 to address volatility in the U.S. banking
system.


22





In
October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was
enacted. The EESA authorizes the Treasury Department to purchase from
financial institutions and their holding companies up to $700 billion in
mortgage loans, mortgage-related securities and certain other financial
instruments, including debt and equity securities issued by financial
institutions and their holding companies in a troubled asset relief program
(“TARP”).  The purpose of TARP is to restore confidence and stability
to the U.S. banking system and to encourage financial institutions to increase
their lending to customers and to each other.  The Treasury Department
has allocated $250 billion towards the TARP Capital Purchase Program
(“CPP”).  Under the CPP, Treasury will purchase debt or equity
securities from participating institutions.  The TARP also will
include direct purchases or guarantees of troubled assets of financial
institutions. Participants in the CPP are subject to executive compensation
limits and are encouraged to expand their lending and mortgage loan
modifications. EESA also temporarily increased FDIC deposit insurance on most
accounts from $100,000 to $250,000.  This increase is in place until
the end of 2009 and is not covered by deposit insurance premiums paid by the
banking industry.





Following
a systemic risk determination, the FDIC established the Temporary Liquidity
Guarantee Program (“TLGP”) on October 14, 2008.  The TLGP includes the
Transaction Account Guarantee Program (“TAGP”), which provides unlimited deposit
insurance coverage through December 31, 2009 for noninterest-bearing transaction
accounts (typically business checking accounts) and certain funds swept into
noninterest-bearing savings accounts.  Institutions participating in
the TAGP pay a 10 basis point fee (annualized) on the balance of each covered
account in excess of $250,000, while the extra deposit insurance is in
place.  The TLGP also includes the Debt Guarantee Program (“DGP”),
under which the FDIC guarantees certain senior unsecured debt of FDIC-insured
institutions and their holding companies.  The unsecured debt must be
issued on or after October 14, 2008 and not later than June 30, 2009, and the
guarantee is effective through the earlier of the maturity date or June 30,
2012.  On March 17, 2009, the FDIC adopted an interim rule that extends the
DGP and imposes surcharges on existing rates for certain debt issuances.
 This extension allows institutions that have issued guaranteed debt before
April 1, 2009 to issue guaranteed debt during the extended issuance period that
ends on October 31, 2009. For such institutions, the guarantee on debt
issued on or after April 1, 2009, will expire no later than December 31,
2012.The
DGP coverage limit is generally 125% of the eligible entity’s eligible debt
outstanding on September 30, 2008 and scheduled to mature on or before June 30,
2009 or, for certain insured institutions, 2% of their liabilities as of
September 30, 2008.  Depending on the term of the debt maturity, the
nonrefundable DGP fee ranges from 60 to 110 basis points (annualized) for
covered debt outstanding until the earlier of maturity or June 30, 2012 and 75
to 125 basis points (annualized) for covered debt outstanding until after June
30, 2012.  The TAGP and DGP are in effect for all eligible entities,
unless the entity opted out on or before December 5, 2008.  We have
elected to participate in the TAGP.





In
addition, on March 23, 2009, the U.S. Treasury, in conjunction with the FDIC and
the Federal Reserve, announced the Public-Private Partnership Investment Program
for Legacy Assets which consists of two separate plans, addressing two distinct
asset groups:





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


·
            The
      Securities Program, which will be administered by the U.S. Treasury,
      involves the creation of public-private investment funds to target
      investments in eligible residential mortgage-backed securities and
      commercial mortgage-backed securities issued before 2009 that originally
      were rated AAA or the equivalent by two or more nationally recognized
      statistical rating organizations, without regard to rating enhancements
      (collectively, “Legacy Securities”). Legacy Securities must be directly
      secured by actual mortgage loans, leases or other assets, and may be
      purchased only from financial institutions that meet TARP eligibility
      requirements





Insurance of
Deposit Accounts and Regulation by the FDIC.  First
National Bank of the South deposits are insured up to applicable limits by the
Deposit Insurance Fund of the FDIC.  The Deposit Insurance Fund is the
successor to the Bank Insurance Fund and the Savings Association Insurance Fund,
which were merged effective March 31, 2006.  As insurer, the FDIC
imposes deposit insurance premiums and is authorized to conduct examinations of
and to require reporting by FDIC- insured institutions.  It also may
prohibit any FDIC-insured institution from engaging in any activity the FDIC
determines by regulation or order to pose a serious risk to the insurance
fund.  The FDIC also has the authority to initiate enforcement actions
against savings institutions, after giving the Office of Thrift Supervision an
opportunity to take such action, and may terminate the deposit insurance if it
determines that the institution has engaged in unsafe or unsound practices or is
in an unsafe or unsound condition.


23


Under
regulations effective January 1, 2007, the FDIC adopted a new risk-based premium
system that provides for quarterly assessments based on an insured institution’s
ranking in one of four risk categories based upon supervisory and capital
evaluations.   For deposits held as of March 31, 2009,
institutions are assessed at annual rates ranging from 12 to 50 basis
points, depending on each institution’s risk of default as measured by
regulatory capital ratios and other supervisory
measures.   Effective April 1, 2009, assessments will
take into account each institution's reliance on secured
liabilities and brokered deposits.   This will result in
assessments ranging from 7 to 77.5 basis points.  We anticipate our future
insurance costs to be substantially higher than in previous periods due to the
change in our regulatory capital classification resulting from the consent order
we executed with our bank’s regulators on April 27, 2009.




FDIC-insured
institutions are required to pay a Financing Corporation assessment, in order to
fund the interest on bonds issued to resolve thrift failures in the
1980’s.  For the first quarter of 2009, the Financing Corporation
assessment equaled 1.14 basis points for domestic
deposits.  These assessments, which may be revised based upon the
level of deposits, will continue until the bonds mature in the years 2017
through 2019.




The FDIC
may terminate the deposit insurance of any insured depository institution,
including the bank, if it determines after a hearing that the institution has
engaged in unsafe or unsound practices, is in an unsafe or unsound condition to
continue operations or has violated any applicable law, regulation, rule, order
or condition imposed by the FDIC or the OCC.  It also may suspend
deposit insurance temporarily during the hearing process for the permanent
termination of insurance, if the institution has no tangible capital.  If
insurance of accounts is terminated, the accounts at the institution at the time
of the termination, less subsequent withdrawals, shall continue to be insured
for a period of six months to two years, as determined by the
FDIC.  Management of the bank is not aware of any practice, condition
or violation that might lead to termination of the bank’s deposit
insurance.





Transactions with
Affiliates and Insiders.The company is a legal entity separate and
distinct from the bank and its other subsidiaries.  Various legal
limitations restrict the bank from lending or otherwise supplying funds to the
company or its non-bank subsidiaries. The company and the bank are subject to
Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation
W.   Section 23A of the Federal Reserve Act places limits on
the amount of loans or extensions of credit to, or investments in, or certain
other transactions with, affiliates and on the amount of advances to third
parties collateralized by the securities or obligations of
affiliates.  The aggregate of all covered transactions is limited in
amount, as to any one affiliate, to 10% of the bank’s capital and surplus and,
as to all affiliates combined, to 20% of the bank’s capital and
surplus.  Furthermore, within the foregoing limitations as to amount,
each covered transaction must meet specified collateral
requirements.  The bank is forbidden to purchase low quality assets
from an affiliate.





Section 23B
of the Federal Reserve Act, among other things, prohibits an institution from
engaging in certain transactions with certain affiliates unless the transactions
are on terms substantially the same, or at least as favorable to such
institution or its subsidiaries, as those prevailing at the time for comparable
transactions with nonaffiliated companies.





Regulation
W generally excludes all non-bank and non-savings association subsidiaries of
banks from treatment as affiliates, except to the extent that the Federal
Reserve Board decides to treat these subsidiaries as affiliates. The regulation
also limits the amount of loans that can be purchased by a bank from an
affiliate to not more than 100% of the bank’s capital and surplus.





The bank
is also subject to certain restrictions on extensions of credit to executive
officers, directors, certain principal shareholders, and their related
interests.  Such extensions of credit (i) must be made on
substantially the same terms, including interest rates, and collateral, as those
prevailing at the time for comparable transactions with third parties and
(ii) must not involve more than the normal risk of repayment or present
other unfavorable features.





Dividends.The
company’s principal source of cash flow, including cash flow to pay dividends to
its shareholders, is dividends it receives from the bank. Statutory and
regulatory limitations apply to the bank’s payment of dividends to the company.
As a general rule, the amount of a dividend may not exceed, without prior
regulatory approval, the sum of net income in the calendar year to date and the
retained net earnings of the immediately preceding two calendar years. A
depository institution may not pay any dividend if payment would cause the
institution to become undercapitalized or if it already is undercapitalized. The
OCC may prevent the payment of a dividend if it determines that the payment
would be an unsafe and unsound banking practice. The OCC also has advised that a
national bank should generally pay dividends only out of current operating
earnings.  As a result of the executed enforcement action with the
OCC, our bank may only pay dividends when it is in compliance with its approved
capital plan required to be completed under the terms of the consent order and
with the approval of the OCC.  There can be no assurance that the OCC
would grant such approval.


24


Branching.  National
banks are required by the National Bank Act to adhere to branch office banking
laws applicable to state banks in the states in which they are located. Under
current South Carolina law, the bank may open branch offices throughout South
Carolina with the prior approval of the OCC.  In addition, with prior
regulatory approval, the bank is able to acquire existing banking operations in
South Carolina.  Furthermore, federal legislation permits interstate
branching, including out-of-state acquisitions by bank holding companies,
interstate branching by banks if allowed by state law, and interstate merging by
banks.  South Carolina law, with limited exceptions, currently permits
branching across state lines only through interstate mergers.





Anti-Tying
Restrictions.Under amendments to the BHCA and Federal Reserve
regulations, a bank is prohibited from engaging in certain tying or reciprocity
arrangements with its customers. In general, a bank may not extend credit,
lease, sell property, or furnish any services, or fix or vary the consideration
for these on the condition that (i) the customer obtain or provide some
additional credit, property, or services from or to the bank, the bank holding
company or subsidiaries thereof or (ii) the customer may not obtain some
other credit, property, or services from a competitor, except to the extent
reasonable conditions are imposed to assure the soundness of the credit
extended. Certain arrangements are permissible: a bank may offer
combined-balance products and may otherwise offer more favorable terms if a
customer obtains two or more traditional bank products; and certain foreign
transactions are exempt from the general rule. A bank holding company or any
bank affiliate also is subject to anti-tying requirements in connection with
electronic benefit transfer services.





Community
Reinvestment Act.  The Community Reinvestment Act requires that
the OCC evaluate the record of the bank in meeting the credit needs of its local
community, including low and moderate income neighborhoods.  These
factors are also considered in evaluating mergers, acquisitions, and
applications to open a branch or facility.  Failure to adequately meet
these criteria could impose additional requirements and limitations on the
bank.





Finance
Subsidiaries.Under the Gramm-Leach-Bliley Act (the “GLBA”), subject to
certain conditions imposed by their respective banking regulators, national and
state-chartered banks are permitted to form “financial subsidiaries” that may
conduct financial or incidental activities, thereby permitting bank subsidiaries
to engage in certain activities that previously were
impermissible.  The GLBA imposes several safeguards and restrictions
on financial subsidiaries, including that the parent bank’s equity investment in
the financial subsidiary be deducted from the bank’s assets and tangible equity
for purposes of calculating the bank’s capital adequacy.  In addition,
the GLBA imposes new restrictions on transactions between a bank and its
financial subsidiaries similar to restrictions applicable to transactions
between banks and non-bank affiliates.





Consumer
Protection Regulations.Activities of the bank are subject to a variety
of statutes and regulations designed to protect consumers.  Interest
and other charges collected or contracted for by the bank are subject to state
usury laws and federal laws concerning interest rates.  The bank’s
loan operations are also subject to federal laws applicable to credit
transactions, such as:





•
            the
      federal Truth-In-Lending Act, governing disclosures of credit terms to
      consumer borrowers;





•
            the
      Home Mortgage Disclosure Act of 1975, requiring financial institutions to
      provide information to enable the public and public officials to determine
      whether a financial institution is fulfilling its obligation to help meet
      the housing needs of the community it
serves;





•
            the
      Equal Credit Opportunity Act, prohibiting discrimination on the basis of
      race, creed or other prohibited factors in extending
    credit;





•
            the
      Fair Credit Reporting Act of 1978, governing the use and provision of
      information to credit reporting
agencies;





•
            the
      Fair Debt Collection Act, governing the manner in which consumer debts may
      be collected by collection agencies;
and





•
            the
      rules and regulations of the various federal agencies charged with the
      responsibility of implementing such federal
  laws.





The
deposit operations of the bank also are subject to a number of federal laws,
such as:





•
            the
      Right to Financial Privacy Act, which imposes a duty to maintain
      confidentiality of consumer financial records and prescribes procedures
      for complying with administrative subpoenas of financial records;
      and





•
            the
      Electronic Funds Transfer Act and Regulation E issued by the Federal
      Reserve Board to implement that Act, which governs automatic deposits to
      and withdrawals from deposit accounts and customers’ rights and
      liabilities arising from the use of automated teller machines and other
      electronic banking services.


25





Enforcement
Powers.  The bank and its “institution-affiliated parties,”
including its management, employees, agents independent contractors and
consultants such as attorneys and accountants and others who participate in the
conduct of the financial institution’s affairs, are subject to potential civil
and criminal penalties for violations of law, regulations or written orders of a
government agency.  These practices can include the failure of an
institution to timely file required reports or the filing of false or misleading
information or the submission of inaccurate reports.  Civil penalties
may be as high as $1,000,000 a day for such violations.  Criminal
penalties for some financial institution crimes have been increased to twenty
years.  In addition, regulators are provided with greater flexibility
to commence enforcement actions against institutions and institution-affiliated
parties.  Possible enforcement actions include the termination of
deposit insurance.  Furthermore, banking agencies’ power to issue
cease-and-desist orders were expanded.  Such orders may, among other
things, require affirmative action to correct any harm resulting from a
violation or practice, including restitution, reimbursement, indemnifications or
guarantees against loss.  A financial institution may also be ordered
to restrict its growth, dispose of certain assets, rescind agreements or
contracts, or take other actions as determined by the ordering agency to be
appropriate.





Anti-Money
Laundering.Financial institutions must maintain anti-money
laundering programs that include established internal policies, procedures, and
controls; a designated compliance officer; an ongoing employee training program;
and testing of the program by an independent audit function. The company and the
bank are also prohibited from entering into specified financial transactions and
account relationships and must meet enhanced standards for due diligence and
“knowing your customer” in their dealings with foreign financial institutions
and foreign customers. Financial institutions must take reasonable steps to
conduct enhanced scrutiny of account relationships to guard against money
laundering and to report any suspicious transactions, and recent laws provide
law enforcement authorities with increased access to financial information
maintained by banks. Anti-money laundering obligations have been substantially
strengthened as a result of the USA Patriot Act, enacted in 2001 and renewed in
2006. Bank regulators routinely examine institutions for compliance with these
obligations and are required to consider compliance in connection with the
regulatory review of applications. The regulatory authorities have been active
in imposing “cease and desist” orders and money penalty sanctions against
institutions found to be violating these obligations.





USA PATRIOT
Act/Bank Secrecy Act.Financial institutions must maintain
anti-money laundering programs that include established internal policies,
procedures, and controls; a designated compliance officer; an ongoing employee
training program; and testing of the program by an independent audit
function.The
USA PATRIOT Act, amended, in part, the Bank Secrecy Act and provides for the
facilitation of information sharing among governmental entities and financial
institutions for the purpose of combating terrorism and money laundering by
enhancing anti-money laundering and financial transparency laws, as well as
enhanced information collection tools and enforcement mechanics for the U.S.
government, including: (i) requiring standards for verifying customer
identification at account opening; (ii) rules to promote cooperation among
financial institutions, regulators, and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering;
(iii) reports by nonfinancial trades and businesses filed with the Treasury
Department’s Financial Crimes Enforcement Network for transactions exceeding
$10,000; and (iv) filing suspicious activities reports if a bank believes a
customer may be violating U.S. laws and regulations and requires enhanced due
diligence requirements for financial institutions that administer, maintain, or
manage private bank accounts or correspondent accounts for non-U.S.
persons.  Bank regulators routinely examine institutions for
compliance with these obligations and are required to consider compliance in
connection with the regulatory review of applications.





Under the
USA PATRIOT Act, the FBI can send to the banking regulatory agencies lists of
the names of persons suspected of involvement in terrorist
activities.  The bank can be requested, to search its records for any
relationships or transactions with persons on those lists.  If the
bank finds any relationships or transactions, it must file a suspicious activity
report and contact the FBI.





The
Office of Foreign Assets Control (“OFAC”), which is a division of the U.S.
Department of the Treasury, is responsible for helping to insure that United
States entities do not engage in transactions with “enemies” of the United
States, as defined by various Executive Orders and Acts of
Congress.  OFAC has sent, and will send, our banking regulatory
agencies lists of names of persons and organizations suspected of aiding,
harboring or engaging in terrorist acts.  If the bank finds a name on
any transaction, account or wire transfer that is on an OFAC list, it must
freeze such account, file a suspicious activity report and notify the
FBI.  The bank has appointed an OFAC compliance officer to oversee the
inspection of its accounts and the filing of any notifications.  The
bank actively checks high-risk OFAC areas such as new accounts, wire transfers
and customer files.  The bank performs these checks utilizing
software, which is updated each time a modification is made to the lists
provided by OFAC and other agencies of Specially Designated Nationals and
Blocked Persons.




26


Privacy and
Credit Reporting.Financial institutions are required to
disclose their policies for collecting and protecting confidential
information.  Customers generally may prevent financial institutions
from sharing nonpublic personal financial information with nonaffiliated third
parties except under narrow circumstances, such as the processing of
transactions requested by the consumer.  Additionally, financial
institutions generally may not disclose consumer account numbers to any
nonaffiliated third party for use in telemarketing, direct mail marketing or
other marketing to consumers.  It is our policy not to disclose any
personal information unless required by law.  The OCC and the federal
banking agencies have prescribed standards for maintaining the security and
confidentiality of consumer information. We are subject to these standards, as
well as standards for notifying consumers in the event of a security
breach.





Like
other lending institutions, our bank utilizes credit bureau data in its
underwriting activities.  Use of such data is regulated under the
Federal Credit Reporting Act on a uniform, nationwide basis, including credit
reporting, prescreening, sharing of information between affiliates, and the use
of credit data.  The Fair and Accurate Credit Transactions Act of 2003
(the “FACT Act”) permits states to enact identity theft laws that are not
inconsistent with the conduct required by the provisions of the FACT
Act.





Check 21.The Check Clearing for the 21st Century Act gives “substitute checks,”
such as a digital image of a check and copies made from that image, the same
legal standing as the original paper check.  Some of the major
provisions include:





•
            allowing
      check truncation without making it
mandatory;





•
            demanding
      that every financial institution communicate to accountholders in writing
      a description of its substitute check processing program and their rights
      under the law;





•
            legalizing
      substitutions for and replacements of paper checks without agreement from
      consumers;





•
            retaining
      in place the previously mandated electronic collection and return of
      checks between financial institutions only when individual agreements are
      in place;





•
            requiring
      that when accountholders request verification, financial institutions
      produce the original check (or a copy that accurately represents the
      original) and demonstrate that the account debit was accurate and valid;
      and





•
            requiring
      the re-crediting of funds to an individual’s account on the next business
      day after a consumer proves that the financial institution has
      erred.





Effect of
Governmental Monetary Policies.  Our earnings are
affected by domestic economic conditions and the monetary and fiscal policies of
the United States government and its agencies.  The Federal Reserve
Bank’s monetary policies have had, and are likely to continue to have, an
important impact on the operating results of commercial banks through its power
to implement national monetary policy in order, among other things, to curb
inflation or combat a recession.  The monetary policies of the Federal
Reserve Board have major effects upon the levels of bank loans, investments and
deposits through its open market operations in United States government
securities and through its regulation of the discount rate on borrowings of
member banks and the reserve requirements against member bank
deposits.  It is not possible to predict the nature or impact of
future changes in monetary and fiscal policies.





Proposed
Legislation and Regulatory Action.  New regulations
and statutes are regularly proposed that contain wide-ranging proposals for
altering the structures, regulations, and competitive relationships of the
nation’s financial institutions.  We cannot predict whether or in what
form any proposed regulation or statute will be adopted or the extent to which
our business may be affected by any new regulation or statute.





Competition





The
banking business is highly competitive, and we experience competition in our
markets from many other financial institutions.  Competition among
financial institutions is based upon interest rates offered on deposit accounts,
interest rates charged on loans, other credit and service charges relating to
loans, the quality and scope of the services rendered, the convenience of
banking facilities, and, in the case of loans to commercial borrowers, relative
lending limits.  We compete with commercial banks, credit unions,
savings and loan associations, mortgage banking firms, consumer finance
companies, securities brokerage firms, insurance companies, money market funds,
and other mutual funds, as well as other super-regional, national, and
international financial institutions that operate offices in the Spartanburg,
Charleston, Greenville, Columbia and Rock Hill markets and
elsewhere.




27


As of
June 30, 2008, there were 17 other financial institutions in Spartanburg
County, 24 other financial institutions in Charleston County, 33 other financial
institutions in Greenville County, 22 other financial institutions in Richland
County, and 14 other financial institutions in York County.  We
compete with institutions in these markets both in attracting deposits and in
making loans.  In addition, we have to attract our customer base from
other existing financial institutions and from new residents.  Many of
our competitors are well established, larger financial institutions with
substantially greater resources and lending limits, such as BB&T, Bank of
America, and Wachovia.  These institutions offer some services, such
as extensive and established branch networks, that we do not
provide.  Other local or regional financial institutions have
considerable business relationships and ties in their respective communities
that assist them in competing for attracting customers.





We also
compete with credit unions, in particular, in attracting deposits from retail
customers.  Additionally, many of our non-bank competitors are not
subject to the same extensive federal regulations that govern bank holding
companies and federally-insured banks.





We
believe our emphasis on decision-making by our market executives and our
management’s and directors’ ties to the communities in which we operate provide
us with a competitive advantage.





Employees





As of
March 31, 2009, we had 156 employees, of which 17 were
part-time.  These employees provide the majority of their services to
our bank.


28


Item 1A. Risk
Factors.





Our
business, financial condition, and results of operations could be harmed by any
of the following risks, or other risks that have not been identified or which we
believe are immaterial or unlikely.  Shareholders should carefully
consider the risks described below in conjunction with the other information in
this Form 10-K and the information incorporated by reference in this Form
10-K.




There
is substantial doubt about our ability to continue as a going
concern.




In its report dated April 29, 2009, our
independent registered public accounting firm stated that the uncertainty
created by our inability to repay or replace our holding company's line of
credit or to obtain a waiver of covenant defaults on that line of credit through
December 31, 2009 raises substantial doubt about our ability to continue as a
going concern.  The lender has agreed in writing not to pursue the
collateral underlying the line of credit through June 30, 2009.  All
other terms and conditions of the loan documents will continue to exist and may
be exercised at any time.  Our board of directors is actively
considering strategic alternatives to secure additional capital for a variety of
corporate purposes, including providing the funds needed to repay the
outstanding balance on our line of credit in accordance with the terms of the
related loan agreement.  We can give no assurance that a capital
transaction or other strategic alternative, once identified, evaluated and
consummated, will provide greater value to our shareholders than that reflected
in the current stock price.  In addition, a transaction, which would
likely involve equity financing, would result in substantial dilution to our
current shareholders and could adversely affect the price of our common
stock.  If we are unable to identify and execute a viable strategic
alternative, we may be unable to continue as a going concern. Therefore, there
is a risk the lender may declare an event of default under the line of credit,
revoke the line of credit and attempt to exercise available remedies under the
loan agreement including foreclosing on our bank stock collateral if the current
agreement preventing this action until June 30, 2009 is not
renewed.




We
have sustained losses from a decline in credit quality and may see further
losses.




Our
ability to generate earnings is significantly affected by our ability to
properly originate, underwrite and service loans. We have sustained losses
primarily because borrowers, guarantors, or related parties have failed to
perform in accordance with the terms of their loans and we failed to detect or
respond to deterioration in asset quality in a timely manner. We could sustain
additional losses for these reasons. Problems with credit quality or asset
quality could cause our interest income and net interest margin to decrease,
which could adversely affect our business, financial condition, and results of
operations. We have recently identified credit deficiencies with respect to
certain loans in our loan portfolio which are primarily related to the downturn
in the residential housing industry. The residential housing market has been
substantially affected by the current economic environment, increased levels of
inventories of unsold homes, and higher foreclosure rates.  As a
result, property values for this type of collateral have declined
substantially.  In response to this determination, we increased our
loan loss reserve during 2008 to $18.0 million to address the risks
inherent within our loan portfolio. Recent developments, including further
deterioration in the South Carolina real estate market as a whole, may cause
management to adjust its opinion of the level of credit quality in our loan
portfolio. Such a determination may lead to an additional increase in our
provisions for loan losses, which could also adversely affect our business,
financial condition, and results of operations.




We
may have higher loan losses than we have allowed for in our allowance for loan
losses.




Our
loan losses could exceed our allowance for loan losses. Our average loan size
has increased in recent years over historic levels, and reliance on our historic
allowance for loan losses may not be adequate. As of December 31, 2008, we had
$114.1 million in loans on our classified list, including loans classified since
December 31, 2008. Classified loans are loans graded as substandard, doubtful or
loss. Industry experience shows that a portion of loans will become delinquent
and a portion of loans will require partial or entire chargeoff. Regardless of
the underwriting criteria utilized, losses may be experienced as a result of
various factors beyond our control, including:




•
            cost
      overruns;





•
            declining
      property values;





•
            mismanaged
      construction;





•
            inferior or improper
      construction techniques;


29


•
            economic changes or
      downturns during construction;





•
            rising interest
      rates that may prevent sale of the property;
and





•
            failure to sell completed
      projects or units in a timely
manner.




The
occurrence of any of the preceding risks could result in the deterioration of
one or more of these loans which could significantly increase our percentage of
nonperforming assets. An increase in
nonperforming loans may result in a loss of earnings from these loans, an
increase in the related provision for loan losses and an increase in chargeoffs,
all of which could have a material adverse effect on our financial condition and
results of operations.




As a result of our bank’s recent
examination by the OCC, we have become subject to a consent order pursuant to
which the OCC will require us to take certain actions.




The bank’s primary federal
regulator, the OCC, recently completed a safety and soundness examination of the
bank, which included a review of our asset quality.  We have received
the final report from this examination.  In addition, the bank entered
into a consent order with the OCC on April 27, 2009, which contains a
requirement that our bank achieve and maintain minimum capital requirements that
exceed the minimum regulatory capital ratios for “well-capitalized” banks by
August 25, 2009.   As a result of the terms of the executed
consent order, the bank is no longer  deemed “well-capitalized,”
regardless of its capital levels.  Under this enforcement
action, we no longer meet the regulatory requirements to be eligible for
expedited processing of branch applications and certain other regulatory
approvals, and we are required to obtain OCC or FDIC approval before making
certain payments to departing executives and before adding new directors or
senior executives. Our regulators have considerable discretion in whether to
grant required approvals, and no assurance can be given that such approvals
would be forthcoming.  In addition, we will be required to take
certain other actions in the areas of capital, liquidity, asset quality and
interest rate risk management, as well as to file periodic reports with the OCC
regarding our progress in complying with the order. We expect that the matters
covered by our commitments, and the requirements of the executed formal
enforcement action, are and would be appropriate and prudent responses to the
issues facing us.   Any material failure to comply with the terms
of the consent offer could result in further enforcement action by the
OCC.  While we intend to take such actions as may be necessary to
comply with the requirements of the consent order, we may be unable to comply
fully with the deadlines or other terms of the consent order.





Our
bank may become subject to a federal conservatorship or receivership if it
cannot comply with the consent order, or if its condition continues to
deteriorate.





As noted
above, the executed consent order requires us to create and implement a capital
plan, including provisions for contingency funding arrangements.  In
addition, the condition of our loan portfolio may continue to deteriorate in the
current economic environment and thus continue to deplete our capital and other
financial resources.  Should we fail to comply with the capital and
liquidity funding requirements in the consent order, or suffer a continued
deterioration in our financial condition, we may be subject to being placed into
a federal conservatorship or receivership by the OCC, with the FDIC appointed as
conservator or receiver.  If these events occur, we probably would
suffer a complete loss of the value of our ownership interest in the bank and we
subsequently may be exposed to significant claims by the FDIC and the
OCC.




If
we do not perform well, we may be required to increase the valuation allowance
against the deferred income tax asset, which could have a material adverse
effect on our results of operations and financial condition.




Deferred
income tax represents the tax effect of the differences between the book and tax
basis of assets and liabilities. Deferred tax assets are assessed periodically
by management to determine if they are realizable. Factors in management’s
determination include the performance of the business including the ability to
generate taxable income from a variety of sources and tax planning strategies.
If, based on available information, it is more likely than not that the deferred
income tax asset will not be realized, then a valuation allowance against the
deferred tax asset must be established with a corresponding charge to net
income. Charges to increase the valuation allowance against the deferred tax
asset could have a material adverse effect on our results of operations and
financial condition.


30


A
significant portion of our loan portfolio is secured by real estate, and the
recent weakening of the local real estate market could continue to hurt our
business.




A significant portion of our loan
portfolio is secured by real estate.  As of December 31, 2008,
approximately 89.8% of our loans had real estate as the primary component of
collateral.  The real estate collateral in each case provides an
alternate source of repayment in the event of default by the borrower and may
deteriorate in value during the time the credit is extended.  As of
December 31, 2008, total residential construction and development loans totaled
$56.1 million, or 8.1% of the loan portfolio. These loans carry a higher degree
of risk than long-term financing of existing real estate since repayment is
dependent on the ultimate completion of the project or home and usually on the
sale of the property or permanent financing. Slow housing conditions have
affected some of these borrowers’ ability to sell the completed projects in a
timely manner. Although we believe that the combination of specific reserves in
the allowance for loan losses and established impairments of these loans will be
adequate to account for the current risk associated with the residential
construction loan portfolio as of December 31, 2008, there can be no assurances
in this regard. Recently, there has been a weakening of the residential real
estate market and property values have been impacted negatively in our primary
market areas. This weakened market has resulted and may continue to result in an
increase in the number of borrowers who default on their loans and a reduction
in the value of the collateral securing their loans, which in turn could have an
adverse effect on our profitability and asset quality.  If we are
required to liquidate the collateral securing a loan to satisfy the debt during
a period of reduced real estate values, our earnings and capital could be
adversely affected.  Acts of nature, including hurricanes, tornados,
earthquakes, fires and floods, which may cause uninsured damage and other loss
of value to real estate that secures these loans, may also negatively impact our
financial condition.




The
lack of seasoning of our loan portfolio makes it difficult to assess the
adequacy of our loan loss reserves accurately.




We
attempt to maintain an appropriate allowance for loan losses to provide for
losses inherent in our loan portfolio. We periodically determine the amount of
the allowance based on consideration of several factors, including:




•
            an ongoing review of
      the quality, mix, and size of our overall loan
  portfolio;





•
            our historical loan
      loss experience;





•
            evaluation of
      economic conditions;





•
            regular reviews of
      loan delinquencies and loan portfolio quality;
  and





•
            the amount and quality of
      collateral, including guarantees, securing the
    loans.




However,
there is no precise method of estimating credit losses, since any estimate of
loan losses is necessarily subjective and the accuracy depends on the outcome of
future events. In addition, due to our rapid growth over the past several years
and our limited operating history, a large portion of the loans in our loan
portfolio were originated in recent years. In general, loans do not begin to
show signs of credit deterioration or default until they have been outstanding
for some period of time, a process referred to as seasoning. As a result, a
portfolio of more mature loans will usually behave more predictably than a newer
portfolio. Because our loan portfolio is relatively new, the current level of
delinquencies and defaults may not be representative of the level that will
prevail when the portfolio becomes more seasoned, which may be higher than
current levels. If chargeoffs in future periods increase, we may be required to
increase our provision for loan losses, which would decrease our net income and
possibly our capital.




Although
we believe the allowance for loan losses is a reasonable estimate of known and
inherent losses in our loan portfolio, we cannot fully predict such losses or
that our loan loss allowance will be adequate in the future. Excessive loan
losses could have a material impact on our financial performance. Consistent
with our loan loss reserve methodology, we expect to make additions to our loan
loss reserve levels to reflect the changing risk inherent in our portfolio of
existing loans and any additions to our loan portfolio,, which may affect our
short-term earnings.




Federal
regulators periodically review our allowance for loan losses and may require us
to increase our provision for loan losses or recognize further loan chargeoffs,
based on judgments different than those of our management. Any increase in the
amount of our provision of loans charged off as required by these regulatory
agencies could have a negative effect on our operating results.




Our
decisions regarding credit risk may materially and adversely affect our
business.




Making
loans and other extensions of credit is an essential element of our business.
Although we seek to mitigate risks inherent in lending by adhering to specific
underwriting practices, we may incur losses on loans that meet our underwriting
criteria, and these losses may exceed our loan loss reserves. The risk of
nonpayment is affected by a number of factors, including:


31




•
            the duration of the
      credit;





•
            credit risks of a
      particular customer;





•
            changes in economic
      and industry conditions; and





•
            in the case of a collateralized
      loan, risks resulting from uncertainties about the future value of the
      collateral.




While
we generally underwrite the loans in our portfolio in accordance with our own
internal underwriting guidelines and regulatory supervisory limits, in certain
circumstances we have made loans that exceed either our internal underwriting
guidelines, supervisory limits, or both. Pending final review by CLO and Credit
Administration, as of December 31, 2008, approximately $96.6 million, or
approximately 13.6% of our loans, net of unearned income, had loan-to-value
ratios that exceeded regulatory supervisory limits. We generally consider making
such loans only after taking into account the financial strength of the
borrower. The number of loans in our portfolio with loan-to-value ratios in
excess of supervisory limits, our internal guidelines, or both could increase
the risk of delinquencies or defaults in our portfolio. Any such delinquencies
or defaults could have an adverse effect on our results of operations and
financial condition.




Liquidity
needs could adversely affect our financial condition and results of
operation.




We
have historically relied on dividends from our bank as a viable source of funds
to service our holding company’s operating expenses, which are typically
dividends and interest payments on preferred stock and other borrowings;
however, given our bank's recent losses, this source of liquidity is no longer
viable.  Therefore, we have a greater dependence on other funding
sources to cover these expenses, such as drawing on our holding company’s line
of credit with a correspondent bank.  As outlined in the terms of our
current waiver, we will not be permitted to make additional draws on our line of
credit other than to pay interest on the line of credit while we are not in
compliance with all covenants associated with the line of credit.  Due
to the increase in our nonperforming assets and the negative impact on our
profitability, we are not in compliance with three of these covenants and are
operating under a temporary waiver of these covenant defaults that is in effect
until the lender completes its quarterly review of our December 31, 2008
financial statements relating to noncompliance with these
covenants.    In addition, the lender has agreed to not
pursue the collateral underlying the line of credit through June 30,
2009.  All other terms and conditions of the loan documents will
continue to exist and may be exercised at any time by the
lender.  Future waivers are discretionary and will be granted based on
our correspondent bank’s review of our quarterly financial
information.  There is no assurance that our lender will grant any
future waivers.




Traditionally,
the primary sources of funds of our bank subsidiary are customer deposits and
loan repayments. While scheduled loan repayments are a relatively stable source
of funds, they are subject to the ability of borrowers to repay the loans. The
ability of borrowers to repay loans can be adversely affected by a number of
factors, including changes in economic conditions, adverse trends or events
affecting business industry groups, reductions in real estate values or markets,
business closings or lay-offs, inclement weather, natural disasters and
international instability.   Additionally, deposit levels may be
affected by a number of factors, including rates paid by competitors, general
interest rate levels, regulatory capital requirements, returns available to
customers on alternative investments and general economic conditions.
Accordingly, we may be required from time to time to rely on secondary sources
of liquidity to meet withdrawal demands or otherwise fund operations. Such
sources include proceeds from FHLB advances, sales of investment securities and
loans, and federal funds lines of credit from correspondent banks, as well as
out-of-market time deposits.  There can be no assurance these sources
will be sufficient to meet our future liquidity demands.  In addition,
several of these sources have become restricted as a result of the issuance of
our final regulatory examination report and the terms of the executed consent
order with the OCC on April 27, 2009.




Our
decision not to declare a dividend on our noncumulative preferred stock for the
first quarter of 2009 and our intention to defer interest on our trust preferred
securities will likely restrict our access to the debt capital markets until
such time as we are current on our interest payments, which will further limit
our sources of liquidity.




In light of the current period of
volatility in the financial markets and our net loss for 2008, our board of
directors did not declare a dividend for the first quarter of 2009 to our
preferred shareholders.  The board expects to evaluate the decision to
declare future dividends to preferred shareholders on a quarterly basis and may
resume payment of these dividends in future quarters.  We also intend
to defer future quarterly interest payments on our trust preferred securities as
allowed by the terms of the underlying documents for similar
reasons.


32




Because
we have ceased to be deemed "well-capitalized" under applicable regulatory
standards, we will no longer be able to accept, renew or roll
over  brokered deposits and will be forced to find other sources of
liquidity, limit our growth and/or sell assets, which could materially and
adversely affect our financial condition and results of operation.




The
bank’s total risk-based capital ratio, Tier 1 risk-based capital ratio, and
leverage capital ratio were 9.75%, 8.48%, and 7.23%, respectively, as of
December 31, 2008.  Generally, the regulatory guidelines for these
measures for a bank to be considered "well-capitalized" are 10.00%, 6.00%, and
5.00%, respectively. However, the bank entered into a
consent order with the OCC on April 27, 2009, which contains a requirement that
our bank achieve and maintain minimum capital requirements by August 25, 2009
that exceed the minimum regulatory capital ratios for “well-capitalized”
banks.    As a result of the  terms of the
executed consent order, the bank is no longer deemed “well-capitalized”
regardless of its capital levels.  As a result, we are not
able to accept, renew or roll over brokered deposits without a waiver from the
FDIC.  Under FDIC regulations, "well-capitalized" insured depository
institutions may accept brokered deposits without
restriction.   “Adequately capitalized” insured depository
institutions may accept, renew, or roll over brokered deposits with a waiver
from the FDIC (subject to certain restrictions on payments of interest rates),
while “undercapitalized” insured depository institutions may not accept or renew
brokered deposits.  There is no assurance that the FDIC will grant us
a waiver.




As of December 31, 2008, we had
brokered deposits of $150.2 million, of which $131.6 million are scheduled to
mature prior to December 31, 2009.  Because of the consent order we
will seek to find other sources of liquidity to replace these deposits as they
mature while we pursue a waiver from the FDIC to regain our ability to accept,
renew or roll over brokered deposits, which is not assured.  As a
result, we must limit our growth, raise additional capital, and/or sell assets,
which could materially and adversely affect our financial condition and results
of operations.




We
may face damage to our reputation and business as a result of negative
publicity, including increase in deposit outflows.





Recent
negative publicity that has been experienced due to our weak earnings
performance, coupled with the substantial drop in our stock price over the last
few quarters, has resulted in a minor level of deposit outflows. We believe that
approximately 16.7% of our deposits are above FDIC insurance limits, and these
deposits are particularly susceptible to withdrawal based on negative publicity
about our current financial condition.  In addition, the increase in
FDIC insurance limits to $250,000 per depositor from $100,000 per depositor is
only in place through December 31, 2009.  We cannot predict whether
the limit will be maintained or reduced when it expires. Future negative news,
such as information about the OCC consent order executed on April 27, 2009, or a
default notice on our line of credit with our correspondent bank, could raise
withdrawal levels beyond the capacity of our currently available liquidity,
which would result in a takeover of the bank by the FDIC.  Negative
public opinion can adversely affect our ability to keep and attract customers
and can expose us to litigation.  We cannot guarantee that we will be
successful in avoiding damage to our business from a decline in our
reputation.





Recent
negative developments in the financial services industry and U.S. and global
credit markets may adversely impact our operations and results.




Negative developments in
the capital markets in the latter half of 2007 and in 2008 and the expectation
of the general economic downturn continuing in 2009 have resulted in uncertainty
in the financial markets in general. Loan portfolio performances have
deteriorated at many institutions resulting from, among other factors, a weak
economy and a decline in the value of the collateral supporting their loans. The
competition for our deposits has increased significantly due to liquidity
concerns at many of these same institutions. Stock prices of bank holding
companies, like ours, have been negatively affected by the current condition of
the financial markets, as has our ability, if needed, to raise capital or borrow
in the debt markets. As a result, there is a potential for new federal or state
laws and regulations regarding lending and funding practices and liquidity
standards, and financial institution regulatory agencies are expected to be very
aggressive in responding to concerns and trends identified in examinations.
Negative developments in the financial services industry and the impact of new
legislation in response to those developments could adversely impact our
operations, including our ability to originate or sell loans, and adversely
impact our financial performance.


33


Continuation
of the economic downturn could reduce our customer base, our level of deposits,
and demand for financial products such as loans.





Our
success significantly depends upon the growth in population, income levels,
deposits, and housing starts in our markets.  The current economic
downturn has negatively affected the markets in which we operate and, in turn,
the quality of our loan portfolio.  If the communities in which we
operate do not grow or if prevailing economic conditions locally or nationally
remain unfavorable, our business may not succeed.  So far in 2009,
there has been a continuation of the economic downturn or prolonged recession,
an extension of which would likely result in the continued deterioration of the
quality of our loan portfolio and reduce our level of deposits, which in turn
would hurt our business.  Interest received on loans represented
approximately 91.7% of our interest income for the year ended December 31,
2008.  If the economic downturn continues or a prolonged economic
recession occurs in the economy as a whole, borrowers will be less likely to
repay their loans as scheduled.  Moreover, in many cases, the value of
real estate or other collateral that secures our loans has been adversely
affected by the economic conditions and could continue to be negatively
affected.  Unlike many larger institutions, we are not able to spread
the risks of unfavorable local economic conditions across a large number of
diversified economies.  A continued economic downturn could,
therefore, result in losses that materially and adversely affect our
business.




We
face strong competition for customers in our market areas, which could prevent
us from obtaining customers and may cause us to pay higher interest rates to
attract deposits.




The
banking business is highly competitive and the level of competition facing us
may increase further. We experience competition in our markets from commercial
banks, savings and loan associations, mortgage banking firms, consumer finance
companies, credit unions, securities brokerage firms, insurance companies, money
market funds, and other mutual funds, as well as other super-regional, national,
and international financial institutions that operate offices in our primary
market areas and elsewhere. Competitors that are not depository institutions are
generally not subject to the extensive regulations that apply to
us.




We
compete with these types of institutions both in attracting deposits and in
making loans. In addition, we have to attract our customer base from other
existing financial institutions and from new residents. Many competitors are
well established, larger financial institutions, such as BB&T, Bank of
America, and Wachovia with substantially greater access to capital and other
resources. These institutions offer larger lending limits and some services,
such as extensive and established branch networks, that we do not provide. In
new markets, we will also compete against well-established community banks that
have developed relationships within the community.




Our
relatively smaller size can be a competitive disadvantage due to the lack of
multi-state geographic diversification and the inability to spread our marketing
costs across a broader market. We may not be able to compete successfully with
other financial institutions in our markets and may have to pay higher interest
rates, as we have done in some marketing promotions in the past to attract
deposits, resulting in reduced profitability. In addition to paying higher
interest rates to attract deposits, we may need to find alternative funding
sources to fund the growth in our loan portfolio. In 2008, deposit growth was
not sufficient to fund our loan growth and we have used proceeds from Federal
Home Loan Bank advances, out-of-market time deposits and principal and interest
payments on available-for-sale securities to make up the difference. However,
our borrowing ability is limited and has become more limited since our bank
entered into the consent order with the OCC on April 27, 2009.  Thus,
we may face contraction in our net interest margin if we must pay higher rates
for deposits and borrowings to sustain our liquidity.




Changes
in interest rates and our ability to successfully manage interest rates may
reduce our profitability.




Our
profitability depends in large part on the net interest income, which is the
difference between interest income from interest-earning assets, such as loans
and investment securities, and interest expense on interest-bearing liabilities,
such as deposits and borrowings. We believe that we are liability sensitive over
a one-year time frame, which means that our net interest income will generally
rise in falling interest rate environments and decline in rising interest rate
environments. Our net interest income will be adversely affected if the market
interest rate changes such that the interest we pay on deposits and borrowings
increases faster than the interest we earn on loans and investments. Many
factors cause changes in interest rates, including governmental monetary
policies and domestic and international economic and political conditions. Right
now, short-term interest rates are at an all-time low, while time deposit rates
remain stubbornly high.  This has severely squeezed our net interest
margin.  If this situation persists, it could have a significant
adverse affect on our profitability.




We
need to raise additional capital that may not be available.




Regulatory
authorities require us to maintain adequate levels of capital to support our
operations. As described above, we have an immediate need to increase our
capital ratios which requires us to raise additional capital and/or reduce the
size of our balance sheet.  In addition, even if we succeed in raising
this capital, we may need to raise additional capital in the future to support
continued growth. The ability to raise additional capital, if needed, will
depend in part on conditions in the capital markets at that time, which are
outside our control, and on our financial performance. Accordingly, additional
capital may not be raised, if and when needed, on terms acceptable to us, or at
all. If we cannot raise additional capital when needed, our ability to increase
our capital ratios could be materially impaired. In addition, if we issue
additional equity capital, our existing shareholders' interest would be
diluted.


34


The
FDIC Deposit Insurance assessments that we are required to pay may materially
increase in the future, which would have an adverse effect on our earnings and
our ability to pay our liabilities as they come due.




As an
FDIC-insured institution, we are required to pay quarterly deposit insurance
premium assessments to the FDIC.  During the year ended December 31,
2008, we paid $529,000 in deposit insurance assessments.  Due to the
recent failure of several unaffiliated FDIC-insured depository institutions, and
the FDIC’s new liquidity guarantee program, the deposit insurance premium
assessments paid by all banks will increase.  In addition to the
increases to deposit insurance assessments approved by the FDIC, the bank’s risk
category has also changed as a result of the recent regulatory examination which
will also increase the bank’s premium assessments in 2009.  The FDIC
has also proposed imposing a 20-basis point special emergency assessment payable
September 30, 2009, with authorization of the FDIC board to implement an
additional 10 basis-point premium in any quarter.  In addition, the
FDIC has indicated that it intends to propose changes to the deposit insurance
premium assessment system that will shift a greater share of any increase in
such assessments onto institutions with higher risk profiles, including banks
with heavy reliance on brokered deposits, such as our bank.  As a
result, we anticipate our future insurance costs to be substantially higher than
in previous periods.




We
may not be able to reduce the balance on our holding company’s outstanding line
of credit with a correspondent bank.




We have
drawn approximately $9.5 million upon a revolving line of credit with a
correspondent bank in the amount of $15 million.  We pledged all of
the stock of our bank subsidiary as collateral for the line of credit, which
contains various debt covenants.  As of December 31, 2008, we were not
in compliance with certain covenants related to net income and asset quality
contained in our related loan agreement.   As outlined in the
terms of our current waiver, we will not be permitted to make additional draws
on our line of credit other than to pay interest on the line of credit while we
are not in compliance with the covenants.  We are currently operating
under a waiver of covenant defaults as of September 30, 2008 that is in effect
until the lender completes its quarterly review of our December 31, 2008
financial statements relating to noncompliance with these
covenants.  We believe that the lender will continue to grant us such
future waivers quarterly, but we do not have any assurances in this
regard.  The lender has agreed not to pursue the collateral underlying
the line of credit through June 30, 2009.  All other terms and
conditions of the loan documents will continue to exist and may be exercised at
any time by the lender.  Therefore, there is a risk that the lender
may declare an event of default under the line of credit when our current waiver
expires, revoke the line of credit and attempt to foreclose on our bank stock
collateral if we are unable to pay off the outstanding balance on the line of
credit or obtain future waivers.




Our
core customer base of small- to medium-sized businesses may have fewer financial
resources to weather the recent downturn in the economy.




We target the banking and financial
services needs of small- and medium-sized businesses.  These
businesses generally have fewer financial resources in terms of capital
borrowing capacity than larger entities.  If the recent harsh economic
conditions continue to negatively impact these businesses in the markets in
which we operate, our business, financial condition, and results of operation
may be adversely affected.




There
can be no assurance that recently enacted legislation will help stabilize the
U.S. financial system.





The
Emergency Economic Stabilization Act of 2008, or EESA, was signed into law on
October 3, 2008 in response to the financial crises affecting the banking system
and financial markets and going concern threats to investment banks and other
financial institutions. Pursuant to EESA, the Treasury has the authority to,
among other things, purchase up to $700 billion of mortgages, mortgage-backed
securities and certain other financial instruments from financial institutions
for the purpose of stabilizing and providing liquidity to the U.S. financial
markets. The Treasury announced the Capital Purchase Program under EESA pursuant
to which it has purchased and may continue to purchase senior preferred stock in
participating financial institutions.




In
addition, the FDIC created the Temporary Liquidity Guarantee Program (“TLGP”) as
part of a larger government effort to strengthen confidence and encourage
liquidity in the nation’s banking system.  The TLGP has two
components. First, the FDIC will provide a complete guarantee of certain
unsecured debt of participating organizations issued before June 30, 2009.
Second, the FDIC will provide full insurance coverage for noninterest bearing
transaction accounts, regardless of dollar amount, until December 31,
2009.  The Company did not opt out of the TLGP so its
noninterest-bearing transaction accounts are fully
FDIC-insured.


35




There can
be no assurance that these government actions will achieve their purpose. The
failure of the financial markets to stabilize, or a continuation or worsening of
the current financial market conditions, could have a material adverse affect on
our business, our financial condition, the financial condition of our customers,
our common stock trading price, as well as our ability to access
credit.  It could also result in declines in our investment portfolio
which could be “other-than-temporary impairments.”




We have only recently adopted our
new business plan and may not be able to implement it
effectively.




Our
future performance will depend on our ability to implement our new business plan
successfully.  This implementation will involve a variety of complex
tasks, including reducing our level of NPAs by continuing to aggressively work
problem credits, exploring a bulk sale of loans or OREO, and possibly requiring
significant write-downs to facilitate disposition.  We will also
continue to increase core deposits, reduce dependency on wholesale funding
(brokered CD’s and FHLB borrowings) and increase low cost accounts (DDA’s, NOW,
etc.).  This should help expand our net interest margin and earnings
without requiring additional capital.   Any failure or delay in
executing these initiatives, whether due to regulatory delays or for other
reasons, which may be beyond our control, is likely to impede, and could
ultimately preclude, our successful implementation of our business plan and
could materially adversely affect our business, financial condition, and results
of operations.




Our
recent operating results may not be indicative of our future operating
results.




We
have historically grown at a rapid rate, but in the current economic climate we
will likely not be able to grow our business as we have in the past and we may
decide to contract our business through the sale of some of our
assets.  Consequently, our historical results of operations will not
necessarily be indicative of our future operations. Various factors, such as
economic conditions, regulatory and legislative considerations, and competition,
may also impede our ability to expand our market presence. If we experience a
significant decrease in our historical rate of growth, our business, financial
condition, and results of operation may be adversely affected because a high
percentage of our operating costs are fixed expenses and would not experience a
proportionate decrease.




Significant
risks accompany our recent expansion.




We have
recently experienced significant growth by opening new branches or loan
production offices and through acquisitions. Such expansion could place a strain
on our resources, systems, operations, and cash flow. Our ability to manage this
expansion will depend on our ability to monitor operations and control costs,
maintain effective quality controls, expand our internal management and
technical and accounting systems and otherwise successfully integrate new
branches and acquired businesses. If we fail to do so, our business, financial
condition, and operating results will be negatively impacted. Risks associated
with our recent acquisition activity include the following:




•
            inaccuracies in
      estimates and judgments to evaluate credit, operations, management, and
      market risks with respect to our recently acquired institution or its
      assets;





•
            our lack of
      experience in markets into which we have
  entered;





•
            difficulties and
      expense in integrating the operations and personnel of the combined
      businesses;





•
            loss of key
      employees and customers as a result of an acquisition that is poorly
      received;





•
              the incurrence and
      possible impairment of goodwill associated with an acquisition and
      possible adverse short-term effects on our results of operations;
      and




•
            impairment
      of total loss of goodwill associated with our
  acquisition.




We may
not be able to integrate any banks we have acquired successfully. Our inability
to overcome these risks could have a material adverse effect on our ability to
achieve our business strategy and on our financial condition and results of
operations.


36




We
depend on key individuals, and the unexpected loss of one or more of these key
individuals could curtail our growth and adversely affect our
prospects.




Jerry
L. Calvert, our president and chief executive officer, has substantial
experience with our operations and has contributed significantly to our growth
since our founding. If we lose Mr. Calvert's services, he would be
difficult to replace and our business and development could be materially and
adversely affected. Our success is dependent on the personal contacts and local
experience of Mr. Calvert and other key management personnel in each of our
market areas. Our success also depends in part on our continued ability to
attract and retain experienced loan originators, as well as our ability to
retain current key executive management personnel, including our chief financial
officer, Kitty B. Payne, and our chief lending officer, David H. Zabriskie. We
have entered into employment agreements with each of these executive officers.
The existence of such agreements, however, does not necessarily assure that we
will be able to continue to retain their services. The unexpected loss of the
services of several of these key personnel could adversely affect our growth
strategy and prospects to the extent we are unable to replace such
personnel.




We
are subject to extensive regulation that could limit or restrict our
activities.




We
operate in a highly regulated industry and are subject to examination,
supervision, and comprehensive regulation by the OCC, the FDIC, and the Federal
Reserve Board. Compliance with these regulations is costly and restricts certain
activities, including payment of dividends, mergers and acquisitions,
investments, loans and interest rates charged, interest rates paid on deposits,
and locations of branches. We must also meet regulatory capital requirements. If
we fail to meet these capital and other regulatory requirements, our financial
condition, liquidity, and results of operations would be materially and
adversely affected. Our failure to remain "well-capitalized" and "well managed"
for regulatory purposes could affect customer confidence, our ability to grow,
our cost of funds and FDIC insurance, our ability to pay dividends on our
capital stock, and our ability to make acquisitions.




The
laws and regulations applicable to the banking industry could change at any
time, and the effects of these changes on our business and profitability cannot
be predicted. For example, new legislation or regulation could limit the manner
in which we may conduct business, including our ability to obtain financing,
attract deposits, make loans and expand our business through opening new branch
offices. Many of these regulations are intended to protect depositors, the
public, and the FDIC, not shareholders. In addition, the burden imposed by these
regulations may place us at a competitive disadvantage compared to competitors
who are less regulated. The laws, regulations, interpretations, and enforcement
policies that apply to us have been subject to significant change in recent
years, sometimes retroactively applied, and may change significantly in the
future. The cost of compliance with these laws and regulations could adversely
affect our ability to operate profitably. Moreover, as a regulated entity, we
can be requested by regulators to implement changes to our operations. In the
past we have addressed areas of regulatory concern through the adoption of board
resolutions and improved policies and procedures.




Changes
in federal laws could adversely affect our wholesale mortgage
division.




Changes
in federal laws regarding the oversight of mortgage brokers and lenders could
adversely affect our ability to originate, finance, and sell residential
mortgage loans. The enactment of federal laws, such as licensing requirements
for mortgage brokers, applicable to the types of mortgage loans originated could
increase costs of operations and adversely affect origination volume, which
would negatively impact our business, financial condition, and results of
operations.





Item 1B.
            Unresolved Staff
      Comments.





We have
no unresolved staff comments with the SEC regarding our periodic or current
reports under the Exchange Act.





Item 2.
            Properties.





Properties





The
following table provides information about our properties.




37




Location
                                                    
                                                    Owned/Leased
                                                    
                                                    Expiration
                                                    
                                                    Square Footage and
    DescriptionUpstate
      RegionCorporate
      Headquarters and Main Office
                                                      215
      North Pine Street
                                                      Spartanburg,
      South Carolina
                                                    
                                                    Leased(1)
                                                    
                                                    02/15/2032
                                                    
                                                    Approximately
      3.0 acre site which includes a 15,000 square foot building with office
      space and a full-service branch opened in February 2001 as well as an
      additional 14,500 square feet of finished space housing our operations
      center completed in April 20072680
      Reidville Road
                                                      Spartanburg,
      South Carolina
                                                    
                                                    Owned/Leased(2)
                                                    
                                                    05/30/2020
                                                    
                                                    3,500
      square foot branch office opened in 20003090
      Boiling Springs Road
                                                      Boiling
      Springs, South Carolina
                                                    
                                                    Leased(1)
                                                    
                                                    02/15/2032
                                                    
                                                    3,000
      square foot branch office opened in 2002Market
      Headquarters
                                                      3401
      Pelham Road
                                                      Greenville,
      South Carolina
                                                    
                                                    Leased(3)
                                                    
                                                    10/9/2032
                                                    
                                                    6,000
      square foot full-service branch office and market headquarters opened in
      June 2007713
      Wade Hampton Blvd.
                                                      Greer,
      South Carolina
                                                    
                                                    Leased(3)
                                                    
                                                    10/9/2032
                                                    
                                                    3,000
      square foot full-service branch office opened in August
    2007200
      North Main Street
                                                      Suite
      200
                                                      Greenville,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    10/31/2008
                                                    
                                                    1,700
      square foot office housing our wholesale mortgage division opened in
      January 2007Coastal
      RegionMarket
      Headquarters
                                                      140
      East Bay Street
                                                      Charleston,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    08/31/2016
                                                    
                                                    5,379
      square foot market headquarters and full-service branch office in historic
      downtown Charleston opened in April 2007651
      Johnnie Dodds Blvd.
                                                      Mount
      Pleasant, South Carolina
                                                    
                                                    Leased(3)
                                                    
                                                    10/09/2032
                                                    
                                                    1,700
      square foot branch office opened in 2005260
      Seven Farms Dr., Suite B
                                                      Daniel
      Island, South Carolina
                                                    
                                                    Leased
                                                    
                                                    01/31/2009
                                                    
                                                    853
      square foot loan production office opened in February 2006Midlands Region(4)Market
      Headquarters
                                                      1350
      Main Street
                                                      Columbia,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    1/31/2012
                                                    
                                                    9,718
      square foot full-service branch office acquired in Carolina National
      acquisition in January 20084840
      Forest Drive
                                                      Columbia,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    1/31/2012
                                                    
                                                    2,000
      square foot full-service branch office acquired in Carolina National
      acquisition in January 20085075
      Sunset Boulevard
                                                      Lexington,
      South Carolina
                                                    
                                                    Owned/Leased(2)
                                                    
                                                    1/31/2023
                                                    
                                                    Opened
      in July 2008
                                                      3,000
      square foot full-service branchCorner
      of Two Notch Road and Sparkleberry Lane
                                                      Columbia,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    8/31/2015
                                                    
                                                    2,000
      square foot full-service branch office acquired in Carolina National
      acquisition in January 20086041
      Garner’s Ferry Road
                                                      Columbia,
      South Carolina
                                                    
                                                    Leased
                                                    
                                                    4/30/2021
                                                    
                                                    3,309
      square foot full-service branch office acquired in Carolina National
      acquisition in January 2008Northern
      Region724
      Arden Way, Suite 230
                                                      Rock
      Hill, South Carolina
                                                    
                                                    Leased
                                                    
                                                    03/01/2008
                                                    
                                                    1,188
      square foot loan production office opened in February 2007




38





(1) These
properties were part of the sale/leaseback transaction we entered into in
February 2007 with First National Holdings, LLC, a limited liability
company owned by nine non-management directors. See "First National
Relationships and Related Transactions" for a more detailed description of this
transaction.





(2) We
have a ground lease for the land and own the building and land
improvements.





(3) These
properties were part of a sale/leaseback transaction we entered into in October
2007 with First National Holdings II, LLC, a limited liability company owned by
eight non-management directors. See "First National Relationships and Related
Transactions" for a more detailed description of this transaction.





(4)  We
also lease a parcel of land one block from the Columbia market headquarters
office on which we operate a drive-through facility under a long-term
lease.





We
intend to open a full-service branch in York County, South Carolina in 2009 on a
parcel of land that we purchased in January of 2008 for approximately $1.4
million.





As part
of our strategy to minimize nonearning assets, we may exercise future
sale/leaseback transactions for the remaining properties we own. We analyze each
transaction to determine whether owning or leasing the real property is the most
efficient method of ownership of these properties and may contract to sell and
lease back future acquired sites.





Item 3.
            Legal
      Proceedings.





There are
no material legal proceedings.





39




PART
II





Item 5.
            Market for Common
      Equity, Related Stockholder Matters and Issuer Purchases of Equity
      Securities.





Our
common stock is listed on The NASDAQ Global Market under the symbol
“FNSC.”  As of March 31, 2009, there were 1,135 shareholders of
record. On April
16, 2009, we received a letter from NASDAQ indicating that we no longer complied
with the continued listing requirements set forth in NASDAQ Listing Rule
5250(c)(1). The letter was issued as a result of our failure to timely file our
Annual Report on Form 10-K for the fiscal year ended December 31, 2008, on or
before April 15, 2009, the grace period provided for by our Notification of Late
Filing on Form 12b-25. With this submission of our Annual Report on Form 10-K,
we anticipate that NASDAQ will find us to be in compliance once
again.





The
following table shows the high and low sales prices published by NASDAQ for each
quarter for the three year period ended December 31, 2008.  The prices
shown reflect historical activity and have been adjusted for the 3 for 2 stock
splits distributed on March 1, 2004 and January 18, 2006, the 6% stock
dividend distributed on May 16, 2006, and the 7% stock dividend distributed
on March 30, 2007.




2008
                  
                  
                  2007
                  
                  
                  2006High
                  
                  
                  Low
                  
                  
                  High
                  
                  
                  Low
                  
                  
                  High
                  
                  
                  LowFirst
      Quarter
                  
                  $
                  13.15
                  
                  
                  $
                  9.61
                  
                  
                  $
                  19.39
                  
                  
                  $
                  14.87
                  
                  
                  $
                  20.32
                  
                  
                  $
                  15.94Second
      Quarter
                  
                  
                  10.45
                  
                  
                  
                  6.50
                  
                  
                  
                  18.73
                  
                  
                  
                  14.40
                  
                  
                  
                  19.63
                  
                  
                  
                  14.32Third
      Quarter
                  
                  
                  7.15
                  
                  
                  
                  4.80
                  
                  
                  
                  15.50
                  
                  
                  
                  12.95
                  
                  
                  
                  18.00
                  
                  
                  
                  14.72Fourth
      Quarter
                  
                  $
                  5.77
                  
                  
                  $
                  1.44
                  
                  
                  $
                  15.47
                  
                  
                  $
                  11.60
                  
                  
                  $
                  15.61
                  
                  
                  $
                  14.52




Our
ability to pay cash dividends is dependent upon receiving cash in the form of
dividends from our bank.  However, certain restrictions exist regarding the
ability of the bank to transfer funds to the company in the form of cash
dividends.  All dividends must be paid out of undivided profits then on
hand, after deducting expenses, including reserves for losses and bad
debts.  In addition, a national bank is prohibited from declaring a
dividend on its shares of common stock until its surplus equals its stated
capital, unless there has been transferred to surplus no less than one-tenth of
the bank’s net profits of the preceding two consecutive half-year periods (in
the case of an annual dividend).  The approval of the OCC is required if
the total of all dividends declared by a national bank in any calendar year
exceeds the total of its net profits for that year combined with its retained
net profits for the preceding two years, less any required transfers to
surplus.  In addition, the terms of the consent order executed by our
bank with the OCC on April 27, 2009 places further restrictions on the bank’s
ability to pay dividends to the holding company.  Further, we cannot
pay cash dividends on our common stock during any calendar quarter unless full
dividends on the Series A Preferred Stock for the dividend period ending during
the calendar quarter have been declared and we have not failed to pay a dividend
in the full amount of the Series A Preferred Stock with respect to the period in
which such dividend payment in respect of our common stock would
occur.





All of
our outstanding shares of common stock are entitled to share equally in
dividends from funds legally available therefore, when, as and if declared by
the board of directors.  To date, we have not paid cash dividends on
our common stock.  We currently intend to retain earnings to support
operations and finance expansion and, therefore, we do not anticipate paying
cash dividends on our common stock in the foreseeable future.




The
following table sets forth equity compensation plan information as of
December 31, 2008.




Equity
Compensation Plan Information




Plan
      Category
                
                Number
      of securities to be
                  issued
      upon exercise
                  of
      outstanding options
                  warrants
      and rights
                
                
                Weighted-average
                  exercise
      price of
                  outstanding
      options,
                  warrants
      and rights
                
                
                Number
      of securities
                  remaining
      available for
                  future
      issuance under
                  equity
      compensation
                  plans
      excluding
                  securities
      reflected in
                  columnEquity
      compensation plans approved by security holders(1)
                
                
                428,238
                
                
                $
                6.98
                
                
                
                308,207Equity
      compensation plans not approved by security holders (2)
                
                
                663,507
                
                
                $
                3.92
                
                
                
                -Total
                
                
                1,091,745
                
                
                $
                5.12
                
                
                
                308,207





40





(1)
            Pursuant
      to the Merger Agreement approved at special meetings of the First National
      and Carolina National shareholders held in December of 2007, an additional
      141,346 shares of common stock are reserved for issuance upon the exercise
      of options outstanding as of the effective date of the Merger that were
      converted into options to purchase shares of First National common
      stock.





(2)
            Each
      of our organizers received, for no additional consideration, a warrant to
      purchase two shares of common stock for $3.92 per share (adjusted for 3
      for 2 stock splits distributed on and March 1, 2004 January 18,
      2006, and 6% stock dividend distributed May 16, 2006 and the 7% stock
      dividend distributed on March 30, 2007) for every three shares purchased
      during our initial public offering completed in February
      2000.  The warrants are represented by separate warrant
      agreements.  One-fifth of the warrants vested on each of the
      first five anniversaries of the completion of the offering and they are
      exercisable in whole or in part during the ten-year period following that
      date.  The warrants may not be assigned, transferred, pledged or
      hypothecated in any way.  The shares issued pursuant to the
      exercise of such warrants are transferable, subject to compliance with
      applicable securities laws.  If the OCC or the FDIC issues a
      capital directive or other order requiring the bank to obtain additional
      capital, the warrants will be forfeited if not immediately
      exercised.




41




Item 6.
            Selected Financial
      Data.




Selected
Consolidated Financial and Other Information


(dollars
in thousands, except per share data)




2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006
                                    
                                    
                                    2005
                                    
                                    
                                    2004Summary
      of OperationsNet
      interest income
                                    
                                    $
                                    20,008
                                    
                                    
                                    $
                                    17,503
                                    
                                    
                                    $
                                    14,161
                                    
                                    
                                    $
                                    9,511
                                    
                                    
                                    $
                                    6,512Provision
      for loan losses
                                    
                                    
                                    20,460
                                    
                                    
                                    
                                    1,396
                                    
                                    
                                    
                                    1,192
                                    
                                    
                                    
                                    594
                                    
                                    
                                    
                                    679Noninterest
      income
                                    
                                    
                                    5,020
                                    
                                    
                                    
                                    4,151
                                    
                                    
                                    
                                    2,079
                                    
                                    
                                    
                                    1,855
                                    
                                    
                                    
                                    1,771Noninterest
      expense
                                    
                                    
                                    51,649
                                    
                                    
                                    
                                    14,159
                                    
                                    
                                    
                                    8,901
                                    
                                    
                                    
                                    6,476
                                    
                                    
                                    
                                    4,966Income
      taxes
                                    
                                    
                                    (2,234
                                    )
                                    
                                    
                                    2,039
                                    
                                    
                                    
                                    2,095
                                    
                                    
                                    
                                    1,461
                                    
                                    
                                    
                                    823Net
      income/(loss)
                                    
                                    $
                                    (44,847
                                    )
                                    
                                    $
                                    4,060
                                    
                                    
                                    $
                                    4,052
                                    
                                    
                                    $
                                    2,835
                                    
                                    
                                    $
                                    1,815Per
      common share - basic
                                    
                                    $
                                    (7.56
                                    )
                                    
                                    $
                                    0.93
                                    
                                    
                                    $
                                    1.12
                                    
                                    
                                    $
                                    0.90
                                    
                                    
                                    $
                                    0.59Per
      common share - diluted
                                    
                                    $
                                    (7.56
                                    )
                                    
                                    $
                                    0.84
                                    
                                    
                                    $
                                    0.94
                                    
                                    
                                    $
                                    0.73
                                    
                                    
                                    $
                                    0.49Year
      End Balance SheetsInvestment
      securities
                                    
                                    $
                                    81,662
                                    
                                    
                                    $
                                    70,530
                                    
                                    
                                    $
                                    63,374
                                    
                                    
                                    $
                                    45,151
                                    
                                    
                                    $
                                    36,165Loans,
      net of unearned income
                                    
                                    
                                    692,876
                                    
                                    
                                    
                                    474,685
                                    
                                    
                                    
                                    379,490
                                    
                                    
                                    
                                    251,405
                                    
                                    
                                    
                                    188,508Allowance
      for loan losses
                                    
                                    
                                    23,033
                                    
                                    
                                    
                                    4,951
                                    
                                    
                                    
                                    3,795
                                    
                                    
                                    
                                    2,719
                                    
                                    
                                    
                                    2,259Mortgage
      loans held for sale
                                    
                                    
                                    16,411
                                    
                                    
                                    
                                    19,408
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
      assets
                                    
                                    
                                    812,742
                                    
                                    
                                    
                                    586,513
                                    
                                    
                                    
                                    465,382
                                    
                                    
                                    
                                    328,769
                                    
                                    
                                    
                                    236,344Noninterest-bearing
      deposits
                                    
                                    
                                    39,088
                                    
                                    
                                    
                                    44,466
                                    
                                    
                                    
                                    31,321
                                    
                                    
                                    
                                    18,379
                                    
                                    
                                    
                                    15,695Interest-bearing
      deposits
                                    
                                    
                                    607,761
                                    
                                    
                                    
                                    427,362
                                    
                                    
                                    
                                    345,380
                                    
                                    
                                    
                                    253,316
                                    
                                    
                                    
                                    176,116FHLB
      advances and other borrowed funds
                                    
                                    
                                    107,736
                                    
                                    
                                    
                                    51,051
                                    
                                    
                                    
                                    45,446
                                    
                                    
                                    
                                    26,612
                                    
                                    
                                    
                                    23,079Junior
      subordinated debentures
                                    
                                    
                                    13,403
                                    
                                    
                                    
                                    13,403
                                    
                                    
                                    
                                    13,403
                                    
                                    
                                    
                                    6,186
                                    
                                    
                                    
                                    6,186Shareholders'
      equity
                                    
                                    
                                    40,624
                                    
                                    
                                    
                                    47,556
                                    
                                    
                                    
                                    26,990
                                    
                                    
                                    
                                    22,029
                                    
                                    
                                    
                                    13,911Tangible
      book value per share
                                    
                                    
                                    3.78
                                    
                                    
                                    
                                    8.02
                                    
                                    
                                    
                                    7.38
                                    
                                    
                                    
                                    7.13
                                    
                                    
                                    
                                    5.22Tangible
      book value per share (diluted)
                                    
                                    
                                    5.36
                                    
                                    
                                    
                                    8.49
                                    
                                    
                                    
                                    7.29
                                    
                                    
                                    
                                    6.21
                                    
                                    
                                    
                                    6.21Book
      value per share (diluted)
                                    
                                    $
                                    5.49
                                    
                                    
                                    $
                                    8.49
                                    
                                    
                                    $
                                    7.29
                                    
                                    
                                    $
                                    6.21
                                    
                                    
                                    $
                                    6.21Average
      Balance SheetsInvestment
      securities
                                    
                                    $
                                    73,371
                                    
                                    
                                    
                                    69,785
                                    
                                    
                                    
                                    52,423
                                    
                                    
                                    
                                    39,683
                                    
                                    
                                    $
                                    35,352Loans,
      net of unearned income
                                    
                                    
                                    682,437
                                    
                                    
                                    
                                    430,683
                                    
                                    
                                    
                                    314,610
                                    
                                    
                                    
                                    222,026
                                    
                                    
                                    
                                    160,914Total
      interest-earning assets
                                    
                                    
                                    779,940
                                    
                                    
                                    
                                    516,757
                                    
                                    
                                    
                                    373,253
                                    
                                    
                                    
                                    269,745
                                    
                                    
                                    
                                    199,653Noninterest-bearing
      demand deposits
                                    
                                    
                                    41,920
                                    
                                    
                                    
                                    32,588
                                    
                                    
                                    
                                    23,056
                                    
                                    
                                    
                                    18,009
                                    
                                    
                                    
                                    15,641Interest-bearing
      deposits
                                    
                                    
                                    600,870
                                    
                                    
                                    
                                    394,223
                                    
                                    
                                    
                                    285,522
                                    
                                    
                                    
                                    208,854
                                    
                                    
                                    
                                    159,386FHLB
      advances
                                    
                                    $
                                    60,538
                                    
                                    
                                    
                                    41,014
                                    
                                    
                                    
                                    33,421
                                    
                                    
                                    
                                    27,966
                                    
                                    
                                    $
                                    13,657Ratios
      and Other DataReturn
      on average assets
                                    
                                    
                                    (5.43
                                    )%
                                    
                                    
                                    0.76
                                    %
                                    
                                    
                                    1.05
                                    %
                                    
                                    
                                    1.01
                                    %
                                    
                                    
                                    0.87
                                    %Return
      on average equity
                                    
                                    
                                    (54.01
                                    )%
                                    
                                    
                                    10.89
                                    %
                                    
                                    
                                    16.82
                                    %
                                    
                                    
                                    17.72
                                    %
                                    
                                    
                                    13.87
                                    %Net
      interest margin
                                    
                                    
                                    2.57
                                    %
                                    
                                    
                                    3.39
                                    %
                                    
                                    
                                    3.79
                                    %
                                    
                                    
                                    3.53
                                    %
                                    
                                    
                                    3.26
                                    %Efficiency
      ratio
                                    
                                    
                                    206.37
                                    %
                                    
                                    
                                    65.39
                                    %
                                    
                                    
                                    54.81
                                    %
                                    
                                    
                                    56.98
                                    %
                                    
                                    
                                    59.94
                                    %Total
      risk-based capital ratio (holding company)
                                    
                                    
                                    8.33
                                    %
                                    
                                    
                                    13.48
                                    %
                                    
                                    
                                    11.13
                                    %
                                    
                                    
                                    13.16
                                    %
                                    
                                    
                                    12.21
                                    %Total
      risk-based capital ratio (bank)
                                    
                                    
                                    9.75
                                    %
                                    
                                    
                                    10.72
                                    %
                                    
                                    
                                    10.01
                                    %
                                    
                                    
                                    11.35
                                    %
                                    
                                    
                                    11.83
                                    %Net
      chargeoffs to average loans
                                    
                                    
                                    0.78
                                    %
                                    
                                    
                                    0.06
                                    %
                                    
                                    
                                    0.04
                                    %
                                    
                                    
                                    0.06
                                    %
                                    
                                    
                                    0.03
                                    %Nonperforming
      assets to loans and OREO, year end
                                    
                                    
                                    10.89
                                    %
                                    
                                    
                                    3.02
                                    %
                                    
                                    
                                    0.15
                                    %
                                    
                                    
                                    0.16
                                    %
                                    
                                    
                                    0.03
                                    %Allowance
      for loan losses to loans, year end
                                    
                                    
                                    3.32
                                    %
                                    
                                    
                                    1.04
                                    %
                                    
                                    
                                    1.00
                                    %
                                    
                                    
                                    1.08
                                    %
                                    
                                    
                                    1.20
                                    %Closing
      market price per share
                                    
                                    $
                                    2.06
                                    
                                    
                                    $
                                    13.14
                                    
                                    
                                    $
                                    14.95
                                    
                                    
                                    $
                                    17.60
                                    
                                    
                                    $
                                    15.58Price
      to earnings, year end
                                    
                                    
                                    (1.26
                                    )
                                    
                                    
                                    15.64
                                    
                                    
                                    
                                    15.90
                                    
                                    
                                    
                                    24.11
                                    
                                    
                                    
                                    31.80




All share
and per share data reflects the 3 for 2 stock splits distributed on
March 1, 2004, and January 18, 2006, the 6% stock dividend distributed
on May 16, 2006, and the 7% stock dividend distributed on March 30,
2007.




42




Item 7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operation.





FIRST
NATIONAL BANCSHARES, INC.


MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION


AND
RESULTS OF OPERATION





The
following discussion and analysis also identifies significant factors that have
affected our financial position and operating results during the periods
included in the accompanying financial statements.  We encourage you
to read this discussion and analysis in conjunction with the financial
statements and the related notes and the other statistical information also
included in this report.





Overview





The
impact of the current economic challenges facing the banking industry negatively
impacted our results of operations during 2008 which included our first net loss
for a reporting period since we recorded our first quarterly profit in the
fourth quarter of 2001.  We reported the following results of
operations for the year ended December 31, 2008:





Provisions for loan losses increased as
a result of the increase in our nonperforming assets.





Our nonperforming assets increased
dramatically during 2008 due to the severe housing downturn and real estate
market deterioration in each of our market areas.  As a result, we
recorded a provision for loan losses during 2008 of $20.5 million, as compared
to $1.4 million during 2007.  Included in the provision for loan
losses of $20.5 million recorded during 2008 is $19.0 million which was recorded
to reflect specific impairment charges related to the increase in our
nonperforming assets during the year, in excess of the general provision for the
loan losses recorded for 2008 of $1.5 million.  The Coastal Region of
our franchise, primarily in and around Charleston, South Carolina, has been
particularly affected by the volatility and weakness in the residential housing
market.  These conditions have negatively affected the economy in this
region of our state, making it especially difficult for a higher percentage of
borrowers in this region to repay their loans to us than in other
regions.   As of December 31, 2008, our nonperforming assets were
$75.5 million, as compared to $38.0 million as of September 30,
2008.   As of December 31, 2007, our nonperforming assets were
$14.3 million.





The net interest margin declined from
2007 to 2008 as a result of the rapidly declining interest rate environment and
continued liquidity pressure.





During 2008, in an effort to alleviate
liquidity, capital and other balance sheet pressures on financial institutions,
the Federal Reserve lowered the federal funds rate from 4.25% in January of 2008
to near zero percent by the end of 2008.  The benchmark two-year
Treasury yield began 2008 at a high of 3.05% but had decreased to 0.77% as of
December 31, 2008 and the ten-year Treasury yield, which began 2008 at 4.03%,
closed 2008 at 2.21%.   These dramatic changes in market interest
rates have resulted in a lower net interest margin for us in 2008 as compared to
previous years, which also caused our 2008 earnings to suffer.  The
unprecedented interest rate reductions by the Federal Reserve described above
had a negative impact on our net interest margin since interest rate cuts
reduced the yield on our adjustable rate loans immediately, but our deposit
costs did not fall as quickly or as far in response to these interest rate
reductions since liquidity pressure in the retail deposit markets has kept these
costs high.





Although the net interest margin fell
by 82 basis points from 3.39% in 2007 to 2.57% in 2008, the increase in earning
assets resulted in an increase of 14.3% in net interest income, which was
relatively lower than the 62% increase in noninterest expense from 2007 to
2008.  The net interest income in 2008 increased to $20.0 million from
$17.5 million in 2007, while noninterest expenses were $51.6 million for 2008,
as compared to $14.2 million in 2007.  The relatively higher increase
in noninterest expenses occurred primarily as a result of added operating costs
related to the $220.9 million in assets added from the acquisition of Carolina
National Corporation (Nasdaq:  CNCP) that closed on January 31,
2008.  In addition, higher noninterest expenses were incurred in 2008
to reflect the costs associated with the higher level of nonperforming assets
from 2007 to 2008.  These expenses include impairment charges on the
value of other real estate owned, salaries of personnel performing the duties of
managing nonperforming assets and various carrying costs related to the
foreclosed properties owned by our bank.




43




A noncash accounting charge was
recorded in 2008 to reflect the impairment of goodwill required to be evaluated
as a result of declining stock prices for financial institutions.





We recorded an after-tax noncash
accounting charge of $28.7 million during the fourth quarter of 2008 as a result
of our annual testing of goodwill for impairment as required by accounting
standards.  The impairment analysis was negatively impacted by the
unprecedented weakness in the financial markets. The first step of the goodwill
impairment analysis involves estimating a hypothetical fair value and comparing
that with the carrying amount or book value of the entity; our initial
comparison suggested that the carrying amount of goodwill exceeded its implied
fair value due to our low stock price, consistent with that of most
publicly-traded financial institutions.  Therefore, we were required
to perform the second step of the analysis to determine the amount of the
impairment.  We prepared a discounted cash flow analysis which
established the estimated fair value of the entity and conducted a full
valuation of the net assets of the entity.  Following these
procedures, we determined that no amount of the net asset value could be
allocated to goodwill and we recorded the impairment to the goodwill balance as
a noncash accounting charge to our earnings in 2008. Our regulatory capital
ratios are not affected by this noncash impairment charge.





Highlights of Results of
Operations





The
following table sets forth selected measures of our financial performance for
the periods indicated (dollars in thousands).




As
of or for the Years Ended December 31,




2008
                  
                  
                  2007
                  
                  
                  2006Total
      revenue(1)
                  
                  $
                  25,028
                  
                  
                  $
                  21,654
                  
                  
                  $
                  16,240Net
      income/(loss)
                  
                  
                  (44,847
                  )
                  
                  
                  4,060
                  
                  
                  
                  4,052Total
      assets
                  
                  
                  812,742
                  
                  
                  
                  586,513
                  
                  
                  
                  465,382Total
      loans(2)
                  
                  
                  692,876
                  
                  
                  
                  474,685
                  
                  
                  
                  379,490Total
      deposits
                  
                  
                  646,849
                  
                  
                  
                  471,828
                  
                  
                  
                  376,701








(1)
            Total
      revenue equals net interest income plus total noninterest
      income.


(2)
            Includes
      nonperforming loans, net of unearned income; does not include mortgage
      loans held for sale.




Like most
financial institutions, we derive the majority of our income from interest we
receive on our interest-earning assets, such as loans and
investments.  Our primary source of funds for making these loans and
investments is our deposits, on which we pay interest.  Consequently,
one of the key measures of our success is our amount of net interest income, or
the difference between the income on our interest-earning assets and the expense
on our interest-bearing liabilities, such as deposits and
borrowings.  Another key measure is the spread between the yield we
earn on these interest-earning assets and the rate we pay on our
interest-bearing liabilities, which is called our net interest
spread.





There are
risks inherent in all loans, so we maintain an allowance for loan losses to
absorb probable losses on existing loans that may become
uncollectible.  We maintain this allowance by charging a provision for
loan losses against our operating earnings.  We have included a
detailed discussion of this process, as well as several tables describing our
allowance for loan losses.





In
addition to earning interest on our loans and investments, we earn income
through other sources, such as fees and surcharges to our customers and income
from the sale and/or servicing of financial assets such as loans and
investments. We describe the various components of this noninterest income, as
well as our noninterest expense, in the following discussion.





In reponse to financial conditions
affecting the banking system and financial markets and the potential threats to
the solvency of investment banks and other financial institutions, the United
States government has taken unprecedented actions.  On October 3,
2008, President Bush signed into law the Emergency Economic Stabilization Act of
2008 (the “EESA”).  Pursuant to the EESA, the  U.S.
Department of Treasury will have the authority to, among other things, purchase
mortgages, mortgage-backed securities, and other financial instruments from
financial institutions for the purpose of stabilizing and providing liquidity to
the U.S. financial markets.  On October 14, 2008, the U.S. Department
of Treasury announced the Capital Purchase Program under the
EESA.  Regardless of our participation, governmental intervention and
new regulations under these programs could materially and adversely affect our
business, financial condition and results of operations.





Critical
Accounting Policies





We have
adopted various accounting policies that govern the application of accounting
principles generally accepted in the United States of America and that are
consistent with general practices within the banking industry in the preparation
of our financial statements.  Our significant accounting policies are
described in footnote 1 to our audited consolidated financial statements as of
December 31, 2008.




44




Certain
accounting policies involve significant judgments and assumptions by us that
have a material impact on the carrying value of certain assets and
liabilities.  We consider these policies to be critical accounting
policies.  The judgments and assumptions we use are based on
historical experience and other factors, which we believe to be reasonable under
the circumstances.  Because of the nature of the judgments and
assumptions we make, actual results could differ from these judgments and
estimates that could have a material impact on the carrying values of our assets
and liabilities and our results of operations.  Management relies
heavily on the use of judgments, assumptions and estimates to make a number of
core decisions, including accounting for the allowance for loan losses, income
taxes and intangible assets.  A brief discussion of each of these
areas follows:





Allowance
for Loan Losses





Some of
the more critical judgments supporting the amount of our allowance for loan
losses include judgments about the creditworthiness of borrowers, the estimated
value of the underlying collateral, cash flow assumptions, the determination of
loss factors for estimating credit losses, the impact of current events, and
other factors impacting the level of probable inherent losses.  Under
different conditions or using different assumptions, the actual amount of credit
losses incurred by us may be different from management’s estimates provided in
our consolidated financial statements.  Please see "Allowance for Loan
Losses" for a more complete discussion of our processes and methodology for
determining our allowance for loan losses.





Income
Taxes





Deferred income tax assets are recorded
to reflect the tax effect of the difference between the book and tax basis of
assets and liabilities.  These differences result in future deductible
amounts that are dependent on the generation of future taxable income through
operations or the execution of tax planning strategies.   Due to
the doubt of the ability of the company to continue as a going concern,
management has established a valuation allowance for the deferred tax
asset.  Based on the assumptions used by management regarding the
ability of the bank to generate future earnings and the execution of tax
planning strategies to generate income, the actual amount of the future tax
benefit received may be different than the amount of the deferred tax asset net
of the associated valuation allowance.





Intangible
Assets





We recorded intangible assets in
connection with the Merger, including goodwill, core deposit intangible, and
purchase accounting adjustments to loans, deposits and leases to reflect the
difference between the fair value and the book value of these assets and
liabilities.  The methodology used to arrive at these fair values
involves a significant degree of judgment.  To determine the value of
assets and liabilities, as well as the extent to which related assets may be
impaired, management makes assumptions and estimates related to discount rates,
asset returns, prepayment rates and other factors.  The use of
different discount rates or other valuation assumptions could produce
significantly different results.  The outcome of valuations performed
by management have a direct  bearing on the carrying amounts of assets
and liabilities, including goodwill and the assets and liabilities acquired in
the Merger.  The valuation and testing methodology used in our
analysis of goodwill impairment are summarized in Note 1 – Summary of
Significant Accounting Policies and Activities to the consolidated financial
statements.





Results
of Operations





Income
Statement Review





Summary





Our net
loss was $44.8 million, or $7.56 per diluted share, for the year ended December
31, 2008, as compared with net income of $4.1 million, or $0.84 per diluted
share, for the year ended December 31, 2007.  Our net loss for the
year ended December 31, 2008 included an impairment provision for goodwill of
$28.7 million and an increase in provision for loan losses due to the severe
housing downturn and real estate market deterioration in each of our market
areas as well as a valuation allowance on our deferred tax asset. Diluted common
shares outstanding for the year ended December 31, 2008, increased by 25.9% over
the same period in 2007, due to the effect of a prorated amount to reflect the
2.7 million common shares issued to the former Carolina National shareholders as
of the merger date of January 31, 2008.  The dilutive effects of the
$18 million in noncumulative convertible perpetual preferred stock issued in
July 2007 are not included in diluted weighted average shares outstanding for
the year ended December 31, 2008 because we recognized a net loss for the year
ended December 31, 2008.  Net interest income for the year ended
December 31, 2008, increased by 14.3% or $2.5 million to $20.0 million, as
compared to $17.5 million recorded during the same period in 2007, primarily due
to the growth in average earning assets since December 31, 2007, of $263.2
million, or 50.9%. The increase in average earning assets during this period
includes $191.3 million from the Carolina National acquisition.




45




Our net
income was $4.1 million, or $0.84 per diluted share, for the year ended December
31, 2007, as compared with $4.0 million, or $0.94 per diluted share, for the
year ended December 31, 2006.  The relatively flat net income included
a $3.3 million, or 23.6%, increase in net interest income.  The
increase in net interest income was due primarily to the growth of our loan
portfolio, which is largely made up of variable-rate loans.  The
favorable blend of variable-rate to fixed-rate loans more than offset the
increase in deposits.  In our deposit portfolio, the cost of funds was
driven by increased rates, which outweighed the increase in volume for
2007.





Our
return on average assets decreased from 0.76% for the year ended December 31,
2007, to (5.43%) in 2008.  This decreased return is due to the current
year’s net loss, compared to prior year’s net income, despite an increased
average asset base.  The diminished return on assets reflects the
impact of the decreased net interest margin and an increased provision for loan
losses.  Loans continued to contribute to net interest income as our
most lucrative earning asset, but their positive contribution was proportionally
matched by the growth in deposits, whose volume contributed approximately $11.8
million in costs, while loan growth generated almost double that expense at
$21.5 million in income.  In contrast, lower loan rates reduced the
positive contribution from loan volume by $16.2 million, or approximately
threefourths of the positive contribution from greater loan volume. This ratio
was matched on the deposit side, for which lower rates reduced those costs by
approximately $8.9 million.





Our
return on average assets decreased from 1.05% in 2006 to 0.76% in 2007 due to
the flat net income compared to an increased average asset base.  The
diminished return on assets reflects the impact of the decreased net interest
margin.  Loans continued to grow consistently and to contribute to net
interest income as our most lucrative earning asset, but their positive
contribution was outweighed by the increased cost of funds, whereas deposit
rates contributed approximately $7.0 million in costs, while deposit growth
generated substantially less expense at $3.5 million.  In contrast,
loan growth, at $8.1 million, contributed almost the same level of expense as
loan rates, at $9.2 million.





Our
return on average equity decreased from 10.89% for the year ended December 31,
2007 to (54.01%) for the year ended December 31, 2008.  This decrease
was driven by our net loss recognized in 2008 versus net income for 2007 and the
large increase in our average equity due to the acquisition of Carolina National
during the first quarter of 2008.  Average equity had increased in
2007 due to $16.5 million in net proceeds received from the completion of the
preferred stock offering in July 2007.





Our
return on average equity decreased 16.82% in 2006 to 10.89% in
2007.  This decrease was driven by the large increase in our average
equity due to the $16.5 million in net proceeds received from the completion of
the preferred stock offering in July 2007, while our net income remained about
the same from 2006 to 2007.  In addition, noninterest expense
increased during 2007 due to the expansion of our branch network and the
continued development of our infrastructure.





Net
Interest Income





Our
primary source of revenue is net interest income.  The level of net
interest income is determined by the balances of interest-earning assets and
interest-bearing liabilities and successful management of the net interest
margin.  In addition to the growth in both interest-earning assets and
interest-bearing liabilities, and the timing of repricing of these assets and
liabilities, net interest income is also affected by the ratio of
interest-earning assets to interest-bearing liabilities and the changes in
interest rates earned on our assets and interest rates paid on our
liabilities.





Our net
interest income increased $2.5 million, or 14.3%, to $20.0 million in 2008, from
$17.5 million in 2007.  Our net interest income increased
$3.3 million, or 23.6%, to $17.5 million in 2007, from
$14.2 million in 2006.  The increase in net interest income from
2007 to 2008 was due primarily to the growth in our average earning assets of
$263.2 million, or 50.9%, which was partially offset by a decrease in our net
interest margin for the years ended December 31, 2007 and 2008.  The
increase in average earning assets during this period includes $215.4 million
from the Carolina National acquisition.  The increase in net interest
income from 2006 to 2007 was due primarily to the growth of our loan portfolio,
as reflected in an increase in our average earning assets of 38.4% in 2007,
which was partially offset by a decrease in our net interest margin of 40 basis
points from 3.79% to 3.39% for the years ended December 31, 2006 and 2007,
respectively.  The decrease in the net interest margin was primarily
attributable to the high cost of deposits due to the increases in the prime rate
that occurred throughout 2006.




46




The
following table sets forth, for the years ended December 31, 2008, 2007 and
2006, information related to our average balances, yields on average assets, and
costs of average liabilities.  We derived average balances from the daily
balances throughout the periods indicated.  We derived these yields by
dividing income or expense by the average balance of the corresponding assets or
liabilities.Average loans are stated
net of unearned income and include nonaccrual loans. Interest income
recognized on nonaccrual loans has been included in interest income (dollars in
thousands).




Average
Balances, Income and Expenses, and Rates


For
the Years Ended December 31,




2008
                        
                        
                        2007
                        
                        
                        2006Average
                        
                        
                        Income/
                        
                        
                        Yield/
                        
                        
                        Average
                        
                        
                        Income/
                        
                        
                        Yield/
                        
                        
                        Average
                        
                        
                        Income/
                        
                        
                        Yield/Balance
                        
                        
                        Expense
                        
                        
                        Rate
                        
                        
                        Balance
                        
                        
                        Expense
                        
                        
                        Rate
                        
                        
                        Balance
                        
                        
                        Expense
                        
                        
                        RateLoans,
      excluding held for sale
                        
                        $
                        682,438
                        
                        
                        $
                        40,901
                        
                        
                        
                        5.98
                        %
                        
                        $
                        430,683
                        
                        
                        $
                        35,661
                        
                        
                        
                        8.28
                        %
                        
                        $
                        314,610
                        
                        
                        $
                        26,237
                        
                        
                        
                        8.34
                        %Mortgage
      loans held for sale
                        
                        
                        11,834
                        
                        
                        
                        703
                        
                        
                        
                        5.92
                        %
                        
                        
                        10,384
                        
                        
                        
                        668
                        
                        
                        
                        6.43
                        %
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Investment
      securities
                        
                        
                        73,371
                        
                        
                        
                        3,477
                        
                        
                        
                        4.73
                        %
                        
                        
                        69,785
                        
                        
                        
                        3,293
                        
                        
                        
                        4.72
                        %
                        
                        
                        52,423
                        
                        
                        
                        2,329
                        
                        
                        
                        4.44
                        %Federal
      funds sold and other
                        
                        
                        12,297
                        
                        
                        
                        306
                        
                        
                        
                        2.48
                        %
                        
                        
                        5,905
                        
                        
                        
                        346
                        
                        
                        
                        5.86
                        %
                        
                        
                        6,220
                        
                        
                        
                        320
                        
                        
                        
                        5.14
                        %Total
      interest-earning assets
                        
                        $
                        779,940
                        
                        
                        $
                        45,387
                        
                        
                        
                        5.80
                        %
                        
                        $
                        516,757
                        
                        
                        $
                        39,968
                        
                        
                        
                        7.73
                        %
                        
                        $
                        373,253
                        
                        
                        $
                        28,886
                        
                        
                        
                        7.74
                        %Time
      deposits
                        
                        $
                        435,285
                        
                        
                        $
                        18,038
                        
                        
                        
                        4.13
                        %
                        
                        $
                        272,730
                        
                        
                        $
                        13,940
                        
                        
                        
                        5.11
                        %
                        
                        $
                        201,957
                        
                        
                        $
                        9,129
                        
                        
                        
                        4.52
                        %Savings
      & money market
                        
                        
                        121,919
                        
                        
                        
                        3,199
                        
                        
                        
                        2.62
                        %
                        
                        
                        76,184
                        
                        
                        
                        3,445
                        
                        
                        
                        4.52
                        %
                        
                        
                        57,962
                        
                        
                        
                        2,331
                        
                        
                        
                        4.02
                        %NOW
      accounts
                        
                        
                        43,666
                        
                        
                        
                        802
                        
                        
                        
                        1.83
                        %
                        
                        
                        45,285
                        
                        
                        
                        1,487
                        
                        
                        
                        3.28
                        %
                        
                        
                        25,603
                        
                        
                        
                        674
                        
                        
                        
                        2.63
                        %FHLB
      advances
                        
                        
                        60,538
                        
                        
                        
                        2,060
                        
                        
                        
                        3.39
                        %
                        
                        
                        41,014
                        
                        
                        
                        1,957
                        
                        
                        
                        4.77
                        %
                        
                        
                        33,421
                        
                        
                        
                        1,570
                        
                        
                        
                        4.70
                        %Junior
      subordinated debentures
                        
                        
                        13,403
                        
                        
                        
                        740
                        
                        
                        
                        5.51
                        %
                        
                        
                        13,403
                        
                        
                        
                        1,025
                        
                        
                        
                        7.65
                        %
                        
                        
                        11,663
                        
                        
                        
                        877
                        
                        
                        
                        7.52
                        %Federal
      funds purchased andshort-term
      borrowings
                        
                        
                        19,365
                        
                        
                        
                        540
                        
                        
                        
                        2.78
                        %
                        
                        
                        10,864
                        
                        
                        
                        611
                        
                        
                        
                        5.63
                        %
                        
                        
                        2,612
                        
                        
                        
                        144
                        
                        
                        
                        5.51
                        %Total
      interest-bearing liabilities
                        
                        $
                        694,176
                        
                        
                        $
                        25,379
                        
                        
                        
                        3.65
                        %
                        
                        $
                        459,480
                        
                        
                        $
                        22,465
                        
                        
                        
                        4.89
                        %
                        
                        $
                        333,218
                        
                        
                        $
                        14,725
                        
                        
                        
                        4.42
                        %Net
      interest spread
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2.15
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        2.84
                        %
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        3.32
                        %Net
      interest income/margin
                        
                        
                        
                        
                        
                        $
                        20,008
                        
                        
                        
                        2.57
                        %
                        
                        
                        
                        
                        
                        $
                        17,503
                        
                        
                        
                        3.39
                        %
                        
                        
                        
                        
                        
                        $
                        14,161
                        
                        
                        
                        3.79
                        %Noninterest-bearing
      demand deposits
                        
                        $
                        41,920
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        32,588
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        23,056





The net
interest spread, which is the difference between the rate we earn on
interest-earning assets and the rate we pay on interest-bearing liabilities, was
2.15% for the year ended December 31, 2008, compared to 2.84% for the year
ended December 31, 2007 and 3.32% for the year ended December 31,
2006.  Our consolidated net interest margin, which is net interest
income divided by average interest-earning assets for the period, was 2.57% for
the year ended December 31, 2008, as compared to 3.39% for the year ended
December 31, 2007 and 3.79% for the year ended December 31,
2006.





The
decrease in our net interest spread and our net interest margin from 2007 to
2008 was principally due to the faster decrease in yields on average
interest-earning assets relative to the repricing of our average
interest-bearing liabilities following the decreases in the prime rate during
2007 and 2008. We anticipate that loans will continue to remain level throughout
2009, as we strive to improve our net interest income by managing our cost of
funds. Changes in interest rates paid on assets and liabilities, the rate of
growth of the asset and liability base, the ratio of interest-earning assets to
interest-bearing liabilities and management of the balance sheet’s interest rate
sensitivity all factor into changes in net interest income. Therefore, improving
our net interest income in the current challenging market will continue to
require deliberate and attentive management.




47




Analysis
of Changes in Net Interest Income





Net
interest income can be analyzed in terms of the impact of changing interest
rates and changing volume.  The following table sets forth the effect
that the varying levels of interest-earning assets and interest-bearing
liabilities and the applicable rates have had on changes in net interest income
for the periods presented (dollars in thousands).




Changes
      in Net Interest IncomeFor
      the Years Ended
                        December
      31, 2008 vs. 2007
                        Increase
      (Decrease) Due to
                      
                      
                      For
      the Years Ended
                        December
      31, 2007 vs. 2006
                        Increase
      (Decrease) Due to
                      
                      
                      For
      the Years Ended
                        December
      31, 2006 vs. 2005
                        Increase
      (Decrease) Due toOne-Day
                        Difference (2)Volume
                      
                      
                      Rate
                      
                      
                      Total
                      
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      Total
                      
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      TotalInterest-Earning
      AssetsFederal
      funds sold and other
                      
                      $
                      376
                      
                      
                      $
                      (417
                      )
                      
                      $
                      1
                      
                      
                      $
                      (40
                      )
                      
                      $
                      (42
                      )
                      
                      $
                      122
                      
                      
                      $
                      80
                      
                      
                      $
                      (68
                      )
                      
                      $
                      89
                      
                      
                      $
                      21Investment
      securities
                      
                      
                      170
                      
                      
                      
                      5
                      
                      
                      
                      9
                      
                      
                      
                      184
                      
                      
                      
                      664
                      
                      
                      
                      989
                      
                      
                      
                      1,653
                      
                      
                      
                      507
                      
                      
                      
                      240
                      
                      
                      
                      748Mortgage
      loans held for sale
                      
                      
                      93
                      
                      
                      
                      (60
                      )
                      
                      
                      2
                      
                      
                      
                      35
                      
                      
                      
                      668
                      
                      
                      
                      -
                      
                      
                      
                      668
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Loans(1)
                      
                      
                      20,902
                      
                      
                      
                      (15,760
                      )
                      
                      
                      98
                      
                      
                      
                      5,240
                      
                      
                      
                      8,052
                      
                      
                      
                      9,151
                      
                      
                      
                      17,203
                      
                      
                      
                      6,444
                      
                      
                      
                      4,329
                      
                      
                      
                      10,776Total
      interest-earning assets
                      
                      $
                      21,541
                      
                      
                      $
                      (16,232
                      )
                      
                      $
                      110
                      
                      
                      $
                      5,419
                      
                      
                      $
                      9,342
                      
                      
                      $
                      10,262
                      
                      
                      $
                      19,604
                      
                      
                      $
                      6,883
                      
                      
                      $
                      4,658
                      
                      
                      $
                      11,545Interest-Bearing
      LiabilitiesDeposits
                      
                      $
                      10,353
                      
                      
                      $
                      (7,236
                      )
                      
                      $
                      51
                      
                      
                      $
                      3,168
                      
                      
                      $
                      3,452
                      
                      
                      $
                      6,988
                      
                      
                      $
                      10,440
                      
                      
                      $
                      2,469
                      
                      
                      $
                      3,180
                      
                      
                      $
                      5,649FHLB
      advances
                      
                      
                      935
                      
                      
                      
                      (837
                      )
                      
                      
                      5
                      
                      
                      
                      103
                      
                      
                      
                      331
                      
                      
                      
                      548
                      
                      
                      
                      879
                      
                      
                      
                      181
                      
                      
                      
                      465
                      
                      
                      
                      645Federal
      funds purchased
                      
                      
                      480
                      
                      
                      
                      (554
                      )
                      
                      
                      2
                      
                      
                      
                      (72
                      )
                      
                      
                      354
                      
                      
                      
                      169
                      
                      
                      
                      523
                      
                      
                      
                      39
                      
                      
                      
                      65
                      
                      
                      
                      104Junior
      subordinated debentures
                      
                      
                      -
                      
                      
                      
                      (288
                      )
                      
                      
                      3
                      
                      
                      
                      (285
                      )
                      
                      
                      132
                      
                      
                      
                      273
                      
                      
                      
                      405
                      
                      
                      
                      336
                      
                      
                      
                      162
                      
                      
                      
                      497Total
      interest-bearing liabilities
                      
                      $
                      11,768
                      
                      
                      
                      (8,915
                      )
                      
                      
                      61
                      
                      
                      
                      2,914
                      
                      
                      $
                      4,269
                      
                      
                      
                      7,978
                      
                      
                      
                      12,247
                      
                      
                      $
                      3,025
                      
                      
                      $
                      3,872
                      
                      
                      $
                      6,895Net
      interest income
                      
                      $
                      9,773
                      
                      
                      $
                      (7,317
                      )
                      
                      $
                      49
                      
                      
                      $
                      2,505
                      
                      
                      $
                      5,073
                      
                      
                      $
                      2,284
                      
                      
                      $
                      7,357
                      
                      
                      $
                      3,858
                      
                      
                      $
                      786
                      
                      
                      $
                      4,650








(1)
            Loan
      fees, which are not material for any of the periods shown, have been
      included for rate calculation
purposes.





Provision
      for Loan Losses





At the
end of each quarter or more often, if necessary, we analyze the collectability
of our loans and accordingly adjust the loan loss allowance to an appropriate
level.  Our loan loss allowance covers estimated credit losses on
individually evaluated loans that are determined to be impaired, as well as
estimated credit losses inherent in the remainder of the loan
portfolio.  We strive to follow a comprehensive, well-documented, and
consistently applied analysis of our loan portfolio in determining an
appropriate level for the loan loss allowance.  We consider what we
believe are all significant factors that affect the collectability of the
portfolio and support the credit losses estimated by this process.  We
believe we have an effective loan review system and controls (including an
effective loan grading system) designed to identify, monitor, and address asset
quality problems in an accurate and timely manner.  We evaluate any
loss estimation model before it is employed and document inherent assumptions
and adjustments.  We promptly charge off loans that we determine are
uncollectible.  It is essential that we maintain an effective loan
review system that works to ensure the accuracy of our internal grading system
and, thus, the quality of the information used to assess the appropriateness of
the loan loss allowance.  Our board of directors is responsible for
overseeing management’s significant judgments and estimates pertaining to the
determination of an appropriate loan loss allowance by reviewing and approving
the institution’s written loan loss allowance policies, procedures and model
quarterly.





In
arriving at our loan loss allowance, we consider those qualitative or
environmental factors that are likely to cause credit losses, as well as our
historical loss experience.  Because of our relatively short history,
we also factor in a five-year trend of peer data on historical
losses.  In addition, as part of our model, we consider changes in
lending policies and procedures, including changes in underwriting standards,
and collection, chargeoff, and recovery practices not considered elsewhere in
estimating credit losses, as well as changes in regional and local economic and
business conditions.  Further, we factor in changes in the nature and
volume of the portfolio and in the terms of loans, changes in the experience,
ability, and depth of lending management and other relevant staff, the volume of
past due and nonaccrual loans, as well as adversely graded loans, changes in the
value of underlying collateral for collateral-dependent loans, and the existence
and effect of any concentrations of credit.  Please see the discussion
below under “Allowance for Loan Losses” for a description of the factors we
consider in determining the amount of the provision we expense each period to
maintain this allowance.





Our
provision for loan losses was $20.5 million, $1.4 million and $1.2 million for
the years ended December 31, 2008, 2007 and 2006,
respectively.  The percentage of allowance for loan losses was
increased to 3.32% of gross
loans outstanding as of December 31, 2008, from 1.04% as of December 31, 2007.
Also included in the allowance for loan losses as of December 31, 2008, is $2.9
million added from the acquisition of Carolina National.  The
allowance has been recorded based on management’s ongoing evaluation of inherent
risk and estimates of probable credit losses within the loan
portfolio.  Management believes that specific reserves have been
allocated in its allowance for loan losses as of December 31, 2008 related to
the nonperforming assets and other nonaccrual loans that it believes will offset
losses it anticipates may arise from less than full recovery of the loans from
the supporting collateral.  No assurances can be given in this regard,
however, especially considering the overall weakness in the commercial real
estate market.




48




The
recent downturn in the real estate market has resulted in increased loan
delinquencies, defaults and foreclosures, primarily in our residential real
estate portfolio, and we believe that these trends are likely to
continue.  In some cases, this downturn has resulted in a significant
impairment to the value of our collateral and our ability to sell the collateral
upon foreclosure, and there is a risk that this trend will
continue.  The real estate collateral in each case provides an
alternate source of repayment in the event of default by the borrower and may
deteriorate in value during the time the credit is extended.  If real
estate values continue to decline, it is also more likely that we would be
required to increase our allowance for loan losses.  If during a
period of reduced real estate values we are required to liquidate the property
collateralizing a loan to satisfy the debt or to increase the allowance for loan
losses, it could materially reduce our profitability and adversely affect our
financial condition.  This downturn in the real estate market has
resulted in an increase in our nonperforming loans, and there is a risk that
this trend will continue, which could result in a net loss of earnings and an
increase in our provision for loan losses and loan chargeoffs, all of which
could have a material adverse effect on our financial condition and results of
operations.





As of
December 31, 2008 and December 31, 2007, nonperforming assets (nonperforming
loans plus other real estate owned) were $75.5 million and $14.3 million,
respectively.  The $75.5 million in nonperforming assets as of
December 31, 2008, included $1.7 million in nonperforming assets related to the
acquisition of Carolina National.  The $1.7 million in nonperforming
assets acquired from Carolina National have been recorded at their net
realizable value as of the merger date of January 31, 2008.  Foregone
interest income on these nonaccrual loans and other nonaccrual loans charged off
during the years ended December 31, 2008 and 2007, was approximately $1,139,000
and $139,000, respectively.  There were no loans contractually past
due in excess of 90 days and still accruing interest at December 31, 2008 and
2007.  There were impaired loans, under the criteria defined in FAS
114, of $69.1 million and $12.0 million with related valuation allowances of
$8.3 million, net of $4.5 million in chargeoffs during 2008 and $655,000 at
December 31, 2008 and 2007, respectively.





Noninterest
Income





The
following table sets forth information related to the various components of our
noninterest income (dollars in thousands).




Years
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Mortgage
      banking income
                    
                    $
                    2,251
                    
                    
                    $
                    1,858
                    
                    
                    $
                    -Service
      charges and fees on deposit accounts
                    
                    
                    1,766
                    
                    
                    
                    1,270
                    
                    
                    
                    1,080Gain
      on sale of investment securities
                    
                    
                    207
                    
                    
                    
                    117
                    
                    
                    
                    33Other
                    
                    
                    796
                    
                    
                    
                    906
                    
                    
                    
                    966Total
      noninterest income
                    
                    $
                    5,020
                    
                    
                    $
                    4,151
                    
                    
                    $
                    2,079





Noninterest
income was $5.0 million for the year ended December 31, 2008 as compared to $4.2
million for the year ended December 31, 2007, an increase of
$800,000.  This increase for the year ended December 31, 2008,
compared to the year ended December 31, 2007, occurred primarily due to
increases in service charges and fees on deposit accounts resulting from growth
in the number of deposit accounts. The income generated by the origination and
sale of residential mortgages for the year ended December 31, 2008 increased by
$393,000, or 21.2%, as compared to $1.9 million earned for the year ended
December 31, 2007.




Noninterest income for the year ended
December 31, 2007 was $4.2 million, a net increase of almost 100% compared
to noninterest income of $2.1 million during the same period in
2006.  This increase is primarily due to income earned from fees and
premiums from the wholesale mortgage division, which was formed on January 29,
2007 and generated fee income of $1.9 million during the year ended December 31,
2007.  This fee income represented 90.0% of the total noninterest
income increase of $2.1 million.  In addition, service charges and
fees on deposit accounts increased by $190,000, or 17.6%, from 2006 to 2007,
resulting from the growth in the number of deposit accounts.





Noninterest
Expenses





The
following table sets forth information related to the various components of our
noninterest expenses (dollars in thousands).




49




Years
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Goodwill
      impairment
                    
                    $
                    28,732
                    
                    
                    $
                    -
                    
                    
                    $
                    -Salaries
      and employee benefits
                    
                    
                    11,429
                    
                    
                    
                    7,876
                    
                    
                    
                    5,128Occupancy
      and equipment
                    
                    
                    3,375
                    
                    
                    
                    2,030
                    
                    
                    
                    1,046Other
      real estate owned expense
                    
                    
                    1,757
                    
                    
                    
                    31
                    
                    
                    
                    -Data
      processing and ATM expense
                    
                    
                    1,303
                    
                    
                    
                    702
                    
                    
                    
                    587Public
      relations
                    
                    
                    708
                    
                    
                    
                    635
                    
                    
                    
                    541Telephone
      and supplies
                    
                    
                    675
                    
                    
                    
                    426
                    
                    
                    
                    295Professional
      fees
                    
                    
                    589
                    
                    
                    
                    513
                    
                    
                    
                    183Loan
      related expenses
                    
                    
                    534
                    
                    
                    
                    409
                    
                    
                    
                    114FDIC
      insurance
                    
                    
                    529
                    
                    
                    
                    331
                    
                    
                    
                    35Other
                    
                    
                    2,018
                    
                    
                    
                    1,206
                    
                    
                    
                    972Total
      noninterest expense
                    
                    $
                    51,649
                    
                    
                    $
                    14,159
                    
                    
                    $
                    8,901




Noninterest expense was
$51.6 million for 2008, as compared to $14.2 million in 2007, an increase of
264.8%.We recorded an after-tax noncash accounting charge of
$28.7 million during the fourth quarter of 2008 as a result of our annual
testing of goodwill for impairment as required by accounting
standards.  The impairment analysis was negatively impacted by the
unprecedented weakness in the financial markets. The first step of the goodwill
impairment analysis involves estimating a hypothetical fair value and comparing
that with the carrying amount or book value of the entity; our initial
comparison suggested that the carrying amount of goodwill exceeded its implied
fair value due to our low stock price, consistent with that of most
publicly-traded financial institutions.  Therefore, we were required
to perform the second step of the analysis to determine the amount of the
impairment.  We prepared a discounted cash flow analysis which
established the estimated fair value of the entity and conducted a full
valuation of the net assets of the entity.  Following these
procedures, we determined that no amount of the net asset value could be
allocated to goodwill and we recorded the impairment to the goodwill balance as
a noncash accounting charge to our earnings in 2008.





The other
significant item included in noninterest expense is salaries and employee
benefits, which totaled $11.4 million, $7.9 million and $5.1 million for the
years ended December 31, 2008, 2007 and 2006, respectively.  This
increase reflects the cost of personnel to support our expansion into new
markets, including our addition of four full-service branches in the Columbia
market with the acquisition of Carolina National on January 31,
2008.  The year ended December 31, 2008 also reflects a full twelve
months of expenses for the three full-service branches added throughout
2007.  In addition, we added our twelfth full-service branch, our
fifth in the Columbia market, in Lexington, South Carolina, in July of
2008.





Noninterest
expense was $14.2 million for 2007, as compared to $8.9 million in 2006, an
increase of $5.3 million. The majority of the 59.1% increase reflects the cost
of salaries and other variable expenses that have grown to support our expansion
efforts.  The most significant item included in noninterest expense is
salaries and employee benefits, which totaled $7.9 million for the twelve months
ended December 31, 2007, as compared to $5.1 million for the same period in
2006, an increase of 54.9%.  This increase reflects the cost of
personnel to support our expansion into new markets, particularly our Greenville
full-service branch, the Rock Hill loan production office and our wholesale
mortgage division, all new cost centers since the year ended December 31,
2006.





Occupancy
and equipment expenses were $3.4 million, $2.0 million and $1.0 million for the
years ended December 31, 2008, 2007 and 2006, respectively. The 66.3% increase,
or $1.3 million, comparing 2008 and 2007 reflects expenses for a full twelve
months for the Greer full-service branch, the Greenville and East Bay market
headquarters, and the Spartanburg home office expansion, all completed during
2007.  In addition, costs of the four new Columbia area full-service
branches added to our branch network on January 31, 2008, are reflected in the
year ended December 31, 2008, as well as the costs of the fifth Columbia market
full-service branch in Lexington, which opened in July 2008.





Other
real estate owned expense increased by $1,726,000, from $31,000 for the year
ended December 31, 2007 to $1,757,000 for the year ended December 31,
2008.  This expense includes costs incurred to maintain properties we
have foreclosed on, including property taxes and insurance, utilities, property
renovations and maintenance.  This amount also includes writedowns of
$1,562,000 to the carrying value of these foreclosed properties as market
conditions have changed subsequent to the foreclosure action. The repossessed
collateral is made up of single-family residential properties in varying stages
of completion and various commercial properties.  These properties are
being actively marketed and maintained with the primary objective of liquidating
the collateral at a level which most accurately approximates fair market value
and allows recovery of as much of the unpaid principal balance as possible upon
the sale of the property in a reasonable period of time.




50




Data
processing and ATM expenses were $1.3 million and $702,000 for the years ended
December 31, 2008 and 2007, respectively.  The majority of the
increase of 85.6% reflects the increased costs associated with growth in
customer transaction processing due to the increasing number of loan and deposit
accounts in our customer base.  We have contracted with an outside
computer service company to provide our core data processing
services.  A significant portion of the fee charged by the third party
processor is directly related to the number of loan and deposit accounts and the
related number of transactions.  The growth in loan and deposit
accounts is primarily due to the acquisition of Carolina National, and also due
to the increased customer base resulting from the full-service branches added
throughout 2007. Data processing and ATM expenses were $702,000 and
$587,000 for the years ended December 31, 2007 and 2006,
respectively.  The majority of the increase of 19.6% in 2007 reflects
the increased costs associated with growth in customer transaction processing
due to the increasing number of loan and deposit accounts in our customer
base.





Public
relations expense increased slightly by 11.5%, or $73,000, to $708,000 for the
year ended December 31, 2008, as compared to $635,000 for the same period in
2007.  During 2008, we implemented a rebranding project, which we
began developing in the fourth quarter of 2007.  The rebranding, which
debuted publicly in the third quarter of 2008, will drive all our future
marketing endeavors.  Public relations expense increased by 17.4% to
$635,000 for 2007, as compared to $541,000 in 2006, primarily due to increased
community relations expenditures and continued expansion of print and television
media advertising as a result of our increasing customer base and expansion into
the Charleston, Columbia, Greenville and Rock Hill markets.





Professional
fees increased by $76,000, or 14.8%, from 2007 to 2008, and $330,000, or 180.3%,
from 2006 to 2007.  The increased from 2006 to 2007 reflect costs
related to our preparation for the compliance with the requirements outlined by
Section 404 of the Sarbanes-Oxley Act of 2002.  We had hired an
outside consultant to assist us in this process.  In addition, the
year ended December 31, 2007 reflected increased expenses for the services of
our third party internal auditor for various department and branch audits and
for the services of our third party loan reviewer.  The bank-employed
internal auditor position was vacant for most of 2007, causing our increased
reliance on the third party provider, compared to the year ended December 31,
2006.  During the third quarter of 2007, we hired a bank-employed
internal auditor, whose role helped decrease reliance on our third party
provider.  Our bank’s expansion and the continual focus on loan
quality, internal controls and performance drove these increased costs during
the year ended December 31, 2007.





The years
ended December 31, 2008 and 2007 also included an additional expense for FDIC
insurance premiums, which were reinstituted during 2007 and reflect the growth
in our deposits of $529,000 and $331,000, respectively, compared to $35,000 for
the year ended December 31, 2006.





Included
in the line item “other,” which increased $812,000, or 67.3%, between 2008 and
2007 and $234,000, or 24.1%, between 2007 and 2006, are charges for fees paid to
our board of directors and our newly formed regional boards in the Greenville
and Columbia markets in 2008; postage, printing and stationery expenses; and
various customer-related expenses. Also included in other noninterest expenses
for the year ended December 31, 2008 were increased regulatory fees of $64,000
and $164,000 in bond and property insurance-related insurance premiums of
$63,000, due to the addition of three full-service branches throughout 2007, as
well as the acquisition of Carolina National effective January 31,
2008.   Finally, the amortization of intangibles related to the
acquisition totaled $146,000 for the year ended December 31, 2008.





Although
we recognize the importance of controlling noninterest expenses to improve
profitability, we remain committed to attracting and retaining a team of
seasoned and well-trained officers and staff, maintaining highly technical
operations support functions, and further developing a professional marketing
program.





Income
tax expense can be analyzed as a percentage of net income before income
taxes.  The following table sets forth information related to our
income tax expense (dollars in thousands).




Years
      ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Income
      tax expense/(benefit)
                  
                  $
                  (2,234
                  )
                  
                  $
                  2,039
                  
                  
                  $
                  2,095Net
      income/(loss) before income taxes
                  
                  
                  (47,081
                  )
                  
                  
                  6,099
                  
                  
                  
                  6,147Effective
      income tax rate
                  
                  
                  4.75
                  %
                  
                  
                  33.43
                  %
                  
                  
                  34.00
                  %





Our
effective tax rate for 2008 decreased from 2007.  The deferred tax
expense recognized to record the valuation allowance against the deferred tax
asset as of December 31, 2008 partially offset the deferred tax benefit
recognized to reflect the impact of nontaxable income in addition to the tax
benefit of the net operating loss reflected for the year ended December 31,
2008.  Our effective tax rate for 2007 was consistent with
2006.




51




Balance
Sheet Review





General





As of
December 31, 2008, we had total assets of $812.7 million, an increase of $226.2
million, or 38.6%, over total assets of $586.5 million on December 31,
2007.  Of this $226.2 million increase, $220.9 million was attributable to
the acquisition of Carolina National.  Total assets on December 31,
2008, and December 31, 2007, consisted of loans including mortgage loans
held for sale and net of unearned income and allowance for loan losses of $709.3
million and $494.1 million, respectively; securities available for sale of $81.7
million and $70.5 million, respectively; other assets of $29.5 million and $15.4
million, respectively; premises and equipment, net accumulated depreciation and
amortization of $7.6 million and $3.0 million, respectively; and cash and cash
equivalents of $7.7 million and $8.4 million, respectively.  Total
loans include $203.3 million from the acquisition of Carolina
National.





Our
interest-earning assets, consisting of total loans net of unearned income,
securities available for sale and interest-bearing bank balances, grew to $801.8
million as of December 31, 2008, or an increase of 41.0% over the balance of
$568.8 million as of December 31, 2007.  As of December 31, 2008
and December 31, 2007, short-term overnight investments in interest-bearing
bank balances comprised less than 1% of total interest-earning assets of $801.8
million and $568.8 million, respectively.  Although the loan portfolio
grew in the year ended December 31, 2008, the majority of the increase was due
to the acquisition of Carolina National, with loan production for the
twelve-month period diminished compared to the twelve-month period ended
December 31, 2007. The continued deterioration in the South Carolina real estate
markets and the volatile economy in general support restraint in the current
growth strategy for our loan portfolio.





Also
included in interest-earning assets as of December 31, 2008 are mortgage loans
held for sale, an asset resulting from the addition of the wholesale mortgage
division effective January 29, 2007.  During the twelve months ended
December 31, 2008, our wholesale mortgage division, combined with our previously
existing retail mortgage staff, originated a total of approximately $318 million
in loans to be sold to secondary market investors.  Of the loans held
for sale, approximately $321 million had been sold as of December 31, 2008, with
approximately $16.4 million remaining on the balance sheet as mortgage loans
held for sale.  The activity for the wholesale mortgage division
during its initial reporting period, the twelve months ended December 31, 2007,
represented an investment of funds, as the loans generated during the period
outweighed the loans sold during the period by approximately $19.4
million.  Due to the nature of this division, the loans held for sale
typically are held for a seven- to ten-day period.  Therefore, the
liquidity needs of this activity have leveled off, as the ongoing activity of
the wholesale mortgage division has begun to provide for funding of future loans
with the proceeds from the sale of loans in the existing portfolio.





Premises
and equipment increased by $4.6 million, net of purchases and depreciation
expense as of December 31, 2008, in part due to the acquisition of Carolina
National whose Columbia area properties represented $1.3 million as of December
31, 2008.  The remaining $3.1 million represented the purchase of a
1.4 acre outparcel of land and the costs of the related construction that is
underway on our future York County market headquarters in the Tega Cay community
of Fort Mill, South Carolina, the purchase of land and costs associated with the
extension of the parking area adjacent to the home office in Spartanburg, and
approximately $1.1 million in construction costs for the new Lexington branch,
which opened in July 2008.





For the
year ended December 31, 2008, our interest-bearing deposits included
wholesale funding in the form of brokered CDs of approximately $150.2
million.  We generally obtain out-of-market time deposits of $100,000
or more through brokers with whom we maintain ongoing
relationships.  The guidelines governing our participation in brokered
CD programs are part of our Asset Liability Management Program Policy, which is
reviewed, revised and approved annually by our Asset Liability
Committee.  These guidelines place limits on our brokered CDs as a
percentage of total assets, dictate that our current interest rate risk profile
determines the terms of brokered CDs and that we only accept brokered CDs from
approved correspondents.  In addition, we do not generally obtain time
deposits of $100,000 or more through the Internet.  These guidelines
allow us to take advantage of the attractive terms that wholesale funding can
offer while mitigating the inherent related risk.





Our
liabilities on December 31, 2008, were $772.1 million, an increase of 43.3%
over liabilities as of December 31, 2007 of $539.0 million, and consisted
primarily of $646.8 million in deposits, $86.3 million in FHLB advances, $13.4
million in junior subordinated debentures, and $9.5 million in long-term
debt.  The deposit growth includes approximately $187.3 in deposits
from the acquisition of Carolina National.  While we have historically
used federal funds as a reliable source of short-term funding, we have
increasingly focused on growing our core deposit base to enhance our
liquidity.  Marketing efforts, such as a new branding initiative
launched in August 2008 and a targeted officer calling program, are being
actively managed and continue to support this objective.




52




Shareholders’
equity on December 31, 2008, was $40.6 million, as compared to shareholders’
equity on December 31, 2007, of $47.6 million.  The slight
increase between December 31, 2007 and December 31, 2008, reflects the
additional 2.7 million common shares issued to the former Carolina National
shareholders as of January 31, 2008.  This increase was partially
offset by the loss recognized for the year ended December 31, 2008, primarily
made up of the chargeoff of goodwill recognized during 2008 in connection with
the merger transaction.  In addition, the unrealized gain on our
securities portfolio increased.   Also, we utilized cash to
purchase shares under our share repurchase program and for cash dividends on our
preferred stock.





Investments





On
December 31, 2008 and 2007, our investment securities portfolio of $81.7
and $70.5 million, respectively, represented approximately 12.4% of our
interest-earning assets.  As of December 31, 2008 and 2007, we
were invested in U.S. Government agency securities, mortgage-backed securities,
and municipal securities with an amortized cost of $80.8 million and $70.5
million, respectively, for an unrealized gain of $861,000 and an unrealized gain
of $56,000, respectively.   As a result of the growth in our loan
portfolio and the historically low fixed rates during the past several years, we
have maintained a lower than normal level of investments.





Fair
values and yields on our investments (all available for sale) as of
December 31, 2008, are shown in the following table based on contractual
maturity dates.  Expected maturities may differ from contractual
maturities because issuers may have the right to call or prepay obligations with
or without call or prepayment penalties.  Yields on municipal
securities are presented on a tax equivalent basis (dollars in
thousands).




As
      of December 31, 2008Within
      one year
                  
                  
                  After
      one but within
                    five
      years
                  
                  
                  After
      five but within
                    ten
      years
                  
                  
                  Over
      ten years
                  
                  
                  TotalAmount
                  
                  
                  Yield
                  
                  
                  Amount
                  
                  
                  Yield
                  
                  
                  Amount
                  
                  
                  Yield
                  
                  
                  Amount
                  
                  
                  Yield
                  
                  
                  Amount
                  
                  
                  YieldU.S.
      Government/government sponsored agencies
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  4,013
                  
                  
                  
                  5.00
                  %
                  
                  $
                  4,013
                  
                  
                  
                  5.10
                  %Mortgage-backed
      securities
                  
                  
                  106
                  
                  
                  
                  5.00
                  %
                  
                  
                  4,117
                  
                  
                  
                  4.24
                  %
                  
                  
                  1,284
                  
                  
                  
                  4.20
                  %
                  
                  
                  52,663
                  
                  
                  
                  5.18
                  %
                  
                  
                  58,170
                  
                  
                  
                  5.09
                  %Municipal
      securities
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,359
                  
                  
                  
                  2.92
                  %
                  
                  
                  5,695
                  
                  
                  
                  3.84
                  %
                  
                  
                  12,425
                  
                  
                  
                  3.52
                  %
                  
                  
                  19,479
                  
                  
                  
                  3.57
                  %Total
                  
                  $
                  106
                  
                  
                  
                  5.00
                  %
                  
                  $
                  5,476
                  
                  
                  
                  3.91
                  %
                  
                  $
                  6,979
                  
                  
                  
                  3.70
                  %
                  
                  $
                  69,101
                  
                  
                  
                  4.88
                  %
                  
                  $
                  81,662
                  
                  
                  
                  4.73
                  %





The amortized cost and fair value of
our investments (all available for sale) as of December 31, 2008, 2007 and
2006 are shown in the following table (dollars in thousands).





December
      31, 2008
                  
                  
                  December
      31, 2007Amortized
                  
                  
                  Fair
                  
                  
                  Amortized
                  
                  
                  FairCost
                  
                  
                  Value
                  
                  
                  Cost
                  
                  
                  ValueU.S.
      Government/government sponsored agencies
                  
                  $
                  3,950
                  
                  
                  $
                  4,013
                  
                  
                  $
                  10,635
                  
                  
                  $
                  10,567Mortgage-backed
      securities
                  
                  
                  56,971
                  
                  
                  
                  58,170
                  
                  
                  
                  42,891
                  
                  
                  
                  43,041Municipal
      securities
                  
                  
                  19,880
                  
                  
                  
                  19,479
                  
                  
                  
                  16,948
                  
                  
                  
                  16,922Total
                  
                  $
                  80,801
                  
                  
                  $
                  81,662
                  
                  
                  $
                  70,474
                  
                  
                  $
                  70,530





We
also maintain certain equity investments required by law that are included in
the consolidated balance sheets as “Other assets.”  The carrying
amounts of these investments as of December 31, 2008, 2007 and 2006
consisted of the following:





As
      of December 31,2008
                  
                  
                  2007Federal
      Reserve Bank stock
                  
                  $
                  1,821
                  
                  
                  $
                  966Federal
      Home Loan Bank stock
                  
                  
                  5,344
                  
                  
                  
                  2,721





The level
of FHLB stock varies with the level of FHLB advances and increased during the
year ended December 31, 2008, to reflect the net increase in FHLB advances
during the year.  The level of Federal Reserve Bank (“FRB”) stock is
tied to our equity and was increased in connection with the Carolina National
merger.




53




No ready
market exists for these stocks and they have no quoted market value. However,
redemption of these stocks has historically been at par value. Accordingly, we
believe the carrying amounts are a reasonable estimate of fair value. Other Assets





As of
December 31, 2008, other assets had grown to $29.5 million from $15.4 million as
of December 31, 2007, an increase of 91.6%.  Included in other assets
are bank owned life insurance (“BOLI”), interest receivable on loans and
investment securities, investments in other banks, as discussed in “Investments”
above, and other miscellaneous assets.  While BOLI growth has been
marginal, deferred taxes grew $3.7 million, or 322.6%, and investments in bank
stock grew $3.5 million, or 91.4%, each compared to December 31,
2007.  Interest receivable and investments in bank stock each grow in
tandem with their related assets, the loan and investment portfolios, and FHLB
advances and our bank’s capital, respectively.





Within
other assets, the category other real estate owned grew significantly, from $2.3
million at December 31, 2007, to $6.4 million at December 31, 2008, including
the addition of Carolina National’s other real estate owned.  The
balance in other real estate owned consists of property acquired through
foreclosure.  The transfer of these properties represents the next
logical step from their previous classification as nonperforming loans to other
real estate owned to give us the ability to control the
properties.  The repossessed collateral is primarily made up of
single-family residential properties in varying stages of completion and is
concentrated in two loan relationships with local real estate
developers.  These properties are being actively marketed and
maintained with the primary objective of liquidating the collateral at a level
which most accurately approximates fair market value and allows recovery of as
much of the unpaid principal balance as possible upon the sale of the property
in a reasonable period of time.  The carrying value of these assets is
believed to be representative of their fair market value, although there can be
no assurance that the ultimate proceeds from the sale of these assets will be
equal to or greater than the carrying values.





Loans





Since
loans typically provide higher interest yields than do other types of
interest-earning assets, we invest a substantial percentage of our earning
assets in our loan portfolio.  Average loans for the years ended
December 31, 2008 and 2007were $682.4 million and $430.7 million,
respectively.  Total loans outstanding as of December 31, 2008 and
2007 were $709.3 million and $494.1 million, respectively, before the allowance
for loan losses.  Beginning in 2007, total loans includes wholesale
mortgages held for sale, pending their sale on the secondary
market.   Included in the $709.3 million total loans at December
31, 2008 was $16.4 million in wholesale mortgages held for sale.




54




The
following table summarizes the composition of our loan portfolio for each of the
five years ended December 31, 2008, (dollars in thousands):





2008
                                                          
                                                          
                                                          2007
                                                          
                                                          
                                                          2006
                                                          
                                                          
                                                          2005
                                                          
                                                          
                                                          2004Amount
                                                          
                                                          
                                                          %
      of Total
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          %
      of Total
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          %
      of Total
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          %
      of Total
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          %
      of TotalCommercial
      and industrial
                                                          
                                                          $
                                                          48,432
                                                          
                                                          
                                                          
                                                          6.83
                                                          %
                                                          
                                                          $
                                                          34,435
                                                          
                                                          
                                                          
                                                          6.97
                                                          %
                                                          
                                                          $
                                                          25,604
                                                          
                                                          
                                                          
                                                          6.75
                                                          %
                                                          
                                                          $
                                                          20,902
                                                          
                                                          
                                                          
                                                          8.31
                                                          %
                                                          
                                                          $
                                                          20,255
                                                          
                                                          
                                                          
                                                          10.74
                                                          %Commercial
      secured by real estate
                                                          
                                                          
                                                          429,868
                                                          
                                                          
                                                          
                                                          60.61
                                                          %
                                                          
                                                          
                                                          322,807
                                                          
                                                          
                                                          
                                                          65.33
                                                          %
                                                          
                                                          
                                                          261,961
                                                          
                                                          
                                                          
                                                          69.03
                                                          %
                                                          
                                                          
                                                          152,726
                                                          
                                                          
                                                          
                                                          60.75
                                                          %
                                                          
                                                          
                                                          104,339
                                                          
                                                          
                                                          
                                                          55.35
                                                          %Real
      estate - residential mortgages
                                                          
                                                          
                                                          206,909
                                                          
                                                          
                                                          
                                                          29.17
                                                          %
                                                          
                                                          
                                                          111,490
                                                          
                                                          
                                                          
                                                          22.56
                                                          %
                                                          
                                                          
                                                          86,022
                                                          
                                                          
                                                          
                                                          22.67
                                                          %
                                                          
                                                          
                                                          71,900
                                                          
                                                          
                                                          
                                                          28.60
                                                          %
                                                          
                                                          
                                                          59,322
                                                          
                                                          
                                                          
                                                          31.47
                                                          %Installment
      and other consumer loans
                                                          
                                                          
                                                          8,440
                                                          
                                                          
                                                          
                                                          1.19
                                                          %
                                                          
                                                          
                                                          6,496
                                                          
                                                          
                                                          
                                                          1.32
                                                          %
                                                          
                                                          
                                                          6,458
                                                          
                                                          
                                                          
                                                          1.70
                                                          %
                                                          
                                                          
                                                          6,273
                                                          
                                                          
                                                          
                                                          2.50
                                                          %
                                                          
                                                          
                                                          4,977
                                                          
                                                          
                                                          
                                                          2.64
                                                          %Total
      loans
                                                          
                                                          $
                                                          693,649
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          475,228
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          380,045
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          251,801
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          188,893Mortgage
      loans held for sale
                                                          
                                                          
                                                          16,411
                                                          
                                                          
                                                          
                                                          2.31
                                                          %
                                                          
                                                          
                                                          19,408
                                                          
                                                          
                                                          
                                                          3.93
                                                          %
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          
                                                          -Unearned
      income
                                                          
                                                          
                                                          (773
                                                          )
                                                          
                                                          
                                                          (0.11
                                                          )%
                                                          
                                                          
                                                          (543
                                                          )
                                                          
                                                          
                                                          (0.11
                                                          )%
                                                          
                                                          
                                                          (555
                                                          )
                                                          
                                                          
                                                          (0.15
                                                          )%
                                                          
                                                          
                                                          (396
                                                          )
                                                          
                                                          
                                                          (0.16
                                                          )%
                                                          
                                                          
                                                          (386
                                                          )
                                                          
                                                          
                                                          (0.20
                                                          )%Total
      loans, net of unearned income
                                                          
                                                          $
                                                          709,287
                                                          
                                                          
                                                          
                                                          100.00
                                                          %
                                                          
                                                          $
                                                          494,093
                                                          
                                                          
                                                          
                                                          100.00
                                                          %
                                                          
                                                          $
                                                          379,490
                                                          
                                                          
                                                          
                                                          100.00
                                                          %
                                                          
                                                          $
                                                          251,405
                                                          
                                                          
                                                          
                                                          100.00
                                                          %
                                                          
                                                          $
                                                          188,507
                                                          
                                                          
                                                          
                                                          100.00
                                                          %Less
      allowance for loan losses
                                                          
                                                          
                                                          (23,033
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (4,951
                                                          )
                                                          
                                                          
                                                          1.04
                                                          %
                                                          
                                                          
                                                          (3,795
                                                          )
                                                          
                                                          
                                                          1.00
                                                          %
                                                          
                                                          
                                                          (2,719
                                                          )
                                                          
                                                          
                                                          1.08
                                                          %
                                                          
                                                          
                                                          (2,258
                                                          )
                                                          
                                                          
                                                          1.20
                                                          %Total
      loans, net
                                                          
                                                          $
                                                          686,254
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          489,142
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          375,695
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          248,686
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          $
                                                          186,249





The principal component of our loan
portfolio for all periods presented was commercial loans secured by real estate
mortgages.  As the loan portfolio grows, the current mix of loans may
change over time.  We do not generally originate traditional long-term
residential mortgages, but we do issue traditional second mortgage residential
real estate loans and home equity lines of credit.  We obtain a
security interest in real estate whenever possible, in addition to any other
available collateral.  This collateral is taken to increase the
likelihood of the ultimate repayment of the loan.  Generally, we limit
the loan-to-value ratio on loans we make to 80%.  Due to the short
time our portfolio has existed, the current mix may not be indicative of the
ongoing portfolio mix.  We attempt to maintain a relatively
diversified loan portfolio to help reduce the risk inherent in concentration in
certain types of collateral.





The increase in our commercial loans
secured by real estate from December 31, 2007, to December 31, 2008, is
primarily due to the commercial real estate loans absorbed in the Carolina
National acquisition.  We have increased the number of our commercial
lending officers over the last several years to support our loan
growth.  We expect to continue to focus our origination efforts in
commercial real estate and commercial lending.  The commercial real
estate loans we originate are primarily secured by shopping centers, office
buildings, warehouse facilities, retail outlets, hotels, motels and multi-family
apartment buildings.




Commercial
real estate lending entails unique risks compared to residential
lending.  Commercial real estate loans typically involve large loan
balances to single borrowers or groups of related borrowers.  The
payment experience of such loans is typically dependent upon the successful
operation of the real estate project.  These risks can be
significantly affected by supply and demand conditions in the market for office
and retail space and for apartments and, as such, may be subject, to a greater
extent, to adverse conditions in the economy.  In dealing with these
risk factors, we generally limit ourselves to a real estate market or to
borrowers with which we have experience.  We generally concentrate on
originating commercial real estate loans secured by properties located within
our market areas.  In addition, many of our commercial real estate
loans are secured by owner-occupied property with personal guarantees for the
debt.




The
recent downturn in the real estate market could continue to increase loan
delinquencies, defaults and foreclosures, and could significantly impair the
value of our collateral and our ability to sell the collateral upon
foreclosure.  The real estate collateral in each case provides
alternate sources of repayment in the event of default by the borrower and may
deteriorate in value during the time the credit is extended.  As real
estate values have declined, we have been required to increase our allowance for
loan losses.  If during a period of reduced real estate values we are
required to liquidate the property collateralizing a loan to satisfy the debt or
to increase the allowance for loan losses, it could materially reduce our
profitability and adversely affect our financial condition.  Our other
real estate owned has grown to $6.4 million as of December 31, 2008, and these
repossessed properties are being actively marketed and maintained with the
primary objective of liquidating the collateral at a level which most accurately
approximates fair market value and allows recovery of as much of the unpaid
principal balance as possible upon the sale of the property in a reasonable
period of time.  Although we closely monitor and manage risk
concentrations and utilize various portfolio management practices, the increase
in overall nonperforming loans could result in a continued decrease in earnings
and future increases in the provision for loan losses and loan chargeoffs, all
of which could have a material adverse effect on our financial condition and
results of operations.




55




Commercial
real estate loans make up the majority of our nonaccrual loans due to the
downturn in the residential housing industry.  The following table
shows the spread of the nonaccrual loans geographically and by product type
(dollars in thousands).




December
      31, 2008 CRE Nonaccrual Loans by GeographyUpstate
                                        
                                        
                                        Midlands
                                        
                                        
                                        Coastal
                                        
                                        
                                        Northern
      &
                                          Other
                                        
                                        
                                        Total
                                        
                                        
                                        % of
      TotalCRE
      Nonaccrual Loans by Product TypeResidential
      construction
                                        
                                        $
                                        1,754
                                        
                                        
                                        $
                                        1,726
                                        
                                        
                                        $
                                        11,653
                                        
                                        
                                        $
                                        2,814
                                        
                                        
                                        $
                                        17,947
                                        
                                        
                                        
                                        26.0
                                        %Residential
      other
                                        
                                        
                                        5,321
                                        
                                        
                                        
                                        1,207
                                        
                                        
                                        
                                        6,497
                                        
                                        
                                        
                                        414
                                        
                                        
                                        
                                        13,440
                                        
                                        
                                        
                                        19.5
                                        %Residential
      land
                                        
                                        
                                        3,658
                                        
                                        
                                        
                                        253
                                        
                                        
                                        
                                        7,281
                                        
                                        
                                        
                                        4,189
                                        
                                        
                                        
                                        15,382
                                        
                                        
                                        
                                        22.3
                                        %Commercial
      owner occupied
                                        
                                        
                                        1,635
                                        
                                        
                                        
                                        269
                                        
                                        
                                        
                                        3,612
                                        
                                        
                                        
                                        105
                                        
                                        
                                        
                                        5,622
                                        
                                        
                                        
                                        8.1
                                        %Commercial
      other
                                        
                                        
                                        1,861
                                        
                                        
                                        
                                        488
                                        
                                        
                                        
                                        4,234
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        10,242
                                        
                                        
                                        
                                        14.8
                                        %Commercial
      land
                                        
                                        
                                        0
                                        
                                        
                                        
                                        250
                                        
                                        
                                        
                                        0
                                        
                                        
                                        
                                        3,658
                                        
                                        
                                        
                                        250
                                        
                                        
                                        
                                        0.4
                                        %Total
                                        
                                        $
                                        14,230
                                        
                                        
                                        $
                                        4,194
                                        
                                        
                                        $
                                        33,277
                                        
                                        
                                        $
                                        11,180
                                        
                                        
                                        $
                                        62,883
                                        
                                        
                                        
                                        91.1
                                        %CRE
      Nonaccrual Loans as % of Total Nonaccrual
                                        
                                        
                                        20.6
                                        %
                                        
                                        
                                        6.1
                                        %
                                        
                                        
                                        48.2
                                        %
                                        
                                        
                                        16.2
                                        %
                                        
                                        
                                        91.1
                                        %Total
      Nonaccrual Loans December 31, 2008
                                        
                                        $
                                        69,052




Maturities
and Sensitivity of Loans to Changes in Interest Rates





The
information in the following tables is based on the contractual maturities of
individual loans, including loans that may be subject to renewal at their
contractual maturity.  Renewal of such loans is subject to review and
credit approval, as well as modification of terms upon their
maturity.  Actual repayments of loans may differ from the maturities
reflected below because borrowers have the right to prepay obligations with or
without prepayment penalties.





The
following table summarizes the loan maturity distribution by type and related
interest rate characteristics as of December 31, 2008 (dollars in
thousands):




As
      of December 31, 2008One
      year
                    or
      less
                  
                  
                  After
      one
                    but
      within
                    five
      years
                  
                  
                  After
      five
                    years
                  
                  
                  TotalCommercial
                  
                  $
                  12,221
                  
                  
                  $
                  12,397
                  
                  
                  $
                  441
                  
                  
                  $
                  25,059Real
      estate - construction
                  
                  
                  171,062
                  
                  
                  
                  51,718
                  
                  
                  
                  226
                  
                  
                  
                  223,006Real
      estate - mortgage
                  
                  
                  78,801
                  
                  
                  
                  294,753
                  
                  
                  
                  63,747
                  
                  
                  
                  437,301Consumer
      and other
                  
                  
                  4,485
                  
                  
                  
                  3,114
                  
                  
                  
                  684
                  
                  
                  
                  8,283Total
                  
                  $
                  266,569
                  
                  
                  $
                  361,982
                  
                  
                  $
                  65,098
                  
                  
                  $
                  693,649Mortgage
      loans held for sale
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  16,411Unearned
      income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (773
                  )Total
      loans, net of unearned income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  709,287Loans
      maturing after one year with:Fixed
      interest rates
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  191,132Floating
      interest rates
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  235,948




Allowance
for Loan Losses





The
allowance for loan losses represents an amount that we believe will be adequate
to absorb probable losses on existing loans that may become uncollectible. 
Assessing the adequacy of the allowance for loan losses is a process that
requires considerable judgment.  Our judgment in determining the
adequacy of the allowance is based on evaluations of the collectability of
loans, including consideration of factors such as the balance of impaired loans;
the quality, mix and size of our overall loan portfolio; economic conditions
that may affect the borrower’s ability to repay; the amount and quality of
collateral securing the loans; our historical loan loss experience; and a review
of specific problem loans.  We adjust the amount of the allowance
periodically based on changing circumstances as a component of the provision for
loan losses.  We charge recognized losses against the allowance and add
subsequent recoveries back to the allowance.




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




56




Specific
Reserve





We
analyze individual loans within the portfolio and make allocations to the
allowance based on each individual loan’s specific factors and other
circumstances that affect the collectability of the credit in accordance with
SFAS No. 114, “Accounting by Creditors for Impairment of a
Loan.”  Significant individual credits classified as doubtful or
substandard/special mention within our credit grading system require both
individual analysis and specific allocation.




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





In these
situations where a loan is determined to be impaired (primarily because it is
probable that all principal and interest due according to the terms of the loan
agreement will not be collected as scheduled), the loan is excluded from the
general reserve calculations described below and is assigned a specific
reserve.  We calculate specific reserves on those impaired loans
exceeding $250,000.  These reserves are based on a thorough analysis
of the most probable source of repayment which is usually the liquidation of the
underlying collateral, but may also include discounted future cash flows or, in
rare cases, the market value of the loan itself.





Generally,
for larger collateral dependent loans, current market appraisals are ordered to
estimate the current fair value of the collateral.  However, in
situations where a current market appraisal is not available, management uses
the best available information (including recent appraisals for similar
properties, communications with qualified real estate professionals, information
contained in reputable trade publications and other observable market data) to
estimate the current fair value.  The estimated costs to sell the
subject property are then deducted from the estimated fair value to arrive at
the “net realizable value” of the loan and to determine the specific reserve on
each impaired loan reviewed.  The credit risk management group
periodically reviews the fair value assigned to each impaired loan and adjusts
the specific reserve accordingly.





General
Reserve





We
calculate our general reserve based on a percentage allocation for each of the
categories of the following unclassified loan types:  real estate,
commercial, SBA, consumer, A&D/construction and mortgage.  We
apply our historical trend loss factors to each category and adjust these
percentages for qualitative or environmental factors, as discussed
below.  The general estimate is then added to the specific allocations
made to determine the amount of the total allowance for loan
losses.





We also
maintain a general reserve in accordance with December 2006 regulatory
interagency guidance in our assessment of the loan loss
allowance.  This general reserve considers qualitative or
environmental factors that are likely to cause estimated credit losses
including, but not limited to:  changes in delinquent loan trends,
trends in risk grades and net chargeoffs, concentrations of credit, trends in
the nature and volume of the loan portfolio, general and local economic trends,
collateral valuations, the experience and depth of lending management and staff,
lending policies and procedures, the quality of loan review systems, and other
external factors.





57





Credit Risk
Management





Our credit
risk management function is comprised of our senior credit officer and the
credit department who execute our loan review process.  Through our
credit risk management function, we continuously review our loan portfolio for
credit risk.  This function is independent of the credit approval
process and reports directly to our CEO. It provides regular reports to the
board of directors and its committees on its activities.  Adherence to
underwriting standards is managed through a documented credit approval process
and post funding review by the credit department.  Based on the volume
and complexity of the problem loans in our portfolio, we adjust the resources
allocated to the process of monitoring and resolution of these
assets.  Compliance with these standards is closely supervised by a
number of procedures including reviews of exception reports.





Once
problem loans are identified, policies require written plans for resolution and
periodic reporting to credit risk management to review and document
progress.  The Asset Classification Committee meets quarterly to
review items such as credit quality trends, problem credits and updates on
specific credits reviewed.  This committee is composed of executive
management and credit risk management personnel, as well as several
representatives from the board of directors.





As a
result of the identification of adverse developments with respect to certain
loans in our loan portfolio, we increased the amount of impaired loans during
2008 to $69.1 million, with related valuation allowances of $8.3 million, to
address the risks within our loan portfolio.  The provision for loan
losses generally, and the loans impaired under the criteria defined in FAS 114
specifically, reflect the negative impact of the continued deterioration in the
residential real estate market, specifically along the South Carolina coast, and
the economy in general.  Recent reviews by the credit department have
specifically included several of our residential real estate development and
construction borrowers.





Our
analysis of impaired loans and their underlying collateral values has revealed
the continued deterioration in the level of property values as well as reduced
borrower ability to make regularly scheduled payments.  Loans in our
residential land development and construction portfolios are secured by
unimproved and improved land, residential lots, and single-family and
multi-family homes.  Generally, current lot sales by the developers
and/or borrowers are taking place at a greatly reduced pace and at reduced
prices.  As home sales volumes have declined, income of residential
developers, contractors and other real estate-dependent borrowers have also been
reduced.  This difficult operating environment, along with the
additional loan carrying time, has caused some borrowers to exhaust payment
sources.  Within the last several months, several of our clients have
reached the point where payment sources have been exhausted.





On
December 31, 2008, and December 31, 2007, $69.1 million and $12.0 million
in loans were on nonaccrual status, respectively.   Foregone
interest income on these nonaccrual loans and other nonaccrual loans charged off
during the twelve-month periods ended December 31, 2008 and 2007, was
approximately $1,139,000 and $139,000, respectively.  There were no
loans contractually past due in excess of 90 days and still accruing interest at
December 31, 2008 and 2007.  There were impaired loans, under the
criteria defined in FAS 114, of $69.1 million and $12.0 million with related
valuation allowances of approximately $8.3 million and $655,000 at December 31,
2008 and 2007, respectively.





The
following table sets forth the breakdown of the allowance for loan losses by
loan category and the percentage of loans in each category to gross loans for
each of the years in the five-year period ended December 31, 2008 (dollars
in thousands):




2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006
                                          
                                          
                                          2005
                                          
                                          
                                          2004Commercial
                                          
                                          $
                                          1,787
                                          
                                          
                                          
                                          3.6
                                          %
                                          
                                          $
                                          227
                                          
                                          
                                          
                                          5.1
                                          %
                                          
                                          $
                                          454
                                          
                                          
                                          
                                          6.8
                                          %
                                          
                                          $
                                          135
                                          
                                          
                                          
                                          11.1
                                          %
                                          
                                          $
                                          191
                                          
                                          
                                          
                                          12.0
                                          %Real
      estate - construction
                                          
                                          
                                          12,648
                                          
                                          
                                          
                                          32.1
                                          %
                                          
                                          
                                          1,551
                                          
                                          
                                          
                                          37.9
                                          %
                                          
                                          
                                          1,062
                                          
                                          
                                          
                                          22.6
                                          %
                                          
                                          
                                          386
                                          
                                          
                                          
                                          20.4
                                          %
                                          
                                          
                                          343
                                          
                                          
                                          
                                          11.2
                                          %Real
      estate - mortgage
                                          
                                          
                                          8,509
                                          
                                          
                                          
                                          63.1
                                          %
                                          
                                          
                                          2,532
                                          
                                          
                                          
                                          55.7
                                          %
                                          
                                          
                                          1,841
                                          
                                          
                                          
                                          68.9
                                          %
                                          
                                          
                                          2,110
                                          
                                          
                                          
                                          66.0
                                          %
                                          
                                          
                                          1,111
                                          
                                          
                                          
                                          74.2
                                          %Consumer
                                          
                                          
                                          89
                                          
                                          
                                          
                                          1.2
                                          %
                                          
                                          
                                          72
                                          
                                          
                                          
                                          1.3
                                          %
                                          
                                          
                                          58
                                          
                                          
                                          
                                          1.7
                                          %
                                          
                                          
                                          48
                                          
                                          
                                          
                                          2.5
                                          %
                                          
                                          
                                          30
                                          
                                          
                                          
                                          2.6
                                          %Unallocated
                                          
                                          
                                          -
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          
                                          569
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          
                                          380
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          
                                          40
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          
                                          584
                                          
                                          
                                          
                                          N/ATotal
      allowance for loan losses
                                          
                                          $
                                          23,033
                                          
                                          
                                          
                                          100.0
                                          %
                                          
                                          $
                                          4,951
                                          
                                          
                                          
                                          100.0
                                          %
                                          
                                          $
                                          3,795
                                          
                                          
                                          
                                          100.0
                                          %
                                          
                                          $
                                          2,719
                                          
                                          
                                          
                                          100.0
                                          %
                                          
                                          $
                                          2,259
                                          
                                          
                                          
                                          100.0
                                          %




We believe that the allowance can be
allocated by category only on an approximate basis.  The allocation of
the allowance to each category is not necessarily indicative of further losses
and does not restrict the use of the allowance to absorb losses in any other
category.




58




The provision for loan losses has
been made primarily as a result of management’s assessment of general loan loss
risk after considering historical operating results, as well as comparable peer
data.  Our evaluation is inherently subjective as it requires
estimates that are susceptible to significant change.  In addition, various
regulatory agencies review our allowance for loan losses through their periodic
examinations, and they may require us to record additions to the allowance for
loan losses based on their judgment about information available to them at the
time of their examinations.  Our losses will undoubtedly vary from our
estimates, and there is a possibility that chargeoffs in future periods will
exceed the allowance for loan losses as estimated at any point in
time.  Please see Note 7- Loans in the Notes to Consolidated Financial
Statements included in this report for additional information.




The
following table sets forth the changes in the allowance for loan losses for each
of the years in the five-year period ended December 31, 2008 (dollars in
thousands).




As
      of December 31,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006
                                      
                                      
                                      2005
                                      
                                      
                                      2004Balance,
      beginning of year
                                      
                                      $
                                      4,951
                                      
                                      
                                      $
                                      3,795
                                      
                                      
                                      $
                                      2,719
                                      
                                      
                                      $
                                      2,258
                                      
                                      
                                      $
                                      1,631Allowance
      from acquisition
                                      
                                      
                                      2,976
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Provision
      charged to operations
                                      
                                      
                                      20,460
                                      
                                      
                                      
                                      1,396
                                      
                                      
                                      
                                      1,192
                                      
                                      
                                      
                                      594
                                      
                                      
                                      
                                      679Loans
      charged offResidential
      housing related
                                      
                                      
                                      (3,771
                                      )
                                      
                                      
                                      (121
                                      )
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (15
                                      )
                                      
                                      
                                      (12
                                      )Owner
      occupied commercial
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Other
                                      
                                      
                                      (1,612
                                      )
                                      
                                      
                                      (129
                                      )
                                      
                                      
                                      (139
                                      )
                                      
                                      
                                      (129
                                      )
                                      
                                      
                                      (42
                                      )Total
      chargeoffs
                                      
                                      
                                      (5,383
                                      )
                                      
                                      
                                      (250
                                      )
                                      
                                      
                                      (139
                                      )
                                      
                                      
                                      (144
                                      )
                                      
                                      
                                      (54
                                      )Recoveries
      of loans previously charged off
                                      
                                      
                                      29
                                      
                                      
                                      
                                      10
                                      
                                      
                                      
                                      23
                                      
                                      
                                      
                                      11
                                      
                                      
                                      
                                      2Balance,
      end of period
                                      
                                      $
                                      23,033
                                      
                                      
                                      $
                                      4,951
                                      
                                      
                                      $
                                      3,795
                                      
                                      
                                      $
                                      2,719
                                      
                                      
                                      $
                                      2,258Allowance
      to loans, year end
                                      
                                      
                                      3.32
                                      %
                                      
                                      
                                      1.04
                                      %
                                      
                                      
                                      1.00
                                      %
                                      
                                      
                                      1.08
                                      %
                                      
                                      
                                      1.20
                                      %Net
      chargeoffs to average loans
                                      
                                      
                                      0.78
                                      %
                                      
                                      
                                      0.06
                                      %
                                      
                                      
                                      0.04
                                      %
                                      
                                      
                                      0.06
                                      %
                                      
                                      
                                      0.03
                                      %Nonaccrual
      loans
                                      
                                      $
                                      69,052
                                      
                                      
                                      $
                                      12,000
                                      
                                      
                                      $
                                      477
                                      
                                      
                                      $
                                      349
                                      
                                      
                                      $
                                      49Past
      due loans in excess of 90 days on accrual status
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -Other
      real estate owned
                                      
                                      $
                                      6,417
                                      
                                      
                                      $
                                      2,320
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -




Generally,
a loan is placed on nonaccrual status when it becomes 90 days past due as to
principal or interest, or when management believes, after considering economic
and business conditions and collection efforts, that the borrower’s financial
condition is such that collection of the loan is doubtful.  A payment
of interest on a loan that is classified as nonaccrual is recognized as income
when received.  We historically have had low levels of nonperforming
loans, but the current economic conditions have increased those levels to $69.1
million since December 31, 2007.  The net chargeoffs to average
loans ratio for the year ended December 31, 2008, was 0.78% as compared to 0.06%
for the year ended December 31, 2007. For the year ended December 31, 2008,
total net chargeoffs were $5.4 million compared to net chargeoffs of $240,000
for the same period in 2007.





Deposits





Our
primary source of funds for loans and investments is our
deposits.  National and local market trends over the past several
years suggest that consumers have moved an increasing percentage of
discretionary savings funds into investments such as annuities, stocks, and
fixed income mutual funds.  Accordingly, it has become more difficult
in recent years to attract retail deposits.





The
following table shows the average balance amounts and the average rates paid on
deposits held by us for the years ended December 31, 2008, 2007 and 2006
(dollars in thousands):





As
      of December 31,2008
                          
                          
                          2007
                          
                          
                          2006Amount
                          
                          
                          Rate
                          
                          
                          Amount
                          
                          
                          Rate
                          
                          
                          Amount
                          
                          
                          RateDemand
      deposit accounts
                          
                          $
                          41,920
                          
                          
                          
                          -
                          
                          
                          $
                          32,588
                          
                          
                          
                          -
                          
                          
                          $
                          23,056
                          
                          
                          
                          -NOW
      accounts
                          
                          
                          43,666
                          
                          
                          
                          1.83
                          %
                          
                          
                          45,285
                          
                          
                          
                          3.28
                          %
                          
                          
                          25,603
                          
                          
                          
                          2.63
                          %Money
      market and savings accounts
                          
                          
                          121,919
                          
                          
                          
                          2.62
                          %
                          
                          
                          76,184
                          
                          
                          
                          4.52
                          %
                          
                          
                          57,962
                          
                          
                          
                          4.02
                          %Time
      deposits
                          
                          
                          435,285
                          
                          
                          
                          4.13
                          %
                          
                          
                          272,730
                          
                          
                          
                          5.11
                          %
                          
                          
                          201,957
                          
                          
                          
                          4.52
                          %Total
      deposits
                          
                          $
                          642,790
                          
                          
                          
                          
                          
                          
                          $
                          426,787
                          
                          
                          
                          
                          
                          
                          $
                          308,578





The
increase in time deposits of $100,000 or more for the period ended December 31,
2008, as compared to the balance as of December 31, 2007, primarily
resulted from the addition of deposits that were originally obtained from
brokered CDs from outside of our primary market by Carolina
National.  The maturity distribution of our time deposits of $100,000
or more as of December 31, 2008 is as follows (dollars in
thousands):




59




As
      of December 31,2008Three
      months or less
                    
                    $
                    111,745Over
      three through six months
                    
                    
                    63,299Over
      six through twelve months
                    
                    
                    69,814Over
      twelve months
                    
                    
                    28,038Total
                    
                    $
                    272,896





As
of December 31, 2008, our non-core deposits included wholesale funding in the
form of brokered CDs of approximately $150.2 million.  We generally
obtain out-of-market time deposits of $100,000 or more through brokers with whom
we maintain ongoing relationships.  The guidelines governing our
participation in brokered CD programs are part of our Asset Liability Management
Program Policy, which is reviewed, revised and approved annually by the Board
Asset Liability Committee.  These guidelines limit our brokered CDs to
25% of total assets and require that we only accept brokered CDs from approved
correspondents.  In addition, we do not obtain time deposits of
$100,000 or more through the Internet.  We believe these guidelines
allow us to take advantage of the attractive terms that wholesale funding can
offer while mitigating the inherent related risk.  While brokered CDs
have represented a reliable source of wholesale funds in recent years, our
recent expansion into new markets throughout South Carolina should allow us to
grow our core deposit base, in turn reducing our reliance on brokered CDs and
other sources of funds.





We
recently received the final report from our bank’s regulatory safety and
soundness examination which was completed in November 2008 and on April 27, 2009
our bank entered into a consent order with the OCC.  Based on these
two regulatory actions, our ability to access brokered deposits through the
wholesale funding market is now restricted as a result of the consent order that
our bank entered with the OCC on April 27, 2009.  Our bank is not able
to accept, renew or rollover brokered deposits without being granted a waiver of
this prohibition by the FDIC.  There is no assurance that the FDIC
will grant us a waiver.  Please see the Regulatory Matters section for
more details on restrictions on our use of brokered CDs as a funding
source.




60




Other
Interest-Bearing Liabilities





The
following tables outline our various sources of borrowed funds during the years
ended December 31, 2008, 2007 and 2006, the amounts outstanding as of the
end of each period, at the maximum point for each component during the periods
the average balance for each period, and the average interest rate that we paid
for each borrowing source.  The maximum balance represents the highest
indebtedness for each component of borrowed funds at any time during each of the
periods shown.  See Note 11 - “Lines of Credit”, Note 12 - “FHLB
Advances”, and Note 16 - “Junior Subordinated Debentures” in the Notes to
Consolidated Financial Statements included in this report for additional
disclosures related to these types of borrowings (dollars in
thousands).




Average
      for the PeriodEnding
                    Balance
                  
                  
                  Period-End
                    Rate
                  
                  
                  Maximum
                    Balance
                  
                  
                  Balance
                  
                  
                  RateAs
      of or for the Year Ended December 31, 2008FHLB
      advances
                  
                  $
                  86,363
                  
                  
                  
                  2.48
                  %
                  
                  $
                  90,849
                  
                  
                  $
                  60,538
                  
                  
                  
                  3.39
                  %Federal
      funds purchased & other short-term borrowings
                  
                  $
                  21,373
                  
                  
                  
                  1.17
                  %
                  
                  $
                  47,845
                  
                  
                  $
                  19,365
                  
                  
                  
                  2.78
                  %Junior
      subordinated debentures
                  
                  $
                  13,403
                  
                  
                  
                  4.52
                  %
                  
                  $
                  13,403
                  
                  
                  $
                  13,403
                  
                  
                  
                  5.51
                  %As
      of or for the Year Ended December 31, 2007FHLB
      advances
                  
                  $
                  41,690
                  
                  
                  
                  4.50
                  %
                  
                  $
                  49,780
                  
                  
                  $
                  41,014
                  
                  
                  
                  4.77
                  %Federal
      funds purchased & other short-term borrowings
                  
                  $
                  9,360
                  
                  
                  
                  3.99
                  %
                  
                  $
                  26,269
                  
                  
                  $
                  10,864
                  
                  
                  
                  5.63
                  %Junior
      subordinated debentures
                  
                  $
                  13,403
                  
                  
                  
                  7.12
                  %
                  
                  $
                  13,403
                  
                  
                  $
                  13,403
                  
                  
                  
                  7.65
                  %As
      of or for the Year Ended December 31, 2006FHLB
      advances
                  
                  $
                  37,476
                  
                  
                  
                  4.94
                  %
                  
                  $
                  48,543
                  
                  
                  $
                  33,421
                  
                  
                  
                  4.70
                  %Federal
      funds purchased & other short-term borrowings
                  
                  $
                  7,970
                  
                  
                  
                  5.41
                  %
                  
                  $
                  14,391
                  
                  
                  $
                  2,612
                  
                  
                  
                  5.51
                  %Junior
      subordinated debentures
                  
                  $
                  13,403
                  
                  
                  
                  7.44
                  %
                  
                  $
                  13,403
                  
                  
                  $
                  11,663
                  
                  
                  
                  7.52
                  %





As of
December 31, 2008, 2007 and 2006, we had short-term lines of credit with
correspondent banks to purchase unsecured federal funds totaling $28.0 million,
$59.5 million, and $30.0 million, respectively.





Regulatory
Actions and Going Concern Considerations





Consent
Order





Due to
our condition, the OCC has required that our Board of Directors sign a formal
enforcement action with the OCC which conveys specific actions needed to address
certain findings from the examination and to address our current financial
condition.  We entered into a consent order with the OCC on April 27,
2009, which contains a list of strict requirements ranging from a capital
directive, which requires us to achieve and maintain minimum regulatory capital
levels in excess of the statutory minimums to be well-capitalized, to developing
a liquidity risk management and contingency funding plan, in connection with
which we will be subject to limitations on the maximum interest rates we can pay
on deposit accounts.  The consent order also contains restrictions on
future extensions of credit and requires the development of various programs and
procedures to improve our asset quality as well as routine reporting on our
progress toward compliance with the consent order to the Board of Directors and
the OCC.  As a result of the terms
of the executed consent order, we are no longer deemed “well-capitalized,”
regardless of our capital  levels.




The
consent order with the OCC requires the establishment of certain plans and
programs.  It requires the bank, among other things,





•
                                        
                                        to
      establish a compliance committee to monitor and coordinate compliance with
      the consent order by May 7, 2009;•
                                        
                                        to
      achieve and maintain Tier 1 capital at least equal to 11% of risk-weighted
      assets and at least equal to 9% of adjusted total assets by August 25,
      2009;




61


•
                      
                      to
      develop, by July 26, 2009, a three-year capital plan for the bank, which
      shall include, among other things, specific plans for maintaining
      adequate capital, a discussion of the sources and timing of additional
      capital, as well as contingency plans for alternative sources of
      capital;•
                      
                      to
      develop, by July 26, 2009, a strategic plan covering at least a three-year
      period, which shall, among other things, include a specific description of
      the strategic goals and objectives to be achieved, the targeted markets,
      the specific bank personnel who are responsible and accountable for the
      plan, and a description of systems to monitor the bank’s
      progress.•
                      
                      to
      revise and maintain, by June 26, 2009, a liquidity risk management
      program, which assesses, on an ongoing basis, the bank’s current and
      projected funding needs, and ensures that sufficient funds exist to meet
      those needs.  The plan must include specific plans for how the
      bank plans to comply with regulatory restrictions which limit the interest
      rates the bank can offer to depositors;•
                      
                      to
      revise, by June 26, 2009, the bank’s loan policy, a commercial real estate
      concentration management program.  The bank also must establish
      a new loan review program to ensure the timely and independent
      identification of problem loans and modify its existing program for the
      maintenance of an adequate allowance for loan and lease
      losses.;•
                      
                      to
      take immediate and continuing action to protect the bank’s interest in
      certain assets identified by the OCC or any other bank examiner by
      developing a criticized assets report covering the entire credit
      relationship with respect to such assets;•
                      
                      to
      develop, by July 26, 2009, an independent appraisal review and analysis
      process to ensure that appraisals conform to appraisal standards and
      regulations, and to order, within 30 days following any event that
      triggers an appraisal analysis, a current independent appraisal or updated
      appraisal on loans secured by certain properties; and•
                      
                      to
      develop, by May 27, 2009, a revised OREO program to ensure that the OREO
      properties are managed in accordance with certain applicable banking
      regulations.




Going
Concern





The going
concern assumption is a fundamental principle in the preparation of financial
statements.  It is the responsibility of management to assess our
ability to continue as a going concern.  In assessing this assumption,
we have taken into account all available information we have deemed relevant
about our foreseeable future, which is at least, but is not limited to, twelve
months from the balance sheet date of December 31, 2008.  We have a
history of profitable operations and sufficient sources of liquidity to meet our
short-term and long-term funding needs.  However, our financial
condition has suffered during 2008 from the extraordinary effects of what may
ultimately be the worst economic downturn since the Great
Depression.





The
effects of the current economic environment are being felt across many
industries, with financial services and residential real estate being
particularly hard hit.  The effects of the economic downturn have been
particularly severe during the last 150 days.  With a loan portfolio
consisting of a concentration in commercial real estate loans including
residential construction and development loans, we have seen a decline in the
value of the collateral securing our portfolio as well as rapid deterioration in
our borrowers' cash flow and ability to repay their outstanding loans to
us.  As a result, our level of nonperforming assets has increased
substantially during 2008 to $75.5 million. The level of nonperforming assets
has caused us to be out of compliance with certain covenants for our line
of credit. For the year ended December 31, 2008, we recorded a $20.5 million
provision for loan losses, of which $19.0 million was required to increase the
allowance for loan losses to a level which we believe adequately reflected the
increased risk inherent in the loan portfolio as of December 31,
2008.





We
operate in a highly-regulated industry and must plan for the liquidity needs of
both our bank and our holding company separately.   A variety of
sources of liquidity are available to us to meet our short-term and long-term
funding needs.  Although a number of these sources have been limited
following execution of the consent order with the OCC, management has prepared
forecasts of these sources of funds and our projected uses of funds during 2009
and believes that the sources available are sufficient to meet our projected
liquidity needs for this period.




62




We rely
on dividends from our bank as our primary source of liquidity.  The
holding company is a legal entity separate and distinct from the
bank.  Various legal limitations restrict the bank from lending or
otherwise supplying funds to the holding company to meet its obligations,
including paying dividends.   In addition, the terms of the
pending consent order described above will further limit the bank's ability to
pay dividends to the holding company to satisfy its funding needs.  As
part of the acquisition of Carolina National Corporation, the holding company
had entered into a loan agreement in December 2007 with a correspondent bank for
a line of credit to finance a portion of the cash paid in the transaction and to
fund operating expenses of the holding company including interest and dividend
payments on its noncumulative preferred stock and trust preferred
securities.  The holding company pledged all of the stock of the bank
as collateral for the line of credit which had an outstanding balance of $9.5
million as of December 31, 2008.





Due to
our increased level of nonperforming assets and reduced profitability, we were
not in compliance with several of the covenants on this line of credit as of
December 31, 2008 relating to profitability and asset quality.  We had
previously satisfied all covenants in the loan agreement.  We are
currently operating under a waiver of these covenants and the note is performing
under all other terms of the loan agreement.  It has been the lender's
practice to perform a quarterly review of our financial condition and to grant a
waiver for the upcoming calendar quarter based on the results of this
review.  The lender has agreed in writing not to pursue the
collateral underlying the line of credit through June 30, 2009.  All
other terms and conditions of the loan documents will continue to exist and may
be exercised at any time.





The
uncertainty surrounding the lender's intention to continue granting quarterly
waivers of the covenant defaults on the line of credit through December 31, 2009
casts doubt about our ability to continue in operation.  Although
uncertainty exists regarding the covenant defaults on the line of credit, the
systemic risk in the financial services industry created by the current period
of economic distress has negatively affected our financial performance which has
resulted in our inability to maintain compliance with all of the covenants on
the line of credit.  Nevertheless, should the lender not grant a
waiver of the covenant defaults for a future quarter, the lender would have the
ability to withdraw the line of credit and require us to secure an alternate
source of financing to repay the outstanding balance on the line of credit
within a short period of time.  Management has assessed the potential
consequences of this action and believes that its current strategy to raise
additional capital will enable us to deal with this event if faced with the
requirement to obtain alternate financing to repay the outstanding balance on
the line of credit within a relatively short period of time if future covenant
defaults are not waived by the lender.   In the alternate, the
lender could take steps to foreclose on our stock as collateral for the loan if
alternate financing to repay the outstanding balance on the line of credit could
not be obtained within the required timeframe.




We
believe that the bank will also need to raise additional capital to absorb the
potential losses associated with the disposition of its nonperforming assets and
to increase capital levels to meet the standards set forth by the
OCC.  As a result of the recent downturn in the financial markets, the
availability of many sources of capital (principally to financial services
companies) has become significantly restricted or has become increasingly costly
as compared to the prevailing market rates prior to the
volatility.  Management cannot predict when or if the capital markets
will return to more favorable conditions.  Our management is actively
evaluating a number of capital sources and balance sheet management strategies
to ensure that our projected level of regulatory capital can support its balance
sheet.





There can
be no assurances that we will be successful in our efforts to raise additional
capital during 2009.  An equity financing transaction of this type
would result in substantial dilution to our current shareholders and could
adversely affect the market price of our common stock.   It is
difficult to predict if these efforts will be successful, either on a short-term
or long-term basis.  Should these efforts be unsuccessful, due to the
regulatory restrictions which exist that restrict cash payments between the bank
and the holding company, the holding company may be unable to realize its assets
and discharge its liabilities in the normal course of business.





As
a result of our assessment of our ability to continue as a going concern, we
have prepared our consolidated financial statements on a going concern basis,
which contemplates the realization of assets and the discharge of liabilities in
the normal course of business for the foreseeable future, and does not include
any adjustments to reflect the possible future effects on the recoverability or
classification of assets, and the amounts or classification of liabilities that
may result from the outcome of a potential future default due to noncompliance
with covenants on the line of credit, which could affect our ability to continue
as a going concern.





Capital
Resources





General





Shareholders’
equity on December 31, 2008, was $40.6 million, as compared to shareholders’
equity on December 31, 2007, of $47.6 million.  The decrease
between December 31, 2007 and December 31, 2008 reflects the loss recognized for
the year ended December 31, 2008, primarily made up of the noncash impairment
charge to write off goodwill recorded during 2008 in connection with the Merger,
partially offset by the market value as of August 26, 2007, the date of the
merger agreement, of the additional 2.7 million common shares issued to the
former Carolina National shareholders as of January 31, 2008.  In
addition, the unrealized gain on our securities portfolio
increased.   This increase was partially offset by the deferred
tax expense recognized during 2008 to record a valuation allowance on a portion
of our net deferred tax asset as of December 31, 2008.  Also, we
utilized cash to purchase shares under our share repurchase program and for cash
dividends on our preferred stock during 2008.




63




The
unrealized gain on securities available for sale as of December 31, 2008
reflects the change in the market value of these securities since
December 31, 2007.  We believe that the change in the unrealized
gain reflected as of December 31, 2008, was attributable to changes in market
interest rates.   Our securities portfolio includes investments
that are direct obligations of the United States (“U.S.”) government, Federal
Agency and U.S. Government obligations and various other bank grade investment
securities rated either “A” or “Aa/AA” by Moody’s Investors Service or Standard
& Poor’s investment advisory service at the time of purchase, as prescribed
by our Investment Policy. We use securities available for sale to pledge as
collateral to secure public deposits and for other purposes required or
permitted by law, including as collateral for FHLB advances outstanding and
borrowings from the short-term FRB discount window.  Due to
availability of various liquidity sources we intend to hold these securities to
maturity.





Regulatory
Capital





The
Federal Reserve and bank regulatory agencies require bank holding companies and
financial institutions to maintain capital at adequate levels based on a
percentage of assets and off-balance sheet exposures, adjusted for risk weights
ranging from 0% to 100%.  Under the capital adequacy guidelines,
capital is classified into two tiers.  These guidelines require an
institution to maintain a certain level of Tier 1 and Tier 2 capital to
risk-weighted assets.  Tier 1 capital consists of common shareholders’
equity, excluding the unrealized gain or loss on securities available for sale,
minus certain intangible assets, plus qualifying preferred stock and trust
preferred securities combined and limited to 45% of Tier 1 capital, with the
excess being treated as Tier 2 capital.  In determining the amount of
risk-weighted assets, all assets, including certain off-balance sheet assets,
are multiplied by a risk-weight factor of 0% to 100% based on the risks believed
to be inherent in the type of asset.  Tier 2 capital consists of Tier 1
capital plus the reserve for loan losses subject to certain limitations. 
As of December 31, 2008, the amount of our reserve for loan losses that was not
included due to these limitations was approximately $14.0
million.  The bank is also required to maintain capital at a minimum
level based on total average assets, which is known as the Tier 1 leverage
ratio.





We
utilize trust preferred securities to meet our capital requirements up to
regulatory limits.  As of December 31, 2008, we had formed three
statutory trust subsidiaries for the purpose of raising capital via this
avenue.  On December 19, 2003, FNSC Capital Trust I, a
subsidiary of our holding company, was formed to issue $3 million in floating
rate trust preferred securities.  On April 30, 2004, FNSC Capital
Trust II was formed to issue an additional $3 million in floating rate trust
preferred securities.  On March 30, 2006, FNSC Statutory Trust III was
formed to issue an additional $7 million in floating rate trust preferred
securities.  These entities are not included in our consolidated
financial statements.  The trust preferred securities qualify as Tier 1
capital up to 25% or less of Tier 1 capital, and up to 45% of Tier 1 capital
when combined with qualifying preferred shares, with the excess includable as
Tier 2 capital.  As of December 31, 2008, the entire $13.0 million of
the trust preferred securities qualified as Tier 1 capital.





Our
holding company and our bank are subject to various regulatory capital
requirements administered by the federal banking agencies.  Under these
capital guidelines, to be considered “adequately capitalized,” we must maintain
a minimum total risk-based capital of 8%, with at least 4% being Tier 1
capital.  In addition, we must maintain a minimum Tier 1 leverage ratio of
at least 4%.  To be considered “well-capitalized,” a bank generally must
maintain total risk-based capital of at least 10%, Tier 1 capital of at least
6%, and a leverage ratio of at least 5%.  However, so long as our bank
is subject to the enforcement action executed with the OCC on April 27, 2009, it
will not be deemed to be well-capitalized even if it maintains these minimum
capital ratios to be well-capitalized.





The
following table sets forth the holding company’s and the bank’s various capital
ratios as of December 31, 2008, and December 31, 2007.  On an
ongoing basis, we continue to evaluate various options, such as issuing trust
preferred securities or common stock, to increase the bank’s capital and related
capital ratios in order to maintain adequate capital levels.




64




As
      of December 31,
                    2008
                  
                  
                  As
      of December 31,
                    2007
                  
                  
                  To
      Be Considered
                    Well-CapitalizedHolding
                  
                  
                  
                  
                  
                  Holding
                  
                  
                  
                  
                  
                  HoldingCo.
                  
                  
                  Bank
                  
                  
                  Co.
                  
                  
                  Bank
                  
                  
                  Co.
                  
                  
                  BankTotal
      risk-based capital
                  
                  
                  8.33
                  %
                  
                  
                  9.75
                  %
                  
                  
                  13.48
                  %
                  
                  
                  10.72
                  %
                  
                  
                  N/A
                  
                  
                  
                  10.00
                  %Tier
      1 risk-based capital
                  
                  
                  6.03
                  %
                  
                  
                  8.48
                  %
                  
                  
                  11.61
                  %
                  
                  
                  9.70
                  %
                  
                  
                  N/A
                  
                  
                  
                  6.00
                  %Leverage
      capital
                  
                  
                  5.20
                  %
                  
                  
                  7.23
                  %
                  
                  
                  9.75
                  %
                  
                  
                  8.17
                  %
                  
                  
                  N/A
                  
                  
                  
                  5.00
                  %




The
decrease in our holding company’s capital ratios from December 31, 2007, to
December 31, 2008, is primarily due to our growth in assets during this period
and to the net loss recorded for the year ended December 31,
2008.  Our bank’s capital ratios only slightly decreased from December
31, 2007 to December 31, 2008 due to the capital contribution from the holding
company from the proceeds received from the line of credit in connection with
the Merger which closed on January 31, 2008.





Strategic Capital
Plan





We have
an active program for managing our shareholder’s
equity.  Historically, we have used capital to fund organic growth,
pay dividends on our preferred stock and repurchase our shares.  Our
management team is focused on carefully managing the size of our loan portfolio
to maintain an asset base that is supported by our capital
resources.  Our objective is to produce above-market long-term returns
by opportunistically using capital when returns are perceived to be high and
issuing/accumulating capital when such costs are perceived to be
low.





As a
result of result of recent market disruptions, the availability of capital
(principally to financial services companies like ours) has become significantly
restricted.  Those companies wishing to survive the current economic
environment and prosper will need a strong capital base that supports the asset
size of the company.  While some companies have been successful at
raising capital, the cost of that capital has been substantially higher than the
prevailing market rates prior to the volatility. During 2008, we formed a
Strategic Planning Committee consisting of five members of our board of
directors.  This committee meets on a very frequent basis and has been
authorized by the board of directors to monitor and make recommendations
regarding the capital, liquidity and asset quality of our bank.  Under
the terms of the consent order that we entered into with the OCC on April 27,
2009, our board is required to submit a written strategic plan to the OCC
following the execution of this action.





Our loss
for 2008 has adversely impacted our projected capital position by eroding our
capital cushion.  As a result, we have been pursuing a plan to
increase our capital ratios in order to strengthen our balance sheet and satisfy
the commitments we expect to make to our bank regulator in this
area.  In light of deteriorating economic conditions in the United
States, increased levels of nonperforming assets, and our level of losses for
the year ended December 31, 2008, the need to raise capital in the short-term
has become more critical to us.





Our
application for participation in the TARP Capital Purchase Program has not been
accepted.  Therefore, we have withdrawn our application.  We
are actively pursuing a variety of other capital raising
efforts.  However, at present, the market for new capital for banks is
limited and uncertain.  Accordingly, we cannot be certain of our
ability to raise capital on terms that satisfy our goals with respect to our
capital ratios.  If we are able to raise additional capital, it would
likely be on terms that are substantially dilutive to current common
shareholders.





Preferred
Stock





On July
9, 2007, we closed an underwritten public offering of 720,000 shares of Series A
Noncumulative Perpetual Preferred Stock at $25.00 per share.  Our net
proceeds after payment of underwriting discounts and other expenses of the
offering were approximately $16.5 million.  The terms of the preferred
stock include the payment of quarterly dividends at an annual interest rate of
7.25%.  Under the terms of the preferred stock, dividends are declared
each quarter at the discretion of our board of directors.  The first
quarterly dividend was paid in October 2007, as prescribed in the Certificate of
Designation of Series A Preferred Stock, and in each subsequent quarter, we have
paid quarterly dividends of $326,250.  Our board of directors did not
declare a dividend for the first quarter of 2009.





We used
the net proceeds of the preferred stock offering to provide additional capital
to support asset growth, expansion of our bank’s branch network, to pay off the
balance of $5 million on a revolving line of credit, and to partially fund the
cash portion of the consideration to close the acquisition of Carolina
National.    The remainder of the cash consideration to
close the Merger was financed through a line of credit from a correspondent
bank.  The collateral for this line of credit is the stock of our
bank.  Because of our unusually high amount of nonperforming loans and
assets as of December 31, 2008 and our reduced profitability for 2008, we were
out of compliance with the covenants governing the line of
credit.  The correspondent bank has granted us a waiver regarding the
noncompliance that was effective until they complete the quarterly review of our
December 31, 2008 financial statements with the mutual expectation that similar
quarterly waivers will be granted in the future until we are once again in
compliance with the covenants governing the line of
credit.    The lender has granted us a waiver through June
30, 2009, of their ability to pursue the collateral underlying the line of
credit.  All other terms and conditions of the loan documents will
continue to exist and may be exercised at any time.




65




Our
common stock is traded on the Nasdaq Global Market under the symbol
FNSC.  As of December 31, 2008, tangible book value per common share
was $3.78, based on 6,296,698 shares outstanding, compared to $8.49, based on
common stock 3,724,548 shares outstanding, as of December 31,
2007.  The closing market price of one share of FNSC common stock was
$2.06, as of December 31, 2008, and $1.72, as of March 31, 2009 as compared to
$13.14 as of December 31, 2007.  There were 1,135 holders of record of
FNSC common stock as of March 31, 2009.





The
following chart compares the price performance of FNSC’s common shares (based on
an initial investment of $100 on December 31, 2003) with that of the Nasdaq
composite index and a group of other banks that constitute FNSC’s peer
group.











Period
      EndingIndex
                  
                  12/31/03
                  
                  
                  12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08First
      National Bancshares, Inc.
                  
                  
                  100.00
                  
                  
                  
                  212.00
                  
                  
                  
                  239.52
                  
                  
                  
                  203.53
                  
                  
                  
                  178.84
                  
                  
                  
                  28.04NASDAQ
      Composite
                  
                  
                  100.00
                  
                  
                  
                  108.59
                  
                  
                  
                  110.08
                  
                  
                  
                  120.56
                  
                  
                  
                  132.39
                  
                  
                  
                  78.72SNL
      Bank and Thrift
                  
                  
                  100.00
                  
                  
                  
                  111.98
                  
                  
                  
                  113.74
                  
                  
                  
                  132.90
                  
                  
                  
                  101.34
                  
                  
                  
                  58.28





Share
price performance is not necessarily indicative of future price
performance.





Since our
inception, we have not paid cash dividends on our common stock.  Our
ability to pay cash dividends is dependent on receiving cash in the form of
dividends from our bank.  However, certain restrictions exist
regarding the ability of our bank to transfer funds to us in the form of cash
dividends.  All dividends are subject to prior approval of the OCC and
are payable only from the undivided profits of our bank.  We
distributed 3-for-2 stock splits on March 1, 2004, and January 18,
2006.




66




We have
also distributed shares of our common stock through stock
dividends.  On May 16, 2006, we issued a stock dividend of 6% to
shareholders of record as of May 1, 2006.  Once this dividend was
distributed, the common stock component of our shareholders' equity increased by
approximately $2,000; additional paid in capital increased approximately $3.8
million, and our retained earnings decreased by an offsetting approximate $3.8
million.  On March 30, 2007, we issued a stock dividend of 7% to
shareholders of record as of March 16, 2007. As a result of this dividend, the
common stock component of our shareholders' equity increased by approximately
$3,000; additional paid in capital increased approximately $4.3 million, and our
retained earnings decreased by an offsetting approximate $4.3
million.  We may distribute future stock splits and dividends based on
our evaluation of a number of factors, including our financial performance and
projected capital and earnings levels.





Employee Share Ownership
Programs





We
encourage employee share ownership through various programs, including the First
National Bancshares, Inc. 2000 Stock Incentive Plan, which absorbed the Carolina
National Corporation 2003 Stock Option Plan (together the “Stock Option Plan”)
as part of the Carolina National acquisition, our Employee Stock Ownership Plan
(“ESOP”), and the First National Bancshares, Inc. 2008 Restricted Stock Plan
(the “Restricted Stock Plan”).  The Stock Option Plan provides for the
issuance of stock options in order to reward the recipients and to promote our
growth and profitability through additional employee motivation toward our
success.   Under the Stock Option Plan, options for 600,341
shares of common stock were authorized for grant including 141,374 stock options
from the Carolina National merger.  Of this amount, net options of
308,530 have been granted to date, with 25,250 of those shares granted in the
year ended December 31, 2008.





On
November 30, 2005, we loaned our ESOP $600,000 which was used to purchase
42,532 shares of our common stock.  As of December 31, 2008, the ESOP
owned 44,912 shares of our stock, of which 34,065 shares were pledged to secure
the loan.  The remainder of the shares is being allocated to
individual accounts of participants as the debt is repaid. In accordance with
the requirements of the SOP 93-6, we presented the shares that were pledged as
collateral as a deduction of $478,000 and $518,000 from shareholders’ equity at
December 31, 2008, and December 31, 2007, respectively, as unearned ESOP
shares in the accompanying consolidated balance sheets.





The
Restricted Stock Plan permits the grant of stock awards to our employees,
officers and directors at the discretion of the compensation
committee.  A total of 320,000 shares of common stock have been
reserved for issuance under this plan.  To date, no shares have been
issued pursuant to the Restricted Stock Plan.





Share Repurchase
Program





On
December 1, 2006, the Company’s board of directors originally authorized a
stock repurchase program of up to 50,000 of its common shares outstanding for a
period of six months ending May 31, 2007.  This program was
extended for consecutive six-month periods, the most recent of which expired
November 30, 2008.  The latest extension also increased the number of
shares authorized to be repurchased to 157,000.  During the year ended
December 31, 2008, 93,200 shares of stock were repurchased under this program at
a cost of $1,131,000, at a weighted average price of $10.58 per share (shares
and per share prices reflect all stock splits and dividends) leaving 50,019
shares available for repurchase under the program.





From time to time, our Board of
Directors authorizes us to repurchase shares of our common
stock.  Although we announce when share repurchases are authorized, we
typically do not give any public notice before we repurchase our
shares.  Various factors determine the amount and timing of our share
repurchases, including our capital requirements, the number of shares we expect
to issue for acquisitions and employee benefit plans, market conditions
(including the trading price of our stock), and legal
considerations.  These factors can change at any time, and there can
be no assurance as to the number of shares we will repurchase or when we will
repurchase them.  Historically, our policy has been to repurchase
shares under the “safe harbor” conditions of Rule 10b-18 of the Exchange
including a limitation on the daily volume of repurchases.





Capital
Commitments





As of
December 31, 2008, construction on our Northern region market headquarters
located in the Tega Cay community of Fort Mill, South Carolina was underway,
with land costs of $1.5 million and construction in progress costs of
approximately $819,000 to date.  We anticipate construction on this
project to be completed in the second quarter of 2009 at a remaining cost of
approximately $1.1 million as of December 31, 2008.





We
do not expect future expansion via branching efforts within the next twelve
months.




67




Return
on Average Equity and Assets





The
following table shows the return on average assets (net income divided by
average total assets), return on average equity (net income divided by average
equity), and equity to assets ratio (average equity divided by average total
assets) for the years ended December 31, 2008, 2007 and 2006:




December
      31,
                    2008
                  
                  
                  December
      31,
                    2007
                  
                  
                  December
      31,
                    2006Return
      on average assets
                  
                  
                  -5.43
                  %
                  
                  
                  0.76
                  %
                  
                  
                  1.05
                  %Return
      on average equity
                  
                  
                  -54.01
                  %
                  
                  
                  10.89
                  %
                  
                  
                  16.82
                  %Equity
      to assets ratio
                  
                  
                  10.06
                  %
                  
                  
                  7.00
                  %
                  
                  
                  5.80
                  %





The
ratios shown above reflect a net loss for the year ended December 31,
2008.   The prior periods reflect the growth in net income and
the proportionally greater increase in our assets, as well as the capital raised
in the 2007 preferred stock offering.  Our asset growth for the year
ended December 31, 2008 outpaced asset growth for the years ended December 31,
2007 and 2006, while the 2007 preferred stock offering led to an increased
equity to assets ratio for the year ended December 31, 2007.  Although
net income for the year ended December 31, 2007 increased compared to net income
for the year ended December 31, 2006, our return on average equity decreased due
to increased average equity, resulting from the capital raised in the preferred
stock offering in addition to income earned during 2007.  For the year
ended December 31, 2008, our return on average equity decreased due to a net
loss for the year as well as increased equity due to the Merger (see Merger with Carolina National
in Part I for more details).  The Merger also led to an increased
equity to assets ratio for the year ended December 31, 2008.





Effect
of Inflation and Changing Prices





The
effect of relative purchasing power over time due to inflation has not been
taken into effect in our financial statements.  Rather, the statements have
been prepared on an historical cost basis in accordance with accounting
principles generally accepted in the United States of America.





Unlike
most industrial companies, the assets and liabilities of financial institutions
such as our holding company and bank are primarily monetary in nature. 
Therefore, the effect of changes in interest rates will have a more significant
impact on our performance than will the effect of changing prices and inflation
in general. In addition, interest rates may generally increase as the rate
of inflation increases, although not necessarily in the same magnitude.  As
discussed under Interest Rate
Sensitivity, we seek to manage the relationships between
interest-sensitive assets and liabilities in order to protect against wide rate
fluctuations, including those resulting from inflation.





Off-Balance
Sheet Arrangements





Through
the operations of our bank, we have made contractual commitments to extend
credit in the ordinary course of our business activities to meet the financing
needs of customers.  Such commitments involve, to varying degrees,
elements of credit risk and interest rate risk in excess of the amount
recognized in the balance sheets.  These commitments are legally
binding agreements to lend money at predetermined interest rates for a specified
period of time and generally have fixed expiration dates or other termination
clauses.  We use the same credit and collateral policies in making these
commitments as we do for on-balance sheet instruments.





We
evaluate each customer’s creditworthiness on a case-by-case basis and obtain
collateral, if necessary, based on our credit evaluation of the borrower. 
In addition to commitments to extend credit, we also issue standby letters of
credit that are assurances to a third party that they will not suffer a loss if
our customer fails to meet its contractual obligation to the third
party.  The credit risk involved in the underwriting of letters of
credit is essentially the same as that involved in extending loan facilities to
customers.





As of
December 31, 2008 and December 31, 2007, we had issued commitments to extend
credit of $145.9 million and $85.3 million, respectively, through various types
of commercial and consumer lending arrangements, of which the majority are at
variable rates of interest.  Standby letters of credit totaled $2,061,000
and $461,000, as of December 31, 2008 and December 31, 2007, respectively. 
Past experience indicates that many of these commitments to extend credit will
expire unused.  However, we believe that we have adequate sources of
liquidity to fund commitments that may be drawn upon by borrowers.




68




As of
December 31, 2008, $49.1 million of these commitments were for mortgages with
locked interest rates that had not yet funded.  We offer a wide
variety of conforming and non-conforming loans with fixed and variable rate
options. Recent financial media attention has focused on mortgage loans that are
considered “sub-prime” (higher credit risk), “Atl-A” (low documentation) and/or
“second lien.”  Our management has evaluated the loans that have been
originated by the bank to date for the purpose of selling in the secondary
market and believes that the majority of these loans conform to FHLMC and FNMA
standards with the remainder of the loans being jumbo residential mortgages and
mortgages with alternative or low documentation.   Therefore, we
believe that the exposure of this division to the sub-prime and Alt-A segments
is low.  The division also offers FHA/VA and construction/permanent
products with a proven history of salability to its customers. The division's
customers are located primarily in South Carolina and include a group of
investors with whom we have established relationships.  Due to the
nature of this division, the loans held for sale typically are held for a seven-
to ten-day period.   As of December 31, 2008, none of these loans
had been on our balance sheet for more than 51 days.





Except as
disclosed in this report, we are not involved in off-balance sheet contractual
relationships, unconsolidated related entities that have off-balance sheet
arrangements, or transactions that could result in liquidity needs or other
commitments that could significantly impact earnings.





Liquidity





Liquidity
represents the ability of a company to convert assets into cash or cash
equivalents without significant loss and to raise additional funds at a
reasonable cost by increasing liabilities in a timely manner and without adverse
consequences.  Liquidity management involves maintaining and
monitoring our sufficient and diverse sources and uses of funds in order to meet
our day-to-day and long-term cash flow requirements while maximizing profits and
maintaining an acceptable level of risk under both normal and adverse
conditions.  These requirements arise primarily from the withdrawal of
deposits, funding loan disbursements and the payment of operating
expenses.  Liquidity management is made more complicated because different
balance sheet components are subject to varying degrees of management
control.  For example, the timing of maturities of the investment portfolio
is fairly predictable and subject to a high degree of control at the time the
investment decisions are made.  However, net deposit inflows and outflows
are far less predictable as they are greatly influenced by general interest
rates, economic conditions and competition, and are not subject to nearly the
same degree of control.  Management has policies and procedures in
place governing the length of time to maturity on its earning assets such as
loans and investments which state that these assets are not typically utilized
for day-to-day liquidity needs.  Therefore, our liabilities have
generally provided our day-to-day liquidity in the past.





We
measure and monitor liquidity on a regular basis, allowing us to better
understand, predict and respond to balance sheet trends.  A
comprehensive liquidity analysis serves management as a vital decision-making
tool by providing a summary of anticipated changes in loans, investments, core
deposits, wholesale funds and construction commitments for capital
expenditures.  This internal funding report provides management with
the details critical to anticipate immediate and long-term cash requirements,
such as expected deposit runoff, loan paydowns and amount and cost of available
borrowing sources, including in secured overnight federal funds lines with our
various correspondent banks.  This liquidity analysis acts as a cash
forecasting tool and is subject to certain assumptions based on past market and
customer trends, as well as other information currently available regarding
current and future funding options and various indicators of future market and
customer behaviors.  Through consideration of the information provided
in this weekly report, management is better able to maximize our earning
opportunities by wisely and purposefully choosing our immediate, and more
critically, our long-term funding sources.  We have historically met
our daily liquidity needs through changes in deposit levels, borrowings under
our federal funds purchased facilities and other short-term borrowing
sources.





We manage
liquidity for our bank and our holding company separately.  This
approach considers the unique funding sources available to each entity, as well
as each entity’s capacity to manage through adverse conditions.  This
approach also recognizes that adverse market conditions or other events could
negatively affect the availability or cost of liquidity for either
entity.





In
addition to our various overnight and short-term borrowing options, we emphasize
deposit retention throughout our retail branch network to enhance our liquidity
position.   We recently have launched several very successful
deposit specials to lessen our current and future dependence on overnight
borrowings.  These specials have lasted only a short number of days,
have offered attractive terms for new money to the bank, and have produced
positive results by increasing market exposure and boosting
liquidity.  As a result, our cash and due from banks, interest bearing
bank balances and federal funds sold had increased to $53.5 million, or 6.4% of
total assets as of March 31, 2009 from $7.7 million or 0.91% of total assets as
of December 31, 2008.





We also
have in place a detailed liquidity contingency plan designed to successfully
respond to an overall decline in the economic environment, the banking industry
or a problem specific to our liquidity, outlined in a formal Contingency Funding
Policy approved by the Asset Liability Management Committee (“ALCO”) of our
board of directors.  This policy contains requirements for contingency
funding planning and analysis, including reporting under a number of different
contingency funding conditions.  The three conditions are described as
follows:




69





·
            Stage
      One Condition – During this stage, core deposits are not affected and the
      institution remains “well-capitalized”, but additional loan loss
      provisions may result in weak or negative quarterly
      earnings.  The ability to quickly open new full-service branches
      may be limited by our internal evaluations of our ability to successfully
      expand further.  In addition, external funding lines could be
      reduced.


·
            Stage
      Two Condition – At this level, the institution has become
      “adequately capitalized,” with serious asset-quality deterioration
      and reduced deposits overall.  At Stage Two, a meaningful level
      of uncertainty and vulnerability exists.  External funding lines
      would likely be reduced.  External factors, such as adverse
      general industry or market conditions and reputation risk, may also impact
      liquidity.


·
            Stage
      Three Condition - At this point, the institution has significant earnings
      deterioration, in part due to significantly increased provisions for loan
      losses, and impaired residual assets. External funding lines would be
      greatly reduced, and the institution has become
      “undercapitalized.”





In
addition, a liquidity crisis action plan is in place, which may be followed in
reaction to or in anticipation of a financial shock to the banking industry,
generally, or us, specifically, which results in strains or expectations of
strains on the bank’s normal funding activities.





As of
December 31, 2008, and December 31, 2007, our liquid assets, consisting of
cash and due from banks, interest-bearing bank balances and federal funds sold,
amounted to $7.7 million and $8.4 million, representing .95% and 1.44% of total
assets, respectively.




Investment
securities may provide a secondary source of liquidity, net of amounts pledged
for deposits and FHLB advances; however, the primary objective for investment
securities is to serve as collateral for public deposits, which limits their
availability as a liquidity source.  Our ability to maintain and
expand our deposit base and borrowing capabilities also serves as a source of
liquidity.   On October 24, 2008, the FDIC announced that it will
fully cover noninterest bearing deposit transaction accounts, regardless of
dollar amount, under the FDIC’s Transaction Account Guarantee Program
(“TAGP”).  A 10-basis point surcharge will be added to a participating
institution’s current insurance assessment in order to fully cover the
noninterest bearing transaction account.  We elected to participate in
the TAGP to further enhance our existing deposit base and assist us in
attracting new deposits.





The
decrease in our liquidity over the past several years has occurred as a result
of funds needed to support the growth of our loan production
offices.  In addition, the demand for retained deposits has increased
in recent months due to the tightness of liquidity in current financial markets,
which also creates more liquidity risk.  These conditions have
challenged us to maximize the various funding options available to
us.   In order to better manage liquidity risk, we have performed
stress tests and developed projections to determine the effect that possible
future events could have on liquidity over various time periods.  The
results of these projections indicate that we could continue to meet our
financial obligations and to fund our operations for at least one
year.





We have
utilized certain nontraditional funding sources to compensate for this increased
liquidity risk.  The sources listed below have been deemed acceptable
by the bank’s board of directors and are monitored regularly by management and
reported on at each formal ALCO meeting:





·
            Federal
      Funds Purchased – funds are purchased from up-stream correspondent
      financial institutions when the need for overnight funds
      exists.  These lines are available for short-term funding needs
      only.  They require no collateral and are generally somewhat
      less expensive than longer-term funding
options.


·
            FHLB
      Advances – this source of borrowing offers both long-term fixed and
      adjustable borrowings, typically at very competitive rates, as well as
      overnight borrowing capacity, all subject to available
      collateral.  This source of borrowing requires us to be a member
      of the FHLB, and as such, to purchase and hold FHLB stock as a percentage
      of the funds borrowed.


·
            CD
      Programs – these programs have historically been known as brokered
      deposits.  Various terms are available, and in considering the
      various CD program options, management balances our current interest rate
      risk profile with our liquidity
demands.


·
            Reverse
      Repurchase Agreements – this source of funds relies on our investment
      portfolio as collateral in borrowing from an up-stream
      correspondent.  Reverse repurchase agreements involve overnight
      borrowings with daily rate changes.





Proactive
and well-advised daily cash management ensures that these lines are accessed and
repaid with careful consideration of all of our available funding options as
well as the associated costs.  Our overnight lines historically have
been tested at least once quarterly to ensure ease of access, continued
availability and that we consistently maintain healthy working relationships
with each correspondent.


70


Historically,
we had planned to meet our future cash needs through the generation of deposits
from retail and wholesale sources, the liquidation of temporary investments, and
the maturities of investment securities as well as these nontraditional funding
sources.  However, in recent months, the effects of the credit crisis have
impacted liquidity for the banking industry. As a result, most of the sources of
liquidity that we rely on have been significantly disrupted.  In the
future, we plan to reduce our reliance on the wholesale funding market for
deposits and capitalize on existing and new retail deposit markets through our
statewide network of twelve full-service branches. In addition, the bank
maintains federal funds purchased lines of credit with correspondent banks that
totaled $28.0 million as of December 31, 2008.




The bank
is also a member of the FHLB of Atlanta from which application for borrowings
can be made for leverage purposes, up to available collateral.  As of
December 31, 2008, qualifying loans held by the bank and collateralized by 1-4
family residences, home equity lines of credit (“HELOC’s”) and commercial
properties totaling $88,382,000 were pledged as collateral for FHLB advances
outstanding of $86,363,000.  We consider advances from the FHLB to be
a reliable and readily available source of funds both for liquidity purposes and
asset liability management, as well as interest rate risk management
strategies.  A key component in borrowing funds from the FHLB is
maintaining good quality collateral to pledge against our
advances.  We primarily rely on our existing loan portfolio for this
collateral.  We access and monitor current FHLB guidelines to
determine the eligibility of loans to qualify as collateral for an FHLB
advance.  We are subject to the FHLB’s credit risk rating which was
effective June 27, 2008.  This revised policy incorporated
enhancements to the FHLB’s credit risk rating system which assigns member
institutions a rating which is reviewed quarterly.  The rating system
utilizes key factors such as loan quality, capital, liquidity, profitability,
etc.  Our ability to access our available borrowing capacity from the
FHLB in the future is subject to our rating and any subsequent changes based on
our financial performance as compared to factors considered by the FHLB in their
assignment of our credit risk rating each quarter.  In addition,
residential collateral discounts have been recently applied which may further
reduce our borrowing capacity. We have been notified by FHLB that it will not
allow future advances to us while we are operating under our current regulatory
enforcement action.





We
recently received the final report from our bank’s regulatory safety and
soundness examination which was completed in November 2008.  Based on
information included in this report and due to the consent order we executed
with the OCC on April 27, 2009, our ability to access brokered deposits through
the wholesale funding market is restricted.  This action will restrict
our bank’s ability to accept, renew or rollover brokered deposits without being
granted a waiver of this prohibition by the FDIC. There is no assurance
that the FDIC will grant us a waiver. Following the execution of the enforcement
action with the OCC, we will be required to revise our comprehensive liquidity
risk management program.  This program will assess our current and
projected funding needs to ensure that sufficient funds or access to funds exist
to meet those needs.  The program must also include effective methods
to achieve and maintain sufficient liquidity and to measure and monitor
liquidity risk including the preparation and submission of liquidity reports on
a regular basis to the board of directors and the OCC. The program will also
contain a contingency funding plan that forecasts funding needs and
funding sources under different stress scenarios. This plan will detail how
the bank will comply with the restrictions in the order, including the
restriction against brokered deposits, as well as require reports detailing all
funding sources and obligations under best case and worse case
scenarios.





During
the fourth quarter of 2007, our holding company established a line of credit
with a correspondent bank secured by the stock of our bank.  The line
of credit, in an amount up to $15,000,000, has a twelve-year final maturity with
interest payable quarterly at a floating rate tied to the Wall Street Journal
Prime Rate.  The terms of the line include two years of quarterly
interest payments followed by ten years of annual principal payments plus
quarterly interest payments on the outstanding principal balance as of December
31, 2009.  The line of credit was secured in connection with the terms
of the Merger Agreement, dated August 26, 2007, between First National and
Carolina National, to support the cash consideration of the Merger and to fund
general operating expenses for the holding company for 2008 and
2009.





As of
December 31, 2008, we had an outstanding balance of $9.5 million on the line of
credit described above.  Because of our unusually high amount of
nonperforming loans and assets as of December 31, 2008 and our reduced
profitability for 2008, we were out of compliance with the covenants governing
the line of credit.  The correspondent bank has granted us a waiver
regarding the noncompliance that is effective until they complete the quarterly
review of our December 31, 2008 financial statements and we believe that
quarterly waivers will be granted in the future until we are once again in
compliance with the covenants governing the line of credit.   The
lender has also granted us a waiver through June 30, 2009, of their ability to
pursue the collateral underlying the line of credit.  All other terms
and conditions of the loan documents continue to exist and may be exercised at
any time.





We
believe that our existing liquidity sources are sufficient to meet our
short-term liquidity needs.  We continue to evaluate other sources of
liquidity to ensure our long-term funding needs are met that may also qualify as
regulatory capital, such as trust preferred securities, subordinated debt and
common stock.  However, further market disruption may reduce the cost
effectiveness and availability of our funding sources for a prolonged period of
time which may require management to more aggressively pursue other funding
alternatives.


71


Interest
Rate Sensitivity





Asset
liability management is the process by which we monitor and control the mix and
maturities of our assets and liabilities.  The essential purposes of
asset liability management are to ensure adequate liquidity and to maintain an
appropriate balance between interest-sensitive assets and liabilities to
minimize the potentially adverse impact on earnings from changes in market
interest rates.  Our asset liability management committee (“ALCO”) monitors
and manages our exposure to interest rate risk through the use of a simulation
model that projects the impact of rate shocks, rate cycles, and rate forecast
estimates on the net interest income and economic value of equity (the net
present value of expected cash flows from assets and
liabilities)  These simulations provide a test for embedded interest
rate risk and take into consideration factors such as maturities, reinvestment
rates, prepayment speeds, repricing limits, decay rates and other
factors.  The results are compared to risk tolerance limits set by
ALCO policy.  The ALCO meets quarterly and consists of members of the board
of directors and senior management of the bank.  The ALCO is charged with
the responsibility of managing our exposure to interest rate risk by maintaining
the level of interest rate sensitivity of the bank’s interest-sensitive assets
and liabilities within board-approved limits. Interest rate risk can be measured
by analyzing the extent to which the repricing of assets and liabilities are
mismatched to create an interest sensitivity “gap.”  An asset or
liability is considered to be interest rate sensitive within a specific time
period if it will mature or reprice within that time period.  The
interest rate sensitivity gap is defined as the difference between the amount of
interest earning assets maturing or repricing within a specific time period and
the amount of interest bearing liabilities maturing or repricing within that
same time period.  A gap is considered positive when the amount of
interest rate sensitive assets exceeds the amount of interest rate sensitive
liabilities.  A gap is considered negative when the amount of interest
rate sensitive liabilities exceeds the amount of interest rate sensitive
assets.  During a period of rising interest rates, therefore, a
negative gap would tend to adversely affect net interest
income.  Conversely, during a period of falling interest rates a
negative gap position would tend to result in an increase in net interest
income.









The
following table sets forth information regarding our interest rate sensitivity
as of December 31, 2008, for each of the time intervals
indicated.  The information in the table may not be indicative of our
interest rate sensitivity position at other points in time.  In
addition, the maturity distribution indicated in the table may differ from the
contractual maturities of the interest-earning assets and interest-bearing
liabilities presented due to consideration of prepayment speeds under various
interest rate change scenarios in the application of the interest rate
sensitivity methods described above (dollars in thousands).





Within three
                          months
                        
                        
                        After three
                          but within
                          twelve months
                        
                        
                        After onebut
                          within five
                          years
                        
                        
                        After five
                          years
                        
                        
                        TotalInterest-earning
      assetsFederal
      funds sold and other
                        
                        $
                        403
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        403Investment
      securities
                        
                        
                        6,114
                        
                        
                        
                        8,947
                        
                        
                        
                        37,098
                        
                        
                        
                        37,135
                        
                        
                        
                        89,294Loans
                        
                        
                        443,755
                        
                        
                        
                        43,497
                        
                        
                        
                        173,896
                        
                        
                        
                        30,105
                        
                        
                        
                        691,253Total
      interest-earning assets
                        
                        $
                        450,272
                        
                        
                        $
                        52,444
                        
                        
                        $
                        210,994
                        
                        
                        $
                        67,240
                        
                        
                        $
                        780,950Interest-bearing
      liabilitiesNOW
      accounts, money market and savings
                        
                        $
                        180,539
                        
                        
                        
                        3,715
                        
                        
                        
                        19,816
                        
                        
                        
                        14,330
                        
                        
                        $
                        218,400Time
      deposits
                        
                        
                        182,482
                        
                        
                        
                        206,624
                        
                        
                        
                        39,091
                        
                        
                        
                        252
                        
                        
                        
                        428,449FHLB
      advances and other
                        
                        
                        22,347
                        
                        
                        
                        31,213
                        
                        
                        
                        34,175
                        
                        
                        
                        20,000
                        
                        
                        
                        107,735Junior
      subordinated debentures
                        
                        
                        13,403
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        13,403Fed
      funds purchased
                        
                        
                        1
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1Total
      interest-bearing liabilities
                        
                        $
                        398,772
                        
                        
                        $
                        241,552
                        
                        
                        $
                        93,082
                        
                        
                        $
                        34,582
                        
                        
                        $
                        767,988Period
      gap
                        
                        $
                        51,500
                        
                        
                        $
                        (189,108
                        )
                        
                        $
                        117,912
                        
                        
                        $
                        32,658Cumulative
      gap
                        
                        $
                        51,500
                        
                        
                        $
                        (137,608
                        )
                        
                        $
                        (19,696
                        )
                        
                        $
                        12,962Ratio
      of cumulative gap to total interest-earning assets
                        
                        
                        6.59
                        %
                        
                        
                        (17.62
                        )%
                        
                        
                        (2.52
                        )%
                        
                        
                        1.66
                        %




Item 7A. Quantitative and Qualitative
Disclosures about Market Risk





Market
risk is the potential loss arising from adverse changes in market prices and
rates that principally arises from interest rate risk inherent in our lending,
investing, deposit gathering, and borrowing activities.  It is our policy
to maintain an acceptable level of interest rate risk over a range of possible
changes in interest rates while remaining responsive to market demand for loan
and deposit products.  Other types of market risks, such as foreign
currency exchange rate risk and commodity price risk, do not normally arise in
the normal course of our business.  We actively monitor and manage our
interest rate risk exposure.


72





The
principal interest rate risk monitoring technique we employ is the measurement
of our interest sensitivity “gap,” which is the positive or negative dollar
difference between assets and liabilities that are subject to interest rate
repricing within a given time period.  Interest rate sensitivity can
be managed by repricing assets or liabilities, selling securities available for
sale, replacing an asset or liability at maturity, or adjusting the interest
rate during the life of an asset or liability.  Managing the amount of
assets and liabilities repricing in this same time interval helps to hedge the
risk and minimize the impact of rising or falling interest rates on net interest
income.  We generally would benefit from increasing market rates of
interest when we have an asset-sensitive gap position and generally would
benefit from decreasing market rates of interest when we are
liability-sensitive.





As of
December 31, 2008, we were liability sensitive over a one-year time
frame.  However, our gap analysis is not a precise indicator of our
interest sensitivity position.  The analysis presents only a static
view of the timing of maturities and repricing opportunities, without taking
into consideration that changes in interest rates do not affect all assets and
liabilities equally.  For example, rates paid on a substantial portion
of core deposits may change contractually within a relatively short time frame,
but those rates are viewed by management as significantly less
interest-sensitive than market-based rates such as those paid on non-core
deposits.  Net interest income may be impacted by other significant
factors in a given interest rate environment, including changes in the volume
and mix of interest-earning assets and interest-bearing
liabilities.





Recently
Issued Accounting Pronouncements





The
following is a summary of recent authoritative pronouncements that affect
accounting, reporting and disclosure of financial information.





In
December 2007, the Financial Accounting Standards Board(“FASB”) issued Statement of
Financial Accounting Standard(“SFAS”) No.
141(R), “Business Combinations,” (“SFAS 141(R)”) which replaces SFAS 141. SFAS
141(R) establishes principles and requirements for how an acquirer in a business
combination recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any controlling interest;
recognizes and measures goodwill acquired in the business combination or a gain
from a bargain purchase; and determines what information to disclose to enable
users of the financial statements to evaluate the nature and financial effects
of the business combination. SFAS 141(R) is effective for acquisitions taking
place on or after January 1, 2009. Early adoption is prohibited. Accordingly, a
calendar year-end company is required to record and disclose business
combinations following existing accounting guidance until January 1, 2009. We
will assess the impact of SFAS 141(R) if and when a future acquisition
occurs.





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51,” (“SFAS 160”).
SFAS 160 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. Before this statement, limited guidance existed for reporting
noncontrolling interests (minority interest). As a result, diversity in practice
exists. In some cases minority interest is reported as a liability and in others
it is reported in the mezzanine section between liabilities and equity.
Specifically, SFAS 160 requires the recognition of a noncontrolling interest
(minority interest) as equity in the consolidated financials statements and
separate from the parent’s equity. The amount of net income attributable to the
noncontrolling interest will be included in consolidated net income on the face
of the income statement. SFAS 160 clarifies that changes in a parent’s ownership
interest in a subsidiary that do not result in deconsolidation are equity
transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the noncontrolling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its noncontrolling interests. SFAS 160
was effective for us on January 1, 2009.  SFAS 160 had no impact on
our financial position, results of operations or cash flows.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities,” (“SFAS 161”).  SFAS 161 requires enhanced
disclosures about an entity’s derivative and hedging activities, thereby
improving the transparency of financial reporting.  It is intended to
enhance the current disclosure framework in SFAS 133 by requiring that
objectives for using derivative instruments be disclosed in terms of underlying
risk and accounting designation. This disclosure is intended to convey the
purpose of derivative use in terms of the risks that the entity is intending to
manage. SFAS 161 was effective for us on January 1, 2009 and will result in
additional disclosures if we enter into any material derivative or hedging
activities but currently has no impact on our financial position, results of
operations or cash flows.





In
February 2008, the FASB issued FASB Staff Position No. 140-3, “Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions,” (“FSP
140-3”).  This FSP provides guidance on accounting for a transfer of a
financial asset and the transferor’s repurchase financing of the asset.
 This FSP presumes that an initial transfer of a financial asset and a
repurchase financing are considered part of the same arrangement (linked
transaction) under SFAS 140. However, if certain criteria are met, the initial
transfer and repurchase financing are not evaluated as a linked transaction and
are evaluated separately under SFAS 140.  FSP 140-3 was effective for us on
January 1, 2009.  The adoption of FSP 140-3 had no impact on our financial
position, results of operations or cash flows.


73





In April
2008, the FASB issued FASB Staff Position No. 142-3, “Determination of the
Useful Life of Intangible Assets,” (“FSP 142-3”).  This FSP amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under SFAS
No. 142, “Goodwill and Other Intangible Assets,” (“SFAS 142”).  The
intent of this FSP is to improve the consistency between the useful life of a
recognized intangible asset under SFAS 142 and the period of expected cash flows
used to measure the fair value of the asset under SFAS 141(R) and other U.S.
generally accepted accounting principles.  This FSP was effective for
us on January 1, 2009 and resulted in the impairment of our intangible asset
goodwill.





In May,
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles,” (“SFAS 162”).  SFAS 162 identifies the sources
of accounting principles and the framework for selecting the principles used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (GAAP) in
the United States (the GAAP hierarchy).  SFAS 162 is effective
November 15, 2008.  The FASB has stated that it does not expect SFAS
162 will result in a change in current practice. The application of SFAS 162 had
no effect on our financial position, results of operations or cash
flows.





In June,
2008, the FASB issued FASB Staff Position No. EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions are Participating
Securities,” (“FSP EITF 03-6-1”).  The Staff Position provides that
unvested share-based payment awards that contain nonforfeitable rights to
dividends or dividend equivalents are participating securities and must be
included in the earnings per share computation.  FSP EITF 03-6-1 was
effective January 1, 2009 and had no effect on our financial position, results
of operations, earnings per share or cash flows.





FSP SFAS
133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain
Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No.
45; and Clarification of the Effective Date of FASB Statement No. 161,” (“FSP
SFAS 133-1 and FIN 45-4”) was issued September 2008, effective for reporting
periods (annual or interim) ending after November 15, 2008.  FSP SFAS
133-1 and FIN 45-4 amends SFAS 133 to require the seller of credit derivatives
to disclose the nature of the credit derivative, the maximum potential amount of
future payments, fair value of the derivative, and the nature of any recourse
provisions.  Disclosures must be made for entire hybrid instruments
that have embedded credit derivatives. The Staff Position also amends FASB
Interpretation No. (“FIN”) 45 to require disclosure of the current status of the
payment/performance risk of the credit derivative guarantee.  If an
entity utilizes internal groupings as a basis for the risk, how the groupings
are determined must be disclosed as well as how the risk is managed. The Staff
Position encourages that the amendments be applied in periods earlier than the
effective date to facilitate comparisons at initial adoption.  After
initial adoption, comparative disclosures are required only for subsequent
periods.FSP SFAS 133-1 and FIN 45-4 clarifies the effective date of SFAS 161
such that required disclosures should be provided for any reporting period
(annual or quarterly interim) beginning after November 15, 2008.  The
adoption of this Staff Position had no material effect on our financial
position, results of operations or cash flows.





The SEC’s
Office of the Chief Accountant and the staff of the FASB issued press release
2008-234 on September 30, 2008 (“Press Release”) to provide clarifications on
fair value accounting.  The Press Release includes guidance on the use
of management’s internal assumptions and the use of “market”
quotes.  It also reiterates the factors in SEC Staff Accounting
Bulletin (“SAB”) Topic 5M which should be considered when determining
other-than-temporary impairment: the length of time and extent to which the
market value has been less than cost; financial condition and near-term
prospects of the issuer; and the intent and ability of the holder to retain its
investment for a period of time sufficient to allow for any anticipated recovery
in market value.  On October 10, 2008, the FASB issued FSP SFAS 157-3,
“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active” (“FSP SFAS 157-3”). This FSP clarifies the application of SFAS
No. 157, “Fair Value Measurements” (see Note 21 – Fair Value of Financial
Instruments) in a market that is not active and provides an example to
illustrate key considerations in determining the fair value of a financial asset
when the market for that asset is not active.  The FSP is effective
upon issuance, including prior periods for which financial statements have not
been issued. For us, this FSP was effective for the quarter ended September 30,
2008. The Company considered the guidance in the Press Release and in FSP SFAS
157-3 when conducting its review for other-than-temporary impairment as of
December 31, 2008 as discussed in Note 21 – Fair Value of Financial
Instruments.





FSP SFAS
140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about
Transfers of Financial Assets and Interests in Variable Interest Entities,”
(“FSP SFAS 140-4 and FIN 46(R)-8”) was issued in December 2008 to require public
entities to disclose additional information about transfers of financial assets
and to require public enterprises to provide additional disclosures about their
involvement with variable interest entities.  The FSP also requires
certain disclosures for public enterprises that are sponsors and servicers of
qualifying special purpose entities.  The FSP is effective for the
first reporting period ending after December 15, 2008.  This FSP had
no material impact on our financial position.


74


FSP SFAS
132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets,”
(“FSP SFAS 132(R)-1”) issued in December 2008, provides guidance on an
employer’s disclosures about plan assets of a defined benefit pension or other
postretirement plan to provide the users of financial statements with an
understanding of: (a) how investment allocation decisions are made, including
the factors that are pertinent to an understanding of investment policies and
strategies; (b) the major categories of plan assets; (c) the inputs and
valuation techniques used to measure the fair value of plan assets; (d) the
effect of fair value measurements using significant unobservable inputs (Level
3) on changes in plan assets for the period; and (e) significant concentrations
of risk within plan assets. The Staff Position also requires a nonpublic entity,
as defined in SFAS 132, to disclose net periodic benefit cost for each period
for which a statement of income is presented.  FSP SFAS 132(R)-1 is
effective for fiscal years ending after December 15, 2009.  The Staff
Position will require us to provide additional disclosures related it to our
benefit plans.





FSP EITF
99-20-1, “Amendments to the Impairment Guidance of EIFT Issue No. 99-20,” (“FSP
EITF 99-20-1”) was issued in January 2009.  Prior to the Staff
Position, other-than-temporary impairment was determined by using either EITF
Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased
Beneficial Interests and Beneficial Interests that Continue to be Held by a
Transferor in Securitized Financial Assets,” (“EITF 99-20”) or SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” (“SFAS 115”)
depending on the type of security.  EITF 99-20 required the use of
market participant assumptions regarding future cash flows regarding the
probability of collecting all cash flows previously projected.  SFAS
115 determined impairment to be other than temporary if it was probable that the
holder would be unable to collect all amounts due according to the contractual
terms. To achieve a more consistent determination of other-than-temporary
impairment, the Staff Position amends EITF 99-20 to determine any
other-than-temporary impairment based on the guidance in SFAS 115, allowing
management to use more judgment in determining any other-than-temporary
impairment.  The Staff Position is effective for interim and annual
reporting periods ending after December 15, 2008 and shall be applied
prospectively.  Retroactive application is not
permitted.  Management has reviewed our security portfolio and
evaluated the portfolio for any other-than-temporary impairments as discussed in
Note 21 – Fair Value of Financial Instruments.





Other
accounting standards that have been issued or proposed by the FASB or other
standards-setting bodies are not expected to have a material impact on our
financial position, results of operations or cash flows.


75


Item 8. Financial
Statements.





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Management
of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting. Management has assessed the effectiveness of
internal control over financial reporting using the criteria established in
Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).





The
Company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. The Company’s internal control
over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the Company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are
being made only in accordance with authorizations of management and directors of
the Company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisitions, use, or disposition of the Company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Therefore, even those systems determined to be
effective can provide only reasonable assurance with respect to financial
statement preparation and presentation. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





Based on
the testing performed using the criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO), management of the Company believes that the
company’s internal control over financial reporting was effective as of December
31, 2008.





This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  The Company’s registered public accounting firm was not
required to issue an attestation on its internal controls over financial
reporting pursuant to temporary rules of the Securities and Exchange
Commission.


76




REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 To the
Shareholders and Board of Directors
 First
National Bancshares, Inc. and Subsidiary
 Spartanburg,
South Carolina
 
 We have
audited the accompanying consolidated balance sheets of First National
Bancshares, Inc. and subsidiary(the
“Company”) as of December 31, 2008 and 2007, and the related consolidated
statements of operations, changes in shareholders’ equity and comprehensive
income (loss) and cash flows for each of the three years in the period ended
December 31, 2008.  These consolidated financial statements are the
responsibility of the Company's management.  Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position ofFirst
National Bancshares, Inc. and subsidiaryas
of December 31, 2008 and 2007 and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2008 in
conformity with United States generally accepted accounting
principles.
 
 The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 2
to the consolidated financial statements, the Company’s nonperforming assets
have increased to $75.5 million related primarily to deterioration in the credit
quality of its acquisition and development loans. The level of nonperforming
assets has caused the Company to be out of compliance with certain covenants for
its line of credit. The uncertainty of the Company’s ability to repay or replace
the line of credit or to mitigate actions by their lender if the lender declares
an event of default, revokes the line of credit or attempts to foreclose on the
stock of the subsidiary that is pledged as collateral, raises substantial
doubt about the Company's ability to continue as a going concern.  The
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.  In addition, the
subsidiary bank (Bank) has entered into a formal agreement with its primary
regulator, the Office of the Comptroller of the Currency, aimed at improving the
performance of the Bank.  The formal agreement requires management to
take a number of actions, including, among other things, reducing the level of
nonperforming assets and increasing and maintaining its capital levels at
amounts in excess of the Bank’s current capital levels.  Management's
plans in regard to these matters are described in Note 2.
 
 We were
not engaged to examine management’s assertion about the effectiveness of First
National Bancshares, Inc. and subsidiary’s internal control over financial
reporting as of December 31, 2008, included in the accompanying Management’s
Report on Internal Controls Over Financial Reporting, and, accordingly, we do
not express an opinion thereon.
 
 
 Greenville,
South Carolina
 April 29,
2009
  77


FIRST
NATIONAL BANCSHARES, INC. AND SUBSIDIARY




Consolidated
Balance Sheets




December 31,
2008 and 2007


(dollars
in thousands)





2008
                    
                    
                    2007AssetsCash
      and cash equivalents
                    
                    $
                    7,700
                    
                    
                    $
                    8,426Securities
      available for sale
                    
                    
                    81,662
                    
                    
                    
                    70,530Loans,
      net of allowance for loan losses of $23,033 and $4,951,
      respectively
                    
                    
                    669,843
                    
                    
                    
                    469,734Mortgage
      loans held for sale
                    
                    
                    16,411
                    
                    
                    
                    19,408Premises
      and equipment, net
                    
                    
                    7,620
                    
                    
                    
                    2,974Other
                    
                    
                    29,506
                    
                    
                    
                    15,441Total
      assets
                    
                    $
                    812,742
                    
                    
                    $
                    586,513Liabilities
      and Shareholders' EquityLiabilities:DepositsNoninterest-bearing
                    
                    $
                    39,088
                    
                    
                    $
                    44,466Interest-bearing
                    
                    
                    607,761
                    
                    
                    
                    427,362Total
      deposits
                    
                    
                    646,849
                    
                    
                    
                    471,828FHLB
      advances
                    
                    
                    86,363
                    
                    
                    
                    41,690Federal
      funds purchased and other short-term borrowings
                    
                    
                    11,873
                    
                    
                    
                    9,360Junior
      subordinated debentures
                    
                    
                    13,403
                    
                    
                    
                    13,403Long-term
      debt
                    
                    
                    9,500
                    
                    
                    
                    -Accrued
      expenses and other liabilities
                    
                    
                    4,130
                    
                    
                    
                    2,676Total
      liabilities
                    
                    $
                    772,118
                    
                    
                    $
                    538,957Commitments
      and contingencies - Notes 2,7,19,20Shareholders'
      equity:Preferred
      stock, par value $0.01 per share, 10,000,000 shares authorized; 720,000
      shares issued and outstanding
                    
                    
                    7
                    
                    
                    
                    7Common
      stock, par value $0.01 per share, 10,000,000 shares authorized; 6,296,698
      and 3,724,948 shares issued and outstanding, respectively, net of treasury
      shares outstanding
                    
                    
                    64
                    
                    
                    
                    37Treasury
      stock, 106,981 and 13,781 shares, respectively, at cost
                    
                    
                    (1,131
                    )
                    
                    
                    (224
                    )Additional
      paid-in capital
                    
                    
                    83,401
                    
                    
                    
                    43,809Unearned
      ESOP shares
                    
                    
                    (478
                    )
                    
                    
                    (518
                    )Retained
      earnings/(deficit)
                    
                    
                    (41,807
                    )
                    
                    
                    4,408Accumulated
      other comprehensive income
                    
                    
                    568
                    
                    
                    
                    37Total
      shareholders' equity
                    
                    $
                    40,624
                    
                    
                    $
                    47,556Total
      liabilities and shareholders' equity
                    
                    $
                    812,742
                    
                    
                    $
                    586,513





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


78


FIRST
NATIONAL BANCSHARES, INC. AND SUBSIDIARY




Consolidated
Statements of Operations




For the
Years Ended December 31, 2008, 2007 and 2006


(dollars
in thousands, except share data)




2008
                            
                            
                            2007
                            
                            
                            2006Interest
      income:Loans
                            
                            $
                            41,604
                            
                            
                            $
                            36,329
                            
                            
                            $
                            26,237Taxable
      securities
                            
                            
                            2,727
                            
                            
                            
                            2,672
                            
                            
                            
                            1,977Nontaxable
      securities
                            
                            
                            750
                            
                            
                            
                            621
                            
                            
                            
                            352Federal
      funds sold and other
                            
                            
                            306
                            
                            
                            
                            346
                            
                            
                            
                            320Total
      interest income
                            
                            
                            45,387
                            
                            
                            
                            39,968
                            
                            
                            
                            28,886Interest
      expense:Deposits
                            
                            
                            22,039
                            
                            
                            
                            18,872
                            
                            
                            
                            12,134FHLB
      advances
                            
                            
                            2,060
                            
                            
                            
                            1,957
                            
                            
                            
                            1,570Junior
      subordinated debentures
                            
                            
                            740
                            
                            
                            
                            1,025
                            
                            
                            
                            877Federal
      funds purchased and other short-term borrowings
                            
                            
                            332
                            
                            
                            
                            611
                            
                            
                            
                            144Long-term
      debt
                            
                            
                            208
                            
                            
                            
                            -
                            
                            
                            
                            -Total
      interest expense
                            
                            
                            25,379
                            
                            
                            
                            22,465
                            
                            
                            
                            14,725Net
      interest income
                            
                            
                            20,008
                            
                            
                            
                            17,503
                            
                            
                            
                            14,161Provision
      for loan losses
                            
                            
                            20,460
                            
                            
                            
                            1,396
                            
                            
                            
                            1,192Net
      interest income/(loss) after provision for loan losses
                            
                            
                            (452
                            )
                            
                            
                            16,107
                            
                            
                            
                            12,969Noninterest
      income:Mortgage
      banking income
                            
                            
                            2,251
                            
                            
                            
                            1,858
                            
                            
                            
                            -Service
      charges and fees on deposit accounts
                            
                            
                            1,766
                            
                            
                            
                            1,270
                            
                            
                            
                            1,080Gain
      on sale of securities available for sale
                            
                            
                            207
                            
                            
                            
                            117
                            
                            
                            
                            33Other
                            
                            
                            796
                            
                            
                            
                            906
                            
                            
                            
                            966Total
      noninterest income
                            
                            
                            5,020
                            
                            
                            
                            4,151
                            
                            
                            
                            2,079Noninterest
      expense:Goodwill
      impairment
                            
                            
                            28,732
                            
                            
                            
                            -
                            
                            
                            
                            -Salaries
      and employee benefits
                            
                            
                            11,429
                            
                            
                            
                            7,876
                            
                            
                            
                            5,128Occupancy
      and equipment expense
                            
                            
                            3,375
                            
                            
                            
                            2,030
                            
                            
                            
                            1,046Other
      real estate owned expense
                            
                            
                            1,757
                            
                            
                            
                            31
                            
                            
                            
                            -Data
      processing and ATM expense
                            
                            
                            1,303
                            
                            
                            
                            702
                            
                            
                            
                            587Public
      relations
                            
                            
                            708
                            
                            
                            
                            635
                            
                            
                            
                            541Telephone
      and supplies
                            
                            
                            675
                            
                            
                            
                            426
                            
                            
                            
                            295Professional
      fees
                            
                            
                            589
                            
                            
                            
                            513
                            
                            
                            
                            183Loan
      related expenses
                            
                            
                            534
                            
                            
                            
                            409
                            
                            
                            
                            114FDIC
      insurance
                            
                            
                            529
                            
                            
                            
                            331
                            
                            
                            
                            35Other
                            
                            
                            2,018
                            
                            
                            
                            1,206
                            
                            
                            
                            972Total
      noninterest expense
                            
                            
                            51,649
                            
                            
                            
                            14,159
                            
                            
                            
                            8,901Net
      income/(loss) before income taxes
                            
                            
                            (47,081
                            )
                            
                            
                            6,099
                            
                            
                            
                            6,147Income
      tax expense/(benefit)
                            
                            
                            (2,234
                            )
                            
                            
                            2,039
                            
                            
                            
                            2,095Net
      income/(loss)
                            
                            
                            (44,847
                            )
                            
                            
                            4,060
                            
                            
                            
                            4,052Cash
      dividends declared on preferred stock
                            
                            
                            1,305
                            
                            
                            
                            626
                            
                            
                            
                            -Net
      income/(loss) available to common shareholders
                            
                            $
                            (46,152
                            )
                            
                            $
                            3,434
                            
                            
                            $
                            4,052Net
      income/(loss) per common shareBasic
                            
                            $
                            (7.56
                            )
                            
                            $
                            0.93
                            
                            
                            $
                            1.12Diluted
                            
                            $
                            (7.56
                            )
                            
                            $
                            0.84
                            
                            
                            $
                            0.94Weighted
      average common shares outstandingBasic
                            
                            
                            6,101,656
                            
                            
                            
                            3,696,464
                            
                            
                            
                            3,615,022Diluted
                            
                            
                            6,101,656
                            
                            
                            
                            4,847,045
                            
                            
                            
                            4,324,561





All share
and per share amounts reflect the 7% stock dividend distributed on
March 30, 2007.


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


79




FIRST
NATIONAL BANCSHARES, INC. AND SUBSIDIARY




Consolidated
Statements of Changes in Shareholders’ Equity and Comprehensive
Income/(Loss)




For the
Years Ended December 31, 2008, 2007 and 2006


(dollars
in thousands)







AccumulatedPreferred
      Stock
                                              
                                              Common
      Stock
                                              
                                              Treasury
      Stock
                                              
                                              Additional
                                                Paid-In
                                              
                                              
                                              Unearned
                                                ESOP
                                              
                                              
                                              Retained

                                                  Earnings
      /
                                              
                                              
                                              Other
                                                Comprehensive
                                              
                                              
                                              Total
                                                Shareholders'Shares
                                              
                                              
                                              Amount
                                              
                                              Shares
                                              
                                              
                                              Amount
                                              
                                              Shares
                                              
                                              
                                              Amount
                                              
                                              Capital
                                              
                                              
                                              Shares
                                              
                                              
                                              (Deficit)
                                              
                                              
                                              Income/(Loss)
                                              
                                              
                                              EquityBalance,
      December 31, 2005
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              3,130,767
                                              
                                              
                                              $
                                              31
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              $
                                              18,189
                                              
                                              
                                              $
                                              (599
                                              )
                                              
                                              $
                                              5,080
                                              
                                              
                                              $
                                              (672
                                              )
                                              
                                              $
                                              22,029Grant
      of employee stock options
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              73
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              73Proceeds
      from exercise of employee stock options/director stock
      warrants
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              139,999
                                              
                                              
                                              
                                              1
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              590
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              591Shares
      issued from the 6% stock dividend
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              187,588
                                              
                                              
                                              
                                              2
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              3,784
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (3,786
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Shares
      issued from the 7% stock dividend
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              242,085
                                              
                                              
                                              
                                              3
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              4,272
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (4,275
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Cash
      paid in lieu of fractional shares
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (4
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (4
                                              )Allocation
      of ESOP shares
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              2
                                              
                                              
                                              
                                              41
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              43Comprehensive
      income:
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Net
      income
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,052
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,052Change
      in net unrealized loss on
                                                securities  available for sale, net of
      income tax of $117
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              228
                                              
                                              
                                              
                                              228Reclassification
      adjustment for gains included in net income, net of income tax of
      $11
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (22
                                              )
                                              
                                              
                                              (22
                                              )Total
      comprehensive income
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,258Balance,
      December 31, 2006
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              3,700,439
                                              
                                              
                                              $
                                              37
                                              
                                              
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              $
                                              26,906
                                              
                                              
                                              $
                                              (558
                                              )
                                              
                                              $
                                              1,071
                                              
                                              
                                              $
                                              (466
                                              )
                                              
                                              $
                                              26,990Grant
      of employee stock options
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              91
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              91Proceeds
      from exercise of employee stock options/director stock
      warrants
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              38,704
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              182
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              182Adjustment
      to 7% stock dividend, reflected in December 31, 2006
    balance
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (414
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              97
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (97
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Cash
      paid in lieu of fractional shares with the 7% stock
    dividend
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (7
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (7
                                              )Proceeds
      from issuance of noncumulative perpetual preferred stock, net
      of $1,450 offering costs
                                              
                                              
                                              720,000
                                              
                                              
                                              
                                              7
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              16,543
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              16,550Shares
      repurchased pursuant to share repurchase program
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (13,781
                                              )
                                              
                                              
                                              (224
                                              )
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (224
                                              )Cash
      dividends declared on preferred stock
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (626
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (626
                                              )Allocation
      of ESOP shares
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (3
                                              )
                                              
                                              
                                              40
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              37Comprehensive
      income:
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              -Net
      income
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,060
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,060Change
      in net unrealized gain on securities available for sale, net of income tax
      of $259
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              580
                                              
                                              
                                              
                                              580Reclassification
      adjustment for gains included in net income, net of income tax of
      $40
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (77
                                              )
                                              
                                              
                                              (77
                                              )Total
      comprehensive income
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,563Balance,
      December 31, 2007
                                              
                                              
                                              720,000
                                              
                                              
                                              $
                                              7
                                              
                                              
                                              3,738,729
                                              
                                              
                                              $
                                              37
                                              
                                              
                                              (13,781
                                              )
                                              
                                              $
                                              (224
                                              )
                                              $
                                              43,809
                                              
                                              
                                              $
                                              (518
                                              )
                                              
                                              $
                                              4,408
                                              
                                              
                                              $
                                              37
                                              
                                              
                                              $
                                              47,556Shares
      issued pursuant to acquisition
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              2,663,674
                                              
                                              
                                              
                                              27
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              39,513
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              39,540Grant
      of employee stock options
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              104
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              104Proceeds
      from exercise of employee stock options
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              1,276
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              9
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              9Cumulative
      adjustment for change in accounting for post retirement benefit
      obligation
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (63
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (63
                                              )Shares
      repurchased pursuant to share repurchase program
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (93,200
                                              )
                                              
                                              
                                              (907
                                              )
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (907
                                              )Cash
      dividends declared on preferred stock
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (1,305
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (1,305
                                              )Allocation
      of ESOP shares
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              (34
                                              )
                                              
                                              
                                              40
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              6Comprehensive
      income/(loss):Net
      loss
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (44,847
                                              )
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (44,847
                                              )Change
      in net unrealized gain on securities available for sale, net of income tax
      of $344
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              668
                                              
                                              
                                              
                                              668Reclassification
      adjustment for gains included in net income, net of income tax of
      $70
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (137
                                              )
                                              
                                              
                                              (137
                                              )Total
      comprehensive income/(loss)
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (44,316
                                              )Balance,
      December 31, 2008
                                              
                                              
                                              720,000
                                              
                                              
                                              $
                                              7
                                              
                                              
                                              6,403,679
                                              
                                              
                                              $
                                              64
                                              
                                              
                                              (106,981
                                              )
                                              
                                              $
                                              (1,131
                                              )
                                              $
                                              83,401
                                              
                                              
                                              $
                                              (478
                                              )
                                              
                                              $
                                              (41,807
                                              )
                                              
                                              $
                                              568
                                              
                                              
                                              $
                                              40,624




All share
amounts reflect the 3 for 2 stock split distributed on January 18, 2006,
the 6% stock dividend distributed on May 16, 2006, and the 7% stock
dividend distributed on March 30, 2007.




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


80


FIRST
NATIONAL BANCSHARES, INC. AND SUBSIDIARY


Consolidated
Statements of Cash Flows


For the
Years Ended December 31, 2008, 2007 and 2006


(dollars
in thousands)




2008
                        
                        
                        2007
                        
                        
                        2006Cash
      flows from operating activities:Net
      income/(loss)
                        
                        $
                        (44,847
                        )
                        
                        $
                        4,060
                        
                        
                        $
                        4,052Adjustments
      to reconcile net income to net cash provided by/(used in) operating
      activities:Provision
      for loan losses
                        
                        
                        20,460
                        
                        
                        
                        1,396
                        
                        
                        
                        1,192Deferred
      income tax benefit
                        
                        
                        (2,123
                        )
                        
                        
                        (365
                        )
                        
                        
                        (384
                        )Depreciation
                        
                        
                        738
                        
                        
                        
                        545
                        
                        
                        
                        409Accretion
      of purchase accounting adjustments, net
                        
                        
                        (523
                        )
                        
                        
                        -
                        
                        
                        
                        -(Accretion)/amortization
      of securities discounts and premiums, net
                        
                        
                        (71
                        )
                        
                        
                        (82
                        )
                        
                        
                        33Gain
      on sale of securities available for sale
                        
                        
                        (207
                        )
                        
                        
                        (117
                        )
                        
                        
                        (33
                        )Gain
      on sale of guaranteed portion of SBA loans
                        
                        
                        (141
                        )
                        
                        
                        (201
                        )
                        
                        
                        (322
                        )Provision
      for impairment of goodwill
                        
                        
                        28,732
                        
                        
                        
                        -
                        
                        
                        
                        -Loss
      on sale of premises and equipment
                        
                        
                        -
                        
                        
                        
                        260
                        
                        
                        
                        -Origination
      of residential mortgage loans held for sale
                        
                        
                        (317,996
                        )
                        
                        
                        (261,780
                        )
                        
                        
                        (18,215
                        )Proceeds
      from sale of residential mortgage loans held for sale
                        
                        
                        320,947
                        
                        
                        
                        242,372
                        
                        
                        
                        18,849Compensation
      expense for employee stock options granted
                        
                        
                        104
                        
                        
                        
                        91
                        
                        
                        
                        73Allocation
      of ESOP shares
                        
                        
                        6
                        
                        
                        
                        37
                        
                        
                        
                        43Changes
      in deferred and accrued amounts:Prepaid
      expenses and other assets
                        
                        
                        (3,713
                        )
                        
                        
                        (3,350
                        )
                        
                        
                        (1,120
                        )Accrued
      expenses and other liabilities
                        
                        
                        (1,624
                        )
                        
                        
                        (296
                        )
                        
                        
                        486Net
      cash provided by/(used in) operating activities
                        
                        
                        (258
                        )
                        
                        
                        (17,430
                        )
                        
                        
                        5,063Cash
      flows from investing activities:Proceeds
      from maturities/prepayment of securities available for
sale
                        
                        
                        19,668
                        
                        
                        
                        11,299
                        
                        
                        
                        6,543Proceeds
      from sale of securities available for sale
                        
                        
                        14,543
                        
                        
                        
                        10,490
                        
                        
                        
                        5,601Purchases
      of securities available for sale
                        
                        
                        (44,260
                        )
                        
                        
                        (27,984
                        )
                        
                        
                        (30,055
                        )Proceeds
      from sale of guaranteed portion of SBA loans
                        
                        
                        4,322
                        
                        
                        
                        3,774
                        
                        
                        
                        5,650Loan
      originations, net of principal collections
                        
                        
                        (21,351
                        )
                        
                        
                        (98,932
                        )
                        
                        
                        (134,039
                        )Investment
      in common securities of trusts
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (217
                        )Net
      purchases of premises and equipment
                        
                        
                        (3,862
                        )
                        
                        
                        (5,842
                        )
                        
                        
                        (2,338
                        )Proceeds
      from the sale of premises and equipment
                        
                        
                        -
                        
                        
                        
                        8,969
                        
                        
                        
                        -Purchase
      of FHLB and other stock
                        
                        
                        (3,478
                        )
                        
                        
                        (729
                        )
                        
                        
                        (953
                        )Acquisition,
      net of funds received
                        
                        
                        (6,462
                        )
                        
                        
                        -
                        
                        
                        
                        -Net
      cash used in investing activities
                        
                        
                        (40,880
                        )
                        
                        
                        (98,955
                        )
                        
                        
                        (149,808
                        )Cash
      flows from financing activities:Dividends
      paid on preferred stock
                        
                        
                        (1,305
                        )
                        
                        
                        (626
                        )
                        
                        
                        -Increase
      in FHLB advances
                        
                        
                        161,873
                        
                        
                        
                        21,000
                        
                        
                        
                        28,400Repayment
      of FHLB advances
                        
                        
                        (117,200
                        )
                        
                        
                        (16,786
                        )
                        
                        
                        (17,536
                        )Net
      increase in federal funds purchased and other short-term
    debt
                        
                        
                        495
                        
                        
                        
                        1,390
                        
                        
                        
                        7,970Proceeds
      from the issuance of long-term debt
                        
                        
                        9,500
                        
                        
                        
                        -
                        
                        
                        
                        -Proceeds
      from issuance of junior subordinated debentures
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        7,217Proceeds
      from issuance of preferred stock, net of offering expenses
                        
                        
                        -
                        
                        
                        
                        16,550
                        
                        
                        
                        -Shares
      repurchased pursuant to share repurchase program
                        
                        
                        (907
                        )
                        
                        
                        (224
                        )
                        
                        
                        -Proceeds
      from exercise of employee stock options/director stock
      warrants
                        
                        
                        9
                        
                        
                        
                        182
                        
                        
                        
                        591Cash
      paid in lieu of fractional shares for stock dividend
                        
                        
                        -
                        
                        
                        
                        (7
                        )
                        
                        
                        (4
                        )Net
      increase/(decrease) in deposits
                        
                        
                        (12,053
                        )
                        
                        
                        95,127
                        
                        
                        
                        105,006Net
      cash provided by financing activities
                        
                        
                        40,412
                        
                        
                        
                        116,606
                        
                        
                        
                        131,644Net
      increase/(decrease) in cash and cash equivalents
                        
                        
                        (726
                        )
                        
                        
                        221
                        
                        
                        
                        (13,101
                        )Cash
      and cash equivalents, beginning of year
                        
                        
                        8,426
                        
                        
                        
                        8,205
                        
                        
                        
                        21,306Cash
      and cash equivalents, end of year
                        
                        $
                        7,700
                        
                        
                        $
                        8,426
                        
                        
                        $
                        8,205





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


81


FIRST
NATIONAL BANCSHARES, INC. AND SUBSIDIARY




Notes to
Consolidated Financial Statements


December 31,
2008 and 2007





Note
1—Summary of Significant Accounting Policies and Activities





Business Activity
and Organization—First National Bancshares, Inc. (the “Company”) was
incorporated on July 14, 1999, under the laws of the state of South
Carolina for the purpose of operating as a bank holding company pursuant to the
federal Bank Holding Company Act of 1956, as amended, and to purchase 100% of
the capital stock of First National Bank of Spartanburg (the
“Bank”).  The Bank was organized as a national bank under the laws of
the United States of America with the purpose of becoming a new bank to be
located in Spartanburg County, South Carolina.  The Bank began
transacting business on March 27, 2000, and provides full personal and
commercial banking services to customers and is subject to regulation by the
Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller
of the Currency (“OCC”).  During 2002, the Company adopted a
resolution changing the legal name of the Bank to First National Bank of the
South.





The
Company’s assets consist primarily of its investment in the Bank, and its
primary activities are conducted through the bank. As of December 31, 2008,
consolidated total assets were $812.7 million, consolidated total loans were
$709.3 million (including loans held for sale), consolidated total deposits were
$646.8 million, and total shareholders’ equity was approximately $40.6
million.




The
Company’s net income is dependent primarily on net interest income, which is the
difference between the interest income earned on loans, investments, and other
interest-earning assets and the interest paid on deposits and other
interest-bearing liabilities.  In addition, its net income is also
supported by noninterest income, derived principally from service charges and
fees on deposit accounts and on the origination, sale and/or servicing of
financial assets such as loans and investments, as well as the level of
noninterest expenses such as salaries, employee benefits, and occupancy
costs.




The
Company’s operations are significantly affected by prevailing economic
conditions, competition, and the monetary, fiscal, and regulatory policies of
governmental agencies. Lending activities are influenced by a number of factors,
including the general credit needs of individuals and small and medium-sized
businesses in its market areas, competition among lenders, the level of interest
rates, and the availability of funds. Deposit flows and costs of funds are
influenced by prevailing market interest rates (primarily the rates paid on
competing investments), account maturities, and the levels of personal income
and savings in its market areas.





The
Company relies on its branch network as a vehicle to deliver products and
services to the customers in its markets throughout South
Carolina.  While it offers traditional banking products and services
to cater to its customers and generate noninterest income, is also provides a
variety of unique options to complement its core business
features.  Combining uncommon options with standard features allows
First National to maximize its appeal to a broad customer base while
capitalizing on noninterest income potential.  The Company has offered
trust and investment management services since August 2002, through a strategic
alliance with Colonial Trust Company, a South Carolina private trust company
established in 1913.  Through a recent alliance with WorkLife
Financial, the Company is able to offer business expertise in a variety of
areas, such as human resource management, payroll administration, risk
management, and other financial services, to its customers.  In
addition, First National earns income through the origination and sale of
residential mortgages.  Each of these distinctive services represents
not only an exceptional opportunity to build and strengthen customer loyalty but
also to enhance the Company’s financial position with noninterest income, as
management believes they are less directly impacted by current economic
challenges.





Since
2003, the Company has expanded into four additional markets in the Carolinas,
with twelve full-service branches operating under the name First National Bank
of the South.  On February 19, 2008, the four Columbia full-service
branches of Carolina National Bank and Trust Company began to operate as First
National Bank of the South.  In connection with the acquisition, the
Columbia loan production office was consolidated into one of the four Columbia
full-service branches acquired.  Additionally, in July 2008, the fifth
full-service branch in the Columbia market opened in Lexington, South
Carolina.  The Company has expanded its banking operations into York
County by opening a loan production office in Rock Hill in February
2007.  In December 2007, the OCC approved the opening of a
full-service branch in the Fort Mill/Tega Cay community.  This new
facility is currently under construction and is projected to open in the Spring
of 2009.


82


The
Company offered its common stock for sale to the public under an initial public
offering which began on November 10, 1999, in which 3.1 million shares
of common stock were sold, including 1,235,400 shares sold to the Company’s
directors and executive officers at $3.92 per share.  The offering
raised approximately $11,800,000, net of underwriting discounts and commissions
and offering expenses, and was completed on February 10,
2000.  These per share and share amounts reflect each of the 3 for 2
stock splits distributed on January 18, 2006, and March 1, 2004, the
6% stock dividend distributed on May 16, 2006, and the 7% stock dividend
distributed on March 30, 2007.  The Company used $11 million of
the proceeds to capitalize the Bank.





The
Company offered its common stock for sale to the public under a best efforts
offering which began on October 14, 2005, in which 628,529 shares of common
stock were sold, including 32,804 shares sold to meet oversubscriptions. 
The shares were sold by the Company’s officers and certain directors at a price
of $14.10 per share.  Total net proceeds to the Company from the
offering were approximately $6.3 million after deducting expenses and the net
proceeds paid to the selling shareholder from the sale of his 146,312 shares
included in the offering which was completed in December 2005.  These
per share and share amounts reflect the 3 for 2 stock split distributed on
January 18, 2006, the 6% stock dividend distributed on May 16, 2006,
and the 7% stock dividend to be distributed on March 30,
2007.  The Company used the net proceeds from the offering for general
corporate purposes and to enhance the Bank’s capital and liquidity.





The
Company priced for sale 720,000 shares of its 7.25% Series A Noncumulative
Perpetual Preferred Stock on July 3, 2007, at $25.00 per share through an
underwritten public offering, as further discussed in “Note 14 – Noncumulative
Perpetual Preferred Stock.”  Total net proceeds after payment of
underwriting discounts and other costs of the offering were approximately $16.5
million.  The Company has used the net proceeds from the offering for
general corporate purposes, which include the repayment of a line of credit and
to fund loan growth.  The offering closed on July 9,
2007.  A registration statement relating to these securities was filed
with and declared effective by the Securities and Exchange Commission (“SEC”) as
of June 26, 2007.





As part
of its previous strategic plan for growth and expansion, the Company executed
the acquisition (the “Merger”) of Carolina National, effective January 31,
2008.  Through the Merger, Carolina National’s wholly owned subsidiary
bank, Carolina National Bank and Trust Company, a national banking association,
became a subsidiary of First National Bancshares, Inc. and, as of the close of
business on February 18, 2008, was merged with and into the Company’s bank
subsidiary.  On May 30, 2008, the core bank data processing system was
successfully converted, bringing closure to the substantial undertaking of
blending the two banks into one cohesive branch network.   (See
Note 26 – Merger with Carolina National Corporation for current details on the
Merger.)





Principles of
Consolidation—The consolidated financial statements include the accounts
of the Company and the Bank.  All significant intercompany balances
and transactions have been eliminated in consolidation.  The
accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States of America (“GAAP”) and to
general practices in the banking industry.





Use of
Estimates—The consolidated financial statements are prepared in
conformity with GAAP which require management to make estimates and
assumptions.  These estimates and assumptions affect the reported
amounts of assets and liabilities at the date of the financial
statements.  In addition, they affect the reported amounts of income
and expense during the reporting period.  Actual results could differ
from these estimates.





Concentration of
Credit Risk—The Company, through the Bank, makes loans to individuals and
small- to mid-sized businesses for various personal and commercial purposes
primarily in Spartanburg, Greenville, and Charleston Counties in South
Carolina.  The Company has a diversified loan portfolio and the
Company’s loan portfolio is not dependent on any specific economic
segment.  The Company regularly monitors its credit concentrations
based on loan purpose, industry and customer base.  As of
December 31, 2008, management has determined that the Company has a
concentration in commercial real estate loans.  Management has
extensive experience in commercial real estate lending, and has implemented and
continues to maintain heightened portfolio monitoring and reporting, and strong
underwriting criteria with respect to its commercial real estate
portfolio.





In
addition to monitoring potential concentrations of loans to particular borrowers
or groups of borrowers, industries and geographic regions, management monitors
exposure to credit risk that could arise from potential concentrations of
lending products and practices, such as loans that subject borrowers to
substantial payment increases (e.g. principal deferral periods, loans with
initial interest-only periods, etc), and loans with high loan-to-value
ratios.  Additionally, there are industry practices that could subject
the Company to increased credit risk should economic conditions change over the
course of a loan’s life.  For example, the Company makes variable rate
loans and fixed rate principal-amortizing loans with maturities prior to the
loan being fully paid (i.e. balloon payment loans).  These loans are
underwritten and monitored to manage the associated risks.  Management
has determined that the Company has a concentration of non-1-to-4-family
residential loans that exceed supervisory limits for loan to value
ratios.  This segment of loans is generally described as the
“commercial basket” and may not exceed thirty percent of total regulatory
capital.  The commercial basket totaled $42.3 million at
December 31, 2008, representing 92.8% of total equity and 6.0% of loans,
net of unearned income, which is not in compliance with the regulatory
guidelines.  The commercial basket totaled $13.8 million at
December 31, 2007, representing 29.0% of total equity and 2.9% of loans,
net of unearned income, which was in compliance with the regulatory
guidelines.


83


Cash and cash
equivalents—The Company considers all highly-liquid investments with
maturity of three months or less to be cash equivalents.





Investment
Securities—Investment securities are accounted for in accordance with
SFAS No. 115, “Accounting for Certain Investments in Debt and Equity
Securities.”  Management classifies securities at the time of purchase
into one of three categories as follows:  (1) Securities Held to
Maturity—securities which the Company has the positive intent and ability to
hold to maturity, which are reported at amortized cost; (2) Trading
Securities—securities that are bought and held principally for the purpose of
selling them in the near future, which are reported at fair value with
unrealized gains and losses included in earnings; and (3) Securities
Available for Sale—securities that may be sold under certain conditions, which
are reported at fair value, with unrealized gains and losses excluded from
earnings and reported as a separate component of shareholders’ equity as
accumulated other comprehensive income.  The amortization of premiums
and accretion of discounts on investment securities are recorded as adjustments
to interest income.  Gains or losses on sales of investment securities
are based on the net proceeds and the adjusted carrying amount of the securities
sold, using the specific identification method.  Unrealized losses on
securities, reflecting a decline in value or impairment judged by the Company to
be other than temporary, are charged to earnings in the consolidated statements
of income.





The
Company’s investment portfolio consists principally of obligations of the United
States, its agencies or its corporations and general obligation municipal
securities.  In the management’s opinion, there is no concentration of
credit risk in its investment portfolio.  The Company places its
deposits and correspondent accounts with and sells its federal funds to high
quality institutions.  Management believes credit risk associated with
correspondent accounts is not significant.  Therefore, management
believes that these particular practices do not subject the Company to unusual
credit risk.





Loans and
Interest Income—Loans of the Bank are carried at principal amounts,
reduced by an allowance for loan losses.  The Bank recognizes interest
income daily based on the principal amount outstanding using the simple interest
method.  The accrual of interest is generally discontinued on loans of
the Bank which become 90 days past due as to principal or interest or when
management believes, after considering economic and business conditions and
collection efforts, that the borrower’s financial condition is such that
collection of interest is doubtful.  Management may elect to continue
accrual of interest when the estimated net realizable value of collateral is
sufficient to cover the principal balances and accrued interest and the loan is
in the process of collection.  Amounts received on nonaccrual loans
generally are applied against principal prior to the recognition of any interest
income.  Generally, loans are restored to accrual status when the
obligation is brought current, has performed in accordance with the contractual
terms for a reasonable period of time and the ultimate collectability of the
total contractual principal and interest is no longer in doubt.





The Bank
also has originated loans to small businesses under various Small Business
Administration (“SBA”) loan programs.  Deferred gains on the sale of
the guaranteed portion of SBA loans are amortized over the lives of the
underlying loans using the interest method.  Excess servicing is
recognized as an asset and is amortized in proportion to and over the period of
the estimated net servicing income and is subject to periodic
assessment.  Excess servicing at December 31, 2008 and 2007 of
$242,000 and $330,000, respectively, is included in the balance sheet caption
“other assets.”  The guaranteed amount of loans sold to the SBA
serviced by the Company was approximately $21.5 million and $17.4 million at
December 31, 2008 and 2007, respectively.





Mortgage Loans
Held for Sale—Mortgage loans originated for sale in the secondary market
are carried at the lower of cost or estimated market value in the
aggregate.  Net unrealized losses are provided for in a valuation
allowance by charges to operations.  The Company obtains commitments
from the secondary market investors prior to closing of the loans; therefore, no
gains or losses are recognized when the loans are sold.  The Company
receives origination fees received from the secondary market
investors.  At December 31, 2008 and 2007, there were residential
mortgage loans held for sale totaling $16.4 million and $19.4, respectively,
which is reflected as “mortgage loans held for sale” on the Consolidated Balance
Sheet.





Impairment of
Loans—Loans are considered to be impaired when, in management’s judgment,
the collection of all amounts of principal and interest is not probable in
accordance with the terms of the loan agreement.  The Company accounts
for impaired loans in accordance with the terms of SFAS No. 114,
“Accounting by Creditors for Impairment of a Loan,” as amended by SFAS
No. 118 in the areas of disclosure requirements and methods of recognizing
income.  SFAS No. 114 requires that impaired loans be recorded at
fair value, which is determined based upon the present value of expected cash
flows discounted at the loan’s effective interest rate, the market price of the
loan, if available, or the value of the underlying collateral.  All
cash receipts on impaired loans are applied to principal until such time as the
principal is brought current.  After principal has been satisfied,
future cash receipts are applied to interest income, to the extent that any
interest has been foregone.  The Bank determines which loans are
impaired through a loan review process.


84


Allowance for
Loan Losses— The allowance for loan losses represents an amount that the
Company believes will be adequate to absorb probable losses on existing loans
that may become uncollectible.  Management’s judgment in determining the
adequacy of the allowance is based on evaluations of the collectability of
loans, including consideration of factors such as the balance of impaired loans;
the quality, mix and size of the overall loan portfolio; economic conditions
that may affect the borrower’s ability to repay; the amount and quality of
collateral securing the loans; the Bank’s historical loan loss experience; and a
review of specific problem loans. The amount of the allowance is adjusted
periodically based on changing circumstances as a component of the provision for
loan losses. Recognized losses are charged against the allowance and
subsequent recoveries are added back to the allowance.  Loan
impairments that are likely to be realized on collateralize-dependent impaired
loans are charged off at the time the estimated credit loss is
determined.




Management
calculates the allowance for loan losses for specific types of loans (excluding
mortgage loans held for sale) and evaluates the adequacy on an overall portfolio
basis utilizing the Bank’s credit grading system which is applied to each
loan.  The estimates of the reserves needed for each component of the
portfolio are combined, including loans analyzed on a pool basis and loans
analyzed individually.  The allowance is divided into two
portions: (1) an amount for specific allocations on significant
individual credits and (2) a general reserve amount.




Management
analyzes individual loans within the portfolio and makes allocations to the
allowance based on historical percentages within the loan portfolio, as well as
on each individual loan’s specific factors and other circumstances that affect
the collectability of the credit.  Significant individual credits
classified as doubtful or substandard/special mention within the Bank’s credit
grading system require both individual analysis and specific
allocation.




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




The
general reserve is calculated based on a percentage allocation for each of the
categories of the following unclassified loan types: real estate,
commercial, consumer, A&D/construction and mortgage.  General loss
factors are applied to each category and may adjust these percentages given
consideration of local economic conditions, exposure to concentrations that may
exist in the portfolio, changes in trends of past due loans, problem loans and
chargeoffs, and anticipated loan growth.  The general estimate is then
added to the specific allocations made to determine the amount of the total
allowance for loan losses.





Management
also maintains a general unallocated reserve in accordance with December 2006
regulatory interagency guidance in its assessment of the loan loss allowance.
This general unallocated reserve considers qualitative or environmental factors
that are likely to cause estimated credit losses including, but not limited to:
changes in delinquent loan trends, trends in net chargeoffs, concentrations of
credit, trends in the nature and volume of the loan portfolio, general economic
trends, collateral valuations, the experience and depth of lending management
and staff, and lending policies, procedures and the quality of loan review
systems.  Please see Note 7 – Loans for specifics on the Bank’s actual
loan loss figures.





Loan
Fees—Loan origination fees and direct costs of loan originations are
deferred and recognized as an adjustment of yield by the interest method based
on the contractual terms of the loan.  Loan commitment fees are
deferred and recognized as an adjustment of yield over the related loan’s life,
or if the commitment expires unexercised, recognized in income upon
expiration.





Goodwill
and Other Intangible Assets—The Company accounts for
goodwill in accordance with SFAS No. 142,Goodwill
and Other Intangible Assets.The
Company recorded an after-tax noncash accounting charge of $28.7 million
during the fourth quarter of 2008 as a result of the annual testing of
goodwill for impairment as required by accounting standards.  The
impairment analysis was negatively impacted by the unprecedented weakness in the
financial markets. The first step of the goodwill impairment analysis involves
estimating a hypothetical fair value and comparing that with the carrying amount
or book value of the entity; our initial comparison suggested that the carrying
amount of goodwill exceeded its implied fair value due to our low stock price,
consistent with that of most publicly-traded financial
institutions.  Therefore, the second step of the analysis was required
to be performed to determine the amount of the impairment.  The
Company prepared a discounted cash flow analysis which established the
estimated fair value of the entity and conducted a full valuation of the net
assets of the entity.  Following these procedures, it
was determined that no amount of the net asset value could be allocated to
goodwill and the Company recorded the impairment to the goodwill balance as a
noncash accounting charge to our earnings in 2008.


85


Off-Balance Sheet
Commitments—In the ordinary course of business, the Bank enters into
off-balance sheet financial instruments consisting of legally binding
commitments to extend credit and letters of credit.  Such financial
instruments are recorded in the financial statements when they are
funded.





Premises and
Equipment—Land is carried at cost.  Premises and equipment are
stated at cost less accumulated depreciation and amortization, computed
principally by the straight line method over the estimated useful lives of the
assets as follows:  building, 40 years; furniture and fixtures, 7 to
10 years; and computer hardware and software, 3 to 5
years.  Amortization of leasehold improvements is recorded using the
straight-line method over the lesser of the estimated useful life of the asset
or the term of the operating lease.  Additions to premises and
equipment and major replacements and betterments are added at
cost.  Maintenance, repairs and minor replacements are included in
operating expense.  When assets are retired or otherwise disposed of,
the cost and accumulated depreciation are removed from the accounts and any gain
or loss is reflected in income.





Income
Taxes—Income taxes are accounted for in accordance with SFAS
No. 109, “Accounting for Income Taxes.”  Under the asset and
liability method of SFAS No. 109, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases.  Deferred tax assets and liabilities are
measured using the enacted rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled.  Under SFAS No. 109, the effect on deferred tax assets
and liabilities of a change in tax rates is recognized in income in the period
that includes the enactment date.  Valuation allowances are
established to reduce deferred tax assets if it is determined to be “more likely
than not” that all or some portion of the potential deferred tax asset will not
be realized.





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





Reclassifications—Certain
prior year amounts have been reclassified to conform with the current year
presentation.  These reclassifications have no effect on previously
reported shareholders’ equity or net income.  Share and per share data
reflect the 3 for 2 stock split distributed on January 18, 2006, the 6%
stock dividend distributed on May 16, 2006, and the 7% stock dividend
distributed on March 30, 2007, as discussed below under “Net Income Per
Share.”





Stock
Compensation Plans—At December 31, 2008, the Company has several
stock-based employee compensation plans, which are more fully described in Notes
15 and 16.  On January 1, 2006, the Company adopted the fair
value recognition provisions of Financial Accounting Standards Board (“FASB”)
SFAS No. 123(R), Accounting for Stock-Based
Compensation, to account for compensation costs under its stock
compensation plans.  The Company previously accounted for its stock
compensation plans under the provisions of Statement of Financial Accounting
Standards (“SFAS”) No. 148, Accounting for Stock-Based
Compensation, which are consistent with the provisions of SFAS
No. 123(R) but allowed it to use the prospective method of adoption since
it did so by December 31, 2003.  Prior to its adoption of SFAS
No. 148, the Company utilized the intrinsic value method under Accounting
Principles Board Opinion No. 25, Accounting for Stock Issues to
Employees (as amended)(“APB 25”).  Under the intrinsic value
method prescribed by APB 25, no compensation costs were recognized for its stock
options granted in years prior to 2003 because the option exercise price in its
plans equals the market price on the date of grant.  Prior to
January 1, 2006, the Company only disclosed the pro forma effects on net
income and earnings per share as if the fair value recognition provisions of
SFAS 123(R) had been utilized for all options granted prior to January 1,
2003.  Since January 1, 2003, the Company has used the fair value
method to record the compensation expense for stock options granted after
January 1, 2003, over the vesting period of these grants under the
prospective method.





In
adopting SFAS No. 123(R), the Company elected to use the modified
prospective method to account for the transition.  Under the modified
prospective method, compensation cost is recognized from the adoption date
forward for all stock options granted after the date of adoption and for any
outstanding unvested awards as if the fair value method had been applied to
those awards as of the date of grant.


86


Net Income/(loss)
Per Share—Basic income per share represents income available to common
stockholders divided by the weighted average number of common shares outstanding
during the period.  Diluted income per share reflects additional
common shares that would have been outstanding if dilutive potential common
shares had been issued, as well as any adjustment 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.





The
following is a reconciliation of the numerators and denominators of the basic
and diluted per share computations for net income/(loss) for the years ended
December 31, 2008, 2007 and 2006.




2008
                
                
                2007
                
                
                2006Basic
                
                
                Diluted(1)
                
                
                Basic
                
                
                Diluted
                
                
                Basic
                
                
                DilutedNet
      income/(loss), as reported
                
                $
                (44,847
                )
                
                $
                (44,847
                )
                
                $
                4,060
                
                
                $
                4,060
                
                
                $
                4,052
                
                
                $
                4,052Preferred
      stock dividends paid
                
                
                1,305
                
                
                
                1,305
                
                
                
                626
                
                
                
                -
                
                
                
                -
                
                
                
                -Net
      income/(loss) available to  common shareholders
                
                $
                (46,152
                )
                
                $
                (46,152
                )
                
                $
                3,434
                
                
                $
                4,060
                
                
                $
                4,052
                
                
                $
                4,052Weighted
      average common shares outstanding
                
                
                6,101,656
                
                
                
                6,101,656
                
                
                
                3,696,464
                
                
                
                3,696,464
                
                
                
                3,615,022
                
                
                
                3,615,022Effect
      of dilutive securities:Stock
      options and warrants
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                657,328
                
                
                
                -
                
                
                
                709,539Noncumulative
      convertible perpetual preferred stock
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                493,253
                
                
                
                -
                
                
                
                -Weighted
      average common shares outstanding
                
                
                6,101,656
                
                
                
                6,101,656
                
                
                
                3,696,464
                
                
                
                4,847,045
                
                
                
                3,615,022
                
                
                
                4,324,561Net
      income/(loss) per common share
                
                $
                (7.56
                )
                
                $
                (7.56
                )
                
                $
                0.93
                
                
                $
                0.84
                
                
                $
                1.12
                
                
                $
                0.94




(1)         For
the year ended December 31, 2008, we recognized a loss available to common
shareholders rather than net income.  In this scenario, diluted
earnings per  common share equals basic earnings per share because
additional shares would be anti-dilutive.





The
assumed exercise of stock options and warrants and the conversion of preferred
stock can create a difference between basic and diluted net income per common
share.  Dilutive common shares arise from the potentially dilutive
effect of our outstanding stock options and warrants, as well as the potential
conversion of our convertible perpetual preferred stock.  In order to
arrive at net income/(loss) available to common shareholders, net income is
reduced by the amount of preferred stock dividends declared for that
period.  This approach reflects the preferred stock dividend as if it
were an expense so that its impact to the common shareholder is not obscured by
its inclusion in retained earnings.  However, when a net loss is
recognized rather than net income, or when the preferred stock dividend during a
period outweighs net income for that period, resulting in a loss available to
common shareholders, diluted earnings per share for that period equals basic
earnings per share.  The average diluted shares have been computed
utilizing the “treasury stock” method and reflect the 7% stock dividend
distributed on March 30, 2007.  The weighted average shares
outstanding exclude 93,200 and 13,781 common shares of treasury stock purchased
through the Company’s share repurchase program during the twelve months ended
December 31, 2008 and 2007, respectively.





On
March 2, 2007, the Company’s board of directors declared a 7% stock
dividend to shareholders of record on March 16, 2007.  The 7%
stock dividend was paid on March 30, 2007.  The 2006
shareholders’ equity, share and per share data reflect the 7%
dividend.  The number of outstanding shares increased from 3,458,354
to 3,700,439.





On
April 18, 2006, the Company’s board of directors approved a 6% stock
dividend on the Company’s outstanding stock.  The dividend was
distributed on May 16, 2006.  The number of outstanding shares
increased from 3,130,767 to 3,318,355.  All share amounts for periods
prior to the dividend have been restated to reflect this dividend, as well as
the two 3 for 2 splits.





On
December 30, 2005, the Company’s board of directors approved a 3 for 2
split of the Company’s outstanding stock.  The split was distributed
on January 18, 2006.  The number of outstanding shares increased
from 2,087,178 to 3,130,767.





Comprehensive
Income—Accounting principles generally require that recognized revenue,
expenses, gains and losses be included in net income.  Although
certain changes in assets and liabilities, such as unrealized gains and losses
on available-for-sale securities, are reported as a separate component of the
equity section of the balance sheet, such items, along with net income, are
components of comprehensive income.


87


Recently Issued
Accounting Pronouncements—In December 2007, the Financial Accounting
Standards Board(“FASB”) issued
Statement of Financial Accounting Standard(“SFAS”) No. 141(R), “Business
Combinations,” (“SFAS 141(R)”) which replaces SFAS 141. SFAS 141(R) establishes
principles and requirements for how an acquirer in a business combination
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any controlling interest; recognizes and
measures goodwill acquired in the business combination or a gain from a bargain
purchase; and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination. SFAS 141(R) is effective for acquisitions by the Company
taking place on or after January 1, 2009. Early adoption is prohibited.
Accordingly, a calendar year-end company is required to record and disclose
business combinations following the new accounting guidance beginning January 1,
2009. The Company will assess the impact of SFAS 141(R) if and when a future
acquisition occurs.





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – an amendment of ARB No. 51,” (“SFAS 160”).
SFAS 160 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. Before this statement, limited guidance existed for reporting
noncontrolling interests (minority interest). As a result, diversity in practice
exists. In some cases minority interest is reported as a liability and in others
it is reported in the mezzanine section between liabilities and equity.
Specifically, SFAS 160 requires the recognition of a noncontrolling interest
(minority interest) as equity in the consolidated financials statements and
separate from the parent’s equity. The amount of net income attributable to the
noncontrolling interest will be included in consolidated net income on the face
of the income statement. SFAS 160 clarifies that changes in a parent’s ownership
interest in a subsidiary that do not result in deconsolidation are equity
transactions if the parent retains its controlling financial interest. In
addition, this statement requires that a parent recognize gain or loss in net
income when a subsidiary is deconsolidated. Such gain or loss will be measured
using the fair value of the noncontrolling equity investment on the
deconsolidation date. SFAS 160 also includes expanded disclosure requirements
regarding the interests of the parent and its noncontrolling interests. SFAS 160
was effective for the Company on January 1, 2009.  SFAS 160 had no
impact on the Company’s financial position, results of operations or cash
flows.





In
February 2008, the FASB issued FASB Staff Position No. 140-3, “Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions,” (“FSP
140-3”).  This FSP provides guidance on accounting for a transfer of a
financial asset and the transferor’s repurchase financing of the asset.
 This FSP presumes that an initial transfer of a financial asset and a
repurchase financing are considered part of the same arrangement (linked
transaction) under SFAS 140. However, if certain criteria are met, the initial
transfer and repurchase financing are not evaluated as a linked transaction and
are evaluated separately under SFAS 140.  FSP 140-3 was effective for the
Company on January 1, 2009.  The adoption of FSP 140-3 had no impact on the
Company’s financial position, results of operations or cash flows.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities,” (“SFAS 161”).  SFAS 161 requires enhanced
disclosures about an entity’s derivative and hedging activities, thereby
improving the transparency of financial reporting.  It is intended to
enhance the current disclosure framework in SFAS 133 by requiring that
objectives for using derivative instruments be disclosed in terms of underlying
risk and accounting designation. This disclosure is intended to convey the
purpose of derivative use in terms of the risks that the entity is intending to
manage. SFAS 161 was effective for the Company on January 1, 2009 and will
result in additional disclosures if the Company enters into any material
derivative or hedging activities but currently has no impact on the Company’s
financial position, results of operations or cash flows.





In April
2008, the FASB issued FASB Staff Position No. 142-3, “Determination of the
Useful Life of Intangible Assets,” (“FSP 142-3”).  This FSP amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under SFAS
No. 142, “Goodwill and Other Intangible Assets,” (“SFAS 142”).  The
intent of this FSP is to improve the consistency between the useful life of a
recognized intangible asset under SFAS 142 and the period of expected cash flows
used to measure the fair value of the asset under SFAS 141(R) and other U.S.
generally accepted accounting principles.  This FSP was effective for
the Company on January 1, 2009 and contributed to the impairment of the
Company’s intangible asset goodwill.





In May,
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles,” (“SFAS 162”).  SFAS 162 identifies the sources
of accounting principles and the framework for selecting the principles used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (GAAP) in
the United States (the GAAP hierarchy).  SFAS 162 is effective
November 15, 2008.  The FASB has stated that it does not expect SFAS
162 will result in a change in current practice. The application of SFAS 162 had
no effect on the Company’s financial position, results of operations or cash
flows.


88


In June,
2008, the FASB issued FASB Staff Position No. EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions are Participating
Securities,” (“FSP EITF 03-6-1”).  The Staff Position provides that
unvested share-based payment awards that contain nonforfeitable rights to
dividends or dividend equivalents are participating securities and must be
included in the earnings per share computation.  FSP EITF 03-6-1 was
effective January 1, 2009 and had no effect on the Company’s financial position,
results of operations, earnings per share or cash flows.





FSP SFAS
133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain
Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No.
45; and Clarification of the Effective Date of FASB Statement No. 161,” (“FSP
SFAS 133-1 and FIN 45-4”) was issued September 2008, effective for reporting
periods (annual or interim) ending after November 15, 2008.  FSP SFAS
133-1 and FIN 45-4 amends SFAS 133 to require the seller of credit derivatives
to disclose the nature of the credit derivative, the maximum potential amount of
future payments, fair value of the derivative, and the nature of any recourse
provisions.  Disclosures must be made for entire hybrid instruments
that have embeddedcredit
derivatives.The Staff Position
also amends FASB Interpretation No. (“FIN”) 45 to require disclosure of the
current status of the payment/performance risk of the credit derivative
guarantee.  If an entity utilizes internal groupings as a basis for
the risk, how the groupings are determined must be disclosed as well as how the
risk is managed. The Staff Position encourages that the amendments be applied in
periods earlier than the effective date to facilitate comparisons at initial
adoption.  After initial adoption, comparative disclosures are
required only for subsequent periods.  FSP SFAS 133-1 and FIN 45-4
clarifies the effective date of SFAS 161 such that required disclosures should
be provided for any reporting period (annual or quarterly interim) beginning
after November 15, 2008.  The adoption of this Staff Position had no
material effect on the Company’s financial position, results of operations or
cash flows.





The SEC’s
Office of the Chief Accountant and the staff of the FASB issued press release
2008-234 on September 30, 2008 (“Press Release”) to provide clarifications on
fair value accounting.  The Press Release includes guidance on the use
of management’s internal assumptions and the use of “market”
quotes.  It also reiterates the factors in SEC Staff Accounting
Bulletin (“SAB”) Topic 5M which should be considered when determining
other-than-temporary impairment: the length of time and extent to which the
market value has been less than cost; financial condition and near-term
prospects of the issuer; and the intent and ability of the holder to retain its
investment for a period of time sufficient to allow for any anticipated recovery
in market value. On October 10, 2008, the FASB issued FSP SFAS 157-3,
“Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active” (“FSP SFAS 157-3”). This FSP clarifies the application of SFAS
No. 157, “Fair Value Measurements” (see Note 20 – Fair Value of Financial
Instruments) in a market that is not active and provides an example to
illustrate key considerations in determining the fair value of a financial asset
when the market for that asset is not active.  The FSP is effective
upon issuance, including prior periods for which financial statements have not
been issued. For the Company, this FSP was effective for the quarter ended
September 30, 2008. The Company considered the guidance in the Press Release and
in FSP SFAS 157-3 when conducting its review for other-than-temporary impairment
as of December 31, 2008 as discussed in Note 21 - Fair Value of Financial
Instruments.





FSP SFAS
140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about
Transfers of Financial Assets and Interests in Variable Interest Entities,”
(“FSP SFAS 140-4 and FIN 46(R)-8”) was issued in December 2008 to require public
entities to disclose additional information about transfers of financial assets
and to require public enterprises to provide additional disclosures about their
involvement with variable interest entities.  The FSP also requires
certain disclosures for public enterprises that are sponsors and servicers of
qualifying special purpose entities.  The FSP is effective for the
first reporting period ending after December 15, 2008.  This FSP had
no material impact on the financial position of the Company.





FSP SFAS
132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets,”
(“FSP SFAS 132(R)-1”) issued in December 2008, provides guidance on an
employer’s disclosures about plan assets of a defined benefit pension or other
postretirement plan to provide the users of financial statements with an
understanding of: (a) how investment allocation decisions are made, including
the factors that are pertinent to an understanding of investment policies and
strategies; (b) the major categories of plan assets; (c) the inputs and
valuation techniques used to measure the fair value of plan assets; (d) the
effect of fair value measurements using significant unobservable inputs (Level
3) on changes in plan assets for the period; and (e) significant concentrations
of risk within plan assets.  The Staff Position also requires a
nonpublic entity, as defined in SFAS 132, to disclose net periodic benefit cost
for each period for which a statement of income is presented.  FSP
SFAS 132(R)-1 is effective for fiscal years ending after December 15,
2009.  The Staff Position will require the Company to provide
additional disclosures related to its benefit plans.


89


FSP EITF
99-20-1, “Amendments to the Impairment Guidance of EIFT Issue No. 99-20,” (“FSP
EITF 99-20-1”) was issued in January 2009.  Prior to the Staff
Position, other-than-temporary impairment was determined by using either EITF
Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased
Beneficial Interests and Beneficial Interests that Continue to be Held by a
Transferor in Securitized Financial Assets,” (“EITF 99-20”) or SFAS No. 115,
“Accounting for Certain Investments in Debt and Equity Securities,” (“SFAS 115”)
depending on the type of security.  EITF 99-20 required the use of
market participant assumptions regarding future cash flows regarding the
probability of collecting all cash flows previously projected.  SFAS
115 determined impairment to be other than temporary if it was probable that the
holder would be unable to collect all amounts due according to the contractual
terms. To achieve a more consistent determination of other-than-temporary
impairment, the Staff Position amends EITF 99-20 to determine any
other-than-temporary impairment based on the guidance in SFAS 115, allowing
management to use more judgment in determining any other-than-temporary
impairment.  The Staff Position is effective for interim and annual
reporting periods ending after December 15, 2008 and shall be applied
prospectively.  Retroactive application is not
permitted.  Management has reviewed the Company’s security portfolio
and evaluated the portfolio for any other-than-temporary impairments as
discussed in Note 20 – Fair Value of Financial Instruments.





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





Note
2 - Regulatory Actions & Going Concern Considerations





Consent
Order




Due
to the Bank's condition, the OCC has required that the Bank's Board of Directors
sign a Consent Order with the OCC which conveys specific actions needed to
address certain findings from the examination and to address the Bank's current
financial condition.  The Bank entered into a Consent Order with the
OCC on April 27, 2009, which contains a list of strict requirements ranging from
a capital directive, which requires the Bank to achieve and maintain minimum
regulatory capital levels in excess of the statutory minimums to be
well-capitalized, to developing a liquidity risk management and contingency
funding plan, in connection with which the Bank will be subject to limitations
on the maximum interest rates the Bank can pay on deposit
accounts.  The Consent Order also contains restrictions on future
extensions of credit and requires the development of various programs and
procedures to improve the asset quality of the Bank as well as routine reporting
on the Bank's progress toward compliance with the consent order to the Board of
Directors and the OCC.  As a result of the terms
of the executed Consent Order, the Bank is no longer deemed “well-capitalized”
regardless of its capital  levels.








In addition, the Consent Order includes
a requirement that the Bank’s Board of Directors develop a written strategic and
capital plan covering at least a three-year period.  The plan must
establish objectives for the Bank’s overall risk profile, earnings performance,
asset growth, balance sheet composition, off-balance sheet activities, funding
sources, capital adequacy, reduction in nonperforming assets, product line where
development and market segments planned for development and growth.





The
Consent Order with the OCC requires the establishment of certain plans and
programs.  It requires the Bank, among other things:





•
            
            to
      establish a Compliance Committee to monitor and coordinate compliance with
      the Consent Order by May 7, 2009;•
            
            to
      achieve and maintain Tier 1 capital at least equal to 11% of risk-weighted
      assets and at least equal to 9% of adjusted total assets by August 25,
      2009;


90





•
                
                to
      develop, by July 26, 2009, a three-year capital plan for the Bank, which
      shall include, among other things, specific plans for maintaining
      adequate capital, a discussion of the sources and timing of additional
      capital, as well as contingency plans for alternative sources of
      capital;•
                
                to
      develop, by July 26, 2009, a strategic plan covering at least a three-year
      period, which shall, among other things, include a specific description of
      the strategic goals and objectives to be achieved, the targeted markets,
      the specific Bank personnel who are responsible and accountable for the
      plan, and a description of systems to monitor the Bank’s
      progress.•
                
                to
      revise and maintain, by June 26, 2009, a liquidity risk management
      program, which assesses, on an ongoing basis, the Bank’s current and
      projected funding needs, and ensures that sufficient funds exist to meet
      those needs.  The plan must include specific plans for how the
      Bank plans to comply with regulatory restrictions which limit the interest
      rates the Bank can offer to depositors;•
                
                to
      revise, by June 26, 2009, the Bank’s loan policy, a commercial real estate
      concentration management program.  The Bank also must establish
      a new loan review program to ensure the timely and independent
      identification of problem loans and modify its existing program for the
      maintenance of an adequate allowance for loan and lease
      losses.;•
                
                to
      take immediate and continuing action to protect the Bank’s interest in
      certain assets identified by the OCC or any other bank examiner by
      developing a criticized assets report covering the entire credit
      relationship with respect to such assets;•
                
                to
      develop, by July 26, 2009, an independent appraisal review and analysis
      process to ensure that appraisals conform to appraisal standards and
      regulations, and to order, within 30 days following any event that
      triggers an appraisal analysis, a current independent appraisal or updated
      appraisal on loans secured by certain properties;•
                
                to
      develop, by May 27, 2009, a revised OREO program to ensure that the OREO
      properties are managed in accordance with certain applicable banking
      regulations; and•
                
                to
      ensure the Bank has competent management in place on a full-time basis to
      carry out the Board’s policies and operate the Bank in a safe and sound
      manner.




Going
Concern





The going
concern assumption is a fundamental principle in the preparation of financial
statements.  It is the responsibility of management to assess the
Company's ability to continue as a going concern.  In assessing this
assumption, the Company has taken into account all available information about
the future, which is at least, but is not limited to, twelve months from the
balance sheet date of December 31, 2008.  The Company has a history of
profitable operations and sufficient sources of liquidity to meet its short-term
and long-term funding needs.  However, The Bank's financial condition
has suffered during 2008 from the extraordinary effects of what may ultimately
be the worst economic downturn since the Great Depression.





The
effects of the current economic environment are being felt across many
industries, with financial services and residential real estate being
particularly hard hit.  The effects of the economic downturn have been
particularly severe during the last 150 days.  The Bank, with a loan
portfolio consisting of a concentration in commercial real estate loans
including residential construction and development loans, has seen a decline in
the value of the collateral securing its portfolio as well as rapid
deterioration in its borrowers' cash flow and ability to repay their outstanding
loans to the Bank.  As a result, the Bank's level of nonperforming
assets has increased substantially during 2008 to $75.5 million.  The level
of nonperforming assets has caused the Company to be out of compliance with
certain covenants for its line of credit.For the year ended
December 31, 2008, the Bank recorded a $20.5 million provision for loan losses,
of which $19.0 million was required to increase the allowance for loan losses to
a level which adequately reflected the increased risk inherent in the loan
portfolio as of December 31, 2008.





The
Company and the Bank operate in a highly-regulated industry and must plan for
the liquidity needs of each entity separately.   A variety of
sources of liquidity are available to the Bank to meet its short-term and
long-term funding needs.  Although a number of these sources have
been limited following execution of the Consent Order with the OCC,
management has prepared forecasts of these sources of funds and the Bank's
projected uses of funds during 2009 and believes that the sources available are
sufficient to meet the Bank's projected liquidity needs for this period. Since
December 31, 2008, liquid, unpledged assets have increased by $140.0 million as
the Bank has executed its strategy to increase its short-term liquidity
position.


91






The
Company relies on dividends from the Bank as its primary source of
liquidity.  The Company is a legal entity separate and distinct from
the Bank.  Various legal limitations restrict the Bank from lending or
otherwise supplying funds to the Company to meet its obligations, including
paying dividends.   In addition, the terms of the consent order
described above will further limit the Bank's ability to pay dividends to the
Company to satisfy its funding needs.  As part of the acquisition of
Carolina National Corporation, the Company had entered into a loan agreement in
December 2007 with a correspondent bank for a line of credit to finance a
portion of the cash paid in the transaction and to fund operating expenses of
the Company including interest and dividend payments on its noncumulative
preferred stock and trust preferred securities.  The Company pledged
all of the stock of the Bank as collateral for the line of credit which had an
outstanding balance of $9.5 million as of December 31, 2008.





Due to
the Bank's increased level of nonperforming assets and the Company's reduced
profitability, the Company was not in compliance with several of the covenants
on this line of credit as of December 31, 2008 relating to profitability and
asset quality.  The Company had previously satisfied all covenants in
the loan agreement.  The Company is currently operating under a waiver
of these covenants while the lender continues to review the Company's 2008
year-end financial results, and the note is performing under all other terms of
the loan agreement.  It has been the lender's practice to
perform a quarterly review of the Company's financial condition and to grant a
waiver for the upcoming calendar quarter based on the results of this
review.  In addition, the lender has agreed not to pursue the
collateral underlying the line of credit through June 30, 2009.  All
other terms and conditions of the loan documents continue to exist and may
be exercised at any time.





The
uncertainty surrounding the lender's intention to continue granting quarterly
waivers of the covenant defaults on the line of credit through December 31, 2009
casts doubt about the Company's ability to continue in
operation.  Although uncertainty exists regarding the waiver of
covenant defaults on the line of credit, the systemic risk in the financial
services industry created by the current period of economic distress has
negatively affected the Bank's financial performance which has resulted in the
Company's inability to maintain compliance with all of the covenants on the line
of credit.  Nevertheless, should the lender not grant a waiver of the
covenant defaults after completion of its review of the Company's 2008 year-end
financial results the lender would have the ability to withdraw the line of
credit and require the Company to secure an alternate source of financing to
repay the outstanding balance on the line of credit within a short period of
time.  Management has assessed the potential consequences of this
action and believes that its current strategy to raise additional capital will
enable the Company to deal with this event if faced with the requirement to
obtain alternate financing to repay the outstanding balance on the line of
credit within a relatively short period of time if future covenant defaults are
not waived by the lender.   In the alternate, the lender could
take steps to foreclose subsequent to June 30, 2009 on the Bank's stock as
collateral for the loan if alternate financing to repay the outstanding balance
on the line of credit could not be obtained within the required timeframe. In
addition, as the Bank is able to execute on the strategy to dispose of its
nonperforming assets and the Company returns to profitability the covenants on
the line of credit would be met and the loan would not be in
default.





Management
believes that the Company will also need to raise additional capital to absorb
the potential losses associated with the disposition of its nonperforming assets
and to increase capital levels to meet the standards set forth by the
OCC.  As a result of the recent downturn in the financial markets, the
availability of many sources of capital (principally to financial services
companies) has become significantly restricted or has become increasingly costly
as compared to the prevailing market rates prior to the
volatility.  Management cannot predict when or if the capital markets
will return to more favorable conditions.  The Bank’s management is
actively evaluating a number of capital sources asset reductions and other
balance sheet management strategies to ensure that the Bank’s projected level of
regulatory capital can support its balance sheet.





There can
be no assurances that the Company will be successful in its efforts to raise
additional capital during 2009.  An equity financing transaction of
this type would result in substantial dilution to the Company's current
shareholders and could adversely affect the market price of the Company's common
stock.   It is difficult to predict if these efforts will be
successful, either on a short-term or long-term basis.  Should these
efforts be unsuccessful, due to the regulatory restrictions which exist that
restrict cash payments between the Bank and the Company, the Company may be
unable to realize its assets and discharge its liabilities in the normal course
of business.





As
a result of management's assessment of the Company's ability to continue as a
going concern, the accompanying consolidated financial statements for the
Company have been prepared on a going concern basis, which contemplates the
realization of assets and the discharge of liabilities in the normal course of
business for the foreseeable future, and does not include any adjustments to
reflect the possible future effects on the recoverability or classification of
assets, and the amounts or classification of liabilities that may result from
the outcome of a potential future default due to noncompliance with covenants on
the line of credit, which could affect the Company's ability to continue as a
going concern.


92





Note
3—Supplemental Noncash Investing and Financing Data





The
following summarizes supplemental cash flow data for the years ended
December 31 (dollars in thousands):




Cash
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006Interest
      paid
                    
                    $
                    24,815
                    
                    
                    $
                    22,623
                    
                    
                    $
                    14,126Cash
      paid for income taxes
                    
                    
                    -
                    
                    
                    
                    2,188
                    
                    
                    
                    2,313Noncash
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006Change
      in fair value of securities available for sale, net of income
      tax
                    
                    $
                    (532
                    )
                    
                    
                    503
                    
                    
                    
                    206Loans
      transferred to other real estate owned, net of write downs of $1,344 and
      $44
                    
                    
                    5,282
                    
                    
                    
                    2,320
                    
                    
                    
                    -Loans
      charged off, net
                    
                    
                    (5,354
                    )
                    
                    
                    (240
                    )
                    
                    
                    (116
                    )





Note
4—Restrictions on Cash and Cash Equivalents





The Bank
is required to maintain average reserve balances, net of vault cash, with the
FRB based upon a percentage of deposits.  The amount of the required
reserve balance which is reported in “Cash and cash equivalents” on the
accompanying consolidated balance sheets at December 31, 2008 and 2007, was
$4,729,000 and $3,124,000, respectively. Subsequent to December 31, 2008, the
Bank has pledged $2.0 million of its cash balances at the FHLB as additional
collateral against its FHLB advances.





Note
5—Investment Securities





The
amortized cost, fair value and gross unrealized holding gains and losses of
securities available for sale at December 31, 2008 and 2007, consisted of
the following (dollars in thousands):





2008Gross
                          
                          
                          GrossAmortized
                          
                          
                          Unrealized
                          
                          
                          Unrealized
                          
                          
                          FairCost
                          
                          
                          Gains
                          
                          
                          Loss
                          
                          
                          ValueU.S.
      Government/government sponsored agencies
                          
                          $
                          3,950
                          
                          
                          $
                          63
                          
                          
                          $
                          -
                          
                          
                          $
                          4,013Mortgage-backed
      securities
                          
                          
                          56,971
                          
                          
                          
                          1,277
                          
                          
                          
                          (78
                          )
                          
                          
                          58,170Municipal
      securities
                          
                          
                          19,880
                          
                          
                          
                          106
                          
                          
                          
                          (507
                          )
                          
                          
                          19,479Total
                          
                          $
                          80,801
                          
                          
                          $
                          1,446
                          
                          
                          $
                          (585
                          )
                          
                          $
                          81,662





2007Gross
                      
                      
                      GrossAmortized
                      
                      
                      Unrealized
                      
                      
                      Unrealized
                      
                      
                      FairCost
                      
                      
                      Gains
                      
                      
                      Loss
                      
                      
                      ValueU.S.
      Government/government sponsored agencies
                      
                      $
                      10,635
                      
                      
                      $
                      -
                      
                      
                      $
                      (68
                      )
                      
                      $
                      10,567Mortgage-backed
      securities
                      
                      
                      42,891
                      
                      
                      
                      357
                      
                      
                      
                      (207
                      )
                      
                      
                      43,041Municipal
      securities
                      
                      
                      16,948
                      
                      
                      
                      72
                      
                      
                      
                      (98
                      )
                      
                      
                      16,922Total
                      
                      $
                      70,474
                      
                      
                      $
                      429
                      
                      
                      $
                      (373
                      )
                      
                      $
                      70,530





At
December 31, 2008 and 2007, securities with a carrying value of
approximately $80.0 million and $60.5 million, respectively, were pledged to
secure public deposits and for other purposes required or permitted by law,
including as collateral for Federal Home Loan Bank (“FHLB”) and FRB credit
window advances outstanding.


93


The
following table shows 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 December 31, 2008 and December 31,
2007 (dollars in thousands).





2008Securities
      available for sale:Less
      than 12 months
                                          
                                          
                                          12
      months or more
                                          
                                          
                                          TotalFair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          UnrealizedValue
                                          
                                          
                                          Losses
                                          
                                          
                                          Value
                                          
                                          
                                          Losses
                                          
                                          
                                          Value
                                          
                                          
                                          LossesU.S.
      Government/government sponsored agencies
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -Mortgage-backed
      securities
                                          
                                          
                                          3,609
                                          
                                          
                                          
                                          (78
                                          )
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          3,609
                                          
                                          
                                          
                                          (78
                                          )Municipal
      securities
                                          
                                          
                                          8,612
                                          
                                          
                                          
                                          (507
                                          )
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          8,612
                                          
                                          
                                          
                                          (507
                                          )Total
                                          
                                          $
                                          12,221
                                          
                                          
                                          $
                                          (585
                                          )
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          12,221
                                          
                                          
                                          $
                                          (585
                                          )2007Securities
      available for sale:Less
      than 12 months
                                          
                                          
                                          12
      months or more
                                          
                                          
                                          TotalFair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Fair
                                          
                                          
                                          UnrealizedValue
                                          
                                          
                                          Losses
                                          
                                          
                                          Value
                                          
                                          
                                          Losses
                                          
                                          
                                          Value
                                          
                                          
                                          LossesU.S.
      Government/government sponsored agencies
                                          
                                          $
                                          3,131
                                          
                                          
                                          $
                                          (4
                                          )
                                          
                                          $
                                          6,436
                                          
                                          
                                          $
                                          (64
                                          )
                                          
                                          $
                                          9,567
                                          
                                          
                                          $
                                          (68
                                          )Mortgage-backed
      securities
                                          
                                          
                                          2,025
                                          
                                          
                                          
                                          (36
                                          )
                                          
                                          
                                          14,416
                                          
                                          
                                          
                                          (171
                                          )
                                          
                                          
                                          16,441
                                          
                                          
                                          
                                          (207
                                          )Municipal
      securities
                                          
                                          
                                          4,760
                                          
                                          
                                          
                                          (49
                                          )
                                          
                                          
                                          2,881
                                          
                                          
                                          
                                          (49
                                          )
                                          
                                          
                                          7,641
                                          
                                          
                                          
                                          (98
                                          )Total
                                          
                                          $
                                          9,916
                                          
                                          
                                          $
                                          (89
                                          )
                                          
                                          $
                                          23,733
                                          
                                          
                                          $
                                          (284
                                          )
                                          
                                          $
                                          33,649
                                          
                                          
                                          $
                                          (373
                                          )





At
December 31, 2008, no individual securities had been in a continuous loss
position for twelve months or more.  At December 31, 2007,
thirty-eight individual securities had been in a continuous loss position for
twelve months or more.  The Company has the ability and intent to hold
these securities until such time as the value recovers or the securities
mature.  The Company believes, based on industry analyst reports and
the credit ratings of the securities, that the deterioration in value is
attributable to changes in market interest rates and not in the credit quality
of the issuer and, therefore, these losses are not considered
other-than-temporary.





The
amortized cost and estimated fair value of investment securities available for
sale at December 31, 2008, by contractual maturity are shown in the
following table.  Expected maturities may differ from contractual
maturities because issuers may have the right to call or repay obligations with
or without prepayment penalties.  Fair value of securities was
determined using quoted market prices (dollars in thousands).




2008Amortized
                      
                      
                      FairCost
                      
                      
                      ValueDue
      after one year, through five years
                      
                      $
                      1,342
                      
                      
                      $
                      1,359Due
      after five years, through ten years
                      
                      
                      5,673
                      
                      
                      
                      5,695Due
      after ten years
                      
                      
                      16,815
                      
                      
                      
                      16,438Subtotal
                      
                      
                      23,830
                      
                      
                      
                      23,492Mortgage-backed
      securities
                      
                      
                      56,971
                      
                      
                      
                      58,170Total
                      
                      $
                      80,801
                      
                      
                      $
                      81,662





Note
6—Investments Required by Law





The Bank,
as a member of the FRB and the FHLB is required to own capital stock in these
organizations.  The Bank’s equity investments required by law are
included in the accompanying consolidated balance sheets in “Other
assets.”  The amount of FRB stock owned is based on the Bank’s capital
levels and totaled $1,821,000 and $966,000 at December 31, 2008 and 2007,
respectively.  The amount of FHLB stock owned is determined based on
the Bank’s advances from the FHLB and totaled $5,344,000 and $2,721,000 at
December 31, 2008 and 2007, respectively.  No ready market exists
for these stocks and they have no quoted market value.  However,
redemption of these stocks has historically been at par
value.  Accordingly, the carrying amounts are deemed to be a
reasonable estimate of fair value.


94


Note
7—Loans





A summary
of loans by classification at December 31 is as follows (dollars in
thousands):




December
      31, 2008
                        
                        
                        December
      31, 2007Amount
                        
                        
                        %
      of
                          Total
      (1)
                        
                        
                        Amount
                        
                        
                        %
      of
                          Total
      (1)Commercial
      and industrial
                        
                        $
                        48,432
                        
                        
                        
                        6.83
                        %
                        
                        $
                        34,435
                        
                        
                        
                        6.97
                        %Commercial
      secured by real estate
                        
                        
                        429,868
                        
                        
                        
                        60.61
                        %
                        
                        
                        322,807
                        
                        
                        
                        65.33
                        %Real
      estate - residential mortgages
                        
                        
                        206,910
                        
                        
                        
                        29.17
                        %
                        
                        
                        111,490
                        
                        
                        
                        22.56
                        %Installment
      and other consumer loans
                        
                        
                        8,439
                        
                        
                        
                        1.19
                        %
                        
                        
                        6,496
                        
                        
                        
                        1.32
                        %Total
      loans
                        
                        
                        693,649
                        
                        
                        
                        
                        
                        
                        
                        475,228Mortgage
      loans held for sale
                        
                        
                        16,411
                        
                        
                        
                        2.31
                        %
                        
                        
                        19,408
                        
                        
                        
                        3.93
                        %Unearned
      income
                        
                        
                        (773
                        )
                        
                        
                        (0.11
                        )%
                        
                        
                        (543
                        )
                        
                        
                        (0.11
                        )%Total
      loans, net of unearned income
                        
                        
                        709,287
                        
                        
                        
                        100.00
                        %
                        
                        
                        494,093
                        
                        
                        
                        100.00
                        %Less
      allowance for loan losses(2)
                        
                        
                        (23,033
                        )
                        
                        
                        3.32
                        %
                        
                        
                        (4,951
                        )
                        
                        
                        1.04
                        %Total
      loans, net
                        
                        $
                        686,254
                        
                        
                        
                        
                        
                        
                        $
                        489,142




(1)  As
a % of total loans includes mortgage loans held for sale.




(2)  Loan
loss allowance % of total loans excludes mortgage loans held for
sale.




Approximately
$447,507,000 of the loans were variable interest rate loans at December 31,
2008.  The remaining portfolio was comprised of fixed interest rate
loans.





As of
December 31, 2008 and 2007, nonperforming assets (nonperforming loans plus other
real estate owned) were $75.5 million and $14.3 million, respectively. The $75.5
million in nonperforming assets as of December 31, 2008, included $1.7 million
in nonperforming assets related to the acquisition of Carolina
National.  The $1.7 million in nonperforming assets acquired from
Carolina National were originally recorded at their net realizable value as of
the merger date of January 31, 2008.  Foregone interest income on
these nonaccrual loans and other nonaccrual loans charged off during the
twelve-month periods ended December 31, 2008, 2007 and 2006, was approximately
$1,139,000, $139,000 and $24,000, respectively.  There were no loans
contractually past due in excess of 90 days and still accruing interest at
December 31, 2008 or 2007.  There were impaired loans, under the
criteria defined in FAS 114, of $69.1
million and $12.0 million with related valuation allowances of approximately
$8.3 million and $655,000 at December 31, 2008 and 2007,
respectively.  Of the impaired loans at December 31, 2008 and 2007,
$21.7 million and $3.1 million, respectively, required no valuation allowance,
with $47.4 and $5.8 million requiring the valuation allowances of $8.3 and
$655,000, respectively.  The amounts discussed above reflect
developments subsequent to December 31, 2008 and 2007 and therefore may differ
from the amounts presented on the face of the consolidated financial
statements.





Significant
nonperforming loans consist primarily of loans made to residential real estate
developers.  The recent downturn in the residential housing market is
the primary factor leading to the abrupt deterioration in these loans.
Therefore, additional reserves have been provided in the allowance for loan
losses during the year ended December 31, 2008, to account for what we believe
is the increased probable credit risk associated with these
loans.  These additional reserves are based on our evaluation of a
number of factors including the estimated real estate values of the collateral
supporting each of these loans.





As of
December 31, 2008, total residential construction and development loans totaled
$56.0 million or 8.1% of the loan portfolio.  These loans carry a
higher degree of risk than long-term financing of existing real estate since
repayment is dependent on the ultimate completion of the project or home and
usually on the sale of the property or permanent financing.  Slow
housing conditions have affected some of these borrowers’ ability to sell the
completed projects in a timely manner.  Management believes that the
combination of specific reserves in the allowance for loan losses and
established impairments of these loans will be adequate to account for the
current risk associated with the residential construction loan portfolio as of
December 31, 2008.


95


Also included in nonperforming assets
as of December 31, 2008, is $6.4
million in other real estate owned, or 8.5% of total nonperforming assets as of
this date.  Other real estate owned consists of property acquired
through foreclosure.  During the year ended December 31, 2008, other
real estate owned increased by $4.1 million net, due to foreclosure on a number
of properties, partially offset by the disposition of several pieces of
foreclosed property.  The transfer of these properties represents the
next logical step from their previous classification as nonperforming loans to
other real estate owned to give First National the ability to control the
properties.  The repossessed collateral is made up of single-family
residential properties in varying stages of completion and various commercial
properties.  These properties are being actively marketed and
maintained with the primary objective of liquidating the collateral at a level
which most accurately approximates fair market value and allows recovery of as
much of the unpaid principal balance as possible upon the sale of the property
in a reasonable period of time.  The cost of owning the properties was
approximately $1,757,000, including writedowns of $1,562,000, for the year ended
December 31, 2008, compared to $31,000 for the year ended December 31, 2007 and
$0 for the year ended December 31, 2006.  The carrying value of these
assets is believed to be representative of their fair market value, although
there can be no assurance that the ultimate net proceeds from the sale of these
assets will be equal to or greater than the carrying values. Other real estate
owned is included in “other assets” in the accompanying consolidated balance
sheets.





Management
regularly evaluates the carrying value of the properties included in other real
estate owned and may record additional writedowns in the future after review of
a number of factors including collateral values and general market conditions in
the area surrounding the properties.  Management continues to evaluate
and assess all nonperforming assets on a regular basis as part of its
well-established loan monitoring and review process.





Qualifying
loans held by the Bank and collateralized by 1-4 family residences, home equity
lines of credit (“HELOC’s”) and commercial properties totaling $88,382,000 were
pledged as collateral for FHLB advances outstanding of $86,363,000 at
December 31, 2008.  At December 31, 2007, qualifying loans
held by the Bank and collateralized by 1-4 and multi-family residences, HELOC’s
and commercial properties totaling $56,988,000 were pledged as collateral for
FHLB advances outstanding of $41,690,000.





Changes
in the allowance for loan losses for the years ended December 31 were as
follows (dollars in thousands):




2008
                    
                    
                    2007
                    
                    
                    2006Balance,
      beginning of year
                    
                    $
                    4,951
                    
                    
                    $
                    3,795
                    
                    
                    $
                    2,719Allowance
      from acquisition
                    
                    
                    2,976
                    
                    
                    
                    -
                    
                    
                    
                    -Provision
      charged to operations
                    
                    
                    20,460
                    
                    
                    
                    1,396
                    
                    
                    
                    1,192Loans
      charged off
                    
                    
                    (5,383
                    )
                    
                    
                    (250
                    )
                    
                    
                    (139
                    )Recoveries
      on loans previously charged off
                    
                    
                    29
                    
                    
                    
                    10
                    
                    
                    
                    23Balance,
      end of year
                    
                    $
                    23,033
                    
                    
                    $
                    4,951
                    
                    
                    $
                    3,795




Directors,
executive officers and associates of such persons are customers of and have
transactions with the Bank in the ordinary course of
business.  Included in such transactions are outstanding loans and
commitments, all of which are made under substantially the same credit terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with unrelated persons and do not involve more than the
normal risk of collectability.





The
aggregate dollar amount of these outstanding loans was approximately $16.9
million and $15.2 million at December 31, 2008 and 2007,
respectively.  During 2008, new loans and advances on these lines of
credit totaled approximately $5.7 million and payments on these loans and lines
totaled approximately $4.0 million.  At December 31, 2008, there
were unfunded commitments and commitments to extend additional credit to related
parties in the amount of approximately $3.8 million.





Under
current Federal Reserve regulations, the Bank is limited to the amount it may
loan to the Company.  Loans made by the Bank may not exceed 10% and
loans to all affiliates may not exceed 20% of the Bank’s capital, surplus and
undivided profits, after adding back the allowance for loan
losses.  There were no loans outstanding between the Bank and the
Company at December 31, 2008 or 2007.


96


Note
8—Premises and Equipment





A summary
of premises and equipment at December 31 follows (dollars in
thousands).




2008
                    
                    
                    2007Land
                    
                    $
                    1,603
                    
                    
                    $
                    150Building
      and improvements
                    
                    
                    1,998
                    
                    
                    
                    3,747Furniture,
      fixtures and equipment
                    
                    
                    5,852
                    
                    
                    
                    617Construction
      in progress
                    
                    
                    819
                    
                    
                    
                    12Subtotal
                    
                    
                    10,272
                    
                    
                    
                    4,526Accumulated
      depreciation
                    
                    
                    (2,652
                    )
                    
                    
                    (1,552
                    )Total
                    
                    $
                    7,620
                    
                    
                    $
                    2,974





Depreciation
expense charged to operations totaled $738,000, $545,000, and $409,000 in 2008,
2007 and 2006, respectively.





The Bank
entered into a long-term land operating lease during 2000, which had an initial
term of 20 years and various renewal options under substantially the same
terms.  Since that time, the Bank has assumed many additional leases
due to the acquisition of Carolina National.  During 2007, the Bank
executed two sale/leaseback transactions (see Note 9 – Sale/Leaseback
Transactions for further details), resulting in increased rental
expense.  Rent expense charged to operations totaled $1,450,000,
$812,000 and $53,000 for each of the years ended December 31, 2008, 2007,
and 2006, respectively.  In addition, the Bank currently has
short-term operating leases for certain branch facilities and loan production
offices.  The annual minimum rental commitments under the terms of the
Company’s noncancellable leases at December 31, 2008, are as follows
(dollars in thousands):





2009
                  
                  $
                  1,3102010
                  
                  
                  1,2682011
                  
                  
                  1,2692012
                  
                  
                  1,1832013
                  
                  
                  1,125Thereafter
                  
                  
                  19,763Total
                  
                  $
                  25,918





Note 9 – Sale/Leaseback
Transactions





In
February of 2007, the Bank entered into a transaction with a related party
entity to sell and subsequently lease back from the entity certain real
properties previously owned by the bank.  The sales price for the
properties was $5,450,000.  In connection with the sale, the Bank
agreed to lease back the properties from the purchaser for an initial term of
twenty-five years with one five-year option to renew at the option of the
Bank.  The terms of the lease portion of the Agreement call for
monthly rental payments of $38,604 during the initial term under a triple-net
lease that will be accounted for as an operating lease under the provisions of
Financial Accounting Standard (“FAS”) No. 13, “Accounting for Leases (as
amended).”  If the Bank exercises the option to renew the lease as
described above, the monthly rental payments will be adjusted to reflect the
increase, if any, in the Consumer Price Index between the date of the Agreement
and the date of commencement of the renewal term.  The sale-leaseback
transaction resulted in a minimal gain.  The Bank will recognize the
gain on a straightline    basis over the initial lease term
of twenty-five years.





The
related party entity, First National Holdings, LLC, is a limited liability
company owned by nine investors who also serve as directors of the Company and
the Bank.  Each investor/director has a one-ninth interest in the
limited liability company.  The transaction was approved by the board
of directors of the bank subsidiary and complies with the NASDAQ Global Market
listing standards, applicable SEC Rules, and the Company’s internal policies and
procedures.





In
October of 2007, the Bank entered into a transaction with a related party entity
to sell, purchase and lease real properties located at 651 Johnnie Dodds
Boulevard, Mt. Pleasant, SC, 3401 Pelham Road, Greenville, SC and 713 W. Wade
Hampton Boulevard, Greer, SC for a price of $3.6 million.  The real
property located at 3401 Pelham Road, Greenville, SC consists of the Bank’s
Greenville County market headquarters and a full-service branch.  The
real properties located at 651 Johnnie Dodds Boulevard, Mt. Pleasant, SC and 713
W. Wade Hampton Boulevard, Greer, SC are full-service branches.  In
connection with the sale/leaseback, the Bank agreed to lease back the real
properties from the Purchaser for an initial term of twenty-five years with one
five-year option to renew at the Bank’s option.  This transaction
resulted in a loss of approximately $417,000, which the Bank will recognize on a
straight-line basis over the initial lease term of twenty-five
years.  The terms of the lease portion of the agreement call for
monthly rental payments of $24,375 during the initial term under a triple-net
lease that will be accounted for as an operating lease under the provisions of
Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for
Leases (as amended).”  If the Bank exercises the option to renew the
lease as described above, the monthly rental payments will be adjusted to
reflect the increase, if any, in the Consumer Price Index between the date of
the Agreement and the date of commencement of the renewal term.


97


The
related party entity, First National Holdings II, LLC, is a limited liability
corporation owned by eight investors who also serve as non-management
directors.  Each investor/director has a one/eighth interest in the
limited liability corporation.  The transaction was approved by the
board of directors of the bank subsidiary and complies with the NASDAQ Global
Market listing standards, applicable SEC Rules, and the Company’s own internal
policies and procedures.  The Company plans to continue to conduct its
normal banking operations out of the real properties without
interruption.





As part
of the Company’s strategy to minimize its nonearning assets, it may exercise
future sale/leaseback transactions for the remaining properties owned by the
Bank.  As part of its growth and expansion strategy, the Company may
contract to acquire additional sites in the future to further expand its branch
network and support infrastructure growth.  It analyzes each
transaction to determine whether owning or leasing the real property is the most
efficient method of ownership of these properties and may contract to sell and
lease back future acquired sites.





Note
10—Deposits





The
aggregate amount of time deposits with a minimum denomination of $100,000 was
approximately $272.9 million and $176.0 million at December 31, 2008 and
2007, respectively.  For the years ended December 31, 2008 and
2007, our interest-bearing deposits included wholesale funding in the form of
brokered certificates of deposit (“CDs”) of approximately $150.2 million and
89.0 million, respectively.  For the years ended December 31, 2008 and
2007, approximately $23,000 and $15,000, respectively, in overdrawn deposit
accounts were classified as loans on the consolidated balance
sheet.





The
scheduled maturities of time deposits at December 31 are as follows
(dollars in thousands):


20082009
                      
                      $
                      386,3242010
                      
                      
                      32,0232011
                      
                      
                      1,7622012
                      
                      
                      2,1732013
                      
                      
                      6,165Thereafter
                      
                      
                      -Total
                      
                      $
                      428,447





As of
December 31, 2008, deposits were made up of the following categories (dollars in
thousands):


2008
                    
                    
                    2007Noninterest-bearing
      DDA
                    
                    $
                    39,088
                    
                    
                    $
                    44,466Interest-bearing
      DDA
                    
                    
                    60,414
                    
                    
                    
                    49,330Money
      market accounts
                    
                    
                    115,945
                    
                    
                    
                    81,710Savings
      accounts
                    
                    
                    2,955
                    
                    
                    
                    3,212Time
      deposits less than $100,000
                    
                    
                    155,551
                    
                    
                    
                    117,110Time
      deposits greater than $100,000
                    
                    
                    272,896
                    
                    
                    
                    176,000Total
                    
                    $
                    646,849
                    
                    
                    $
                    471,828





Note 11—Lines of
Credit





At
December 31, 2008 and 2007, the Bank had short-term lines of credit with
correspondent banks to purchase unsecured federal funds totaling $28 million and
$59.5 million, respectively.  The interest rate on any borrowings
under these lines would be the prevailing market rate for federal funds
purchased.





In
addition, during the fourth quarter of 2007, the Company established a line of
credit with a third party bank.  The line of credit, in an amount up
to $15,000,000, has a twelve-year final maturity with interest payable quarterly
at a floating rate tied to the Wall Street Journal Prime Rate.  The
terms of the line include two years of quarterly interest payments followed by
ten years of annual principal payments plus quarterly interest payments on the
outstanding principal balance as of December 31, 2009.  The line of
credit was secured in connection with the terms of the Merger Agreement, dated
August 26, 2007, between First National and Carolina National, to support the
cash consideration of the Merger and to fund general operating
expenses.


98


As of
December 31, 2008, the Company had an outstanding balance of $9.5 million on the
line of credit described above.  The Company pledged all of the stock
of its bank subsidiary as collateral for the line of credit, which contains
various debt covenants related to net income and asset
quality.  Because of the Company’s unusually high amount of
nonperforming loans as of December 31, 2008, it was out of compliance with the
covenants governing the line of credit. As outlined in the terms of the
Company’s current waiver, it will not be permitted to make additional draws on
its line of credit other than to pay interest on the line of
credit.  The Company is currently operating under a waiver of covenant
defaults as of September 30, 2008 that is in effect until the lender completes
its quarterly review of the December 31, 2008 financial statements relating to
this noncompliance.  The Company believes that the lender will grant
such waivers quarterly, but it does not have any assurances in this
regard.  The lender has granted us a waiver through June 30, 2009, of
their ability to pursue the collateral underlying the line of
credit.  All other terms and conditions of the loan documents will
continue to exist and may be exercised at any time.  The lender may
declare an event of default under the line of credit, revoke the line of credit
and attempt to foreclose on the Bank stock collateral.  Please see
Note 2 – “Regulatory Actions and Going Concern Considerations” for a discussion
of recent regulatory developments and their impact on the company’s lines of
credit.





Note 12—FHLB
Advances





The
Company has been notified by FHLB that it will not allow future advances by the
Company while it is operating under its current regulatory enforcement action.
Please see Note 2 – “Regulatory Actions and Going Concern Considerations” for a
discussion of recent regulatory developments and their impact on the Bank’s FHLB
advances.





Qualifying
loans held by the Bank and collateralized by 1-4 and multi-family residences,
HELOC’s and commercial properties totaling $88,382,000 were pledged as
collateral for FHLB advances outstanding of $86,363,000 at December 31,
2008.  At December 31, 2007, qualifying loans held by the Bank
and collateralized by 1-4 family residences, HELOC’s and commercial properties
totaling $56,988,000 were pledged as collateral for FHLB advances outstanding of
$41,690,000, and letters of credit totaling $15,000,000 pledged to a public
depositor.





At
December 31, 2008, fixed rate FHLB advances outstanding ranged from $1
million to $7.5 million with initial maturities of two to seven years and rates
of 2.12% to 4.95%.  At December 31, 2008, advances totaling $42.5
million were subject to call features at the option of the FHLB with call dates
ranging from January 2009 to March 2010 and rates of 2.12% to
4.95%.  The Bank had one variable rate FHLB advance totaling $27.2
million with a rate of 0.46% at December 31, 2008.





The
following table lists a summary of the terms and contractual maturities for the
advances as of December 31, 2008 (dollars in thousands).




2008Due
      in 2009
                      
                      $
                      28,240Due
      in 2010
                      
                      
                      4,052Due
      in 2011
                      
                      
                      15,381Due
      in 2012
                      
                      
                      6,190Due
      in 2013
                      
                      
                      12,500Thereafter
                      
                      
                      20,000Total
                      
                      $
                      86,363








99


Note 13—Income
Taxes





The
following is a summary of the items which caused recorded income taxes to differ
from taxes computed using the statutory tax rate for the periods ended
December 31 (dollars in thousands):





2008
                    
                    
                    2007
                    
                    
                    2006Income
      tax expense/(benefit) at federal statutory rate of 34%
                    
                    $
                    (16,007
                    )
                    
                    $
                    2,074
                    
                    
                    $
                    2,090State
      income tax, net of federal effect
                    
                    
                    -
                    
                    
                    
                    139
                    
                    
                    
                    146Valuation
      allowance for deferred tax asset
                    
                    
                    4,200
                    
                    
                    
                    -
                    
                    
                    
                    -Tax-exempt
      securities income
                    
                    
                    (217
                    )
                    
                    
                    (190
                    )
                    
                    
                    (108
                    )Bank-owned
      life insurance earnings
                    
                    
                    (47
                    )
                    
                    
                    (45
                    )
                    
                    
                    (42
                    )Other,
      net
                    
                    
                    68
                    
                    
                    
                    61
                    
                    
                    
                    9Impairment
      of non-deductible goodwill
                    
                    
                    9,769
                    
                    
                    
                    -
                    
                    
                    
                    -Income
      tax expense/(benefit)
                    
                    $
                    (2,234
                    )
                    
                    $
                    2,039
                    
                    
                    $
                    2,095





The
provision for income taxes for the years ended December 31 is as follows
(dollars in thousands):





2008
                        
                        
                        2007
                        
                        
                        2006Current:Federal
                        
                        $
                        (107
                        )
                        
                        $
                        2,193
                        
                        
                        $
                        2,258State
                        
                        
                        (4
                        )
                        
                        
                        211
                        
                        
                        
                        221Total
                        
                        $
                        (111
                        )
                        
                        $
                        2,404
                        
                        
                        $
                        2,479Deferred:Federal
                        
                        $
                        (2,123
                        )
                        
                        $
                        (365
                        )
                        
                        $
                        (384
                        )State
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Total
                        
                        $
                        (2,123
                        )
                        
                        $
                        (365
                        )
                        
                        $
                        (384
                        )Provision
      for income taxes
                        
                        $
                        (2,234
                        )
                        
                        $
                        2,039
                        
                        
                        $
                        2,095





The
components of the deferred tax assets and liabilities at December 31 are as
follows (dollars in thousands):


2008
                        
                        
                        2007Deferred
      tax liability:Core
      deposit intangible
                        
                        $
                        438
                        
                        
                        $
                        -Unrealized
      gain on securities available for sale
                        
                        
                        293
                        
                        
                        
                        19Tax
      depreciation in excess of book
                        
                        
                        219
                        
                        
                        
                        148Prepaid
      expenses deducted currently for tax
                        
                        
                        192
                        
                        
                        
                        95Deferred
      loss on sale/leaseback transaction
                        
                        
                        107
                        
                        
                        
                        -Loan
      servicing rights
                        
                        
                        82
                        
                        
                        
                        112Other
                        
                        
                        5
                        
                        
                        
                        116Total
      deferred tax liability
                        
                        
                        1,336
                        
                        
                        
                        490Deferred
      tax asset:Allowance
      for loan losses
                        
                        $
                        7,469
                        
                        
                        $
                        1,625Net
      operating loss carryforward
                        
                        
                        2,649
                        
                        
                        
                        -Writedowns
      on other real estate owned
                        
                        
                        797
                        
                        
                        
                        -Other
                        
                        
                        33
                        
                        
                        
                        3Total
      deferred tax asset
                        
                        
                        10,948
                        
                        
                        
                        1,628Valuation
      allowance
                        
                        
                        4,200
                        
                        
                        
                        -Deferred
      tax asset after valuation allowance
                        
                        
                        6,748
                        
                        
                        
                        1,628Net
      deferred tax asset
                        
                        $
                        5,412
                        
                        
                        $
                        1,138





The net
deferred tax asset is included in “Other assets” in the accompanying
consolidated balance sheets.





The
Company has analyzed the tax positions taken or expected to be taken in its tax
returns and concluded it has no liability related to uncertain tax positions in
accordance with FIN 48.


100


Deferred
tax assets represent the future tax benefit of deductible differences and, if it
is more likely than not that a tax asset will not be realized, a valuation
allowance is required to reduce the recorded deferred tax assets to net
realizable value.  As of December 31, 2008, a valuation allowance has
been recorded to reflect the portion of the deferred income tax asset that is
not able to be offset against net operating loss carrybacks and reversals of net
future taxable temporary differences projected to occur in
2009.  Management determined that this valuation allowance of
$4,200,000 has been recorded due to the substantial doubt of the ability of the
Company to be able to realize all of the tax assets.  As of December
31, 2007, management determined that it was more likely than not that all tax
assets would be realized and no valuation allowance was
necessary.  The net deferred asset is included in “other assets” in
the balance sheet.





A portion
of the change in the net deferred tax asset relates to the change of $274,000 in
the tax effect of the unrealized gain on securities available for sale. In
addition, $2,425,000 of the change in the net deferred tax asset reflects the
tax effect of purchase accounting adjustments recorded as part of the
acquisition of Carolina National Corporation and its bank subsidiary Carolina
National Bank and Trust on January 31, 2008. The remainder of the change in the
net deferred tax asset is due to the current period deferred tax benefit of
$4,623,000.





Note 14—Noncumulative
Convertible Perpetual Preferred Stock





On July
3, 2007, the Company priced for sale 720,000 shares of its 7.25% Series A
Noncumulative Perpetual Preferred Stock (the “Preferred Stock”), at $25.00 per
share through an underwritten public offering.  Keefe, Bruyette &
Woods, Inc. served as sole underwriter and manager for the
offering.  Net proceeds after payment of underwriting discounts and
other costs of the offering were approximately $16.5 million.  The net
proceeds from the offering were used for general corporate purposes, which
include, among other things, providing additional capital to the Bank subsidiary
to support asset growth and the expansion of the Bank’s branch network, to repay
a line of credit and to fund loan growth.  The offering closed on July
9, 2007.  A registration statement relating to these securities was
filed with, and declared effective by the SEC as of June 26, 2007.





Subject
to certain limitations, the net proceeds received in the Preferred Stock
offering qualify as Tier 1 capital for capital adequacy calculations (see
“Capital Resources” in the MD&A section for further discussion of
capital).  This injection of capital positions the Bank for the future
growth through the expansion of its branch network.  The Preferred
Stock features a conversion option at any time into shares of the Company’s
common stock at an initial conversion price of $17.50 per share of common stock,
subject to adjustment.  This conversion price is also subject to
anti-dilution adjustments upon the occurrence of certain events.  The
number of shares of common stock issuable upon conversion of each share of
Preferred Stock will be equal to $25.00 divided by the conversion price then in
effect.  The Preferred Stock is redeemable at the Company’s option at
any time, in whole or in part, on and after the third anniversary of the issue
date, at $26.50 per share, plus declared and unpaid dividends, if any, with the
redemption price declining in equal increments on a quarterly basis to $25.00
per share on or after the fifth anniversary of the issue
date.   The Preferred Stock is also redeemable by us at the
redemption price of $25.00 per share if the last reported sale price of the
Company’s common stock has equaled or exceeded 140% of the Preferred Stock
conversion price for at least 20 consecutive trading days.  During the
year ended December 31, 2008 and 2007, cash dividends of $1,305,000 and
$626,000, respectively, were declared and paid to preferred stock
shareholders.  In light of the current period of volatility in the
financial markets and our net loss for 2008, our Board of Directors did not
declare a dividend for the first quarter of 2009 to our preferred
shareholders.  The Board expects to evaluate the decision to declare
future dividends to preferred shareholders on a quarterly basis and may resume
payment of these dividends in future quarters.





Note 15—Regulatory Capital
Requirements and Dividend Restrictions





The
Company (on a consolidated basis) and the Bank are subject to various regulatory
capital requirements administered by the federal banking
agencies.  Failure to meet minimum capital requirements can initiate
certain mandatory and possibly additional discretionary actions by regulators
that, if undertaken, could have a material effect on the financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Company and the Bank must meet
specific capital guidelines that involve quantitative measures of their assets,
liabilities and certain off-balance sheet items as calculated under regulatory
accounting practices.  The Company’s and the Bank’s capital amounts
and classification are also subject to qualitative judgments by the regulators
about components, risk weightings, and other factors. Prompt corrective action
provisions are not applicable to bank holding companies.





The Company and the Bank
are required to maintain minimum amounts and ratios of total risk-based capital,
Tier 1 capital, and Tier 1 leverage capital (as defined in the regulations) as
set forth in the following table.The Bank’s primary federal
regulator, the OCC, recently completed a safety and soundness examination of the
bank, which included a review of its asset quality.  The Bank has
received the final report from this examination.  In addition, the
Bank entered into a Consent Order with the OCC on April 27, 2009, which contains
a requirement that it maintain minimum capital requirements that exceed the
minimum regulatory capital ratios for “well-capitalized”
banks.    As a result of the terms of the consent order
executed April 27, 2009, the Bank is not longer deemed “well-capitalized”,
regardless of its capital levels.


101




The
following table presents the Company’s and the Bank’s actual capital amounts and
ratios at December 31, 2008 and 2007, as well as the minimum calculated
amounts for each regulatory-defined category (dollars in
thousands).




Actual
                    
                    
                    For Capital Adequacy
                      Purposes
                    
                    
                    Minimum to be
                      Categorized as Well
                      Capitalized UnderPrompt
                      CorrectiveAction
                      ProvisionsAmount
                    
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    RatioAs
      of December 31, 2008The
      CompanyTotal
      capital to risk-weighted assets
                    
                    $
                    61,522
                    
                    
                    
                    8.33
                    %
                    
                    $
                    59,090
                    
                    
                    
                    8.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/ATier
      1 capital risk-weighted assets
                    
                    $
                    44,545
                    
                    
                    
                    6.03
                    %
                    
                    $
                    29,545
                    
                    
                    
                    4.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/ATier
      1 capital to average assets
                    
                    $
                    44,545
                    
                    
                    
                    5.20
                    %
                    
                    $
                    34,261
                    
                    
                    
                    4.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/AThe
      BankTotal
      capital to risk-weighted assets
                    
                    $
                    68,764
                    
                    
                    
                    9.75
                    %
                    
                    $
                    56,414
                    
                    
                    
                    8.00
                    %
                    
                    $
                    71,270
                    
                    
                    
                    10.00
                    %Tier
      1 capital risk-weighted assets
                    
                    $
                    59,774
                    
                    
                    
                    8.48
                    %
                    
                    $
                    28,207
                    
                    
                    
                    4.00
                    %
                    
                    $
                    42,762
                    
                    
                    
                    6.00
                    %Tier
      1 capital to average assets
                    
                    $
                    59,774
                    
                    
                    
                    7.23
                    %
                    
                    $
                    33,069
                    
                    
                    
                    4.00
                    %
                    
                    $
                    41,351
                    
                    
                    
                    5.00
                    %As
      of December 31, 2007The
      CompanyTotal
      capital to risk-weighted assets
                    
                    $
                    65,514
                    
                    
                    
                    13.48
                    %
                    
                    $
                    38,870
                    
                    
                    
                    8.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/ATier
      1 capital risk-weighted assets
                    
                    $
                    56,387
                    
                    
                    
                    11.61
                    %
                    
                    $
                    19,435
                    
                    
                    
                    4.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/ATier
      1 capital to average assets
                    
                    $
                    56,387
                    
                    
                    
                    9.75
                    %
                    
                    $
                    23,130
                    
                    
                    
                    4.00
                    %
                    
                    $
                    N/A
                    
                    
                    
                    N/AThe
      BankTotal
      capital to risk-weighted assets
                    
                    $
                    52,137
                    
                    
                    
                    10.72
                    %
                    
                    $
                    38,911
                    
                    
                    
                    8.00
                    %
                    
                    $
                    48,639
                    
                    
                    
                    10.00
                    %Tier
      1 capital risk-weighted assets
                    
                    $
                    47,186
                    
                    
                    
                    9.70
                    %
                    
                    $
                    19,455
                    
                    
                    
                    4.00
                    %
                    
                    $
                    29,183
                    
                    
                    
                    6.00
                    %Tier
      1 capital to average assets
                    
                    $
                    47,186
                    
                    
                    
                    8.17
                    %
                    
                    $
                    23,093
                    
                    
                    
                    4.00
                    %
                    
                    $
                    28,866
                    
                    
                    
                    5.00
                    %




The ability of the Company to pay cash
dividends is dependent upon receiving cash in the form of dividends from the
Bank.  The dividends that may be paid by the Bank to the Company are
subject to legal limitations and regulatory capital requirements.  The
approval of the OCC is required if the total of all dividends declared by a
national bank in any calendar year exceeds the total of its net profits for that
year combined with its retained net profits for the preceding two years, less
any required transfers to surplus.  Further, we cannot pay cash
dividends on our common stock during any calendar quarter unless full dividends
on the Series A Preferred Stock for the dividend period ending during the
calendar quarter have been declared and we have not failed to pay a dividend in
the full amount of the Series A Preferred Stock with respect to the period in
which such dividend payment in respect of our common stock would
occur.  As of December 31, 2008, no cash dividends have been
declared or paid by the Bank.





Note 16—Junior Subordinated
Debentures





The
Company issued trust preferred securities totaling $13 million through its
statutory trust subsidiaries, FNSC Capital Trust I, FNSC Statutory Trust II and
FNSC Statutory Trust III, during 2003, 2004 and 2006,
respectively.  On December 19, 2003, FNSC Capital Trust I issued
and sold floating rate trust preferred securities having an aggregate
liquidation amount of $3 million to institutional buyers in a private placement
of trust preferred securities.  On April 30, 2004, FNSC Statutory
Trust II, issued an additional $3 million through a pooled offering of trust
preferred securities.  On March 30, 2006, FNSC Statutory Trust
III (collectively with FNSC Capital Trust I and FNSC Statutory Trust II [the
“Trusts”]), issued an additional $7 million through a pooled offering of trust
preferred securities.  The Trusts also issued common securities having
an aggregate liquidation amount of approximately 3% of the total capital of the
Trusts, or $403,000, to the Company.





The 2003,
2004 and 2006 trust preferred securities accrue and pay cumulative distributions
quarterly in arrears at a rate per annum equal to 90-day LIBOR plus 292 basis
points, 90-day LIBOR plus 270 basis points and 90-day LIBOR plus 145 basis
points, respectively.  The Company has the right, subject to events of
default, to defer payments of interest on the trust preferred securities for a
period not to exceed 20 consecutive quarters from the date of
issuance.  The Company did not pay interest for first quarter of
2009 and is considering whether to resume payments in future quarters or to
continue to exercise the right of deferral.  At December 31,
2008, the distribution rates on the 2003, 2004 and 2006 issuances were 6.97%,
4.57% and 3.45%, respectively.


102





The 2003,
2004 and 2006 trust preferred securities issues are mandatorily redeemable upon
maturity on December 19, 2033, April 30, 2034, and March 30,
2036, respectively.  The Company has the right to redeem them in whole
or in part, on or after December 19, 2008, April 30, 2009, and
March 29, 2018, and at any time thereafter, respectively.  If
they are redeemed on or after these dates, the redemption price will be 100% of
the principal amount plus accrued and unpaid interest.  In addition,
the Company may redeem any of these issuances in whole (but not in part) at any
time within 90 days following the occurrence of a tax event, an investment
company event, or a capital treatment event at a special redemption price (as
defined in the indenture).  The Trusts invested the gross proceeds of
$13 million from the issuance of the trust preferred securities and $403,000
from the issuance of the common securities in an equivalent amount of floating
rate junior subordinated debentures of the Company or
$13,403,000.  The Company contributed the net proceeds from the
issuance of the subordinated debentures of $13 million after purchase of the
common securities for $403,000 to the Bank for general corporate
purposes.  Issuance costs from the 2003 and 2004 transactions totaling
$104,000 and $15,000, respectively, are being amortized over the anticipated
life.





The
junior subordinated debentures are unsecured obligations of the Company and are
subordinate and junior in right of payment to all present and future senior
indebtedness of the Company.  The Company has entered into guarantees,
which, together with its obligations under the junior subordinated debentures
and the declaration of trusts governing the Trusts, provides full and
unconditional guarantees of the trust preferred securities.





The
common securities owned by the Company rank equal to the trust preferred
securities in priority of payment.  The common securities generally
have sole voting power on matters to be voted upon by the holders of the Trusts’
securities.





The
junior subordinated debentures and the common securities are presented in the
Company’s financial statements as liabilities and other assets,
respectively.  The trust preferred securities are a part of the
financial statements of the Trusts and they are not reflected in the Company’s
financial statements under the provisions of FIN 46R.





Note 17—Stock Compensation
Plans





Effective
March 6, 2000, the Company adopted the First National Bancshares, Inc. 2000
Stock Incentive Plan (the “Plan”).  Under the Plan, options are
periodically granted to employees and directors by the Company’s Board of
Directors at the recommendation of its Personnel Committee at a price not less
than the fair market value of the shares at the date of
grant.  Options granted are exercisable for a period of ten years from
the date of grant and become exercisable at a rate of 20% each year on the first
five anniversaries of the date of grant.  The Plan authorizes the
granting of stock options up to a maximum of 459,351 shares of common
stock.  As of December 31, 2008, 100,355 option shares were
available to be granted under the Plan.  As of December 31, 2008,
based on a market value of $2.06 per share, the aggregate intrinsic value for
the outstanding stock options and warrants was approximately $2.5
million.  Unrecognized compensation expense on these options and
warrants to be recognized in the future was approximately $257,000 at December
31, 2008.  These amounts reflect each of the 3 for 2 stock splits
distributed on January 18, 2006, and March 1, 2004, the 6% stock
dividend distributed on May 16, 2006, and the 7% stock dividend distributed
on March 30, 2007.





Upon
consummation of the initial public offering, the organizers were issued stock
warrants to purchase 799,611 shares of common stock for $3.92 per share, of
which 663,507 remain unexercised.  These warrants vested ratably over
a five-year period beginning February 10, 2000, and are exercisable in
whole or in part during the ten-year period following that
date.


103


The
following is a summary of the activity under the plans for the years ended
December 31:




2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006Shares
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
                                        Price Per
                                        Share
                                      
                                      
                                      Shares
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
                                        Price Per
                                        Share
                                      
                                      
                                      Shares
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
                                        Price Per
                                        ShareOutstanding,
      beginning of period
                                      
                                      
                                      963,474
                                      
                                      
                                      $
                                      4.89
                                      
                                      
                                      
                                      991,248
                                      
                                      
                                      $
                                      4.14
                                      
                                      
                                      
                                      1,113,501
                                      
                                      
                                      $
                                      4.37Granted
                                      
                                      
                                      166,422
                                      
                                      
                                      
                                      8.47
                                      
                                      
                                      
                                      16,885
                                      
                                      
                                      
                                      15.52
                                      
                                      
                                      
                                      31,715
                                      
                                      
                                      
                                      3.79Forfeited
                                      
                                      
                                      (36,875
                                      )
                                      
                                      
                                      12.64
                                      
                                      
                                      
                                      (5,955
                                      )
                                      
                                      
                                      11.71
                                      
                                      
                                      
                                      (4,169
                                      )
                                      
                                      
                                      4.16Exercised
                                      
                                      
                                      (1,276
                                      )
                                      
                                      
                                      7.35
                                      
                                      
                                      
                                      (38,704
                                      )
                                      
                                      
                                      4.71
                                      
                                      
                                      
                                      (149,799
                                      )
                                      
                                      
                                      3.95Outstanding,
      December 31
                                      
                                      
                                      1,091,745
                                      
                                      
                                      $
                                      4.49
                                      
                                      
                                      
                                      963,474
                                      
                                      
                                      $
                                      4.89
                                      
                                      
                                      
                                      991,248
                                      
                                      
                                      $
                                      4.14Exerciseable,
      December 31
                                      
                                      
                                      1,034,993
                                      
                                      
                                      $
                                      4.74
                                      
                                      
                                      
                                      899,014
                                      
                                      
                                      $
                                      3.95
                                      
                                      
                                      
                                      921,592
                                      
                                      
                                      $
                                      4.75




The
following table summarizes information about stock options and warrants
outstanding under the stock-based option plans at December 31,
2008:




Outstanding
                                      
                                      
                                      ExercisableRange of Exercise Prices
                                      
                                      Number
                                        Outstanding
                                      
                                      
                                      Weighted
                                        Average
                                        Remaining
                                        Contractual
                                        Life
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
                                        Price
                                      
                                      
                                      Number
                                        Exercisable
                                      
                                      
                                      Weighted
                                        Average
                                        Exercise
                                        Price$3.02
      - $3.92
                                      
                                      
                                      860,508
                                      
                                      
                                      
                                      1.16
                                      
                                      
                                      $
                                      3.92
                                      
                                      
                                      
                                      860,008
                                      
                                      
                                      $
                                      3.924.23
      - $4.75
                                      
                                      
                                      8,380
                                      
                                      
                                      
                                      2.92
                                      
                                      
                                      
                                      4.36
                                      
                                      
                                      
                                      6,380
                                      
                                      
                                      
                                      4.23$5.29
      - $6.81
                                      
                                      
                                      110,471
                                      
                                      
                                      
                                      3.54
                                      
                                      
                                      
                                      6.73
                                      
                                      
                                      
                                      99,971
                                      
                                      
                                      
                                      6.76$7.35
      - $9.50
                                      
                                      
                                      8,674
                                      
                                      
                                      
                                      5.11
                                      
                                      
                                      
                                      8.51
                                      
                                      
                                      
                                      6,164
                                      
                                      
                                      
                                      8.12$11.06
      - $11.75
                                      
                                      
                                      46,440
                                      
                                      
                                      
                                      7.98
                                      
                                      
                                      
                                      11.21
                                      
                                      
                                      
                                      39,310
                                      
                                      
                                      
                                      11.17$12.06
      - $13.06
                                      
                                      
                                      18,827
                                      
                                      
                                      
                                      8.04
                                      
                                      
                                      
                                      12.57
                                      
                                      
                                      
                                      6,627
                                      
                                      
                                      
                                      12.55$14.17
      - $16.89
                                      
                                      
                                      29,885
                                      
                                      
                                      
                                      6.77
                                      
                                      
                                      
                                      15.12
                                      
                                      
                                      
                                      14,286
                                      
                                      
                                      
                                      15.02$17.24
      - $18.69
                                      
                                      
                                      8,560
                                      
                                      
                                      
                                      7.84
                                      
                                      
                                      
                                      18.41
                                      
                                      
                                      
                                      2,247
                                      
                                      
                                      
                                      18.41$  3.02
      - $18.69
                                      
                                      
                                      1,091,745
                                      
                                      
                                      
                                      1.82
                                      
                                      
                                      $
                                      5.12
                                      
                                      
                                      
                                      1,034,993
                                      
                                      
                                      $
                                      4.74




The above
information reflects each of the 3 for 2 stock splits distributed on
January 18, 2006, and March 1, 2004, as well as the 6% stock dividend
distributed on May 16, 2006, and the 7% stock dividend distributed on
March 30, 2007.





Note 18—Employee Benefit
Plans





The
Company maintains an employee benefit plan for all eligible employees of the
Company and the Bank under the provisions of Internal Revenue Code
Section 401(k).  The First National Retirement Savings Plan (the
“Savings Plan”) allows for employee contributions and, upon annual approval of
the Board of Directors, the Company matches 50% of employee contributions up to
a maximum of six percent of annual compensation.  Totals of $217,000,
$91,000 and $68,000 were charged to operations in 2008, 2007, and 2006,
respectively, for the Company’s matching contribution.  Employees are
immediately vested in their contributions to the Savings Plan and become fully
vested in the employer matching contribution after five years of
service.





On
May 31, 2004, the Company adopted a leveraged Employee Stock Ownership Plan
(“ESOP”) for the exclusive benefit of employee
participants.  Employees become vested in their account balances after
seven years of service.





On
November 30, 2005, the Company loaned the ESOP $600,000 which was used to
purchase 42,532 shares of the Company’s common stock.  The ESOP shares
initially were pledged as collateral for its debt. As the debt is repaid, shares
are released from collateral and allocated to eligible employees, based on the
proportion of debt service paid in the year.  At December 31,
2008, the ESOP owned 44,912 shares of the Company’s stock, of which 34,065
shares were pledged to secure the loan to the Company.  The remainder
of the shares was allocated to individual accounts of
participants.  In accordance with the requirements of the SOP 93-6,
the Company presented the shares that were pledged as collateral as a deduction
of $478,000 and $518,000 from shareholders’ equity at December 31, 2008 and
2007, respectively, as unearned ESOP shares in the accompanying consolidated
balance sheets.  The Board of Directors approved a $24,000
discretionary contribution paid to the ESOP for the year ended December 31,
2006, which the Company recorded as compensation expense.  The Company
also recorded $6,000 and $37,000 of expense during the years ended
December 31, 2008 and 2007, respectively, to reflect the fair market value
of the shares allocated to eligible employees.  The fair market value
of the unallocated shares was $92,519 as of December 31,
2008.


104


The
Company made contributions during December 31, 2008 and 2007, of $64,908
and $66,824, respectively, equal to the ESOP annual debt service.  The
note payable to the ESOP requires annual principal payments plus interest at a
fixed interest rate of 4.79%.  Future principal payments will be
$40,000 annually until a final payment will be made on December 31,
2020.





During
2004, the Company also adopted a formal incentive compensation plan, the First
National Incentive Plan (the “FNIP”) for members of its management
team.  Approximately $0, $354,000, and $711,000 were expensed in 2008,
2007 and 2006, respectively, and paid in the subsequent year based on
achievement of individual and corporate performance goals.





Note 19—Commitments and
Contingencies





The
Company entered into employment agreements with its President and its two
Executive Vice Presidents that include an annually renewing two-year
compensation term and one-year non-compete agreements upon
termination.





In the
normal course of business, the Company and the Bank are periodically subject to
various pending or threatened lawsuits in which claims for monetary damages may
be asserted.  At December 31, 2008, neither the Company nor the
Bank were involved with any material litigation matters.





See Note
7 for specifics on the Company’s lease commitments.





Note 20—Financial
Instruments with Off-Balance Sheet Risk





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and standby letters of credit and involve, to varying degrees, elements
of credit and interest rate risk in excess of the amount recognized in the
balance sheet.  The Company’s exposure to credit loss in the event of
nonperformance by the other party to the financial instrument for commitments to
extend credit and standby letters of credit is represented by the contractual
amounts of those instruments.





The
Company uses the same credit and collateral policies in making commitments and
conditional obligations as it does for on-balance sheet
instruments.  The Company evaluates each customer’s creditworthiness
on a case-by-case basis.  The amount of collateral obtained if deemed
necessary by the Company upon extension of credit is based on management’s
credit evaluation.  Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract.  Commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee.  Since
many of the commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements.





At
December 31, 2008, the Company’s commitments to extend additional credit
totaled approximately $145.9 million, the majority of which are at variable
rates of interest and expire within one year.  Included in the
Company’s total commitments are standby letters of credit.  Letters of
credit are commitments issued by the Company to guarantee the performance of a
customer to a third party and totaled $2,061,000 at December 31,
2008.  The credit risk involved in the underwriting of letters of
credit is essentially the same as that involved in extending loan facilities to
customers.





Note 21—Fair Value of
Financial Instruments





Effective
January 1, 2008, the Company adopted SFAS 157 for its financial assets
and liabilities. SFAS 157 defines fair value, establishes a consistent
framework for measuring fair value and expands disclosure requirements about
fair value measurements.  SFAS 157 requires us, among other
things, to maximize the use of observable inputs and minimize the use of
unobservable inputs in its fair value measurement techniques.  The adoption
of SFAS 157 resulted in no change to January 1, 2008 retained
earnings.


105


SFAS 157
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date.   SFAS 157 also
establishes a fair value hierarchy which requires an entity to maximize the use
of observable inputs and minimize the use of unobservable inputs when measuring
fair value. The standard describes three levels of inputs that may be used to
measure fair value:





·
            Level
      1 - Valuations are based on quoted prices in active markets for identical
      assets and liabilities. Level 1 assets include debt and equity securities
      that are traded in an active exchange market, as well as certain U.S.
      Treasury securities that are highly liquid and are actively traded in
      over-the-counter markets.





·
            Level
      2 - Valuations are based on observable inputs other than Level 1 prices,
      such as quoted prices for similar assets or liabilities; quoted prices in
      markets that are not active; or other inputs that are observable or can be
      corroborated by observable market data. Level 2 assets and liabilities
      include debt securities with quoted prices that are traded less frequently
      than exchange-traded instruments and derivative contracts whose value is
      determined using a pricing model with inputs that are observable in the
      market or can be derived principally from or corroborated by observable
      market data.  Valuations are obtained from third party pricing
      services for similar assets or liabilities. This category generally
      includes U.S. government agencies, agency mortgage-backed debt securities,
      private-label mortgage-backed debt securities, state and municipal bonds,
      corporate bonds, certain derivative contracts, and mortgage loans held for
      sale.





·
            Level
      3 - Valuations include unobservable inputs that are supported by little or
      no market activity and that are significant to the fair value of the
      assets.  For example, certain available for sale securities
      included in this category are not readily marketable and may only be
      redeemed with the issuer at par.  This category includes certain
      derivative contracts for which independent pricing information was not
      able to be obtained for a significant portion of the underlying
      assets.





The
estimated fair values of the Company’s financial instruments at December 31
are as follows (dollars in thousands):




2008
                  
                  
                  2007Carrying
                  
                  
                  Estimated
                  
                  
                  Carrying
                  
                  
                  EstimatedAmount
                  
                  
                  Fair Value
                  
                  
                  Amount
                  
                  
                  Fair ValueFinancial
      assets:Cash
      and cash equivalents
                  
                  $
                  7,700
                  
                  
                  $
                  7,700
                  
                  
                  $
                  8,426
                  
                  
                  $
                  8,426Securities
      available for sale
                  
                  
                  81,662
                  
                  
                  
                  81,662
                  
                  
                  
                  70,530
                  
                  
                  
                  70,530Investment
      in FHLB/FRB stock
                  
                  
                  7,165
                  
                  
                  
                  7,165
                  
                  
                  
                  3,687
                  
                  
                  
                  3,687Loans,
      net
                  
                  
                  686,254
                  
                  
                  
                  680,966
                  
                  
                  
                  489,142
                  
                  
                  
                  488,859Accrued
      interest receivable
                  
                  
                  31,093
                  
                  
                  
                  31,093
                  
                  
                  
                  15,441
                  
                  
                  
                  15,441Financial
      liabilities:Deposits
                  
                  $
                  646,849
                  
                  
                  $
                  649,069
                  
                  
                  $
                  471,828
                  
                  
                  $
                  469,984FHLB
      advances
                  
                  
                  86,363
                  
                  
                  
                  83,148
                  
                  
                  
                  41,690
                  
                  
                  
                  41,690Long-term
      debt
                  
                  
                  9,500
                  
                  
                  
                  9,500
                  
                  
                  
                  -
                  
                  
                  
                  -Junior
      subordinated debentures
                  
                  
                  13,403
                  
                  
                  
                  13,403
                  
                  
                  
                  13,403
                  
                  
                  
                  13,403Federal
      funds purchased and other
                  
                  
                  11,873
                  
                  
                  
                  11,873
                  
                  
                  
                  9,360
                  
                  
                  
                  9,360Accrued
      interest payable and other liabilities
                  
                  
                  4,130
                  
                  
                  
                  4,130
                  
                  
                  
                  2,676
                  
                  
                  
                  2,676





The table
below presents the balances of assets and liabilities measured at fair value on
a recurring basis (in thousands).





December 31, 2008Total
                          
                          
                          Level1
                          
                          
                          Level2
                          
                          
                          Level3Securities
      available for sale
                          
                          $
                          81,662
                          
                          
                          $
                          -
                          
                          
                          $
                          81,662
                          
                          
                          $
                          -Mortgage
      loans held for sale
                          
                          
                          16,411
                          
                          
                          
                          -
                          
                          
                          
                          16,411
                          
                          
                          
                          -Impaired
      loans
                          
                          
                          69,052
                          
                          
                          
                          -
                          
                          
                          
                          69,052
                          
                          
                          
                          -Equity
      investments
                          
                          
                          7,935
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          7,935Total
                          
                          $
                          157,811
                          
                          
                          $
                          -
                          
                          
                          $
                          149,876
                          
                          
                          $
                          7,935


106


Available-for-sale
investment securities are the only assets whose fair values are measured on a
recurring basis using Level 1 inputs (active market quotes).  We have
no liabilities carried at fair value or measured at fair value on a nonrecurring
basis.





The Bank
is are predominantly an asset-based lender with real estate serving as
collateral on a substantial majority of loans. Loans which are deemed to be
impaired are primarily valued on a nonrecurring basis at the fair values of the
underlying real estate collateral.  When practical, such fair values
are obtained using independent appraisals, which the Company considers to be
level 2 inputs.  The aggregate carrying amount of impaired loans at
December 31, 2008 was $69.1 million.




Certain
parts of SFAS 157 have been delayed to fiscal year beginning after November 15,
2008.  This deferral includes non-financial assets and liabilities
initially measured at fair value in a business combination, but not measured at
fair value in subsequent periods (nonrecurring fair value measurements). This
deferral also includes reporting units measured at fair value in the first step
of a goodwill impairment test and nonfinancial assets and nonfinancial
liabilities measured at fair value in the second step of the goodwill impairment
test. The Company is currently evaluating the impact that the delayed component
of SFAS 157 will have on its financial position, results of operations and cash
flows.





Note 22—Parent Company
Financial Information





The
following is condensed financial information of First National Bancshares, Inc.
(parent company only) at December 31, 2008 and 2007, and for each of the
years in the three year period ended December 31, 2008.




First
National Bancshares, Inc.


Condensed
Balance Sheets


(dollars
in thousands)




2008
                  
                  
                  2007AssetsCash
      and cash equivalents
                  
                  $
                  308
                  
                  
                  $
                  13,434Investment
      in bank subsidiary
                  
                  
                  61,279
                  
                  
                  
                  47,253Investment
      in Trust subsidiaries
                  
                  
                  403
                  
                  
                  
                  403Other
      assets
                  
                  
                  1,562
                  
                  
                  
                  616Total
      assets
                  
                  $
                  63,552
                  
                  
                  $
                  61,706Liabilities
      and Shareholders' EquityJunior
      subordinated debentures
                  
                  
                  13,403
                  
                  
                  
                  13,403Long-term
      debt
                  
                  
                  9,500
                  
                  
                  
                  -Other
      liabilities
                  
                  
                  25
                  
                  
                  
                  747Total
      shareholders' equity
                  
                  
                  40,624
                  
                  
                  
                  47,556Total
      liabilities and shareholders' equity
                  
                  $
                  63,552
                  
                  
                  $
                  61,706


107


First
National Bancshares, Inc.


Condensed
Statements of Operations


(dollars
in thousands)





2008
                
                
                2007
                
                
                2006Interest
      income
                
                $
                118
                
                
                $
                276
                
                
                $
                84Interest
      expense on junior subordinated debentures
                
                
                948
                
                
                
                1,127
                
                
                
                877Net
      interest expense
                
                
                (830
                )
                
                
                (851
                )
                
                
                (793
                )Professional
      fees
                
                
                20
                
                
                
                12
                
                
                
                11Shareholder
      relations
                
                
                203
                
                
                
                97
                
                
                
                85Data
      processing
                
                
                33
                
                
                
                23
                
                
                
                13Other
                
                
                1
                
                
                
                -
                
                
                
                -Miscellaneous
      noninterest expense
                
                
                257
                
                
                
                132
                
                
                
                109Equity
      in undistributed net income/(loss) of bank subsidiary
                
                
                (44,061
                )
                
                
                4,709
                
                
                
                4,750Net
      income/(loss) before income taxes
                
                
                (45,148
                )
                
                
                3,726
                
                
                
                3,848Income
      tax benefit
                
                
                (301
                )
                
                
                (334
                )
                
                
                (204
                )Net
      income/(loss)
                
                $
                (44,847
                )
                
                $
                4,060
                
                
                $
                4,052




108




First
National Bancshares, Inc.


Condensed
Statements of Cash Flows


(dollars
in thousands)





2008
                
                
                2007
                
                
                2006Operating
      activities:Net
      income/(loss)
                
                $
                (44,847
                )
                
                $
                4,060
                
                
                $
                4,052Adjustments
      to reconcile net income/(loss) to net cash used in operating
      activities:Equity
      in undistributed net (income)/loss of bank subsidiary
                
                
                15,328
                
                
                
                (4,709
                )
                
                
                (4,750
                )Provision
      for impairment of goodwill
                
                
                28,732Allocation
      of ESOP shares
                
                
                6
                
                
                
                37
                
                
                
                43Compensation
      expense for employee stock options
                
                
                104
                
                
                
                91
                
                
                
                73Increase  in
      other assets
                
                
                (946
                )
                
                
                (529
                )
                
                
                (5
                )(Decrease)/increase
      in other liabilities
                
                
                (5
                )
                
                
                (10
                )
                
                
                40Increase
      in intercompany payable/(receivable)
                
                
                (717
                )
                
                
                754
                
                
                
                (18
                )Net
      cash used in operating activities
                
                
                (2,345
                )
                
                
                (306
                )
                
                
                (565
                )Investing
      activities:Investment
      in common securities of Trusts
                
                
                -
                
                
                
                -
                
                
                
                (217
                )Capital
      contribution to bank subsidiary
                
                
                (1,700
                )
                
                
                (6,000
                )
                
                
                (7,000
                )Acquisition,
      net of funds received
                
                
                (16,378
                )
                
                
                -
                
                
                
                -Net
      cash used in investing activities
                
                
                (18,078
                )
                
                
                (6,000
                )
                
                
                (7,217
                )Financing
      activities:Proceeds
      from exercise of employee stock options/director stock
      warrants
                
                
                9
                
                
                
                182
                
                
                
                591Proceeds
      from issuance of preferred stock, net of offering expenses
                
                
                -
                
                
                
                16,550
                
                
                
                -Dividends
      paid on preferred stock
                
                
                (1,305
                )
                
                
                (626
                )
                
                
                -Proceeds
      from the issuance of long-term debt
                
                
                9,500
                
                
                
                -
                
                
                
                -Shares
      repurchased pursuant to share repurchase program
                
                
                (907
                )
                
                
                (224
                )
                
                
                -Cash
      paid in lieu of fractional shares for stock dividend
                
                
                -
                
                
                
                (7
                )
                
                
                (4
                )Proceeds
      from junior subordinated debentures
                
                
                -
                
                
                
                -
                
                
                
                7,217Net
      cash provided by financing activities
                
                
                7,297
                
                
                
                15,875
                
                
                
                7,804Net
      increase/(decrease) in cash and cash equivalents
                
                
                (13,126
                )
                
                
                9,569
                
                
                
                22Cash,
      beginning of year
                
                
                13,434
                
                
                
                3,865
                
                
                
                3,843Cash,
      end of year
                
                $
                308
                
                
                $
                13,434
                
                
                $
                3,865




For a
complete discussion of the junior subordinated debentures, common securities and
the related trust preferred securities, see Note 16—Junior Subordinated
Debentures.


109


Note 23—Selected Quarterly
Financial Data (unaudited)





Following
is a summary of operations by quarter (dollars in thousands, except share and
per share data).




2008


Quarters
      endedMarch 31
                
                
                June 30
                
                
                September 30
                
                
                December 31Interest
      income
                
                $
                11,680
                
                
                $
                11,662
                
                
                $
                11,472
                
                
                $
                10,573Interest
      expense
                
                
                6,522
                
                
                
                6,302
                
                
                
                6,288
                
                
                
                6,267Net
      interest income
                
                
                5,158
                
                
                
                5,360
                
                
                
                5,184
                
                
                
                4,306Provision
      for loan losses
                
                
                466
                
                
                
                943
                
                
                
                4,618
                
                
                
                14,433Noninterest
      income
                
                
                1,331
                
                
                
                1,233
                
                
                
                1,204
                
                
                
                1,252Noninterest
      expenses
                
                
                4,917
                
                
                
                5,366
                
                
                
                5,989
                
                
                
                35,377Income/(loss)
      before provision for income taxes
                
                
                1,106
                
                
                
                284
                
                
                
                (4,219
                )
                
                
                (44,252
                )Income
      tax expense/(benefit)
                
                
                370
                
                
                
                95
                
                
                
                (1,413
                )
                
                
                (1,286
                )Net
      income/(loss)
                
                $
                736
                
                
                $
                189
                
                
                $
                (2,806
                )
                
                $
                (42,966
                )Cash
      dividends declared on preferred stock
                
                
                326
                
                
                
                326
                
                
                
                326
                
                
                
                327Net
      income/(loss) available to common shareholders
                
                
                410
                
                
                
                (137
                )
                
                
                (3,132
                )
                
                
                (43,293
                )Earnings
      per share:Basic
                
                
                0.07
                
                
                
                (0.02
                )
                
                
                (0.50
                )
                
                
                (6.88
                )Diluted
                
                
                0.10
                
                
                
                (0.02
                )
                
                
                (0.50
                )
                
                
                (6.88
                )Weighted
      average common shares:Basic
                
                
                5,469,281
                
                
                
                6,333,833
                
                
                
                6,302,459
                
                
                
                6,296,698Diluted
                
                
                7,122,692
                
                
                
                6,333,833
                
                
                
                6,302,459
                
                
                
                6,296,698





2007


Quarters
      endedMarch 31
                  
                  
                  June 30
                  
                  
                  September 30
                  
                  
                  December 31Interest
      income
                  
                  $
                  8,895
                  
                  
                  $
                  9,891
                  
                  
                  $
                  10,618
                  
                  
                  $
                  10,564Interest
      expense
                  
                  
                  4,939
                  
                  
                  
                  5,631
                  
                  
                  
                  5,981
                  
                  
                  
                  5,914Net
      interest income
                  
                  
                  3,956
                  
                  
                  
                  4,260
                  
                  
                  
                  4,637
                  
                  
                  
                  4,650Provision
      for loan losses
                  
                  
                  339
                  
                  
                  
                  452
                  
                  
                  
                  422
                  
                  
                  
                  183Noninterest
      income
                  
                  
                  666
                  
                  
                  
                  1,039
                  
                  
                  
                  1,182
                  
                  
                  
                  1,264Noninterest
      expenses
                  
                  
                  2,972
                  
                  
                  
                  3,629
                  
                  
                  
                  3,551
                  
                  
                  
                  4,007Income
      before provision for income taxes
                  
                  
                  1,311
                  
                  
                  
                  1,218
                  
                  
                  
                  1,846
                  
                  
                  
                  1,724Income
      tax expense
                  
                  
                  459
                  
                  
                  
                  426
                  
                  
                  
                  567
                  
                  
                  
                  587Net
      income
                  
                  $
                  852
                  
                  
                  $
                  792
                  
                  
                  $
                  1,279
                  
                  
                  $
                  1,137Earnings
      per share:Basic
                  
                  
                  0.23
                  
                  
                  
                  0.21
                  
                  
                  
                  0.26
                  
                  
                  
                  0.22Diluted
                  
                  
                  0.19
                  
                  
                  
                  0.18
                  
                  
                  
                  0.24
                  
                  
                  
                  0.21Weighted
      average common shares:Basic
                  
                  
                  3,696,774
                  
                  
                  
                  3,695,822
                  
                  
                  
                  3,695,822
                  
                  
                  
                  3,697,219Diluted
                  
                  
                  4,411,231
                  
                  
                  
                  4,400,011
                  
                  
                  
                  5,289,673
                  
                  
                  
                  5,344,626





Note 24—Stock Repurchase
Program





On
December 1, 2006, the Company’s board of directors authorized a stock
repurchase program of up to 50,000 of its 3,458,354 shares outstanding effective
immediately for a period of six months ending May 31, 2007.  This
stock repurchase program was subsequently extended through November 30, 2008,
and on August 18, 2008, was increased to 157,000 shares.  The
repurchases are made through registered broker-dealers from shareholders in open
market purchases at the discretion of management.  The Company intends
to hold the shares repurchased as treasury shares and may utilize such shares to
fund stock benefit plans or for any other general corporate purposes permitted
by applicable law.  As of December 31, 2008, the Company had purchased
106,981 shares at an average price of $10.58 per share.  The shares
repurchased under the stock repurchase program are included in treasury shares
in the accompanying consolidated balance sheets and statements of changes in
shareholders’ equity and comprehensive income/(loss).


110


Note 25—Merger with Carolina
National Corporation and Goodwill





On
January 31, 2008, Carolina National, the holding company for Carolina National
Bank and Trust Company, merged with and into First National (the “Merger”). On
February 18, 2008, Carolina National Bank and Trust Company merged with and into
the Company’s bank subsidiary, First National Bank of the South. As a result of
this acquisition, four full-service branches in the Columbia market were added
to First National’s operations that had been previously operated as Carolina
National Bank and Trust Company.





Columbia’s
central location in the state and convenient access to I-20, I-26, and I-77 make
this area one of the fastest growing areas in South Carolina according to U.S.
Census data. Home to the state capital, the University of South Carolina, and a
variety of service-based and light manufacturing companies, this area provides a
growing and diverse economy. According to SNL Financial (“SNL”), Columbia had an
estimated population of 356,842 residents as of July 1, 2007, and is
projected to grow 7.6% from 2007 to 2012. The South Carolina Department of
Commerce reports that Richland County attracted over $442.0 million in
announced capital investment since 2000. Additionally, as reported by the
Central Midlands Council of Governments, new single family housing units
approved for construction in Richland County and surrounding areas increased
from 2,172 in 1990 to 4,941 in 2004, an increase of over 127%. As of
September 30, 2007, FDIC-insured institutions in Richland County and the
Columbia metropolitan area had approximately $8.71 billion and
$12.4 billion in deposits, respectively.





Carolina
National was a South Carolina corporation registered as a bank holding company
with the Federal Reserve Board. Carolina National engaged in a general banking
business through its subsidiary, Carolina National Bank and Trust Company, a
national banking association, which commenced operations in July 2002. As a
result of the Merger, First National moved its Columbia loan production office
to Carolina National’s former main office and full-service branch and the former
Carolina National loan production office in Rock Hill moved to the existing
First National loan production office in Rock Hill.





Under the
terms of the definitive agreement, Carolina National's shareholders were given
the option to elect to receive either 1.4678 shares of First National common
stock or $21.65 of cash for each share of Carolina National common stock held,
or a combination of stock and cash, provided that the aggregate consideration
consisted of 70% stock and 30% cash. Based on the “Final Buyer Stock Price”, as
defined in Section 9.1(g) of the Agreement and Plan of Merger dated August 26,
2007, by and between First National and Carolina National (the “Merger
Agreement”), of $12.85, and including the value of Carolina National's
outstanding options and warrants, the transaction closed with an aggregate value
of $54.1 million. After the allocation and proration processes set forth in the
Merger Agreement were applied to the elections made by Carolina National
shareholders, the total Merger consideration resulted in an additional 2,663,674
shares of First National common stock outstanding upon the completion of the
exchange of Carolina National shares on March 31, 2008. In addition, cash
consideration of $16,848,809 was paid in exchange for shares of Carolina
National common stock.





In
connection with the Merger, the balance sheet reflects intangible assets
consisting of core deposit intangibles and purchase accounting adjustments to
reflect the fair valuation of loans, deposits and leases. The core deposit
intangible represents the excess intangible value of acquired deposit customer
relationships as determined by valuation specialists. The core deposit
intangible is being amortized over a ten-year period using the declining balance
line method. Adjustments recorded to the fair market values of loans and
certificates of deposit are being recognized over 34 months and 5 months,
respectively. Adjustments to leases are being amortized over the terms of the
respective leases. See further discussion in Note 1 – Summary of Significant
Accounting Policies and Activities” for additional information on purchase
accounting adjustments and intangible assets associated with the
Merger.





We
recorded an after-tax noncash accounting charge of $28.7 million during the
fourth quarter of 2008 as a result of our annual testing of goodwill for
impairment as required by accounting standards.  The impairment
analysis was negatively impacted by the unprecedented weakness in the financial
markets. The first step of the goodwill impairment analysis involves estimating
a hypothetical fair value and comparing that with the carrying amount or book
value of the entity; our initial comparison suggested that the carrying amount
of goodwill exceeded its implied fair value due to our low stock price,
consistent with that of most publicly-traded financial
institutions.  Therefore, we were required to perform the second step
of the analysis to determine the amount of the impairment.  We
prepared a discounted cash flow analysis which established the estimated fair
value of the entity and conducted a full valuation of the net assets of the
entity.  Following these procedures, we determined that no amount of
the net asset value could be allocated to goodwill and recorded the impairment
to the goodwill balance as a noncash accounting charge to our earnings in
2008.


111




The
following pro forma financial information presents the combined results of
operations for the year ended December 31, 2008, as if the Merger had occurred
on January 1, 2008 (in thousands).




First NationalCombined
                      
                      
                      Purchase
                      
                      
                      Pro Forma12/31/2008
                      
                      
                      Adjustments
                      
                      
                      CombinedInterest
      income:Loans
                      
                      $
                      41,604
                      
                      
                      $
                      -
                      
                      
                      $
                      41,604Securities
                      
                      
                      3,477
                      
                      
                      
                      -
                      
                      
                      
                      3,477Other
                      
                      
                      306
                      
                      
                      
                      (518
                      )(1)
                      
                      
                      (212
                      )Total
      interest income
                      
                      
                      45,387
                      
                      
                      
                      (518
                      )
                      
                      
                      44,869Interest
      expense:Deposits
                      
                      
                      22,039
                      
                      
                      
                      -
                      
                      
                      
                      22,039Short-term
      debt
                      
                      
                      332
                      
                      
                      
                      -
                      
                      
                      
                      332Long-term
      debt
                      
                      
                      3,008
                      
                      
                      
                      -
                      
                      
                      
                      3,008Total
      interest expense
                      
                      
                      25,379
                      
                      
                      
                      -
                      
                      
                      
                      25,379Net
      interest income
                      
                      
                      20,008
                      
                      
                      
                      (518
                      )
                      
                      
                      19,490Loan
      loss provision
                      
                      
                      20,460
                      
                      
                      
                      -
                      
                      
                      
                      20,460Noninterest
      income:Mortgage
      banking income
                      
                      
                      2,251
                      
                      
                      
                      -
                      
                      
                      
                      2,251Other
                      
                      
                      2,769
                      
                      
                      
                      -
                      
                      
                      
                      2,769Total
      noninterest income
                      
                      
                      5,020
                      
                      
                      
                      -
                      
                      
                      
                      5,020Noninterest
      expense:Goodwill
      impairment
                      
                      
                      28,732
                      
                      
                      
                      -
                      
                      
                      
                      28,732Salaries
      and employee benefits
                      
                      
                      11,429
                      
                      
                      
                      -
                      
                      
                      
                      11,429Occupancy
      and equipment expense
                      
                      
                      3,375
                      
                      
                      
                      -
                      
                      
                      
                      3,375Other
      real estate owned expenses
                      
                      
                      1,757
                      
                      
                      
                      -
                      
                      
                      
                      1,757Data
      processing and ATM expense
                      
                      
                      1,303
                      
                      
                      
                      -
                      
                      
                      
                      1,303Public
      relations
                      
                      
                      708
                      
                      
                      
                      -
                      
                      
                      
                      708Other
                      
                      
                      4,345
                      
                      
                      
                      -
                      
                      
                      
                      4,345Total
      noninterest expense
                      
                      
                      51,649
                      
                      
                      
                      -
                      
                      
                      
                      51,649Intangibles
      amortization
                      
                      
                      -
                      
                      
                      
                      11
                      (2)
                      
                      
                      11Income
      before income taxes
                      
                      
                      (47,081
                      )
                      
                      
                      (529
                      )
                      
                      
                      (47,610
                      )Provision
      for income taxes
                      
                      
                      (2,234
                      )
                      
                      
                      49
                      (3)
                      
                      
                      (2,185
                      )Net
      income/(loss)
                      
                      
                      (44,847
                      )
                      
                      
                      (578
                      )
                      
                      
                      (45,425
                      )Preferred
      stock dividends
                      
                      
                      1,305
                      
                      
                      
                      -
                      
                      
                      
                      1,305Net
      income/(loss) available to common shareholders
                      
                      $
                      (46,152
                      )
                      
                      $
                      (578
                      )
                      
                      $
                      (46,730
                      )Weighted
      average common shares outstanding
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      6,360,138Net
      income/(loss) per common share
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      $
                      (7.35
                      )




Notes


(1)
            To
      reduce interest income for the effects of cash used in the acquisition
      based upon a 2.35% rate earned on overnight
  funds.


(2)
            To
      record amortization of the core deposit intangible using the 150 declining
      balance line method.


(3)
            To
      adjust income tax expense at a rate of 37% applied to the foregoing
      adjustments to income before income
taxes.


112


The
following pro forma financial information presents the combined results of
operations for the twelve months ended December 31, 2007, as if the Merger had
occurred on January 1, 2007 (in thousands).





Pro Forma 2007 Income Statement




First National
                          
                          
                          Carolina NationalStand-alone
                          
                          
                          Stand-alone
                          
                          
                          Purchase
                          
                          
                          Pro FormaFull Year 2007
                          
                          
                          Full Year 2007
                          
                          
                          Adjustments
                          
                          
                          CombinedInterest
      income:Loans
                          
                          $
                          35,661
                          
                          
                          $
                          15,540
                          
                          
                          
                          
                          
                          $
                          51,201Securities
                          
                          
                          3,293
                          
                          
                          
                          64
                          
                          
                          
                          
                          
                          
                          3,357Other
                          
                          
                          1,014
                          
                          
                          
                          792
                          
                          
                          
                          (1,150
                          )(1)
                          
                          
                          656Total
      interest income
                          
                          
                          39,968
                          
                          
                          
                          16,396
                          
                          
                          
                          (1,150
                          )
                          
                          
                          55,214Interest
      expense:Deposits
                          
                          
                          18,872
                          
                          
                          $
                          8,025
                          
                          
                          
                          
                          
                          
                          
                          26,897Short-term
      debt
                          
                          
                          2,568
                          
                          
                          
                          10
                          
                          
                          
                          
                          
                          
                          
                          2,578Long-term
      debt
                          
                          
                          1,025
                          
                          
                          
                          -
                          
                          
                          
                          
                          
                          
                          
                          1,025Total
      interest expense
                          
                          
                          22,465
                          
                          
                          
                          8,035
                          
                          
                          
                          
                          
                          
                          
                          30,500Net
      interest income
                          
                          
                          17,503
                          
                          
                          
                          8,361
                          
                          
                          
                          (1,150
                          )
                          
                          
                          24,714Loan
      loss provision
                          
                          
                          1,396
                          
                          
                          
                          209
                          
                          
                          
                          -
                          
                          
                          
                          1,605Noninterest
      income:Mortgage
      banking income
                          
                          
                          1,858
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,858Other
                          
                          
                          2,293
                          
                          
                          
                          386
                          
                          
                          
                          
                          
                          
                          
                          2,679Total
      noninterest income
                          
                          
                          4,151
                          
                          
                          
                          386
                          
                          
                          
                          
                          
                          
                          
                          4,537Noninterest
      expense:Salaries
      and employee benefits
                          
                          
                          7,876
                          
                          
                          
                          2,859
                          
                          
                          
                          
                          
                          
                          
                          10,735Occupancy
      and equipment expense
                          
                          
                          2,030
                          
                          
                          
                          893
                          
                          
                          
                          
                          
                          
                          
                          2,923Public
      relations
                          
                          
                          734
                          
                          
                          
                          120
                          
                          
                          
                          
                          
                          
                          
                          854Data
      processing and ATM expense
                          
                          
                          702
                          
                          
                          
                          468
                          
                          
                          
                          
                          
                          
                          
                          1,170Other
                          
                          
                          2,817
                          
                          
                          
                          1,763
                          
                          
                          
                          
                          
                          
                          
                          4,580Total
      noninterest expense
                          
                          
                          14,159
                          
                          
                          
                          6,103
                          
                          
                          
                          
                          
                          
                          
                          20,262Intangibles
      amortization
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          376
                          (2)
                          
                          
                          376Income
      before income taxes
                          
                          
                          6,099
                          
                          
                          
                          2,435
                          
                          
                          
                          (1,526
                          )
                          
                          
                          7,008Provision
      for income taxes
                          
                          
                          2,039
                          
                          
                          
                          1,021
                          
                          
                          
                          (562
                          )(3)
                          
                          
                          2,498Net
      income
                          
                          
                          4,060
                          
                          
                          
                          1,414
                          
                          
                          
                          (964
                          )
                          
                          
                          4,510Preferred
      stock dividends
                          
                          
                          626
                          
                          
                          
                          -
                          
                          
                          
                          
                          
                          
                          
                          626Net
      income available to common
                          
                          $
                          3,434
                          
                          
                          $
                          1,414
                          
                          
                          $
                          (964
                          )
                          
                          $
                          3,884Weighted
      average common shares outstanding
                          
                          
                          3,696,464
                          
                          
                          
                          2,582,825
                          
                          
                          
                          305,330
                          
                          
                          
                          6,584,619Net
      income per common share
                          
                          $
                          0.93
                          
                          
                          $
                          0.55
                          
                          
                          
                          
                          
                          
                          $
                          0.59





Notes


(1) To
reduce interest income for the effects of cash used in the acquisition based
upon a 5.5% rate earned on overnight funds.


(2) To
record amortization of the core deposit intangible using the sum of years'
digits method over a 10 year life.


(3) To
adjust income tax expense at a rate of 37% applied to the foregoing adjustments
to income before income taxes.





Item 9. Changes in and Disagreements
With Accountants on Accounting and Financial
Disclosure.





There was
no change in or disagreement with our accountants related to our accounting and
financial disclosures.





Item 9A. Controls and
Procedures.





Evaluation
of Disclosure Controls and Procedures





As of the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of our
disclosure controls and procedures as defined in Exchange Act Rule
13a-15(e).  Based upon that evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that our current disclosure controls and
procedures are effective as of December 31, 2008.  There have been no
significant changes in our internal controls over financial reporting during the
fourth fiscal quarter ended December 31, 2008, that have materially
affected, or are reasonably likely to materially affect, our internal controls
over financial reporting.


113





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





Management’s
Report on Internal Controls Over Financial Reporting




We are responsible for
establishing and maintaining adequate internal controls over financial
reporting.  Management’s assessment of the effectiveness of our
internal control over financial reporting as of December 31, 2008 is included in
Item 8 of this report under the heading “Management’s Report on Internal
Controls Over Financial Reporting.”





Item 9B. Other
Information.




On
April 27, 2009, First National Bank of the South entered into a consent order
with the OCC. For a more detailed discussion of the consent order, see Note 2 to
our Financial Statements included in this Annual Report.
 
 On
April 30, 2009, First National entered into a letter agreement with Nexity Bank
regarding issues relating to the loan agreement dated December 27, 2007. For a
more detailed discussion of this letter agreement, see Note 2 to our Financial
Statements included in this Annual Report.
 
 On
April 30, 2009, First National provided notice to the Federal Reserve that it
was decertifying as a financial holding company as of April 30, 2009. For a more
detailed discussion of this letter, see “Supervision and Regulation - First
National Bancshares, Inc. – Permitted Activities” in this Annual
Report.


Part III.





Item 10. Directors, and Executive
Officers and Corporate Governance.





Board
of Directors and Executive Officers





The board
of directors is divided into three classes with staggered terms, so that the
terms of approximately one-third of the board members expire at each annual
meeting.  Set forth below is certain information about the Class I
directors. With the exception of Mr. Johnson, each of the Class I directors is
also an organizer and director of our company’s subsidiary, First National Bank
of the South, and has served in this capacity since each company’s inception in
1999.  Mr. Johnson joined our Board in February of 2008, pursuant to
the merger of Carolina National Corporation (“Carolina National”) with and into
First National.





Mellnee G. Buchheit, 61,
Class I director, has been the president of Buchheit News Management, Inc., a
firm specializing in media investments, since 1993.  She also serves
as a director for Wayne Printing Co., Inc. and Hometown News,
Inc.  Ms. Buchheit graduated from Winthrop University with a
degree in education in 1969.





Jerry L. Calvert, 60, Class I
director, is the president and chief executive officer of First National
Bancshares, Inc. and the First National Bank of the South.  He is a
native of South Carolina and has over 30 years of banking experience in the
Greenville and Spartanburg markets.  Mr. Calvert was the senior vice
president and regional manager for American Federal Bank from 1984 until March
1999, when he resigned to help organize First National Bank of the
South.  Mr. Calvert is a retired Lieutenant Colonel in the U.S.
Marine Reserves and a Vietnam veteran.  Mr. Calvert graduated
from Wofford College in 1974 with a bachelor of arts degree in
economics.





W. Russel Floyd, Jr., 58,
Class I director, has been the president of W. R. Floyd Services, Inc., a
funeral home, and W. R. Floyd Corporation, a cemetery operation located in
Spartanburg, since 1978.  He has also served as the vice president of
Piedmont Crematory since 1980.  He also has served as the president of
Business Communications, Inc., a local provider of telephone services and
equipment, since 1984.  Mr. Floyd graduated from the University
of North Carolina – Chapel Hill in 1972 with a bachelor of science degree
in business administration, and he received a bachelor of arts degree in
psychology from the University of North Carolina – Charlotte in
1977.





I.S. Leevy Johnson,66, Class I director, has
been an attorney with Johnson, Toal & Battiste, P.A. since 1976. Mr. Johnson
is also an owner of Leevy Johnson Funeral Home, Inc.





Norman F. Pulliam, 66, Class
I director, was founder and formerly chairman of the board of Pulliam Investment
company, Inc., a real estate development and investment firm located in
Spartanburg.  Mr. Pulliam served as board chairman from First
National’s inception until June 2005, and now serves as chairman
emeritus.  He is a graduate of Clemson University and Harvard
University School of Business Administration.





Set forth
below is also information about each of our other directors and executive
officers.  The terms of the Class II directors will expire at the
2010 Annual Shareholders Meeting.  The terms of the Class III
directors expire at the 2011 Annual Shareholders Meeting.  The
directors who were an organizer and an original director of our subsidiary bank
and have served in this capacity since each company’s inception in 1999 are as
follows:  C. Dan Adams, Mellnee Buchheit, Jerry L. Calvert, Martha
Chapman, W. Russel Floyd, Jr., C. Tyrone Gilmore, Sr., Benjamin Hines, Norman
Pulliam, Peter Weisman, Donald B. Wildman and Coleman L. Young,
Jr.  The following directors joined our Board in February of 2008,
pursuant to the merger of Carolina National with and into First
National:  Robert E. Staton, Jr., I.S. Leevy Johnson, Joel A. Smith,
III and William H. Stern.


114


C. Dan Adams, 49, Class III
director, is the Chairman of our board of directors.  Mr. Adams has
been the president and principal owner of The Capital Corporation of America,
Inc., an investment banking company located in Greenville/Spartanburg, since
1991.  He is also president and owner of Southeastern Capital
Partners, LLC, a private equity company that is affiliated with The Capital
Corporation and invests in privately held companies. Southeastern currently has
four (4) portfolio companies.  Mr. Adams graduated from the University
of South Carolina Upstate in 1983 with a degree in business
administration.  He graduated in 1989 from The Banking School of the
South at Louisiana State University and is a Certified Commercial Investment
member.





Martha Cloud Chapman, 86, Class III director,
graduated from the University of North Carolina – Greensboro in 1942 with a
degree in art.  Ms. Chapman previously was the first female board
member of the Spartanburg County Foundation, the South Carolina Development
Board, and the South Carolina Mining Council, and she served as the chairperson
of Governor Jim Edward’s Inaugural Ball.  She has served as a board
member of the Walker Foundation, Charles Lea Center Foundation, Queens College,
Spartanburg Methodist College and the Music Foundation.





Dr. C. Tyrone Gilmore,
Sr., 65,
Class III director, is vice president/customer relations at Compass
Learning, Inc.  He graduated from Livingstone College in 1965 with a
bachelor of arts degree.  Dr. Gilmore earned his Master’s degree
in 1971 from Converse College and received his Ed. S. in Educational
Administration studies in 1976 from the University of South Carolina –
Upstate.





Benjamin R. Hines, 52, Class II director, has
been president of Spencer/Hines Properties, a commercial real estate firm
located in Spartanburg, since 1986.  Mr. Hines graduated from Wofford
College in 1978 with a bachelor’s degree in economics.





Joel A. Smith, III,63, Class II director, has
been Dean of the Moore School of Business since October of 2000.  From
June of 1998 until August of 2000, Mr. Smith was President of the East Region of
Bank of America.  Prior to that time, from 1991 through June of 1998,
Mr. Smith was President of NationsBank Carolinas.  Additionally, he
serves on the board of directors and the Audit and Governance Committees of
Avanex Corporation, and the board of directors and on the Executive Committee
for NETBANK, Inc., chairing the Compensation Committee.





Robert E. Staton, Sr.,62,Class III
director,  has
been  Executive  Vice  President
External  Relations
for  Presbyterian  College  since  January
2007,  served as President of the United Way of South Carolina from
May of 2002 until December of 2005 and was Chairman,  President and
Chief Executive Officer of Colonial Life & Accident Insurance company from
1994 until his retirement in July of 2001.





William H. Stern, 52, Class
II director, has been President of Stern & Stern and Associates, a
commercial real estate development company, since 1984. Mr. Stern currently
serves as Chairman of the South Carolina State Ports Authority.





Peter E. Weisman, 71, Class
II director, is an owner and managing member of Peter Weisman/Kinney Hill
Associates, LLC, a real estate development company established in 1989 and
located in Spartanburg.  Mr. Weisman has also been a general
partner of P & J Realty Co., a real estate development company located
in New York, New York, since 1969.  He graduated from the University
of Pennsylvania in 1961 with a degree in architecture.





Donald B. Wildman, 59, Class II director, is a
managing partner of the law firm of Johnson, Smith, Hibbard, and Wildman,
LLP.  Mr. Wildman has been a transactions attorney with the firm
since 1974.  He graduated from Wofford College in 1971 with a bachelor
of arts degree and received his juris doctor from the University of South
Carolina School of Law in 1974.





Coleman L. Young, Jr.,52,
Class III director, has been the president of CLY, Inc., a dry cleaning business
located in Spartanburg, since 1994.  Mr. Young also serves as
property manager for Coleman Young Family Limited Partnership, a real estate
development company, and is chairman of Upward Unlimited, a non-profit ministry
headquartered in Spartanburg.  Mr. Young
graduated from Clemson University in 1979 with a bachelor of science
degree.





Kitty B. Payne, CPA, 38, is executive vice
president and chief financial officer of First National Bancshares, Inc. and
First National Bank of the South. She has over 15 years of experience in the
financial services industry, including seven years with KPMG LLP as a senior tax
manager where she worked extensively with community banks in the Carolinas.
Ms. Payne received her bachelor’s degree in financial management and
accounting from Clemson University in 1992.


115


Roger B. Whaley, age 62, has
served as executive vice president of First National Bancshares, Inc. since
February 2008, pursuant to the merger of Carolina National Bank Corporation with
and into First National Bancshares, Inc.  Prior to February 2008, Mr.
Whaley served as a director, president and chief executive officer of Carolina
National Corporation. Mr. Whaley was employed by an investment firm from
November of 2000 until November, 2001.  From 1971 until his retirement
in August of 2000, Mr.  Whaley was with Bank of America, where for the
last four years of employment he served as President of Bank of America,
Oklahoma, and, in 1999, also assumed responsibilities as Small Business Banking
Executive for the Midwest (Arkansas, Illinois, Iowa, Kansas, Missouri and
Oklahoma).





David H. Zabriskie, 47,is
executive vice president and senior lending officer of First National Bank of
the South. He has over 21 years of experience in the financial services
industry, including 15 years in commercial lending. Mr. Zabriskie has also
served as a bank examiner for the OCC and the OTS. Mr. Zabriskie received
his bachelor’s degree in business administration from Furman University in
1984.





Compliance
with Section 16(a) of the Securities Exchange Act of 1934





As
required by Section 16(a) of the Securities Exchange Act of 1934, our
directors and executive officers and certain other individuals are required to
report periodically their ownership of our common stock and any changes in
ownership to the SEC.  Based on a review of Forms 3, 4, and 5 and
any written representations made to us, it appears that these forms were filed
in a timely fashion during 2008.





Code
of Ethics





We have
adopted a Code of Ethics that is designed to ensure that our directors,
executive officers and employees meet the highest standards of ethical
conduct.  The Code of Ethics requires that our directors, executive
officers and employees avoid conflicts of interest, comply with all laws and
other legal requirements, conduct business in an honest and ethical manner and
otherwise act with integrity and in our best interest.  Under the
terms of the Code of Ethics, directors, executive officers and employees are
required to report any conduct that they believe in good faith to be an actual
or apparent violation of the Code of Ethics.





As a
mechanism to encourage compliance with the Code of Ethics, we have adopted a
policy regarding our method receiving, retaining and treating complaints
received regarding accounting, internal accounting controls or auditing
matters.  This policy ensures that employees may submit concerns in
good faith regarding questionable accounting or auditing matters in a
confidential and anonymous manner without fear of dismissal or retaliation of
any kind.  A copy of the Code of Ethics can be found on our website,
www.firstnational-online.com.





Nominating
Committee





The
nominating committee is composed of C. Dan Adams, W. Russel Floyd,
Jr., Coleman L. Young, Jr., and Robert E. Staton, Sr.  Each
member is considered independent as contemplated in the listing standards of the
NASDAQ Global Market.  The nominating committee acts under a written
charter adopted by the board of directors.  A copy of the charter is
available in the investor relations section of our website at
www.firstnational-online.com. The nominating committee met one time in
2008.





Our
nominating committee will consider director candidates recommended by
shareholders who submit nominations in accordance with our bylaws.  In
evaluating such recommendations, the committee uses a variety of criteria to
evaluate the qualifications and skills necessary for members of our
Boards.  While no single qualification is determinative, the
nominating committee shall consider the skills and background needed by the
company and possessed by the person, diversity of the Board, actual or potential
conflicts of interest, and the willingness and ability to devote time and energy
to the duties of a director.  The nominating committee uses these
criteria in evaluating the qualifications of director candidates in addition to
any other factor relevant to a person’s potential service on the board of
directors.  At least annually, the nominating committee reviews and
reassesses director fees and qualifications and recommends any proposed changes
to the board of directors.


116


Shareholders
must deliver nominations in writing either by personal delivery or by United
States mail, postage prepaid, return receipt requested, to the Secretary of the
company no later than (i) with respect to an election to be held at an
annual meeting of shareholders, ninety days in advance of such meeting; and
(ii) with respect to an election to be held at a special meeting of
shareholders for the election of directors, following the close of business on
the seventh day after notice of the date on which notice of such special meeting
is given to the shareholder.  Each notice shall set forth:
(i) the name and address of the shareholder who intends to make the
nomination and of the person or persons to be nominated; (ii) a
representation that the shareholder is a holder of record of stock of the
company entitled to vote at such meeting and intends to appear in person or by
proxy at the meeting to nominate the person or persons specified in the notice;
(iii) a description of all arrangements or understandings between the
shareholder and each nominee and any other person or persons (naming such person
or persons) pursuant to which the nomination or nominations are to be made by
the shareholder; (iv) such other information regarding each nominee
proposed by such shareholder as would be required to be included in a proxy
statement filed pursuant to the proxy rules of the Securities and Exchange
Commission, had the nominee been nominated, or intended to be nominated, by the
board of directors; and (v) the consent of each nominee to serve as a
director of the company if so elected.  The chairman of the meeting
may refuse to acknowledge the nomination of any person not made in compliance
with the foregoing procedure.





Our
nominating committee uses a variety of methods for identifying and evaluating
nominees for director.  The nominating committee regularly assesses
the appropriate size of the board of directors, and whether any vacancies are
expected due to retirement or otherwise.  If vacancies are
anticipated, or otherwise arise, the nominating committee considers various
potential candidates for director.  Candidates may come to their
attention through current members of the Board, shareholders, or other
persons.  These candidates are evaluated at regular or special
meetings of the Board, and may be considered at any point during the
year.  The nominating committee considers all properly submitted
shareholder recommendations for candidates.  In evaluating such
recommendations, the nominating committee uses the qualifications and standards
discussed above and seeks to achieve a balance of knowledge, experience and
capability on the board of directors.





Audit
Committee





The audit
committee is composed of Coleman L. Young, Jr., Mellnee G. Buchheit,
Dr. C. Tyrone Gilmore, Sr., Benjamin R. Hines, Joel A. Smith, I.
S. Leevy Johnson, and W. Russel Floyd, Jr.  The audit
committee met four times in 2008.  Each member is considered
independent as contemplated in the listing standards of the NASDAQ Global
Market.





The
functions of the audit committee are set forth in its charter, which is included
as Appendix A.  The initial charter was adopted in March 2000 and was
most recently ratified in March 2008 with no amendments to the existing version
filed with the company’s current proxy statement for the 2009 Annual Meeting of
Shareholders.  The audit committee has the responsibility of reviewing
our financial statements, evaluating internal accounting controls, reviewing
reports of regulatory authorities, and determining that all audits and
examinations required by law are performed.  The audit committee is
responsible for overseeing the entire audit function and appraising the
effectiveness of internal and external audit efforts.  The audit
committee reports its findings to the board of directors.





The
compensation committee is composed of Mellnee G. Buchheit, Martha C.
Chapman, Norman F. Pulliam, C. Dan Adams, Robert E. Staton, Sr., William H.
Stern, and Coleman L. Young, Jr.  The compensation committee
met four times in 2008.  Each member is considered independent as
contemplated in the listing standards of the NASDAQ Global
Market.  The compensation committee does not operate under a formal
charter.





The
board of directors believes that each current member of our audit committee is
financially literate and fully qualified to monitor the performance of
management, our public disclosures of our financial condition and performance,
our internal accounting operations, and our independent registered public
accounting firm.  The audit committee does not include an “audit
committee financial expert” as defined by the rules of the Securities and
Exchange Commission as no individual committee member meets the five attributes
and qualifies as an “audit committee financial expert”.  However, we
believe that our committee members collectively are capable of (i)
an understanding of GAAP and financial statements, (ii) the ability to
assess the general application of GAAP in connection with the accounting for
estimates, accruals and reserves, (iii) experience preparing, auditing,
analyzing, or evaluating financial statements that present a breadth and
complexity of issues that are generally comparable to the breadth and complexity
of issues that can reasonably be expected to be inherent in our financial
statements, (iv) understanding internal controls and procedures for
financial reporting, and (v) understanding audit committee functions, all
of which are attributes of an “audit committee financial expert” under the
current rules adopted by the SEC.


117


Item 11. Executive
Compensation.





Compensation
of Directors and Executive Officers





Summary
of Cash and Certain Other Compensation





The
following table summarizes the compensation paid or earned by each of the named
executive officers for the year ended December 31, 2008.





Summary
Compensation Table


Name and Principal Position
                                                
                                                Year
                                                
                                                Salary
                                                
                                                
                                                Bonus
                                                
                                                
                                                StockAwards
                                                
                                                
                                                OptionAwards(1)
                                                
                                                
                                                Non-Equity
                                                  Incentive Plan
                                                  Compensation(2)
                                                
                                                
                                                Deferred
                                                  Compensation
                                                  Earnings
                                                
                                                
                                                Value and All
                                                  Other
                                                  Compensation(3)
                                                
                                                
                                                TotalJerry
      L. Calvert
                                                
                                                2008
                                                
                                                
                                                286,000
                                                
                                                
                                                
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                39,180
                                                
                                                
                                                
                                                325,180President,
      CEO and Director
                                                
                                                2007
                                                
                                                
                                                266,000
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                70,000
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                39,471
                                                
                                                
                                                
                                                375,471of
      the Company and the BankKitty
      B. Payne
                                                
                                                2008
                                                
                                                
                                                162,616
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,681
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                12,644
                                                
                                                
                                                
                                                180,941Executive
      Vice President and Chief
                                                
                                                2007
                                                
                                                
                                                155,000
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,681
                                                
                                                
                                                
                                                29,000
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                15,944
                                                
                                                
                                                
                                                205,625Financial
      Officer of the Company and the BankRoger B. Whaley(4)
                                                
                                                2008
                                                
                                                
                                                254,625
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                23,065
                                                
                                                
                                                
                                                277,690Executive
      Vice PresidentDavid
      H. Zabriskie
                                                
                                                2008
                                                
                                                
                                                178,460
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,681
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                15,436
                                                
                                                
                                                
                                                199,577Executive
      Vice President and Chief
                                                
                                                2007
                                                
                                                
                                                169,959
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,681
                                                
                                                
                                                
                                                33,000
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                18,962
                                                
                                                
                                                
                                                227,602Lending
      Officer of the Bank





(1)
            The
      amounts in this column reflect the dollar amount recognized as
      compensation expense for financial statement reporting purposes for the
      fiscal year ended December 31, 2008, in accordance with SFAS
      No. 123(R) which outlines the accounting requirements for awards
      pursuant to the company’s stock option plan and include amounts from
      awards granted prior to 2008.  Assumptions used in the
      calculation of this amount for the fiscal year ended December 31,
      2008, are included in footnote 2 to the company’s audited financial
      statements for the fiscal year ended December 31, 2008, included in
      the company’s Annual Report on
Form 10-K.


(2)
            Amounts
      awarded for the fiscal year under the FNIP were paid in the subsequent
      fiscal year.


(3)
            All
      other compensation for 2008 includes the following items: (a) company
      contributions under the 401k plan, (b) car allowance or value
      attributable to personal use of company provided automobiles,
      (c) club dues, (d) premiums for the portion of the death
      benefits shared by the company with the named executive officers pursuant
      to bank owned life insurance, (e) premiums for life, accident and
      long-term disability insurance policies (f) the dollar amount recognized
      for financial statement reporting purposes for the fiscal year ended
      December 31, 2008 for shares allocated to each named executive officer
      under the First National Employee Stock Ownership Plan, and (g) in the
      case of Mr. Calvert, premiums for keyman life insurance and medical and
      dental insurance coverage. The amount attributable to each such perquisite
      or benefit for each named executive officer does not exceed the greater of
      $25,000 or 10% of the total amount of perquisites received by such named
      executive officer.


(4)
            Mr.
      Whaley became an executive officer of First National pursuant to the
      acquisition of Carolina National, effective January 31,
    2007.





Employment
Agreements





The
company recognizes that the named executive officers’ contributions to the
growth and success of the company are substantial.  The company
desires to provide for the continued employment of the named executive officers,
to reinforce and encourage the continued dedication of these individuals to the
company and to promote the best interest of the company and its
shareholders.





On
December 31, 2008, First National Bancshares, Inc., and its wholly-owned
subsidiary, First National Bank of the South, entered into an employment
agreement with Jerry L. Calvert to serve as the President and Chief Executive
Officer of the company and its bank subsidiary.  This agreement is for
a term of three years and is extended automatically at the end of each year so
that the remaining term continues to be three years.  Under the
agreement, Mr. Calvert receives a base salary of not less than $286,000 per
year, which may be increased from time to time with the approval from the board
of directors. He also receives his medical insurance premium.  He is
eligible to receive an annual cash bonus of up to 50% of his base salary based
on the accomplishment of performance goals established by the board of
directors.  Mr. Calvert is entitled to a term life insurance
policy in the amount of $500,000 payable to his designated beneficiaries and an
accident liability policy totaling $1,000,000.  Mr. Calvert will
receive an automobile or an automobile allowance and is entitled to participate
in all retirement, welfare, and other benefit plans of the company and the
bank.  During his employment and for a period of one year thereafter,
or during any period that Mr. Calvert is receiving a severance payment
under the agreement, he is prohibited from (a) competing with the company
or the bank within a radius of 40 miles of the main office or any branch or loan
production office; (b) soliciting the company’s or the bank’s customers for
a competing business; or (c) soliciting the company’s or bank’s employees
for a competing business.


118





If we
terminate the employee agreement for Mr. Calvert without cause before or
after a change in control, or if Mr. Calvert terminates his agreement for
good reason within the 90-day period beginning on the 30th day
after a change in control or within the 90-day period beginning on the one year
anniversary of a change in control, he will be entitled to severance in an
amount equal to his then current monthly base salary multiplied by 36 (24 for a
termination without cause), plus any bonus which may have been earned or accrued
through the date of termination (including any amounts awarded for previous
years but which were not yet vested) and a pro rata share of any bonus with
respect to the current fiscal year which may have been earned as of the date of
termination.





On
December 31, 2008, First National Bancshares, Inc. and its wholly owned
subsidiary, First National Bank of the South, also entered into employment
agreements with Kitty B. Payne and David H. Zabriskie.  Pursuant to
the agreements, Ms. Payne serves as an Executive Vice President and the
Chief Financial Officer of the company and the bank and receives a minimum
annual base salary of $164,000 and Mr. Zabriskie serves as an Executive Vice
President and Senior Lending Officer of the bank and receives a minimum annual
base salary of $180,000.  Each executive’s annual base salary may be
increased from time to time with the approval of the board of directors, but may
not be decreased.





Each
agreement is for a term of two years and is extended automatically at the end of
each year so that the remaining term continues to be two years; however, the
executive or the employer may at any time fix the term to a finite period of two
years.  Each executive is entitled to participate in all employee
benefit plans or programs of the company and its bank subsidiary, as well as
club dues.  In addition, the terms of the agreement entitle Mr.
Zabriskie to the use of an automobile owned or leased by the
bank.  During each executive’s employment and for a period of one year
thereafter, each executive is prohibited from (a) competing with the
company or the bank within a radius of 30 miles of any office or branch;
(b) soliciting the company’s or bank’s customers for a competing business;
or (c) soliciting the company’s or the bank’s employees for a competing
business.  Notwithstanding the foregoing, each executive may serve as
an officer of or consultant to a depository institution or holding company with
offices in the restricted territory, if such employment does not involve the
restricted territory.





If we
terminate the employment agreements for Ms. Payne or Mr. Zabriskie without
cause before or after a change in control, or if Ms. Payne or Mr. Zabriskie
terminate their agreement for good reason within the 90-day period beginning on
the 30th day
after a change in control, they will be entitled to severance in an amount equal
to their then current monthly base salary multiplied by 12, plus any bonus which
may have been earned or accrued through the date of termination (including any
amounts awarded for previous years but which were not yet vested) and a pro rata
share of any bonus with respect to the current fiscal year which may have been
earned as of the date of termination.





Outstanding
Equity Awards at Fiscal Year-End





The
following table shows the number of shares covered by both exercisable and
non-exercisable options owned by the individuals named in the Summary
Compensation Table as of December 31, 2008, as well as the related exercise
prices and expiration dates. Options are granted pursuant to the company’s stock
option plan.





OptionAwards
                
                
                StockAwardsEquity IncentiveEquity Incentive
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                Equity Incentive
                
                
                Plan Awards:Plan Awards:
                
                
                
                
                
                
                
                
                Number of
                
                
                Market Value of
                
                
                Plan Awards:
                
                
                Market or Payout ValueNumber of Securities Underlying
                
                
                Number of Securities
                
                
                Option
                
                
                Option
                
                
                Shares or Units of
                
                
                Shares or Units of
                
                
                Number of Unearned Shares
                
                
                of Unearned Shares, Units orUnexercised Options
                
                
                Underlying Unexercised
                
                
                Exercise
                
                
                Expiration
                
                
                Stock that
                
                
                Stock that Have
                
                
                or Other Rights That
                
                
                Other Rights That HaveName
                
                Exercisable
                
                
                Non-exercisable(1)
                
                
                Unearned Options
                
                
                Price
                
                
                Date
                
                
                Have Not Vested(2)
                
                
                Not Vested(2)
                
                
                Have Not Vested
                
                
                Not VestedJerry
      L. Calvert
                
                
                153,117
                
                
                
                -
                
                
                
                -
                
                
                $
                3.92
                
                
                3/27/2010
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                --
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                426
                
                
                $
                877
                
                
                
                -
                
                
                
                -Kitty
      B. Payne
                
                
                12,760
                
                
                
                -
                
                
                
                -
                
                
                $
                3.92
                
                
                3/27/2010
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -2,552
                
                
                
                -
                
                
                
                -
                
                
                $
                4.23
                
                
                12/3/2011
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -2,552
                
                
                
                1,701
                
                
                
                -
                
                
                $
                14.99
                
                
                1/31/2015
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                --
                
                
                
                -
                
                
                
                -
                
                
                
                
                
                
                
                -
                
                
                
                352
                
                
                $
                726Roger
      B Whaley
                
                
                94,968
                
                
                
                -
                
                
                
                -
                
                
                $
                6.81
                
                
                7/15/2012
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -2,936
                
                
                
                -
                
                
                
                -
                
                
                $
                11.08
                
                
                7/1/2017
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -David
      H. Zabriskie
                
                
                25,520
                
                
                
                -
                
                
                
                -
                
                
                $
                3.92
                
                
                3/27/2010
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -2,552
                
                
                
                -
                
                
                
                -
                
                
                $
                4.23
                
                
                12/3/2011
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -2,552
                
                
                
                1,701
                
                
                
                -
                
                
                $
                14.99
                
                
                1/31/2015
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                --
                
                
                
                -
                
                
                
                -
                
                
                
                
                
                
                
                -
                
                
                
                381
                
                
                $
                787





(1)Options
granted pursuant to the company’s stock option plan expire ten years from the
date of grant and vest at a rate of 20% each year on the first five
anniversaries of the date of grant.


(2)Each
named executive officer fully vests in the shares allocated pursuant to the
First National Employee Stock Ownership Plan after seven years of service with
20% of the shares allocated vesting each year, beginning with the third year of
service. As of December 31, 2008, each named executive officer had been credited
with four full years of service.


119


Option
Grants in Last Fiscal Year





For the
year ended December 31, 2008, no options were granted to the named
executive officers.





Director
Compensation





The
following table shows the fees paid to each of our elected directors for board
meeting and committee meeting attendance in 2008.




Name
                  
                  Fees Earnedor
                    Paid inCash
                  
                  
                  Stock Awards
                  
                  
                  Option Awards
                  
                  
                  Non-Equity
                    Incentive Plan
                    Compensation
                  
                  
                  Nonqualified
                    Deferred
                    Compensation
                    Earnings
                  
                  
                  All Other
                    Compensation
                  
                  
                  TotalC.
      Dan Adams
                  
                  $
                  23,900
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  23,900Mellnee
      Buchheit
                  
                  
                  12,300
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  3,150
                  
                  
                  
                  15,450Jerry
      L. Calvert
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Martha
      Chapman
                  
                  
                  11,100
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  11,100W.
      Russel Floyd, Jr.
                  
                  
                  16,700
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  16,700C.
      Tyrone Gilmore, Sr.
                  
                  
                  17,100
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  17,100Benjamin
      Hines
                  
                  
                  22,700
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  22,700I.
      S. Leevy Johnson
                  
                  
                  9,100
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  9,100Norman
      Pulliam
                  
                  
                  14,700
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,500
                  
                  
                  
                  17,200Joel
      Smith
                  
                  
                  9,600
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  9,600Robert
      E. Staton
                  
                  
                  18,300
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  18,300William
      Stern
                  
                  
                  16,400
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  16,400Peter
      Weisman
                  
                  
                  20,700
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20,700Donald
      B. Wildman
                  
                  
                  13,100
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  13,100Coleman
      L. Young, Jr.
                  
                  
                  25,500
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  500
                  
                  
                  
                  26,000




During
2008, we paid our outside directors $800 for each board meeting they attended,
with the exception of the January 2008 board meeting, for which they received
$700.  Our directors were also paid $400 for each committee meeting
they attended.


120


Item 12. Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder
Matters.





Security
Ownership of Certain Beneficial Owners and Management





The
following table shows how much of our common stock is considered to be
beneficially owned by the directors, named executive officers, and owners of
more than 5% of the outstanding common stock, as of March 31,
2009.  During the initial public offering completed in February of
2000, each organizer received a warrant to purchase two shares of common stock
at a purchase price of $3.92 per share for every three shares purchased by that
organizer in the offering, for a total of 799,611 shares.  As part of
the acquisition of Carolina National, four new directors were added to First
National’s Board.  The stock options granted to these directors under
Carolina National’s stock option plan vested immediately upon the effective date
of the merger and are included in the Right to Acquire figures presented
below.  In addition to the options granted to the four new directors,
the Right to Acquire figures include options previously granted to the named
executive officers.  These figures reflect the 3-for-2 stock splits
distributed on March 1, 2004, and January 18, 2006, the 6% stock dividend
distributed on May 16, 2006, and the 7% stock dividend distributed on
March 30, 2007.  The warrants, which are represented by a
separate warrant agreement, vested over a five-year period beginning on
February 10, 2001, and are exercisable in whole or in part until February
10, 2010.  Unless otherwise indicated, the address of each beneficial
owner is c/o First National Bancshares, Inc., 215 North Pine Street,
Spartanburg, South Carolina 29302.




Shares
      Beneficially
                        
                        
                        Right
      ToName
                        
                        Owned(1)
                        
                        
                        Acquire(2)
                        
                        
                        Percent(3)C.
      Dan Adams (4)
                        
                        
                        148,860
                        
                        
                        
                        85,065
                        
                        
                        
                        3.61
                        %Mellnee
      G. Buchheit
                        
                        
                        85,646
                        
                        
                        
                        51,039
                        
                        
                        
                        2.12
                        %Jerry
      L. Calvert  (5)
                        
                        
                        79,106
                        
                        
                        
                        204,156
                        
                        
                        
                        4.29
                        %Martha
      C. Chapman
                        
                        
                        80,582
                        
                        
                        
                        -
                        
                        
                        
                        1.26
                        %W.
      Russel Floyd, Jr. (6)
                        
                        
                        100,499
                        
                        
                        
                        51,039
                        
                        
                        
                        2.35
                        %Dr.
      C. Tyrone Gilmore, Sr.
                        
                        
                        25,835
                        
                        
                        
                        17,013
                        
                        
                        
                        0.67
                        %Benjamin
      R. Hines  (7)
                        
                        
                        114,270
                        
                        
                        
                        71,455
                        
                        
                        
                        2.87
                        %I.S.
      Leevy Johnson
                        
                        
                        18,470
                        
                        
                        
                        2,248
                        
                        
                        
                        0.32
                        %Kitty
      B. Payne  (8)
                        
                        
                        12,760
                        
                        
                        
                        18,658
                        
                        
                        
                        0.49
                        %Norman
      F. Pulliam
                        
                        
                        180,050
                        
                        
                        
                        102,078
                        
                        
                        
                        4.34
                        %Joel
      A. Smith
                        
                        
                        27,860
                        
                        
                        
                        2,935
                        
                        
                        
                        0.48
                        %Robert
      E. Staton, Sr.
                        
                        
                        24,627
                        
                        
                        
                        2,935
                        
                        
                        
                        0.43
                        %William
      H. Stern
                        
                        
                        107,764
                        
                        
                        
                        4,563
                        
                        
                        
                        1.75
                        %Peter
      E. Weisman (9)
                        
                        
                        87,445
                        
                        
                        
                        56,143
                        
                        
                        
                        2.22
                        %Roger
      B. Whaley
                        
                        
                        17,735
                        
                        
                        
                        97,904
                        
                        
                        
                        1.78
                        %Donald
      B. Wildman  (10)
                        
                        
                        60,234
                        
                        
                        
                        34,026
                        
                        
                        
                        1.46
                        %Coleman
      L. Young, Jr.  (11)
                        
                        
                        74,687
                        
                        
                        
                        42,533
                        
                        
                        
                        1.82
                        %David
      H. Zabriskie
                        
                        
                        6,590
                        
                        
                        
                        31,418
                        
                        
                        
                        0.59
                        %All
      directors & executive officers as a group (18 persons)
                        
                        
                        1,253,020
                        
                        
                        
                        875,208
                        
                        
                        
                        29.24
                        %





(1)
            Includes
      shares for which the named person:


•has
      sole voting and investment power,


•has
      shared voting and investment power with a spouse or other family member in
      trust, or


•holds
      in an IRA or other retirement plan program, unless otherwise indicated in
      these footnotes.


•does
      not include shares that may be acquired by exercising stock options or
      warrants.


(2)
            Includes
      shares that may be acquired within the next 60 days by exercising vested
      stock options or warrants, but does not include any other stock options or
      warrants.


(3)
            Based
      on 6,403,679 shares of common stock of the company outstanding as of
      the record date of March 31, 2009, plus the number of shares which
      the named person exercising all options or warrants has the right to
      acquire within 60 days, but that no other persons exercise any options or
      warrants.


(4)
            Includes
      84 shares in trust each for Carey Adams and Abby Adams, in which he acts
      as custodian. Includes 75,257 shares pledged as collateral for
      loans.


(5)
            Includes
      254 shares owned by his son Jerry Calvert, Jr., 254 shares owned by his
      son Timothy R. Calvert and 254 shares owned by his daughter Casey M.
      Calvert, all in a trust in which he acts as trustee. Includes 15,056
      shares pledged as collateral for
loans.


(6)
            Includes
      2,971 shares in trust each for Whitley Stevens Floyd and Frances Hunter
      Floyd, in which he acts as
custodian.


(7)
            Includes
      107,182 shares held in the name of The Hines Family Ltd Partnership, of
      which Mr. Hines is the sole voting
member.


(8)
            Includes
      12,759 shares pledged as collateral for
loans.


(9)
            Includes
      680 shares in trust for William Desvallees and 680 shares for Lucie
      Desvallees for which he acts as
custodian.


(10)
            Includes
      1,095 shares in trust for William Reid Wildman for which he acts as
      custodian.


(11)
            Includes 63,799 sharesheld in the name of
      the Coleman Young Family Limited Partnership, of which Mr. Young is the
      sole owner and voting
member.


121


Item 13. Certain Relationships and
Related Transactions.





Certain
Relationships and Related Transactions


Interests
of Management and Others in Certain Transactions





We enter
into banking and other transactions in the ordinary course of business with our
directors and officers and their affiliates.  In February 2007, we
entered into a transaction with a related party entity to sell and subsequently
lease back from the entity certain real properties previously owned by our bank
subsidiary for a price of $5,450,000.  The related party entity is a
limited liability company owned by a group of nine investors who serve as
non-management directors of the company and our bank subsidiary as follows:
Gaines W. Hammond, Jr., M.D., Benjamin R. Hines, C. Dan Adams, Norman F.
Pulliam, Mellnee Buchheit, the Coleman Young Family Limited Partnership, Weisman
Associates Limited Partnership, a limited partnership of which Peter E. Weisman
is the sole owner and voting member, Donald B. Wildman (as managing member) and
W. Russel Floyd, Jr.  Dr. Hammond has since retired from our board of
directors.  Each investor has a one/ninth interest in the limited
liability company.  The transaction was approved by the board of
directors of our bank subsidiary.





In
October 2007, we entered into a transaction with a related party entity to sell
and subsequently lease back from the entity certain real properties previously
owned by our bank subsidiary for a price of $3.6 million.  The related
party entity is a limited liability company owned by a group of nine investors
who serve as non-management directors of the company and our bank subsidiary as
follows:  C. Dan Adams, Norman F. Pulliam, Donald B. Wildman (as
managing member), Mellnee Buchheit, the Coleman Young Family Limited
Partnership, Peter E. Weisman, William A. Hudson and Benjamin R.
Hines.  Each investor/director has a one/eighth interest in the
limited liability corporation.  Mr. Hudson has since retired from our
board of directors.  The transaction was approved by the board of
directors of our bank subsidiary.





It is our
policy that these related party transactions be on substantially the same terms
(including price, or interest rates and collateral) as those prevailing at the
time for comparable transactions with unrelated parties.  We do not
expect these transactions to involve more than the normal risk of collectability
nor present other unfavorable features to us or the bank.  Loans to
individual directors and officers must also comply with our bank subsidiary
lending policies and statutory lending limits, and directors with a personal
interest in any loan application are excluded from the consideration of the loan
application.  We intend for all of our transactions with our
affiliates to be on terms no less favorable to us than could be obtained from an
unaffiliated third party and to be approved by a majority of disinterested
directors.  Director independence is reviewed on an annual basis by
the audit committee.





The
company has a written policy contained in its Code of Ethics which describes the
procedures for reviewing transactions between the company and its directors and
executive officers, their immediate family members and entities with which they
have a position or relationship.  These procedures are intended to
determine whether any such related party transaction impairs the independence of
a director or presents a conflict of interest on the part of a director or
executive officer.





The
company annually requires each of its directors and executive officers to
complete a directors’ and officers’ questionnaire that elicits information about
related party transactions.  The company’s management annually reviews
all transactions and relationships disclosed in the director and officer
questionnaires, and the board of directors makes a formal determination
regarding each director’s independence under NASDAQ Global Market listing
standards and applicable SEC rules.





In
addition, the company’s bank subsidiary is subject to the provisions of Section
23A of the Federal Reserve Act, which places limits on the amount of loans or
extensions of credit to, or investments in, or certain other transactions with,
affiliates and on the amount of advances to third parties collateralized by the
securities or obligations of affiliates.  The bank is also subject to
the provisions of Section 23B of the Federal Reserves Act which, among other
things, prohibits an institution from engaging in certain transactions with
certain affiliates unless the transactions are on terms substantially the same,
or at least as favorable to such institution or its subsidiaries, as those
prevailing at the time for comparable transactions with nonaffiliated
companies.  Under Regulation O, the bank is subject to certain
restrictions on extensions of credit to executive officers, directors, certain
principal shareholders, and their related interests.  Such extensions
of credit (i) must be made on substantially the same terms, including interest
rates and collateral, as those prevailing at the time for comparable
transactions with third parties and (ii) must not involve more than the normal
risk of repayment or present other unfavorable features.


122


In
addition to the annual review, the company’s Code of Ethics requires that the
company’s CEO be notified of any proposed transaction involving a director or
executive officer that may present an actual or potential conflict of interest,
and that such transaction be presented to and approved by the audit
committee.  Upon receiving any notice of a related party transaction
involving a director or executive officer, the CEO will discuss the transaction
with the Chair of the company’s audit committee.  If the likelihood
exists that the transaction would present a conflict of interest or, in the case
of a director, impair the director’s independence, the audit committee will
review the transaction and its ramifications.  If, in the case of a
director, the audit committee determines that the transaction presents a
conflict of interest or impairs the director’s independence, the board of
directors will determine the appropriate response.  If, in the case of
an executive officer, the audit committee determines that the transaction
presents a conflict of interest, the audit committee will determine the
appropriate response.





Item 14.Principal Accounting Firm
Fees and Services.





Consolidated
Audit Fees





The
aggregate fees billed for professional services rendered by Elliott Davis, LLC
during the years ended 2008 and 2007 for the audit of our annual financial
statements and reviews of those financial statements included in our quarterly
reports filed on SEC Form 10-Q, as well as Form 10-K, respectively,
totaled $105,000 and $60,000, respectively.  For the year ended
December 31, 2008, these services included $10,000 in fees for the audit of the
consolidated financial statements of Carolina National and its wholly-owned
subsidiary Carolina National Bank and Trust as of and for the year ended
December 31, 2008, prior to its merger with and into First National effective
January 31, 2008.





Audit
— Related Fees





The
aggregate fees billed for non-audit services, exclusive of the fees disclosed
relating to audit fees, rendered by Elliott Davis, LLC during the years ended
December 31, 2008 and 2007, were $25,500 and $116,100,
respectively.   For the year ended December 31, 2008, these fees
included $12,700 for services related to First National’s acquisition of
Carolina National.  For the year ended December 31, 2007, these
services include the assistance related to reviewing and analyzing the tax and
accounting treatment of the sale/leaseback transactions completed in February
and October 2007.  For the year ended December 31, 2007, these
services also included the assistance related to providing comfort related to
the offering of our noncumulative perpetual preferred stock completed in July
2007 and the review of the prospectus/joint proxy statement filed in November
2007 for our acquisition of Carolina National Corporation.





Tax
Fees





The
aggregate fees billed for professional services rendered by Elliott Davis, LLC
during the year ended 2008 for tax services for Carolina National during the
years ended December 31, 2008 and 2007, totaled $800 and $4,300,
respectively.  We did not engage the independent registered public
accounting firm to provide, and the independent registered public accounting
firm did not bill for, any tax services during the year ended December 31,
2007.





All
Other Fees





We did
not engage the independent registered public accounting firm to provide, and the
independent registered public accounting firm did not bill for, any other
services during the years ended December 31, 2008 or 2007.


123


Item 15. Exhibits.





(a)(1)  Financial
Statements





The
      following consolidated financial statements are located in Item 8 of this
      report.Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets as of December 31, 2008 and 2007
                    78Consolidated
      Statements of Operations for the years ended December 31, 2008, 2007 and
      2006
                    79Consolidated
      Statements of Changes in Shareholders’ Equity and Comprehensive Income for
      the years ended December 31, 2008, 2007 and 2006
                    80Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007 and
      2006
                    81Notes
      to the Consolidated Financial Statements
                    82


(2)       Financial
Statement Schedules





These
schedules have been omitted because they are not required, are not applicable or
have been included in our consolidated financial statements.





(3)        Exhibits





The
following exhibits are required to be filed with this Report on Form 10-K by
Item 601 of Regulation S-K:




2.1
              Agreement
      and Plan of Merger by and between First National Bancshares, Inc. and
      Carolina National Corporation dated as of August 26, 2007. (1)3.1
              Articles
      of Incorporation(2)3.2
              Articles
      of Amendment to the Company’s Articles of Incorporation(3)3.3
              Amended
      and Restated Bylaws4.1
              Form
      of Certificate of Common Stock(2)10.1
              Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and Jerry Calvert.*10.2
              Form
      of Stock Warrant Agreement, as amended(6)*10.3
              2000
      First National Bancshares, Inc. Stock Incentive Plan and Form of
      Agreement(7)*10.4
              Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and Kitty B. Payne*10.5
              Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and David H. Zabriskie*10.7
              Amendment
      No. 1 to the Stock Incentive Plan(6)*10.8
              Agreement
      to Sale, Purchase and Lease between First National Bank of the South and
      First National Holdings, LLC for sale/leaseback transaction dated February
      16, 2007(9)10.9
              Blanket
      Transfer Agreement between First National Bank of the South and First
      National Holdings, LLC for sale/leaseback transaction dated February 16,
      2007(9)10.10
              First National Incentive Plan for
      Executive Management(8)10.12
              Agreement
      to Sell, Purchase and Lease dated September 24, 2007 between First
      National Bank of the South and First National Holdings II, LLC(4)10.13
              Lease
      Agreement dated September 24, 2007 between First National Bank of the
      South and First National Holdings II, LLC(4)
                10.14


124





10.14
                Employee
      Agreement dated January 31, 2008 between First National Bank of the South
      and Roger B. Whaley(9)10.15
                First National Bancshares, Inc.
      2008 Restricted Stock Plan(10)10.16
                  
                  
                  10.17
                  
                  10.18
                  
                  10.19
                  
                  10.20
                  
                  10.21
                  
                  10.22
                  
                  13
                Commitment
      letter to continue Agreements by and among First National Bancshares, Inc.
      and Nexity Bank, dated January 7, 2009.(11)
                  
                  Loan
      Agreement dated December 28, 2007 between First National Bancshares, Inc.
      and Nexity Bank.(11)
                  
                  Pledge
      Agreement dated December 28, 2007 between First National Bancshares, Inc.
      and Nexity Bank.(11)
                  
                  Promissory
      Note dated December 28, 2007 between First National Bancshares, Inc. and
      Nexity Bank.(11)
                  
                  Consent
      Order with OCC dated April 27, 2009
                  
                  Letter Agreement with Nexity Bank dated April 30, 2009
                  
                  Letter to Federal Reserve to decertify First
      National Bancshares as a financial holding company.
                  
                  2008 Company Annual Report21
                Subsidiaries23.1
                Consent
      of Independent Registered Public Accounting Firm24
                Power
      of Attorney (included on signature page)31.1
                Rule
      13a-14(a) Certification of the Chief Executive Officer.31.2
                Rule
      13a-14(a) Certification of the Chief Financial Officer.32
                Section
      1350 Certifications.





(1)
            Incorporated
      by reference to Exhibit 2.1 of the company’s Form S-4/A filed on November
      7, 2007.


(2)
            Incorporated
      by reference to the Company’s Registration Statement on Form SB-2 filed on
      September 21, 1999.


(3)
            Incorporated
      by reference to the Company’s Form S-1/A filed on June 18,
      2007.


(4)
            Incorporated
      by reference to the Company’s Form S-4/A filed on November 7,
      2007.


(5)
            Incorporated
      by reference to the Company’s Form 8-K filed on August 22,
      2005.


(6)
            Incorporated
      by reference to the Company’s 10-QSB for the quarter ended March 31,
      2000, filed on May 15, 2000.


(7)
            Incorporated
      by reference to the Company’s Form 10-K for the year ended December 31,
      2006, filed on March 20, 2007.


(8)
            Incorporated
      by reference to the Company’s Form S-1 filed on April 5,
    2007.





(9)
            Incorporated
      by reference to the Company’s Form 8-K filed on March 3,
    2008.


(10)
            Incorporated
      by reference to Exhibit 10.1 of the Company’s Form 8-K filed on May 23,
      2008.


(11)
              Incorporated
      by reference to the Company’s Form 8-K filed on April 1,
    2009.


The
Exhibits listed above will be furnished to any security holder free of charge
upon written request to Ms. Kitty B. Payne, Chief Financial Officer,
First National Bancshares, Inc., Post Office Box 3508, Spartanburg, South
Carolina, 29304.




*
            Management
      contract or compensatory plan or arrangement required to be filed as an
      exhibit to this annual report on Form
10-K.


125


SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act
of 1934 (the “Exchange Act”), the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.




FIRST
      NATIONAL BANCSHARES, INC.Date:
      April 30, 2009
              By:
              /s/
      Jerry L. CalvertPresident
      and Chief Executive Officer





KNOW ALL
MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Jerry L. Calvert and C. Dan Adams as the true and
lawful attorney-in-fact and agent with full power of substitution and
resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any and all amendments to this Form 10-K, and to file the
same, with all exhibits thereto, and other documents in connection therewith,
with the Securities and Exchange Commission, granting unto such attorney-in-fact
and agent, full power and authority to do and perform each and every act and
thing requisite or necessary to be done in and about the premises, as fully to
all intents and purposes as he might or could do in person, hereby ratifying and
confirming all that such attorney-in-fact and agent, or his substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant in the
capacities and on the dates indicated.




Signature
                  
                  Title
                  
                  Date/s/
      C. Dan AdamsC.
      Dan Adams
                  
                  Director,
      Chairman of the Board
                  
                  April
      30, 2009/s/
      Mellnee G. Buchheit
                  
                  Director
                  
                  April
      30, 2009Mellnee
      G. Buchheit/s/
      Jerry L. Calvert
                  
                  Director,
      Vice Chairman, President, Chief
                  
                  April
      30, 2009Jerry
      L. Calvert
                  
                  Executive
      Officer/s/
      Martha Cloud Chapman
                  
                  Director
                  
                  April
      30, 2009Martha
      Cloud Chapman/s/
      W. Russel Floyd, Jr.
                  
                  Director
                  
                  April
      30, 2009W.
      Russel Floyd, Jr./s/
      C. Tyrone Gilmore, Sr.
                  
                  Director
                  
                  April
      30, 2009C.
      Tyrone Gilmore, Sr./s/
      Benjamin R. Hines
                  
                  Director
                  
                  April
      30, 2009Benjamin
      R. Hines


126




Signature
              
              Title
              
              Date/s/
      I.S. Leevy Johnson
              
              Director
              
              April
      30, 2009I.S.
      Leevy Johnson/s/
      Kitty B. Payne
              
              Chief
      Financial Officer, Principal Financial
              
              April
      30, 2009Kitty
      B. Payne
              
              and
      Accounting Officer/s/
      Norman F. Pulliam
              
              Director,
      Chairman Emeritus
              
              April
      30, 2009Norman
      F. Pulliam/s/
      Joel A. Smith, III
              
              Director
              
              April
      30, 2009Joel
      A. Smith, III/s/
      Robert E. Staton, Sr.
              
              Director
              
              April
      30, 2009Robert
      E. Staton, Sr./s/
      William H. Stern
              
              Director
              
              April
      30, 2009William
      H. Stern/s/
      Peter E. Weisman
              
              Director
              
              April
      30, 2009Peter
      E. Weisman/s/
      Donald B. Wildman
              
              Director
              
              April
      30, 2009Donald
      B. Wildman/s/
      Coleman L. Young, Jr.
              
              Director
              
              April
      30, 2009Coleman
      L. Young, Jr.


127




INDEX TO
EXHIBITS





2.1
                Agreement
      and Plan of Merger by and between First National Bancshares, Inc. and
      Carolina National Corporation dated as of August 26, 2007. (1)3.1
                Articles
      of Incorporation(2)3.2
                Articles
      of Amendment to the Company’s Articles of Incorporation(3)3.3
                Amended
      and Restated Bylaws4.1
                Form
      of Certificate of Common Stock(2)10.1
                Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and Jerry Calvert.*10.2
                Form
      of Stock Warrant Agreement, as amended(6)*10.3
                2000
      First National Bancshares, Inc. Stock Incentive Plan and Form of
      Agreement(7)*10.4
                Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and Kitty B. Payne*10.5
                Employment
      Agreement dated December 31, 2008 between First National Bancshares, Inc.,
      First National Bank of the South and David H. Zabriskie*10.7
                Amendment
      No. 1 to the Stock Incentive Plan(6)*10.8
                Agreement
      to Sale, Purchase and Lease between First National Bank of the South and
      First National Holdings, LLC for sale/leaseback transaction dated February
      16, 2007(9)10.9
                Blanket
      Transfer Agreement between First National Bank of the South and First
      National Holdings, LLC for sale/leaseback transaction dated February 16,
      2007(9)10.10
                First National Incentive Plan for
      Executive Management(8)10.12
                Agreement
      to Sell, Purchase and Lease dated September 24, 2007 between First
      National Bank of the South and First National Holdings II, LLC(4)10.13
                Lease
      Agreement dated September 24, 2007 between First National Bank of the
      South and First National Holdings II, LLC(4)
                  10.1410.14
                Employee
      Agreement dated January 31, 2008 between First National Bank of the South
      and Roger B. Whaley(9)10.15
                First National Bancshares, Inc.
      2008 Restricted Stock Plan(10)10.16
                Commitment
      letter to continue Agreements by and among First National Bancshares, Inc.
      and Nexity Bank, dated January 7, 2009.(11)10.17
                Loan
      Agreement dated December 28, 2007 between First National Bancshares, Inc.
      and Nexity Bank.(11)10.18
                Pledge
      Agreement dated December 28, 2007 between First National Bancshares, Inc.
      and Nexity Bank.(11)


128





10.19
                              Promissory
      Note dated December 28, 2007 between First National Bancshares, Inc. and
      Nexity Bank.(11)10.20
                              Consent
      Order with OCC dated April 27, 200910.21
                              Letter Agreement with Nexity Bank dated April 30,
    200910.22
                              Letter to
      Federal Reserve to decertify First National Bancshares as a financial
      holding company.13
                              2008
      Company Annual Report21
                              Subsidiaries23.1
                              Consent
      of Independent Registered Public Accounting Firm24
                              Power
      of Attorney (included on signature page)31.1
                              Rule
      13a-14(a) Certification of the Chief Executive Officer.31.2
                              Rule
      13a-14(a) Certification of the Chief Financial Officer.32
                              Section
      1350
Certifications.





(1)
            Incorporated
      by reference to Exhibit 2.1 of the company’s Form S-4/A filed on November
      7, 2007.


(2)
            Incorporated
      by reference to the Company’s Registration Statement on Form SB-2 filed on
      September 21, 1999.


(3)
            Incorporated
      by reference to the Company’s Form S-1/A filed on June 18,
      2007.


(4)
            Incorporated
      by reference to the Company’s Form S-4/A filed on November 7,
      2007.


(5)
            Incorporated
      by reference to the Company’s Form 8-K filed on August 22,
      2005.


(6)
            Incorporated
      by reference to the Company’s 10-QSB for the quarter ended March 31,
      2000, filed on May 15, 2000.


(7)
            Incorporated
      by reference to the Company’s Form 10-K for the year ended December 31,
      2006, filed on March 20, 2007.


(8)
            Incorporated
      by reference to the Company’s Form S-1 filed on April 5,
    2007.


*
            Management
      contract or compensatory plan or arrangement required to be filed as an
      exhibit to this annual report on Form
10-K.


(9)
            Incorporated
      by reference to the Company’s Form 8-K filed on March 3,
    2008.


(10)
            Incorporated
      by reference to Exhibit 10.1 of the Company’s Form 8-K filed on May 23,
      2008.


(11)
            Incorporated
      by reference to the Company’s Form 8-K filed on April 1,
    2009.


129