**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

**ý****Quarterly Report Pursuant toSection 13 or 15(d)**

**of theSecurities Exchange Act of 1934**

 

**For the quarterly period ended March 31, 2005**

 

**o****Transition Report Pursuant toSection 13 or 15(d)**

**of theSecurities Exchange Act of 1934**

 

**For the transition period from             to              **

 

**Commission File Number:  0-24557**

 

**CARDINAL FINANCIAL CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **Virginia**                                                    | ** ** | **54-1874630**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | ** ** | (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, including areacode)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 
|   |   | Yes  ý | No  o |
|--------|--------|------------------|------------|

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule12b-2 of the ExchangeAct)

 
|   |   |   |             |
|--------|--------|--------|------------------|
|   |   |   | Yes  ý | No  o |
|        |        |        |                  |  |

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

18,530,894 shares of common stock, par value$1.00 per share,

outstanding as of May 2, 2005

 

 

----

 

**CARDINAL FINANCIAL CORPORATION**

 

**INDEX TO FORM 10-Q**

 
| **PART I – FINANCIAL INFORMATION** | 3                                                                                                                                |
|-----------------------------------------|----------------------------------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                                             |   |   |
| Item 1.                                 |                                                                                                                             | Financial Statements: | 3 |
|                                    |                                                                                                                             |   |   |
|                                    | Consolidated Statements of Condition  At March 31, 2005 (unaudited) and December 31, 2004                                        | 3 |
|                                    |                                                                                                                             |   |   |
|                                    | Consolidated Statements of Income  For the three months ended March 31, 2005 and 2004 (unaudited)                                | 4 |
|                                    |                                                                                                                             |   |   |
|                                    | Consolidated Statements of Comprehensive Income  For the three months ended March 31, 2005 and 2004 (unaudited)                  | 5 |
|                                    |                                                                                                                             |   |   |
|                                    | Consolidated Statements of Changes In  Shareholders’ Equity  For the three months ended March 31, 2005 and 2004 (unaudited) | 6 |
|                                    |                                                                                                                             |   |   |
|                                    | Consolidated Statements of Cash Flows  For the three months ended March 31, 2005 and 2004 (unaudited)                            | 7 |
|                                    |                                                                                                                             |   |   |
|                                    | Notes to Consolidated Financial Statements                                                                                       | 8 |
|                                    |                                                                                                                             |   |   |
| Item 2.                                 |                                                                                                                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 13 |
|                                    |                                                                                                                             |   |   |
| Item 3.                                 |                                                                                                                             | Quantitative and Qualitative Disclosures About  Market Risk | 35 |
|                                    |                                                                                                                             |   |   |
| Item 4.                                 |                                                                                                                             | Controls and Procedures | 36 |
|                                    |                                                                                                                             |   |   |
| **PART  II – OTHER INFORMATION**   | 37                                                                                                                               |
|                                    |                                                                                                                             |   |   |
| Item 1.                                 |                                                                                                                             | Legal Proceedings | 37 |
| Item 2.                                 |                                                                                                                             | Unregistered Sales of Equity Securities and  Use of Proceeds | 37 |
| Item 3.                                 |                                                                                                                             | Defaults Upon Senior Securities | 37 |
| Item 4.                                 |                                                                                                                             | Submission of Matters to a Vote of Security  Holders | 37 |
| Item 5.                                 |                                                                                                                             | Other Information | 37 |
| Item 6.                                 |                                                                                                                             | Exhibits | 37 |
|                                    |                                                                                                                             |   |   |
| **SIGNATURES**                          | 38                                                                                                                               |
|                                         |                                                                                                                                  |  |  |  |

 

2

----

 

**PART I –FINANCIAL INFORMATION**

 

**Item 1.****  Financial Statements**

 

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATEDSTATEMENTS OF CONDITION

March31, 2005 and December 31, 2004

(Inthousands, except share data)

 
| ** **                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | **(Unaudited)**     | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|---------------------|------------|------------------------|------------|
| ** **                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| **Assets**                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** **          | ** ** | ** **             | ** ** |
| Cash and due from banks                                                                                                                |       |       |       |       |       | $                   | 15,979     |                   | $          | 15,205 |   |
| Federal funds sold                                                                                                                     |       |       |       |       |       | 17,650              |       | 8,203                  |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total cash and cash equivalents                                                                                                        |       |       |       |       |       | 33,629              |       | 23,408                 |       |
| Investment securities available-for-sale                                                                                               |       |       |       |       |       | 163,377             |       | 151,554                |       |
| Investment securities held-to-maturity  (market value of $130,717 and $136,609 at March 31, 2005 and December 31,  2004, respectively) |       |       |       |       |       | 133,435             |       | 137,953                |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total investment securities                                                                                                            |       |       |       |       |       | 296,812             |       | 289,507                |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Other investments                                                                                                                      |       |       |       |       |       | 7,621               |       | 8,110                  |       |
| Loans held for sale, net                                                                                                               |       |       |       |       |       | 364,126             |       | 365,454                |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Loans receivable, net of deferred fees and  costs                                                                                      |       |       |       |       |       | 535,704             |       | 489,896                |       |
| Allowance for loan losses                                                                                                              |       |       |       |       |       | (6,432              | )          | (5,878                 | )          |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Loans receivable, net                                                                                                                  |       |       |       |       |       | 529,272             |       | 484,018                |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Premises and equipment, net                                                                                                            |       |       |       |       |       | 17,383              |       | 15,531                 |       |
| Deferred tax asset                                                                                                                     |       |       |       |       |       | 3,559               |       | 3,238                  |       |
| Goodwill and intangibles, net                                                                                                          |       |       |       |       |       | 14,645              |       | 14,694                 |       |
| Accrued interest receivable and other  assets                                                                                          |       |       |       |       |       | 11,309              |       | 7,616                  |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total assets                                                                                                                           |       |       |       |       |       | $                   | 1,278,356  |                   | $          | 1,211,576 |   |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| **Liabilities and Shareholders’ Equity**                                                                                          |       |       |       |       |       |                |       |                   |       |
| ** **                                                                                                                             |       |       |       |       |       |                |       |                   |       |
| Deposits                                                                                                                               |       |       |       |       |       | $                   | 894,871    |                   | $          | 824,210 |   |
| Other borrowed funds                                                                                                                   |       |       |       |       |       | 188,715             |       | 201,085                |       |
| Warehouse financing                                                                                                                    |       |       |       |       |       | —              |       | 30,245                 |       |
| Mortgage funding checks                                                                                                                |       |       |       |       |       | 74,263              |       | 46,392                 |       |
| Escrow liabilities                                                                                                                     |       |       |       |       |       | 8,549               |       | 3,020                  |       |
| Accrued interest payable and other  liabilities                                                                                        |       |       |       |       |       | 16,228              |       | 11,519                 |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total liabilities                                                                                                                      |       |       |       |       |       | 1,182,626           |       | 1,116,471              |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
|                                                                                                                                   |       | **2005**   | ** ** | **2004**   |       |                |       |                   |       |
| Common stock, $1 par value                                                                                                             |       | ** ** | ** ** | ** ** |       |                |       |                   |       |
| Authorized                                                                                                                             |       | 50,000,000 |       | 50,000,000 |       |                |       |                   |       |
| Issued and outstanding                                                                                                                 |       | 18,530,894 |       | 18,462,597 |       | 18,531              |       | 18,463                 |       |
| Additional paid-in capital                                                                                                             |       |       |       |       |       | 93,260              |       | 92,868                 |       |
| Accumulated deficit                                                                                                                    |       |       |       |       |       | (13,533             | )          | (15,145                | )          |
| Accumulated other comprehensive loss                                                                                                   |       |       |       |       |       | (2,528              | )          | (1,081                 | )          |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total shareholders’ equity                                                                                                        |       |       |       |       |       | 95,730              |       | 95,105                 |       |
|                                                                                                                                   |       |       |       |       |       |                |       |                   |       |
| Total liabilities and shareholders’ equity                                                                                        |       |       |       |       |       | $                   | 1,278,356  |                   | $          | 1,211,576 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

----

 

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFINCOME

Three months ended March 31,2005 and 2004

(In thousands, except pershare data)

(Unaudited)

 
| ** **                                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Interest income:                                               |       |     |       |     |       |
| Loans receivable                                               |       | $        | 7,280      |     | $          | 4,728 |   |
| Loans held for sale                                            |       | 3,358    |       | —   |       |
| Federal funds sold                                             |       | 61       |       | 28       |       |
| Investment securities available-for-sale                       |       | 1,431    |       | 1,271    |       |
| Investment securities held-to-maturity                         |       | 1,307    |       | 1,350    |       |
| Other investments                                              |       | 54       |       | 38       |       |
| Total interest income                                          |       | 13,491   |       | 7,415    |       |
| Interest expense:                                              |       |     |       |     |       |
| Deposits                                                       |       | 4,677    |       | 2,282    |       |
| Other borrowed funds                                           |       | 992      |       | 300      |       |
| Total interest expense                                         |       | 5,669    |       | 2,582    |       |
| Net interest income                                            |       | 7,822    |       | 4,833    |       |
| Provision for loan losses                                      |       | 549      |       | 74       |       |
| Net interest income after provision for  loan losses           |       | 7,273    |       | 4,759    |       |
|                                                           |       |     |       |     |       |
| Non-interest income:                                           |       |     |       |     |       |
| Service charges on deposit accounts                            |       | 280      |       | 241      |       |
| Loan service charges                                           |       | 626      |       | 195      |       |
| Investment fee income                                          |       | 159      |       | 178      |       |
| Net gain on sales of loans                                     |       | 3,581    |       | 13       |       |
| Net realized gain on investment securities  available-for-sale |       | —   |       | 241      |       |
| Management fee income                                          |       | 524      |       | —   |       |
| Other income                                                   |       | 13       |       | 9        |       |
| Total non-interest income                                      |       | 5,183    |       | 877      |       |
|                                                           |       |     |       |     |       |
| Non-interest expense:                                          |       |     |       |     |       |
| Salary and benefits                                            |       | 4,870    |       | 2,164    |       |
| Occupancy                                                      |       | 1,046    |       | 496      |       |
| Professional fees                                              |       | 474      |       | 154      |       |
| Depreciation                                                   |       | 680      |       | 310      |       |
| Data processing                                                |       | 508      |       | 195      |       |
| Telecommunications                                             |       | 333      |       | 103      |       |
| Amortization of intangibles                                    |       | 49       |       | —   |       |
| Other operating expenses                                       |       | 2,135    |       | 1,133    |       |
| Total non-interest expense                                     |       | 10,095   |       | 4,555    |       |
| Net income before income taxes                                 |       | 2,361    |       | 1,081    |       |
| Provision for income taxes                                     |       | 749      |       | 362      |       |
| Net income                                                     |       | $        | 1,612      |     | $          | 719 |   |
| Earnings per share - basic                                     |       | $        | 0.09       |     | $          | 0.04 |   |
| Earnings per share - diluted                                   |       | $        | 0.09       |     | $          | 0.04 |   |
| Weighted-average shares outstanding - basic                    |       | 18,525   |       | 17,461   |       |
| Weighted-average shares outstanding -  diluted                 |       | 18,830   |       | 17,885   |       |

 

See accompanying notes to consolidatedfinancial statements.

 

4

----

 

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Three months ended March 31,2005 and 2004

(Inthousands)

(Unaudited)

 
| ** **                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                            |       |     |       |     |       |
| Net income                                                                      |       | $        | 1,612      |     | $          | 719 |   |
| Other comprehensive income:                                                     |       |     |       |     |       |
| Unrealized gain (loss) on  available-for-sale investment securities:            |       |     |       |     |       |
| Unrealized holding gain (loss) arising during  the quarter, net of tax          |       | (1,447   | )          | 976      |       |
| Less: reclassification adjustment for gains  included in net income, net of tax |       | —   |       | 159      |       |
|                                                                            |       |     |       |     |       |
| Comprehensive income                                                            |       | $        | 165        |     | $          | 1,536 |   |

 

See accompanying notes toconsolidated financial statements.

 

5

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Threemonths ended March 31, 2005 and 2004

(Inthousands)

(Unaudited)

 
| ** **                                                                    | ** ** | **Preferred  Shares** | ** ** | **Preferred  Stock** | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total**  | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|------------------------------------------------------|------------|------------|------------|
| ** **                                                                    | ** ** | ** **            | ** ** | ** **           | ** ** | ** **         | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **               | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Balance, December  31, 2003                                                   |       | 1,364                 |       | $                    | 1,364      |               | 16,377     |              | $          | 16,377                           |       | $                        | 86,790     |                                                 | $          | (18,614    | )          | $ | (505 | ) | $ | 85,412 |   |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Stock options  exercised                                                      |       | —                |       | —               |       | 23                 |       | 23                |       | 66                               |       | —                   |       | —                                               |       | 89         |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Public offering  shares issued                                                |       | —                |       | —               |       | 945                |       | 945               |       | 5,358                            |       | —                   |       | —                                               |       | 6,303      |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Preferred stock  converted to common stock                                    |       | (1,364                | )          | (1,364               | )          | 1,026              |       | 1,026             |       | 338                              |       | —                   |       | —                                               |       | —     |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Change in  unrealized gain (loss) on investment securities available-for-sale |       | —                |       | —               |       | —             |       | —            |       | —                           |       | —                   |       | 817                                                  |       | 817        |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Net income                                                                    |       | —                |       | —               |       | —             |       | —            |       | —                           |       | 719                      |       | —                                               |       | 719        |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Balance, March  31, 2004                                                      |       | —                |       | $                    | —     |               | 18,371     |              | $          | 18,371                           |       | $                        | 92,552     |                                                 | $          | (17,895    | )          | $ | 312 |   | $ | 93,340 |   |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |   |   |   |   |   |   |
| Balance, December  31, 2004                                                   |       | —                |       | $                    | —     |               | 18,463     |              | $          | 18,463                           |       | $                        | 92,868     |                                                 | $          | (15,145    | )          | $ | (1,081 | ) | $ | 95,105 |   |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Stock options  exercised                                                      |       | —                |       | —               |       | 68                 |       | 68                |       | 392                              |       | —                   |       | —                                               |       | 460        |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Change in  unrealized gain (loss) on investment securities available-for-sale |       | —                |       | —               |       | —             |       | —            |       | —                           |       | —                   |       | (1,447                                               | )          | (1,447     | )          |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Net income                                                                    |       | —                |       | —               |       | —             |       | —            |       | —                           |       | 1,612                    |       | —                                               |       | 1,612      |       |
|                                                                          |       |                  |       |                 |       |               |       |              |       |                             |       |                     |       |                                                 |       |       |       |
| Balance, March  31, 2005                                                      |       | —                |       | $                    | —     |               | 18,531     |              | $          | 18,531                           |       | $                        | 93,260     |                                                 | $          | (13,533    | )          | $ | (2,528 | ) | $ | 95,730 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

6

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**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF CASH FLOWS

Three months ended March 31,2005 and 2004

(In thousands)

(Unaudited)

 
| ** **                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Cash flows from operating activities:                                                   |       |     |       |     |       |
| Net income                                                                              |       | $        | 1,612      |     | $          | 719 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:      |       |     |       |     |       |
| Depreciation                                                                            |       | 680      |       | 310      |       |
| Amortization of premiums, discounts and  intangibles                                    |       | 450      |       | 503      |       |
| Provision for loan losses                                                               |       | 549      |       | 74       |       |
| Loans held for sale, net originated and  acquired                                       |       | (883,678 | )          | (2,569   | )          |
| Proceeds from the sale of loans held for  sale                                          |       | 885,931  |       | 1,894    |       |
| Gain on sale of loans held for sale                                                     |       | (3,581   | )          | (13      | )          |
| Gain on sale of investment securities  available-for-sale                               |       | —   |       | (241     | )          |
| Increase in accrued interest receivable,  other assets, and deferred tax asset          |       | (4,014   | )          | (20      | )          |
| Increase in accrued interest payable,  escrow liabilities and other liabilities         |       | 10,238   |       | 172      |       |
|                                                                                    |       |     |       |     |       |
| Net cash provided by operating activities                                               |       | 8,187    |       | 829      |       |
|                                                                                    |       |     |       |     |       |
| Cash flows from investing activities:                                                   |       |     |       |     |       |
| Purchase of premises and equipment                                                      |       | (2,532   | )          | (710     | )          |
| Proceeds from sale, maturity and call of  investment securities available-for-sale      |       | —   |       | 4,000    |       |
| Proceeds from sale, maturity and call of  mortgage-backed securities available-for-sale |       | —   |       | 9,719    |       |
| Proceeds from maturity and call of  investment securities held-to-maturity              |       | —   |       | 3,490    |       |
| Proceeds from sale of other investments                                                 |       | 3,609    |       | 261      |       |
| Purchase of investment securities  available-for-sale                                   |       | (12,964  | )          | (4,000   | )          |
| Purchase of mortgage-backed securities  available-for-sale                              |       | (8,432   | )          | (51,485  | )          |
| Purchase of investment securities  held-to-maturity                                     |       | —   |       | (10,472  | )          |
| Purchase of mortgage-backed securities  held-to-maturity                                |       | —   |       | (8,015   | )          |
| Purchase of other investments                                                           |       | (3,120   | )          | (729     | )          |
| Redemptions of investment securities  available-for-sale                                |       | 7,183    |       | 3,602    |       |
| Redemptions of investment securities  held-to-maturity                                  |       | 4,319    |       | 5,389    |       |
| Net (increase) decrease in loans receivable                                             |       | (42,406  | )          | 1,274    |       |
|                                                                                    |       |     |       |     |       |
| Net cash used in investing activities                                                   |       | (54,343  | )          | (47,676  | )          |
|                                                                                    |       |     |       |     |       |
| Cash flows from financing activities:                                                   |       |     |       |     |       |
| Net increase in deposits                                                                |       | 70,661   |       | 51,802   |       |
| Net decrease in other borrowed funds                                                    |       | (10,745  | )          | (7,074   | )          |
| Net decrease in warehouse financing                                                     |       | (30,245  | )          | —   |       |
| Net increase in mortgage funding checks                                                 |       | 27,871   |       | —   |       |
| Proceeds from FHLB advances - long term                                                 |       | —   |       | 5,000    |       |
| Repayments of FHLB advances - long term                                                 |       | (1,625   | )          | (625     | )          |
| Proceeds from public offering                                                           |       | —   |       | 6,303    |       |
| Stock options exercised                                                                 |       | 460      |       | 89       |       |
|                                                                                    |       |     |       |     |       |
| Net cash provided by financing activities                                               |       | 56,377   |       | 55,495   |       |
|                                                                                    |       |     |       |     |       |
| Net increase in cash and cash equivalents                                               |       | 10,221   |       | 8,648    |       |
|                                                                                    |       |     |       |     |       |
| Cash and cash equivalents at beginning of  the quarter                                  |       | 23,408   |       | 13,083   |       |
|                                                                                    |       |     |       |     |       |
| Cash and cash equivalents at end of the  quarter                                        |       | $        | 33,629     |     | $          | 21,731 |   |
|                                                                                    |       |     |       |     |       |
| **Supplemental disclosure of cash flow  information:**                                  |       |     |       |     |       |
| Cash paid during the period for interest                                                |       | $        | 5,659      |     | $          | 2,574 |   |
| Cash paid for income taxes                                                              |       | 50       |       | —   |       |
| Trade dated investment securities  available-for-sale                                   |       | 5,000    |       | —   |       |

 

See accompanying notes toconsolidated financial statements.

 

7

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CARDINAL FINANCIALCORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2005

(Unaudited)

 

Note 1

 

*Organization*

 

Cardinal Financial Corporation (the ”Company”) was incorporated onNovember 24, 1997 under the laws of the Commonwealth of Virginia as aholding company whose activities consist of investment in its wholly ownedsubsidiaries.  The Company openedCardinal Bank, N.A. (the “Bank”) in 1998 and Cardinal Wealth Services, Inc., an investment services subsidiary, in1999.  In 1999, the Company opened twoadditional banking subsidiaries and, in late 2000, completed an acquisition ofHeritage Bancorp, Inc. and its banking subsidiary, The Heritage Bank.  These banking subsidiaries were consolidatedinto the Bank as of March 1, 2002.  OnApril 15, 2004, the Company received approval from the Federal Reserve Bank ofRichmond to be a financial holding company. Effective July 7, 2004, the Bank acquired George Mason Mortgage, LLC (“GMM”).  In December 2004, the Bank converted to astate chartered institution and changed its name to Cardinal Bank.

 

*Basis of Presentation*

 

In the opinion of management,the accompanying consolidated financial statements have been prepared inaccordance with the requirements of Regulation S-X, Article 10.  Accordingly, they do not include all of theinformation and footnotes required by U.S. generally accepted accountingprinciples for complete financial statements. However, all adjustments that are, in the opinion of management,necessary for a fair presentation have been included.  The results of operations for the threemonths ended March 31, 2005 are not necessarily indicative of the results to beexpected for the full year ending December 31, 2005.  The unaudited interim financial statementsshould be read in conjunction with the audited financial statements and notesto financial statements that are included in the Company’s Annual Report onForm 10-K for the year ended December 31, 2004 (the “2004 Form 10-K”).

 

*Stock-BasedCompensation*

 

At March 31, 2005, the Companyhad two stock-based employee compensation plans, the 1999 Stock Option Plan andthe 2002 Equity Compensation Plan.  Theseplans are described more fully in Footnote 18 of the 2004 Form 10-K.

 

As permitted under Statement ofFinancial Accounting Standards (“SFAS”) No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure,*which amended SFAS No. 123, *Accounting forStock-Based Compensation,* the Company has elected to continue tofollow the intrinsic value method in accounting for its stock-based employeecompensation arrangements as defined by Accounting Principles Board Opinion (“APB”)No. 25, *Accounting for Stock Issued toEmployees,* and related interpretations including FinancialAccounting Standards Board Interpretation No. 44, *Accounting for Certain Transactions Involving Stock Compensation,*aninterpretation of APB No. 25.  Thefollowing table illustrates the effect on net income and

 

8

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earnings per common share as ifthe Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation.

* *
| ** **                                                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands)**                                                                 | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Net income                                                                                 |       | $                                | 1,612      |   | $ | 719 |   |
| Deduct: Total stock-based employee                                                         |       |                             |       |   |   |
| compensation expense determined under fair value- based method for  all awards, net of tax |       | (2,212                           | )          | (396 | ) |
| Pro forma net income (loss)                                                                |       | $                                | (600       | ) | $ | 323 |   |
|                                                                                       |       |                             |       |   |   |
| Earnings (loss) per share:                                                                 |       |                             |       |   |   |
| Basic - as reported                                                                        |       | $                                | 0.09       |   | $ | 0.04 |   |
| Basic - pro forma                                                                          |       | (0.03                            | )          | 0.01 |   |
| Diluted - as reported                                                                      |       | 0.09                             |       | 0.04 |   |
| Diluted - pro forma                                                                        |       | (0.03                            | )          | 0.01 |   |

 

The weightedaverage per share fair values of grants made for the three months ended March31, 2005 and 2004 were $6.48 and $2.91, respectively.  The fair values of the options granted wereestimated as of the grant date using the Black- Scholes option-pricing modelbased on the following weighted average assumptions:

 
| ** **              | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Estimated option life   |       | 10 years                         |       | 10 years |   |
| Risk free interest rate |       | 4.29                             | %          | 3.99 | % |
| Expected volatility     |       | 43.11                            | %          | 11.80 | % |
| Expected dividend yield |       | 0.00                             | %          | 0.00 | % |

 

There were options to purchase494,735 shares of common stock granted during the three months ended March 31,2005.  Of those grants, 486,735immediately vested on the grant date.

 

Note 2

 

*SegmentInformation*

* *

Prior to July 7, 2004, theCompany operated and reported in two business segments, commercial banking andinvestment services.  As of July 7, 2004,the Company began operating in a third business segment, mortgage banking, withthe completion of its acquisition of GMM. The commercial banking segment includes both commercial and consumerlending and provides customers such products as commercial loans, real estateloans, and other business financing and consumer loans.  In addition, this segment also providescustomers with several choices of deposit products including demand depositaccounts, savings accounts and certificates of deposit.  The mortgage banking segment engages primarily in the origination andacquisition of residential mortgages for sale into the secondary market on abest efforts basis.  Theinvestment services

 

9

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segment provides advisoryservices to businesses and individuals, including financial planning andretirement/estate planning.

 

Information about thereportable segments, and reconciliation of this information to the consolidatedfinancial statements at and for the three months ended March 31, 2005 and 2004,are as follows:

 

**(Dollars in thousands)**

**At and for the Three Months Ended March 31, 2005:**

 
| ** **                 | ** ** | **Commercial  Banking** | ** ** | **Mortgage  Banking** | ** ** | **Investment  Services** | ** ** | **Intersegment  Elimination** | ** ** | **Other** | ** ** | **Consolidated** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------|------------|--------------------------|------------|-------------------------------|------------|-----------|------------|------------------|------------|
| Net interest income        |       | $                       | 6,742      |                  | $          | 1,311                    |       | $                             | —     |      | $          | —           |       | $ | (231 | ) | $ | 7,822 |   |
| Provision for loan losses  |       | 549                     |       | —                |       | —                   |       | —                        |       | —    |       | 549              |       |
| Non-interest income        |       | 374                     |       | 4,642                 |       | 159                      |       | —                        |       | 8         |       | 5,183            |       |
| Non-interest expense       |       | 5,593                   |       | 3,952                 |       | 221                      |       | —                        |       | 329       |       | 10,095           |       |
| Provision for income taxes |       | 379                     |       | 579                   |       | (21                      | )          | —                        |       | (188      | )          | 749              |       |
| Net income (loss)          |       | $                       | 595        |                  | $          | 1,422                    |       | $                             | (41        | )         | $          | —           |       | $ | (364 | ) | $ | 1,612 |   |
|                       |       |                    |       |                  |       |                     |       |                          |       |      |       |             |       |
| Total Assets               |       | $                       | 1,192,690  |                  | $          | 379,403                  |       | $                             | 691        |      | $          | (411,226         | )          | $ | 116,798 |   | $ | 1,278,356 |   |

 

**At and for the Three Months Ended March 31, 2004:**

 
| ** **                 | ** ** | **Commercial  Banking** | ** ** | **Mortgage  Banking** | ** ** | **Investment  Services** | ** ** | **Intersegment  Elimination** | ** ** | **Other** | ** ** | **Consolidated** | ** ** |
|----------------------------|------------|-------------------------|------------|-----------------------|------------|--------------------------|------------|-------------------------------|------------|-----------|------------|------------------|------------|
| Net interest income        |       | $                       | 4,800      |                  | $          | —                   |       | $                             | —     |      | $          | —           |       | $ | 33 |   | $ | 4,833 |   |
| Provision for loan losses  |       | 74                      |       | —                |       | —                   |       | —                        |       | —    |       | 74               |       |
| Non-interest income        |       | 699                     |       | —                |       | 178                      |       | —                        |       | —    |       | 877              |       |
| Non-interest expense       |       | 4,050                   |       | —                |       | 239                      |       | —                        |       | 266       |       | 4,555            |       |
| Provision for income taxes |       | 462                     |       | —                |       | (21                      | )          | —                        |       | (79       | )          | 362              |       |
| Net income (loss)          |       | $                       | 913        |                  | $          | —                   |       | $                             | (40        | )         | $          | —           |       | $ | (154 | ) | $ | 719 |   |
|                       |       |                    |       |                  |       |                     |       |                          |       |      |       |             |       |
| Total Assets               |       | $                       | 687,543    |                  | $          | —                   |       | $                             | 741        |      | $          | (88,338          | )          | $ | 93,505 |   | $ | 693,451 |   |

 

At March 31, 2005, the Companydid not have any operating segments other than those reported.  Parent company financial information isincluded in the “Other” category and represents an overhead function ratherthan an operating segment.  The parentcompany’s most significant assets are its net investments in itssubsidiaries.  The parent company’s netinterest income is comprised of interest income from short-term investments andinterest expense on trust preferred securities.

 

Note 3

 

*EarningsPer Share*

* *

The following is thecalculation of basic and diluted earnings per share for the three months endedMarch 31, 2005 and 2004. Stock options outstanding at March 31, 2005 and 2004were 1,661,055 and 1,108,835, respectively. Stock options issued that were not included in the calculation ofdiluted earnings per share because the exercise prices were greater than theaverage market price were 7,094 and 10,000 for the three months ended March 31,2005 and 2004, respectively.

 

10

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| **(Dollars in thousands,**            | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| **except share and per share  data)** | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Net income to common shareholders     |       | $                                | 1,612      |   | $ | 719 |   |
| Weighted average shares - basic       |       | 18,524,847                       |       | 17,460,989 |   |
| Weighted average shares - diluted     |       | 18,830,265                       |       | 17,884,580 |   |
| Earnings per share - basic            |       | $                                | 0.09       |   | $ | 0.04 |   |
| Earnings per share - diluted          |       | $                                | 0.09       |   | $ | 0.04 |   |

 

Note 4

 

*Derivatives*

* *

Weaccount for our derivatives and hedging activities in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 133, *Accountingfor Derivative Instruments and Hedging Activity*, as amended by SFASNo. 138, *Accounting for Certain Derivative Instruments andCertain Hedging Activities,*and SFAS No. 149*, Amendmentof Statement 133 on Derivative Instruments and Hedging Activities.*

 

TheCompany utilizes forward sales commitments to economically hedge the interestrate risk inherent in entering into interest rate lock loan commitments andoriginating fixed-rate closed loans for sale through GMM.  At March 31, 2005, the fair value of interestrate lock commitments with a notional value of $203 million was $(517,000), andthe fair value of forward sale commitments with a notional value of $500million was $2.4 million.  Thesederivatives are recorded in other assets and other liabilities on theconsolidated statements of condition at their fair values.  In addition to these market adjustments foropen interest rate lock loan commitments and forward sale commitments, at March31, 2005, a basis adjustment of $(1.9 million) has been recorded related to theclosed loans held for sale and is included in loans held for sale, net in theconsolidated statements of condition.

 

Note 5

 

*SubsequentEvent*

* *

OnApril 29, 2005, the Company entered into an Agreement and Plan of ShareExchange with Wilson/Bennett Capital Management, Inc., an asset management firmbased in Alexandria, Virginia.  John W.Fisher, a member of the Company’s Board of Directors, is the founder andPresident and Chief Investment Officer of Wilson/Bennett and owns 90% ofWilson/Bennett.  Under the terms theAgreement, the Company plans to acquire Wilson/Bennett from Mr. Fisher andJames Moloney, the other shareholder of Wilson/Bennett, for approximately $6.6million in a combination of common stock and cash.  The cash portion of the transaction will beapproximately $1.1 million.

 

11

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Theclosing of the transaction is subject to all necessary regulatory approvals andcustomary closing conditions.  Inaddition, the closing of the transaction is also subject to the conditions thatclients of Wilson/Bennett representing at least 75% of the assets undermanagement have consented to the transaction, that the Company enters into an employmentagreement with Mr. Fisher and that Wilson/Bennett obtain, at the Company’sexpense, a term life insurance policy on the life of Mr. Fisher in an amount ofno less than $3,000,000.  The Companywill be the beneficiary under that policy. The Company expects that, if the conditions are satisfied, thetransaction will close early in the third quarter of 2005.  At that time, Wilson/Bennett will become asubsidiary of the Company.

 

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**Item 2.****  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

The following presents management’s discussionand analysis of our consolidated financial condition at March 31, 2005 andDecember 31, 2004 and the results of our operations for the three months endedMarch 31, 2005 and 2004.  This discussionshould be read in conjunction with our unaudited consolidated financialstatements and the notes thereto appearing elsewhere in this report and the auditedfinancial statements and the notes to financial statements included in ourAnnual Report on Form 10-K for the year ended December 31, 2004.

 

**Overview**

 

**Cardinal Financial Corporation, a locally managed financialholding company headquartered in Tysons Corner, Virginia, is committed toproviding superior customer service, a diversified mix of financial productsand services, and convenient banking to our retail and business consumers.  We own Cardinal Bank, a Virginia state-charteredcommunity bank, and Cardinal Wealth Services, Inc., an investment servicessubsidiary.  Through these twosubsidiaries and George Mason Mortgage, LLC (“George Mason”), a mortgagebanking subsidiary of Cardinal Bank, we offer a wide range of traditional bankingproducts and services to both our commercial and retail customers.  Our commercial relationship managers focus onattracting with small and medium-sized businesses as well as commercial realestate developers and builders in addition to professionals, such asphysicians, accountants and attorneys. We have 19 retail bank branch locations and provide competitive retailproducts and services.  We complement ourcore banking operations by offering a full range of investment products andservices to our customers through our third-party brokerage relationship with RaymondJames Financial Services, Inc.**

** **

On July 7, 2004, we acquired George Masonfrom United Bank – Virginia, a wholly owned subsidiary of United Bankshares,Inc. in a cash transaction for $17.0 million. This transaction resulted in the recognition of $12.9 million ofgoodwill and $1.7 million of amortizable intangibles.  This transaction was accounted for as apurchase, and George Mason’s assets and liabilities were recorded at fair valueas of the purchase date.  George Mason’soperating results are included in our consolidated results since theacquisition date.  George Mason, based inFairfax, Virginia, engages primarily in the origination and acquisition ofresidential mortgages for sale into the secondary market on a best effortsbasis through eight branches located throughout the metropolitan Washingtonregion.  George Mason has approximately200 employees and does business in eight states, including Virginia, Marylandand the District of Columbia.  GeorgeMason is one of the largest residential mortgage originators in the greaterWashington metropolitan area, reporting originations of over $3.5 billion in2004 and $4.5 billion in 2003.  GeorgeMason’s primary sources of revenue include net interest income earned on loansheld for sale, gain on the sale of loans held for sale and contractualmanagement fees earned relating to services provided to other mortgagecompanies owned by local home builders. Loans are made pursuant to purchase commitments and are sold servicingreleased.

 

13

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In July 2004, we formed a wholly-owned subsidiary, Cardinal StatutoryTrust I, for the purpose of issuing $20.0 million of floating rate juniorsubordinated deferrable interest debentures (“trust preferred securities”).  These trust preferred securities are due in2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate)plus 2.40%, which adjusts quarterly. These securities are redeemable at a premium through March 2008 and atpar thereafter.  We have guaranteedpayment of these securities.  The $20.6million payable by us to Cardinal Statutory Trust I is included in otherborrowed funds in the Consolidated Statements of Condition since CardinalStatutory Trust I is an unconsolidated subsidiary as we are not the primarybeneficiary of this entity.  We utilizedthe proceeds from the issuance of the trust preferred securities to make acapital contribution into the Bank.

 

OnApril 29, 2005, we signed a definitive agreement to acquire Wilson/BennettCapital Management, Inc., an asset management firm based in Alexandria,Virginia.  John W. Fisher, a member ofour Board of Directors, is the founder and President and Chief InvestmentOfficer of Wilson/Bennett and owns 90% of the firm.  Under the terms the agreement, we plan toacquire Wilson/Bennett for approximately $6.6 million in a combination ofcommon stock and cash.  The cash portionof the transaction will be approximately $1.1 million.  We expect that, if the conditions to theclosing of the transaction are satisfied, the transaction will close early inthe third quarter of 2005.  At that time,Wilson/Bennett will become a subsidiary of Cardinal Financial Corporation.

 

Webelieve that the acquisition furthers our strategy of enhancing fee income andfurther diversifying our revenue stream. Wilson/Bennett has approximately 500 institutional and personal clientsand approximately $227 million of assets under management. Wilson/Bennettutilizes a value-oriented investment approach that focuses on large capitalizationstocks. Wilson/Bennett’s 2004 revenues were approximately $1.4 million.  We anticipate that the acquisition ofWilson/Bennett will not have a material impact on our 2005 earnings.

 

Net interest income is our primary source of revenue.  We define revenue as net interest income plusnon-interest income.  As discussedfurther in our interest rate sensitivity section, we manage our balance sheetand interest rate risk to maximize, and concurrently stabilize, net interestincome.  We do this by monitoring thespread between the interest rates earned on interest earning assets and theinterest rates paid on interest bearing liabilities.  We attempt to minimize our exposure tointerest rate risk, but are unable to eliminate it.  In addition to management of interest raterisk, we analyze our loan portfolio for exposure to credit risk.  Risk of loan defaults and foreclosures areunavoidable in the banking industry and we try to limit our exposure to thisrisk by carefully underwriting and monitoring our extensions of credit.  In addition to net interest income,non-interest income is an increasingly important source of income for us and includesservice charges on deposits and loans, investment fee income and gains on saleson investment securities available-for-sale, gains on sales of loans held forsale, and management fee income.  Ouracquisition of George Mason in July 2004 has resulted in non-interest incomebecoming a larger component of our total revenues.

 

**Our business strategy is to grow through geographicexpansion while maintaining strong asset quality and achieving sustainedprofitability.  We completed a secondarycommon stock offering that raised $41.7 million in capital in December 2003 andan additional $6.3 million in capital following the exercise of theunderwriters’ over-allotment option in January 2004.  This capital is being used to support the continuingexpansion of our branch office network and balance sheet growth.  As a result of this increased capital andretained earnings, we increased our legal lending limit to $14.3 million as ofMarch 31, 2005, which allows us to more quickly**

 

14

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**expand our commercial and realestate lending loan portfolios.  Weexpect to increase our loan-to-deposit ratio and shift the mix of our earningassets to higher yielding loans.  We used$17.0 million of the cash that was raised in December 2003 and January 2004 toacquire George Mason.  The acquisition ofGeorge Mason furthers our goal of broadening the financial products andservices we offer and allows us to diversify our revenue base, increase feeincome, and strengthen customer relationships.**

 

**Critical Accounting Policies**

 

*General*

 

U. S. generallyaccepted accounting principles are complex and require management to applysignificant judgment to various accounting, reporting, and disclosurematters.  Management must use assumptionsand estimates to apply these principles where actual 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 or estimates may have asignificant impact on the consolidated financial statements.  Actual results could differ from initialestimates.

 

The accountingpolicies we view as critical are those relating to judgments, assumptions and estimatesregarding the determination of the allowance for loan losses, accounting foreconomic hedging activities, and the valuation of deferred tax 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 economic conditions, actual andexpected credit losses, historical trends and specific conditions of theindividual borrower.  As a part of our analysis,we use comparative peer group data, duration factors and qualitative factorssuch as levels of and trends in delinquencies and nonaccrual loans, nationaland local economic trends and conditions and concentrations of loans exhibitingsimilar risk profiles to support our estimates.**

** **

**Credit losses are an inherent part of ourbusiness and, although we believe the methodologies for determining theallowance for loan losses and the current level of the allowance are adequate,it is possible that there may be unidentified losses in the portfolio at March31, 2005 that may become evident at a future date pursuant to additionalanalysis or regulatory comment. Additional provisions for such losses, if necessary, would be recordedin the commercial banking segment or mortgage banking segment, as appropriate, andwould negatively impact earnings.**

** **

For purposes of our analysis, we categorize our loans into one of fivecategories:  commercial and industrial,commercial real estate (including construction), home equity lines of credit,residential mortgages, and consumer. Peer group annual loss factors (in the absence of historical results)are applied to all categories and are adjusted by the projected duration of theloan category and by the qualitative factors mentioned above.  The indicated loss factors resulting fromthis analysis are applied to each of the loan categories to determine a reservelevel for each of the five categories of loans. In addition, we individually assign loss factors to all loans that havebeen identified as having loss attributes, as indicated by deterioration in thefinancial condition of the borrower or a decline in underlying collateralvalues if the loan is collateral

 

15

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dependent.  Since we have limited historical data onwhich to base loss factors for classified loans, we apply, in accordance withregulatory guidelines, a 5% loss factor to all special mention loans, a 15%loss factor to all substandard loans and a 50% loss factor to all loansclassified as doubtful.  Loans classifiedas loss loans are fully reserved or charged off.

 

*Hedging*

 

Weaccount for our derivatives and hedging activities in accordance with Statementof Financial Accounting Standards (“SFAS”) No. 133, *Accountingfor Derivative Instruments and Hedging Activity*, as amended by SFASNo. 138, *Accounting for Certain Derivative Instruments andCertain Hedging Activities,*and SFAS No. 149*, Amendmentof Statement 133 on Derivative Instruments and Hedging Activities.*

 

Inthe normal course of business, we enter into contractual commitments, includingloan commitments and rate lock commitments to extend credit to financeresidential mortgages.  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 on these commitments and subsequently closedloans if interest rates move between the time of the interest rate lock and thedelivery of the loan to the investor. Loan commitments related to mortgage loans that are intended to be soldare considered derivatives in accordance with the guidance of SEC StaffAccounting Bulletin No. 105, *Application of AccountingPrinciples to Loan Commitments*. Accordingly, the fair value of these derivatives as of the end of thereporting period has been determined through an analysis of changes in marketinterest rates from the interest rate lock date and loan closing date.

 

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 sale contracts. These forward contracts are marked to market through earnings and arenot designated as accounting hedges under SFAS No. 133.  The change in the fair value of loancommitments and the change in the fair value of forward sales contractsgenerally move in opposite directions and, accordingly, the impact of changesin these valuations on net income during the loan commitment period isgenerally inconsequential.

 

Althoughthe forward loan sale contracts also serve as an economic hedge of loans heldfor sale, forward contracts have not been designated as accounting hedges underSFAS No. 133 and, accordingly, loans held for sale are accounted for at thelower of cost or market in accordance with SFAS No. 65, *Accountingfor Certain Mortgage Banking Activities.*

 

#### ***Valuation ofDeferred Tax Assets***

 

We record aprovision for income tax expense based on the amounts of current taxes payable(or refundable) and the change in net deferred tax assets or liabilities duringthe year.  Deferred tax assets andliabilities are recognized for the tax effects of differing carrying values ofassets and liabilities for tax and financial statement purposes that willreverse 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.  The amount of any valuation allowanceestablished is based upon an estimate of the deferred tax asset that isprobable of recovery.  The establishmentof a valuation allowance increases the provision for income taxes.

 

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###### **New FinancialAccounting Standards**

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 123R, *Share-Based Payments:  an Amendment of FASB Statements 123 and 95.*  This statement requires that companiesrecognize to the income statement the grant-date fair value of stock optionsand other equity-based compensation. This statement requires that stock awards be classified as either anequity award or a liability award. Equity classified awards are valued as of the grant date using either anobservable market price or a valuation methodology.  Liability classified awards are valued atfair value as of each reporting date.  Weestimate that this new standard will result in an increase in pretax expense ofapproximately $72,000 quarterly and $288,000 annually beginning January 1, 2006,the effective date of the standard for us.

 

##### **Statementsof Income**

 

Netincome for the three months ended March 31, 2005 and 2004 was $1.6 million and$719,000, respectively, an improvement of $893,000, or 124%.  The increase in net income was primarily aresult of increased net interest income of $3.0 million and non-interest incomeof $4.3 million, offset by increases in non-interest expense of $5.5 million.  The 2005 results were positively impacted by theresults of operations of George Mason, which were not included in the threemonths ended March 31, 2004 results since George Mason was acquired on July 7,2004.  Net income reported by GeorgeMason for the quarter ended March 31, 2005 was $1.4 million and comprisedapproximately two-thirds of our consolidated net income for the quarter.

 

Basic and diluted earnings per share were $0.09 for the three monthsended March 31, 2005.  For the threemonths ended March 31, 2004, basic and diluted earnings per share were $0.04.  Weighted average fully diluted sharesoutstanding for the three months ended March 31, 2005 were 18,830,265 comparedto 17,884,580 for the three months ended March 31, 2004.

 

Return on average assets for the three months ended March 31, 2005 and2004 was 0.57% and 0.43%, respectively. Return on average equity for the three months ended March 31, 2005 and2004 was 6.61% and 3.14%, respectively.  Theincreases in our returns of average assets and average equity were a result ofthe increases in net income in our 2005 results compared to the same period of2004.

 

Net interest income represents the difference between interest and feesearned on interest earning assets and the interest paid on deposits and otherinterest bearing liabilities.  The levelof net interest income is impacted primarily by variations in the volume andmix of these assets and liabilities, as well as changes in interest rates.  Net interest income for the three monthsended March 31, 2005 and 2004 was $7.8 million and $4.8 million, respectively,a period-to-period increase of $3.0 million, or 61.9%.  The increase in net interest income was primarilythe result of the increase in the average volume of loans receivable and loansheld for sale compared with the same period of 2004.  These increases were funded through theincreases in total deposits and other borrowed funds.

 

Our net interest margin for the three months ended March 31, 2005 and2004 was 2.84% and 3.00%, respectively.  Thiscompares to a net interest margin of 2.72% for the year ended December 31,2004.  The decrease in the net interestmargin for the period ended March 31, 2005 compared to the same period in 2004 wasa result of a higher volume of deposits and borrowings at an increased rate ofinterest paid than the interest rate received on the increased volume of loansreceivable and loans held for sale primarily due to the addition of GeorgeMason in the first quarter of 2005. We remain asset sensitive and thereforeanticipate that net interest margin will improve in a rising rateenvironment.  Tables 1 and 2 present ananalysis of average earning

 

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assets, interest bearingliabilities and demand deposits with related components of interest income andinterest expense.

 

**Table 1.**

 

**Average Balance Sheets and Interest Rates on Earning Assetsand Interest - Bearing Liabilities**

ThreeMonths Ended March 31, 2005, 2004 and 2003

(Dollarsin thousands)

 
| ** **                                               | ** ** | **2005**             | ** ** | **2004**                       | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|--------------------------------|------------|----------|------------|
| ** **                                               | ** ** | **Average  Balance** | ** ** | **Interest  Income/  Expense** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest  Income/  Expense** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest  Income/  Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                               |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                                |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1):                                               |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and  industrial                               |       | $                    | 60,873     |                           | $          | 856      |       | 5.62 | % | $ | 59,327 |   | $ | 796 |   | 5.37 | % | $ | 53,060 |   | $ | 833 |   | 6.28 | % |
| Real estate -  commercial                                |       | 223,879              |       | 3,380                          |       | 6.04     |       | 137,776 |   | 2,223 |   | 6.45 |   | 115,685 |   | 2,064 |   | 7.14 |   |
| Real estate -  construction                              |       | 68,969               |       | 1,117                          |       | 6.48     |       | 41,609 |   | 567 |   | 5.45 |   | 8,955 |   | 137 |   | 6.12 |   |
| Real estate -  residential                               |       | 84,962               |       | 1,143                          |       | 5.38     |       | 42,871 |   | 617 |   | 5.76 |   | 34,284 |   | 577 |   | 6.73 |   |
| Home equity lines                                        |       | 61,268               |       | 684                            |       | 4.53     |       | 44,829 |   | 363 |   | 3.24 |   | 28,352 |   | 241 |   | 3.40 |   |
| Consumer                                                 |       | 5,909                |       | 100                            |       | 6.77     |       | 10,373 |   | 162 |   | 6.25 |   | 9,639 |   | 179 |   | 7.43 |   |
| Total loans                                              |       | 505,860              |       | 7,280                          |       | 5.76     |       | 336,785 |   | 4,728 |   | 5.62 |   | 249,975 |   | 4,031 |   | 6.45 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for  sale, net                                |       | 289,024              |       | 3,358                          |       | 4.65     |       | — |   | — |   | 0.00 |   | — |   | — |   | 0.00 |   |
| Investment  securities available-for-sale                |       | 153,907              |       | 1,431                          |       | 3.72     |       | 142,128 |   | 1,271 |   | 3.58 |   | 180,044 |   | 1,678 |   | 3.73 |   |
| Investment  securities held-to-maturity                  |       | 135,945              |       | 1,307                          |       | 3.85     |       | 150,016 |   | 1,350 |   | 3.60 |   | — |   | — |   | 0.00 |   |
| Other investments                                        |       | 5,172                |       | 54                             |       | 4.19     |       | 3,634 |   | 38 |   | 4.18 |   | 1,853 |   | 24 |   | 5.18 |   |
| Federal funds  sold                                      |       | 11,162               |       | 61                             |       | 2.20     |       | 12,146 |   | 28 |   | 0.92 |   | 13,503 |   | 39 |   | 1.16 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets and interest income       |       | 1,101,070            |       | 13,491                         |       | 4.90     |       | 644,709 |   | 7,415 |   | 4.60 |   | 445,375 |   | 5,772 |   | 5.18 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest earning  assets:                            |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                 |       | 2,519                |       |                           |       |     |       | 10,256 |   |   |   |   |   | 14,720 |   |   |   |   |   |
| Premises and  equipment, net                             |       | 17,000               |       |                           |       |     |       | 6,833 |   |   |   |   |   | 5,007 |   |   |   |   |   |
| Goodwill and  other intangibles, net                     |       | 14,501               |       |                           |       |     |       | 22 |   |   |   |   |   | 646 |   |   |   |   |   |
| Accrued interest  and other assets                       |       | 7,804                |       |                           |       |     |       | 7,212 |   |   |   |   |   | 4,467 |   |   |   |   |   |
| Allowance for  loan losses                               |       | (5,988               | )          |                           |       |     |       | (4,408 | ) |   |   |   |   | (3,397 | ) |   |   |   |   |
| Total assets                                             |       | $                    | 1,136,906  |                           |       |     |       |   | $ | 664,624 |   |   |   |   |   | $ | 466,818 |   |   |   |   |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**           |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing liabilities:                         |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -  bearing deposits:                            |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                        |       | $                    | 139,160    |                           | $          | 429      |       | 1.25 | % | $ | 155,523 |   | $ | 529 |   | 1.36 | % | $ | 139,080 |   | $ | 638 |   | 1.83 | % |
| Money markets                                            |       | 43,021               |       | 170                            |       | 1.58     |       | 24,470 |   | 36 |   | 0.59 |   | 26,131 |   | 69 |   | 1.06 |   |
| Statement savings                                        |       | 8,688                |       | 22                             |       | 1.01     |       | 7,191 |   | 9 |   | 0.50 |   | 4,493 |   | 9 |   | 0.80 |   |
| Certificates of  deposit                                 |       | 553,079              |       | 4,056                          |       | 2.93     |       | 237,562 |   | 1,708 |   | 2.88 |   | 173,249 |   | 1,524 |   | 3.52 |   |
| Total interest -  bearing deposits                       |       | 743,948              |       | 4,677                          |       | 2.55     |       | 424,746 |   | 2,282 |   | 2.15 |   | 342,953 |   | 2,240 |   | 2.61 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed  funds                                    |       | 153,580              |       | 992                            |       | 2.59     |       | 73,545 |   | 300 |   | 1.63 |   | 14,957 |   | 73 |   | 1.95 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities and interest expense |       | 897,528              |       | $                              | 5,669      |     | 2.56       |   | 498,291 |   | $ | 2,582 |   | 2.07 |   | 357,910 |   | $ | 2,313 |   | 2.59 |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                        |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                          |       | 103,883              |       |                           |       |     |       | 72,399 |   |   |   |   |   | 66,638 |   |   |   |   |   |
| Other liabilities                                        |       | 37,980               |       |                           |       |     |       | 2,204 |   |   |   |   |   | 1,588 |   |   |   |   |   |
| Preferred  shareholders’ equity                     |       | —               |       |                           |       |     |       | 6,391 |   |   |   |   |   | 6,825 |   |   |   |   |   |
| Common  shareholders’ equity                        |       | 97,515               |       |                           |       |     |       | 85,339 |   |   |   |   |   | 33,857 |   |   |   |   |   |
| Total liabilities  and shareholders’ equity         |       | $                    | 1,136,906  |                           |       |     |       |   | $ | 664,624 |   |   |   |   |   | $ | 466,818 |   |   |   |   |   |
|                                                     |       |                 |       |                           |       |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income and net interest margin (2)         |       |                 |       | $                              | 7,822      |     | 2.84       | % |   |   | $ | 4,833 |   | 3.00 | % |   |   | $ | 3,459 |   | 3.11 | % |

 

----

(1)   Non-accrual loans are included in average balances and do not havea material effect on the average yield. Interest income on non-accruing loans was not material for the quarterspresented.

(2)   We do not have investments that have tax benefit attributes; therefore,there are no tax equivalent adjustments to our net interest income.

 

18

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**Table 2.**

 

**Rate and Volume Analysis**

Three Months Ended March 31,2005, 2004 and 2003

(Dollarsin thousands)

 
| ** **                               | ** ** | **2005 Compared to 2004** | ** ** | **2004 Compared to 2003** | ** ** |
|------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                               | ** ** | **Change Due to**         | ** ** | ** **                | ** ** | **Change Due to** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Average  Volume**       | ** ** | **Average  Rate**         | ** ** | **Increase  (Decrease)** | ** ** | **Average  Volume** | ** ** | **Average  Rate** | ** ** | **Increase  (Decrease)** | ** ** |
| **Interest income:**                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Loans (1):                               |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Commercial and industrial                |       | $                         | 21         |                      | $          | 39 |   | $ | 60 |   | $ | 98 |   | $ | (135 | ) | $ | (37 | ) |
| Real estate - commercial                 |       | 1,389                     |       | (232                      | )          | 1,157 |   | 394 |   | (235 | ) | 159 |   |
| Real estate - construction               |       | 373                       |       | 177                       |       | 550 |   | 500 |   | (70 | ) | 430 |   |
| Real estate - residential                |       | 606                       |       | (80                       | )          | 526 |   | 145 |   | (105 | ) | 40 |   |
| Home equity lines                        |       | 128                       |       | 193                       |       | 321 |   | 140 |   | (18 | ) | 122 |   |
| Consumer                                 |       | (70                       | )          | 8                         |       | (62 | ) | 14 |   | (31 | ) | (17 | ) |
| Total loans                              |       | 2,447                     |       | 105                       |       | 2,552 |   | 1,291 |   | (594 | ) | 697 |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Loans held for sale, net                 |       | 3,358                     |       | —                    |       | 3,358 |   | — |   | — |   | — |   |
| Investment securities available-for-sale |       | 105                       |       | 55                        |       | 160 |   | (353 | ) | (54 | ) | (407 | ) |
| Investment securities held-to-maturity   |       | (127                      | )          | 84                        |       | (43 | ) | 1,350 |   | — |   | 1,350 |   |
| Other investments                        |       | 16                        |       | 0                         |       | 16 |   | 23 |   | (9 | ) | 14 |   |
| Federal funds sold                       |       | (2                        | )          | 35                        |       | 33 |   | (4 | ) | (7 | ) | (11 | ) |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Total interest income                    |       | 5,797                     |       | 279                       |       | 6,076 |   | 2,307 |   | (664 | ) | 1,643 |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                    |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:             |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Interest checking                        |       | (59                       | )          | (41                       | )          | (100 | ) | 75 |   | (184 | ) | (109 | ) |
| Money markets                            |       | 27                        |       | 107                       |       | 134 |   | (4 | ) | (29 | ) | (33 | ) |
| Statement savings                        |       | 2                         |       | 11                        |       | 13 |   | 5 |   | (5 | ) | — |   |
| Certificates of deposit                  |       | 2,252                     |       | 96                        |       | 2,348 |   | 565 |   | (381 | ) | 184 |   |
| Total interest - bearing deposits        |       | 2,222                     |       | 173                       |       | 2,395 |   | 641 |   | (599 | ) | 42 |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Other borrowed funds                     |       | 318                       |       | 374                       |       | 692 |   | 286 |   | (59 | ) | 227 |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Total interest expense                   |       | 2,540                     |       | 547                       |       | 3,087 |   | 927 |   | (658 | ) | 269 |   |
|                                     |       |                      |       |                      |       |   |   |   |   |   |   |   |   |
| Net interest income (2)                  |       | $                         | 3,257      |                      | $          | (268 | ) | $ | 2,989 |   | $ | 1,380 |   | $ | (6 | ) | $ | 1,374 |   |

 

----

(1)   Non-accrual loans are included in average balances and do not havea material effect on the average yield. Interest income on non-accruing loanswas not material for the quarters presented.

(2)   We do not have investments that have tax benefit attributes;therefore, there are no tax equivalent adjustments to our net interest income.

 

19

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The provision for loan losses for the three months ended March 31, 2005and 2004 was $549,000 and $74,000, respectively.  The increase in provision expense wasprimarily a result of the net increase of $45.8 million in the loan portfolioduring the first three months of 2005.  Theallowance for loan losses at March 31, 2005 and December 31, 2004 was $6.4million and $5.9 million, respectively. Our allowance for loan loss ratio was 1.20% at each of March 31, 2005 andDecember 31, 2004.  We continued toexperience strong loan quality with annualized net charged-off loans equal to0.00% of total loans for the three months ended March 31, 2005, compared to 0.08%for the same period of 2004. Non-performing loans were equal to 0.11% of total loans at each of March31, 2005 and December 31, 2004. Additional information on the allowance for loan losses, its allocationto the total loans receivable portfolio and information on nonperforming loanscan be found in Tables 3, 4 and 5.

 

**Table 3.**

 

**Allowancefor Loan Losses**

Three Months Ended March 31,2005 and 2004

(Dollars in thousands)

 
| ** **                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| Beginning balance, January 1 |       | $        | 5,878      |     | $          | 4,344 |   |
|                         |       |     |       |     |       |
| Provision for loan losses    |       | 549      |       | 74       |       |
|                         |       |     |       |     |       |
| Loans charged off:           |       |     |       |     |       |
| Commercial and industrial    |       | —   |       | (74      | )          |
| Consumer                     |       | (1       | )          | (1       | )          |
| Total loans charged off      |       | (1       | )          | (75      | )          |
|                         |       |     |       |     |       |
| Recoveries:                  |       |     |       |     |       |
| Commercial and industrial    |       | 2        |       | 2        |       |
| Consumer                     |       | 4        |       | 2        |       |
| Total recoveries             |       | 6        |       | 4        |       |
|                         |       |     |       |     |       |
| Net (charge offs) recoveries |       | 5        |       | (71      | )          |
|                         |       |     |       |     |       |
| Ending balance, March 31,    |       | $        | 6,432      |     | $          | 4,347 |   |

 
| ** **                                                  | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| Loans:                                                      |       |                |       |                   |       |
| Balance at period end                                       |       | $                   | 535,704    |                   | $          | 489,896 |   |
| Allowance for loan losses to loans  receivable, net of fees |       | 1.20                | %          | 1.20                   | %          |
| Annualized net charge-offs to average loans  receivable     |       | 0.00                | %          | 0.02                   | %          |
|                                                             |            |                     |            |                        |            |  |  |

 

20

----

 

**Table 4.**

 

**Allocationof the Allowance for Loan Losses**

At March 31, 2005 andDecember 31, 2004

(Dollars in thousands)

 
| ** **                      | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                      | ** ** | **Allocation**      | ** ** | **% of Total***        | ** ** | **Allocation** | ** ** | **% of Total*** | ** ** |
| Commercial and industrial       |       | $                   | 1,148      |                   | 11.32      | % | $ | 963 |   | 11.53 | % |
| Real estate - commercial        |       | 2,838               |       | 43.53                  | %          | 2,732 |   | 44.88 | % |
| Real estate - construction      |       | 838                 |       | 14.22                  | %          | 768 |   | 14.18 | % |
| Real estate - residential       |       | 936                 |       | 18.61                  | %          | 692 |   | 15.69 | % |
| Home equity lines               |       | 570                 |       | 11.45                  | %          | 612 |   | 12.32 | % |
| Consumer                        |       | 102                 |       | 0.87                   | %          | 111 |   | 1.40 | % |
|                            |       |                |       |                   |       |   |   |   |   |
| Total allowance for loan losses |       | $                   | 6,432      |                   | 100.00     | % | $ | 5,878 |   | 100.00 | % |

 

----

* Percentage of loan type tothe total loan portfolio.

 

21

----

 

**Table 5.**

 

**Nonperforming Loans Receivable**

At March 31, 2005 and December 31, 2004

(Dollars in thousands)

 
| ** **                                    | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------|------------|---------------------|------------|------------------------|------------|
| Nonaccruing loans                             |       | $                   | 604        |                   | $          | 547 |   |
|                                          |       |                |       |                   |       |
| Loans contractually past-due 90 days or  more |       | —              |       | —                 |       |
|                                          |       |                |       |                   |       |
| Troubled debt restructurings                  |       | —              |       | —                 |       |
| Total nonperforming loans receivable          |       | $                   | 604        |                   | $          | 547 |   |

 

22

----

 

Non-interest income includes, among other things, servicecharges on deposits and loans, gains on the sale of loans held for sale,investment fee income, and management fee income, and continues to be an importantfactor in our operating results.  Non-interestincome for the three months ended March 31, 2005 and 2004 was $5.2 million and$877,000, respectively, a period-to-period increase of $4.3 million.  The increase in non-interest income wasprimarily attributable to the increase in net gains on sale of loans held forsale by George Mason of $3.6 million and an increase in management fee incomeof $524,000 attributable to George Mason. Management fee income represents theincome earned for services provided to other mortgage banking companies ownedby local home builders.  Gains on thesale of loans held for sale include the gross gains on the sale of mortgageloans, net of origination costs. Included in the gross gains on sale of mortgage loans are anyorigination, underwriting, and discount points and other funding fees receivedand deferred at origination.  Costs,which are originally capitalized when the loan closes and are deferred andsubsequently recognized when the loan is sold, include direct costs associatedwith origination, such as commissions and direct salaries for funded loans.

 

Service charges on deposit accounts increased$39,000 to $280,000 for the three months ended March 31, 2005 compared to thesame period of 2004.  Loan service chargeincome increased $431,000 to $626,000 for the three months ended March 31, 2005,compared to $195,000 for the same period of 2004, primarily related to the inclusionof George Mason in the 2005 period.  Investmentfee income decreased slightly to $159,000 for the three months ended March 31,2005 compared to $178,000 for the same three month period of 2004.

 

Non-interest expense includes salaries andbenefits, occupancy, professional fees, depreciation, data processing,telecommunications and miscellaneous expenses. Non-interest expense for the three months ended March 31, 2005 was $10.1million, compared to $4.6 million for the same period of 2004, an increase of $5.5million.  The increase was attributableto the addition of George Mason and the branch expansion we have completed overthe past twelve months.  During the twelvemonths ended March 31, 2005, we opened seven branch banking facilities,including our nineteenth branch, which is located in Sterling, Virginia, inJanuary 2005.  Expenses related to thebranch expansion are represented in the increases in our salaries and benefitsexpense, occupancy expense and depreciation expense.  We expect non-interest expense to continue toincrease going forward as we continue our branch expansion in 2005.

 

23

----

 

In January 2005, we began deferred compensationplans for our directors and certain employees. As of March 31, 2005, we had a deferred compensation liability of$281,000, and the deferred compensation expense during the quarter ended March31, 2005 was $21,000.

 

The effective tax rate for thefirst quarter of 2005 was 31.7%, compared to 33.5% for the same period of2004.  The 2005 effective rate is basedon the estimated annual effective tax rate. We recorded a provision for income tax expense of $749,000 and $362,000for the three months ended March 31, 2005 and 2004, respectively.    For more information, see “CriticalAccounting Policies” above in this discussion.

 

**Statements of Condition**

 

Total assets were $1.28 billion at March 31, 2005, compared to $1.21billion at December 31, 2004, an increase of $66.8 million or 5.5%.  This growth was driven by increases in loansreceivable and deposits.

 

Investment securities were $296.8 million at March 31, 2005, comparedto $289.5 million at December 31, 2004, an increase of $7.3 million.  The investment portfolio consists ofinvestment securities available-for-sale and investment securitiesheld-to-maturity.  Investment securitiesheld-to-maturity are those securities that we have the intent and ability tohold to maturity and are carried at amortized cost.  Investment securities available-for-sale arethose securities that we intend to hold for an indefinite period of time, butnot necessarily until maturity.  Thesesecurities are carried at fair value and may be sold as part of anasset/liability strategy, liquidity management, regulatory capital managementor similar factors.  At March 31, 2005,investment securities available-for-sale were $163.4 million and investment securitiesheld-to-maturity were $133.4 million. See Table 6 for additional information on our investment securitiesportfolio.

 

**Table 6.**

 

**Investment Securities**

AtMarch 31, 2005 and December 31, 2004

(Dollarsin thousands)

 
| ** **                                                         | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|--------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at March 31,  2005**                          | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| Obligations of U.S. government-sponsored  agencies and enterprises |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 15,965     |      | $          | 15,793      |       | 4.05 | % |
| Five to ten years                                                  |       | 3,000         |       | 2,977     |       | 4.48        | %          |
| Total U.S. government-sponsored agencies                           |       | $             | 18,965     |      | $          | 18,770      |       | 4.12 | % |
|                                                               |       |          |       |      |       |        |       |
| Mortgage-backed securities*                                        |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 2,025      |      | $          | 1,980       |       | 3.64 | % |
| Five to ten years                                                  |       | 18,870        |       | 18,596    |       | 4.21        | %          |
| After ten years                                                    |       | 125,442       |       | 122,038   |       | 4.08        | %          |
| Total mortgage-backed securities                                   |       | $             | 146,337    |      | $          | 142,614     |       | 4.09 | % |
|                                                               |       |          |       |      |       |        |       |
| Treasury bonds                                                     |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 2,027      |      | $          | 1,993       |       | 2.63 | % |
| Total treasury bonds                                               |       | $             | 2,027      |      | $          | 1,993       |       | 2.63 | % |
| Total investment securities  available-for-sale                    |       | $             | 167,329    |      | $          | 163,377     |       | 4.07 | % |

 
| ** **                                                         | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|--------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Held-to-maturity at March 31,  2005**                            | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| Obligations of U.S. government-sponsored  agencies and enterprises |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 6,500      |      | $          | 6,315       |       | 3.36 | % |
| Five to ten years                                                  |       | 16,019        |       | 15,607    |       | 4.26        | %          |
| After ten years                                                    |       | 2,999         |       | 2,993     |       | 4.20        | %          |
| Total U.S. government-sponsored agencies                           |       | $             | 25,518     |      | $          | 24,915      |       | 4.03 | % |
|                                                               |       |          |       |      |       |        |       |
| Mortgage-backed securities*                                        |       |          |       |      |       |        |       |
| Five to ten years                                                  |       | $             | 9,900      |      | $          | 9,776       |       | 4.07 | % |
| After ten years                                                    |       | 90,012        |       | 88,166    |       | 4.16        | %          |
| Total mortgage-backed securities                                   |       | $             | 99,912     |      | $          | 97,942      |       | 4.15 | % |
|                                                               |       |          |       |      |       |        |       |
| Corporate bonds                                                    |       |          |       |      |       |        |       |
| After ten years                                                    |       | $             | 8,005      |      | $          | 7,860       |       | 4.21 | % |
| Total corporate bonds                                              |       | $             | 8,005      |      | $          | 7,860       |       | 4.21 | % |
| Total investment securities  held-to-maturity                      |       | $             | 133,435    |      | $          | 130,717     |       | 4.13 | % |
|                                                               |       |          |       |      |       |        |       |
| Total investment securities                                        |       | $             | 300,764    |      | $          | 294,094     |       | 4.10 | % |

 

----

*Based on contractual maturities.

 

24

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| ** **                                                         | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|--------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at December  31, 2004**                       | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| Obligations of U.S. government-sponsored  agencies and enterprises |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 3,000      |      | $          | 2,947       |       | 3.33 | % |
| Five to ten years                                                  |       | 3,000         |       | 3,009     |       | 4.46        | %          |
| Total U.S. government-sponsored agencies                           |       | $             | 6,000      |      | $          | 5,956       |       | 3.89 | % |
|                                                               |       |          |       |      |       |        |       |
| Mortgage-backed securities*                                        |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 2,161      |      | $          | 2,131       |       | 3.59 | % |
| Five to ten years                                                  |       | 14,662        |       | 14,603    |       | 3.96        | %          |
| After ten years                                                    |       | 128,477       |       | 126,846   |       | 3.97        | %          |
| Total mortgage-backed securities                                   |       | $             | 145,300    |      | $          | 143,580     |       | 3.96 | % |
|                                                               |       |          |       |      |       |        |       |
| Treasury bonds                                                     |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 2,031      |      | $          | 2,018       |       | 2.63 | % |
| Total treasury bonds                                               |       | $             | 2,031      |      | $          | 2,018       |       | 2.63 | % |
| Total investment securities  available-for-sale                    |       | $             | 153,331    |      | $          | 151,554     |       | 3.94 | % |

 
| ** **                                                         | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|--------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Held-to-maturity at December  31, 2004**                         | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| Obligations of U.S. government-sponsored  agencies and enterprises |       |          |       |      |       |        |       |
| One to five years                                                  |       | $             | 6,500      |      | $          | 6,427       |       | 3.36 | % |
| Five to ten years                                                  |       | 16,018        |       | 15,901    |       | 4.28        | %          |
| After ten years                                                    |       | 2,999         |       | 2,962     |       | 4.22        | %          |
| Total U.S. government-sponsored agencies                           |       | $             | 25,517     |      | $          | 25,290      |       | 4.03 | % |
|                                                               |       |          |       |      |       |        |       |
| Mortgage-backed securities*                                        |       |          |       |      |       |        |       |
| Five to ten years                                                  |       | $             | 10,392     |      | $          | 10,406      |       | 3.83 | % |
| After ten years                                                    |       | 94,039        |       | 92,990    |       | 4.04        | %          |
| Total mortgage-backed securities                                   |       | $             | 104,431    |      | $          | 103,396     |       | 4.02 | % |
|                                                               |       |          |       |      |       |        |       |
| Corporate bonds                                                    |       |          |       |      |       |        |       |
| After ten years                                                    |       | $             | 8,005      |      | $          | 7,923       |       | 4.21 | % |
| Total corporate bonds                                              |       | $             | 8,005      |      | $          | 7,923       |       | 4.21 | % |
| Total investment securities  held-to-maturity                      |       | $             | 137,953    |      | $          | 136,609     |       | 4.03 | % |
|                                                               |       |          |       |      |       |        |       |
| Total investment securities                                        |       | $             | 291,284    |      | $          | 288,163     |       | 3.98 | % |

 

----

*Based on contractual maturities.

 

Loansreceivable, net of deferred fees and costs, increased by $45.8 million, or9.4%, to $535.7 million at March 31, 2005 from $489.9 million at December 31,2004 (see Table 7 for details on the loans receivable portfolio). Weexperienced growth in our commercial and industrial, commercial real estate,real estate construction, residential real estate and home equity loanportfolios.  We expect continued growthwithin these loan categories over the next three quarters of 2005 due to ourincreased legal lending limit of $14.3 million and the volume of loans we havescheduled for funding.  In addition, wehad $364.1 million in loans held for sale at March 31, 2005, compared to $365.5million at December 31, 2004, a decrease of $1.3 million.  Loans that are held for sale are valued atthe lower of cost or market value.

 

25

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**Table 7.**

 

**LoansReceivable**

At March 31, 2005 andDecember 31, 2004

(Dollars in thousands)

 
| ** **                      | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------|------------|--------------------|------------|-----------------------|------------|
|                            |       |               |       |                  |       |   |   |   |   |
| Commercial and industrial       |       | $                  | 60,655     |                  | 11.32      | % | $ | 56,512 |   | 11.53 | % |
| Real estate - commercial        |       | 233,324            |       | 43.53                 | %          | 220,012 |   | 44.88 | % |
| Real estate - construction      |       | 76,186             |       | 14.22                 | %          | 69,535 |   | 14.18 | % |
| Real estate - residential       |       | 99,763             |       | 18.61                 | %          | 76,932 |   | 15.69 | % |
| Home equity lines               |       | 61,361             |       | 11.45                 | %          | 60,408 |   | 12.32 | % |
| Consumer                        |       | 4,667              |       | 0.87                  | %          | 6,816 |   | 1.40 | % |
|                            |       |               |       |                  |       |   |   |   |   |
| Gross loans                     |       | $                  | 535,956    |                  | 100.00     | % | $ | 490,215 |   | 100.00 | % |
|                            |       |               |       |                  |       |   |   |   |   |
| Add: net deferred (fees) costs  |       | (252               | )          |                  |       | (319 | ) |   |   |
| Less: allowance for loan losses |       | (6,432             | )          |                  |       | (5,878 | ) |   |   |
|                            |       |               |       |                  |       |   |   |   |   |
| Loans receivable, net           |       | $                  | 529,272    |                  |       |   | $ | 484,018 |   |   |   |
|                                 |            |                    |            |                       |            |  |  |  |  |  |  |  |  |

 

Total deposits increased $70.7 million, or 8.6%, to $894.9 million atMarch 31, 2005, compared to $824.2 million at December 31, 2004 (see Table 8for details on certificates of deposit with balances of $100,000 or more).  We experienced increases in non-interestbearing demand deposits, money market and savings deposits and certificates of deposit.  The increase in deposits is a result of newcustomers from our branch expansion, competitive deposit pricing and increasedadvertising efforts.  Brokeredcertificates of deposit decreased $20.0 million to $66.7 million at March 31,2005 compared to $86.7 million at December 31, 2004.  Additional information on brokeredcertificates of deposit can be found in “Contractual Obligations” below.

 

26

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**Table 8.**

 

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

At March 31, 2005

(Dollars in thousands)

 
| **Maturities:**                       |   |    |    |
|---------------------------------------|--------|---------|---------|
| Three months or less                  |   | $       | 22,826  |   |
| Over three months through six months  |   | 22,983  |    |
| Over six months through twelve months |   | 16,316  |    |
| Over twelve months                    |   | 163,226 |    |
|                                  |   | $       | 225,351 |   |

 

27

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Other borrowed funds decreased$12.4 million to $188.7 million at March 31, 2005, compared to $201.1 millionat December 31, 2004.  We had FederalHome Loan Bank advances that matured during the first quarter of 2005 and wereable to replace this funding source with other short term funding and throughour increased deposit growth.  Table 9provides information on our short-term borrowings.

 

**Table 9.**

 

**Short-TermBorrowings and Other Borrowed Funds**

At March 31, 2005

(Dollars in thousands)

 
| ** **                                                | ** ** | ** **        | ** ** | ** **          | ** ** | **Date Amount** | ** ** | ** **      | ** ** |
|-----------------------------------------------------------|------------|-------------------|------------|---------------------|------------|-----------------|------------|-----------------|------------|
| **Advance Date**                                          | ** ** | **Interest Rate** | ** ** | **Term of Advance** | ** ** | **Due**         | ** ** | **Outstanding** | ** ** |
| Jul-04                                                    |       | 3.01              | %          | 12 months           |       | Jul-05          |       | $               | 25,000     |   |
| Jan-04                                                    |       | 1.83              | %          | 18 months           |       | Jul-05          |       | $               | 5,000      |   |
| Mar-03                                                    |       | 2.33              | %          | 3 years             |       | Mar-06          |       | 1,000           |       |
| Weighted average rate and total short-term  FHLB advances |       | 2.80              | %          |                |       |            |       | $               | 31,000     |   |
| All other borrowed funds                                  |       |              |       |                |       |            |       | 157,715         |       |
| Total other borrowed funds                                |       |              |       |                |       |            |       | $               | 188,715    |   |

 

28

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At March 31, 2005, mortgage check fundings increasedby $27.9 million to $74.3 million, compared to $46.4 million at December 31,2004.  Warehouse financing decreased tozero at March 31, 2005 compared to $30.2 million at December 31, 2004.  These liabilities are related to George Masonand are used to fund the loans in process of being sold.  George Mason has credit facilities with theBank and has a third party facility totaling $250 million, of which there wereno borrowings outstanding at March 31, 2005. George Mason had a $60.0 million line of credit with an unaffiliatedthird party and, due to our limited use, we did not renew this line of creditafter it matured on March 1, 2005.

 

Shareholders’ equity at March 31,2005 was $95.7 million, an increase of $625,000, or 0.7%, compared to $95.1 millionat December 31, 2004. The increase of $625,000 from the prior year end wasprimarily driven by net income of $1.6 million for the quarter ended March 31,2005 offset by an unfavorable market value adjustment of $1.4 million oninvestment securities available-for-sale as of March 31, 2005.  Book value per share at March 31, 2005 was$5.17, compared to $5.15 at December 31, 2004. Tangible book value per share at March 31, 2005 was $4.38 compared to$4.36 at December 31, 2004.

 

##### **BusinessSegment Operations**

 

**We provide banking and non-banking financialservices and products through our subsidiaries. Prior to July 7, 2004, management operated and reported on the resultsof our operations through two business segments, commercial banking andinvestment services.  With the completionof our acquisition of George Mason during the third quarter of 2004, we nowoperate in a third business segment, mortgage banking.**

 

#### ***CommercialBanking***

 

The commercial banking segmentprovides a wide range of banking services to small businesses and individualsthrough multiple delivery channels. Services offered include commercial and consumer lending, depositproducts and banking via the Internet or telephone.

 

For the three months ended March31, 2005, the commercial banking segment recorded net income of $595,000compared to $913,000 for the three months ended March 31, 2004, a decrease of$318,000.  The decrease in earnings was aresult of the support needed for our branch expansion.  At March 31, 2005, total assets were $1.19 billion,loans receivable, net of fees, were $535.7 million and total deposits were$894.9 million.  At March 31, 2004, totalassets were $687.5 million, loans receivable, net of fees were $334.5 millionand total deposits were $525.9 million.

 

29

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*Mortgage Banking*

 

The operations of the mortgage banking segment are conducted throughGeorge Mason.  George Mason engagesprimarily in the origination and acquisition of residential mortgages for salesinto the secondary market on a best efforts basis.

 

For the three months ended March31, 2005, the mortgage banking segment recorded net income of $1.4million.  At March 31, 2005, total assetswere $379.4 million, loans held for sale, net were $364.1 million and mortgagecheck fundings were $74.3 million.

 

#### ***InvestmentServices***

#### ** **

The investment services segment provides investment and financialservices through an affiliation with a third party broker-dealer.

 

For the three months ended March 31, 2005, the investment servicessegment recorded a net loss of $41,000, compared to a net loss of $40,000 forthe same period of 2004, a decrease of $1,000. At March 31, 2005, total assets were $691,000 and total assets undermanagement were $135.7 million.  At March31, 2004, total assets were $741,000 and total assets under management were$175.8 million.

 

Informationpertaining to our business segments can be found in Note 2 to the Notes toConsolidated Financial Statements.

 

## **Capital Resources**

 

Capital adequacy is an important measure of financial stability andperformance.  Our objectives are tomaintain a level of capitalization that is sufficient to sustain asset growthand promote depositor and investor confidence.

 

Regulatory agencies measure capital adequacy utilizing a formula thattakes into account the individual risk profile of a financial institution.  The guidelines define capital as both Tier 1(primarily common shareholders’ equity, defined to include certain debtobligations) and Tier 2 (to include certain other debt obligations and aportion of the allowance for loan losses and 45% of unrealized gains in equitysecurities).

 

At March 31, 2005, our Tier 1 and total (Tier 1 and Tier 2) risk-basedcapital ratios were 12.1% and 12.8%, respectively.  At December 31, 2004, our Tier 1 and totalrisk-based capital ratios were 12.7% and 13.4%, respectively.  Our regulatory capital levels for the Bankand bank holding company meet those established for well-capitalizedinstitutions. Table 10 provides additional information pertaining to ourcapital ratios.

 

**Table 10.**

 

**Capital Components**

At March 31, 2005 and December 31, 2004

(Dollars in thousands)

 
|                                                            |       |       |       |                  |       |                  |       |                  |       | **To Be Well**        |       |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
|                                                            |       |       |       |                  |       |                  |       |                  |       | **Capitalized Under** |       |
|                                                            |       |       |       |                  |       | **For Capital**       |       | **Prompt Corrective** |       |
|                                                            |       | **Actual** |       | **Adequacy Purposes** |       | **Action Provisions** |       |
| ** **                                                      | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
|                                                            |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| **At March 31, 2005**                                           |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total risk based capital/ Total capital to risk-weighted assets |       | $          | 110,157    |                  | 12.83      | %                     | $          | 68,711                | >       | 8.00                  | %          | $ | 85,888 | > | 10.00 | % |
| Tier 1 capital/ Tier 1 capital to risk-weighted assets          |       | 103,613    |       | 12.06                 | %          | 34,355                | >       | 4.00                  | %          | 51,533                | >       | 6.00 | % |
| Tier 1 capital/ Tier 1 to average assets                        |       | 103,613    |       | 9.23                  | %          | 44,890                | >       | 4.00                  | %          | 56,113                | >       | 5.00 | % |
|                                                            |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| **At December 31, 2004**                                        |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total risk based capital/ Total capital to risk-weighted assets |       | $          | 107,660    |                  | 13.40      | %                     | $          | 64,294                | >       | 8.00                  | %          | $ | 80,368 | > | 10.00 | % |
| Tier 1 capital/ Tier 1 capital to risk-weighted assets          |       | 101,670    |       | 12.65                 | %          | 32,147                | >       | 4.00                  | %          | 48,221                | >       | 6.00 | % |
| Tier 1 capital/ Tier 1 to average assets                        |       | 101,670    |       | 8.83                  | %          | 46,075                | >       | 4.00                  | %          | 57,594                | >       | 5.00 | % |

 

**Contractual Obligations**

 

We have entered into a number of long-term contractual obligations tosupport our ongoing activities.  Thesecontractual obligations will be funded through operating revenues and liquiditysources held or available to us.  Therequired payments under such obligations are detailed in Table 11.

 

30

----

 

**Table 11.**

 

**ContractualObligations**

At March 31, 2005

(Dollars in thousands)

 
| ** **                                           | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **Total**                  | ** ** | **Less than 1  Year** | ** ** | **1 - 2 Years** | ** ** | **3 - 5 Years** | ** ** | **More than 5  Years** | ** ** |
| Certificates of deposit of $100,000 or more          |       | $                          | 225,351    |   | $ | 62,125 |   | $ | 19,087 |   | $ | 142,752 |   | $ | 1,387 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| Brokered certificates of deposit                     |       | 66,678                     |       | 64,826 |   | 1,852 |   | — |   | — |   |
|                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| Advances from the Federal Home Loan Bank of  Atlanta |       | 100,333                    |       | 31,000 |   | 9,250 |   | 40,083 |   | 20,000 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| Trust preferred securities                           |       | 20,000                     |       | — |   | — |   | — |   | 20,000 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| Operating lease obligations                          |       | 15,293                     |       | 3,918 |   | 3,886 |   | 6,221 |   | 1,268 |   |
|                                                 |       |                       |       |   |   |   |   |   |   |   |   |
| Total                                                |       | $                          | 427,655    |   | $ | 161,869 |   | $ | 34,075 |   | $ | 189,056 |   | $ | 42,655 |   |

 

**Financial Instruments with Off-Balance Sheet Risk and Credit Risk**

 

In the normal course of business, we are a party to financialinstruments with off-balance sheet risk to meet the financing needs of ourcustomers.  These financial instrumentsinclude commitments to extend credit and standby letters of credit.  Those instruments involve, to varyingdegrees, elements of credit risk in excess of the amount recognized on thebalance sheet.

 

The Bank’s exposure to credit loss in the event of nonperformance bythe other party to the financial instrument for commitments to extend creditand standby letters of credit is represented by the contractual amount of thoseinstruments.  The Bank uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments.

 

At March 31, 2005, commitments to extend credit were $371.6 million andstandby letters of credit were $4.8 million.

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected toexpire without being drawn upon, the total commitment amounts do notnecessarily represent future funding requirements.  We evaluate each customer’s credit worthinesson a case-by-case basis.  The amount ofcollateral obtained is based on management’s credit evaluation of thecounterparty.  Collateral held varies butmay include accounts receivable, inventory, property and equipment, andincome-producing commercial properties.

 

Unfunded commitments under lines of credit are commitments for possiblefuture extensions of credit to existing customers.  Those lines of credit may not be drawn uponto the total extent to which we have committed.

 

**Standby letters of credit are conditionalcommitments we issued to guarantee the performance of a customer to a thirdparty.  Those guarantees are primarilyissued to support public and private borrowing arrangements, includingcommercial paper, bond financing, and similar transactions.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loan facilitiesto customers.  We hold certificates ofdeposit, deposit accounts, and real estate as collateral supporting thosecommitments for which collateral is deemed necessary.**

** **

## **Liquidity**

## ** **

Liquidityin the banking industry is defined as the ability to meet the demand for fundsof both depositors and borrowers.  Wemust be able to meet these needs with cash on hand by obtaining funding fromdepositors or other lenders or by converting non-cash items to cash.  The objective of our liquidity managementprogram is to ensure that we always have sufficient liquid resources to meetthe demands of our depositors and borrowers. Stable core deposits and a strong capital position provide the base forour liquidity position.  In addition, wehave demonstrated our ability to attract retail deposits because of ourconvenient branch locations, personal service and pricing.

 

31

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In additionto retail deposits, we have access to the different wholesale fundingmarkets.  These markets include thebrokered CD market, the repurchase agreement market and the federal fundsmarket.  In addition, we maintain securedlines of credit with the Federal Reserve Bank of Richmond and the Federal HomeLoan Bank of Atlanta.  Having diversefunding alternatives reduces our reliance on any one source for funding.

 

Cash flowfrom amortizing assets or maturing assets can also provide funding to meet theneeds of depositors and borrowers.

 

We haveestablished a formal liquidity contingency plan which establishes a liquiditymanagement team and provides guidelines for liquidity management.  For our liquidity management program, wefirst determine our current liquidity position. Liquidity is then forecasted based on forecasted changes in the balancesheet.  The Bank expects to maintain acertain liquidity cushion throughout the forecast period.  In addition to the forecast, we also stresstest our liquidity position under several different stress scenarios.  Guidelines for the forecasted liquiditycushion and for liquidity cushions for each stress scenario have beenestablished.  In addition, one stresstest combines all other stress tests to see how liquidity would react toseveral negative scenarios occurring at the same time.  We believe that we currently have sufficientresources to meet our anticipated liquidity needs.

 

InSeptember 2004, George Mason and the Bank entered into a one year $150 millionfloating rate revolving credit and security agreement with a third party.  The purpose of this credit facility is tofund residential mortgage loans at George Mason prior to their sale into thesecondary market.  The credit facilityrequires, among other things, that George Mason and the Bank have positivequarterly net income and maintain specified minimum tangible and regulatory networth levels.  The Company has guaranteedrepayment of this debt.  The interestrate on this credit facility is LIBOR plus between 1.50% and 1.875%.  At March 31, 2005, $0 of this line wasutilized.

 

In additionto this facility, this same lender has also provided a $100 million facilitythat is utilized by George Mason to warehouse residential mortgage loans heldfor sale to this lender.  The terms ofthis facility are substantially the same as the above-referenced revolvingcredit and security agreement and the cost of this facility is netted againstinterest earned on the loans pending settlement with the lender.  At March 31, 2005, $0 of this line wasutilized.

 

Liquidassets, which include cash and due from banks, federal funds sold andinvestment securities available for sale totaled $197.0 million at March 31,2005 or 15.4% of total assets.  We heldinvestments that are classified as held-to-maturity in the amount of $133.4million at March 31, 2005.  To maintainready access to the Bank’s secured lines of credit, the Bank has pledged themajority of its securities to the Federal Home Loan Bank of Atlanta withadditional securities pledged to the Federal Reserve Bank of Richmond.  Additional borrowing capacity at the FederalHome Loan Bank of Atlanta at March 31, 2005 was approximately $146.0 million.  Borrowing capacity with the Federal ReserveBank of Richmond was approximately $43.5 million at March 31, 2005.  GMM has $250 million of lines of creditavailable to it.  We are committed tomaintaining liquidity at a level sufficient to protect depositors, provide forreasonable growth and fully comply with all regulatory requirements.

 

32

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##### **InterestRate Sensitivity**

 

Weare exposed to various business risks including interest rate risk.  Our goal is to maximize net interest incomewithout incurring excessive interest rate risk. Management of net interest income and interest rate risk must beconsistent with the level of capital and liquidity that we maintain.  We manage interest rate risk through an assetand liability committee (“ALCO”).  ALCOis responsible for managing the interest rate risk for the company inconjunction with liquidity and capital management.

 

Throughthe middle of 2004, the ALCO committee used gap analysis to measure interestrate sensitivity.  Beginning with theinterest rate sensitivity analysis for the third quarter of 2004, we hired anindependent consulting firm to model the interest rate sensitivity of thecompany.  Instead of gap analysis, webegan using a net interest income simulation model as our primary tool tomeasure interest rate sensitivity.  Manyassumptions are developed based on expected activity in the balance sheet.  For maturing assets, assumptions are createdfor the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacementof these funding sources.  Assumptionsare also developed for assets and liabilities that could reprice during themodeled time period.  These assumptionsalso cover how we expect rates to change on non-maturity deposits such as NOW,Money Market and savings accounts.  Basedon inputs that include the current balance sheet, the current level of interestrates and the developed assumptions, the model then produces an expected levelof net interest income assuming that market rates remain unchanged.  This is considered the base case.  Next, the model determines what net interestincome would be given changes in interest rates.  The rate simulations performed include aramped rate change of down 100 basis points and up 200 basis points over a twoyear time period.  In the ramped downrate change, the model moves rates gradually down 100 basis points over thefirst year and then rates remain flat in the second year.  For the up 200 basis point scenario, ratesare gradually moved up 200 basis points in the first year and then rates remainflat in the second year.  In both the upand down scenarios, the model assumes a parallel shift in the yield curve.  The results of these simulations are thencompared to the base case.

 

AtMarch 31, 2005, we were asset sensitive. Asset sensitive means that we had more assets maturing and repricingthan liabilities.  We have a significantportion of our assets as floating rate assets and we have taken a significantamount of term funding through fixed rate, fixed term, certificates ofdeposit.  In a rising rate environment,net interest income should grow for an asset sensitive Bank.  In the up 200 basis point scenario for oneyear, net interest income would have improved by not more than 10% compared tothe base case and by not more than 15% over the two year time horizon.  Being asset sensitive, net interest income wouldhave declined compared to the base case in the down 100 basis pointscenario.  At March 31, 2005, netinterest income has a negative variance to the base case of less than 6% forthe one year period and a negative variance of less than 9% over the cumulativetwo year period.

 

**Caution About Forward-Looking Statements**

 

We makeforward-looking statements in this Form 10-Q that are subject to risks anduncertainties.  These forward lookingstatements include statements regarding our profitability, liquidity, allowancefor loan losses, interest rate sensitivity, market risk, growth strategy, andfinancial and other goals.  The words “believes,”“expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,”“intends,” or other similar words or terms are intended to identifyforward-looking statements.

 

Theseforward-looking statements are subject to significant uncertainties becausethey are based upon or are affected by factors including:

 

33

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•                  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;

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

•                  maintainingcapital levels adequate to support our growth;

•                  reliance on ourmanagement team, including the 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;

•                  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.

 

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**Item 3****. Quantitative and Qualitative Disclosures About Market Risk**

 

OurAsset/Liability Committee is responsible for reviewing our liquidityrequirements and maximizing our net interest income consistent with capitalrequirements, liquidity, interest rate and economic outlooks, competitivefactors and customer needs.  Interestrate risk arises because the assets of the Bank and the liabilities of the Bankhave different maturities and characteristics. In order to measure this interest rate risk, we use a simulation processthat measures the impact of changing interest rates on net interestincome.  This model is run for the Bankby an independent consulting firm that was hired by the Bank in the fourthquarter of 2004.  The simulationsincorporate assumptions related to expected activity in the balance sheet.  For maturing assets, assumptions aredeveloped for the redeployment of these assets. For maturing liabilities, assumptions are developed for the replacementof these funding sources.  Assumptionsare also developed for assets and liabilities that reprice during the modeledtime period.  These assumptions alsocover how we expect rates to change on non-maturity deposits such as NOW, MoneyMarket and savings accounts.  Based oninputs that include the most recent period end balance sheet, the current levelof interest rates and the developed assumptions, the model then produces anexpected level of net interest income assuming that interest rates remainunchanged.  This becomes the base case.  Next, the model determines the impact on netinterest income given certain interest rate changes.  The rate changes include a ramped rate changeof down 100 basis points and up 200 basis points over a two year timeperiod.  In the ramped down rate change,the model moves rates gradually down 100 basis points over the first year andthen rates remain flat in the second year. For the up 200 basis point scenario, rates are gradually increased by200 basis points in the first year and remain flat in the second year.  In both the up and down scenarios, the modelassumes a parallel shift in the yield curve. The results for net interest income are then compared to the base casewith a variance to the base case determined. Guidelines have been established that limit the net income variancesfrom the base case in both the down 100 basis point scenario and the up 200basis point scenario.

 

AtMarch 31, 2005, we were asset sensitive. Asset sensitive means that we had more assets maturing or repricing thanliabilities.  We have a significantportion of our assets as floating rate assets and we have also taken asignificant amount of term funding through fixed rate, fixed term, certificatesof deposit.  In a rising rateenvironment, net interest income should grow for an asset sensitive bank.  In the up 200 basis point scenario for oneyear, net interest income would have improved by not more than 10% compared tothe base case and by not more than 15% over the two year cumulative timehorizon.

 

Beingan asset sensitive bank, net interest income would have declined compared tothe base case in the down 100 basis point simulation by less than 6% for oneyear and by 9% over the cumulative two year period.

 

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

 

TheCompany maintains disclosure controls and procedures that are designed toensure that the information required to be disclosed by it in the reports thatit files or submits under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods requiredby the Securities and Exchange Commission, including, without limitation, thosecontrols and procedures designed to ensure that such information is accumulatedand communicated to the Company’s management to allow timely decisionsregarding required disclosures.

 

Asof the end of the period covered by this report, an evaluation of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures was carried out under the supervision and with the participationof the Company’s management, including its chief executive officer and chieffinancial officer. Based on and as of the date of such evaluation, theseofficers concluded that the Company’s disclosure controls and procedures wereeffective.

 

TheCompany also maintains a system of internal accounting controls that isdesigned to provide assurance that assets are safeguarded and that transactionsare executed in accordance with management’s authorization and are properlyrecorded. This system is continually reviewed and is augmented by writtenpolicies and procedures, the careful selection and training of qualifiedpersonnel and an internal audit program to monitor its effectiveness.  In the Annual Report on Form 10-K for the yearended December 31, 2004, management’s assessment of the effectiveness of ourinternal control over financial reporting reported a material weaknessregarding accounting for non-routine transactions which resulted in arestatement of the financial statements contained in the Company’s QuarterlyReport on Form 10-Q as of and for the period ended September 30, 2004.Specifically, our accounting personnel lacked sufficient resources andexpertise to properly account for certain non-routine transactions; ourpolicies and procedures did not provide for timely review of significantnon-routine transactions and accounting entries;  and we did not maintain sufficientdocumentation related to the application of U.S. generally accepted accountingprinciples to significant non-routine transactions.  To address this material weakness, weexpanded our accounting staff through the addition of a chief financialofficer, who completed his first full quarter as an employee of the Companyduring the quarter ended March 31, 2005, and a senior accountant. In addition,during the first quarter of 2005, we implemented timely review and sign-offprocedures that include the utilization of a disclosure checklist. Finally, weimplemented procedures to ensure that we document the application of U.S.generally accepted accounting principles to significant non-routine transactions.  Except as noted above, there were no changesin our internal control over financial reporting identified in connection withour evaluation of it that occurred during our last fiscal quarter thatmaterially affected, or are likely to materially affect, our internal controlover 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.  Currently, we are not partyto any material legal proceedings and no such proceedings are, to management’sknowledge, threatened against us.

 

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

** **

(a) None.

(b) Not applicable.

(c) None.

 

**Item 3****.  Defaults Upon Senior Securities**

 

(a) None.

(b) None.

 

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

 

(a) None.

(b) Not applicable.

(c) Not applicable.

(d) None.

 

**Item 5****.  Other Information**

 

(a) None.

(b) None.

 

**Item 6****.  Exhibits**

 

10.1                           Agreementand Plan of Share Exchange between Wilson/Bennett Capital Management, Inc. andCardinal Financial Corporation, dated as of April 29, 2005

31.1                           Rule 13a-14(a) Certification of Chief ExecutiveOfficer

31.2                           Rule 13a-14(a) Certification of Chief FinancialOfficer

32.1                           Statement of Chief Executive Officer Pursuant to18 U.S.C. Section 1350

32.2                           Statement of Chief Financial Officer Pursuant to18 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: May 9, 2005** | **  /s/ Bernard H. Clineburg**                 | ** ** |
| ** **            | **Bernard H. Clineburg**                                 |
| ** **            | **Chairman, President and Chief Executive Officer**      |
| ** **            | (Principal Executive Officer)                            |
| ** **            | ** **                                               |
| ** **            | ** **                                               |
| **Date: May 9, 2005** | **  /s/ Robert A. Cern**                       | ** ** |
| ** **            | **Robert A. Cern**                                       |
| ** **            | **Executive Vice President and Chief Financial Officer** |
| ** **            | (Principal Financial Officer)                            |
| ** **            | ** **                                               |
| ** **            | ** **                                               |
| **Date: May 9, 2005** | **  /s/ Jennifer L. Deacon**                   | ** ** |
| ** **            | **Jennifer L. Deacon**                                   |
| ** **            | **Senior Vice President and Controller**                 |
| ** **            | (Principal Accounting Officer)                           |

 

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