Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**x****Quarterly Report Pursuant to Section 13or 15(d)****of the Securities Exchange Act of 1934**

 

**For thequarterly period ended September 30, 2008**

 

**or**

 

**o****Transition Report Pursuant to Section 13or 15(d)**

**of theSecurities Exchange Act of 1934**

 

**For thetransition period from                 to              **

 

**CommissionFile Number:  0-24557**

 

**CARDINAL FINANCIAL CORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **Virginia**  (State or other jurisdiction of  incorporation or organization) | ** ** | **54-1874630**  (I.R.S. Employer  Identification No.) |
|-------------------------------------------------------------------------------|------------|-------------------------------------------------------|
| ** **                                                                    | ** ** | ** **                                            |
| **8270 Greensboro Drive, Suite 500  McLean, Virginia**                   | ** ** | **22102**                                             |
| (Address of principal executive offices)                                      |       | (Zip Code)                                            |

 

**(703) 584-3400**

(Registrant’s telephone number, includingarea code)

 

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

 

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

 
| Large  accelerated filer o |   | Accelerated filer x |
|---------------------------------|--------|--------------------------|

 
| Non-accelerated  filer o | (Do  not check if a smaller reporting company) |   | Smaller reporting company o |
|-------------------------------|------------------------------------------------|--------|----------------------------------|

 

 

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

 

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

 

24,085,392 shares of common stock, par value $1.00 per share, outstandingas of November 3, 2008

 

 

 

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Table of Contents

 

**CARDINAL FINANCIAL CORPORATION**

 

**INDEX TO FORM 10-Q**

 
| **PART I – FINANCIAL INFORMATION**                                                        |                                                                                                                                     |
|-----------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                |                                                                                                                                     |
| Item 1. Financial Statements:                                                                       |                                                                                                                                     |
|                                                                                                |                                                                                                                                     |
|                                                                                                | Consolidated Statements of Condition  At September 30, 2008 (unaudited) and December 31, 2007                                  | 3 |
|                                                                                                |                                                                                                                                     |   |
|                                                                                                | Consolidated Statements of Income  For the three and nine months ended September 30, 2008 and 2007  (unaudited)                     | 4 |
|                                                                                                |                                                                                                                                     |   |
|                                                                                                | Consolidated Statements of Comprehensive  Income  For the three and nine months ended September 30, 2008 and 2007  (unaudited)      | 5 |
|                                                                                                |                                                                                                                                     |   |
|                                                                                                | Consolidated Statements of Changes in  Shareholders’ Equity  For the nine months ended September 30, 2008 and 2007 (unaudited) | 6 |
|                                                                                                |                                                                                                                                     |   |
|                                                                                                | Consolidated Statements of Cash Flows  For the nine months ended September 30, 2008 and 2007 (unaudited)                            | 7 |
|                                                                                                |                                                                                                                                     |   |
|                                                                                                | Notes to Consolidated Financial Statements  (unaudited)                                                                                  | 8 |
|                                                                                                |                                                                                                                                     |   |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations | 22                                                                                                                                       |
|                                                                                                |                                                                                                                                     |
| Item 3. Quantitative and Qualitative  Disclosures About Market Risk                                 | 54                                                                                                                                       |
|                                                                                                |                                                                                                                                     |
| Item 4. Controls and Procedures                                                                     | 55                                                                                                                                       |
|                                                                                                |                                                                                                                                     |
| **PART II – OTHER INFORMATION**                                                           | 56                                                                                                                                       |
| ** **                                                                                          |                                                                                                                                     |
| Item 1. Legal Proceedings                                                                           | 56                                                                                                                                       |
| Item 1A. Risk Factors                                                                               | 56                                                                                                                                       |
| Item 2. Unregistered Sales of Equity  Securities and Use of Proceeds                                | 58                                                                                                                                       |
| Item 3. Defaults Upon Senior Securities                                                             | 58                                                                                                                                       |
| Item 4. Submission of Matters to a Vote of  Security Holders                                        | 59                                                                                                                                       |
| Item 5. Other Information                                                                           | 59                                                                                                                                       |
| Item 6. Exhibits                                                                                    | 59                                                                                                                                       |
|                                                                                                |                                                                                                                                     |
| **SIGNATURES**                                                                                      | 60                                                                                                                                       |

 

2

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Table of Contents

 

**PART I– FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

** **

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATED STATEMENTS OFCONDITION

 

September 30, 2008 and December 31, 2007

 

(In thousands, except share data)

 
| ** **                                                                                                                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                         | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                         | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                         |       |                   |       |                  |       |
| ** **                                                                                                                                         |       |                   |       |                  |       |
| Cash and due from banks                                                                                                                            |       | $                      | 22,124     |                  | $          | 20,622 |   |
| Federal funds sold                                                                                                                                 |       | 21,785                 |       | 1,799                 |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Total cash and cash equivalents                                                                                                                    |       | 43,909                 |       | 22,421                |       |
| Investment securities available-for-sale                                                                                                           |       | 231,044                |       | 285,998               |       |
| Investment securities held-to-maturity  (market value of $48,745 and $78,168 at September 30, 2008 and  December 31, 2007, respectively) |       | 52,229                 |       | 78,948                |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Total investment securities                                                                                                                        |       | 283,273                |       | 364,946               |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Other investments                                                                                                                                  |       | 16,822                 |       | 14,188                |       |
| Loans held for sale                                                                                                                                |       | 134,553                |       | 170,487               |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Loans receivable, net of deferred fees and  costs                                                                                                  |       | 1,086,531              |       | 1,039,684             |       |
| Allowance for loan losses                                                                                                                          |       | (13,257                | )          | (11,641               | )          |
|                                                                                                                                               |       |                   |       |                  |       |
| Loans receivable, net                                                                                                                              |       | 1,073,274              |       | 1,028,043             |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Premises and equipment, net                                                                                                                        |       | 16,995                 |       | 18,463                |       |
| Deferred tax asset                                                                                                                                 |       | 7,701                  |       | 6,638                 |       |
| Goodwill and intangibles, net                                                                                                                      |       | 14,232                 |       | 17,239                |       |
| Bank-owned life insurance                                                                                                                          |       | 33,056                 |       | 32,316                |       |
| Accrued interest receivable and other  assets                                                                                                      |       | 14,377                 |       | 15,290                |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Total assets                                                                                                                                       |       | $                      | 1,638,192  |                  | $          | 1,690,031 |   |
|                                                                                                                                               |       |                   |       |                  |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                     |       |                   |       |                  |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Noninterest bearing deposits                                                                                                                       |       | $                      | 147,499    |                  | $          | 123,994 |   |
| Interest bearing deposits                                                                                                                          |       | 938,065                |       | 972,931               |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Total deposits                                                                                                                                     |       | 1,085,564              |       | 1,096,925             |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Other borrowed funds                                                                                                                               |       | 374,007                |       | 400,060               |       |
| Mortgage funding checks                                                                                                                            |       | 7,293                  |       | 9,403                 |       |
| Escrow liabilities                                                                                                                                 |       | 1,250                  |       | 1,016                 |       |
| Accrued interest payable and other  liabilities                                                                                                    |       | 15,538                 |       | 23,164                |       |
|                                                                                                                                               |       |                   |       |                  |       |
| Total liabilities                                                                                                                                  |       | 1,483,652              |       | 1,530,568             |       |
|                                                                                                                                               |       |                   |       |                  |       |
|                                                                                                                                               |       | **2008**               |       | **2007**              |       |   |   |   |   |
| Common stock, $1 par value                                                                                                                         |       |                   |       |                  |       |   |   |   |   |
| Shares authorized                                                                                                                                  |       | 50,000,000             |       | 50,000,000            |       |   |   |   |   |
| Shares issued and outstanding                                                                                                                      |       | 24,103,690             |       | 24,201,561            |       | 24,104 |   | 24,202 |   |
| Additional paid-in capital                                                                                                                         |       |                   |       |                  |       | 131,040 |   | 131,516 |   |
| Retained earnings                                                                                                                                  |       |                   |       |                  |       | 1,899 |   | 4,213 |   |
| Accumulated other comprehensive loss, net                                                                                                          |       |                   |       |                  |       | (2,503 | ) | (468 | ) |
|                                                                                                                                               |       |                   |       |                  |       |   |   |   |   |
| Total shareholders’ equity                                                                                                                    |       |                   |       |                  |       | 154,540 |   | 159,463 |   |
|                                                                                                                                               |       |                   |       |                  |       |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                                                    |       |                   |       |                  |       | $ | 1,638,192 |   | $ | 1,690,031 |   |
|                                                                                                                                                    |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATED STATEMENTS OFINCOME

 

Three and nine months ended September 30, 2008 and 2007

(In thousands, except share data)

(Unaudited)

 
| ** **                                                     | ** ** | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                   | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest income:                                               |       |                                       |       |                                      |       |   |   |   |   |
| Loans receivable                                               |       | $                                          | 16,130     |                                      | $          | 16,551 |   | $ | 48,497 |   | $ | 46,568 |   |
| Loans held for sale                                            |       | 1,709                                      |       | 4,256                                     |       | 5,792 |   | 13,954 |   |
| Federal funds sold                                             |       | 118                                        |       | 70                                        |       | 433 |   | 1,220 |   |
| Investment securities available-for-sale                       |       | 3,295                                      |       | 3,606                                     |       | 10,050 |   | 9,496 |   |
| Investment securities held-to-maturity                         |       | 586                                        |       | 896                                       |       | 1,963 |   | 2,858 |   |
| Other investments                                              |       | 113                                        |       | 166                                       |       | 548 |   | 442 |   |
| Total interest income                                          |       | 21,951                                     |       | 25,545                                    |       | 67,283 |   | 74,538 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense:                                              |       |                                       |       |                                      |       |   |   |   |   |
| Deposits                                                       |       | 7,244                                      |       | 11,378                                    |       | 24,451 |   | 35,188 |   |
| Other borrowed funds                                           |       | 3,427                                      |       | 3,834                                     |       | 10,172 |   | 8,949 |   |
| Total interest expense                                         |       | 10,671                                     |       | 15,212                                    |       | 34,623 |   | 44,137 |   |
| Net interest income                                            |       | 11,280                                     |       | 10,333                                    |       | 32,660 |   | 30,401 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Provision for loan losses                                      |       | 1,645                                      |       | 915                                       |       | 2,734 |   | 1,670 |   |
| Net interest income after provision for  loan losses           |       | 9,635                                      |       | 9,418                                     |       | 29,926 |   | 28,731 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Noninterest income:                                            |       |                                       |       |                                      |       |   |   |   |   |
| Service charges on deposit accounts                            |       | 522                                        |       | 505                                       |       | 1,584 |   | 1,472 |   |
| Loan service charges                                           |       | 365                                        |       | 365                                       |       | 1,029 |   | 1,187 |   |
| Investment fee income                                          |       | 893                                        |       | 1,101                                     |       | 2,715 |   | 3,236 |   |
| Realized and unrealized gains on mortgage  banking activities  |       | 1,985                                      |       | 2,093                                     |       | 5,878 |   | 7,157 |   |
| Net realized gain on investment securities  available-for-sale |       | 306                                        |       | —                                    |       | 539 |   | 14 |   |
| Net realized loss on investment securities  trading            |       | —                                     |       | —                                    |       | (9 | ) | (11 | ) |
| Management fee income                                          |       | 204                                        |       | 229                                       |       | 590 |   | 899 |   |
| Litigation recovery on previously impaired  investment         |       | —                                     |       | 17                                        |       | 190 |   | 83 |   |
| Other income                                                   |       | 120                                        |       | 433                                       |       | 866 |   | 1,324 |   |
| Total noninterest income                                       |       | 4,395                                      |       | 4,743                                     |       | 13,382 |   | 15,361 |   |
|                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Noninterest expense:                                           |       |                                       |       |                                      |       |   |   |   |   |
| Salary and benefits                                            |       | 5,754                                      |       | 5,592                                     |       | 17,250 |   | 18,237 |   |
| Occupancy                                                      |       | 1,429                                      |       | 1,362                                     |       | 4,205 |   | 3,989 |   |
| Professional fees                                              |       | 489                                        |       | 770                                       |       | 1,687 |   | 1,686 |   |
| Depreciation                                                   |       | 583                                        |       | 748                                       |       | 1,821 |   | 2,345 |   |
| Data processing                                                |       | 402                                        |       | 345                                       |       | 1,257 |   | 1,044 |   |
| Telecommunications                                             |       | 256                                        |       | 278                                       |       | 742 |   | 856 |   |
| Amortization of intangibles                                    |       | 59                                         |       | 63                                        |       | 186 |   | 190 |   |
| Impairment of Fannie Mae perpetual  preferred stock            |       | 4,408                                      |       | —                                    |       | 4,408 |   | — |   |
| Impairment of goodwill                                         |       | 2,821                                      |       | —                                    |       | 2,821 |   | — |   |
| Loss related to escrow arrangement                             |       | —                                     |       | 3,500                                     |       | — |   | 3,500 |   |
| Settlement with mortgage correspondent                         |       | —                                     |       | —                                    |       | 1,800 |   | — |   |
| Other operating expenses                                       |       | 3,055                                      |       | 2,811                                     |       | 8,541 |   | 8,293 |   |
| Total noninterest expense                                      |       | 19,256                                     |       | 15,469                                    |       | 44,718 |   | 40,140 |   |
| Net income (loss) before income taxes                          |       | (5,226                                     | )          | (1,308                                    | )          | (1,410 | ) | 3,952 |   |
| Provision for income taxes                                     |       | (816                                       | )          | (702                                      | )          | 84 |   | 851 |   |
| Net income (loss)                                              |       | $                                          | (4,410     | )                                         | $          | (606 | ) | $ | (1,494 | ) | $ | 3,101 |   |
| Earnings (loss) per common share - basic                       |       | $                                          | (0.18      | )                                         | $          | (0.02 | ) | $ | (0.06 | ) | $ | 0.13 |   |
| Earnings (loss) per common share - diluted                     |       | $                                          | (0.18      | )                                         | $          | (0.02 | ) | $ | (0.06 | ) | $ | 0.12 |   |
| Weighted-average common shares outstanding  - basic            |       | 24,327,751                                 |       | 24,253,187                                |       | 24,393,167 |   | 24,424,037 |   |
| Weighted-average common shares outstanding  - diluted          |       | 24,327,751                                 |       | 24,253,187                                |       | 24,393,167 |   | 24,900,401 |   |

 

See accompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCOMPREHENSIVE INCOME (LOSS)

Three and nine months ended September 30, 2008 and 2007

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                                                                                                                                                                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                    | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                                                                                                                                                                                                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income (loss)                                                                                                                                                                                                                                                                                                             |       | $                                                        | (4,410     | )                                                       | $          | (606 | ) | $ | (1,494 | ) | $ | 3,101 |   |
| Other comprehensive income (loss):                                                                                                                                                                                                                                                                                            |       |                                                     |       |                                                    |       |   |   |   |   |
| Unrealized gain (loss) on  available-for-sale investment securities:                                                                                                                                                                                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Unrealized holding gain (loss) arising  during the period, net of tax benefit of $447,000 and $1.2 million for the  three and nine months ended September 30, 2008, respectively and tax  expense of $1.2 million and $163,000 for the three and nine months ended  September 30, 2007, respectively                |       | (643                                                     | )          | 2,230                                                   |       | (1,902 | ) | 307 |   |
|                                                                                                                                                                                                                                                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Less: reclassification adjustment for gains  included in net income net of tax expense of $104,000 and $184,000 for the  three and nine months ended September 30, 2008, respectively and $5,000  for the nine months ended September 30, 2007                                                                      |       | (202                                                     | )          | —                                                  |       | (355 | ) | (9 | ) |
|                                                                                                                                                                                                                                                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
|                                                                                                                                                                                                                                                                                                                          |       | (845                                                     | )          | 2,230                                                   |       | (2,257 | ) | 298 |   |
| Unrealized gain (loss) on derivative  instruments designated as cash flow hedges, net of tax expense of $250,000  and $135,000 for the three and nine months ended September 30, 2008,  respectively and tax benefit of $106,000 and $218,000 for the three and nine  months ended September 30, 2007, respectively |       | 429                                                      |       | (191                                                    | )          | 222 |   | (393 | ) |
|                                                                                                                                                                                                                                                                                                                          |       |                                                     |       |                                                    |       |   |   |   |   |
| Comprehensive income (loss)                                                                                                                                                                                                                                                                                                   |       | $                                                        | (4,826     | )                                                       | $          | 1,433 |   | $ | (3,529 | ) | $ | 3,006 |   |

 

See accompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCHANGES IN SHAREHOLDERS’ EQUITY

Nine months ended September 30, 2008 and 2007

(In thousands)

(Unaudited)

 
| ** **                                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                                                  | ** ** | **Common** | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                                  | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Earnings** | ** ** | **Loss**          | ** ** | **Total**  | ** ** |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Balance, December 31, 2006                                                             |       | 24,459     |       | $          | 24,459     |           | $          | 132,985      |       | $                 | 705        |       | $          | (2,276 | ) | $ | 155,873 |   |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Stock options exercised                                                                     |       | 19         |       | 19         |       | 82             |       | —       |       | —            |       | 101        |       |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Payment of deferred compensation shares                                                     |       | —     |       | —     |       | 3              |       | —       |       | —            |       | 3          |       |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Purchase and retirement of common stock                                                     |       | (224       | )          | (224       | )          | (1,966         | )          | —       |       | —            |       | (2,190     | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Dividends on common stock of $0.03 per  share                                               |       | —     |       | —     |       | —         |       | (732         | )          | —            |       | (732       | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Change in accumulated other comprehensive  loss                                             |       | —     |       | —     |       | —         |       | —       |       | (95               | )          | (95        | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Net income                                                                                  |       | —     |       | —     |       | —         |       | 3,101        |       | —            |       | 3,101      |       |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Balance, September 30, 2007                                                            |       | 24,254     |       | $          | 24,254     |           | $          | 131,104      |       | $                 | 3,074      |       | $          | (2,371 | ) | $ | 156,061 |   |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Balance, December 31, 2007                                                             |       | 24,202     |       | $          | 24,202     |           | $          | 131,516      |       | $                 | 4,213      |       | $          | (468 | ) | $ | 159,463 |   |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Stock compensation expense, net of tax  benefits                                            |       | —     |       | —     |       | 271            |       | —       |       | —            |       | 271        |       |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Cumulative effect adjustment at  January 1, 2008 for the adoption of SFAS No. 157 |       | —     |       | —     |       | —         |       | (96          | )          | —            |       | (96        | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Stock options exercised                                                                     |       | 11         |       | 11         |       | 44             |       | —       |       | —            |       | 55         |       |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Purchase and retirement of common stock                                                     |       | (109       | )          | (109       | )          | (791           | )          | —       |       | —            |       | (900       | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Dividends on common stock of $0.03 per  share                                               |       | —     |       | —     |       | —         |       | (724         | )          | —            |       | (724       | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Change in accumulated other comprehensive  loss                                             |       | —     |       | —     |       | —         |       | —       |       | (2,035            | )          | (2,035     | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Net loss                                                                                    |       | —     |       | —     |       | —         |       | (1,494       | )          | —            |       | (1,494     | )          |
|                                                                                        |       |       |       |       |       |           |       |         |       |              |       |       |       |
| Balance, September 30, 2008                                                            |       | 24,104     |       | $          | 24,104     |           | $          | 131,040      |       | $                 | 1,899      |       | $          | (2,503 | ) | $ | 154,540 |   |

 

See accompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCASH FLOWS

Nine months ended September 30, 2008 and 2007

(In thousands)

(Unaudited)

 
| ** **                                                                                 | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash flows from operating activities:                                                      |       |       |       |       |       |
| Net income (loss)                                                                          |       | $          | (1,494     | )          | $          | 3,101 |   |
| Adjustments to reconcile net income (loss) to  net cash provided by operating activities:  |       |       |       |       |       |
| Depreciation                                                                               |       | 1,821      |       | 2,345      |       |
| Amortization of premiums, discounts and  intangibles                                       |       | 255        |       | 468        |       |
| Impairment of goodwill                                                                     |       | 2,821      |       | —     |       |
| Provision for loan losses                                                                  |       | 2,734      |       | 1,670      |       |
| Loans held for sale originated                                                             |       | (1,034,323 | )          | (1,807,962 | )          |
| Proceeds from the sale of loans held for  sale                                             |       | 1,076,135  |       | 2,009,402  |       |
| Gain on sales of loans held for sale                                                       |       | (5,878     | )          | (7,157     | )          |
| Proceeds from sale, maturity and call of  investment securities trading                    |       | 7,848      |       | 3,988      |       |
| Purchase of investment securities trading                                                  |       | (7,856     | )          | (3,999     | )          |
| Loss on sale of investments securities  trading                                            |       | 8          |       | 11         |       |
| Gain on sale of investment securities  available-for-sale                                  |       | (539       | )          | (14        | )          |
| Loss on sale of other assets                                                               |       | —     |       | 3          |       |
| Impairment of Fannie Mae perpetual  preferred stock                                        |       | 4,408      |       | —     |       |
| Increase in cash surrender value of  bank-owned life insurance                             |       | (740       | )          | (1,285     | )          |
| Stock compensation expense, net of tax  benefits                                           |       | 271        |       | 256        |       |
| Increase in accrued interest receivable,  other assets and deferred tax asset              |       | 826        |       | 803        |       |
| Increase (decrease) in accrued interest  payable, escrow liabilities and other liabilities |       | (1,209     | )          | 20,412     |       |
|                                                                                       |       |       |       |       |       |
| Net cash provided by operating activities                                                  |       | 45,088     |       | 222,042    |       |
|                                                                                       |       |       |       |       |       |
| Cash flows from investing activities:                                                      |       |       |       |       |       |
| Purchases of premises and equipment                                                        |       | (353       | )          | (1,201     | )          |
| Proceeds from sale, maturity and call of  investment securities available-for-sale         |       | 160,303    |       | 33,946     |       |
| Proceeds from sale of mortgage-backed  securities available-for-sale                       |       | 4,942      |       | —     |       |
| Proceeds from maturity and call of  investment securities held-to-maturity                 |       | 17,492     |       | 4,000      |       |
| Proceeds from sale of other investments                                                    |       | 913        |       | 3,328      |       |
| Purchase of investment securities  available-for-sale                                      |       | (110,216   | )          | (130,758   | )          |
| Purchase of mortgage-backed securities  available-for-sale                                 |       | (36,267    | )          | (32,421    | )          |
| Purchase of other investments                                                              |       | (3,547     | )          | (6,844     | )          |
| Redemptions of investment securities  available-for-sale                                   |       | 22,214     |       | 17,678     |       |
| Redemptions of investment securities  held-to-maturity                                     |       | 9,112      |       | 10,740     |       |
| Net increase in loans receivable, net of  deferred fees and costs                          |       | (46,847    | )          | (128,520   | )          |
|                                                                                       |       |       |       |       |       |
| Net cash provided by (used in) investing  activities                                       |       | 17,746     |       | (230,052   | )          |
|                                                                                       |       |       |       |       |       |
| Cash flows from financing activities:                                                      |       |       |       |       |       |
| Net decrease in deposits                                                                   |       | (11,361    | )          | (81,012    | )          |
| Net increase (decrease) in other borrowed  funds - short term                              |       | (84,595    | )          | 39,882     |       |
| Net decrease in mortgage funding checks                                                    |       | (2,110     | )          | (28,383    | )          |
| Proceeds from FHLB advances - long term                                                    |       | 90,000     |       | 115,000    |       |
| Repayments of FHLB advances - long term                                                    |       | (31,458    | )          | (27,125    | )          |
| Gain from early extinguishment of long term  FHLB advance                                  |       | (253       | )          | —     |       |
| Stock options exercised                                                                    |       | 55         |       | 101        |       |
| Purchase and retirement of common stock                                                    |       | (900       | )          | (2,190     | )          |
| Deferred compensation payments                                                             |       | —     |       | 3          |       |
| Dividends on common stock                                                                  |       | (724       | )          | (732       | )          |
|                                                                                       |       |       |       |       |       |
| Net cash provided by (used in) financing  activities                                       |       | (41,346    | )          | 15,544     |       |
|                                                                                       |       |       |       |       |       |
| Net increase in cash and cash equivalents                                                  |       | 21,488     |       | 7,534      |       |
|                                                                                       |       |       |       |       |       |
| Cash and cash equivalents at beginning of  the period                                      |       | 22,421     |       | 36,076     |       |
|                                                                                       |       |       |       |       |       |
| Cash and cash equivalents at end of the  period                                            |       | $          | 43,909     |       | $          | 43,610 |   |
|                                                                                       |       |       |       |       |       |
| **Supplemental disclosure of cash flow  information:**                                     |       |       |       |       |       |
| Cash paid during the period for interest                                                   |       | $          | 34,354     |       | $          | 43,693 |   |
| Cash paid for income taxes                                                                 |       | 4,106      |       | 3,925      |       |
|                                                                                       |       |       |       |       |       |
| **Supplemental schedule of noncash investing  and financing activities:**                  |       |       |       |       |       |
| Unsettled purchases of investment  securities available-for-sale                           |       | $          | —     |       | $          | 413 |   |

 

See accompanying notes to consolidated financial statements.

 

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CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008

(Unaudited)

 

Note 1

 

*Organization*

 

CardinalFinancial Corporation (the “Company”) is incorporated under the laws ofthe Commonwealth of Virginia as a financial holding company whose activitiesconsist of investment in its wholly-owned subsidiaries. The principal operatingsubsidiary of the Company is Cardinal Bank (the “Bank”), a state-charteredinstitution and its subsidiary, George Mason Mortgage, LLC (“George Mason”), amortgage banking company based in Fairfax, Virginia. The Company also ownsWilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an assetmanagement firm and Cardinal Wealth Services, Inc. (“CWS”), an investmentservices subsidiary.  The Bank also has atrust division, Cardinal Trust and Investment Services.

 

*Basis of Presentation*

 

Inthe opinion of management, the accompanying consolidated financial statementshave been prepared in accordance with the requirements of Regulation S-X, Article 10.Accordingly, they do not include all of the information and footnotes requiredby U.S. generally accepted accounting principles for complete financialstatements. However, all adjustments that are, in the opinion of management,necessary for a fair presentation have been included. The results of operationsfor the three and nine months ended September 30, 2008 are not necessarilyindicative of the results to be expected for the full year ending December 31,2008. The unaudited interim financial statements should be read in conjunctionwith the audited financial statements and notes to financial statements thatare included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2007.

 

**Note 2**

** **

***Stock-Based Compensation***

** **

AtSeptember 30, 2008, the Company had two stock-based employee compensationplans, the 1999 Stock Option Plan (the “Option Plan”) and the 2002 EquityCompensation Plan (the “Equity Plan”).

 

In1998, the Company adopted the Option Plan pursuant to which the Company maygrant stock options for up to 625,000 shares of the Company’s common stock toemployees and members of the Company’s and its subsidiaries’ boards ofdirectors. There were 671 shares of the Company’s common stock available forfuture grants in the Option Plan as of September 30, 2008.

 

In2002, the Company adopted the Equity Plan. The Equity Plan authorizes thegranting and award of incentive stock options, non-qualified stock options,stock appreciation rights, restricted stock awards, phantom stock awards andperformance share awards to directors, eligible officers and key employees ofthe Company.  The Equity Plan currentlyauthorizes grants and awards with respect to 2,420,000 shares of the Company’scommon stock.  There were 227,908 sharesof the Company’s common stock available for future grants and awards in theEquity Plan as of September 30, 2008.

 

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Stockoptions are granted with an exercise price equal to the common stock’s fairmarket value at the date of grant. Director stock options have ten year termsand vest and become fully exercisable at the grant date. Certain employee stockoptions have ten year terms and vest and become fully exercisable after threeyears. Other employee stock options have ten year terms and vest and becomefully exercisable in 20% increments beginning as of the grant date. Inaddition, the Company has granted stock options to employees of the Companythat have ten year terms and vest and become fully exercisable in 20%increments beginning after their first year of service. During 2005, certainstock options granted to employees had ten year terms and vested and becamefully exercisable immediately.

 

TheCompany has only made awards of stock options under the Option Plan and theEquity Plan.

 

Totalexpense related to the Company’s share-based compensation plans for the threemonths ended September 30, 2008 and 2007 were $73,000 and $77,000,respectively. Total stock compensation expense, net of tax benefits for thenine months ended September 30, 2008 and 2007 were $271,000 and $256,000,respectively.  The total income taxbenefit recognized in the income statement for share-based compensationarrangements were $25,000 and $27,000 for the three months ended September 30,2008 and 2007, respectively.  For thenine months ended September 30, 2008 and 2007, the total income taxbenefit recognized in the income statement for share-based compensation were$92,000 and $90,000, respectively.

 

Optionsgranted for the three and nine months ended September 30, 2008 were 1,000and 17,200, respectively. There were no options granted during the three monthsended September 30, 2007.  For thenine months ended September 30, 2007, options granted were 500.  The weighted average per share fair values ofstock option grants during the three and nine months ended September 30,2008 were $3.52 and $3.10, respectively. The weighted average per share fair values of stock option grants madefor the nine months ended September 30, 2007 was $4.89.  The fair values of the options granted duringall periods for 2008 and 2007 were estimated as of the grant date using theBlack-Scholes option-pricing model based on the following weighted averageassumptions:

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                     |       |                                                 |       |                                                |       |   |   |   |   |
| Estimated  option life   |       | 6.5 years                                            |       | —                                              |       | 6.5 years |   | 6.5 years |   |
| Risk  free interest rate |       | 3.77                                                 | %          | —                                              |       | 3.44 - 3.77 | % | 4.81 | % |
| Expected  volatility     |       | 40.50                                                | %          | —                                              |       | 40.50 | % | 42.10 | % |
| Expected  dividend yield |       | 0.56                                                 | %          | —                                              |       | 0.56 | % | 0.40 | % |

 

Expectedvolatility is based upon the average annual historical volatility of theCompany’s common stock. The estimated option life is derived from the “simplifiedmethod” formula as described in Staff Accounting Bulletin No. 110. Therisk free interest rate is based upon the five-year U.S. Treasury note rate ineffect at the time of grant.  The expected dividend yield is based uponimplied and historical dividend declarations.

 

Stockoption activity during the nine months ended September 30, 2008 issummarized as follows:

 

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| ** **                                      | ** ** | ** **         | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-------------------------------------------------|------------|--------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                      | ** ** | ** **         | ** ** | **Weighted** | ** ** | **Average**           | ** ** | **Aggregate** | ** ** |
| ** **                                      | ** ** | ** **         | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Intrinsic** | ** ** |
| ** **                                      | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Value**     | ** ** |
| ** **                                      | ** ** | **Shares**         | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **($000)**    | ** ** |
| Outstanding at December 31, 2007           |       | 2,428,353          |       | $            | 8.53       |                  |       |          |       |   |
| Granted                                         |       | 17,200             |       | 7.13         |       |                  |       |          |       |
| Exercised                                       |       | (11,570            | )          | 4.83         |       |                  |       |          |       |
| Forfeited                                       |       | (12,350            | )          | 9.93         |       |                  |       |          |       |
| Outstanding at September 30, 2008          |       | 2,421,633          |       | $            | 8.73       |                  | 5.98       |          | $          | (2,171 | ) |
| Options exercisable at September 30,  2008 |       | 2,202,383          |       | $            | 8.47       |                  | 5.79       |          | $          | (1,444 | ) |

 

Total intrinsic value of options exercised for the three and ninemonths ended September 30, 2008 were $37,000 and $38,000,respectively.  For the options exercisedduring the three and nine months ended September 30, 2007, the intrinsicvalues were $12,000 and $89,000, respectively.

 

A summary of the status of the Company’s non-vested stock options andchanges during the nine months ended September 30, 2008 is as follows:

 

| ** **                         | ** ** | ** **         | ** ** | **Weighted**        | ** ** |
|------------------------------------|------------|--------------------|------------|---------------------|------------|
| ** **                         | ** ** | ** **         | ** ** | **Average**         | ** ** |
| ** **                         | ** ** | **Number of** | ** ** | **Grant Date** | ** ** |
| ** **                         | ** ** | **Shares**         | ** ** | **Fair Value** | ** ** |
| Balance at December 31, 2007  |       | 292,028            |       | $                   | 5.30       |   |
| Granted                            |       | 17,200             |       | 3.10                |       |
| Vested                             |       | (89,878            | )          | 4.67                |       |
| Forfeited                          |       | (100               | )          | 3.05                |       |
| Balance at September 30, 2008 |       | 219,250            |       | $                   | 5.39       |   |

 

AtSeptember 30, 2008, there was $1.6 million of total unrecognizedcompensation cost related to non-vested share-based compensation arrangementsgranted under the plans. The cost is expected to be recognized over a weightedaverage period of 2.8 years. The total fair value of shares that vested duringthe three months ended September 30, 2008 and 2007 were $52,000 and$53,000, respectively. For the nine months ended September 30, 2008 and2007, the total fair value of shares that vested were $331,000 and $578,000,respectively.

 

Note 3

 

*SegmentInformation*

 

TheCompany operates in three business segments: commercial banking, mortgagebanking, and wealth management and trust services.

 

Thecommercial banking segment includes both commercial and consumer lending andprovides customers with such products as commercial loans, real estate loans,business financing and consumer loans. In addition, this segment providescustomers with several choices of deposit products including demand depositaccounts, savings accounts and certificates of deposit. The

 

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mortgagebanking segment engages primarily in the origination and acquisition ofresidential mortgages for sale into the secondary market on a best effortsbasis. The wealth management and trust services segment provides investment andfinancial advisory services to businesses and individuals, including financialplanning, retirement/estate planning, trust, estates, custody, investmentmanagement, escrows, and retirement plans.

 

Informationabout the reportable segments and reconciliation of this information to theconsolidated financial statements at and for the three and nine months ended September 30,2008 and 2007 is as follows:

 

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**At and for the Three Months Ended September 30, 2008 (inthousands):**

 
| ** **                 | ** ** | ** **     | ** ** | ** **   | ** ** | **Wealth Management** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------|------------|----------------|------------|--------------|------------|----------------------------|------------|------------|------------|------------------|------------|------------------|------------|
| ** **                 | ** ** | **Commercial** | ** ** | **Mortgage** | ** ** | **and**                    | ** ** | ** ** | ** ** | **Intersegment** | ** ** | ** **       | ** ** |
| ** **                 | ** ** | **Banking**    | ** ** | **Banking**  | ** ** | **Trust Services**    | ** ** | **Other**  | ** ** | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest income        |       | $              | 10,720     |         | $          | 837                        |       | $          | —     |             | $          | (277             | )          | $ | — |   | $ | 11,280 |   |
| Provision for loan losses  |       | 865            |       | 780          |       | —                     |       | —     |       | —           |       | 1,645            |       |
| Non-interest income        |       | 1,142          |       | 2,352        |       | 893                        |       | 8          |       | —           |       | 4,395            |       |
| Non-interest expense       |       | 12,096         |       | 5,728        |       | 859                        |       | 573        |       | —           |       | 19,256           |       |
| Provision for income taxes |       | 605            |       | (1,148       | )          | 13                         |       | (286       | )          | —           |       | (816             | )          |
| Net income (loss)          |       | $              | (1,704     | )            | $          | (2,171                     | )          | $          | 21         |             | $          | (556             | )          | $ | — |   | $ | (4,410 | ) |
|                       |       |           |       |         |       |                       |       |       |       |             |       |             |       |
| Total Assets               |       | $              | 1,615,119  |         | $          | 147,255                    |       | $          | 3,579      |             | $          | 167,788          |       | $ | (295,549 | ) | $ | 1,638,192 |   |
| Average Assets             |       | $              | 1,612,406  |         | $          | 124,567                    |       | $          | 3,589      |             | $          | 172,889          |       | $ | (292,558 | ) | $ | 1,620,893 |   |

 

**At and for the Three Months Ended September 30, 2007 (inthousands):**

 
| ** **                 | ** ** | ** **     | ** ** | ** **   | ** ** | **Wealth Management** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------|------------|----------------|------------|--------------|------------|----------------------------|------------|------------|------------|------------------|------------|------------------|------------|
| ** **                 | ** ** | **Commercial** | ** ** | **Mortgage** | ** ** | **and**                    | ** ** | ** ** | ** ** | **Intersegment** | ** ** | ** **       | ** ** |
| ** **                 | ** ** | **Banking**    | ** ** | **Banking**  | ** ** | **Trust Services**    | ** ** | **Other**  | ** ** | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest income        |       | $              | 9,969      |         | $          | 767                        |       | $          | —     |             | $          | (403             | )          | $ | — |   | $ | 10,333 |   |
| Provision for loan losses  |       | 915            |       | —       |       | —                     |       | —     |       | —           |       | 915              |       |
| Non-interest income        |       | 1,029          |       | 2,601        |       | 1,101                      |       | 12         |       | —           |       | 4,743            |       |
| Non-interest expense       |       | 7,533          |       | 2,697        |       | 4,363                      |       | 876        |       | —           |       | 15,469           |       |
| Provision for income taxes |       | 715            |       | 242          |       | (1,222                     | )          | (437       | )          | —           |       | (702             | )          |
| Net income (loss)          |       | $              | 1,835      |         | $          | 429                        |       | $          | (2,040     | )                | $          | (830             | )          | $ | — |   | $ | (606 | ) |
|                       |       |           |       |         |       |                       |       |       |       |             |       |             |       |
| Total Assets               |       | $              | 1,641,766  |         | $          | 163,896                    |       | $          | 4,152      |             | $          | 173,607          |       | $ | (305,821 | ) | $ | 1,677,600 |   |
| Average Assets             |       | $              | 1,650,498  |         | $          | 239,395                    |       | $          | 4,247      |             | $          | 173,802          |       | $ | (408,502 | ) | $ | 1,659,440 |   |

 

**At and for the Nine Months Ended September 30, 2008 (inthousands):**

 
| ** **                 | ** ** | ** **     | ** ** | ** **   | ** ** | **Wealth Management** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------|------------|----------------|------------|--------------|------------|----------------------------|------------|------------|------------|------------------|------------|------------------|------------|
| ** **                 | ** ** | **Commercial** | ** ** | **Mortgage** | ** ** | **and**                    | ** ** | ** ** | ** ** | **Intersegment** | ** ** | ** **       | ** ** |
| ** **                 | ** ** | **Banking**    | ** ** | **Banking**  | ** ** | **Trust Services**    | ** ** | **Other**  | ** ** | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest income        |       | $              | 31,110     |         | $          | 2,470                      |       | $          | —     |             | $          | (920             | )          | $ | — |   | $ | 32,660 |   |
| Provision for loan losses  |       | 1,790          |       | 944          |       | —                     |       | —     |       | —           |       | 2,734            |       |
| Non-interest income        |       | 3,565          |       | 7,075        |       | 2,715                      |       | 27         |       | —           |       | 13,382           |       |
| Non-interest expense       |       | 27,165         |       | 12,979       |       | 2,575                      |       | 1,999      |       | —           |       | 44,718           |       |
| Provision for income taxes |       | 2,528          |       | (1,512       | )          | 51                         |       | (983       | )          | —           |       | 84               |       |
| Net income (loss)          |       | $              | 3,192      |         | $          | (2,866                     | )          | $          | 89         |             | $          | (1,909           | )          | $ | — |   | $ | (1,494 | ) |
|                       |       |           |       |         |       |                       |       |       |       |             |       |             |       |
| Total Assets               |       | $              | 1,615,119  |         | $          | 147,255                    |       | $          | 3,579      |             | $          | 167,788          |       | $ | (295,549 | ) | $ | 1,638,192 |   |
| Average Assets             |       | $              | 1,628,002  |         | $          | 138,243                    |       | $          | 3,647      |             | $          | 176,287          |       | $ | (309,726 | ) | $ | 1,636,453 |   |

 

**At and for the Nine Months Ended September 30, 2007 (inthousands):**

 
| ** **                 | ** ** | ** **     | ** ** | ** **   | ** ** | **Wealth Management** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------|------------|----------------|------------|--------------|------------|----------------------------|------------|------------|------------|------------------|------------|------------------|------------|
| ** **                 | ** ** | **Commercial** | ** ** | **Mortgage** | ** ** | **and**                    | ** ** | ** ** | ** ** | **Intersegment** | ** ** | ** **       | ** ** |
| ** **                 | ** ** | **Banking**    | ** ** | **Banking**  | ** ** | **Trust Services**    | ** ** | **Other**  | ** ** | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest income        |       | $              | 29,055     |         | $          | 2,319                      |       | $          | —     |             | $          | (973             | )          | $ | — |   | $ | 30,401 |   |
| Provision for loan losses  |       | 1,670          |       | —       |       | —                     |       | —     |       | —           |       | 1,670            |       |
| Non-interest income        |       | 3,052          |       | 9,036        |       | 3,236                      |       | 37         |       | —           |       | 15,361           |       |
| Non-interest expense       |       | 22,693         |       | 9,045        |       | 6,267                      |       | 2,135      |       | —           |       | 40,140           |       |
| Provision for income taxes |       | 2,365          |       | 828          |       | (1,283                     | )          | (1,059     | )          | —           |       | 851              |       |
| Net income (loss)          |       | $              | 5,379      |         | $          | 1,482                      |       | $          | (1,748     | )                | $          | (2,012           | )          | $ | — |   | $ | 3,101 |   |
|                       |       |           |       |         |       |                       |       |       |       |             |       |             |       |
| Total Assets               |       | $              | 1,641,766  |         | $          | 163,896                    |       | $          | 4,152      |             | $          | 173,607          |       | $ | (305,821 | ) | $ | 1,677,600 |   |
| Average Assets             |       | $              | 1,628,777  |         | $          | 265,305                    |       | $          | 4,680      |             | $          | 169,925          |       | $ | (428,502 | ) | $ | 1,640,185 |   |

 

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AtSeptember 30, 2008, the Company did not have any operating segments otherthan those reported. Parent company financial information is included in the “Other”category and represents an overhead function rather than an operating segment.The parent company’s most significant assets are its net investments in itssubsidiaries. The parent company’s net interest expense is comprised ofinterest income from short-term investments and interest expense on trustpreferred securities. The parent company’s non-interest expense is primarilynon-allocable executive salaries and professional services related to theCompany’s regulatory requirements.

 

Note 4

 

*EarningsPer Share*

 

Thefollowing is the calculation of basic and diluted earnings (loss) per share forthe three and nine months ended September 30, 2008 and 2007. Stock optionsissued that were not included in the calculation of diluted earnings per sharebecause the exercise prices were greater than the average market price were238,880 and 81,359 for the three months ended September 30, 2008 and 2007,respectively. For the nine months ended September 30, 2008 and 2007, stockoptions issued that were excluded in the diluted earnings per share calculationbecause the exercise prices were greater than the average market price were234,503 and 54,887, respectively.

 
| **(In thousands,**                             | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| **except per share data)**           | ** ** | **2008**               | ** ** | **2007**               | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                |       |                   |       |                   |       |   |   |   |   |
| Net income (loss) available to common  shareholders |       | $                      | (4,410     | )                      | $          | (606 | ) | $ | (1,494 | ) | $ | 3,101 |   |
|                                                |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares - basic              |       | 24,328                 |       | 24,253                 |       | 24,393 |   | 24,424 |   |
|                                                |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares - diluted            |       | 24,328                 |       | 24,253                 |       | 24,393 |   | 24,900 |   |
|                                                |       |                   |       |                   |       |   |   |   |   |
| Earnings (loss) per common share - basic            |       | $                      | (0.18      | )                      | $          | (0.02 | ) | $ | (0.06 | ) | $ | 0.13 |   |
|                                                |       |                   |       |                   |       |   |   |   |   |
| Earnings (loss) per common share - diluted          |       | $                      | (0.18      | )                      | $          | (0.02 | ) | $ | (0.06 | ) | $ | 0.12 |   |

 

Basicearnings (loss) per share is impacted by the number of shares required to beissued under the Company’s various deferred compensation plans, and dilutedearnings per share is impacted by those common shares which may be, but are notrequired to be, issued (depending on the elections of the participants) underthese plans.

 

Thefollowing shows the composition of basic outstanding shares for the three andnine months ended September 30, 2008 and 2007:

 

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| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands)**                                                  | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Weighted average common shares outstanding                               |       | 24,105                                               |       | 24,253                                              |       | 24,146 |   | 24,369 |   |
| Weighted average shares attributable to the  deferred compensation plans |       | 223                                                  |       | —                                              |       | 247 |   | 55 |   |
| Total weighted average shares - basic                                    |       | 24,328                                               |       | 24,253                                              |       | 24,393 |   | 24,424 |   |

 

Thefollowing shows the composition of diluted outstanding shares for the three andnine months ended September 30, 2008 and 2007:

 
| ** **                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(in thousands)**                                                          | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Weighted average shares outstanding - basic  (from above)                        |       | 24,328                                               |       | 24,253                                              |       | 24,393 |   | 24,424 |   |
| Incremental weighted average shares  attributable to deferred compensation plans |       | —                                               |       | —                                              |       | — |   | 210 |   |
| Weighted average shares attributable to  vested stock options                    |       | —                                               |       | —                                              |       | — |   | 266 |   |
| Incremental shares attributable to unvested  stock options                       |       | —                                               |       | —                                              |       | — |   | — |   |
| Total weighted average shares - diluted                                          |       | 24,328                                               |       | 24,253                                              |       | 24,393 |   | 24,900 |   |

 

Note 5

 

*DerivativeInstruments and Hedging Activities*

 

TheCompany is a party to forward loan sales contracts, which are utilized tomitigate exposure to fluctuations in interest rates related to closed loansthat are held for sale.

 

TheCompany designates these derivatives as cash flow hedges in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 133, *Accounting for Derivative Instruments and Hedging Activities*,as amended. These hedges are recorded at fair value in the statement ofcondition as an other asset or other liability with a corresponding offset toaccumulated other comprehensive loss in shareholders’ equity. Amounts arereclassified from accumulated other comprehensive loss to the income statementin the period or periods that the loan sale is reflected in income.

 

AtSeptember 30, 2008, accumulated other comprehensive loss included anafter-tax unrealized gain of $45,127 related to forward loan sales contracts.Loans held for sale are generally sold within sixty days of closing and,therefore, substantially all of the amount recorded in accumulated othercomprehensive loss at September 30, 2008 that is related to the Company’scash flow hedges will be recognized in earnings during the fourth quarter of2008. For the three and nine months ended September 30, 2008, the hedgeineffectiveness recorded through earnings was immaterial.

 

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AtSeptember 30, 2008, the Company had $75.9 million in loan commitments andassociated forward sales and had $96.8 million in forward sales associated with$96.8 million of loans held for sale. Loans held for sale that are classifiedas construction-to-permanent total $41.8 million at September 30, 2008 andare not sold forward until the construction phase has been completed.  At September 30, 2008, the fair value ofthe derivative asset was $3.3 million and the derivative liability was $2.3million.

 

TheCompany has interest rate swaps to mitigate its exposure to interest rate riskfor certain loans receivable.  Inaddition, the Company has an interest rate swap for $5.0 million of the $20.0million it has in its trust preferred security issuance.  At September 30, 2008, accumulated othercomprehensive loss included an after-tax unrealized gain of $107,000 related tothese interest rate swaps.  For the threeand nine months ended September 30, 2008, the hedge ineffectivenessrecorded through earnings was immaterial.

 

Note 6

 

*Goodwill and Other Intangibles*

 

Informationconcerning total amortizable other intangible assets at September 30, 2008is as follows:

 
| ** **                         | ** ** | **Mortgage Banking**   | ** ** | **Wealth Management  and Trust Services** | ** ** | **Total**                   | ** ** |
|------------------------------------|------------|-----------------------------|------------|----------------------------------------------------------|------------|-----------------------------|------------|
| **(In thousands)**            | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization**                            | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Balance at December 31, 2007  |       | $                           | 1,781      |                                                     | $          | 643                         |       | $ | 795 |   | $ | 489 |   | $ | 2,576 |   | $ | 1,132 |   |
| 2008 activity:                     |       |                        |       |                                                     |       |                        |       |   |   |   |   |   |   |
| Customer relationship intangibles  |       | —                      |       | 148                                                      |       | —                      |       | 31 |   | — |   | 179 |   |
| Trade name                         |       | —                      |       | —                                                   |       | —                      |       | 7 |   | — |   | 7 |   |
| Balance at September 30, 2008 |       | $                           | 1,781      |                                                     | $          | 791                         |       | $ | 795 |   | $ | 527 |   | $ | 2,576 |   | $ | 1,318 |   |

 

Theaggregate amortization expense was $59,000 and $63,000 for the three monthsended September 30, 2008 and 2007, respectively.    For the nine months ended September 30,2008 and 2007, the aggregate amortization expense was $186,000 and $190,000,respectively.

 

Theestimated amortization expense for the next five years is as follows:

 

| ** **                          | ** ** | **(In thousands)** | ** ** |
|-------------------------------------|------------|-------------------------|------------|
| 2008 (October – December) |       | $                       | 60         |   |
| 2009                                |       | 238                     |       |
| 2010                                |       | 238                     |       |
| 2011                                |       | 238                     |       |
| 2012                                |       | 238                     |       |
| 2013 and thereafter                 |       | 246                     |       |
|                                     |            |                         |            |  |

 

Thecarrying amount of goodwill at September 30, 2008 was as follows:

 

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| **(In thousands)**       | ** ** | **Commercial  Banking** | ** ** | **Mortgage  Banking** | ** ** | **Wealth  Management  and Trust  Services** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------|------------|--------------------------------------------------|------------|-----------|------------|
| Balance at December 31, 2007  |       | $                       | 22         |                  | $          | 12,941                                           |       | $         | 2,832      |   | $ | 15,795 |   |
| Goodwill impairment charge    |       | —                  |       | (2,821                | )          | —                                           |       | (2,821    | )          |
| Balance at September 30, 2008 |       | $                       | 22         |                  | $          | 10,120                                           |       | $         | 2,832      |   | $ | 12,974 |   |

 

Goodwillof each of the Company’s business segments is tested for impairment on anannual basis or more frequently if events or circumstances warrant. During theperiod ended September 30, 2008, the Company performed an evaluation ofthe goodwill associated with its acquisition of George Mason, which is includedin the mortgage banking segment. Goodwill of $12.9 million was recognized as a result of thisacquisition.  During the third quarter of2008, the Company employed the services of a valuation consultant to assistwith the goodwill evaluation.  Theanalysis included certain valuation techniques, including a discounted cashflow approach.  Following the acquisitiondate, George Mason has delivered excellent financial results and returns on theCompany’s investment.  Recent and ongoingchallenges in the regional residential real estate market have negativelyimpacted the cash flows expected to be generated by George Mason in the nearterm.  The valuation analysis indicatedthat goodwill was impaired and the Company recorded a non-cash impairmentcharge of $2.8 million in the mortgage banking segment.

 

Note 7

 

*Commitments and Contingencies*

 

TheCompany is a party to financial instruments with off-balance sheet risk in thenormal course of business to meet the financing needs of its customers. Thesefinancial instruments include commitments to extend credit and standby lettersof credit and financial guarantees. Commitments to extend credit are agreementsto lend to a customer so long as there is no violation of any condition establishedin the contract.  Commitments generallyhave fixed expiration dates up to one year or other termination clauses and mayrequire payment of a fee.  Since many ofthe commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future funding requirements.

 

Standbyletters of credit are conditional commitments issued by the Company toguarantee the performance of the contractual obligations by a customer to athird party.  The majority of these guaranteesextend until satisfactory completion of the customer’s contractualobligations.  These instruments representobligations of the Company to extend credit or guarantee borrowings and are notrecorded on the consolidated statements of financial condition.  The rates and terms of these instruments arecompetitive with others in the market in which the Company operates.  The Company uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance-sheetinstruments.  The Company evaluates eachcustomer’s creditworthiness on a case-by-case basis and requires collateral tosupport financial instruments when deemed necessary.  The amount of collateral obtained uponextension of credit is based on management’s evaluation of thecounterparty.  Collateral held varies butmay include deposits held by the Company, marketable securities, accountsreceivable, inventory, property, plant and equipment, and income-producingcommercial properties.

 

AtSeptember 30, 2008, commitments to extend credit were $431.0 million andstandby letters of credit were $9.7 million. The Company has a liability of$11,000 associated with standby letters of credit at September 30, 2008.The majority of standby letters of credit outstanding at

 

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September 30,2008 are collateralized.  Commitments toextend credit of $73.1 million as of September 30, 2008 are related toGeorge Mason’s pipeline and are of a short term nature.

 

Thoseinstruments may involve, to varying degrees, elements of credit and interestrate risk in excess of the amount recognized in the consolidated statements offinancial condition.  Credit risk isdefined as the possibility of sustaining a loss because the other parties to afinancial instrument fail to perform in accordance with the terms of thecontract.  The Company’s maximum exposureto credit loss under standby letters of credit and commitments to extend creditis represented by the contractual amounts of those instruments.

 

GeorgeMason maintains a reserve for loans sold that pay off earlier than thecontractual agreed upon period, thereby requiring that George Mason refund partof the service release premium and/or premium pricing received from theinvestor.  The reserve as of September 30,2008 was $14,000.

 

GeorgeMason has a reserve for its estimated exposure to repurchase loans previouslysold to investors for which borrowers failed to provide full and accurateinformation on their loan application or for which appraisals have not beenacceptable.  In addition, George Mason,as part of the service it provides to its managed companies, purchases theloans managed companies originate at the time of origination.  These loans are then sold by George Mason toinvestors.  George Mason has agreementswith its managed companies requiring that, for any loans that were originatedby a managed company and for which investors have requested George Mason torepurchase due to the borrowers failure to provide full and accurateinformation on or related to their loan application or for which appraisalshave not been acceptable, the managed company be responsible for buying backthe loan.  In the event that the managedcompany’s financial condition deteriorates and it is unable to fund therepurchase of such loans, George Mason may have to provide the funds torepurchase these loans from investors.

 

Duringthe second quarter of 2008, George Mason entered into an agreement with amortgage correspondent related to the loan purchase agreement between the twoparties.  This agreement provided for therelease of known and unknown claims by the mortgage correspondent in exchangefor a $2.8 million payment to the correspondent.  The terms of this agreement require that theCompany may be obligated to make additional payments to the correspondent infuture periods based on certain conditions. The Company believes the additional exposure under this agreement is notmaterial as over the course of the next two years there is a potential paymentof no more than $0.03 diluted earnings per share in total.  The amount of this potential exposuredeclines with the passage of time.  Inconjunction with the agreement, George Mason entered into similar agreementswith certain managed companies, from which George Mason purchased loans andsubsequently sold to this mortgage correspondent.  These settlement agreements provided for atotal payment of $1.0 million to George Mason by those managed companies ofwhich $550,000 has already been paid.

 

GeorgeMason’s reserve for possible loan repurchases was $562,000 at September 30,2008.

 

TheCompany has counter-party risk that may arise from the possible inability ofGeorge Mason’s third party investors to meet the terms of their forward salescontracts.  George Mason works withthird-party investors that are generally well-capitalized, are investment gradeand exhibit strong financial performance to mitigate this risk.  The Company does not expect any third-partyinvestor to fail to meet its obligation. In addition, the Company has derivative counterparty risk relating tocertain interest rate swaps it has with a third party.  This risk may arise from the inability of thethird party to meet the terms of the contracts. The Company monitors the financial condition of this third party on anannual basis.  The Company does notexpect this third party to fail to meet its obligation.

 

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Note8

 

*FairValue Measurements*

* *

EffectiveJanuary 1, 2008, the Company adopted SFAS No. 157, *Fair Value Measurements,*which established a framework formeasuring fair value in accordance with U.S. generally accepted accountingprinciples, and expands disclosures about fair value measurements.  In addition, the Company adopted SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities – including an amendment of FAS 115. *SFAS No. 159 allows entitiesto choose, at specified election dates, to measure eligible financial assetsand liabilities at fair value that are not otherwise required to be measured atfair value.

 

SFASNo. 157 defines fair value as the exchange price that would be receivedfor an asset or paid to transfer a liability (an exit price) in the principalor most advantageous market for the asset or liability in an orderlytransaction between market participants on the measurement date.  SFAS No. 157 also establishes a fairvalue hierarchy which requires an entity to maximize the use of observableinputs and minimize the use of unobservable inputs when measuring the fairvalue.  There are three levels of inputsthat may be used to measure fair value:

 

Level1 – Quoted prices in active markets for identical assets or liabilities as ofthe measurement date.

 

Level2 – Quoted prices for similar instruments in active markets; quoted prices foridentical or similar instruments in markets that are not active; andmodel-derived valuations in which all significant inputs and significant valuedrivers are observable in active markets.

 

Level3 – Valuations derived from valuation techniques in which one or moresignificant inputs or significant value drivers are unobservable.

 

Uponadoption or at any point during the nine months ended September 30, 2008,the Company did not designate any asset or liability to be measured at fairvalue under SFAS No. 159.

 

FairValue of Investment Securities Available-for-Sale and Interest Rate SwapDerivatives

 

TheCompany’s investment securities available-for-sale are recorded at fair valueusing reliable and unbiased evaluations by an industry-wide valuation serviceand therefore fall into the Level 2 category. This service uses evaluated pricing models that vary based on assetclass and include available trade, bid, and other market information.  Generally, the methodology includes brokerquotes, proprietary models, vast descriptive terms and conditions databases, aswell as extensive quality control programs.

 

TheCompany’s interest rate swap derivatives are recorded at fair value usingobservable rates from a national valuation service.  These rates are applied to a third partyindustry-wide valuation model, and therefore, the valuations fall into a Level2 category.

 

Informationpertaining to the Company’s investment securities available-for-sale portfolioand interest rate swap derivatives as of September 30, 2008 is shownbelow:

 

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**At September 30, 2008 (in thousands)**

 
| ** **                                 | ** ** | ** **  | ** ** | **Fair Value Measurements Using**                                                    | ** ** |
|--------------------------------------------|------------|-------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Description**                            | ** ** | **Balance** | ** ** | **Quoted Prices in  Active markets for  Identical Assets  (Level 1)** | ** ** | **Significant  Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
| Investment securities available-for-sale   |       | $           | 231,044    |                                                                                                |       |   | $ | 231,044 |   |   |   |
| Derivative asset - interest rate swaps     |       | 837         |       |                                                                                                |       | 837 |   |   |   |
| Derivative liability - interest rate swaps |       | 725         |       |                                                                                                |       | 725 |   |   |   |
|                                            |            |             |            |                                                                                                     |            |  |  |  |  |  |  |

 

FairValue of Interest Rate Lock Commitments, Forward Loan Sales and Mortgage LoansHeld for Sale

 

Inthe normal course of business, George Mason enters into contractual interestrate lock commitments to extend credit to borrowers with fixed expirationdates.  The commitments become effectivewhen the borrowers “lock-in” a specified interest rate within the time framesestablished by George Mason.  Allborrowers are evaluated for credit worthiness prior to the extension of thecommitment.  Market risk arises ifinterest rates move adversely between the time of the interest rate lock by theborrower and the sale date of the loan to an investor.  To mitigate the effect of the interest raterisk inherent in providing rate lock commitments to borrowers, George Masonenters into best efforts forward sales contracts to sell loans toinvestors.  The forward sales contractslock in an interest rate and price for the sale of loans similar to thespecific rate lock commitments.  Both therate lock commitments to the borrowers and the forward sales contracts toinvestors are undesignated derivatives pursuant to the requirements of SFAS No. 133*,*and, accordingly, are marked to fair value throughearnings.

 

StaffAccounting Bulletin No. 109, *Written Loan CommitmentsRecorded at Fair Value Through Earnings,* (“SAB No. 109”) waseffective for written loan commitments initiated on or after January 1,2008.  SAB No. 109 requires that theexpected cash flows related to the servicing of a loan be included in the fairvalue measurement of a derivative loan commitment.  SAB No. 109 replaces Staff AccountingBulletin No. 105, *Application of AccountingPrinciples to Loan Commitments,*which precluded the consideration ofservicing cash flows in determining the fair value of a written loancommitment.

 

Theeffects of fair value measurements for the interest rate lock commitmentderivatives and forward sales contract derivatives on earnings in the ninemonths ended September 30, 2008 were as follows and were all based onLevel 2 inputs:

 
| **(in thousands)** | ** ** | **Notional  or  Principal  Amount** | ** ** | **Expected  Premium  (Discount)  to Par** | ** ** | **Movement  of Interest  Rates** | ** ** | **Security  Price  Change** | ** ** | **Total Fair  Value  Adjustment** | ** ** |
|-------------------------|------------|-------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|
| Rate lock commitments   |       | $                                   | 73,094     |                                           | $          | 475                                   |       | $                           | 369        |                                   | $          | — |   | $ | 844 |   |
| Forward sales contracts |       | 123,711                             |       | —                                         |       | —                                |       | (172                        | )          | (172                                   | )          |
| Loans held for sale     |       | 50,617                              |       | 520                                            |       | (197                                  | )          | —                      |       | 323                                    |       |
|                    |       |                                |       | $                                              | 995        |                                  | $          | 172                         |       | $                                      | (172       | ) | $ | 995 |   |
|                         |            |                                     |            |                                                |            |                                       |            |                             |            |                                        |            |  |  |  |  |  |

 

Theexpected premium (discount) to par considers two elements (a) the interestrate differential and (b) the servicing rights value.  The interest rate differential is thedifference, if any, between

 

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themortgage loan rates to be paid by the borrower in the retail market andmortgage loan pricing demanded by investors in the secondary or wholesalemarket.  The Company sells all of itsloans on a servicing released basis, and receives a servicing release premiumupon sale.  The servicing rights value isbased on contractual terms with investors and ranged from 0.17% to 2.75% of theloan amount, depending on the loan type. The Company assumes an approximate 40% fallout rate based on recent historicalexperience when measuring the fair value of the rate lock commitments.  Fallout is defined as interest rate lockcommitments for which the Company does not close a mortgage loan.

 

Thefair value of the forward sales contracts to investors considers the marketprice movement of the same type of security between the trade date and thebalance sheet date.  The market pricechanges are multiplied by the notional amount of the forward sales contracts tomeasure the fair value.

 

Tocalculate the effects of the changes in interest rates from the date of thecommitment through loan origination, and then period end, the Company utilizesapplicable published mortgage-backed investment security prices, and multipliesthe price movement between the rate lock date and the balance sheet date by thenotional loan commitment amount.

 

Atloan closing, the fair value of the interest rate lock commitment is includedin the cost basis of loans held for sale. Loans held for sale are carried at the lower of cost or fair value.

 

Priorto the adoption of SAB No. 109 and SFAS No. 157, the fair valuecalculation for interest rate lock commitments and forward sales contracts onlyconsidered the effects of interest rate changes between the date of the ratelock and either the loan closing date or the balance sheet date.  For the three months ended September 30,2008, the change in fair value of the interest rate lock commitments, loansheld for sale, and forward loan sales contracts based only on changes in marketinterest rates was $172,000.   Interestrate movements have an offsetting impact on the security prices that serve tomeasure the fair value of these instruments.

 

SFASNo. 157 Adoption Adjustment

 

Thetransition provisions of SFAS No. 157 provide for retrospective applicationto financial instruments that were measured at fair value at initialrecognition using a transaction pricing in accordance with specific accountingliterature.  The Company’s interest ratelock commitments were measured at inception at the transaction price.  SFAS No. 157 provides that at the dateof adoption (January 1, 2008) a difference between the carrying amountsand the fair values of these instruments should be recognized as a cumulativeeffect adjustment to the opening balance of retained earnings.  The amount of this cumulative effectadjustment was $96,000.

 

ManagedCompany Loans

 

George Mason serves as apass through conduit for the managed companies to sell loans to investors onthe secondary market.  Concurrent withentering into a rate lock agreement with a borrower, the managed company loanis sold forward to an investor in the secondary market.  After the managed company closes the loan, itis assigned to George Mason.  GeorgeMason then facilitates the transfer of the loan to the investor.  George Mason does not earn any spread orother fees from the loan assignment nor from the transfer to the investor.  All gains in the loan sale are earned by themanaged company.  At September 30,2008, loans held for sale includes $46.3 million of loans originated by themanaged companies that will be delivered to the investors by George Mason.  Any change in the fair value of the loansheld for sale originated by the managed company will result in an equal andoffsetting change in liability to the managed company.

 

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Note9

 

*Other-Than-TemporaryImpairment*

* *

For the three months ended September 30,2008, the Company recorded a one-time noncash other-than-temporary impairmentcharge of $4.4 million as a result of its investment in Fannie Mae perpetualpreferred stock.  This impairment charge,net of tax, was $4.0 million.  The taxbenefit recognized on the other-than-temporary impairment charge was based onthe treatment of the impairment as a capital loss, which limited the taxbenefit recorded.  Subsequently, on October 3,2008, the Emergency Economic Stabilization Act was enacted which includes aprovision permitting banks to recognize the other-than-temporary impairmentcharge related to Fannie Mae perpetual preferred stock as an ordinary losswhich will allow the Company to recognize an additional tax benefit for thisloss in the fourth quarter of 2008 in the amount of $1.1 million.  This noncash impairment charge was recordedin the commercial banking segment.

 

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

** **

Thefollowing presents management’s discussion and analysis of our consolidatedfinancial condition at September 30, 2008 and December 31, 2007 andthe unaudited results of our operations for the three and nine months ended September 30,2008 and 2007. This discussion should be read in conjunction with our unauditedconsolidated financial statements and the notes thereto appearing elsewhere inthis report and the audited consolidated financial statements and the notes toconsolidated financial statements included in our Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

**Caution About Forward-Looking Statements**

** **

We makecertain forward-looking statements in this Form 10-Q that are subject torisks and uncertainties.  Theseforward-looking statements include statements regarding our profitability,liquidity, allowance for loan losses, interest rate sensitivity, market risk,growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,”“anticipates,” “forecasts,” “intends,” or other similar words or terms areintended to identify forward-looking statements.

 

These forward-looking statements are subject to significantuncertainties because they are based upon or are affected by factors including:

 

·                  the ability tosuccessfully manage our growth or implement our growth strategies if we areunable to identify attractive markets, locations or opportunities to expand inthe future;

·                  changes ininterest rates and the successful management of interest rate risk;

·                  risks inherentin making loans such as repayment risks and fluctuating collateral values;

·                  changes inmarket conditions, specifically declines in the residential real estate market,volatility and disruption of the capital and credit markets, soundness of otherfinancial institutions we do business with;

·                  impact ofrecently enacted legislation, in particular the Emergency EconomicStabilization Act of 2008, there is no assurance that such legislation willstabilize the U.S. financial system and there is uncertainty in theimplementation of this legislation by federal regulators

·                  maintaining costcontrols and asset quality as we open or acquire new branches;

·                  maintainingcapital levels adequate to support our growth;

·                  reliance on ourmanagement team, including our ability to attract and retain key personnel;

·                  competition withother banks and financial institutions, and companies outside of the bankingindustry, including those companies that have substantially greater access tocapital and other resources;

·                  changes ingeneral economic and business conditions in our market area including the localand national economy;

·                  risks and uncertainties related to futuretrust operations;

 

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·                  changesin the operations of Wilson/Bennett Capital Management, Inc., its customerbase and assets under management and any associated impact on the fair value ofgoodwill in the future;

·                  demand,development and acceptance of new products and services;

·                  problems withtechnology utilized by us;

·                  changing trendsin customer profiles and behavior; and

·                  changes inbanking and other laws and regulations applicable to us.

 

Because ofthese uncertainties, our actual future results may be materially different fromthe results indicated by these forward-looking statements.  In addition, our past results of operationsdo not necessarily indicate our future results.

 

Inaddition, this section should be read in conjunction with the description ofour “Risk Factors” in Item 1A of this Quarterly Report on Form 10-Q andour Annual Report on Form 10-K for the year ended December 31, 2007.

 

**Overview**

** **

Weare a locally managed financial holding company headquartered in Tysons Corner,Virginia, committed to providing superior customer service, a diversified mixof financial products and services, and convenient banking to our retail andbusiness customers. We own Cardinal Bank (the “Bank”), a Virginiastate-chartered community bank, Cardinal Wealth Services, Inc. (“CWS”), aninvestment services subsidiary, and Wilson/Bennett Capital Management, Inc.(“Wilson/Bennett”), an asset management firm. Through these three subsidiariesand George Mason Mortgage, LLC (“George Mason”), a mortgage banking subsidiaryof the Bank, we offer a wide range of traditional banking products and servicesto both our commercial and retail customers. Our commercial relationshipmanagers focus on attracting small and medium-sized businesses as well asgovernment contractors, commercial real estate developers and builders andprofessionals, such as physicians, accountants and attorneys. We have 25 branchoffice locations and six mortgage banking office locations and providecompetitive products and services. We complement our core banking operations byoffering a full range of investment products and services to our customersthrough our third-party brokerage relationship with Raymond James Financial Services, Inc.,asset management services through Wilson/Bennett and services through our trustdivision which include trust, estates, custody, investment management, escrows,and retirement plans. The trust division is included, along with CWS andWilson/Bennett, in the wealth management and trust services segment.

 

Netinterest income is our primary source of revenue. We define revenue as netinterest income plus noninterest income. As discussed further in the interestrate sensitivity section, we manage our balance sheet and interest rate riskexposure to maximize, and concurrently stabilize, net interest income. We dothis by monitoring our liquidity position and the spread between the interestrates earned on interest-earning assets and the interest rates paid oninterest-bearing liabilities. We attempt to minimize our exposure to interestrate risk, but are unable to eliminate it entirely.  In addition tomanagement of interest rate risk, we analyze our loan portfolio for exposure tocredit risk. Loan defaults and foreclosures are inherent risks in the bankingindustry, and we attempt to limit our exposure to these risks by carefullyunderwriting and then monitoring our extensions of credit. In addition to netinterest income, noninterest income is an important source of revenue for usand includes, among other things, service charges on deposits and loans,investment fee income, which includes trust revenues, gains and losses on salesof investment securities available-for-sale, gains on sales of mortgage loans,and management fee income.

 

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**Critical Accounting Policies**

** **

*General*

* *

U. S. generally acceptedaccounting principles are complex and require management to apply significantjudgment to various accounting, reporting, and disclosure matters.  Management must use assumptions, judgmentsand estimates when applying these principles where precise measurements are notpossible or practical.  These policiesare critical because they are highly dependent upon subjective or complexjudgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have asignificant impact on the consolidated financial statements.  Actual results, in fact, could differ frominitial estimates.

 

The accounting policieswe view as critical are those relating to judgments, assumptions and estimatesregarding the determination of the allowance for loan losses, accounting foreconomic hedging activities, accounting for business combinations andimpairment testing of goodwill, accounting for the impairment of amortizingintangible assets and other long-lived assets, and the valuation of deferredtax assets.

 

*Allowance forLoan Losses*

 

**We maintain the allowance for loan losses ata level that represents management’s best estimate of known and inherent lossesin our loan portfolio.  Both the amountof the provision expense and the level of the allowance for loan losses areimpacted by many factors, including general and industry-specific economicconditions, actual and expected credit losses, historical trends and specificconditions of individual borrowers. Unusual and infrequently occurring events, such as weather-relateddisasters, may impact our assessment of possible credit losses.  As a part of our analysis, we use comparativepeer group data and qualitative factors such as levels of and trends indelinquencies and nonaccrual loans, national and local economic trends andconditions and concentrations of loans exhibiting similar risk profiles tosupport our estimates.**

 

Forpurposes of our analysis, we categorize our loans into one of fivecategories:  commercial and industrial, commercial real estate (includingconstruction), home equity lines of credit, residential mortgages, and consumerloans. In the absence of meaningful historical loss factors, peer group lossfactors are applied and are adjusted by the qualitative factors mentionedabove. The indicated loss factors resulting from this analysis are applied foreach of the five categories of loans. In addition, we individually assign lossfactors to all loans that have been identified as having loss attributes, asindicated by deterioration in the financial condition of the borrower or adecline in underlying collateral value if the loan is collateral dependent.Since we have limited historical data on which to base loss factors forclassified loans, we typically apply, in accordance with regulatory guidelines,a 5% loss factor to loans classified as special mention, a 15% loss factor toloans classified as substandard and a 50% loss factor to loans classified asdoubtful. Loans classified as loss loans are fully reserved or charged off.   In certain instances, we evaluate theimpairment of certain loans on a loan by loan basis.  For these loans, we analyze the fair value ofthe collateral underlying the loan and consider estimated costs to sell thecollateral on a discounted basis.  If thenet collateral value is less than the loan balance (including accrued interestand any unamortized premium or discount associated with the loan) we recognizean impairment and establish a specific reserve for the impaired loan.

 

Creditlosses are an inherent part of our business and, although we believe themethodologies for determining the allowance for loan losses and the currentlevel of the allowance are adequate, it is possible that there may beunidentified losses in the portfolio at any

 

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particulartime that may become evident at a future date pursuant to additional internalanalysis or regulatory comment. Additional provisions for such losses, ifnecessary, would be recorded in the commercial banking or mortgage bankingsegments, as appropriate, and would negatively impact earnings.

 

*Accountingfor Economic Hedging Activities*

* *

Weaccount for our derivatives and hedging activities in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 133, *Accountingfor Derivative Instruments and Certain Hedging Activities,* asamended, which requires that all derivative instruments be recorded on thestatement of condition at their fair values*.*We do not enter intoderivative transactions for speculative purposes. For derivatives designated ashedges, we contemporaneously document the hedging relationship, including therisk management objective and strategy for undertaking the hedge, howeffectiveness will be assessed at inception and at each reporting period andthe method for measuring ineffectiveness. We evaluate the effectiveness of these transactions at inception and onan ongoing basis.  Ineffectiveness isrecorded through earnings.  Forderivatives designated as cash flow hedges, the fair value adjustment isrecorded as a component of other comprehensive income, except for theineffective portion which is recorded in earnings.  For derivatives designated as fair valuehedges, the fair value adjustments for both the hedged item and the hedginginstrument are recorded through the income statement with any differenceconsidered the ineffective portion of the hedge.

 

Wediscontinue hedge accounting prospectively when it is determined that thederivative is no longer highly effective. In situations in which cash flowhedge accounting is discontinued, we continue to carry the derivative at itsfair value on the statement of condition and recognize any subsequent changesin fair value in earnings over the term of the forecasted transaction. Whenhedge accounting is discontinued because it is probable that a forecastedtransaction will not occur, we recognize immediately in earnings any gains andlosses that were accumulated in other comprehensive income.

 

Inthe normal course of business, we enter into contractual commitments, includingrate lock commitments, to finance residential mortgage loans. Thesecommitments, which contain fixed expiration dates, offer the borrower aninterest rate guarantee provided the loan meets underwriting guidelines andcloses within the time frame established by us. Interest rate risk arises onthese commitments and subsequently closed loans if interest rates changebetween the time of the interest rate lock and the delivery of the loan to theinvestor. Loan commitments related to residential mortgage loans intended to besold are considered derivatives and are marked to market through earnings.

 

Tomitigate the effect of the interest rate risk inherent in providing rate lockcommitments, we economically hedge our commitments by entering into bestefforts delivery forward loan sales contracts. During the rate lock commitmentperiod, these forward loan sales contracts are marked to market throughearnings and are not designated as accounting hedges under SFAS No. 133,as amended. The fair values of loan commitments and the fair values of forwardloan sales contracts generally move in opposite directions, and the net impactof changes of these valuations on net income during the loan commitment periodis generally inconsequential. At the closing of the loan, the loan commitmentderivative expires and we record a loan held for sale and continue to beobligated under the same forward loan sales contract.   The forward sales contract is thendesignated as a hedge against the variability in cash to be received from theloan sale.  Loans held for sale areaccounted for at the lower of cost or market in accordance with SFAS No. 65,*Accounting for Certain Mortgage Banking Activities.*

 

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*Accounting for BusinessCombinations and Impairment Testing of Goodwill*

* *

Weaccount for acquisitions of other businesses in accordance with SFAS No. 141,*Business Combinations*. Thisstatement mandates the use of purchase accounting and, accordingly, assets andliabilities, including previously unrecorded assets and liabilities, arerecorded at fair values as of the acquisition date. We utilize a variety ofvaluation methods to estimate fair value of acquired assets and liabilities. Tosupport our purchase allocations, we have utilized independent consultants toidentify and value identifiable purchased intangibles. The difference betweenthe fair value of assets acquired and the liabilities assumed is recorded asgoodwill. Goodwill and other intangible assets are accounted for in accordancewith SFAS No. 142, *Goodwill and OtherIntangible Assets*. In accordance with this statement, goodwill willnot be amortized but will be tested on at least an annual basis for impairment.

 

Totest goodwill for impairment, we perform an analysis to compare the fair valueof the reporting unit to which the goodwill is assigned to the carrying valueof the reporting unit. We make estimates of the discounted cash flows from theexpected future operations of the reporting unit. If the analysis indicatesthat the fair value of the reporting unit is less than its carrying value, wedo an analysis to compare the implied fair value of the reporting unit’sgoodwill with the carrying amount of that goodwill. The implied fair value ofthe goodwill is determined by allocating the fair value of the reporting unitto all its assets and liabilities. If the implied fair value of the goodwill isless than the carrying value, an impairment loss is recognized.

 

Duringthe third quarter of 2008, we performed an evaluation of the goodwillassociated with our acquisition of George Mason, which is included in themortgage banking segment.  Goodwill of$12.9 million was recognized as a result of this acquisition.  During the third quarter of 2008, we employedthe services of a valuation consultant to assist with the goodwillevaluation.  The analysis includedcertain valuation techniques, including a discounted cash flow approach.  Following the acquisition date, George Masonhas delivered excellent financial results and returns on our investment.  Recent and ongoing challenges in the regionalresidential real estate market have negatively impacted the cash flows expectedto be generated by George Mason in the near term.  The valuation analysis indicated thatgoodwill was impaired and we recorded a non-cash impairment charge of $2.8million in the mortgage banking segment.

 

*Accounting for the Impairment of Amortizing IntangibleAssets and Other Long-Lived Assets*

* *

Inaccordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, we continuallyreview our long-lived assets for impairment whenever events or changes incircumstances indicate that the remaining estimated useful life of such assetsmight warrant revision or that the balances may not be recoverable. We evaluatepossible impairment by comparing estimated future cash flows, before interestexpense and on an undiscounted basis, with the net book value of long-termassets, including amortizable intangible assets. If undiscounted cash flows areinsufficient to recover assets, further analysis is performed in order to determinethe amount of the impairment.

 

Animpairment loss is then recorded for the excess of the carrying amount of theassets over their fair values. Fair value is usually determined based on thepresent value of estimated expected future cash flows using a discount ratecommensurate with the risks involved.

 

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*Valuationof Deferred Tax Assets*

 

Werecord a provision for income tax expense based on the amounts of current taxespayable or refundable and the change in net deferred tax assets or liabilitiesduring the year. Deferred tax assets and liabilities are recognized for the taxeffects of differing carrying values of assets and liabilities for tax andfinancial statement purposes that will reverse in future periods. Whensubstantial uncertainty exists concerning the recoverability of a deferred taxasset, the carrying value of the asset is reduced by a valuation allowance. Theamount of any valuation allowance established is based upon an estimate of thedeferred tax asset that is more likely than not to be recovered. Increases ordecreases in the valuation allowance result in increases or decreases to theprovision for income taxes.

 

**NewFinancial Accounting Standards**

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements.*  SFAS No. 157defines fair value, establishes a framework for measuring fair value inaccordance with U.S. generally accepted accounting principles, and expandsdisclosures about fair value measurements. The statement clarifies that the exchange price is the price in anorderly transaction between market participants to sell an asset or transfer aliability at the measurement date.  Thestatement emphasizes that fair value is a market-based measurement and not anentity-specific measurement.  It alsoestablishes a fair value hierarchy used in fair value measurements and expandsthe required disclosures of assets and liabilities measured at fair value.  This standard is effective for fiscal yearsbeginning after December 15, 2007. See Note 8 to the notes to the consolidated financial statementsabove.  On October 10, 2008, theFASB issued FASB Staff Position (“FSP”) FAS 157-3, *Determiningthe Fair Value of a Financial Asset When the Market for That Asset is NotActive.*  This FSP clarifiesthe application of SFAS No. 157 in a market that is not active andprovides an example to illustrate key considerations in determining the fair valueof a financial asset when the market for that financial asset is not active.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities – including anamendment of FAS 115.*  SFAS No. 159allows entities to choose, at specified election dates, to measure eligiblefinancial assets and liabilities at fair value that are not otherwise requiredto be measured at fair value.  If acompany elects the fair value option for an eligible item, changes in that item’sfair value in subsequent reporting periods must be recognized in currentearnings.  SFAS No. 159 alsoestablishes presentation and disclosure requirements designed to drawcomparison between entities that elect different measurement attributes forsimilar assets and liabilities.  SFAS No. 159is effective for fiscal years beginning after November 15, 2007.  We have not designated any instruments to beaccounted for under SFAS No. 159.

 

InNovember 2007, the SEC issued Staff Accounting Bulletin No. 109 (“SABNo. 109”), *Written Loan Commitments Recorded at FairValue Through Earnings*.  SAB No. 109requires fair value measurements of derivatives or other written loancommitments recorded through earnings to include the future cash flows relatedto the loan’s servicing rights.  SAB No. 109also states that internally developed intangible assets should be excluded fromthese measurements.  SAB No. 109,which supersedes SAB No. 105, *Application of AccountingPrinciples to Loan Commitments*, applies to all loan commitments thatare accounted for at fair value through earnings.  Previously, SAB No. 105 applied to onlyderivative loan commitments accounted for at fair value through earnings.  SAB No. 109 should be appliedprospectively to derivative loan commitments issued or modified in fiscalquarters beginning after December 15, 2007.  See Note 8 to the notes to the consolidatedfinancial statements above.

 

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InDecember 2007, the SEC issued Staff Accounting Bulletin No. 110 (“SABNo. 110”), *Certain Assumptions Used in ValuationMethods. *SAB No. 110extends the use of the “simplified” method, under certain circumstances, indeveloping an estimate of expected term of “plain vanilla” share options inaccordance with SFAS No. 123R, *Share-Based Payment. *Prior to the issuance of SAB No. 110,SAB No. 107 stated that the simplified method was only available forgrants made up to December 31, 2007. We are continuing the use of the simplified method.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities. *SFAS No. 161 amends SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities,*requires companies with derivative instruments to disclose information abouthow and why a company uses derivative instruments, how derivative instrumentsand related hedged items are accounted for under SFAS No. 133, and howderivative instruments and related hedged items affect a company’s financialposition, financial performance, and cash flows.  The required disclosures include the fairvalue of derivative instruments and their gains and losses in tabular format,information about credit-risk-related contingent features in derivativeagreements, counterparty credit risk, and the company’s strategies andobjectives for using derivative instruments. SFAS No. 161 is effective prospectively for periods beginning on orafter November 15, 2008.  Theadoption of this standard is not expected to have a material impact on ourconsolidated financial condition or results of operations.

 

##### **2008 EconomicEnvironment**

 

Ourcredit quality remains relatively strong despite the challenges we face duringthe current economic environment.  Forthe fourth consecutive quarter, we have no nonaccrual loans and we had adecrease in nonperforming loans of $379,000 from $963,000 at December 31,2007 to $584,000 at September 30, 2008. Net charge-offs were 0.14% of our average loans receivable for theyear-to-date September 30, 2008.

 

Theslowing economy and declining housing prices have continued to impact ourmortgage banking operations, resulting in an impairment to the goodwillassociated with our 2004 acquisition of George Mason.  The market dislocations that have beenexperienced in the financial markets over the past year continue to impact ourresults. We incurred an other-than-temporary impairment charge on our FannieMae preferred stock investment.  Marketilliquidity continues to impact certain portions of our investment securitiesportfolio, specifically the ratings of certain monoline insurance providers,which has affected the pricing of certain municipal securities in ourportfolio. In addition, we hold investments in pooled trust preferredsecurities, which are significantly below book value as of September 30,2008 due to the lack of liquidity in the market.

 

Theabove conditions together with deterioration in the overall economy willcontinue to affect these and other markets in which we do business and couldadversely impact our results throughout the remainder of 2008. The degree ofthe impact is dependent upon the duration and severity of the aforementionedconditions.

 

On October 14,2008, as provided in the Emergency Economic Stabilization Act, the U.S.Treasury and Federal Deposit Insurance Corporation (“FDIC”) have announcedcertain programs to encourage financial institutions to build capital and tostrengthen confidence and encourage liquidity in the banking system.  Specifically, the U.S. Treasury announced avoluntary Capital Purchase Program, pursuant to which the U.S. Treasury willpurchase up to $250 billion of senior preferred securities from eligible U.S.financial institutions on standardized terms. In addition, the FDIC announced a Temporary Liquidity Guarantee Programpursuant to which the FDIC will

 

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guarantee certainnewly-issued senior unsecured debt issued by eligible institutions on or beforeJune 30, 2009, as well as funds in noninterest-bearing transaction depositaccounts held by FDIC-insured banks until December 31, 2009.  Eligible institutions will be covered underthe Liquidity Guarantee Program for a period of 30 days, and fees for thecoverage will be waived during that time. Prior to the expiration of the 30 day period, however, eligibleinstitutions must inform the FDIC whether they intend to opt out of theprogram.  We are consideringparticipation in both programs as of the date of this filing.

 

##### **Statements ofIncome**

##### ** **

*General – Three and Nine Month Periods*

 

Forthe three months ended September 30, 2008 and 2007, we reported a net lossof $4.4 million and $606,000, respectively. Net interest income after the provision for loan losses increased$217,000 to $9.6 million for the three months ended September 30, 2008compared to $9.4 million for the three months ended September 30,2007.  The increase in net interestincome after provision for loan losses is a direct result of a decrease in ourinterest expense for the three months ended September 30, 2008 of $4.5million, offset by a decrease in interest income of $3.6 million and anincrease in provision for loan losses of $730,000 all as compared to the sameperiod of 2007. Noninterest income for the three months ended September 30,2008 was $4.4 million, a decrease of $348,000, or 7%, compared to $4.7 millionfor the three months ended September 30, 2007.  The decrease in noninterest income isprimarily due to a decrease in investment fee income of $208,000 for the threemonths ended September 30, 2008 as compared to the same period of2007.  The decrease in investment feeincome is a result of a decrease in the managed assets at our trust divisiondue to the loss of low margin custody relationships with two clients.  In addition, assets under management at CWShave decreased as compared to the same three months period of 2007 followingthe departure of certain employees. Noninterest expense increased $3.8 million, or 24%, to $19.3 million forthe three months ended September 30, 2008, compared to $15.5 million forthe same period of 2007.  The increase innoninterest expense for the three and nine months ended September 30, 2008as compared to the same periods of 2007 was a result of an other-than-temporaryimpairment charge of $4.4 million and a goodwill impairment charge of $2.8million, both of which are explained in more detail below.

 

Forthe three months ended September 30, 2008, basic and diluted loss percommon share were each $0.18.  Basic anddiluted loss per common share for the three months ended September 30, 2007were each $0.02.  Weighted average fullydiluted shares outstanding for the three months ended September 30, 2008and 2007 were 24,327,751 and 24,253,187, respectively.

 

Returnon average assets for the three months ended September 30, 2008 and 2007 was(1.09)% and (0.15)%, respectively. Return on average equity for the threemonths ended September 30, 2008 and 2007 was (11.03)% and (1.54)%,respectively.

 

Werecorded a net loss for the nine months ended September 30, 2008 of $1.5million compared to net income of $3.1 million for the nine months ended September 30,2007.   For the nine months ended September 30,2008 and 2007, net interest income after provision for loan losses was $30.0million and $28.7 million, respectively, an increase of $1.2 million, or4%.  The increase in net interest incomeafter provision for loan losses is a direct result of a decrease in ourinterest expense for the nine months ended September 30, 2008 of $9.5million, offset by a decrease in interest income of $7.3 million and anincrease in provision for loan losses of $1.1 million, all as compared to thesame year to date period of 2007.

 

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Forthe nine months ended September 30, 2008, noninterest income decreased$2.0 million, or 13%, to $13.4 million from $15.4 million for the nine monthsended September 30, 2007.   Thedecrease in noninterest income is primarily due to the decrease in realized andunrealized gains on mortgage banking activities of $1.3 million for nine monthsended September 30, 2008 as compared to the nine months ended September 30,2007.  Management fee income alsodecreased $309,000 to $590,000 for the nine months ended September 30,2008 as compared to $899,000 for the nine months ended September 30,2007.  These decreases are a result ofthe ongoing deterioration in the residential real estate market.  Investment fee income for the nine monthsended September 30, 2008 and 2007 were $2.7 million and $3.2 million,respectively, a decrease of $521,000. The decrease in investment fee income is a result of the above mentioneddecreases in managed and custodial assets.

 

Forthe nine months ended September 30, 2008 and 2007, noninterest expense was$44.7 million and $40.1 million, respectively, an increase of $4.6 million, or11%.  The increase in noninterest expensefor the nine months ended September 30, 2008 as compared to the sameperiod of 2007 was a result of an other-than-temporary impairment charge of$4.4 million and a goodwill impairment charge of $2.8 million, both of whichare explained in more detail below.

 

Forthe nine months ended September 30, 2008, basic and diluted loss per sharewere $0.06 and for the nine months ended September 30, 2007, basic anddiluted earnings per share were $0.13 and $0.12, respectively.  For the nine months ended September 30,2008 and 2007, weighted average fully diluted shares outstanding were24,393,167 and 24,900,401, respectively.

 

Forthe nine months ended September 30, 2008 and 2007, return on averageassets was (0.12)% and 0.25%, respectively. For the nine months ended September 30, 2008 and 2007, return onaverage equity was (1.23)% and 2.63%, respectively.

 

Our operating results for the three and nine months ended September 30,2008 and 2007 were adversely impacted by several events.  These events are discussed in detail below:

 

·      During the three months ended September 30, 2008, we performed ourannual evaluation of the goodwill associated with our acquisition of GeorgeMason.  Goodwill of $12.9 million wasrecognized as a result of this acquisition. We employed the services of a valuation consultant to assist us with thegoodwill evaluation.  The analysisincluded certain valuation techniques, including a discounted cash flowapproach.  Following the acquisition,George Mason delivered excellent financial results and returns on ourinvestment.  Recent and ongoingchallenges in the regional residential real estate market have negativelyimpacted the cash flows expected to be generated by George Mason in the nearterm.  The valuation analysis indicatedthat the goodwill was impaired and we recorded a noncash impairment charge of$2.8 million in the mortgage banking segment.

 

·                  During the third quarter of 2008, werecognized a one-time noncash other-than-temporary impairment charge of $4.4million on our investment in Fannie Mae perpetual preferred stock.  This impairment charge, net of tax, was $4.0million.  The tax benefit recognized onthe other-than-temporary impairment charge was based on the treatment of the

 

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impairmentas a capital loss, which limited the tax benefit we recorded.  Subsequently, on October 3, 2008, theEmergency Economic Stabilization Act was enacted which includes a provisionpermitting banks to recognize the other-than-temporary impairment chargerelated to Fannie Mae perpetual preferred stock as an ordinary loss rather thana capital loss and will allow us to recognize an additional tax benefit forthis loss in the fourth quarter of 2008 in the amount of $1.1 million.  This noncash impairment charge was recordedin the commercial banking segment.

 

·                  During the second quarter of 2008, GeorgeMason recorded a one-time cash settlement to one of its mortgage correspondentsrelated to the loan purchase agreement between the two parties.  This one-time settlement agreement providedfor the release of known and unknown claims by the mortgage correspondent inexchange for a $2.8 million payment to the correspondent.  George Mason also entered into similaragreements with certain third party mortgage companies from which George Masonpurchased mortgage loans and subsequently sold to this mortgagecorrespondent.  These settlementagreements provided for a total payment of $1.0 million to George Mason bythose third party mortgage companies. Although we from time to time repurchase mortgage loans sold to variousinvestors under the normal representation and warranty provisions of the loansale contracts, we believe this cash settlement to be a one-time event becausewe do not have the level of exposure to repurchase mortgage loans previouslysold to other investors as we had with this particular third party due to thevolume of loans sold to this investor.

 

·                  During the third quarter of 2007, we recordeda $3.5 million loss on an escrow arrangement with Liberty Growth Fund, LP andAIMS Worldwide, Inc. We served as the escrow agent in connection with anequity financing transaction between Liberty Growth Fund and AIMSWorldwide.  In that transaction, LibertyGrowth Fund had agreed to purchase from AIMS Worldwide shares of its preferredstock for $3.85 million.  AIMS Worldwide would then use these proceeds tofund its acquisition of two other companies. As provided in the escrow agreement, Liberty Growth Fund delivered acheck to us in the amount of $3.85 million on July 24, 2007.  On July 25,2007, we released funds totaling $3.85 million to AIMS Worldwide and certain ofits designated beneficiaries and shares of AIMS Worldwide’s preferred stock andwarrants to an agent of Liberty Growth Fund.  We then learned that LibertyGrowth Fund had previously stopped payment on its check.  Liberty GrowthFund issued another check in the same amount, but that check was dishonored forlack of sufficient funds. Of the total amount charged-off, we recovered$350,000 from one of the parties involved in the transaction.

 

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*General –Business Segments*

 

Net income (loss)attributable to the commercial banking segment for the three months ended September 30,2008 and 2007 was $(1.7) million and $3.2 million, respectively.  For the nine months ended September 30,2008 and 2007, net income from the commercial banking segment was $1.8 millionand $5.4 million, respectively.  The 2008results reported were impacted by the aforementioned other-than-temporaryimpairment charge. For the three and nine months ended September 30, 2008, netinterest income increased $751,000 and $2.0 million, respectively, compared tothe same three and nine month periods of 2007.

 

The mortgage banking segmentreported a net loss of $2.2 million for the three months ended September 30,2008 compared to net income of $429,000 for the three months ended September 30,2007.  The net loss for the three monthsended September 30, 2008 was primarily attributable to the previouslymentioned goodwill impairment charge. For the nine months ended September 30, 2008, the mortgage bankingsegment reported a net loss of $2.9 million compared to net income of $1.5million for the nine months ended September 30, 2007.  In addition to the goodwill impairment chargerecorded during the third quarter of 2008, a one-time cash settlement to amortgage correspondent was recorded during the second quarter of 2008.  Additionally, decreases in net income forthis business segment include decreases in noninterest income due to decreasedloan sales volume, a result of the slowdown in the regional residential realestate market.

 

Thewealth management and trust services segment, which includes CWS,Wilson/Bennett and the trust division of the Bank, recorded net income of$21,000 and $89,000 for the three and nine month periods ended September 30,2008, respectively.  For the three andnine months ended September 30, 2007, this business segment reported a netloss of $2.0 million and $1.7 million, respectively.  The net losses were a result of the loss recordedas a result of an escrow arrangement during 2007.  Non interest income decreased in the 2008periods as compared to the 2007 periods due to the aforementioned decrease inmanaged and custodial assets during 2008 as compared to 2007.

 

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*Net Interest Income*

 

Netinterest income represents the difference between interest and fees earned oninterest -earning assets and the interest paid on deposits and otherinterest-bearing liabilities. The level of net interest income is impactedprimarily by variations in the volume and mix of these assets and liabilities,as well as changes in interest rates. Net interest income for the three monthsended September 30, 2008 and 2007 was $11.3 million and $10.3 million,respectively, a period-to-period increase of $947,000, or 9%. For the ninemonths ended September 30, 2008 and 2007, net interest income was $32.7million and $30.4 million, respectively, an increase of $2.3 million, or7%.  The increase in net interest incomeis primarily the result of a greater decrease in our cost of interest-bearingliabilities than our decrease in the yields earned for average earning assets.  During 2008, we have been liabilitysensitive, which means that we have more liabilities repricing than assets inthe current decreasing interest rate environment, which has contributed to theimprovement in our net interest margin.

 

Specifically,interest income on loans held for sale decreased $2.5 million for the threemonths ended September 30, 2008 compared to the same three month period of2007.  For the year-to-date period endingSeptember 30, 2008, interest income on loans held for sale decreased $8.2million as compared to the year-to-date period of 2007.  The decrease in interest income on loans heldfor sale is directly related to decreased volumes of loans sold due to theongoing deterioration in the residential real estate market.  Total interest expense has decreased $4.5million and $9.5 million for the three and nine months periods ending September 30,2008 as compared to the same periods of 2007. The decrease in total interest expense is mostly related to short-termcertificates of deposit which have matured and repriced at lower rates over thethree and nine months periods of 2008.

 

Wehave certain loans and investment securities for which a portion of the incomerealized is tax-exempt.  Net interestincome on a tax equivalent basis for the three months ended September 30,2008 and 2007 was $11.4 million and $10.4 million, respectively.  For the nine months ended September 30,2008 and 2007, net interest income on a tax equivalent basis was $33.1 millionand $30.7 million, respectively.

 

Ournet interest margin, which equals net interest income divided by averageearning assets, was 2.96% and 2.65% for the three months ended September 30,2008 and 2007, respectively.  For theyear to date September 30, 2008 and 2007, our net interest margin was2.84% and 2.63%, respectively.  Theincrease in the net interest margin for the three and nine months ended September 30,2008 compared to the same periods of 2007 is a result of a greater decrease inthe cost of interest-bearing liabilities than the decrease in yields earned foraverage earning assets.  Tables 1 through4 present an analysis of average earning assets and interest-bearingliabilities with related components of interest income and interest expense ona tax equivalent basis.

 

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Table 1.

 

**Average Balance Sheets and Interest Rates onInterest-Earning Assets and Interest-Bearing Liabilities**

Three Months Ended September 30, 2008, 2007 and 2006

(In thousands)

 
| ** **                                               | ** ** | **2008**    | ** ** | **2007**     | ** ** | **2006**    | ** ** |
|----------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------|------------|
| ** **                                               | ** ** | ** **  | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                               | ** ** | **Average** | ** ** | **Income/**  | ** ** | **Yield/**  | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                               | ** ** | **Balance** | ** ** | **Expense**  | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                                |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1):                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and  industrial                               |       | $           | 119,891    |         | $          | 1,843       |       | 6.15 | % | $ | 108,266 |   | $ | 2,132 |   | 7.88 | % | $ | 86,592 |   | $ | 1,649 |   | 7.62 | % |
| Real estate -  commercial                                |       | 454,513     |       | 7,447        |       | 6.55        | %          | 385,432 |   | 6,556 |   | 6.80 | % | 294,680 |   | 4,881 |   | 6.63 | % |
| Real estate -  construction                              |       | 189,041     |       | 2,703        |       | 5.72        | %          | 171,846 |   | 3,639 |   | 8.47 | % | 146,803 |   | 3,214 |   | 8.76 | % |
| Real estate -  residential                               |       | 213,360     |       | 2,984        |       | 5.60        | %          | 200,792 |   | 2,749 |   | 5.48 | % | 173,942 |   | 2,315 |   | 5.32 | % |
| Home equity lines                                        |       | 96,196      |       | 1,131        |       | 4.66        | %          | 72,365 |   | 1,323 |   | 7.25 | % | 71,888 |   | 1,339 |   | 7.45 | % |
| Consumer                                                 |       | 2,608       |       | 40           |       | 6.08        | %          | 8,222 |   | 165 |   | 7.96 | % | 5,008 |   | 97 |   | 7.75 | % |
| Total loans                                              |       | 1,075,609   |       | 16,148       |       | 6.01        | %          | 946,923 |   | 16,564 |   | 7.00 | % | 778,913 |   | 13,495 |   | 6.93 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale                                      |       | 118,009     |       | 1,709        |       | 5.79        | %          | 233,646 |   | 4,256 |   | 7.29 | % | 275,885 |   | 5,193 |   | 7.53 | % |
| Investment securities -  trading                         |       | —      |       | —       |       | 0.00        | %          | — |   | — |   | 0.00 | % | — |   | — |   | 0.00 | % |
| Investment securities  available-for-sale                |       | 258,807     |       | 3,421        |       | 5.29        | %          | 293,554 |   | 3,696 |   | 5.04 | % | 243,259 |   | 2,891 |   | 4.75 | % |
| Investment securities  held-to-maturity                  |       | 54,373      |       | 586          |       | 4.30        | %          | 85,850 |   | 896 |   | 4.17 | % | 104,768 |   | 1,079 |   | 4.12 | % |
| Other investments                                        |       | 15,726      |       | 113          |       | 2.91        | %          | 10,944 |   | 166 |   | 6.05 | % | 5,584 |   | 84 |   | 6.03 | % |
| Federal funds sold                                       |       | 19,068      |       | 118          |       | 2.45        | %          | 5,003 |   | 71 |   | 5.69 | % | 15,219 |   | 181 |   | 4.71 | % |
| Total interest-earning  assets and interest income (2)   |       | 1,541,592   |       | 22,095       |       | 5.73        | %          | 1,575,920 |   | 25,649 |   | 6.51 | % | 1,423,628 |   | 22,923 |   | 6.44 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                             |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                 |       | 7,241       |       |         |       |        |       | $ | 5,659 |   |   |   |   |   | $ | 4,966 |   |   |   |   |   |
| Premises and  equipment, net                             |       | 17,276      |       |         |       |        |       | 19,347 |   |   |   |   |   | 20,528 |   |   |   |   |   |
| Goodwill and  other intangibles, net                     |       | 17,060      |       |         |       |        |       | 17,341 |   |   |   |   |   | 20,425 |   |   |   |   |   |
| Accrued interest  and other assets                       |       | 50,487      |       |         |       |        |       | 51,685 |   |   |   |   |   | 28,265 |   |   |   |   |   |
| Allowance for  loan losses                               |       | (12,763     | )          |         |       |        |       | (10,512 | ) |   |   |   |   | (8,970 | ) |   |   |   |   |
| Total assets                                             |       | $           | 1,620,893  |         |       |        |       |   | $ | 1,659,440 |   |   |   |   |   | $ | 1,488,842 |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**           |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing liabilities:                         |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing deposits:                            |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                        |       | 114,362     |       | 605          |       | 2.10        | %          | 117,665 |   | 904 |   | 3.05 | % | 134,293 |   | 976 |   | 2.91 | % |
| Money markets                                            |       | 40,434      |       | 230          |       | 2.26        | %          | 53,155 |   | 345 |   | 2.58 | % | 89,179 |   | 517 |   | 2.32 | % |
| Statement savings                                        |       | 345,687     |       | 2,379        |       | 2.73        | %          | 359,379 |   | 4,226 |   | 4.66 | % | 232,930 |   | 2,802 |   | 4.78 | % |
| Certificates of  deposit                                 |       | 446,411     |       | 4,030        |       | 3.58        | %          | 498,113 |   | 5,903 |   | 4.70 | % | 584,089 |   | 6,383 |   | 4.37 | % |
| Total interest -  bearing deposits                       |       | 946,894     |       | 7,244        |       | 3.04        | %          | 1,028,312 |   | 11,378 |   | 4.39 | % | 1,040,491 |   | 10,678 |   | 4.07 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed  funds                                    |       | 359,976     |       | 3,427        |       | 3.78        | %          | 319,767 |   | 3,834 |   | 4.76 | % | 154,047 |   | 1,768 |   | 4.55 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities and interest expense |       | 1,306,870   |       | 10,671       |       | 3.24        | %          | 1,348,079 |   | 15,212 |   | 4.48 | % | 1,194,538 |   | 12,446 |   | 4.13 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                        |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                          |       | 136,575     |       |         |       |        |       | 123,178 |   |   |   |   |   | 119,448 |   |   |   |   |   |
| Other liabilities                                        |       | 17,477      |       |         |       |        |       | 31,216 |   |   |   |   |   | 22,658 |   |   |   |   |   |
| Common  shareholders’ equity                        |       | 159,971     |       |         |       |        |       | 156,967 |   |   |   |   |   | 152,198 |   |   |   |   |   |
| Total liabilities  and shareholders’ equity         |       | $           | 1,620,893  |         |       |        |       |   | $ | 1,659,440 |   |   |   |   |   | $ | 1,488,842 |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income and net interest margin (2)         |       |        |       | $            | 11,424     |        | 2.96       | % |   |   | $ | 10,437 |   | 2.65 | % |   |   | $ | 10,477 |   | 2.93 | % |

 

----

(1) Non-accrualloans are included in average balances and do not have a material effect on theaverage yield.  Interest income onnon-accruing loans was not material for the periods presented.

(2) Interest income for loans receivable,investment securities available-for-sale and fed funds sold (which includesinvestments in money market preferred stock) is reported on a fully taxable-equivalentbasis at a rate of 34%.

 

34

----

Table of Contents

 

Table 2.

 

**Rate and Volume Analysis**

Three Months Ended September 30, 2008, 2007 and 2006

(In thousands)

 
| ** **                                      | ** ** | **2008 Compared to 2007** | ** ** | **2007 Compared to 2006** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Change Due to**              | ** ** | ** **                               | ** ** | **Change Due to** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Average**                              | ** ** | **Average**                              | ** ** | **Increase** | ** ** | **Average** | ** ** | **Average** | ** ** | **Increase** | ** ** |
| ** **                                      | ** ** | **Volume (3)**                      | ** ** | **Rate**                                 | ** ** | **(Decrease)** | ** ** | **Volume (3)** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| **Interest income:**                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|  Loans (1):                                |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Commercial and industrial                       |       | $                                        | 229        |                                     | $          | (518 | ) | $ | (289 | ) | $ | 413 |   | $ | 70 |   | $ | 483 |   |
| Real estate - commercial                        |       | 1,175                                    |       | (284                                     | )          | 891 |   | 1,503 |   | 172 |   | 1,675 |   |
| Real estate - construction                      |       | 364                                      |       | (1,300                                   | )          | (936 | ) | 548 |   | (123 | ) | 425 |   |
| Real estate - residential                       |       | 168                                      |       | 67                                       |       | 235 |   | 357 |   | 77 |   | 434 |   |
| Home equity lines                               |       | 428                                      |       | (620                                     | )          | (192 | ) | 20 |   | (36 | ) | (16 | ) |
| Consumer                                        |       | (113                                     | )          | (12                                      | )          | (125 | ) | 64 |   | 4 |   | 68 |   |
| Total loans                                     |       | 2,251                                    |       | (2,667                                   | )          | (416 | ) | 2,905 |   | 164 |   | 3,069 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|  Loans held for sale                       |       | (2,106                                   | )          | (441                                     | )          | (2,547 | ) | (795 | ) | (142 | ) | (937 | ) |
|  Investment securities - trading           |       | —                                   |       | —                                   |       | — |   | — |   | — |   | — |   |
|  Investment securities  available-for-sale |       | (437                                     | )          | 162                                      |       | (275 | ) | 598 |   | 207 |   | 805 |   |
|  Investment securities  held-to-maturity   |       | (327                                     | )          | 17                                       |       | (310 | ) | (195 | ) | 12 |   | (183 | ) |
|  Other investments                         |       | 70                                       |       | (123                                     | )          | (53 | ) | 81 |   | 1 |   | 82 |   |
|  Federal funds sold                        |       | 201                                      |       | (154                                     | )          | 47 |   | (122 | ) | 12 |   | (110 | ) |
| Total interest income (2)                       |       | (348                                     | )          | (3,206                                   | )          | (3,554 | ) | 2,472 |   | 254 |   | 2,726 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                           |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:                    |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest checking                               |       | (25                                      | )          | (274                                     | )          | (299 | ) | (114 | ) | 42 |   | (72 | ) |
| Money markets                                   |       | (83                                      | )          | (32                                      | )          | (115 | ) | (206 | ) | 34 |   | (172 | ) |
| Statement savings                               |       | (166                                     | )          | (1,681                                   | )          | (1,847 | ) | 1,539 |   | (115 | ) | 1,424 |   |
| Certificates of deposit                         |       | (613                                     | )          | (1,260                                   | )          | (1,873 | ) | (895 | ) | 415 |   | (480 | ) |
| Total interest - bearing deposits               |       | (887                                     | )          | (3,247                                   | )          | (4,134 | ) | 324 |   | 376 |   | 700 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Other borrowed funds                            |       | 482                                      |       | (889                                     | )          | (407 | ) | 1,900 |   | 166 |   | 2,066 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Total interest expense                          |       | (405                                     | )          | (4,136                                   | )          | (4,541 | ) | 2,224 |   | 542 |   | 2,766 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Net interest income (2)                         |       | $                                        | 57         |                                     | $          | 930 |   | $ | 987 |   | $ | 248 |   | $ | (288 | ) | $ | (40 | ) |

 

----

| (1) | Non-accrual loans are included in average balances  and do not have a material effect on the average yield. Interest income on  non-accruing loans was not material for the periods presented.                                      |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Interest income for loans receivable, investment  securities available-for-sale and fed funds sold (which includes investments  in money market preferred stock) is reported on a fully taxable-equivalent  basis at a rate of 34%. |
| (3) | Changes attributable to rate/volume have been  allocated to volume.                                                                                                                                                                 |

 

35

----

Table ofContents

 

Table3.

 

**AverageBalance Sheets and Interest Rates on Interest-Earning Assets andInterest-Bearing Liabilities**

Nine Months Ended September 30,2008, 2007 and 2006

(In thousands)

 
| ** **                                               | ** ** | **2008**    | ** ** | **2007**     | ** ** | **2006**    | ** ** |
|----------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------|------------|
| ** **                                               | ** ** | ** **  | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                               | ** ** | **Average** | ** ** | **Income/**  | ** ** | **Yield/**  | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                               | ** ** | **Balance** | ** ** | **Expense**  | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                                |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1):                                               |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and  industrial                               |       | $           | 127,572    |         | $          | 6,080       |       | 6.35 | % | $ | 106,764 |   | $ | 6,143 |   | 7.67 | % | $ | 80,964 |   | $ | 4,409 |   | 7.26 | % |
| Real estate -  commercial                                |       | 432,948     |       | 21,304       |       | 6.56        | %          | 354,731 |   | 17,815 |   | 6.70 | % | 281,599 |   | 13,940 |   | 6.60 | % |
| Real estate -  construction                              |       | 190,428     |       | 8,723        |       | 6.11        | %          | 164,295 |   | 10,393 |   | 8.43 | % | 138,066 |   | 8,596 |   | 8.30 | % |
| Real estate -  residential                               |       | 213,018     |       | 8,970        |       | 5.61        | %          | 199,342 |   | 8,156 |   | 5.46 | % | 166,637 |   | 6,470 |   | 5.18 | % |
| Home equity lines                                        |       | 90,593      |       | 3,338        |       | 4.92        | %          | 66,832 |   | 3,674 |   | 7.35 | % | 75,146 |   | 3,831 |   | 6.80 | % |
| Consumer                                                 |       | 2,680       |       | 130          |       | 6.48        | %          | 7,020 |   | 424 |   | 8.08 | % | 4,825 |   | 276 |   | 7.63 | % |
| Total loans                                              |       | 1,057,239   |       | 48,545       |       | 6.12        | %          | 898,984 |   | 46,605 |   | 6.91 | % | 747,237 |   | 37,522 |   | 6.70 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale                                      |       | 132,921     |       | 5,792        |       | 5.81        | %          | 261,505 |   | 13,954 |   | 7.11 | % | 264,994 |   | 14,746 |   | 7.42 | % |
| Investment securities -  trading                         |       | —      |       | —       |       | 0.00        | %          | 15 |   | 1 |   | 4.61 | % | — |   | — |   | 0.00 | % |
| Investment securities  available-for-sale                |       | 264,376     |       | 10,400       |       | 5.25        | %          | 264,249 |   | 9,748 |   | 4.92 | % | 222,847 |   | 7,633 |   | 4.57 | % |
| Investment securities  held-to-maturity                  |       | 61,475      |       | 1,963        |       | 4.25        | %          | 91,343 |   | 2,858 |   | 4.17 | % | 108,927 |   | 3,306 |   | 4.05 | % |
| Other investments                                        |       | 15,138      |       | 548          |       | 4.82        | %          | 9,893 |   | 442 |   | 5.96 | % | 6,152 |   | 262 |   | 5.67 | % |
| Federal funds sold                                       |       | 23,023      |       | 433          |       | 2.52        | %          | 31,244 |   | 1,235 |   | 5.28 | % | 26,887 |   | 915 |   | 4.55 | % |
| Total interest-earning  assets and interest income (2)   |       | 1,554,172   |       | 67,681       |       | 5.81        | %          | 1,557,233 |   | 74,843 |   | 6.41 | % | 1,377,044 |   | 64,384 |   | 6.23 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                             |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                 |       | 7,526       |       |         |       |        |       | $ | 7,297 |   |   |   |   |   | $ | 6,766 |   |   |   |   |   |
| Premises and  equipment, net                             |       | 17,765      |       |         |       |        |       | 19,835 |   |   |   |   |   | 19,560 |   |   |   |   |   |
| Goodwill and  other intangibles, net                     |       | 17,140      |       |         |       |        |       | 17,403 |   |   |   |   |   | 20,514 |   |   |   |   |   |
| Accrued interest  and other assets                       |       | 52,042      |       |         |       |        |       | 48,513 |   |   |   |   |   | 17,201 |   |   |   |   |   |
| Allowance for  loan losses                               |       | (12,192     | )          |         |       |        |       | (10,096 | ) |   |   |   |   | (8,677 | ) |   |   |   |   |
| Total assets                                             |       | $           | 1,636,453  |         |       |        |       |   | $ | 1,640,185 |   |   |   |   |   | $ | 1,432,408 |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**           |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing liabilities:                         |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing deposits:                            |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                        |       | 121,338     |       | 2,101        |       | 2.31        | %          | 124,155 |   | 2,738 |   | 2.95 | % | 139,949 |   | 2,875 |   | 2.74 | % |
| Money markets                                            |       | 40,860      |       | 764          |       | 2.50        | %          | 57,531 |   | 1,076 |   | 2.50 | % | 133,062 |   | 2,480 |   | 2.49 | % |
| Statement savings                                        |       | 366,209     |       | 8,312        |       | 3.03        | %          | 357,343 |   | 12,641 |   | 4.73 | % | 107,484 |   | 3,703 |   | 4.59 | % |
| Certificates of  deposit                                 |       | 450,650     |       | 13,274       |       | 3.93        | %          | 531,418 |   | 18,733 |   | 4.71 | % | 607,555 |   | 18,547 |   | 4.08 | % |
| Total interest -  bearing deposits                       |       | 979,057     |       | 24,451       |       | 3.34        | %          | 1,070,447 |   | 35,188 |   | 4.39 | % | 988,050 |   | 27,605 |   | 3.74 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed  funds                                    |       | 349,178     |       | 10,172       |       | 3.89        | %          | 264,551 |   | 8,949 |   | 4.52 | % | 157,372 |   | 5,145 |   | 4.37 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities and interest expense |       | 1,328,235   |       | 34,623       |       | 3.48        | %          | 1,334,998 |   | 44,137 |   | 4.42 | % | 1,145,422 |   | 32,750 |   | 3.82 | % |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                        |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                          |       | 127,945     |       |         |       |        |       | 123,621 |   |   |   |   |   | 114,889 |   |   |   |   |   |
| Other liabilities                                        |       | 18,706      |       |         |       |        |       | 24,196 |   |   |   |   |   | 21,156 |   |   |   |   |   |
| Common  shareholders’ equity                        |       | 161,567     |       |         |       |        |       | 157,370 |   |   |   |   |   | 150,941 |   |   |   |   |   |
| Total liabilities  and shareholders’ equity         |       | $           | 1,636,453  |         |       |        |       |   | $ | 1,640,185 |   |   |   |   |   | $ | 1,432,408 |   |   |   |   |   |
|                                                     |       |        |       |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income and net interest margin (2)         |       |        |       | $            | 33,058     |        | 2.84       | % |   |   | $ | 30,706 |   | 2.63 | % |   |   | $ | 31,634 |   | 3.05 | % |

 

----

(1) Non-accrualloans are included in average balances and do not have a material effect on theaverage yield.  Interest income onnon-accruing loans was not material for the periods presented.

(2) Interestincome for loans receivable, investment securities available-for-sale and fedfunds sold (which includes investments in money market preferred stock) isreported on a fully taxable-equivalent basis at a rate of 34%.

 

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Table 4.

 

**Rate and Volume Analysis**

Nine Months Ended September 30, 2008, 2007 and 2006

(In thousands)

 
| ** **                                      | ** ** | **2008 Compared to 2007** | ** ** | **2007 Compared to 2006** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Change Due to**              | ** ** | ** **                               | ** ** | **Change Due to** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Average**                              | ** ** | **Average**                              | ** ** | **Increase** | ** ** | **Average** | ** ** | **Average** | ** ** | **Increase** | ** ** |
| ** **                                      | ** ** | **Volume (3)**                      | ** ** | **Rate**                                 | ** ** | **(Decrease)** | ** ** | **Volume (3)** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| **Interest income:**                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|  Loans (1):                                |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Commercial and industrial                       |       | $                                        | 1,197      |                                     | $          | (1,260 | ) | $ | (63 | ) | $ | 1,405 |   | $ | 329 |   | $ | 1,734 |   |
| Real estate - commercial                        |       | 3,928                                    |       | (439                                     | )          | 3,489 |   | 3,620 |   | 255 |   | 3,875 |   |
| Real estate - construction                      |       | 1,653                                    |       | (3,323                                   | )          | (1,670 | ) | 1,633 |   | 164 |   | 1,797 |   |
| Real estate - residential                       |       | 560                                      |       | 254                                      |       | 814 |   | 1,270 |   | 416 |   | 1,686 |   |
| Home equity lines                               |       | 1,313                                    |       | (1,649                                   | )          | (336 | ) | (433 | ) | 276 |   | (157 | ) |
| Consumer                                        |       | (262                                     | )          | (32                                      | )          | (294 | ) | 124 |   | 24 |   | 148 |   |
| Total loans                                     |       | 8,389                                    |       | (6,449                                   | )          | 1,940 |   | 7,619 |   | 1,464 |   | 9,083 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|  Loans held for sale                       |       | (6,861                                   | )          | (1,301                                   | )          | (8,162 | ) | (194 | ) | (598 | ) | (792 | ) |
|  Investment securities - trading           |       | (1                                       | )          | —                                   |       | (1 | ) | 1 |   | — |   | 1 |   |
|  Investment securities  available-for-sale |       | 5                                        |       | 647                                      |       | 652 |   | 1,418 |   | 697 |   | 2,115 |   |
|  Investment securities  held-to-maturity   |       | (930                                     | )          | 35                                       |       | (895 | ) | (534 | ) | 86 |   | (448 | ) |
|  Other investments                         |       | 235                                      |       | (129                                     | )          | 106 |   | 159 |   | 21 |   | 180 |   |
|  Federal funds sold                        |       | (326                                     | )          | (476                                     | )          | (802 | ) | 148 |   | 172 |   | 320 |   |
| Total interest income (2)                       |       | 511                                      |       | (7,673                                   | )          | (7,162 | ) | 8,619 |   | 1,841 |   | 10,461 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                           |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:                    |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest checking                               |       | (58                                      | )          | (579                                     | )          | (637 | ) | (334 | ) | 197 |   | (137 | ) |
| Money markets                                   |       | (311                                     | )          | (1                                       | )          | (312 | ) | (1,408 | ) | 4 |   | (1,404 | ) |
| Statement savings                               |       | 327                                      |       | (4,656                                   | )          | (4,329 | ) | 8,555 |   | 383 |   | 8,938 |   |
| Certificates of deposit                         |       | (2,843                                   | )          | (2,616                                   | )          | (5,459 | ) | (2,324 | ) | 2,510 |   | 186 |   |
| Total interest - bearing deposits               |       | (2,885                                   | )          | (7,852                                   | )          | (10,737 | ) | 4,489 |   | 3,094 |   | 7,583 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Other borrowed funds                            |       | 2,867                                    |       | (1,644                                   | )          | 1,223 |   | 3,504 |   | 300 |   | 3,804 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Total interest expense                          |       | (18                                      | )          | (9,496                                   | )          | (9,514 | ) | 7,993 |   | 3,394 |   | 11,387 |   |
|                                            |       |                                     |       |                                     |       |   |   |   |   |   |   |   |   |
| Net interest income (2)                         |       | $                                        | 529        |                                     | $          | 1,823 |   | $ | 2,352 |   | $ | 626 |   | $ | (1,552 | ) | $ | (926 | ) |

 

----

| (1) | Non-accrual loans are included in average balances  and do not have a material effect on the average yield.  Interest income on non-accruing loans was  not material for the periods presented.                                |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Interest income for loans receivable, investment  securities available-for-sale and fed funds sold (which includes investments  in money market preferred stock) is reported on a fully taxable-equivalent  basis at a rate of 34%. |
| (3) | Changes attributable to rate/volume have been  allocated to volume.                                                                                                                                                                 |

 

**37**

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*Provision for Loan Losses*

 

Theprovision for loan losses for the three months ended September 30, 2008and 2007 was $1.6 million and $915,000, respectively. For the nine months endedSeptember 30, 2008 and 2007, the provision for loan losses was $2.7million and $1.7 million, respectively. During the third quarter of 2008, we charged off residential loans heldat George Mason totaling $660,000, one commercial loan (partially guaranteed bythe Small Business Administration) of $72,000, took a partial charge off on aresidential loan at the Bank of $41,000 and took a credit card receivablescharge off of $5,000.   Prior to the thirdquarter, net loan charge offs were $340,000. In addition to the above mentioned charge offs, our provision expensewas impacted by an increase in watch list credits and net new loan growth inaddition to our evaluation of the credit quality in our loan portfolio and thequalitative factors we use to determine the adequacy of our loan loss reservesas described above in “Critical Accounting Policies—Allowance for Loan Losses.”The allowance for loan losses at September 30, 2008 and December 31,2007 were $13.3 million and $11.6 million, respectively. Our allowance for loanlosses ratio to loans receivable, net were 1.22% and 1.12% at September 30,2008 and December 31, 2007, respectively. Nonperforming loans at September 30, 2008 and December 31,2007, were $584,000 and $963,000, respectively. There were no nonaccrual loansat September 30, 2008 and December 31, 2007.

 

Additionalinformation on the allowance for loan losses, its allocation to the loansreceivable portfolio and information on nonperforming loans can be found inTables 5, 6 and 7, respectively.

 

Table 5.

 

**Allowance for Loan Losses**

Nine Months Ended September 30, 2008 and 2007

(In thousands)

 
| ** **                         | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Beginning balance, January 1, |       | $        | 11,641     |     | $          | 9,638 |   |
|                               |       |     |       |     |       |
| Provision for loan losses          |       | 2,734    |       | 1,670    |       |
|                               |       |     |       |     |       |
| Loans charged off:                 |       |     |       |     |       |
| Commercial and industrial          |       | (88      | )          | (448     | )          |
| Consumer                           |       | (1,053   | )          | (3       | )          |
| Total loans charged off            |       | (1,141   | )          | (451     | )          |
|                               |       |     |       |     |       |
| Recoveries:                        |       |     |       |     |       |
| Commercial and industrial          |       | 3        |       | —   |       |
| Consumer                           |       | 20       |       | —   |       |
| Total recoveries                   |       | 23       |       | —   |       |
|                               |       |     |       |     |       |
| Net (charge offs) recoveries       |       | (1,118   | )          | (451     | )          |
|                               |       |     |       |     |       |
| Ending balance, September 30, |       | $        | 13,257     |     | $          | 10,857 |   |

 
| ** **                                                  | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Loans:                                                      |       |                         |       |                        |       |
| Balance at period end                                       |       | $                            | 1,086,531  |                        | $          | 1,039,684 |   |
| Allowance for loan losses to loans receivable,  net of fees |       | 1.22                         | %          | 1.12                        | %          |
| Annualized net charge-offs to average loans  receivable     |       | 0.14                         | %          | 0.06                        | %          |
|                                                             |            |                              |            |                             |            |  |  |

 

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Table 6.

 

**Allocation of the Allowance for Loan Losses**

At September 30, 2008 and December 31, 2007

(In thousands)

 
| ** **                      | ** ** | **September 30,** | ** ** | **December 31,**     | ** ** |
|---------------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | **2008**               | ** ** | **2007**                  | ** ** |
| ** **                      | ** ** | **Allocation**         | ** ** | **% of Total*** | ** ** | **Allocation** | ** ** | **% of Total*** | ** ** |
| Commercial and industrial       |       | $                      | 1,465      |                      | 10.93      | % | $ | 1,956 |   | 13.51 | % |
| Real estate - commercial        |       | 5,654                  |       | 42.34                     | %          | 5,225 |   | 39.95 | % |
| Real estate - construction      |       | 3,027                  |       | 17.74                     | %          | 2,217 |   | 17.93 | % |
| Real estate - residential       |       | 2,039                  |       | 19.65                     | %          | 1,402 |   | 20.50 | % |
| Home equity lines               |       | 1,015                  |       | 9.11                      | %          | 772 |   | 7.81 | % |
| Consumer                        |       | 57                     |       | 0.23                      | %          | 69 |   | 0.30 | % |
|                            |       |                   |       |                      |       |   |   |   |   |
| Total allowance for loan losses |       | $                      | 13,257     |                      | 100.00     | % | $ | 11,641 |   | 100.00 | % |

 

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*Percentage of loan type to the total loan portfolio.

 

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Table 7.

 

**Nonperforming Loans Receivable**

At September 30, 2008 and December 31, 2007

(In thousands)

 
| ** **                                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Nonaccruing loans                                                |       | $                      | —     |                  | $          | — |   |
|                                                             |       |                   |       |                  |       |
| Loans contractually past-due 90 days or  more and still accruing |       | 584                    |       | 963                   |       |
|                                                             |       |                   |       |                  |       |
| Total nonperforming loans receivable                             |       | $                      | 584        |                  | $          | 963 |   |

 

*NoninterestIncome*

 

Noninterestincome includes service charges on deposits and loans, realized and unrealizedgains on mortgage banking activities, investment fee income, and management feeincome, and continues to be an important factor in our operating results.Noninterest income for the three months ended September 30, 2008 and 2007were $4.4 million and $4.7 million, respectively, a decrease of $348,000, or7%.   Noninterest income for the ninemonths ended September 30, 2008 and 2007 was $13.4 million and $15.4million, respectively.  Realized andunrealized gains on mortgage banking activities by George Mason for the threemonths ended September 30, 2008 and 2007 were $2.0 million and $2.1million, respectively, a decrease of $108,000, or 5%.  For the year to date September 30, 2008and 2007, realized and unrealized gains on mortgage banking activities were$5.9 million and $7.2 million, respectively. Included in realized and unrealized gains on mortgage banking activitiesare any origination, underwriting, and discount points and other funding feesreceived and deferred at loan origination. Costs include direct costsassociated with the loan origination, such as commissions and salaries that aredeferred at the time of origination. In addition, we adopted SFAS No. 157and SAB No. 109 during the first quarter of 2008.  Additional information on the adoption ofthese standards can be found in Note 8 to our notes to the consolidatedfinancial statements.  Management feeincome for the three months ended September 30, 2008 and 2007 was $204,000and $229,000, respectively, a decrease of $25,000, or 11%. For the nine monthsended September 30, 2008 and 2007, management fee income was $590,000 and$899,000, respectively, a decrease of $309,000, or 34%.  The decrease in realized and unrealized gainson mortgage banking activities and management fee income is directly related tothe ongoing deterioration in the residential real estate market.  Management fee income represents the incomeearned for services George Mason provides to other mortgage companies owned bylocal home builders and generally fluctuates based on the volume of loan sales.

 

Servicecharges on deposit accounts increased $17,000 to $522,000 for the three monthsended September 30, 2008 compared to $505,000 for the same period of 2007.For the year to

 

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dateSeptember 30, 2008 and 2007, service charges on deposit accounts were $1.6million and $1.5 million, respectively, an increase of $112,000.  The increases in service charges on depositaccounts are primarily the result of an increased number of deposit accounts in2008 compared to 2007. Loan service charge income remained at $365,000 for thethree months ended September 30, 2008 as compared to the three monthsended September 30, 2007, but decreased $158,000 to $1.0 million for thethree months ended September 30, 2008, compared to $1.2 million for thesame period of 2007 and is related to the decrease in service charges recordedin the mortgage banking segment, which is related to ongoing deterioration inthe residential real estate housing market.

 

Investmentfee income decreased $208,000 to $893,000 for the three months ended September 30,2008 compared to $1.1 million for the same period of 2007. For the nine monthsended September 30, 2008 and 2007, investment fee income was $2.7 millionand $3.2 million, respectively, a decrease of $521,000.  The decrease in investment fee income isattributable to the decrease in net commissions earned at CWS as a result ofemployee turnover in that subsidiary and decreased fee income at our trustdivision due to the loss of low margin custody relationships with two clients.

 

Noninterestincome represented 28% and 31% of our total revenues for the three months endedSeptember 30, 2008 and 2007, respectively. For the year to date September 30, 2008 and 2007, noninterestincome represented 29% and 34%, respectively, of our total revenues.

 

*NoninterestExpense*

 

Noninterestexpense includes salaries and benefits, occupancy costs, professional fees,depreciation, data processing, telecommunications and miscellaneous expenses.Noninterest expense for the three months ended September 30, 2008 was$19.3 million, compared to $15.5 million for the same period of 2007, anincrease of $3.8 million, or 24%.  Forthe year to date September 30, 2008 and 2007, noninterest expense was$44.7 million and $40.1 million, respectively, an increase of $4.6 million, or11%.  The increase in noninterest expensefor the three and nine months ended September 30, 2008 as compared to thesame periods of 2007 was primarily a result of the aforementionedother-than-temporary impairment charge related to an investment in Fannie Maeperpetual preferred stock, the goodwill impairment charge recorded at GeorgeMason during the third quarter of 2008 and the one-time cash settlement GeorgeMason made to a mortgage correspondent during the second quarter of 2008.  For the nine months ended September 30,2007, noninterest expense was impacted by the above mentioned escrowarrangement loss.  Salary and benefitsexpense decreased $987,000 for the nine months ended September 30, 2008compared to the same period of 2007 due to the decrease in the level ofstaffing and commissions paid at our mortgage banking subsidiary.

 

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*IncomeTaxes*

 

For the three months ended September 30,2008, we recorded an income tax benefit of $816,000, compared to a tax benefitof $702,000 for the same period of 2007. For the year to date September 30, 2008 and 2007, provision forincome tax expense was $84,000 and $851,000, respectively.  Our income tax provision for the three andnine months ended September 30, 2008 were impacted by the capital losstreatment of our other-than-temporary impairment of our investment in FannieMae perpetual preferred stock. Subsequent to the end of the third quarter of 2008, the EmergencyEconomic Stabilization Act was enacted, which includes a provision permittingbanks to recognize the other-than-temporary impairment in Fannie Mae perpetualpreferred stock as an ordinary loss, which will increase the tax benefitavailable to us.  During the fourthquarter of 2008, we will record an additional tax benefit of $1.1 million relatingto this impairment.   See also “CriticalAccounting Policies — Valuation of Deferred Tax Assets.”

 

**Statements of Condition**

 

Totalassets were $1.64 billion and $1.69 billion at September 30, 2008 and December 31,2007, respectively.  The decrease in ourtotal assets was primarily driven by the decrease in total deposits and otherborrowed funds.  Total deposits decreased$11.4 million at September 30, 2008 compared to December 31,2007.  Other borrowed funds decreased$26.1 million to $374.0 million at September 30, 2008 compared to $400.1million at December 31, 2007.

 

*InvestmentSecurities*

 

Investmentsecurities were $283.3 million at September 30, 2008, compared to $364.9million at December 31, 2007, a decrease of $81.7 million. The decrease ininvestment securities is primarily due to sales, calls and maturities ofcertain of our U.S. government sponsored agency securities, for which wereinvested funds received from these transactions in our loan portfolio ordecreased certain other borrowed funds positions.  The investment portfolio consists ofinvestment securities available-for-sale and investment securitiesheld-to-maturity. Investment securities available-for-sale are those securitiesthat we intend to hold for an indefinite period of time, but not necessarilyuntil maturity. These securities are carried at fair value and may be sold aspart of an asset/liability strategy, liquidity management or regulatory capitalmanagement.  Investment securities held-to-maturityare those securities that we have the intent and ability to hold to maturityand are carried at amortized cost. At September 30, 2008, investmentsecurities available-for-sale were $231.0 million and investment securitiesheld-to-maturity were $52.2 million. At December 31, 2007, investmentsecurities available-for-sale were $286.0 million and investment securitiesheld-to-maturity were $78.9 million.  SeeTable 8 for additional information on our investment securities portfolio.

 

Ourinvestment portfolio consists primarily of securities backed or guaranteed bythe Federal National Mortgage Association (FNMA), Federal Home Loan MortgageCorporation (FHLMC) and Government National Mortgage Association (GNMA). For all non government or agency securities, we complete reviews at least quarterly.As of September 30, 2008, 93% of our investment securities portfolioconsisted of securities rated AAA by a leading rating agency.  Investmentsecurities which carry a AAA rating are judged to be of the best quality andcarry the smallest degree of investment risk.   We expect to receivefull payment of interest and principal on the securities in the investmentportfolio. The various protective elements on our non agency securities maychange in the future if market conditions or the financial stability of creditinsurers changes, which could impact the ratings of our securities.

 

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AtSeptember 30, 2008, we recorded an other-than-temporary impairment of $4.4million related to our investment in Fannie Mae perpetual preferred stock.  This impairment was due to the shares beingtraded well below their par value following the placement of Fannie Mae into conservatorshipby federal regulators in September.  Themarket value of the preferred shares was $436,000 as of September 30,2008.  We continue to hold shares inFannie Mae and will continue to review this investment for other-than-temporaryimpairment on at least a quarterly basis.

 

AtSeptember 30, 2008 and December 31, 2007, certain of our investmentgrade securities were in an unrealized loss position.  Investment securities with unrealized losseshave interest rates that are less than current market interest rates and,therefore, the indicated decrease in values are not a result of permanentcredit impairment.  Municipal securities,which totaled $33.3 million at September 30, 2008, are the primarycomponent of the unrealized losses in the available-for-sale investmentsecurities portfolio at those dates.  Ourmunicipal securities are AAA rated except for approximately $19.4 million ofpar value which was downgraded during 2008 to AA or single A status due to thedowngrades of the monoline insurance companies that insured those bonds.  The downgraded bonds remain generalobligations of the municipalities and while prices for these municipalsecurities are generally below book value, we expect to receive repayment ofall principal amounts due to us.  Thereis no other-than-temporary impairment on these municipal securities or anyother securities in our investment portfolio. In addition, our held-to-maturity investment securities portfolioincludes investments in pooled trust preferred securities, totaling $8.0million at September 30, 2008. These bonds are significantly below book value as of September 30,2008 due to the lack of liquidity in the market.  These bonds are rated AAA and we expect toreceive repayment of all principal amounts due to us. These bonds areclassified as held to maturity as we have the ability and intent to hold thesebonds in our portfolio until liquidity returns to the market or the bondsmature.  We expect the decrease in themarket value of these bonds to be temporary in nature.

 

Table 8.

 

**Investment Securities**

At September 30, 2008 and December 31, 2007

(In thousands)

 

 
| ** **                                                       | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at September 30, 2008** | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies                               |       |          |       |      |       |        |       |
| Five to ten years                                                |       | 28,763        |       | 28,498    |       | 5.33        | %          |
| After ten years                                                  |       | 436           |       | 436       |       | 8.25        | %          |
| Total U.S. government-sponsored agencies                         |       | 29,199        |       | 28,934    |       | 5.38        | %          |
|                                                             |       |          |       |      |       |        |       |
| Mortgage-backed securities (1)                                   |       |          |       |      |       |        |       |
| One to five years                                                |       | 2,897         |       | 2,920     |       | 4.31        | %          |
| Five to ten years                                                |       | 29,746        |       | 29,128    |       | 4.10        | %          |
| After ten years                                                  |       | 139,200       |       | 139,007   |       | 5.11        | %          |
| Total mortgage-backed securities                                 |       | 171,843       |       | 171,055   |       | 4.92        | %          |
|                                                             |       |          |       |      |       |        |       |
| Municipal securities (2)                                         |       |          |       |      |       |        |       |
| After ten years                                                  |       | 33,264        |       | 30,455    |       | 4.09        | %          |
| Total municipal securities                                       |       | 33,264        |       | 30,455    |       | 4.09        | %          |
|                                                             |       |          |       |      |       |        |       |
| U. S. treasury securities                                        |       |          |       |      |       |        |       |
| One to five years                                                |       | 600           |       | 600       |       | 1.43        | %          |
| Total U.S. treasury securities                                   |       | 600           |       | 600       |       | 1.43        | %          |
| Total investment securities  available-for-sale                  |       | $             | 234,906    |      | $          | 231,044     |       | 4.85 | % |
|                                                             |       |          |       |      |       |        |       |
| ** **                                                       | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
| **Held-to-maturity at September 30, 2008**   | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies                               |       |          |       |      |       |        |       |
| One to five years                                                |       | $             | 2,001      |      | $          | 1,996       |       | 4.30 | % |
| Total U.S. government-sponsored agencies                         |       | 2,001         |       | 1,996     |       | 4.30        | %          |
|                                                             |       |          |       |      |       |        |       |
| Mortgage-backed securities (1)                                   |       |          |       |      |       |        |       |
| One to five years                                                |       | 1,985         |       | 1,977     |       | 4.27        | %          |
| Five to ten years                                                |       | 9,740         |       | 9,632     |       | 4.48        | %          |
| After ten years                                                  |       | 30,499        |       | 30,356    |       | 4.58        | %          |
| Total mortgage-backed securities                                 |       | 42,224        |       | 41,965    |       | 4.54        | %          |
|                                                             |       |          |       |      |       |        |       |
| Corporate bonds                                                  |       |          |       |      |       |        |       |
| After ten years                                                  |       | 8,004         |       | 4,784     |       | 3.77        | %          |
| Total corporate bonds                                            |       | 8,004         |       | 4,784     |       | 3.77        | %          |
| Total investment securities  held-to-maturity                    |       | 52,229        |       | 48,745    |       | 4.42        | %          |
|                                                             |       |          |       |      |       |        |       |
| Total investment securities                                      |       | $             | 287,135    |      | $          | 279,789     |       | 4.77 | % |

 

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| ** **                                                      | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|-----------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at December 31, 2007** | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies                              |       |          |       |      |       |        |       |
| One to five years                                               |       | $             | 44,160     |      | $          | 44,161      |       | 5.59 | % |
| Five to ten years                                               |       | 39,116        |       | 39,850    |       | 5.99        | %          |
| Total U.S. government-sponsored agencies                        |       | 83,276        |       | 84,011    |       | 5.78        | %          |
|                                                            |       |          |       |      |       |        |       |
| Mortgage-backed securities (1)                                  |       |          |       |      |       |        |       |
| One to five years                                               |       | 3,552         |       | 3,526     |       | 4.25        | %          |
| Five to ten years                                               |       | 10,902        |       | 10,746    |       | 3.89        | %          |
| After ten years                                                 |       | 154,435       |       | 153,912   |       | 5.13        | %          |
| Total mortgage-backed securities                                |       | 168,889       |       | 168,184   |       | 5.03        | %          |
|                                                            |       |          |       |      |       |        |       |
| Municipal securities (2)                                        |       |          |       |      |       |        |       |
| After ten years                                                 |       | 33,671        |       | 33,219    |       | 4.09        | %          |
| Total municipal securities                                      |       | 33,671        |       | 33,219    |       | 4.09        | %          |
|                                                            |       |          |       |      |       |        |       |
| U. S. treasury securities                                       |       |          |       |      |       |        |       |
| One to five years                                               |       | 592           |       | 584       |       | 4.09        | %          |
| Total U.S. treasury securities                                  |       | 592           |       | 584       |       | 4.09        | %          |
| Total investment securities  available-for-sale                 |       | $             | 286,428    |      | $          | 285,998     |       | 5.14 | % |
|                                                            |       |          |       |      |       |        |       |
| ** **                                                      | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
| **Held-to-maturity at December 31, 2007**   | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies                              |       |          |       |      |       |        |       |
| One to five years                                               |       | $             | 6,500      |      | $          | 6,468       |       | 3.63 | % |
| Five to ten years                                               |       | 11,011        |       | 10,998    |       | 4.52        | %          |
| After ten years                                                 |       | 2,000         |       | 2,002     |       | 5.30        | %          |
| Total U.S. government-sponsored agencies                        |       | 19,511        |       | 19,468    |       | 4.30        | %          |
|                                                            |       |          |       |      |       |        |       |
| Mortgage-backed securities (1)                                  |       |          |       |      |       |        |       |
| One to five years                                               |       | 379           |       | 383       |       | 4.71        | %          |
| Five to ten years                                               |       | 7,618         |       | 7,555     |       | 4.29        | %          |
| After ten years                                                 |       | 43,436        |       | 43,133    |       | 4.52        | %          |
| Total mortgage-backed securities                                |       | 51,433        |       | 51,071    |       | 4.49        | %          |
|                                                            |       |          |       |      |       |        |       |
| Corporate bonds                                                 |       |          |       |      |       |        |       |
| After ten years                                                 |       | 8,004         |       | 7,629     |       | 4.56        | %          |
| Total corporate bonds                                           |       | 8,004         |       | 7,629     |       | 4.56        | %          |
| Total investment securities held-to-maturity                    |       | 78,948        |       | 78,168    |       | 4.45        | %          |
|                                                            |       |          |       |      |       |        |       |
| Total investment securities                                     |       | $             | 365,376    |      | $          | 364,166     |       | 4.99 | % |

 

----

| (1) | Based  on contractual maturities.                                                        |
|-----|------------------------------------------------------------------------------------------|
| (2) | Yields  for tax-exempt municipal securities are not reported on a tax-equivalent  basis. |

 

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*Loans*

 

Loansreceivable, net of deferred fees and costs, were $1.09 billion at September 30,2008 and $1.04 billion at December 31, 2007, an increase of $46.8million.  See Table 9 for details on theloans receivable portfolio. During the nine months of 2008, the mix of our loanportfolio changed slightly, with decreases in commercial and industrial loansand consumer loans, and increases in real estate commercial, real estateconstruction, real estate residential and home equity loans.  Loans held for sale at September 30,2008 was $134.6 million compared to $170.5 million at December 31, 2007, adecrease of $35.9 million.  Loans heldfor sale are valued at the lower of cost or market value. The decrease in loansheld for sale at September 30, 2008 compared to December 31, 2007 isdue to decreased loan origination volume as a result of the deterioration ofthe residential real estate market.

 

Table 9.

 

**Loans Receivable**

At September 30, 2008 and December 31, 2007

(In thousands)

 
| ** **                      | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|---------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                            |       |                             |       |                            |       |   |   |   |   |
| Commercial and industrial       |       | $                                | 118,848    |                            | 10.93      | % | $ | 140,531 |   | 13.51 | % |
| Real estate - commercial        |       | 460,294                          |       | 42.34                           | %          | 415,471 |   | 39.95 | % |
| Real estate - construction      |       | 192,840                          |       | 17.74                           | %          | 186,514 |   | 17.93 | % |
| Real estate - residential       |       | 213,655                          |       | 19.65                           | %          | 213,197 |   | 20.50 | % |
| Home equity lines               |       | 99,021                           |       | 9.11                            | %          | 81,247 |   | 7.81 | % |
| Consumer                        |       | 2,513                            |       | 0.23                            | %          | 3,129 |   | 0.30 | % |
|                            |       |                             |       |                            |       |   |   |   |   |
| Gross loans                     |       | $                                | 1,087,171  |                            | 100.00     | % | 1,040,089 |   | 100.00 | % |
|                            |       |                             |       |                            |       |   |   |   |   |
| Net deferred (fees) costs       |       | (640                             | )          |                            |       | (405 | ) |   |   |
| Less: allowance for loan losses |       | (13,257                          | )          |                            |       | (11,641 | ) |   |   |
|                            |       |                             |       |                            |       |   |   |   |   |
| Loans receivable, net           |       | $                                | 1,073,274  |                            |       |   | $ | 1,028,043 |   |   |   |

 

*Deposits*

 

Totaldeposits were $1.09 billion at September 30, 2008 compared to $1.10billion at December 31, 2007. We had increases in our noninterest bearingchecking products and decreases in our interest checking, money market, savingsand certificates of deposit products. Overall, 

 

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depositbalances decreased as customers who were seeking premium pricing withdrew fundsfrom us because we choose not to match our competitors higher rates in order topreserve our interest rate margin.  SeeTable 10 for details on certificates of deposit with balances of $100,000 ormore. During 2008, we joined the Certificates of Deposit Account RegistryService (“CDARS”).  CDARS allows ourcustomers to access FDIC insurance protection on multi-million dollarcertificates of deposit through our Bank. When a customer places a large deposit through CDARS, we place their fundsinto certificates of deposit with other banks in the CDARS network inincrements of less than $100,000 so that principal and interest are eligiblefor FDIC insurance protection.  At September 30,2008, we had $42.2 million in CDARS deposits, which are considered to bebrokered deposits.  Brokered certificatesof deposit not in the CDARS network were $28.3 million and $10.0 million at September 30,2008 and December 31, 2007, respectively.

 

Table 10.

 

**Certificates of Deposit of $100,000 or More**

At September 30, 2008

(In thousands)

 
| **Maturities:**                       | ** ** | **Fixed Term** | ** ** | **No-Penalty*** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------------------|------------|-----------------|------------|-----------|------------|
| Three months or less                  |       | $                   | 40,238     |            | $          | 4,686     |       | $ | 44,924 |   |
| Over three months through six months  |       | 25,421              |       | 3,225           |       | 28,646    |       |
| Over six months through twelve months |       | 28,224              |       | 11,359          |       | 39,583    |       |
| Over twelve months                    |       | 55,754              |       | 1,680           |       | 57,434    |       |
|                                  |       | $                   | 149,637    |            | $          | 20,950    |       | $ | 170,587 |   |

 

----

*No-Penalty certificates of deposit can be redeemed at anytime at the request ofthe depositor.

 

*Borrowings*

 

Otherborrowed funds decreased $26.1 million to $374.0 million at September 30,2008, compared to $400.1 million at December 31, 2007.  Federal funds purchased at September 30,2008 and December 31, 2007 were $0 and $68.0 million, respectively.   Treasury, Tax & Loan Note optionborrowings decreased $10.1 million to $1.0 million at September 30, 2008compared to $11.2 million at December 31, 2007.  FHLB advances increased $58.5 million to$290.0 million at September 30, 2008 compared to $233.5 million at December 31,2007. Customer repurchase agreements decreased $4.4 million to $62.4 million atSeptember 30, 2008 compared to $66.8 million at December 31,2007.  The overall decrease in ournon-deposit borrowed funds was due to the decrease in our investment securitiesportfolio offset by loan growth we have had over the past nine months.  Table 11 provides information on ourborrowings.

 

Table 11.

 

**Short-Term Borrowings and Other Borrowed Funds**

At September 30, 2008

(In thousands)

 
| ** **                                                     | ** ** | ** **             | ** ** | **Amount**      | ** **  |
|----------------------------------------------------------------|------------|------------------------|------------|-----------------|-------------|
| ** **                                                     | ** ** | **Interest Rate** | ** ** | **Outstanding** | ** **  |
| ** **                                                     | ** ** | ** **             | ** ** | ** **      | ** **  |
| **Short-term borrowed funds:**                                 | ** ** | ** **             | ** ** | ** **      | ** **  |
| TT&L note option                                           |       | 2.80                   | %          | $               | 1,025       |   |
| Customer repurchase agreements                                 |       | 2.20                   | %          | 62,363          |        |
|                                                           |       |                   |       |            |        |
| **Total short-term borrowed funds and  weighted average rate** | ** ** | **2.21**               | **%**      | **$**           | **63,388**  | ** ** |
| ** **                                                     | ** ** | ** **             | ** ** | ** **      | ** **  |
| **Other borrowed funds:**                                      | ** ** | ** **             | ** ** | ** **      | ** **  |
| Trust preferred                                                |       | 5.97                   | %          | $               | 20,619      |   |
| FHLB advances - long term                                      |       | 3.95                   | %          | 290,000         |        |
| **Other borrowed funds and weighted average  rate**            | ** ** | **4.08**               | **%**      | **$**           | **310,619** | ** ** |
|                                                           |       |                   |       |            |        |
| **Total other borrowed funds and weighted  average rate**      | ** ** | **3.77**               | **%**      | **$**           | **374,007** | ** ** |

 

*Shareholders’Equity*

 

Shareholders’equity at September 30, 2008 was $154.5 million compared to $159.5 millionat December 31, 2007, a decrease of $4.9 million, or 3%. During the firstnine months of 2008, we repurchased 109,441 shares of our common stock underour share repurchase plan for a cost of $900,000.  In addition, our accumulated othercomprehensive loss increased $2.0 million for the year to date September 30,2008, which was primarily related to the change in the market value of ouravailable-for-sale investment securities. Our year-to-date net loss of $1.5 million also contributed to ourdecrease in shareholders’ equity.  Bookvalue per share at September 30, 2008 was $6.41 compared to $6.45 at December 31,2007. Tangible book value per share (which is book value per share adjusted forchanges in other comprehensive income, less goodwill and other intangibleassets) at September 30, 2008 was $5.92 compared to $5.82 at December 31,2007.

 

##### **Business SegmentOperations**

##### ** **

Weprovide banking and non-banking financial services and products through oursubsidiaries. We operate in three business segments, commercial banking,mortgage banking and wealth management and trust services.

 

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*Commercial Banking*

 

Thecommercial banking segment includes both commercial and consumer lending andprovides customers such products as commercial loans, real estate loans, andother business financing and consumer loans. In addition, this segment alsoprovides customers with various deposit products including demand depositaccounts, savings accounts and certificates of deposit.

 

Forthe three months ended September 30, 2008, the commercial banking segmentrecorded a net loss of $1.7 million compared to net income of $1.8 million forthe same period of 2007. For the nine months ended September 30, 2008,this segment recorded net income of $3.2 million compared to $5.4 million forthe year to date 2007, a decrease of $2.2 million.  The decrease in net income is primarilyrelated to the aforementioned other-than-temporary impairment charge related toour investment in Fannie Mae perpetual preferred stock. Operating results forthis business segment were supplemented by an increase in net interest incomeand noninterest income for the three and nine months ended September 30,2008 as compared to the same periods of 2007. Provision for loan losses decreased $50,000 to $865,000 for the threemonths ended September 30, 2008 compared to $915,000 for the three monthsended September 30, 2007.  For thenine months ended September 30, 2008 and 2007, provision for loan lossexpense was $1.8 million and $1.7 million, respectively.  Noninterest income increased $113,000 to $1.1million for the three months ended September 30, 2008 compared to $1.0million for the three months ended September 30, 2007.  For the year to date September 30, 2008and 2007, noninterest income was $3.6 million and $3.1 million,respectively.  The increase innoninterest income in both the three and nine months ended September 30,2008 compared to the same periods of 2007 were primarily related to gainsrecorded on sales of investment securities held-for-sale.  Noninterest expense increased $4.6 million to$12.1 million for the three months ended September 30, 2008 compared to$7.5 million for the same period of 2007. The increase in noninterest expense for the third quarter of 2008compared to the same period of 2007, was directly related to theother-than-temporary impairment charge. For the nine months ended September 30, 2008 and 2007, noninterestexpense was $27.2 million and $22.7 million, respectively.  At September 30, 2008, total assets forthis segment were $1.62 billion, loans receivable, net of deferred fees andcosts, were $1.09 billion and total deposits were $1.09 billion. At September 30,2007, total assets were $1.64 billion, loans receivable, net of deferred feesand costs, were $973.5 million and total deposits were $1.14 billion.

 

*MortgageBanking*

 

Theoperations of the mortgage banking segment are conducted through George Mason.George Mason engages primarily in the origination and acquisition ofresidential mortgages for sale into the secondary market on a best effortsbasis.

 

Forthe three months ended September 30, 2008 and 2007, the mortgage bankingsegment recorded a net loss of $2.2 million and net income of $429,000,respectively. For the nine months ended September 30, 2008 and 2007,George Mason recorded a net loss of $2.9 million and net income of $1.5million, respectively.  The decrease innet income is primarily attributable to the aforementioned goodwill impairmentof $2.8 million during the third quarter of 2008 and the cash settlement of$1.8 million to a mortgage correspondent during the second quarter of2008.  In addition, decreases in netinterest income and noninterest income are due to the decreased loan volumeover the comparable periods.  Noninterestincome decreased $249,000 to $2.4 million for the three months ended September 30,2008 compared to $2.6 million for the same three month

 

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periodof 2007.  For the nine months ended September 30,2008 and 2007, noninterest income was $7.1 million and $9.0 million,respectively.  Noninterest expenseincreased $3.0 million to $5.7 million for the three months ended September 30,2008 compared to $2.7 million for the same three month period of 2007.  For the nine months ended September 30,2008 and 2007, noninterest expense was $13.0 million and $9.0 million,respectively.  At September 30,2008, total assets for this segment were $147.3 million; loans held for salewere $134.6 million and mortgage funding checks were $7.3 million. At September 30,2007, total assets were $163.9 million; loans held for sale were $144.4 millionand mortgage funding checks were $17.8 million.

 

*Wealth Management and Trust Services*

 

Thewealth management and trust services segment provides investment and financialservices to businesses and individuals, including financial planning,retirement/estate planning, trusts, estates, custody, investment management,escrows, and retirement plans. Operations of the Bank’s trust division, CWS andWilson/Bennett are included in this operating segment.

 

Forthe three months ended September 30, 2008 and 2007, the wealth managementand trust services segment recorded net income of $21,000 and a net loss of$2.0 million, respectively. For the year to date September 30, 2008 and2007, this business segment recorded net income of $89,000 and a net loss of$1.7 million, respectively.  During the2007 periods, this business segment recorded a loss on an escrow arrangement of$3.8 million, attributing to the net loss for those periods.  For the three months ended September 30,2008 and 2007, noninterest income was $893,000 and $1.1 million,respectively.  For the nine months ended September 30,2008 and 2007, noninterest income was $2.7 million and $3.2 million,respectively.  Noninterest expense forthe three months ended September 30, 2008 and 2007 was $859,000 and $4.4million, respectively.  For the ninemonths ended September 30, 2008 and 2007, noninterest expense was $2.6million and $6.3 million, respectively. At September 30, 2008, total assets were $3.6 million and managedand custodial assets were $3.2 billion. At September 30, 2007, totalassets for this segment were $4.2 million and managed and custodial assets were$6.2 billion. The decrease in managed and custodial assets the relatednoninterest income is primarily attributable to a decrease in managed assets atour trust division due to the loss of low margin custody relationships with twoclients and the departure of certain personnel at CWS.

 

Informationpertaining to our business segments can be found in Note 3 to the notes toconsolidated financial statements.

 

## **Capital Resources**

## ** **

Capitaladequacy is an important measure of financial stability and performance. Ourobjectives are to maintain a level of capitalization that is sufficient tosustain asset growth and promote depositor and investor confidence.

 

Regulatoryagencies measure capital adequacy utilizing a formula that takes into accountthe individual risk profile of the financial institution. The guidelines definecapital as both Tier 1 (which includes common shareholders’ equity, defined toinclude certain debt obligations) and Tier 2 (which includes certain other debtobligations, a portion of the allowance for loan losses, and 45% of anyunrealized gains in equity securities).

 

AtSeptember 30, 2008, our Tier 1 and total (Tier 1 and Tier 2) risk-basedcapital ratios were 11.93% and 12.91%, respectively. Included in our risk-basedcapital ratios at September 30, 2008 is the additional tax benefit of $1.1million associated with the other-than-temporary

 

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impairmentof our investment in Fannie Mae perpetual preferred stock.  This additional tax benefit will be recordedduring the fourth quarter of 2008, allowing for an ordinary loss treatment onthis impairment.  For risk-based capitalpurposes only, we are including this ordinary tax benefit as federal bankingagencies are allowing banks to adjust the tax effects associated with theseimpairments as if the Emergency Economic Stabilization Act had been enacted asof September 30, 2008.  Ourregulatory capital levels for the Bank and bank holding company meet thoseestablished for well-capitalized institutions.

 

  At December 31, 2007, our Tier 1 andtotal risk-based capital ratios were 12.10% and 12.98%, respectively.  Table 12 provides additional informationpertaining to our capital ratios.

 

Table 12.

 

**Capital Components**

At September 30, 2008 and December 31,2007

(In thousands)

 
| ** **                                                        | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                        | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                                                        | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                                                        | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **Cardinal Financial Corporation (Consolidated):** | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
|                                                              |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| **At September 30, 2008**                                    |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based capital/ Total capital to  risk-weighted assets  |       | $          | 177,377    |                       | 12.91      | %                          | $          | 109,904                    | >  | 8.00                       | %          | $ | 137,380 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets           |       | 163,914    |       | 11.93                      | %          | 54,952                     | >  | 4.00                       | %          | 82,428                     | >  | 6.00 | % |
| Tier I capital/ Total capital to average  assets                  |       | 163,914    |       | 10.22                      | %          | 64,153                     | >  | 4.00                       | %          | 80,192                     | >  | 5.00 | % |
|                                                              |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| **At December 31, 2007**                                     |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based capital/ Total capital to  risk-weighted assets  |       | $          | 174,523    |                       | 12.98      | %                          | $          | 107,569                    | >  | 8.00                       | %          | $ | 134,461 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets           |       | 162,691    |       | 12.10                      | %          | 53,785                     | >  | 4.00                       | %          | 80,677                     | >  | 6.00 | % |
| Tier I capital/ Total capital to average  assets                  |       | 162,691    |       | 10.26                      | %          | 63,456                     | >  | 4.00                       | %          | 79,320                     | >  | 5.00 | % |

 
| ** **                                                       | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well**   | ** ** |
|------------------------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                       | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                                                       | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                                                       | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **Cardinal Bank:**                                               | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| ** **                                                       |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| **At September 30, 2008**                                   |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based capital/ Total capital to  risk-weighted assets |       | $          | 166,139    |                       | 12.12      | %                          | $          | 109,652                    | >  | 8.00                       | %          | $ | 137,065 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets          |       | 152,676    |       | 11.14                      | %          | 54,826                     | >  | 4.00                       | %          | 82,239                     | >  | 6.00 | % |
| Tier I capital/ Total capital to average  assets                 |       | 152,676    |       | 9.54                       | %          | 64,027                     | >  | 4.00                       | %          | 80,034                     | >  | 5.00 | % |
|                                                             |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| **At December 31, 2007**                                    |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Total risk-based capital/ Total capital to  risk-weighted assets |       | $          | 159,745    |                       | 11.91      | %                          | $          | 107,308                    | >  | 8.00                       | %          | $ | 134,135 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets          |       | 147,913    |       | 11.03                      | %          | 53,654                     | >  | 4.00                       | %          | 80,481                     | >  | 6.00 | % |
| Tier I capital/ Total capital to average  assets                 |       | 147,913    |       | 9.34                       | %          | 63,331                     | >  | 4.00                       | %          | 79,163                     | >  | 5.00 | % |

 

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**Contractual Obligations**

 

We have entered into anumber of long-term contractual obligations to support our ongoing businessactivities. These contractual obligations will be funded through operatingrevenues and liquidity sources held or available to us and exclude contractualinterest costs, where applicable. The required payments under such obligationsare detailed in Table 13.

 

Table 13.

 

**Contractual Obligations**

At September 30, 2008

(In thousands)

 
| ** **                                           | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **Total**                                 | ** ** | **Less than 1  Year** | ** ** | **1 - 3 Years** | ** ** | **3 - 5 Years** | ** ** | **More than 5  Years** | ** ** |
| Long-Term Debt Obligations:                          | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Certificates of deposit                              |       | $                                         | 404,189    |   | $ | 262,736 |   | $ | 138,070 |   | $ | 3,383 |   | $ | — |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Brokered certificates of deposit                     |       | 70,479                                    |       | 62,076 |   | 8,403 |   | — |   | — |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Advances from the Federal Home Loan Bank of  Atlanta |       | 290,000                                   |       | — |   | 10,000 |   | 125,000 |   | 155,000 |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Trust preferred securities                           |       | 20,619                                    |       | — |   | — |   | — |   | 20,619 |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating lease obligations                          |       | 17,609                                    |       | 4,743 |   | 3,573 |   | 5,242 |   | 4,051 |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |   |   |
| Total                                                |       | $                                         | 802,896    |   | $ | 329,555 |   | $ | 160,046 |   | $ | 133,625 |   | $ | 179,670 |   |

 

**Commitments and Contingencies**

 

In the normal course ofbusiness, we are a party to financial instruments with off-balance sheet riskto meet the financing needs of our customers. These financial instrumentsinclude commitments to extend credit and standby letters of credit. Thoseinstruments involve, to varying degrees, elements of credit risk in excess ofthe amount recognized on the balance sheet.

 

TheBank’s maximum exposure to credit loss in the event of nonperformance by theother party to the financial instrument for commitments to extend credit andstandby letters of credit is represented by the contractual amount of thoseinstruments. The Bank uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the agreement. Commitments generallyhave expiration dates or other termination clauses and may require payment of afee. Since many of the commitments are expected to expire without being drawnupon, the total commitment amounts do not necessarily represent future fundingrequirements. We evaluate each customer’s credit worthiness on a case-by-casebasis.  The amount of collateral obtainedis based on management’s credit evaluation of the counterparty.  Collateral held varies but may include accountsreceivable, inventory, property and equipment, and income-producing commercialproperties.

 

Standbyletters of credit are conditional commitments we issued to guarantee theperformance of the contractual obligations by a customer to a third party. Thoseguarantees are primarily issued to support public and private borrowingarrangements, including commercial paper, bond financing, and similartransactions. The credit risk involved in issuing standby letters of credit isessentially the same as that involved in extending loan facilities tocustomers. We hold certificates of deposit, deposit accounts, real estate orother appropriate forms of collateral 

 

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supportingthose commitments for which collateral is deemed necessary.  The majority of these guarantees extend untilsatisfactory completion of the customer’s contractual obligations.

 

AtSeptember 30, 2008, commitments to extend credit were $431.0 million andstandby letters of credit were $9.7 million. The liability associated withstandby letters of credit at September 30, 2008 was $11,000.

 

GeorgeMason maintains a reserve for loans sold that pay off earlier than thecontractual agreed upon period, thereby requiring that George Mason refund partof the service release premium and/or premium pricing received from theinvestor.  The reserve as of September 30,2008 was $14,000.

 

GeorgeMason has a reserve for its estimated exposure to repurchase loans previouslysold to investors for which borrowers failed to provide full and accurateinformation on or related to their loan application or for which appraisalshave not been acceptable.  In addition,George Mason, as part of the service it provides to its managed companies,purchases the loans managed companies originate at the time oforigination.  These loans are then soldby George Mason to investors.  GeorgeMason has agreements with its managed companies requiring that, for any loansthat were originated by a managed company and for which investors haverequested George Mason to repurchase due to the borrowers failure to providefull and accurate information on or related to their loan application or for whichappraisals have not been acceptable, the managed company be responsible forbuying back the loan.  In the event thatthe managed company’s financial condition deteriorates and it is unable to fundthe repurchase of such loans, George Mason may have to provide the funds torepurchase these loans from investors.

 

During the second quarter of2008, George Mason entered into an agreement with a mortgage correspondentrelated to the loan purchase agreement between the two parties.  This agreement provided for the release ofknown and unknown claims by the mortgage correspondent in exchange for a $2.8million payment to the correspondent. The terms of this agreement require that we may be obligated to makeadditional payments to the correspondent in future periods based on certainconditions.  We believe the additionalexposure under this agreement is not material as over the course of the nexttwo years there is a potential payment of no more than $0.03 diluted earnings pershare in total.  The amount of this potentialexposure declines with the passage of time. In conjunction with the agreement, George Mason entered into similaragreements with certain managed companies, from which George Mason purchasedloans and subsequently sold to this mortgage correspondent.  These settlement agreements provided for atotal payment of $1.0 million to George Mason by those managed companies ofwhich $550,000 has already been paid.

 

George Mason’s reserve forpossible loan repurchases was $562,000 at September 30, 2008.

 

We have counter-party riskthat may arise from the possible inability of George Mason’s third partyinvestors to meet the terms of their forward sales contracts.  George Mason works with third-party investorsthat are generally well-capitalized, are investment grade and exhibit strongfinancial performance to mitigate this risk. We do not expect any third-party investor to fail to meet itsobligation.  In addition, we havederivative counterparty risk relating to certain interest rate swaps we havewith a third party.  This risk may arisefrom the inability of the third party to meet the terms of the contracts.  We monitor the financial condition of thisthird party on an annual basis.  We donot expect this third party to fail to meet its obligation.

 

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## **Liquidity**

## ** **

Liquidityin the banking industry is defined as the ability to meet the demand for fundsof both depositors and borrowers. We must be able to meet these needs byobtaining funding from depositors or other lenders or by converting noncashitems into cash.  The objective of ourliquidity management program is to ensure that we always have sufficientresources to meet the demands of our depositors and borrowers. Stable coredeposits and a strong capital position provide the base for our liquidityposition. We believe we have demonstrated our ability to attract depositsbecause of our convenient branch locations, personal service and pricing.

 

Inaddition to deposits, we have access to various wholesale funding markets.These markets include the brokered CD market, the repurchase agreement marketand the federal funds market. During 2008, we joined the Certificates ofDeposit Account Registry Service (“CDARS”). CDARS allows our customers to access FDIC insurance protection onmulti-million dollar certificates of deposit through our Bank.  When a customer places a large deposit throughCDARS, we place their funds into certificates of deposit with other banks inthe CDARS network in increments of less than $100,000 so that principal andinterest are eligible for FDIC insurance protection.  We also maintain secured lines of credit withthe Federal Reserve Bank of Richmond and the Federal Home Loan Bank of Atlanta.Having diverse funding alternatives reduces our reliance on any one source forfunding.

 

Cashflow from amortizing assets or maturing assets can also provide funding to meetthe needs of depositors and borrowers.

 

Wehave established a formal liquidity contingency plan which establishes aliquidity management team and provides guidelines for liquidity management. Forour liquidity management program, we first determine our current liquidityposition and then forecast liquidity based on anticipated changes in thebalance sheet. In this forecast, we expect to maintain a liquidity cushion. Wealso stress test our liquidity position under several different stressscenarios. Guidelines for the forecasted liquidity cushion and for liquiditycushions for each stress scenario have been established. In addition, onestress test combines all other stress tests to see how liquidity would react toseveral negative scenarios occurring at the same time. We believe that we havesufficient resources to meet our liquidity needs.

 

Liquidassets, which include cash and due from banks, federal funds sold andinvestment securities available for sale, totaled $275.0 million at September 30,2008 or 17% of total assets. We held investments that are classified asheld-to-maturity in the amount of $52.2 million at September 30, 2008. Tomaintain ready access to the Bank’s secured lines of credit, the Bank haspledged roughly half of its investment securities and a portion of itsresidential real estate loan portfolio to the Federal Home Loan Bank of Atlantawith additional investment securities and certain loans in its commercial realestate and commercial & industrial portfolios pledged to the FederalReserve Bank of Richmond. Additional borrowing capacity at the Federal HomeLoan Bank of Atlanta at September 30, 2008 was $35 million. Borrowingcapacity with the Federal Reserve Bank of Richmond was $372 million at September 30,2008. We anticipate maintaining liquidity at a level sufficient to protectdepositors, provide for reasonable growth and fully comply with all regulatoryrequirements.

 

##### **Interest RateSensitivity**

##### ** **

We are exposed to variousbusiness risks including interest rate risk. Our goal is to maximize netinterest income without incurring excessive interest rate risk. Management ofnet

 

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interestincome and interest rate risk must be consistent with the level of capital andliquidity that we maintain. We manage interest rate risk through an asset andliability committee (“ALCO”). ALCO is responsible for managing the interestrate risk in conjunction with liquidity and capital management.

 

Weemploy an independent consulting firm to model our interest ratesensitivity.  We use a net interestincome simulation model as our primary tool to measure interest ratesensitivity. Many assumptions are developed based on expected activity in thebalance sheet. For maturing assets, assumptions are created for theredeployment of these assets. For maturing liabilities, assumptions aredeveloped for the replacement of these funding sources. Assumptions are alsodeveloped for assets and liabilities that could reprice during the modeled timeperiod. These assumptions also cover how we expect rates to change onnon-maturity deposits such as interest checking, money market checking, savingsaccounts as well as certificates of deposit. With the funding markets stilllacking liquidity, forecasts for deposit rate movements carry greateruncertainty than when this market is functioning normally. Based on inputs thatinclude the current balance sheet, the current level of interest rates and thedeveloped assumptions, the model then produces an expected level of netinterest income assuming that market rates remain unchanged. This is consideredthe base case. Next, the model determines what net interest income would bebased on specific changes in interest rates. The rate simulations are performedfor a two year period and include ramped rate changes of down 100 basis pointsand up 200 basis points. The down 200 basis point scenario was discontinuedgiven the current level of interest rates. In the ramped down rate change, the model moves rates gradually down 100basis points over the first year and then rates remain flat in the second year.

 

Forthe up 200 basis point scenario, rates are gradually moved up 200 basis pointsin the first year and then rates remain flat in the second year. In both the upand down scenarios, the model assumes a parallel shift in the yield curve. Theresults of these simulations are then compared to the base case.

 

AtSeptember 30, 2008, we were asset sensitive for the entire two year simulation.  Asset sensitive means that yields on theBank’s interest-earning assets will rise faster than interest-bearing liabilitycosts in a rising rate environment.  Fora declining rate environment, asset yields will fall faster thaninterest-bearing liability costs.  Beingasset sensitive means our net interest income should increase in a rising ratescenario.  In the up 200 basis point ratescenario, our net interest income would improve by not more than 2.4% for theone year period and by not more than 4.9% over the two year time horizon.  In the down 100 basis point scenario theinterest rate risk model indicates that our net interest income will be nearlyunchanged from the base case over the one year period and the two year timehorizon.

 

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**Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

Our Asset/LiabilityCommittee is responsible for reviewing our liquidity requirements and maximizingour net interest income consistent with capital requirements, liquidity,interest rate and economic outlooks, competitive factors and customer needs.Interest rate risk arises because the assets of the Bank and the liabilities ofthe Bank have different maturities and characteristics. In order to measurethis interest rate risk, we use a simulation process that measures the impactof changing interest rates on net interest income. This model is run for theBank by an independent consulting firm. The simulations incorporate assumptionsrelated to expected activity in the balance sheet. For maturing assets,assumptions are developed for the redeployment of these assets. For maturingliabilities, assumptions are developed for the replacement of these fundingsources. Assumptions are also developed for assets and liabilities that repriceduring the modeled time period. These assumptions also cover how we expectrates to change on non-maturity deposits such as interest checking, moneymarket checking, savings accounts as well as certificates of deposit. With thefunding markets still lacking liquidity, forecasts for deposit rate movementscarry greater uncertainty than when this market is functioning normally. Basedon inputs that include the most recent period end balance sheet, the currentlevel of interest rates and the developed assumptions, the model then producesan expected level of net interest income assuming that interest rates remainunchanged. This becomes the base case. Next, the model determines the impact onnet interest income given specified changes in interest rates. The ratesimulations are performed for a two year period and include ramped rate changesof down 100 basis points and up 200 basis points. The down 200 basis pointscenario was discontinued given the current level of interest rates.  In the ramped down rate change, the modelmoves rates gradually down 100 basis points over the first year and then ratesremain flat in the second year. For the up 200 basis point scenario, rates aregradually increased by 200 basis points in the first year and remain flat inthe second year. In both the up and down scenarios, the model assumes aparallel shift in the yield curve. The results of these simulations are thencompared to the base case.

 

At September 30, 2008, we were asset sensitive for the entire two yearsimulation.  Asset sensitive means thatyields on the Bank’s interest-earning assets will rise faster thaninterest-bearing liability costs in a rising rate environment.  For a declining rate environment, assetyields will fall faster than interest-bearing liability costs.  Being asset sensitive means our net interestincome should increase in a rising rate scenario.  In the up 200 basis point rate scenario, ournet interest income would improve by not more than 2.4% for the one year periodand by not more than 4.9% over the two year time horizon.  In the down 100 basis point scenario theinterest rate risk model indicates that our net interest income will be nearlyunchanged from the base case over the one year period and the two year timehorizon.

 

See also “Interest RateSensitivity” in Item 2 above for a discussion of our interest rate risk.

 

We have counter-party riskthat may arise from the possible inability of George Mason’s third partyinvestors to meet the terms of their forward sales contracts.  George Mason works with third-party investorsthat are generally well-capitalized, are investment grade and exhibit strongfinancial performance to mitigate this risk. We do not expect any third-party investor to fail to meet itsobligation.  In addition, we havederivative counterparty risk relating to certain interest rate swaps we havewith a third party.  This risk may arisefrom the inability of the third party to meet the terms of the contracts.  We monitor the financial condition of thisthird party on an annual basis.  We donot expect this third party to fail to meet its obligation.

 

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**Item 4.  Controls and Procedures**

 

The Company maintainsdisclosure controls and procedures that are designed to ensure that theinformation required to be disclosed by it in the reports that it files or submitsunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods required by the Securities andExchange Commission, including, without limitation, those controls andprocedures designed to ensure that such information is accumulated andcommunicated to the Company’s management to allow timely decisions regardingrequired disclosures.

 

As of the end of the periodcovered by this report, an evaluation of the effectiveness of the design and operationof the Company’s disclosure controls and procedures was carried out under thesupervision and with the participation of the Company’s management, includingits chief executive officer and chief financial officer. Based on and as of thedate of such evaluation, these officers concluded that the Company’s disclosurecontrols and procedures were effective.

 

The Company also maintains asystem of internal accounting controls that is designed to provide assurancethat assets are safeguarded and that transactions are executed in accordancewith management’s authorization and are properly recorded. This system iscontinually reviewed and is augmented by written policies and procedures, thecareful selection and training of qualified personnel and an internal auditprogram to monitor its effectiveness. There were no changes in our internalcontrol over financial reporting identified in connection with our evaluationof it that occurred during our last fiscal quarter that materially affected, orare likely to materially affect, our internal control over financial reporting.

 

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**PART II – OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

In the ordinary course of our operations, we may become party to legalproceedings.

 

On February 28, 2008,OneBeacon Midwest Insurance Company (“OneBeacon”) filed a complaint fordeclaratory judgment in the U.S. District Court for the Eastern District ofVirginia.  OneBeacon provides insurancecoverage for us and we have filed an insurance claim and proof of loss torecover the loss recorded in 2007 on the escrow arrangement between LibertyGrowth Fund LP and AIMS Worldwide, Inc. On September 2, 2008, we entered into a Settlement Agreement andFull and Final Release of All Claims (the “Settlement Agreement”) withOneBeacon.  Pursuant to the SettlementAgreement, the parties dismissed all claims asserted, with prejudice and on themerits.  The consideration paid byOneBeacon under the Settlement Agreement is immaterial to our consolidatedfinancial statements for the quarter ended September 30, 2008.

 

**Item 1A. Risk Factors**

 

Our operationsare subject to many risks that could adversely affect our future financialcondition and performance and, therefore, the market value of oursecurities.  The risk factors that areapplicable to us are outlined in our Annual Report on Form 10-K for theyear ended December 31, 2007.  Exceptas noted below, there have been no material changes in our risk factors fromthose disclosed in our Annual Report on Form 10-K for the year endedDecember 31, 2007.

 

***Difficult market conditions have adversely affected our industry.***

 

Dramatic declines in thehousing market over the past year, with falling home prices and increasingforeclosures, unemployment and under-employment, have negatively impacted thecredit performance of real estate related loans and resulted in significantwrite-downs of asset values by financial institutions. These write-downs,initially of asset-backed securities but spreading to other securities andloans, have caused many financial institutions to seek additional capital, toreduce or eliminate dividends, to merge with larger and stronger institutionsand, in some cases, to fail. Reflecting concern about the stability of thefinancial markets generally and the strength of counterparties, many lendersand institutional investors have reduced or ceased providing funding toborrowers, including to other financial institutions. This market turmoil andtightening of credit have led to an increased level of commercial and consumerdelinquencies, lack of consumer confidence, increased market volatility andwidespread reduction of business activity generally. The resulting economicpressure on consumers and lack of confidence in the financial markets hasadversely affected our business and results of operations. Market developmentsmay affect consumer confidence levels and may cause adverse changes in payment patterns,causing increases in delinquencies and default rates, which may impact ourcharge-offs and provision for credit losses. A worsening of these conditionswould likely exacerbate the adverse effects of these difficult marketconditions on us and others in the financial institutions industry.

 

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***Current levels of market volatility are unprecedented.***

 

The capital and creditmarkets have been experiencing volatility and disruption for more than 12months. Recently, the volatility and disruption has reached unprecedentedlevels. In some cases, the markets have produced downward pressure on stockprices and credit availability for certain issuers without regard to thoseissuers’ underlying financial strength. If current levels of market disruptionand volatility continue or worsen, there can be no assurance that we will notexperience an adverse effect, which may be material, on our ability to accesscapital and on our business, financial condition and results of operations.

 

***The soundness of other financial institutions could adversely affectus.***

 

Our ability to engage inroutine funding transactions could be adversely affected by the actions andcommercial soundness of other financial institutions. Financial servicesinstitutions are interrelated as a result of trading, clearing, counterparty orother relationships. We have exposure to many different industries and counterparties,and we routinely execute transactions with counterparties in the financialindustry. As a result, defaults by, or even rumors or questions about, one ormore financial services institutions, or the financial services industrygenerally, have led to market-wide liquidity problems and could lead to lossesor defaults by us or by other institutions. Many of these transactions exposeus to credit risk in the event of default of our counterparty or client. Inaddition, our credit risk may be exacerbated when the collateral held by uscannot be realized upon or is liquidated at prices not sufficient to recoverthe full amount of the financial instrument exposure due us. There is noassurance that any such losses would not materially and adversely affect ourresults of operations.

 

***There can be no assurance that recently enacted legislation willstabilize the U.S. financial system.***

 

On October 3, 2008,President Bush signed into law the Emergency Economic Stabilization Act of 2008(the “EESA”). The legislation was the result of a proposal by TreasurySecretary Henry Paulson to the U.S. Congress in response to the financialcrises affecting the banking system and financial markets and threats toinvestment banks and other financial institutions. Pursuant to the EESA, theU.S. Treasury will have the authority to, among other things, purchase up to$700 billion of mortgages, mortgage-backed securities and certain otherfinancial instruments from financial institutions for the purpose ofstabilizing and providing liquidity to the U.S. financial markets. On October 14,2008, the U.S. Department of Treasury announced a program under the EESApursuant to which it would make senior preferred stock investments inparticipating financial institutions (the “TARP Capital Purchase Program”). On October 14,2008, the Federal Deposit Insurance Corporation announced the development of aguarantee program under the systemic risk exception to the Federal Deposit Act(“FDA”) pursuant to which the FDIC would offer a guarantee of certain financialinstitution indebtedness in exchange for an insurance premium to be paid to theFDIC by issuing financial institutions (the “FDIC Temporary Liquidity GuaranteeProgram”).

 

                There can be no assurance,however, as to the actual impact that the EESA and its implementingregulations, the FDIC programs, or any other governmental program will have onthe financial markets. The failure of the EESA, the FDIC, or the U.S.government to stabilize the financial markets and a continuation or worseningof current financial market conditions could materially and adversely affectour business, financial condition, results of operations, access to credit orthe trading price of our common stock.

 

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***The impact on us of recently enacted legislation, in particular theEmergency Economic Stabilization Act of 2008 and its implementing regulations,and actions by the FDIC, cannot be predicted at this time.***

 

                The programs established or tobe established under the EESA and Troubled Asset Relief Program may haveadverse effects upon us. We may face increased regulation of our industry.Compliance with such regulation may increase our costs and limit our ability topursue business opportunities. Also, participation in specific programs maysubject us to additional restrictions. For example, participation in the TARPCapital Purchase Program will limit (without the consent of the Department ofTreasury) our ability to increase our dividend or to repurchase our commonstock for so long as any securities issued under such program remainoutstanding. It will also subject us to additional executive compensationrestrictions. Similarly, programs established by the FDIC under the systemicrisk exception of the FDA, whether we participate or not, may have an adverseeffect on us. Participation in the FDIC Temporary Liquidity Guarantee Programlikely will require the payment of additional insurance premiums to the FDIC.We may be required to pay significantly higher Federal Deposit InsuranceCorporation premiums even if we do not participate in the FDIC TemporaryLiquidity Guarantee Program because market developments have significantlydepleted the insurance fund of the FDIC and reduced the ratio of reserves toinsured deposits. The affects of participating or not participating in any suchprograms, and the extent of our participation in such programs cannot reliablybe determined at this time.

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

** **
| (a) | None.                                                                                                                                                                                  |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (b) | Not applicable.                                                                                                                                                                        |
| (c) | For the three months ended  September 30, 2008, we purchased 14,665 shares of our common stock at a  total cost of $124,000. All of these shares have been cancelled and retired. |

 
| **Period**                                       | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b) Average  Price Paid per  Share ($ )** | ** ** | **(c) Total  Number of  Shares  Purchased as  Part of Publicly  Announced  Program** | ** ** | **(d) Maximum  Number of  Shares that May  Yet Be  Purchased  Under the  Program** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| July 1 – July 31,  2008           |       | —                                                |       | —                                                               |       | —                                                                                                        |       | 627,084                                                                                                          |       |
| August 1 – August 31,  2008       |       | —                                                |       | —                                                               |       | —                                                                                                        |       | 627,084                                                                                                          |       |
| September 1 –  September 30, 2008 |       | 14,665                                                |       | 8.46                                                                 |       | 14,665                                                                                                        |       | 627,084                                                                                                          |       |
| **Total**                                        | ** ** | **14,665**                                            | ** ** | **8.46**                                                             | ** ** | **14,665**                                                                                                    | ** ** | **612,419**                                                                                                      | ** ** |

 

On February 26, 2007, the Board of Directorsadopted a program torepurchase up to 1,000,000 shares of our common stock.  The timing and amount of repurchases, if any,will depend on market conditions, share price, trading volume and otherfactors, and there is no assurance that we will purchase shares during anyperiod.  No termination date was set forthe buyback program. Shares may be purchased in the open market or throughprivately negotiated transactions.

 

**Item 3.  Defaults Upon Senior Securities**

 

(a)  None.

(b)  None.

 

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**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

(a)  None.

(b)  Not applicable.

(c) None.

(d) None.

 

**Item 5.  Other Information**

 

(a)  None.

(b)  None.

 

**Item 6.  Exhibits**

 
| 10.1 | Cardinal Financial Corporation  Executive Deferred Income Plan, as amended and restated, October 21,  2008              |
|------|------------------------------------------------------------------------------------------------------------------------------|
| 10.2 | Cardinal Financial Corporation  Non-Employee Directors Deferred Income Plan, as amended and restated,  October 21, 2008 |
| 10.3 | George Mason Mortgage, LLC  Executive Deferred Income Plan, as amended and restated, October 21,  2008                  |
| 31.1 | Rule 13a-14(a) Certification  of Chief Executive Officer                                                           |
| 31.2 | Rule 13a-14(a) Certification  of Chief Financial Officer                                                           |
| 32.1 | Statement  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350                                                |
| 32.2 | Statement  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350                                                |

 

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**SIGNATURES**

** **

**Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this Report to be signed on its behalf by theundersigned thereunto duly authorized.**

** **
| ** **                      | **CARDINAL FINANCIAL CORPORATION**                                                      |
|---------------------------------|-----------------------------------------------------------------------------------------|
| ** **                      | **(Registrant)**                                                                        |
| ** **                      | ** **                                                                              |
| **Date: November 8, 2008** | **/s/ Bernard H. Clineburg**                                                            |
| ** **                      | **Bernard H. Clineburg**                                                                |
| ** **                      | **Chairman and Chief Executive Officer**                                                |
| ** **                      | **(Principal Executive Officer)**                                                       |
| ** **                      | ** **                                                                              |
| ** **                      | ** **                                                                              |
| **Date: November 8, 2008** | **/s/ Mark A. Wendel**                                                                  |
| ** **                      | **Mark A. Wendel**                                                                      |
| ** **                      | **Executive Vice President and Chief Financial Officer  (Principal Financial Officer)** |
| ** **                      | ** **                                                                              |
| ** **                      | ** **                                                                              |
| **Date: November 8, 2008** | **/s/ Jennifer L. Deacon**                                                              |
| ** **                      | **Jennifer L. Deacon**                                                                  |
| ** **                      | **Senior Vice President and Controller**                                                |
| ** **                      | **(Principal Accounting Officer)**                                                      |

 

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