**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

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

 

 

**For the quarterly period ended September 30, 2007**

 

**or**

 
| **o** | **Transition Report Pursuant to Section 13 or  15(d)  of the Securities Exchange Act of 1934** |
|-------|------------------------------------------------------------------------------------------------|

 

 

**For the transition period from                  to                   **

** **

Commission File Number:**  0-24557**

 

**CARDINALFINANCIAL CORPORATION**

(Exactname of registrant as specified in its charter)

 

 

| **Virginia**                                                                | ** ** | **54-1874630**       |
|-----------------------------------------------------------------------------|------------|----------------------|
| (State  or other jurisdiction of                                            | ** ** | (I.R.S.  Employer    |
| incorporation  or organization)                                             |       | 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 area code) |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.   Yes  x   No  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.  (Check one):

 

Large accelerated filer  o        Acceleratedfiler  x    Non-acceleratedfiler  o

 

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act)Yes  o  No  x

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date:

 

| 24,254,361  shares of common stock, par value $1.00 per share, |
|----------------------------------------------------------------|
| outstanding  as of October 29, 2007                            |

 

** **

** **

----

 

 

**CARDINAL FINANCIAL CORPORATION**

 

**INDEX TO FORM 10-Q**

 

**PART I — FINANCIAL INFORMATION**

 

| Item 1.                               | Financial Statements:                                                                       |   |
|---------------------------------------|---------------------------------------------------------------------------------------------|--------|
|                                  |                                                                                        |   |
|                                  | Consolidated  Statements of Condition                                                       |   |
|                                  | At September  30, 2007 (unaudited) and December 31, 2006                                    |   |
|                                  |                                                                                        |   |
|                                  | Consolidated  Statements of Income                                                          |   |
|                                  | For the three and  nine months ended September 30, 2007 and 2006 (unaudited)                |   |
|                                  |                                                                                        |   |
|                                  | Consolidated  Statements of Comprehensive Income                                            |   |
|                                  | For the three  and nine months ended September 30, 2007 and 2006 (unaudited)                |   |
|                                  |                                                                                        |   |
|                                  | Consolidated  Statements of Changes in Shareholders’ Equity                            |   |
|                                  | For the nine  months ended September 30, 2007 and 2006 (unaudited)                          |   |
|                                  |                                                                                        |   |
|                                  | Consolidated  Statements of Cash Flows                                                      |   |
|                                  | For the nine  months ended September 30, 2007 and 2006 (unaudited)                          |   |
|                                  |                                                                                        |   |
|                                  | Notes to Consolidated Financial Statements (unaudited)                                      |   |
|                                  |                                                                                        |   |
| Item 2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                  |                                                                                        |   |
| Item 3.                               | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |
|                                  |                                                                                        |   |
| Item 4.                               |  Controls and Procedures                                                               |   |
|                                  |                                                                                        |   |
| **PART  II — OTHER INFORMATION** |                                                                                        |
|                                  |                                                                                        |   |
| Item  1.                              | Legal  Proceedings                                                                          |   |
| Item  1A.                             | Risk  Factors                                                                               |   |
| Item 2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   |
| Item 3.                               | Defaults Upon  Senior Securities                                                            |   |
| Item 4.                               | Submission of  Matters to a Vote of Security Holders                                        |   |
| Item  5.                              | Other  Information                                                                          |   |
| Item 6.                               | Exhibits                                                                                    |   |
|                                  |                                                                                        |   |
| **SIGNATURES**                        |                                                                                        |

 

 

 

** **

----

**PART I - FINANCIAL INFORMATION**

**Item1.  Financial Statements**

 

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF CONDITION

September30, 2007 and December 31, 2006

(In thousands, except sharedata)

 

| **Assets**                                                                                                                              | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                              | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| ** **                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Cash and due from banks                                                                                                                 |       | $                       | 17,860     |                   | $          | 24,585 |   |
| Federal funds sold                                                                                                                      |       | 25,750                  |       | 11,491                 |       |
| Total cash and cash equivalents                                                                                                         |       | 43,610                  |       | 36,076                 |       |
|                                                                                                                                    |       |                    |       |                   |       |
| Investment securities  available-for-sale                                                                                               |       | 343,517                 |       | 231,631                |       |
| Investment securities held-to-maturity (market value of $81,426 and $95,450  at September 30, 2007 and December 31, 2006, respectively) |       | 82,740                  |       | 97,665                 |       |
| Total investment securities                                                                                                             |       | 426,257                 |       | 329,296                |       |
|                                                                                                                                    |       |                    |       |                   |       |
| Other investments                                                                                                                       |       | 12,674                  |       | 9,158                  |       |
| Loans held for sale, net                                                                                                                |       | 144,448                 |       | 338,731                |       |
|                                                                                                                                    |       |                    |       |                   |       |
| Loans receivable, net of deferred fees and costs                                                                                        |       | 973,518                 |       | 845,449                |       |
| Allowance for loan losses                                                                                                               |       | (10,857                 | )          | (9,638                 | )          |
| Loans receivable, net                                                                                                                   |       | 962,661                 |       | 835,811                |       |
|                                                                                                                                    |       |                    |       |                   |       |
| Premises and equipment,  net                                                                                                            |       | 18,892                  |       | 20,039                 |       |
| Deferred tax asset                                                                                                                      |       | 6,600                   |       | 6,415                  |       |
| Goodwill and intangibles,  net                                                                                                          |       | 17,303                  |       | 17,493                 |       |
| Bank-owned life insurance                                                                                                               |       | 31,931                  |       | 30,646                 |       |
| Accrued interest  receivable and other assets                                                                                           |       | 13,224                  |       | 14,764                 |       |
| Total assets                                                                                                                            |       | $                       | 1,677,600  |                   | $          | 1,638,429 |   |
|                                                                                                                                    |       |                    |       |                   |       |
| **Liabilities and Shareholders’ Equity**                                                                                           | ** ** | ** **              | ** ** | ** **             | ** ** |
| ** **                                                                                                                              | ** ** | ** **              | ** ** | ** **             | ** ** |
| Non-interest bearing  deposits                                                                                                          |       | $                       | 127,119    |                   | $          | 123,301 |   |
| Interest bearing deposits                                                                                                               |       | 1,010,751               |       | 1,095,581              |       |
| Other borrowed funds                                                                                                                    |       | 322,388                 |       | 194,631                |       |
| Mortgage funding checks                                                                                                                 |       | 17,776                  |       | 46,159                 |       |
| Escrow liabilities                                                                                                                      |       | 1,594                   |       | 3,229                  |       |
| Accrued interest payable  and other liabilities                                                                                         |       | 41,911                  |       | 19,655                 |       |
| Total liabilities                                                                                                                       |       | 1,521,539               |       | 1,482,556              |       |
|                                                                                                                                    |       |                    |       |                   |       |
|                                                                                                                                    |       |                    |       |                   |       |   |   |   |   |
| Common stock, $1 par value                                                                                                              |       | **2007**                |       | **2006**               |       |   |   |   |   |
| Shares authorized                                                                                                                       |       | 50,000,000              |       | 50,000,000             |       |   |   |   |   |
| Shares issued and outstanding                                                                                                           |       | 24,254,361              |       | 24,459,155             |       | 24,254 |   | 24,459 |   |
| Additional paid-in capital                                                                                                              |       | 131,104                 |       | 132,985                |       |
| Retained earnings                                                                                                                       |       | 3,074                   |       | 705                    |       |
| Accumulated other  comprehensive loss                                                                                                   |       | (2,371                  | )          | (2,276                 | )          |
| Total shareholders’ equity                                                                                                         |       | 156,061                 |       | 155,873                |       |
| Total liabilities and shareholders’ equity                                                                                         |       | $                       | 1,677,600  |                   | $          | 1,638,429 |   |
|                                                                                                                                    |       |                    |       |                   |       |   |   |

 

See accompanying notes to consolidated financial statements.

** **

** **

** **

**3**

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF INCOME

 

Three and nine months endedSeptember 30, 2007 and 2006 

(In thousands, except shareand per share data) 

(Unaudited) 

 

| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |       |
|---------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|------------|
| ** **                                                    | ** ** | ** **                            | ** ** |                                 |
|                                                          | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007**   | ** ** | **2006** | ** ** |   |
| Interest income:                                              |       |                                  |       |                                 |       |       |   |   |   |   |
| Loans receivable                                              |       | $                                     | 16,551     |                                 | $          | 13,495     |   | $ | 46,568 |   | $ | 37,522 |   |
| Loans held for sale                                           |       | 4,256                                 |       | 5,193                                |       | 13,954     |   | 14,746 |   |   |
| Federal funds sold                                            |       | 70                                    |       | 181                                  |       | 1,220      |   | 915 |   |   |
| Investment securities available-for-sale                      |       | 3,606                                 |       | 2,834                                |       | 9,496      |   | 7,525 |   |   |
| Investment securities held-to-maturity                        |       | 896                                   |       | 1,079                                |       | 2,858      |   | 3,306 |   |   |
| Other investments                                             |       | 166                                   |       | 84                                   |       | 442        |   | 262 |   |   |
| Total interest income                                         |       | 25,545                                |       | 22,866                               |       | 74,538     |   | 64,276 |   |   |
|                                                          |       |                                  |       |                                 |       |       |   |   |   |   |
| Interest expense:                                             |       |                                  |       |                                 |       |       |   |   |   |   |
| Deposits                                                      |       | 11,378                                |       | 10,678                               |       | 35,188     |   | 27,605 |   |   |
| Other borrowed funds                                          |       | 3,834                                 |       | 1,768                                |       | 8,949      |   | 5,145 |   |   |
| Total interest expense                                        |       | 15,212                                |       | 12,446                               |       | 44,137     |   | 32,750 |   |   |
| Net interest income                                           |       | 10,333                                |       | 10,420                               |       | 30,401     |   | 31,526 |   |   |
| Provision for loan losses                                     |       | 915                                   |       | 230                                  |       | 1,670      |   | 870 |   |   |
| Net interest income after provision for loan losses           |       | 9,418                                 |       | 10,190                               |       | 28,731     |   | 30,656 |   |   |
|                                                          |       |                                  |       |                                 |       |       |   |   |   |   |
| Non-interest income:                                          |       |                                  |       |                                 |       |       |   |   |   |   |
| Service charges on deposit accounts                           |       | 505                                   |       | 418                                  |       | 1,472      |   | 1,176 |   |   |
| Loan service charges                                          |       | 365                                   |       | 386                                  |       | 1,187      |   | 1,567 |   |   |
| Investment fee income                                         |       | 1,101                                 |       | 849                                  |       | 3,236      |   | 2,486 |   |   |
| Net gain on sales of loans                                    |       | 2,093                                 |       | 2,455                                |       | 7,157      |   | 7,753 |   |   |
| Net realized gain on investment securities available-for-sale |       | —                                |       | 66                                   |       | 14         |   | 66 |   |   |
| Net realized loss on investment securities trading            |       | —                                |       | —                               |       | (11        | ) | — |   |   |
| Management fee income                                         |       | 229                                   |       | 583                                  |       | 899        |   | 1,665 |   |   |
| Litigation recovery on previously impaired investment         |       | 17                                    |       | —                               |       | 83         |   | — |   |   |
| Increase in cash surrender value of bank-owned life insurance |       | 428                                   |       | 212                                  |       | 1,285      |   | 212 |   |   |
| Other income                                                  |       | 5                                     |       | (7                                   | )          | 39         |   | 741 |   |   |
| Total non-interest income                                     |       | 4,743                                 |       | 4,962                                |       | 15,361     |   | 15,666 |   |   |
|                                                          |       |                                  |       |                                 |       |       |   |   |   |   |
| Non-interest expense:                                         |       |                                  |       |                                 |       |       |   |   |   |   |
| Salary and benefits                                           |       | 5,592                                 |       | 6,195                                |       | 18,237     |   | 18,224 |   |   |
| Occupancy                                                     |       | 1,362                                 |       | 1,399                                |       | 3,989      |   | 3,902 |   |   |
| Professional fees                                             |       | 770                                   |       | 456                                  |       | 1,686      |   | 1,677 |   |   |
| Depreciation                                                  |       | 748                                   |       | 831                                  |       | 2,345      |   | 2,369 |   |   |
| Data processing                                               |       | 345                                   |       | 362                                  |       | 1,044      |   | 1,002 |   |   |
| Telecommunications                                            |       | 278                                   |       | 316                                  |       | 856        |   | 937 |   |   |
| Loss related to escrow arrangement                            |       | 3,500                                 |       | —                               |       | 3,500      |   | — |   |   |
| Amortization of intangibles                                   |       | 63                                    |       | 63                                   |       | 190        |   | 356 |   |   |
| Impairment of goodwill and intangible assets                  |       | —                                |       | 2,927                                |       | —     |   | 2,927 |   |   |
| Other operating expenses                                      |       | 2,811                                 |       | 2,496                                |       | 8,293      |   | 7,531 |   |   |
| Total non-interest expense                                    |       | 15,469                                |       | 15,045                               |       | 40,140     |   | 38,925 |   |   |
| Net income (loss) before income taxes                         |       | (1,308                                | )          | 107                                  |       | 3,952      |   | 7,397 |   |   |
| Provision for income taxes                                    |       | (702                                  | )          | (148                                 | )          | 851        |   | 2,209 |   |   |
| Net income (loss)                                             |       | $                                     | (606       | )                                    | $          | 255        |   | $ | 3,101 |   | $ | 5,188 |   |
| Earnings per common share — basic                        |       | $                                     | (0.02      | )                                    | $          | 0.01       |   | $ | 0.13 |   | $ | 0.21 |   |
| Earnings per common share — diluted                      |       | $                                     | (0.02      | )                                    | $          | 0.01       |   | $ | 0.12 |   | $ | 0.21 |   |
| Weighted-average common shares outstanding — basic       |       | 24,253,187                            |       | 24,430,917                           |       | 24,424,037 |   | 24,411,330 |   |   |
| Weighted-average common shares outstanding — diluted     |       | 24,253,187                            |       | 24,917,422                           |       | 24,900,401 |   | 24,970,941 |   |   |
|                                                          |       |                                  |       |                                 |       |       |   |   |   |   |
|                                                               |            |                                       |            |                                      |            |            |  |  |  |  |  |  |  |  |  |

 

Seeaccompanying notes to consolidated financial statements.

** **

** **

**4**

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** **

**CARDINAL FINANCIAL CORPORATION ANDSUBSIDIARIES**

** **

CONSOLIDATED STATEMENTSOF COMPREHENSIVE INCOME

 

Three and nine months ended September 30, 2007 and2006

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                                                                                                                                                                                                                             | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                             | ** ** | ** **                            | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                             | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|                                                                                                                                                                                                                                                                                                                                                   |       |                                  |       |                                 |       |       |       |       |       |
| Net income (loss)                                                                                                                                                                                                                                                                                                                                      |       | $                                     | (606       | )                                    | $          | 255        |       | $          | 3,101      |   | $ | 5,188 |   |
| Other comprehensive gain:                                                                                                                                                                                                                                                                                                                              |       |                                  |       |                                 |       |       |       |       |       |
| Unrealized gain on available-for-sale investment securities:                                                                                                                                                                                                                                                                                           |       |                                  |       |                                 |       |       |       |       |       |
|                                                                                                                                                                                                                                                                                                                                                   |       |                                  |       |                                 |       |       |       |       |       |
| Unrealized holding gain arising during the period, net of tax expense  of $1.2 million and $163 thousand for the three and nine months ended  September 30, 2007, respectively, and tax expense of $1.5 million and $26  thousand for the three and nine months ended September 30, 2006, respectively                                                 |       | 2,230                                 |       | 2,851                                |       | 307        |       | 97         |       |
|                                                                                                                                                                                                                                                                                                                                                   |       |                                  |       |                                 |       |       |       |       |       |
| Less: reclassification adjustment for gains included in net income net  of tax expense of $5 thousand for the nine months ended September 30, 2007  and $23 thousand for each of the three and nine months ended September 30,  2006.                                                                                                                  |       | —                                |       | (43                                  | )          | (9         | )          | (43        | )          |
|                                                                                                                                                                                                                                                                                                                                                   |       | 2,230                                 |       | 2,808                                |       | 298        |       | 54         |       |
|                                                                                                                                                                                                                                                                                                                                                   |       |                                  |       |                                 |       |       |       |       |       |
| Unrealized gain (loss) on derivative instruments designated as cash  flow hedges, net of tax benefit of $106 thousand and $218 thousand for the  three and nine months ended September 30, 2007, respectively, and tax expense  of $137 thousand and tax benefit of $31 thousand for the three and nine  months ended September 30, 2006, respectively |       | (191                                  | )          | 234                                  |       | (393       | )          | (34        | )          |
| Comprehensive income                                                                                                                                                                                                                                                                                                                                   |       | $                                     | 1,433      |                                 | $          | 3,297      |       | $          | 3,006      |   | $ | 5,208 |   |
|                                                                                                                                                                                                                                                                                                                                                        |            |                                       |            |                                      |            |            |            |            |            |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

** **

** **

**5**

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** **

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

** **

CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

 

Nine months ended September30, 2007 and 2006

(In thousands)

(Unaudited)

 
| ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** **              | ** ** | ** **             | ** ** | **Accumulated  Other  Comprehensive** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-------------------------|------------|------------------------|------------|---------------------------------------|------------|------------|------------|
| ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-in** | ** ** | **Retained  Earnings** | ** ** | ** **                            | ** ** | ** ** |
| ** **                                                                      | ** ** | **Common** | ** ** | **Common** | ** ** | ** **              | ** ** | ** **             | ** ** | ** **                            |
| ** **                                                                      | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**             | ** ** | **(Deficit)**          | ** ** | **Loss**                              | ** ** | **Total**  | ** ** |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Balance, December 31, 2005                                                      |       | 24,363     |       | $          | 24,363     |                    | $          | 132,150                |       | $                                     | (5,269     | )          | $          | (3,365 | ) | $ | 147,879 |   |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Cumulative effect at January 1, 2006 of change in method of  quantifying errors |       | —     |       | —     |       | 25                      |       | (438                   | )          | —                                |       | (413       | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Stock options exercised                                                         |       | 34         |       | 34         |       | 222                     |       | —                 |       | —                                |       | 256        |       |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Payment of deferred compensation shares                                         |       | —     |       | —     |       | (4                      | )          | —                 |       | —                                |       | (4         | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Dividends on common stock of $0.03 per share                                    |       | —     |       | —     |       | —                  |       | (732                   | )          | —                                |       | (732       | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Change in accumulated other comprehensive loss                                  |       | —     |       | —     |       | —                  |       | —                 |       | 20                                    |       | 20         |       |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Net income                                                                      |       | —     |       | —     |       | —                  |       | 5,188                  |       | —                                |       | 5,188      |       |
| Balance, September 30, 2006                                                     |       | 24,397     |       | $          | 24,397     |                    | $          | 132,393                |       | $                                     | (1,251     | )          | $          | (3,345 | ) | $ | 152,194 |   |
| Balance, December 31, 2006                                                      |       | 24,459     |       | $          | 24,459     |                    | $          | 132,985                |       | $                                     | 705        |       | $          | (2,276 | ) | $ | 155,873 |   |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Stock options exercised                                                         |       | 19         |       | 19         |       | 82                      |       | —                 |       | —                                |       | 101        |       |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Payment of deferred compensation shares                                         |       | —     |       | —     |       | 3                       |       | —                 |       | —                                |       | 3          |       |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Purchase and retirement of common stock                                         |       | (224       | )          | (224       | )          | (1,966                  | )          | —                 |       | —                                |       | (2,190     | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Dividends on common stock of $0.03 per share                                    |       | —     |       | —     |       | —                  |       | (732                   | )          | —                                |       | (732       | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Change in accumulated other comprehensive loss                                  |       | —     |       | —     |       | —                  |       | —                 |       | (95                                   | )          | (95        | )          |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| Net income                                                                      |       | —     |       | —     |       | —                  |       | 3,101                  |       | —                                |       | 3,101      |       |
| Balance, September 30, 2007                                                     |       | 24,254     |       | $          | 24,254     |                    | $          | 131,104                |       | $                                     | 3,074      |       | $          | (2,371 | ) | $ | 156,061 |   |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
|                                                                            |       |       |       |       |       |                    |       |                   |       |                                  |       |       |       |
| See accompanying notes to  consolidated financial statements.                   |       |       |       |       |       |                    |       |

** **

** **

**6**

----

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

Nine months endedSeptember 30, 2007 and 2006

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                                                                                                                          | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash flows from  operating activities:                                                                                                                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                                                                                                                                                                          |       | $          | 3,101      |       | $          | 5,188 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                                                                                                                                                  |       |       |       |       |       |
| Depreciation                                                                                                                                                                                                                                        |       | 2,345      |       | 2,369      |       |
| Amortization of  premiums, discounts and intangibles                                                                                                                                                                                                |       | 468        |       | 887        |       |
| Impairment of  goodwill and intangible assets                                                                                                                                                                                                       |       | —     |       | 2,927      |       |
| Provision for  loan losses                                                                                                                                                                                                                          |       | 1,670      |       | 870        |       |
| Loans held for  sale originated                                                                                                                                                                                                                     |       | (1,807,962 | )          | (2,277,231 | )          |
| Proceeds from the  sale of loans held for sale                                                                                                                                                                                                      |       | 2,009,402  |       | 2,388,590  |       |
| Gain on sales of  loans held for sale                                                                                                                                                                                                               |       | (7,157     | )          | (7,753     | )          |
| Proceeds from  sale, maturity and call of investment securities trading                                                                                                                                                                             |       | 3,988      |       | —     |       |
| Purchase of  investment securities trading                                                                                                                                                                                                          |       | (3,999     | )          | —     |       |
| Loss on sale of  investments securities trading                                                                                                                                                                                                     |       | 11         |       | —     |       |
| Gain on sale of  investment securities available-for-sale                                                                                                                                                                                           |       | (14        | )          | (66        | )          |
| Loss on sale of  other assets                                                                                                                                                                                                                       |       | 3          |       | 2          |       |
| Increase in cash  surrender value of bank-owned life insurance                                                                                                                                                                                      |       | (1,285     | )          | —     |       |
| (Increase)  decrease in accrued interest receivable, other assets and deferred tax asset                                                                                                                                                            |       | 803        |       | (13,065    | )          |
| Increase in  accrued interest payable, escrow liabilities and other liabilities                                                                                                                                                                     |       | 20,668     |       | 7,086      |       |
| Net cash provided  by operating activities                                                                                                                                                                                                          |       | 222,042    |       | 109,804    |       |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| Cash flows from  investing activities:                                                                                                                                                                                                              |       |       |       |       |       |
| Purchases of  premises and equipment                                                                                                                                                                                                                |       | (1,201     | )          | (4,568     | )          |
| Proceeds from  sale, maturity and call of investment securities available-for-sale                                                                                                                                                                  |       | 33,946     |       | —     |       |
| Proceeds from  maturity and call of investment securities held-to-maturity                                                                                                                                                                          |       | 4,000      |       | —     |       |
| Proceeds from  sale of other investments                                                                                                                                                                                                            |       | 3,328      |       | 2,938      |       |
| Purchase of  investment securities available-for-sale                                                                                                                                                                                               |       | (130,758   | )          | (29,300    | )          |
| Purchase of  mortgage-backed securities available-for-sale                                                                                                                                                                                          |       | (32,421    | )          | (62,568    | )          |
| Purchase of other  investments                                                                                                                                                                                                                      |       | (6,844     | )          | (2,522     | )          |
| Purchase of  Bank-owned life insurance                                                                                                                                                                                                              |       | —     |       | (30,212    | )          |
| Redemptions of  investment securities available-for-sale                                                                                                                                                                                            |       | 17,678     |       | 18,893     |       |
| Redemptions of  investment securities held-to-maturity                                                                                                                                                                                              |       | 10,740     |       | 12,315     |       |
| Net cash paid in  acquisition                                                                                                                                                                                                                       |       | —     |       | (339       | )          |
| Net increase in  loans receivable, net of deferred fees and costs                                                                                                                                                                                   |       | (128,520   | )          | (100,913   | )          |
| Net cash used in  investing activities                                                                                                                                                                                                              |       | (230,052   | )          | (196,276   | )          |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| Cash flows from  financing activities:                                                                                                                                                                                                              |       |       |       |       |       |
| Net increase  (decrease) in deposits                                                                                                                                                                                                                |       | (81,012    | )          | 106,987    |       |
| Net increase in  other borrowed funds - short term                                                                                                                                                                                                  |       | 39,882     |       | 21,757     |       |
| Net increase  (decrease) in mortgage funding checks                                                                                                                                                                                                 |       | (28,383    | )          | 3,758      |       |
| Proceeds from  FHLB advances - long term                                                                                                                                                                                                            |       | 115,000    |       | 15,000     |       |
| Repayments of  FHLB advances - long term                                                                                                                                                                                                            |       | (27,125    | )          | (41,125    | )          |
| Stock options  exercised                                                                                                                                                                                                                            |       | 101        |       | 256        |       |
| Purchase and  retirement of common stock                                                                                                                                                                                                            |       | (2,190     | )          | —     |       |
| Deferred  compensation payments                                                                                                                                                                                                                     |       | 3          |       | (4         | )          |
| Dividends on  common stock                                                                                                                                                                                                                          |       | (732       | )          | (732       | )          |
| Net cash provided  by financing activities                                                                                                                                                                                                          |       | 15,544     |       | 105,897    |       |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| Net increase in  cash and cash equivalents                                                                                                                                                                                                          |       | 7,534      |       | 19,425     |       |
| Cash and cash  equivalents at beginning of the period                                                                                                                                                                                               |       | 36,076     |       | 36,589     |       |
| Cash and cash  equivalents at end of the period                                                                                                                                                                                                     |       | $          | 43,610     |       | $          | 56,014 |   |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| **Supplemental  disclosure of cash flow information:**                                                                                                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid during  the period for interest                                                                                                                                                                                                           | ** ** | $          | 43,693     | ** ** | $          | 32,942 | ** ** |
| Cash paid for  income taxes                                                                                                                                                                                                                         |       | 3,925      |       | 4,963      |       |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| **Supplemental  schedule of noncash investing and financing activities:**                                                                                                                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unsettled  purchases of investment securities available-for-sale                                                                                                                                                                                    | ** ** | $          | 413        | ** ** | $          | 1,419 | ** ** |
| Unsettled sale of  investment securities available-for-sale                                                                                                                                                                                         |       | —     |       | 10,210     |       |
|                                                                                                                                                                                                                                                |       |       |       |       |       |
| On February 9,  2006, the Company acquired certain fiduciary and other assets and assumed the  liabilities of FBR National Trust Company. In conjunction with the  acquisition, the following noncash changes to our financial condition  occurred: | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fair value of  non-cash assets acquired                                                                                                                                                                                                             |       |       |       | $          | 507        |   |
| Fair value of  liabilities assumed                                                                                                                                                                                                                  |       |       |       | 127        |       |
| ** **                                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |

 

See accompanying notes toconsolidated financial statements.

** **

**7**

----

 

 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September30, 2007

(Unaudited)

** **

Note 1

 

*Organization*

 

Cardinal Financial Corporation (the ”Company”)is incorporated under the laws of the Commonwealth of Virginia as a financialholding company whose activities consist of investment in its wholly-ownedsubsidiaries. The principal operating subsidiary of the Company is CardinalBank (the “Bank”), a state-chartered institution. On July 7, 2004, theBank acquired George Mason Mortgage, LLC (“George Mason”), a mortgage bankingcompany based in Fairfax, Virginia. On June 9, 2005, the Company acquiredWilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an assetmanagement firm. The Company also owns Cardinal Wealth Services, Inc. (“CWS”),an investment services subsidiary. On February 9, 2006, the Bank acquiredcertain fiduciary and other assets and assumed certain liabilities of FBRNational Trust Company, formerly a subsidiary of Friedman, Billings, RamseyGroup, Inc.

 

*Basis of Presentation*

 

In the opinion of management, theaccompanying consolidated financial statements have been prepared in accordancewith the requirements of Regulation S-X, Article 10. Accordingly, they donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements. However, alladjustments that are, in the opinion of management, necessary for a fairpresentation have been included. The results of operations for the three andnine months ended September 30, 2007 are not necessarily indicative of theresults to be expected for the full year ending December 31, 2007. Theunaudited interim financial statements should be read in conjunction with theaudited financial statements and notes to financial statements that areincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2006.

 

Note 2

 

*Summary of Significant AccountingPolicies*

 

*Investment Securities Held forTrading*

 

During the first quarter of 2007, the Companyestablished a new investment securities category, investment securities heldfor trading. Investment securities held for trading are those securities forwhich the Company has purchased and holds for the purpose of selling in the nearfuture.

 

Investmentsecurities held for trading are carried at estimated fair value. Unrealizedmarket value adjustments, fees, and realized gains or losses, net of applicabletax, on trading securities are reported in non-interest income.  Interest income on trading securities isincluded in interest income from investment securities within the consolidatedstatements of income.

 

 

8

----

 

 

**Note 3**

** **

***Stock-BasedCompensation***

** **

At September 30, 2007, the Company had twostock-based employee compensation plans, the 1999 Stock Option Plan (the “OptionPlan”) and the 2002 Equity Compensation Plan (the “Equity Plan”).

 

In 1998, the Company adopted the Option Planpursuant to which the Company may grant stock options for up to 625,000 sharesof the Company’s common stock to employees and members of the Company’s and itssubsidiaries’ boards of directors. There were 16,371 shares of the Company’scommon stock available for future grants in the Option Plan as of September 30,2007.

 

In 2002, the Company adopted the Equity Plan.The Equity Plan authorizes the granting and award of incentive stock options,non-qualified stock options, stock appreciation rights, restricted stockawards, phantom stock awards and performance share awards to directors,eligible officers and key employees of the Company.  The Equity Plan currently authorizes grantsand awards with respect to 2,420,000 shares of the Company’s common stock.  There were 263,258 shares of the Company’scommon stock available for future grants and awards in the Equity Plan as ofSeptember 30, 2007.

 

Stock options are granted with an exerciseprice equal to the common stock’s fair market value at the date of grant.Director stock options have ten year terms and vest and become fullyexercisable at the grant date. Certain employee stock options have ten yearterms and vest and become fully exercisable after three years. Other employeestock options have ten year terms and vest and become fully exercisable in 20%increments beginning as of the grant date. In addition, the Company has grantedstock options to employees of the Company that have ten year terms and vest andbecome fully exercisable in 20% increments beginning after their first year ofservice. During 2005, certain stock options granted to employees had ten yearterms and vested and became fully exercisable immediately.

 

The Company has only made awards of stockoptions under the Option Plan and the Equity Plan.

 

Total expense related to the Company’sshare-based compensation plans for the three months ended September 30, 2007and 2006 was $77,000 and $103,000, respectively. Total expense related to theCompany’s share-based compensation plans for the nine months ended September30, 2007 and 2006 was $256,000 and $250,000, respectively.  The total income tax benefit recognized inthe income statement for share-based compensation arrangements was $27,000 and$36,000 for the three months ended September 30, 2007 and 2006, respectively.The total income tax benefit recognized in the income statement for share-basedcompensation arrangements was $90,000 and $88,000 for the nine months endedSeptember 30, 2007 and 2006, respectively.

 

There were no options granted during thethree months ended September 30, 2007. The weighted average per share fairvalues of stock option grants made during the three months ended September 30,2006 was $5.38.  The weighted average pershare fair values of stock option grants made during the nine months endedSeptember 30, 2007 and 2006 were $4.89 and $5.71, respectively. The fair valuesof the options granted for these periods were estimated as of the grant dateusing the Black-Scholes option-pricing model based on the following weightedaverage assumptions:

 

| ** **              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **              | ** ** | **2006**               | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Estimated option life   |       | 6.5  years             |       | 6.5  years            |       | 6.5  years |   |
| Risk free interest rate |       | 4.69  — 5.02      | %          | 4.81                  | %          | 4.44  — 5.03 | % |
| Expected volatility     |       | 43.20                  | %          | 42.10                 | %          | 43.20 | % |
| Expected dividend yield |       | 0.50                   | %          | 0.40                  | %          | 0.50 | % |

 

 

9

----

 

Expected volatility is based upon the averageannual historical volatility of the Company’s common stock. The estimatedoption life is derived from the “simplified method” formula as described inStaff Accounting Bulletin No. 107. The risk free interest rate is based uponthe five-year U.S. Treasury Note rate in effect at the time of grant.  Theexpected dividend yield is based upon implied and historical dividenddeclarations.

 

Stock option activity during the nine monthsended September 30, 2007 is summarized as follows:

** **
| ** **                                | ** ** | ** **    | ** ** | ** **   | ** ** | **Weighted**     | ** ** | ** **    | ** ** |
|-------------------------------------------|------------|---------------|------------|--------------|------------|------------------|------------|---------------|------------|
| ** **                                | ** ** | ** **    | ** ** | **Weighted** | ** ** | **Average**      | ** ** | **Aggregate** | ** ** |
| ** **                                | ** ** | ** **    | ** ** | **Average**  | ** ** | **Remaining**    | ** ** | **Intrinsic** | ** ** |
| ** **                                | ** ** | **Number of** | ** ** | **Exercise** | ** ** | **Contractual**  | ** ** | **Value**     | ** ** |
| ** **                                | ** ** | **Shares**    | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **($000)**    | ** ** |
| Outstanding at December 31, 2006          |       | 2,419,274     |       | $            | 8.70       |             |       |          |       |   |
| Granted                                   |       | 500           |       | 10.18        |       |             |       |          |       |
| Exercised                                 |       | (18,946       | )          | 5.31         |       |             |       |          |       |
| Forfeited                                 |       | (17,075       | )          | 10.13        |       |             |       |          |       |
| Outstanding at September 30, 2007         |       | 2,383,753     |       | $            | 8.71       |             | 6.88       |          | $          | 3,057 |   |
| Options exercisable at September 30, 2007 |       | 2,137,675     |       | $            | 8.39       |             | 6.71       |          | $          | 3,428 |   |
|                                      |       |          |       |         |       |             |       |          |       |

 

Total intrinsicvalues of options exercised during the three months ended September 30, 2007and 2006 were $12,000 and $5,000, respectively. Total intrinsic values ofoptions exercised during the nine months ended September 30, 2007 and 2006 were$89,000 and $124,000, respectively.

 

A summary of thestatus of the Company’s non-vested stock options and changes during the ninemonths ended September 30, 2007 is as follows:

 

| ** **                    | ** ** | ** **     | ** ** | **Weighted**    | ** ** |
|-------------------------------|------------|----------------|------------|-----------------|------------|
| ** **                    | ** ** | ** **     | ** ** | **Average**     | ** ** |
|                          | ** ** | **Number  of** | ** ** | **Grant  Date** | ** ** |
|                          | ** ** | **Shares**     | ** ** | **Fair  Value** | ** ** |
| Balance at December 31, 2006  |       | 410,606        |       | $               | 4.63       |   |
| Granted                       |       | 500            |       | 4.89            |       |
| Vested                        |       | (158,828       | )          | 3.42            |       |
| Forfeited                     |       | (6,200         | )          | 4.48            |       |
| Balance at September 30, 2007 |       | 246,078        |       | $               | 5.42       |   |
|                          |       |           |       |            |       |

 

 

At September 30, 2007, there were $1.5million of total unrecognized compensation cost related to non-vestedshare-based compensation arrangements granted under the plans. The cost isexpected to be recognized over a weighted average period of 3.4 years. Thetotal fair value of shares that vested during the three months ended September30, 2007 and 2006 were $53,000 and $10,000, respectively. The total fair valueof shares that vested during the nine months ended September 30, 2007 and 2006were $578,000 and $368,000, respectively.

 

 

 

10

----

 

Note 4

*** ***

***SegmentInformation***

 

The Company operates in three businesssegments: Commercial Banking, Mortgage Banking, and Wealth Management and TrustServices.

 

The Commercial Banking segment includes bothcommercial and consumer lending and provides customers with such products ascommercial loans, real estate loans, business financing and consumer loans. Inaddition, this segment provides customers with several choices of depositproducts including demand deposit accounts, savings accounts and certificatesof deposit. The Mortgage Banking segment engages primarily in the originationand acquisition of residential mortgages for sale into the secondary market ona best efforts basis. The Wealth Management and Trust Services segment providesinvestment and financial advisory services to businesses and individuals,including financial planning, retirement/estate planning, trust, estates,custody, investment management, escrows, and retirement plans.

 

Results related to the assets acquired, andliabilities assumed, from FBR National Trust Company are reflected in theWealth Management and Trust Services segment since the date of theiracquisition and assumption, February 9, 2006.

 

Information about the reportable segments andreconciliation of this information to the consolidated financial statements atand for the three and nine months ended September 30, 2007 and 2006 is asfollows:

 

 

11

----

 

** **

**At and for the Three Months EndedSeptember 30, 2007 (in thousands):**

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

 

**At and for the Three Months EndedSeptember 30, 2006 (in thousands):**

 
|                        | ** ** | ** **     | ** **      | ** **   | ** ** | **Wealth  Management**  | ** ** | ** ** | ** **   | ** **       | ** ** | ** **       | ** ** |
|-----------------------------|------------|----------------|-----------------|--------------|------------|-------------------------|------------|------------|--------------|------------------|------------|------------------|------------|
|                        | ** ** | **Commercial** | ** **      | **Mortgage** | ** ** | **and**                 | ** ** | ** ** | ** **   | **Intersegment** | ** ** | ** **       | ** ** |
|                        | ** ** | **Banking**    | ** **      | **Banking**  | ** ** | **Trust Services** | ** ** | **Other**  | ** **   | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest  income        |       | $              |  9,565     |         | $          |  1,126             |       | $          |  — |             | $          |  (271       | )          | $ |  — |   | $ |  10,420 |   |
| Provision for  loan losses  |       | 230            |            | —       |       | —                  |       | —     |         | —           |       | 230              |       |
| Non-interest  income        |       | 759            |            | 3,341        |       | 849                     |       | 13         |         | —           |       | 4,962            |       |
| Non-interest  expense       |       | 6,972          |            | 3,615        |       | 3,912                   |       | 546        |         | —           |       | 15,045           |       |
| Provision for  income taxes |       | 893            |            | 305          |       | (1,093                  | )          | (253       | )            | —           |       | (148             | )          |
| Net income (loss)           |       | $              |  2,229     |         | $          |  547               |       | $          |  (1,970 | )                | $          |  (551       | )          | $ |  — |   | $ |  255 |   |
|                        |       |           |            |         |       |                    |       |       |         |             |       |             |       |
| Total Assets                |       | $              |  1,481,653 |         | $          |  273,126           |       | $          |  5,501  |             | $          |  160,511    |       | $ |  (371,646 | ) | $ |  1,549,145 |   |
| Average Assets              |       | $              |  1,470,211 |         | $          |  276,383           |       | $          |  7,602  |             | $          |  158,898    |       | $ |  (424,252 | ) | $ |  1,488,842 |   |

 

**At andfor the Nine Months Ended September 30, 2007 (in thousands):**

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

 

**At andfor the Nine Months Ended September 30, 2006 (in thousands):**

 
|                        | ** ** | ** **     | ** **      | ** **   | ** ** | **Wealth   Management** | ** ** | ** ** | ** **   | ** **       | ** ** | ** **       | ** ** |
|-----------------------------|------------|----------------|-----------------|--------------|------------|-------------------------|------------|------------|--------------|------------------|------------|------------------|------------|
|                        | ** ** | **Commercial** | ** **      | **Mortgage** | ** ** | **and**                 | ** ** | ** ** | ** **   | **Intersegment** | ** ** | ** **       | ** ** |
|                        | ** ** | **Banking**    | ** **      | **Banking**  | ** ** | **Trust Services**      | ** ** | **Other**  | ** **   | **Elimination**  | ** ** | **Consolidated** | ** ** |
| Net interest  income        |       | $              |  28,921    |         | $          |  3,405             |       | $          |  — |             | $          |  (800       | )          | $ |  — |   | $ |  31,526 |   |
| Provision for  loan losses  |       | 870            |            | —       |       | —                  |       | —     |         | —           |       | 870              |       |
| Non-interest  income        |       | 2,527          |            | 10,618       |       | 2,487                   |       | 34         |         | —           |       | 15,666           |       |
| Non-interest  expense       |       | 20,077         |            | 11,604       |       | 5,543                   |       | 1,701      |         | —           |       | 38,925           |       |
| Provision for  income taxes |       | 3,290          |            | 853          |       | (1,071                  | )          | (863       | )            | —           |       | 2,209            |       |
| Net income (loss)           |       | $              |  7,211     |         | $          |  1,566             |       | $          |  (1,985 | )                | $          |  (1,604     | )          | $ |  — |   | $ |  5,188 |   |
|                        |       |           |            |         |       |                    |       |       |         |             |       |             |       |
| Total Assets                |       | $              |  1,481,653 |         | $          |  273,126           |       | $          |  5,501  |             | $          |  160,511    |       | $ |  (371,646 | ) | $ |  1,549,145 |   |
| Average Assets              |       | $              |  1,417,778 |         | $          |  268,592           |       | $          |  7,397  |             | $          |  159,849    |       | $ |  (421,208 | ) | $ |  1,432,408 |   |

 

At September 30, 2007, the Company did nothave any operating segments other than those reported. Parent company financialinformation is included in the “Other” category and represents

 

 

12

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an overhead function rather than an operatingsegment. The parent company’s most significant assets are its net investmentsin its subsidiaries. The parent company’s net interest expense is comprised ofinterest income from short-term investments and interest expense on trustpreferred securities. The parent company’s non-interest expense is primarilynon-allocable executive salaries and professional services related to theCompany’s regulatory requirements.

 

#### **Note5**

 

##### ***Earnings Per Share***

 

The following is the calculation of basic anddiluted earnings per share for the three and nine months ended September 30,2007 and 2006. Stock options issued that were not included in the calculationof diluted earnings per share because the exercise prices were greater than theaverage market price were 81,359 and 2,971 for the three months ended September30, 2007 and 2006, respectively. Stock options issued that were not included inthe calculation of diluted earnings per share because the exercise prices weregreater than the average market price were 54,887 and none for the nine monthsended September 30, 2007 and 2006, respectively.

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands,****except per share data)**   | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income available to  common shareholders   |       | $                      | (606       | )                     | $          | 255 |   | $ | 3,101 |   | $ | 5,188 |   |
| Weighted average common  shares — basic   |       | 24,253                 |       | 24,431                |       | 24,424 |   | 24,411 |   |
| Weighted average common  shares — diluted |       | 24,253                 |       | 24,917                |       | 24,900 |   | 24,971 |   |
| Earnings per common share —  basic        |       | $                      | (0.02      | )                     | $          | 0.01 |   | $ | 0.13 |   | $ | 0.21 |   |
| Earnings per common share —  diluted      |       | $                      | (0.02      | )                     | $          | 0.01 |   | $ | 0.12 |   | $ | 0.21 |   |

 

The following shows the calculation ofdiluted outstanding shares for the three and nine months ended September 30,2007 and 2006:

 
| ** **                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands)**                                                  | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                |       |                   |       |                  |       |   |   |   |   |
| Weighted average shares outstanding — basic                    |       | 24,253                 |       | 24,431                |       | 24,424 |   | 24,411 |   |
| Weighted average shares attributable to deferred compensation plans |       | —                 |       | 185                   |       | 210 |   | 175 |   |
| Weighted average shares attributable to vested stock options        |       | —                 |       | 301                   |       | 266 |   | 385 |   |
| Incremental shares attributable to unvested stock options           |       | —                 |       | —                |       | — |   | — |   |
| Total weighted average shares — diluted                        |       | 24,253                 |       | 24,917                |       | 24,900 |   | 24,971 |   |
|                                                                |       |                   |       |                  |       |   |   |   |   |

 

For the three months ended September 30,2007, weighted average shares attributable to the deferred compensation plansand vested stock options were excluded from the diluted weighted

 

 

13

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average shares calculation because they areantidilutive to the diluted earnings per share calculation due to the net lossrecorded during the third quarter of 2007.

 

#### **Note6**

 

##### ***Derivatives and Hedging Activities***

 

The Company is a party to forward loan salescontracts, which are utilized to mitigate exposure to fluctuations in interestrates related to closed loans that are held for sale.

 

The Company designates these derivatives ascash flow hedges in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 133, *Accounting for Derivative Instruments andHedging Activities*, as amended. These hedges are recorded at fairvalue in the statement of condition as an other asset or other liability with acorresponding offset to accumulated other comprehensive income in shareholders’equity. Amounts are reclassified from accumulated other comprehensive income tothe income statement in the period or periods that the loan sale is reflectedin income.

 

At September 30, 2007, accumulated othercomprehensive income included an after-tax unrealized loss of $394,000 relatedto forward loan sales contracts. Loans held for sale are generally sold withinsixty days of closing and, therefore, substantially all of the amounts recordedin accumulated other comprehensive income at September 30, 2007 that is relatedto the Company’s cash flow hedges will be recognized in earnings during thefourth quarter of 2007. For the three and nine months ended September 30, 2007and 2006, the hedge ineffectiveness recorded through earnings was immaterial.

 

At September 30, 2007, the derivative assetwas $1.4 million and the derivative liability was $2.0 million. The Company had$95.1 million in loan commitments and $95.1 million in associated forwardloan sales. The Company also had $106.9 million in forward loan sales contractshedging the majority of its loans held for sale portfolio.

 

#### **Note7**

 

*Goodwilland Other Intangibles*

 

Information concerning total amortizableother intangible assets at September 30, 2007 is as follows:

 
| ** **                        | ** ** | ** **                 | ** ** | ** **                   | ** ** | **Wealth Management**      | ** ** | ** **                   | ** ** | ** **                 | ** ** |
|-----------------------------------|------------|----------------------------|------------|------------------------------|------------|----------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **Mortgage Banking**       | ** ** | **and Trust Services**       | ** ** | **Total**                  | ** ** |
| **(In thousands)**                | ** ** | **Gross  Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** | **Gross  Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** | **Gross  Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** |
| Balance at December 31, 2006      |       | $                          | 1,781      |                         | $          | 445                        |       | $                            | 795        |                       | $          | 433 |   | $ | 2,576 |   | $ | 878 |   |
| 2007 activity:                    |       |                       |       |                         |       |                       |       |                         |       |                       |       |   |   |
| Customer relationship intangibles |       | —                     |       | 148                          |       | —                     |       | 30                           |       | —                     |       | 178 |   |
| Trade name                        |       | —                     |       | —                       |       | —                     |       | 12                           |       | —                     |       | 12 |   |
| Balance at September 30, 2007     |       | $                          | 1,781      |                         | $          | 593                        |       | $                            | 795        |                       | $          |  475 |   | $ | 2,576 |   | $ | 1,068 |   |
|                                   |            |                            |            |                              |            |                            |            |                              |            |                            |            |  |  |  |  |  |  |  |  |  |

 

 

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The aggregate amortization expense for eachof the three month periods ended September 30, 2007 and 2006 was $63,000. Theaggregate amortization expense for the nine months ended September 30, 2007 and2006 was $190,000 and $356,000, respectively.

 

The estimated amortization expense for thenext five years is as follows:

 

| ** **                     | ** ** | **(In thousands)** |
|--------------------------------|------------|--------------------|
| 2007 (October — December) |       | $                  | 63 |
| 2008                           |       | 245                |
| 2009                           |       | 238                |
| 2010                           |       | 238                |
| 2011                           |       | 238                |
| 2012                           |       | 238                |
| Thereafter                     |       | 248                |

 

The carrying amount of goodwill at September30, 2007 was as follows:

 
| ** **                    | ** ** | ** **     | ** ** | ** **   | ** ** | **Wealth**     | ** ** | ** ** | ** ** |
|-------------------------------|------------|----------------|------------|--------------|------------|----------------|------------|------------|------------|
| ** **                    | ** ** | ** **     | ** ** | ** **   | ** ** | **Management** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Commercial** | ** ** | **Mortgage** | ** ** | **and Trust**  | ** ** | ** ** | ** ** |
| **(In thousands)**            | ** ** | **Banking**    | ** ** | **Banking**  | ** ** | **Services**   | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2006 | ** ** | $              | 22         | ** **   | $          | 12,941         | ** ** | $          | 2,832      | ** ** | $ | 15,795 | ** ** |
| 2007 activity                 | ** ** | **—**     | ** ** | **—**   | ** ** | **—**     | ** ** | **—** | ** ** |
| Balance at September 30, 2007 |       | $              | 22         |         | $          | 12,941         |       | $          | 2,832      |   | $ | 15,795 |   |
|                          |       |           |       |         |       |           |       |       |       |

 

Goodwill of each of the Company’s businesssegments is tested for impairment on an annual basis or more frequently ifevents or circumstances warrant. During the quarter ended September 30, 2007,the Company performed an evaluation of the goodwill associated with itsacquisition of George Mason, and no impairment was indicated.

 

 

Note 8

 

*Commitments and Contingencies*

 

The Company is a party to financialinstruments with off-balance sheet risk in the normal course of business tomeet the financing needs of its customers. These financial instruments includecommitments to extend credit and standby letters of credit. Commitments toextend credit are agreements to lend to a customer so long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates up to one year or other termination clauses and may require payment of afee.  Since many of the commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future funding requirements.

 

Commitments to extend credit representobligations of the Company to extend credit or guarantee borrowings and are notrecorded on the consolidated statements of financial condition.  The rates and terms of these instruments arecompetitive with others in the market in which the Company operates.  These instruments involve, to varyingdegrees, elements of credit and interest rate risk in excess of the amountrecognized in the consolidated statements of financial condition. Credit riskis defined as the possibility of sustaining a loss because the other parties toa financial instrument fail to perform in accordance with the terms of thecontract.  The Company’s maximum exposureto credit loss under commitments to extend credit is represented by

 

 

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the contractual amounts of thoseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance sheet instruments. The Company evaluates each customer’screditworthiness on a case-by-case basis and requires collateral to supportfinancial instruments when deemed necessary. The amount of collateral obtainedupon extension of credit is based on management’s credit evaluation of thecounterparty. Collateral held varies but may include accounts receivable,inventory, property and equipment, and income-producing commercial properties.

 

Standby letters of credit are conditionalcommitments issued by the Company to guarantee the performance of thecontractual obligations by a customer to a third party.  Those guarantees are primarily issued tosupport public and private borrowing arrangements, including commercial paper,bond financing, and similar transactions. The credit risk involved in issuingstandby letters of credit is essentially the same as that involved in extendingloan facilities to customers. The Company holds certificates of deposit,deposit accounts, real estate or other appropriate forms of collateralsupporting those commitments when collateral is deemed necessary.  The majority of these guarantees extend untilsatisfactory completion of the customer’s contractual obligations.

 

At September 30, 2007, commitments to extendcredit were $440.6 million and standby letters of credit were $10.1 million.The fair value of the liability associated with standby letters of credit atSeptember 30, 2007 was immaterial.

 

George Mason maintains a reserve for loanssold that pay off earlier than the contractual agreed upon period, therebyrequiring that George Mason refund part of the service release premium and/orpremium pricing received from the investor. The reserve as of September 30, 2007 was $47,000.

 

The Company has derivative counter-party riskthat may arise from the possible inability of George Mason’s third partyinvestors to meet the terms of their forward sales contracts.  George Mason works with third-party investorsthat are generally well-capitalized, are investment grade and exhibit strongfinancial performance to mitigate this risk. The Company does not expect any third-party investor to fail to meet itsobligation.

 

Note 9

 

*Capital Resources*

 

In October 2007, George Mason and the Bankcancelled its one year $150 million floating rate revolving credit and securityagreement with a third party. The purpose of this credit facility was to fundresidential mortgage loans made by George Mason prior to their sale into thesecondary market. However, we determined that as a result of the limited use ofthis credit facility and the available liquidity at the Bank, this creditfacility was no longer needed.  AtSeptember 30, 2007, none of this line was utilized.

 

In addition to this facility, this samelender had also provided a $100 million facility that was utilized by GeorgeMason to warehouse residential mortgage loans held for sale to this lender.Again, this credit facility was cancelled in October 2007 as a result of thelimited use by George Mason of this facility and the available liquidity at theBank.

 

 

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Note 10

 

*New Accounting Pronouncement*

 

The Company adopted the provisions ofFinancial Accounting Standards Board Interpretation No. 48 (“FIN No. 48”), *Accounting for Uncertainty in Income Taxes*, on January 1,2007.  This interpretation clarifies theaccounting for uncertainty in income taxes recognized in an entity’s financialstatements in accordance with SFAS No. 109,*Accounting for IncomeTaxes.* FIN No. 48 prescribes a recognition threshold and measurementprinciples for financial statement disclosure of tax positions taken orexpected to be taken on a tax return. FIN No. 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.

 

As of September 30, 2007, the Company had nounrecognized tax benefits.  The Companyalso had no interest expense and/or tax penalties during the three and ninemonths ended September 30, 2007.  If theCompany had such expenses, they would be classified in the consolidatedstatements of income as part of the provision for income tax expense.

 

 

Note 11

 

*Loss on Escrow Arrangement*

 

The Company’s financial results for the threeand nine months ended September 30, 2007 reflect a loss of $3.5 million thatarose from an escrow arrangement with Liberty Growth Fund, LP and AIMSWorldwide, Inc on July 25, 2007.  The Company served as the escrow agent in connection with an equityfinancing transaction between Liberty Growth Fund and AIMS Worldwide.

 

Inthat transaction, Liberty Growth Fund had agreed to purchase from AIMSWorldwide shares of its preferred stock for $3.85 million.  AIMS Worldwidewould then use these proceeds to fund its acquisition of two other companies,Target America and Ikon Public Affairs Group, LLC.

 

Asprovided in the escrow agreement, Liberty Growth Fund delivered a check to theCompany in the amount of $3.85 million on July 24, 2007.  On July 25,2007, the Company released funds totaling $3.85 million to AIMS Worldwide andcertain of its designated beneficiaries and shares of AIMS Worldwide’spreferred stock and warrants to an agent of Liberty Growth Fund.  TheCompany then learned that Liberty Growth Fund had previously stopped payment onits check.  Liberty Growth Fund issued another check in the same amount,but that check was dishonored for lack of sufficient funds.

 

Promptlyfollowing the Company’s release of funds, the Company attempted to retrieve thefunds from the persons and entities who had received them.  The recipients of the funds, however, refusedto return the funds.  The Company also madean unsuccessful demand on Liberty Growth Fund and Philip A. Seifert, the principalof Liberty Growth Fund, for performance of Liberty Growth Fund’s obligationsunder the escrow arrangement and the payment of the proper amount into escrow.

 

OnAugust 9, 2007, the Company filed a complaint against defendants Philip A.Seifert and Liberty Growth Fund, LP in the Circuit Court of Fairfax County,Virginia.  The complaint sets forthseveral causes of action including actual fraud and claims associated with thestopped payment check and dishonored check tendered to the Company.  The complaint seeks to recover the entireamount of the Company’s loss, interest and costs and, under the fraud count,punitive damages and attorneys’ fees. The defendants filed an answer acknowledging that Seifert, on behalf ofLiberty Growth Fund, did stop payment on the check delivered to the Company onJuly 24, 2007.  The defendants’ answeralso admitted that the account on which the check was drawn lacked sufficientfunds to pay the amount of the check, and that the defendants knew that at thetime the check was tendered to the Company.

 

 

17

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OnSeptember 17, 2007, the Company amended its complaint to add a claim forconstructive fraud and to seek the imposition of a constructive trust on theshares of AIMS Worldwide’s preferred stock and warrants that the Company hadreleased.  Those shares and warrants arecurrently being held in escrow by the Company pending resolution of certaindisputes in a separate interpleader proceeding involving Seifert and hisspouse, to whom Seifert had purportedly delivered the securities at issue.  The Company is a party to that proceeding inorder to seek the constructive trust.

 

TheCompany had previously disclosed that the maximum amount of its exposure inconnection with the escrow arrangement was $3.85 million.  Since that time, however, the Company hasrecovered the $350,000 brokerage fee and certain AIMS Worldwide warrants fromLerota, LLC, the broker who represented Liberty Growth Fund in the transactionwith AIMS Worldwide.  The Companyunderstands that Lerota voluntarily returned the fee and the warrants becausethe financing transaction between AIMS Worldwide and Liberty Growth Fund wasnever completed, given Liberty Growth Fund’s failure to make the requiredpayment.   In addition, the Companycontinues to hold in escrow additional shares of AIMS Worldwide’s preferredstock that may be issued in a potential second round of financing with LibertyGrowth Fund.

 

TheCompany will continue to take all steps necessary to resolve this matter withLiberty Growth Fund and Seifert and all other appropriate parties in order torecover the total amount that it is due. These steps include litigation and any remedies available to a federallyinsured institution.  The Company hasturned to the federal and local law enforcement authorities for assistance inthis matter.  The Company has also made aclaim to its insurance company in order to recover any amounts that may becovered.  The final resolution of thissituation will not be known for several months or longer.

 

 

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** **

** **

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

The following presentsmanagement’s discussion and analysis of our consolidated financial condition atSeptember 30, 2007 and December 31, 2006 and the unaudited results of ouroperations for the three and nine months ended September 30, 2007 and 2006.This discussion should be read in conjunction with our unaudited consolidatedfinancial statements and the notes thereto appearing elsewhere in this reportand the audited consolidated financial statements and the notes to consolidatedfinancial statements included in our Annual Report on Form 10-K for theyear ended December 31, 2006.

 

**Caution About Forward-Looking Statements**

We make forward-looking statementsin this Form 10-Q that are subject to risks and uncertainties.  These forward-looking statements includestatements regarding our profitability, liquidity, allowance for loan losses,interest rate sensitivity, market risk, growth strategy, and financial and othergoals.  The words “believes,” “expects,” “may,”“will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,”or other similar words or terms are intended to identify forward-lookingstatements.

 

                These forward-looking statementsare subject to significant uncertainties because they are based upon or areaffected by factors including:

 

•                  the ability to successfully manage ourgrowth or implement our growth strategies if we are unable to identifyattractive markets, locations or opportunities to expand in the future;

•                  changes in interest rates and thesuccessful management of interest rate risk;

•                  risks inherent in making loans such asrepayment risks and fluctuating collateral values;

•                  maintaining cost controls and assetquality as we open or acquire new branches;

•                  maintaining capital levels adequate tosupport our growth;

•                  reliance on our management team,including our ability to attract and retain key personnel;

•                  competition with other banks andfinancial institutions, and companies outside of the banking industry,including those companies that have substantially greater access to capital andother resources;

•                  changes in general economic and businessconditions in our market area;

•                  risks and uncertaintiesrelated to future trust operations;

•                  changes in theoperations of Wilson/Bennett Capital Management, Inc., its customer base andassets under management and any associated impact on the fair value of goodwillin the future;

•                  demand, development and acceptance of newproducts and services;

•                  problems with technology utilized by us;

•                  changing trends in customer profiles andbehavior; and

•                  changes in banking and other laws andregulations applicable to us.

 

 

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Because of these uncertainties, ouractual future results may be materially different from the results indicated bythese forward-looking statements.  Inaddition, our past results of operations do not necessarily indicate our futureresults.

 

In addition, this section should beread in conjunction with the description of our “Risk Factors” in Item 1A ofour Annual Report on Form 10-K for the year ended December 31, 2006.

 

**Overview**

 

We are a locally managedfinancial holding company headquartered in Tysons Corner, Virginia, committedto providing superior customer service, a diversified mix of financial productsand services, and convenient banking to our retail and business customers. Weown Cardinal Bank (the “Bank”), a Virginia state-chartered community bank,Cardinal Wealth Services, Inc. (“CWS”), an investment services subsidiary,and Wilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an assetmanagement firm. Through these three subsidiaries and George Mason Mortgage,LLC (“George Mason”), a mortgage banking subsidiary of the Bank, we offer awide range of traditional banking products and services to both our commercialand retail customers. Our commercial relationship managers focus on attractingsmall and medium-sized businesses as well as government contractors, commercialreal estate developers and builders and professionals, such as physicians,accountants and attorneys. We have 25 branch office locations and sevenmortgage banking office locations and provide competitive products andservices. We complement our core banking operations by offering a full range ofinvestment products and services to our customers through our third-partybrokerage relationship with Raymond James Financial Services, Inc. andasset management services through Wilson/Bennett.

 

On February 9, 2006, weacquired certain fiduciary and other assets and assumed certain liabilities ofFBR National Trust Company, formerly a subsidiary of Friedman, Billings, RamseyGroup, Inc. Our trust division acts as trustee or custodian for assets inexcess of $6.02 billion as of September 30, 2007. Services provided by thisdivision include trust, estates, custody, investment management, escrows, andretirement plans. The trust division is included, along with CWS andWilson/Bennett, in the Wealth Management and Trust Services segment. In priorperiods, this segment was called Investment Services or Trust and InvestmentServices.

 

Net interest income is ourprimary source of revenue. We define revenue as net interest income plusnon-interest income. As discussed further in the interest rate sensitivitysection, we manage our balance sheet and interest rate risk exposure tomaximize, and concurrently stabilize, net interest income. We do this bymonitoring our liquidity position and the spread between the interest ratesearned on interest-earning assets and the interest rates paid oninterest-bearing liabilities. We attempt to minimize our exposure to interestrate risk, but are unable to eliminate it entirely.  In addition tomanagement of interest rate risk, we analyze our loan portfolio for exposure tocredit risk. Loan defaults and foreclosures are inherent risks in the bankingindustry, and we attempt to limit our exposure to these risks by carefullyunderwriting and then monitoring our extensions of credit. In addition to netinterest income, non-interest income is an increasingly important source ofrevenue for us and includes, among other things, service charges on depositsand loans, investment fee income, which includes trust revenues, gains andlosses on sales of investment securities available-for-sale, gains on sales ofloans, and management fee income.

 

 

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**Critical Accounting Policies**

 

*General*

 

U. S. generally accepted accounting principles are complex and requiremanagement to apply significant judgment to various accounting, reporting, anddisclosure matters.  Management must useassumptions, judgments and estimates when applying these principles whereprecise measurements are not possible or practical.  These policies are critical because they arehighly dependent upon subjective or complex judgments, assumptions andestimates.  Changes in such judgments,assumptions and estimates may have a significant impact on the consolidatedfinancial statements.  Actual results, infact, could differ from initial estimates.

 

The accounting policies we view as critical are those relating tojudgments, assumptions and estimates regarding the determination of theallowance for loan losses, accounting for economic hedging activities,accounting for business combinations and impairment testing of goodwill,accounting for the impairment of intangible assets, and the valuation ofdeferred tax assets.

 

#### ***Allowance for Loan Losses***

 

**Wemaintain the allowance for loan losses at a level that represents management’sbest estimate of known and inherent losses in our loan portfolio.  Both the amount of the provision expense andthe level of the allowance for loan losses are impacted by many factors,including general and industry-specific economic conditions, actual andexpected credit losses, historical trends and specific conditions of individualborrowers.  Unusual and infrequentlyoccurring events, such as weather-related disasters, may impact our assessmentof possible credit losses.  As a part ofour analysis, we use comparative peer group data and qualitative factors suchas levels of and trends in delinquencies and nonaccrual loans, national andlocal economic trends and conditions and concentrations of loans exhibitingsimilar risk profiles to support our estimates.**

 

For purposes of ouranalysis, we categorize our loans into one of five categories:  commercialand industrial, commercial real estate (including construction), home equitylines of credit, residential mortgages, and consumer loans. In the absence ofmeaningful historical loss factors, peer group loss factors are applied and areadjusted by the qualitative factors mentioned above. The indicated loss factorsresulting from this analysis are applied for each of the five categories ofloans. 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 collateral valueif the loan is collateral dependent. Since we have limited historical data onwhich to base loss factors for classified loans, we typically apply, inaccordance with regulatory guidelines, a 5% loss factor to loans classified asspecial mention, a 15% loss factor to loans classified as substandard and a 50%loss factor to loans classified as doubtful. Loans classified as loss loans arefully reserved or charged off.

 

Credit losses are aninherent part of our business and, although we believe the methodologies fordetermining the allowance for loan losses and the current level of theallowance are adequate, it is possible that there may be unidentified losses inthe portfolio at any particular time that may become evident at a future datepursuant to additional internal analysis or regulatory comment. Additionalprovisions for such losses, if necessary, would be recorded in the CommercialBanking or Mortgage Banking segments, as appropriate, and would negativelyimpact earnings.

 

 

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*Accounting for Economic HedgingActivities*

 

We account for ourderivatives and hedging activities in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 133, *Accounting for DerivativeInstruments and Certain Hedging Activities,* as amended, whichrequires that all derivative instruments be recorded on the statement ofcondition at their fair values*.*We do not enter into derivative transactionsfor speculative purposes. For derivatives designated as hedges, wecontemporaneously document the hedging relationship, including the riskmanagement objective and strategy for undertaking the hedge, how effectivenesswill be assessed at inception and at each reporting period and the method formeasuring ineffectiveness.  We evaluatethe effectiveness of these transactions at inception and on an ongoingbasis.  Ineffectiveness is recordedthrough earnings.  For derivativesdesignated as cash flow hedges, the fair value adjustment is recorded as acomponent of other comprehensive income, except for the ineffective portionwhich is recorded in earnings.  Forderivatives designated as fair value hedges, the fair value adjustments forboth the hedged item and the hedging instrument are recorded through the incomestatement with any difference considered the ineffective portion of the hedge.

 

We discontinue hedgeaccounting prospectively when it is determined that the derivative is no longerhighly effective. In situations in which cash flow hedge accounting isdiscontinued, we continue to carry the derivative at its fair value on thestatements of condition and recognize any subsequent changes in fair value inearnings over the term of the forecasted transaction. When hedge accounting isdiscontinued because it is probable that a forecasted transaction will notoccur, we recognize immediately in earnings any gains and losses that wereaccumulated in other comprehensive income.

 

In the normal course ofbusiness, we enter into contractual commitments, including rate lock commitments,to finance residential mortgage loans. These commitments, which contain fixedexpiration dates, offer the borrower an interest rate guarantee provided theloan meets underwriting guidelines and closes within the time frame establishedby us. Interest rate risk arises on these commitments and subsequently closedloans if interest rates change between the time of the interest rate lock andthe delivery of the loan to the investor. Loan commitments related toresidential mortgage loans intended to be sold are considered derivatives andare marked to market through earnings.

 

To mitigate the effect ofthe interest rate risk inherent in providing rate lock commitments, weeconomically hedge our commitments by entering into a best efforts deliveryforward loan sales contracts. During the rate lock commitment period, theseforward loan sales contracts are marked to market through earnings and are notdesignated as accounting hedges under SFAS No. 133, as amended. The fairvalues of loan commitments and the fair values of forward loan sales contractsgenerally move in opposite directions, and the net impact of changes of thesevaluations on net income during the loan commitment period is generallyinconsequential. At the closing of the loan, the loan commitment derivativeexpires and we record a loan held for sale and continue to be obligated underthe same forward loan sales contract. Loans held for sale are accounted for atthe lower of cost or market in accordance with SFAS No. 65, *Accounting for Certain Mortgage Banking Activities.*

 

*Accounting for BusinessCombinations and Impairment Testing of Goodwill*

 

                We account for acquisitionsof other businesses in accordance with SFAS No. 141, *Business Combinations*. This statementmandates the use of purchase accounting and, accordingly, assets andliabilities, including previously unrecorded assets and liabilities, arerecorded at fair values as of the acquisition date. We utilize a variety ofvaluation methods to estimate fair value of acquired assets and liabilities.These methodologies are often based upon 

 

 

22

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assumptions and estimates which may change ata future date and require that the carrying amount of assets and liabilitiesacquired be adjusted. To support our purchase allocations, we have utilizedindependent consultants to identify and value identifiable purchasedintangibles. The difference between the fair value of assets acquired and theliabilities assumed is recorded as goodwill. Goodwill and other intangibleassets are accounted for in accordance with SFAS No. 142, *Goodwill and Other Intangible Assets*. Inaccordance with this statement, goodwill will not be amortized but will betested on at least an annual basis for impairment.

 

To test goodwill for impairment,we perform an analysis to compare the fair value of the reporting unit to whichthe goodwill is assigned to the carrying value of the reporting unit. We makeestimates of the discounted cash flows from the expected future operations ofthe reporting unit. If the analysis indicates that the fair value of thereporting unit is less than its carrying value, we do an analysis to comparethe implied fair value of the reporting unit’s goodwill with the carryingamount of that goodwill. The implied fair value of the goodwill is determinedby allocating the fair value of the reporting unit to all its assets andliabilities. If the implied fair value of the goodwill is less than thecarrying value, an impairment loss is recognized.

 

*Accountingfor the Impairment of Amortizing Intangible Assets and Other Long-Lived Assets*

 

In accordance with SFASNo. 144, *Accounting for the Impairmentor Disposal of Long-Lived Assets*, we continually review ourlong-lived assets for impairment whenever events or changes in circumstancesindicate that the remaining estimated useful life of such assets might warrantrevision or that the balances may not be recoverable. We evaluate possibleimpairment by comparing estimated future cash flows, before interest expenseand on an undiscounted basis, with the net book value of long-term assets,including amortizable intangible assets. If undiscounted cash flows areinsufficient to recover assets, further analysis is performed in order todetermine the amount of the impairment.

 

An impairment loss is thenrecorded for the excess of the carrying amount of the assets over their fairvalues. Fair value is usually determined based on the present value ofestimated expected future cash flows using a discount rate commensurate withthe risks involved.

#### ** **

#### ***Valuation of Deferred Tax Assets***

 

We record a provision forincome tax expense based on the amounts of current taxes payable or refundableand the change in net deferred tax assets or liabilities during the year.Deferred tax assets and liabilities are recognized for the tax effects ofdiffering carrying values of assets and liabilities for tax and financialstatement purposes that will reverse in future periods. When substantialuncertainty exists concerning the recoverability of a deferred tax asset, thecarrying value of the asset is reduced by a valuation allowance. The amount ofany valuation allowance established is based upon an estimate of the deferredtax asset that is more likely than not to be recovered. Increases or decreasesin the valuation allowance result in increases or decreases to the provisionfor income taxes.

 

###### **New Financial AccountingStandards**

 

On July 13, 2006,the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48(“FIN No. 48”), *Accounting for Uncertainty in Income Taxes:an interpretation of FASB Statement No. 109.* This interpretationclarifies the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109,*Accounting for Income Taxes.* FIN No. 48 prescribes arecognition threshold and 

 

 

23

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measurement principlesfor financial statement disclosure of tax positions taken or expected to betaken on a tax return. This interpretation is effective for fiscal yearsbeginning after December 15, 2006. The adoption of FIN No. 48 did not have anyimpact on our consolidated financial position or results of operations.

 

                InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements.*  SFAS No. 157defines fair value, establishes a framework for measuring fair value inaccordance with U.S. generally accepted accounting principles, and expandsdisclosures about fair value measurements. The statement clarifies that the exchange price is the price in anorderly transaction between market participants to sell an asset or transfer aliability at the measurement date.  Thestatement emphasizes that fair value is a market-based measurement and not anentity-specific measurement.  It alsoestablishes a fair value hierarchy used in fair value measurements and expandsthe required disclosures of assets and liabilities measured at fair value.  This standard is effective for fiscal yearsbeginning after December 15, 2007.  Theadoption of this standard is not expected to have a material impact on ourconsolidated financial position or results of operations.

 

                InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities — including anamendment of FAS 115.*  SFASNo. 159 allows entities to choose, at specified election dates, to measureeligible financial assets and liabilities at fair value that are not otherwiserequired to be measured at fair value. If a company elects the fair value option for an eligible item, changesin that item’s fair value in subsequent reporting periods must be recognized incurrent earnings.  SFAS No. 159 alsoestablishes presentation and disclosure requirements designed to drawcomparison between entities that elect different measurement attributes forsimilar assets and liabilities.  SFAS No.159 is effective for fiscal years beginning after November 15, 2007.  We are currently evaluating the requirementsof this standard.

 

##### **Statements of Income**

 

*General*

 

Forthe three months ended September 30, 2007, we recorded a net loss of $606,000compared to net income of $255,000 for the three months ended September 30,2006, a decrease of $861,000.  The netloss for the three months ended September 30, 2007 compared to the net incomereported in the same period of 2006 is primarily a result of the loss werecorded on the escrow arrangement with Liberty Growth Fund, LP and AIMSWorldwide, Inc. (see note 11 to the notes to the consolidated financialstatements for more information pertaining to this transaction).  In addition, our results for the three monthsended September 30, 2006 were negatively impacted by the impairment charges tothe goodwill and certain other intangible assets related to our acquisition ofWilson/Bennett.  Excluding the loss onthe escrow arrangement during 2007 and the impairment charges recorded in 2006,we would have recorded net income of $1.9 million and $2.2 million for thethree months ended September 30, 2007 and 2006, respectively, a decrease of$242,000, or 11%.  A reconciliation ofthese non-GAAP financial measures to our GAAP financial information ispresented in Table 1 below.

 

Netinterest income after provision for loan losses decreased $772,000, or 8%, to$9.4 million for the three months ended September 30, 2007 compared to $10.2million for the same period of 2006.  Thedecrease in net interest income after provision for loan losses is primarily aresult of an increase in provision for loan losses to $915,000 for the threemonths ended September 30, 2007, compared to $230,000 for the three monthsended September 30, 2006, an 

 

 

 

24

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increaseof $685,000.  The increase in provisionfor loan losses during the third quarter of 2007 was due to a charge-off of a nonaccrualloan totaling $417,000 and an increase in the reserve for loan losses as aresult of net new loan growth during the quarter totaling $44.9 million.  In addition, net interest income for thethird quarter of 2007 decreased $87,000 to $10.3 million as compared to $10.4million for the same period of 2006 due to increases in interest expense thatwas greater than the increases in interest income as discussed below.

 

Non-interestincome decreased $219,000 to $4.7 million for the three months ended September30, 2007 compared to $5.0 million for the same period of 2006.  The decrease in non-interest income wasprimarily a result of decreases in net gains on loan sales of $362,000 andmanagement fee income of $354,000 for the third quarter of 2007 as compared tothe same period of 2006, due to tightening credit conditions within themortgage industry and the slowdown in the regional housing market.  These decreases were offset by an increase ininvestment fee income of $252,000 and an increase in the cash surrender valuerelated to our bank-owned life insurance of $216,000 for the three months endedSeptember 30, 2007 compared to the three months ended September 30, 2006.

 

Non-interestexpense increased $424,000, or 3%, to $15.5 million for the three months endedSeptember 30, 2007, compared to $15.0 million for the same period of 2006.  The increase in non-interest expense isprimarily related to the aforementioned loss on the escrow arrangement recordedduring the third quarter of 2007. Excluding the loss on the escrow arrangement during 2007 and theimpairment charges recorded during the third quarter of 2006, non-interestexpense would have decreased $497,000 to $11.6 million during the third quarterof 2007 as compared to $12.1 million for the same period of 2006.  A reconciliation of these non-GAAP financialmeasures to our GAAP financial information is presented in Table 1 below.

 

Basicand diluted loss per common share was $(0.02) for the three months endedSeptember 30, 2007.  Basic and dilutedearnings per common share for the three months ended September 30, 2006 was$0.01.  Excluding the aforementionednonrecurring expenses during the third quarter of 2007 and 2006, basic anddiluted earnings per common share for each of the three months ended September30, 2007 and 2006 would have been $0.08 and $0.09, respectively.  A reconciliation of these non-GAAP financialmeasures to our GAAP financial information is presented in Table 1 below.

 

Netincome for the nine months ended September 30, 2007 and 2006 was $3.1 millionand $5.2 million, respectively.  The netincome for each of these periods was impacted by the aforementionednonrecurring expenses totaling $3.8 million and $2.9 million for theyear-to-date September 30, 2007 and 2006, respectively.  Excluding these nonrecurring expenses, netincome for the nine months ended September 30, 2007 and 2006 would have been$5.6 million and $7.1 million, respectively. A reconciliation of these non-GAAP financial measures to our GAAPfinancial information is presented in Table 1 below.

 

Netinterest income after provision for loan losses was $28.7 million and $30.7million for the nine months ended September 30, 2007 and 2006,respectively.  The decrease in netinterest income after provision for loan losses was a result of a decrease innet interest income of $1.1 million due to increased interest expense overinterest income as discussed in more detail below.  In addition, provision for loan lossesincreased $800,000 during the nine months ended September 30, 2007 as comparedto the same period of 2006.  The increasein provision expense was related to the aforementioned loan charge-off of$417,000 recorded during the third quarter of 2007 and the increase in thereserve for loan losses as a result of our net new loan growth of $128.1million for the year-to-date 2007.

 

 

25

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Non-interestincome for the nine months ended September 30, 2007 and 2006 was $15.4 millionand $15.7 million, respectively, a decrease of $305,000 or 2%.  The decrease was primarily attributable todecreases in gains on sales of loans and management fee income of $596,000 and$766,000, respectively.  These decreaseswere offset by an increase in investment fee income of $750,000 and an increasein the cash surrender value of our bank-owned life insurance of $1.1million.  Non-interest income for thenine months ended September 30, 2006 included gains from the extinguishment oftwo borrowings totaling $769,000.

 

Non-interestexpense increased $1.2 million, or 3%, to $40.1 million for the nine monthsended September 30, 2007, compared to $38.9 million for the same period of2006.  The increase in non-interestexpense is primarily related to the aforementioned loss on the escrowarrangement recorded during the third quarter of 2007.  Excluding the loss on the escrow arrangementduring 2007 and the impairment charges recorded during the third quarter of2006, non-interest expense would have increased $294,000 to $36.3 millionduring the year-to-date 2007 as compared to $36.0 million for the same periodof 2006.  A reconciliation of thesenon-GAAP financial measures to our GAAP financial information is presented inTable 1 below.

 

Basicand diluted earnings per common share were $0.13 and $0.12, respectively, forthe nine months ended September 30, 2007. Basic and diluted earnings per common share for the nine months endedSeptember 30, 2006 was $0.21.  Excludingthe aforementioned nonrecurring expenses during the third quarter of 2007 and2006, basic earnings per common share for the nine months ended September 30,2007 and 2006 would have been $0.23 and $0.29, respectively, and dilutedearnings per common share for the nine months ended September 30, 2007 and2006, would have been $0.22 and $0.28, respectively.  A reconciliation of these non-GAAP financialmeasures to our GAAP financial information is presented in Table 1 below.

 

Return on average assets forthe three months ended September 30, 2007 and 2006 was (0.15)% and 0.07%,respectively. Return on average assets for the nine months ended September 30,2007 and 2006 was 0.25% and 0.48%, respectively.  Return on average equity for the three monthsended September 30, 2007 and 2006 was (1.54)% and 0.67%, respectively. Returnon average equity for the nine months ended September 30, 2007 and 2006 was2.63% and 4.58%, respectively.

 

Net income attributable tothe Commercial Banking segment for the three months ended September 30, 2007and 2006 was $1.8 million and $2.2 million, respectively.  For the nine months ended September 30, 2007and 2006, net income attributable to the Commercial Banking segment was $5.4million and $7.2 million, respectively. The decreases in net income for the three and nine months ended September30, 2007 compared to the same periods of 2006 in the Commercial Banking segmentis primarily attributable to an increase in non-interest expense related to theadditional branch offices opened over the past twelve months and an increase inour FDIC insurance premiums due to the change in the assessment calculations asa result of the deposit insurance reform implemented during 2007 by the FDIC.

 

Net income attributable tothe Mortgage Banking segment for the three months ended September 30, 2007 and2006 was $429,000 and $547,000, respectively. For the nine months ended September 30, 2007 and 2006, net incomeattributable to the Mortgage Banking segment was $1.5 million and $1.6 million,respectively.  The decrease in net incomefor the three and nine months ended September 30, 2007 compared to the sameperiods of 2006 was primarily attributable to decreases in net interest incomeand non-interest income due to decreased loan sale volume when comparing theperiods.

 

** **

** **

**26**

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TheWealth Management and Trust Services segment, which includes CWS,Wilson/Bennett and the trust division of the Bank, recorded a net loss of $2.0million for each of the three month periods ended September 30, 2007 and 2006.  For the nine months ended September 30, 2007and 2006, this business segment recorded a net loss of $1.7 million and $2.0million, respectively.  The lossesrecorded in the Wealth Management and Trust Services segment are directlyrelated to the loss on the escrow arrangement recorded during the third quarterof 2007 and the impairment charges recorded during the third quarter of2006.  Excluding these losses, thisbusiness segment would have recorded net income of $253,000 and a net loss of$67,000 for the three months ended September 30, 2007 and 2006,respectively.  For the nine months endedSeptember 30, 2007 and 2006, the Wealth Management and Trust Services segmentwould have recorded net income of $545,000 and a net loss of $82,000, respectively,excluding the aforementioned losses.  Thetrust division of the Bank is included in the results of operations since thedate of acquisition, February 9, 2006. A reconciliation of these non-GAAP financial measures to our GAAPfinancial information is presented in Table 1 below.

 

We believe that, because theloss on the escrow arrangement during the third quarter of 2007 and theimpairment charges recorded during the third quarter of 2006 were nonrecurringone-time charges to earnings, excluding these losses from our operating resultssupplements the GAAP financial information and provides more useful comparablemeasures of evaluating the operating results and any related trends that may beaffecting our business.

 

 

27

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Table1.

 

**Reconciliationof GAAP to Non-GAAP Financial Measures**

For the Three and NineMonths Ended September 30, 2007 and 2006 

(Dollars in thousands,except per share data)

 
| ** **                                                               | ** ** | ** ** | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | ** ** | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                               | ** ** | ** ** | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
| GAAP reported non-interest expense                                       |       |       |       | $                      | 15,469     |                  | $          | 15,045 |   | $ | 40,140 |   | $ | 38,925 |   |
| Less nonrecurring expenses, pretax                                       |       |       |       |                   |       |                  |       |   |   |   |   |
| Loss related to escrow arrangement                                       |       |       |       | 3,500                  |       | —                |       | 3,500 |   | — |   |
| Legal expenses related to escrow arrangement                             |       |       |       | 349                    |       | —                |       | 349 |   | — |   |
| Impairment of goodwill                                                   |       |       |       | —                 |       | 960                   |       | — |   | 960 |   |
| Impairment of customer relationships intangible                          |       |       |       | —                 |       | 1,455                 |       | — |   | 1,455 |   |
| Impairment of employment/non-compete agreement                           |       |       |       | —                 |       | 513                   |       | — |   | 513 |   |
| Non-interest expense without nonrecurring expenses                       |       |       |       | $                      | 11,620     |                  | $          | 12,117 |   | $ | 36,291 |   | $ | 35,997 |   |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
| GAAP reported net income                                                 |       |       |       | $                      | (606       | )                     | $          | 255 |   | $ | 3,101 |   | $ | 5,188 |   |
| Less nonrecurring expenses, after tax                                    |       |       |       |                   |       |                  |       |   |   |   |   |
| Loss related to escrow arrangement                                       |       |       |       | 2,293                  |       | —                |       | 2,293 |   | — |   |
| Legal expenses related to escrow arrangement                             |       |       |       | 229                    |       | —                |       | 229 |   | — |   |
| Impairment of goodwill                                                   |       |       |       | —                 |       | 624                   |       | — |   | 624 |   |
| Impairment of customer relationships intangible                          |       |       |       | —                 |       | 946                   |       | — |   | 946 |   |
| Impairment of employment/non-compete agreement                           |       |       |       | —                 |       | 333                   |       | — |   | 333 |   |
| Net income without nonrecurring expenses                                 |       |       |       | $                      | 1,916      |                  | $          | 2,158 |   | $ | 5,623 |   | $ | 7,091 |   |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
| GAAP reported net income per common share, basic                         |       |       |       | $                      | (0.02      | )                     | $          | 0.01 |   | $ | 0.13 |   | $ | 0.21 |   |
| Less nonrecurring expenses, after tax:                                   |       |       |       |                   |       |                  |       |   |   |   |   |
| Loss related to escrow arrangement                                       |       |       |       | 0.09                   |       | —                |       | 0.09 |   | — |   |
| Legal expenses related to escrow arrangement                             |       |       |       | 0.01                   |       | —                |       | 0.01 |   | — |   |
| Impairment of goodwill                                                   |       |       |       | —                 |       | 0.03                  |       | — |   | 0.02 |   |
| Impairment of customer relationships intangible                          |       |       |       | —                 |       | 0.04                  |       | — |   | 0.04 |   |
| Impairment of employment/non-compete agreement                           |       |       |       | —                 |       | 0.01                  |       | — |   | 0.01 |   |
| Earnings per common share without nonrecurring expenses - basic          |       |       |       | $                      | 0.08       |                  | $          | 0.09 |   | $ | 0.23 |   | $ | 0.29 |   |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
| GAAP reported net income per common share, fully diluted                 |       |       |       | $                      | (0.02      | )                     | $          | 0.01 |   | $ | 0.12 |   | $ | 0.21 |   |
| Less nonrecurring expenses, after tax:                                   |       |       |       |                   |       |                  |       |   |   |   |   |
| Loss related to escrow arrangement                                       |       |       |       | 0.09                   |       | —                |       | 0.09 |   | — |   |
| Legal expenses related to escrow arrangement                             |       |       |       | 0.01                   |       | —                |       | 0.01 |   | — |   |
| Impairment of goodwill                                                   |       |       |       | —                 |       | 0.03                  |       | — |   | 0.02 |   |
| Impairment of customer relationships intangible                          |       |       |       | —                 |       | 0.04                  |       | — |   | 0.04 |   |
| Impairment of employment/non-compete agreement                           |       |       |       | —                 |       | 0.01                  |       | — |   | 0.01 |   |
| Earnings per common share without nonrecurring expenses - fully  diluted |       |       |       | $                      | 0.08       |                  | $          | 0.09 |   | $ | 0.22 |   | $ | 0.28 |   |
|                                                                     |       |       |       |                   |       |                  |       |   |   |   |   |
| **Wealth Management and Trust Services Business  Segment**               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| GAAP reported net income                                                 |       |       |       | $                      | (2,040     | )                     | $          | (1,970 | ) | $ | (1,748 | ) | $ | (1,985 | ) |
| Less nonrecurring expenses, after tax                                    |       |       |       |                   |       |                  |       |   |   |   |   |
| Loss related to escrow arrangement                                       |       |       |       | 2,293                  |       | —                |       | 2,293 |   | — |   |
| Impairment of goodwill                                                   |       |       |       | —                 |       | 624                   |       | — |   | 624 |   |
| Impairment of customer relationships intangible                          |       |       |       | —                 |       | 946                   |       | — |   | 946 |   |
| Impairment of employment/non-compete agreement                           |       |       |       | —                 |       | 333                   |       | — |   | 333 |   |
| Net income without nonrecurring expenses                                 |       |       |       | $                      | 253        |                  | $          | (67 | ) | $ | 545 |   | $ | (82 | ) |
|                                                                          |            |            |            |                        |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

28

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*Net Interest Income*

 

Net interest incomerepresents the difference between interest and fees earned on interest -earningassets and the interest paid on deposits and other interest-bearingliabilities. The level of net interest income is impacted primarily byvariations in the volume and mix of these assets and liabilities, as well aschanges in interest rates. Net interest income for the three months endedSeptember 30, 2007 and 2006 was $10.3 million and $10.4 million, respectively,a period-to-period decrease of $87,000, or 0.8%. Net interest income for thenine months ended September 30, 2007 and 2006 was $30.4 million and $31.5million, respectively.  The decrease innet interest income is primarily the result of a greater increase in our costof interest-bearing liabilities than our increase in the yields earned foraverage earning assets.  We have certainloans and investment securities for which a portion of the income realized istax-exempt.  Net interest income on a taxequivalent basis for the three months ended September 30, 2007 and 2006 was$10.4 million and $10.5 million, respectively. For the nine months ended September 30, 2007 and 2006, net interestincome on a tax equivalent basis was $30.7 million and $31.6 million,respectively.

 

Our net interest margin,which equals net interest income divided by average earning assets, was 2.65%and 2.93%, respectively, for the three months ended September 30, 2007 and2006. For the nine months ended September 30, 2007 and 2006, our net interestmargin was 2.63% and 3.05%, respectively. The decrease in the net interest margin for the three and nine monthsended September 30, 2007 compared to the same periods of 2006 is a result ofthe higher increase in the cost of interest-bearing liabilities than theincrease in yields earned for average earning assets.  Tables 2 through 5 present an analysis ofaverage earning assets and interest-bearing liabilities with related componentsof interest income and interest expense on a tax equivalent basis.

 

Table 2.

** **

**AverageBalance Sheets and Interest Rates on Earning Assets and Interest - BearingLiabilities**

Three Months EndedSeptember 30, 2007, 2006 and 2005

(In thousands)

 
| ** **                                               | **2007**    | ** ** | **2006**     | ** ** | **2005**   | ** ** |
|----------------------------------------------------------|-------------|------------|--------------|------------|------------|------------|
| ** **                                               | ** **  | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                               | **Average** | ** ** | **Income/**  | ** ** | ** ** | ** ** | **Average** | ** ** | **Income/** | ** ** | ** ** | ** ** | **Average** | ** ** | **Income/** | ** ** | ** ** | ** ** |
| ** **                                               | **Balance** | ** ** | **Expense**  | ** ** | **Rate**   | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                               |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                 |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1):                                               |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and  industrial                               | $           | 108,266    |         | $          | 2,132      |       | 7.88 | % | $ | 86,592 |   | $ | 1,649 |   | 7.62 | % | $ | 67,519 |   | $ | 1,089 |   | 6.45 | % |
| Real estate -  commercial                                | 385,432     |       | 6,556        |       | 6.80       |       | 294,680 |   | 4,881 |   | 6.63 |   | 277,487 |   | 4,466 |   | 6.44 |   |
| Real estate -  construction                              | 171,846     |       | 3,639        |       | 8.47       |       | 146,803 |   | 3,214 |   | 8.76 |   | 65,414 |   | 1,189 |   | 7.27 |   |
| Real estate -  residential                               | 200,792     |       | 2,749        |       | 5.48       |       | 173,942 |   | 2,315 |   | 5.32 |   | 130,390 |   | 1,607 |   | 4.93 |   |
| Home equity lines                                        | 72,365      |       | 1,323        |       | 7.25       |       | 71,888 |   | 1,339 |   | 7.45 |   | 68,624 |   | 927 |   | 5.36 |   |
| Consumer                                                 | 8,222       |       | 165          |       | 7.96       |       | 5,008 |   | 97 |   | 7.75 |   | 4,760 |   | 87 |   | 7.31 |   |
| Total loans                                              | 946,923     |       | 16,564       |       | 7.00       |       | 778,913 |   | 13,495 |   | 6.93 |   | 614,194 |   | 9,365 |   | 6.10 |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale, net                                 | 233,646     |       | 4,256        |       | 7.29       |       | 275,885 |   | 5,193 |   | 7.53 |   | 468,808 |   | 6,101 |   | 5.21 |   |
| Investment securities - trading                          | —      |       | —       |       | 0.00       |       | — |   | — |   | 0.00 |   | — |   | — |   | 0.00 |   |
| Investment securities - available-for-sale               | 293,554     |       | 3,696        |       | 5.04       |       | 243,259 |   | 2,891 |   | 4.75 |   | 149,207 |   | 1,414 |   | 3.79 |   |
| Investment securities held-to-maturity                   | 85,850      |       | 896          |       | 4.17       |       | 104,768 |   | 1,079 |   | 4.12 |   | 124,632 |   | 1,197 |   | 3.84 |   |
| Other investments                                        | 10,944      |       | 166          |       | 6.05       |       | 5,584 |   | 84 |   | 6.03 |   | 6,718 |   | 56 |   | 3.31 |   |
| Federal funds sold                                       | 5,003       |       | 71           |       | 5.69       |       | 15,219 |   | 181 |   | 4.71 |   | 23,863 |   | 208 |   | 3.46 |   |
| Total interest-earning assets and interest income (2)    | 1,575,920   |       | 25,649       |       | 6.51       |       | 1,423,628 |   | 22,923 |   | 6.44 |   | 1,387,422 |   | 18,341 |   | 5.29 |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest  earning assets:                            |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                                 | 5,659       |       |         |       |       |       | 4,966 |   |   |   |   |   | 13,963 |   |   |   |   |   |
| Premises and  equipment, net                             | 19,347      |       |         |       |       |       | 20,528 |   |   |   |   |   | 17,525 |   |   |   |   |   |
| Goodwill and  other intangibles, net                     | 17,341      |       |         |       |       |       | 20,425 |   |   |   |   |   | 20,649 |   |   |   |   |   |
| Accrued interest  and other assets                       | 51,685      |       |         |       |       |       | 28,265 |   |   |   |   |   | 21,119 |   |   |   |   |   |
| Allowance for  loan losses                               | (10,512     | )          |         |       |       |       | (8,970 | ) |   |   |   |   | (7,378 | ) |   |   |   |   |
| Total assets                                             | $           | 1,659,440  |         |       |       |       |   | $ | 1,488,842 |   |   |   |   |   | $ | 1,453,300 |   |   |   |   |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders' Equity**                 |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing liabilities:                          |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:                             |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                        | 117,665     |       | 904          |       | 3.05       | %          | 134,293 |   | 976 |   | 2.91 | % | 109,030 |   | 316 |   | 1.15 | % |
| Money markets                                            | 53,155      |       | 345          |       | 2.58       |       | 89,179 |   | 517 |   | 2.32 |   | 223,210 |   | 1,570 |   | 2.81 |   |
| Statement savings                                        | 359,379     |       | 4,226        |       | 4.66       |       | 232,930 |   | 2,802 |   | 4.78 |   | 9,979 |   | 29 |   | 1.14 |   |
| Certificates of  deposit                                 | 498,113     |       | 5,903        |       | 4.70       |       | 584,089 |   | 6,383 |   | 4.37 |   | 555,193 |   | 4,867 |   | 3.51 |   |
| Total interest -  bearing deposits                       | 1,028,312   |       | 11,378       |       | 4.39       |       | 1,040,491 |   | 10,678 |   | 4.07 |   | 897,412 |   | 6,782 |   | 3.00 |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed funds                                     | 319,767     |       | 3,834        |       | 4.76       |       | 154,047 |   | 1,768 |   | 4.55 |   | 258,735 |   | 1,448 |   | 2.22 |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities and interest  expense | 1,348,079   |       | 15,212       |       | 4.48       |       | 1,194,538 |   | 12,446 |   | 4.13 |   | 1,156,147 |   | 8,230 |   | 2.82 |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                         |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                          | 123,178     |       |         |       |       |       | 119,448 |   |   |   |   |   | 124,553 |   |   |   |   |   |
| Other liabilities                                        | 31,216      |       |         |       |       |       | 22,658 |   |   |   |   |   | 25,202 |   |   |   |   |   |
| Common  shareholders' equity                             | 156,967     |       |         |       |       |       | 152,198 |   |   |   |   |   | 147,398 |   |   |   |   |   |
| Total liabilities and shareholders' equity               | $           | 1,659,440  |         |       |       |       |   | $ | 1,488,842 |   |   |   |   |   | $ | 1,453,300 |   |   |   |   |   |
|                                                     |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income and net interest margin (2)          |        |       | $            | 10,437     |       | 2.65       | % |   |   | $ | 10,477 |   | 2.93 | % | $ | 10,111 |   |   |   | 2.92 | % |
|                                                          |             |            |              |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

 

(2) Interest income forloans receivable, investment securities available-for-sale and fed funds sold(which includes investments in money market preferred stock) is reported on afully taxable-equivalent basis at a rate of 35%.

 

29

----

 

Table3.

** **

**Rate andVolume Analysis**

Three Months EndedSeptember 30, 2007, 2006 and 2005

(In thousands)

 
| ** **                                 | ** ** | **2007  Compared to 2006** | ** ** | **2006  Compared to 2005** | ** **         |
|--------------------------------------------|------------|----------------------------|------------|----------------------------|--------------------|
| ** **                                 | ** ** | **Change  Due to**         | ** ** | ** **                 | **Change  Due to** | ** ** | ** ** |
| ** **                                 | ** ** | **Average**                | ** ** | **Average**                | ** **         | **Increase** | ** ** | **Average** | ** ** | **Average** | ** ** | **Increase** | ** ** |
|                                       |       | **Volume  (3)**            | ** ** | **Rate**                   | ** **         | **(Decrease)** | ** ** | **Volume  (3)** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| **Interest income:**                       | ** ** | ** **                 | ** ** | ** **                 | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Loans (1):                                 |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Commercial and industrial                  |       | $                          | 413        |                       | $                  | 70 |   | $ | 483 |   | $ | 308 |   | $ | 252 |   | $ | 560 |   |
| Real estate - commercial                   |       | 1,503                      |       | 172                        |               | 1,675 |   | 277 |   | 138 |   | 415 |   |
| Real estate - construction                 |       | 548                        |       | (123                       | )                  | 425 |   | 1,479 |   | 546 |   | 2,025 |   |
| Real estate - residential                  |       | 357                        |       | 77                         |               | 434 |   | 537 |   | 171 |   | 708 |   |
| Home equity lines                          |       | 20                         |       | (36                        | )                  | (16 | ) | 44 |   | 368 |   | 412 |   |
| Consumer                                   |       | 64                         |       | 4                          |               | 68 |   | 5 |   | 5 |   | 10 |   |
| Total loans                                |       | 2,905                      |       | 164                        |               | 3,069 |   | 2,650 |   | 1,480 |   | 4,130 |   |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Loans held for sale, net                   |       | (795                       | )          | (142                       | )                  | (937 | ) | (2,511 | ) | 1,603 |   | (908 | ) |
| Investment securities - trading            |       | —                     |       | —                     |               | — |   | — |   | — |   | — |   |
| Investment securities - available-for-sale |       | 598                        |       | 207                        |               | 805 |   | 891 |   | 586 |   | 1,477 |   |
| Investment securities held-to-maturity     |       | (195                       | )          | 12                         |               | (183 | ) | (191 | ) | 73 |   | (118 | ) |
| Other investments                          |       | 81                         |       | 1                          |               | 82 |   | (9 | ) | 37 |   | 28 |   |
| Federal funds sold                         |       | (122                       | )          | 12                         |               | (110 | ) | (75 | ) | 48 |   | (27 | ) |
| Total interest income (2)                  |       | 2,472                      |       | 254                        |               | 2,726 |   | 755 |   | 3,827 |   | 4,582 |   |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| **Interest expense:**                      | ** ** | ** **                 | ** ** | ** **                 | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:               |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Interest checking                          |       | (114                       | )          | 42                         |               | (72 | ) | 73 |   | 587 |   | 660 |   |
| Money markets                              |       | (206                       | )          | 34                         |               | (172 | ) | (942 | ) | (111 | ) | (1,053 | ) |
| Statement savings                          |       | 1,539                      |       | (115                       | )                  | 1,424 |   | 641 |   | 2,132 |   | 2,773 |   |
| Certificates of deposit                    |       | (895                       | )          | 415                        |               | (480 | ) | 255 |   | 1,261 |   | 1,516 |   |
| Total interest - bearing deposits          |       | 324                        |       | 376                        |               | 700 |   | 27 |   | 3,869 |   | 3,896 |   |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Other borrowed funds                       |       | 1,900                      |       | 166                        |               | 2,066 |   | (586 | ) | 906 |   | 320 |   |
|                                       |       |                       |       |                       |               |   |   |   |   |   |   |   |   |
| Total interest expense                     |       | 2,224                      |       | 542                        |               | 2,766 |   | (559 | ) | 4,775 |   | 4,216 |   |
| Net interest income (2)                    |       | $                          | 248        |                       | $                  | (288 | ) | $ | (40 | ) | $ | 1,314 |   | $ | (948 | ) | $ | 366 |   |
|                                            |            |                            |            |                            |                    |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1) Non-accrual loans areincluded in average balances and do not have a material effect on the averageyield.  Interest income on non-accruingloans was not material for the periods presented.

 

(2) Interestincome for loans receivable, investment securities available-for-sale and fedfunds sold (which includes investments in money market preferred stock) isreported on a fully taxable-equivalent basis at a rate of 35%.

 

(3) Changesattributable to rate/volume have been allocated to volume.

** **

**30**

----

** **

Table 4.

** **

**AverageBalance Sheets and Interest Rates on Earning Assets and Interest - BearingLiabilities**

Nine Months EndedSeptember 30, 2007, 2006 and 2005

(In thousands)

 
| ** **                                               | ** ** | **2007**    | ** ** | **2006**     | ** ** | **2005**   | ** ** |        |
|----------------------------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|-------------|
| ** **                                               | ** ** | ** **  | ** ** | **Interest** | ** ** | ** ** | ** ** | ** **  | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                               | ** ** | **Average** | ** ** | **Income/**  | ** ** | ** ** | ** ** | **Average** | ** ** | **Income** | ** ** | ** ** | ** ** | **Average** | ** ** | **Income** | ** ** | ** ** | ** ** |
| ** **                                               | ** ** | **Balance** | ** ** | **Expense**  | ** ** | **Rate**   | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                               | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest-earning  assets:                                |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Loans (1):                                               |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Commercial and  industrial                               |       | $106,764    |       | $6,143       |       | 7.67       | %          | $80,964     |   | $4,409 |   | 7.26 | % | $65,077 |   | $2,898 |   | 5.94 | % |
| Real estate -  commercial                                |       | 354,731     |       | 17,815       |       | 6.70       |       | 281,599     |   | 13,940 |   | 6.60 |   | 249,501 |   | 11,738 |   | 6.27 |   |
| Real estate -  construction                              |       | 164,295     |       | 10,393       |       | 8.43       |       | 138,066     |   | 8,596 |   | 8.30 |   | 67,582 |   | 3,451 |   | 6.81 |   |
| Real estate -  residential                               |       | 199,342     |       | 8,156        |       | 5.46       |       | 166,637     |   | 6,470 |   | 5.18 |   | 108,084 |   | 4,201 |   | 5.18 |   |
| Home equity lines                                        |       | 66,832      |       | 3,674        |       | 7.35       |       | 75,146      |   | 3,831 |   | 6.80 |   | 64,884 |   | 2,418 |   | 4.98 |   |
| Consumer                                                 |       | 7,020       |       | 424          |       | 8.08       |       | 4,825       |   | 276 |   | 7.63 |   | 5,195 |   | 273 |   | 7.03 |   |
| Total loans                                              |       | 898,984     |       | 46,605       |       | 6.91       |       | 747,237     |   | 37,522 |   | 6.70 |   | 560,323 |   | 24,979 |   | 5.94 |   |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for  sale, net                                |       | 261,505     |       | 13,954       |       | 7.11       |       | 264,994     |   | 14,746 |   | 7.42 |   | 382,603 |   | 14,117 |   | 4.92 |   |
| Investment  securities - trading                         |       | 15          |       | 1            |       | 4.61       |       | —      |   | — |   | 0.00 |   | — |   | — |   | 0.00 |   |
| Investment  securities - available-for-sale              |       | 264,249     |       | 9,748        |       | 4.92       |       | 222,847     |   | 7,633 |   | 4.57 |   | 154,356 |   | 4,376 |   | 3.78 |   |
| Investment  securities held-to-maturity                  |       | 91,343      |       | 2,858        |       | 4.17       |       | 108,927     |   | 3,306 |   | 4.05 |   | 130,479 |   | 3,757 |   | 3.84 |   |
| Other investments                                        |       | 9,893       |       | 442          |       | 5.96       |       | 6,152       |   | 262 |   | 5.67 |   | 6,141 |   | 183 |   | 3.97 |   |
| Federal funds  sold                                      |       | 31,244      |       | 1,235        |       | 5.28       |       | 26,887      |   | 915 |   | 4.55 |   | 15,148 |   | 346 |   | 3.06 |   |
| Total  interest-earning assets and interest income (2)   |       | 1,557,233   |       | 74,843       |       | 6.41       |       | 1,377,044   |   | 64,384 |   | 6.23 |   | 1,249,050 |   | 47,758 |   | 5.10 |   |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Non-interest  earning assets:                            |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Cash and due from  banks                                 |       | 7,297       |       |         |       |       |       | 6,766       |   |   |   |   |   | 8,906 |   |   |   |   | ** ** |
| Premises and  equipment, net                             |       | 19,835      |       |         |       |       |       | 19,560      |   |   |   |   |   | 17,288 |   |   |   |   | ** ** |
| Goodwill and  other intangibles, net                     |       | 17,403      |       |         |       |       |       | 20,514      |   |   |   |   |   | 17,613 |   |   |   |   | ** ** |
| Accrued interest  and other assets                       |       | 48,513      |       |         |       |       |       | 17,201      |   |   |   |   |   | 13,557 |   |   |   |   | ** ** |
| Allowance for  loan losses                               |       | (10,096     | )          |         |       |       |       | (8,677      | ) |   |   |   |   | (6,643 | )  |   |   |   | ** ** |
| Total assets                                             |       | $1,640,185  |       |         |       |       |       | $1,432,408  |   |   |   |   |   | $1,299,771 |   |   |   |   | ** ** |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| **Liabilities  and Shareholders' Equity**                | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest -  bearing liabilities:                         |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Interest -  bearing deposits:                            |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Interest checking                                        |       | 124,155     |       | 2,738        |       | 2.95       | %          | 139,949     |   | 2,875 |   | 2.74 | % | 123,055 |   | 1,106 |   | 1.20 | % |
| Money markets                                            |       | 57,531      |       | 1,076        |       | 2.50       |       | 133,062     |   | 2,480 |   | 2.49 |   | 144,187 |   | 2,852 |   | 2.64 |   |
| Statement savings                                        |       | 357,343     |       | 12,641       |       | 4.73       |       | 107,484     |   | 3,703 |   | 4.59 |   | 9,279 |   | 75 |   | 1.09 |   |
| Certificates of deposit                                  |       | 531,418     |       | 18,733       |       | 4.71       |       | 607,555     |   | 18,547 |   | 4.08 |   | 543,859 |   | 12,956 |   | 3.19 |   |
| Total interest - bearing deposits                        |       | 1,070,447   |       | 35,188       |       | 4.39       |       | 988,050     |   | 27,605 |   | 3.74 |   | 820,380 |   | 16,989 |   | 2.77 |   |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed funds                                     |       | 264,551     |       | 8,949        |       | 4.52       |       | 157,372     |   | 5,145 |   | 4.37 |   | 223,562 |   | 3,711 |   | 2.22 |   |
| Total interest-bearing liabilities and interest  expense |       | 1,334,998   |       | 44,137       |       | 4.42       |       | 1,145,422   |   | 32,750 |   | 3.82 |   | 1,043,942 |   | 20,700 |   | 2.65 |   |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Noninterest-bearing  liabilities:                        |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Demand deposits                                          |       | 123,621     |       |         |       |       |       | 114,889     |   |   |   |   |   | 113,634 |   |   |   |   | ** ** |
| Other liabilities                                        |       | 24,196      |       |         |       |       |       | 21,156      |   |   |   |   |   | 20,195 |   |   |   |   | ** ** |
| Common  shareholders' equity                             |       | 157,370     |       |         |       |       |       | 150,941     |   |   |   |   |   | 122,000 |   |   |   |   | ** ** |
| Total liabilities  and shareholders' equity              |       | $1,640,185  |       |         |       |       |       | $1,432,408  |   |   |   |   |   | $1,299,771 |   |   |   |   | ** ** |
|                                                     |       |        |       |         |       |       |       |        |   |   |   |   |   |   |   |   |   |   | ** ** |
| Net interest  income and net interest margin (2)         |       |        |       | $30,706      |       | 2.63       | %          |        |   | $31,634 |   | 3.05 | % |   |   | $27,058 |   | 2.89 | % |
|                                                          |            |             |            |              |            |            |            |             |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

 

(2) Interest income for loans receivable, investment securitiesavailable-for-sale and fed funds sold (which includes investments in moneymarket preferred stock) is reported on a fully taxable-equivalent basis at arate of 35%.

** **

**31**

----

** **

Table5.

** **

**Rate andVolume Analysis**

Nine Months EndedSeptember 30, 2007, 2006 and 2005

(In thousands)

 
| ** **                                 | ** ** | **2007  Compared to 2006** | ** ** | **2006  Compared to 2005** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **Change  Due to**         | ** ** | ** **                 | ** ** | **Change  Due to** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Average**                | ** ** | **Average**                | ** ** | **Increase** | ** ** | **Average** | ** ** | **Average** | ** ** | **Increase** | ** ** |
|                                       |       | **Volume  (3)**            | ** ** | **Rate**                   | ** ** | **(Decrease)** | ** ** | **Volume  (3)** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| **Interest income:**                       | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Loans (1):                                 |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Commercial and industrial                  |       | $                          | 1,405      |                       | $          | 329 |   | $ | 1,734 |   | $ | 709 |   | $ | 802 |   | $ | 1,511 |   |
| Real estate - commercial                   |       | 3,620                      |       | 255                        |       | 3,875 |   | 1,504 |   | 698 |   | 2,202 |   |
| Real estate - construction                 |       | 1,633                      |       | 164                        |       | 1,797 |   | 3,601 |   | 1,544 |   | 5,145 |   |
| Real estate - residential                  |       | 1,270                      |       | 416                        |       | 1,686 |   | 2,273 |   | (4 | ) | 2,269 |   |
| Home equity lines                          |       | (433                       | )          | 276                        |       | (157 | ) | 382 |   | 1,031 |   | 1,413 |   |
| Consumer                                   |       | 124                        |       | 24                         |       | 148 |   | (19 | ) | 22 |   | 3 |   |
| Total loans                                |       | 7,619                      |       | 1,464                      |       | 9,083 |   | 8,450 |   | 4,093 |   | 12,543 |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Loans held for sale, net                   |       | (194                       | )          | (598                       | )          | (792 | ) | (4,339 | ) | 4,968 |   | 629 |   |
| Investment securities - trading            |       | 1                          |       | —                     |       | 1 |   | — |   | — |   | — |   |
| Investment securities - available-for-sale |       | 1,418                      |       | 697                        |       | 2,115 |   | 1,942 |   | 1,315 |   | 3,257 |   |
| Investment securities held-to-maturity     |       | (534                       | )          | 86                         |       | (448 | ) | (620 | ) | 169 |   | (451 | ) |
| Other investments                          |       | 159                        |       | 21                         |       | 180 |   | 0 |   | 79 |   | 79 |   |
| Federal funds sold                         |       | 148                        |       | 172                        |       | 320 |   | 270 |   | 299 |   | 569 |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Total interest income (2)                  |       | 8,617                      |       | 1,842                      |       | 10,459 |   | 5,703 |   | 10,923 |   | 16,626 |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                      | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:               |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Interest checking                          |       | (334                       | )          | 197                        |       | (137 | ) | 152 |   | 1,617 |   | 1,769 |   |
| Money markets                              |       | (1,408                     | )          | 4                          |       | (1,404 | ) | (220 | ) | (152 | ) | (372 | ) |
| Statement savings                          |       | 8,555                      |       | 383                        |       | 8,938 |   | 801 |   | 2,827 |   | 3,628 |   |
| Certificates of deposit                    |       | (2,324                     | )          | 2,510                      |       | 186 |   | 1,520 |   | 4,071 |   | 5,591 |   |
| Total interest - bearing deposits          |       | 4,489                      |       | 3,094                      |       | 7,583 |   | 2,253 |   | 8,363 |   | 10,616 |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Other borrowed funds                       |       | 3,504                      |       | 300                        |       | 3,804 |   | (1,099 | ) | 2,533 |   | 1,434 |   |
|                                       |       |                       |       |                       |       |   |   |   |   |   |   |   |   |
| Total interest expense                     |       | 7,993                      |       | 3,394                      |       | 11,387 |   | 1,154 |   | 10,896 |   | 12,050 |   |
| Net interest income (2)                    |       | $                          | 624        |                       | $          | (1,552 | ) | $ | (928 | ) | $ | 4,549 |   | $ | 27 |   | $ | 4,576 |   |
|                                            |            |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(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 years presented.

 

(2) Interest income for loans receivable, investment securitiesavailable-for-sale and fed funds sold (which includes investments in money marketpreferred stock is reported on a fully taxable-equivalent basis at a rate of35%.

 

(3) Changes attributable to rate/volume have been allocated to volume.

** **

**32**

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** **

 

 

*Provision for Loan Losses*

 

The provision for loanlosses for the three months ended September 30, 2007 and 2006 was $915,000 and$230,000, respectively. For the nine months ended September 30, 2007 and 2006,the provision for loan losses was $1.7 million and $870,000, respectively.  The increase in provision expense for thethree and nine months ended September 30, 2007 compared to the same periods of2006 is primarily the result our charging-off one nonaccrual loan totaling$417,000 and net new loan growth in addition to our evaluation of the creditquality in our loan portfolio and the qualitative factors we use to determinethe adequacy of our loan loss reserves as described above in “CriticalAccounting Policies—Allowance for Loan Losses.” The allowance for loan lossesat September 30, 2007 and December 31, 2006 was $10.9 million and $9.6million, respectively. Our allowance for loan losses ratio to loans receivable,net was 1.12% and 1.14% at September 30, 2007 and December 31, 2006,respectively. Non-performing loans were equal to 0.01% total loans receivablefor each of September 30, 2007 and December 31, 2006, respectively.

 

Additional information onthe allowance for loan losses, its allocation to the loans receivable portfolioand information on nonperforming loans can be found in Tables 6, 7 and 8.

 

Table6.

** **

**Allowancefor Loan Losses**

Nine Months EndedSeptember 30, 2007 and 2006

(In thousands)

 
| ** **                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Beginning balance, January 1, |       | $        | 9,638      |     | $          | 8,301 |   |
|                          |       |     |       |     |       |
| Provision for loan losses     |       | 1,670    |       | 870      |       |
|                          |       |     |       |     |       |
| Loans charged off:            |       |     |       |     |       |
| Commercial and industrial     |       | (448     | )          | (42      | )          |
| Consumer                      |       | (3       | )          | (1       | )          |
| Total loans charged off       |       | (451     | )          | (43      | )          |
|                          |       |     |       |     |       |
| Recoveries:                   |       |     |       |     |       |
| Commercial and industrial     |       | —   |       | 77       |       |
| Consumer                      |       | —   |       | —   |       |
| Total recoveries              |       | —   |       | 77       |       |
|                          |       |     |       |     |       |
| Net (charge offs) recoveries  |       | (451     | )          | 34       |       |
|                          |       |     |       |     |       |
| Ending balance, September 30, |       | $        | 10,857     |     | $          | 9,205 |   |

 
| ** **                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| **Loans:**                                                 | ** ** | **2007**          | ** ** | **2006**         | ** ** |
| Balance at period end                                      |       | $                 | 973,518    |             | $          | 845,449 |   |
| Allowance for loan losses to loans receivable, net of fees |       | 1.12              | %          | 1.14             | %          |
| Annualized net charge-offs to average loans receivable     |       | 0.07              | %          | 0.00             | %          |
|                                                            |            |                   |            |                  |            |  |  |

 

 

Table7.

** **

**Allocationof the Allowance for Loan Losses**

At September 30, 2007 andDecember 31, 2006

(In thousands)

 
| ** **                      | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **Allocation**          | ** ** | **% of Total***        | ** ** | **Allocation** | ** ** | **% of Total*** | ** ** |
| Commercial and industrial       |       | $                       | 1,573      |                   | 10.99      | % | $ | 1,670 |   | 12.09 | % |
| Real estate —commercial    |       | 4,882                   |       | 40.91                  |       | 3,687 |   | 37.50 |   |
| Real estate — construction |       | 2,144                   |       | 18.43                  |       | 1,764 |   | 18.27 |   |
| Real estate — residential  |       | 1,361                   |       | 21.12                  |       | 2,025 |   | 23.80 |   |
| Home equity lines               |       | 713                     |       | 7.71                   |       | 384 |   | 7.75 |   |
| Consumer                        |       | 184                     |       | 0.84                   |       | 108 |   | 0.59 |   |
| Total allowance for loan losses |       | $                       | 10,857     |                   | 100.00     | % | $ | 9,638 |   | 100.00 | % |

----

* Percentage of loan type tothe total loan portfolio.

 

 

 

33

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Table8.

** **

**NonperformingLoans Receivable**

At September 30, 2007 andDecember 31, 2006

(In thousands)

 
|                                 |   | **September  30,  2007** |   | **December  31,  2006** |   |
|--------------------------------------|--------|--------------------------|--------|-------------------------|--------|
| Nonaccruing loans                    |   | $                        | 86     |                    | $      | 82 |   |
|                                 |   |                     |   |                    |   |
| Loans contractually past-due         |   |                     |   |                    |   |
| 90 days or more and still accruing   |   | —                   |   | —                  |   |
|                                 |   |                     |   |                    |   |
| Total nonperforming loans receivable |   | $                        | 86     |                    | $      | 82 |   |
|                                 |   |                     |   |                    |   |

 

 

*Non-Interest Income*

 

Non-interest incomeincludes, among other things, service charges on deposits and loans, gains onthe sale of mortgage loans, investment fee income, and management fee income,and continues to be an important factor in our operating results. Non-interestincome for the three months ended September 30, 2007 and 2006 was $4.7 millionand $5.0 million, respectively, a decrease of $219,000, or 4%. For the ninemonths ended September 30, 2007 and 2006, non-interest income was $15.4 millionand $15.7 million, respectively.  Netgains on sales of loans held for sale by George Mason for the three monthsended September 30, 2007 and 2006 were $2.1 million and $2.5 million,respectively, a decrease of $362,000, or 15%. For the nine months ended September 30, 2007 and 2006, net gains onloans held for sale were $7.2 million and $7.8 million, respectively.  Included in the net gains on sales of loansheld for sale are any origination, underwriting, and discount points and otherfunding fees received and deferred at loan origination. Costs include directcosts associated with the loan origination, such as commissions and salariesthat are deferred at the time of origination.   Management fee income forthe three months ended September 30, 2007 and 2006 was $229,000 and $583,000,respectively, a decrease of $354,000, or 61%. For the nine months ended September30, 2007 and 2006, management fee income was $899,000 and $1.7 million,respectively.  The decrease in managementfee income is directly related to the tightening credit conditions within themortgage industry and the slowdown in the regional housing market.  Management fee income represents the incomeearned for services George Mason provides to other mortgage companies owned bylocal home builders and generally fluctuates based on the volume of loanoriginations and sales.

 

Service charges on depositaccounts increased $87,000 to $505,000 for the three months ended September 30,2007 compared to $418,000 for the same period of 2006. For the year to dateSeptember 30, 2007, service charges on deposit accounts increased $296,000, or25%, to $1.5 million from $1.2 million for the same period of 2006.  The increases in service charges on depositaccounts are primarily the result of an increased number of deposit accounts in2007 compared to 2006. Loan service charge income decreased $21,000 to $365,000for the three months ended September 30, 2007, compared to $386,000 for thesame period of 2006.  For the nine monthsended September 30, 2007 and 2006, loan service charge income was $1.2 millionand

 

** **

** **

**34**

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** **

 

and $1.6 million, respectively, a decrease of$380,000 or 24%.  The decreases in loanservice charge income for the three and nine months ended September 30, 2007compared to the same periods of 2006 is related to a decrease in prepaymentpenalties incurred by the Bank’s loan customers and a decrease in servicecharges recorded in the mortgage banking segment, which is related to theslowdown in the regional housing market.

 

Investment fee incomeincreased $252,000 to $1.1 million for the three months ended September 30,2007 compared to $849,000 for the same period of 2006. For the nine monthsended September 30, 2007, investment fee income increased $750,000 to $3.2million from $2.5 million for the nine months ended September 30, 2006.  The increases in investment fee income areprimarily attributable to the trust division whose operations are included forthe full three and nine months ended September 30, 2007 as compared to eight ofthe nine months through September 30, 2006.

 

Non-interest income represented31% and 32% of our total revenues for the three months ended September 30, 2007and 2006, respectively.  For the ninemonths ended September 30, 2007 and 2006, non-interest income represented 34%and 33% of our total revenues, respectively.

 

*Non-Interest Expense*

 

Non-interest expenseincludes, among other things, salaries and benefits, occupancy costs,professional fees, depreciation, data processing, telecommunications andmiscellaneous expenses. Non-interest expense for the three months ended September30, 2007 was $15.5 million, compared to $15.0 million for the same period of2006, an increase of $424,000, or 3%. For the nine months ended September 30, 2007 and 2006, non-interestexpense was $40.1 million and $38.9 million, respectively, an increase of $1.2million, or 3%.  The increase innon-interest expense for the three and nine months ended September 30, 2007compared to the same periods of September 30, 2006 was primarily attributableto the previously mentioned loss on the escrow arrangement and related legalfees totaling $3.8 million.   Excludingthis loss and the impairment charges recorded during 2006, non-interest expensewould have decreased $497,000 for the three months ended September 30, 2007 comparedto third quarter results for 2006.  (SeeTable 1 for a reconciliation of non-GAAP financial measures to our GAAPfinancial information.)  This decrease isprimarily due to a decrease in our salaries and benefits expense attributableto a decrease in the level of staffing and commission paid at our mortgagebanking subsidiary.

 

Excluding the nonrecurringlosses, non-interest expense would have increased by $294,000 for the ninemonths ended September 30, 2007 compared to the year-to-date 2006 results.  (See Table 1 for a reconciliation of non-GAAPfinancial measures to our GAAP financial information.)  Year-to-date non-interest expense hasincreased as a result of our branch office expansion during the past twelvemonths and an increase in our FDIC insurance premiums as a result of the depositinsurance reform implemented by the FDIC during 2007. In addition, non-interestexpense related to our trust division, which we acquired in February 2006, areincluded for the full nine months period for 2007 along with additionalinvestments made to this division over the past twelve months.

 

*IncomeTaxes*

 

For the three months endedSeptember 30, 2007, we recorded an income tax benefit of $702,000, compared toan income tax benefit of $148,000 for the same period of 2006.  The benefits recorded during these reportingperiods primarily resulted from the escrow arrangement loss recorded in thethird quarter of 2007 and the impairment charges recorded during the third

 

 

35

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quarter of 2006, each recorded with a taxbenefit calculated at our statutory rate of 34.5% and 35% for the three monthsended September 30, 2007 and 2006, respectively.  Our effective tax rate decreased in the thirdquarter of 2007 as compared to the same period of 2006 primarily as a result ofour increase in tax-exempt investments over the past twelve months.

 

Provision for income taxexpense for the nine months ended September 30, 2007 and 2006 was $851,000 and$2.2 million, respectively, a decrease of $1.4 million, or 61%.  For the nine months ended September 30, 2007and 2006, our effective tax rate was 21.5% and 29.9%, respectively.  Each of these effective tax rates wasimpacted by the aforementioned tax benefits recorded at the applicable statutoryrates in conjunction with the nonrecurring expenses reported in 2007 and2006.  In addition, the effective taxrate decreased from 2006 to 2007 as a result of our adding tax-exemptinvestments during the second half of 2006 and continuing into 2007.  See also “Critical Accounting Policies —Valuation of Deferred Tax Assets.”

 

**Statements of Condition**

 

Total assets were $1.68billion at September 30, 2007, compared to $1.64 billion at December 31,2006, an increase of $39.2 million, or 2%. This growth was driven primarily byincreases in loans receivable and investment securities portfolios, which werefunded by growth in other borrowed funds. Total assets have decreased $100.3million from September 30, 2007 as compared to June 30, 2007 primarily due todecreases in our loans held for sale portfolio and the funding which supportedthat portfolio.

 

*Investment Securities*

 

Investment securities were$426.3 million at September 30, 2007, compared to $329.3 million atDecember 31, 2006, an increase of $97.0 million, or 29%. The increase ininvestment securities was primarily a result of the additional liquidity we hadas the volume of originations in our loans held for sale portfolio decreaseddue to the slowdown in the regional housing market.  The investment portfolio consists ofinvestment securities available-for-sale and investment securitiesheld-to-maturity. Investment securities available-for-sale are those securitiesthat we intend to hold for an indefinite period of time, but not necessarilyuntil maturity. These securities are carried at fair value and may be sold aspart of an asset/liability strategy, liquidity management or regulatory capitalmanagement.  Investment securitiesheld-to-maturity are those securities that we have the intent and ability tohold to maturity and are carried at amortized cost. At September 30, 2007,investment securities available-for-sale were $343.5 million and investmentsecurities held-to-maturity were $82.7 million. See Table 9 for additionalinformation on our investment securities portfolio.

 

Investment securities withunrealized losses are investment grade securities.  Investment securities with unrealized losseshave interest rates that are less than current marketinterest rates and, therefore, the indicated temporary losses are not a resultof permanent credit impairment. Mortgage-backed investment securities, which are the primary componentof the unrealized losses in the investment securities portfolio at those dates,are primarily comprised of securities issued by the Federal National MortgageAssociation (FNMA), Federal Home Loan Mortgage Corporation (FHLMC) andGovernment National Mortgage Association (GNMA).

 

Our investment portfolioconsists primarily of securities backed or guaranteed by FNMA or FHLMC. For all non government or agency securities, we complete reviews at leastquarterly. As of September 30, 2007, our investment securities portfolioconsists of all AAA rated securities.  Investment securities which carry aAAA rating are judged to be of the best quality and carry the smallest degreeof investment risk.   We expect to receive full payment of interestand principal on the securities in the investment portfolio. The variousprotective elements on our non agency securities may change in the future ifmarket conditions or the financial stability of credit insurers changes, whichcould impact the ratings of our securities.

 

36

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Table 9.

** **

**InvestmentSecurities**

At September 30,2007 and December 31, 2006

(In thousands)

 
| ** **                                     | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at September 30, 2007**   | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies             |       |          |       |      |       |        |       |
| One to five years                              |       | $             | 111,979    |      | $          | 111,939     |       | 4.59 | % |
| Five to ten years                              |       | 45,660        |       | 46,098    |       | 6.03        |       |
| Total U.S. government-sponsored agencies       |       | 157,639       |       | 158,037   |       | 5.01        |       |
|                                           |       |          |       |      |       |        |       |
| Mortgage-backed securities*                    |       |          |       |      |       |        |       |
| One to five years                              |       | 3,736         |       | 3,673     |       | 4.23        |       |
| Five to ten years                              |       | 11,846        |       | 11,599    |       | 3.85        |       |
| After ten years                                |       | 141,233       |       | 138,943   |       | 5.06        |       |
| Total mortgage-backed securities               |       | 156,815       |       | 154,215   |       | 4.95        |       |
|                                           |       |          |       |      |       |        |       |
| Municipal securities                           |       |          |       |      |       |        |       |
| After ten years                                |       | 31,596        |       | 30,665    |       | 4.08        |       |
| Total municipal securities                     |       | 31,596        |       | 30,665    |       | 4.08        |       |
|                                           |       |          |       |      |       |        |       |
| U. S. treasury securities                      |       |          |       |      |       |        |       |
| One to five years                              |       | 598           |       | 600       |       | 5.06        |       |
| Total U.S. treasury securities                 |       | 598           |       | 600       |       | 5.06        |       |
| Total investment securities available-for-sale |       | $             | 346,648    |      | $          | 343,517     |       | 4.90 | % |

 
| ** **                                   | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|----------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Held-to-maturity at September 30, 2007**   | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies           |       |          |       |      |       |        |       |
| One to five years                            |       | $             | 6,967      |      | $          | 6,872       |       | 3.64 | % |
| Five to ten years                            |       | 11,012        |       | 10,912    |       | 4.50        |       |
| After ten years                              |       | 2,000         |       | 1,989     |       | 5.27        |       |
| Total U.S. government-sponsored agencies     |       | 19,979        |       | 19,773    |       | 4.28        |       |
|                                         |       |          |       |      |       |        |       |
| Mortgage-backed securities*                  |       |          |       |      |       |        |       |
| Five to ten years                            |       | 6,357         |       | 6,234     |       | 4.18        |       |
| After ten years                              |       | 48,400        |       | 47,535    |       | 4.44        |       |
| Total mortgage-backed securities             |       | 54,757        |       | 53,769    |       | 4.41        |       |
|                                         |       |          |       |      |       |        |       |
| Corporate bonds                              |       |          |       |      |       |        |       |
| After ten years                              |       | 8,004         |       | 7,884     |       | 4.21        |       |
| Total corporate bonds                        |       | 8,004         |       | 7,884     |       | 4.21        |       |
| Total investment securities held-to-maturity |       | 82,740        |       | 81,426    |       | 4.36        |       |
| Total investment securities                  |       | $             | 429,388    |      | $          | 424,943     |       | 4.79 | % |

 

37

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| ** **                                     | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|------------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Available-for-sale at December 31, 2006**    | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies             |       |          |       |      |       |        |       |
| One to five years                              |       | $             | 51,973     |      | $          | 51,517      |       | 4.90 | % |
| Five to ten years                              |       | 15,520        |       | 15,480    |       | 5.72        |       |
| Total U.S. government-sponsored agencies       |       | 67,493        |       | 66,997    |       | 5.09        |       |
|                                           |       |          |       |      |       |        |       |
| Mortgage-backed securities*                    |       |          |       |      |       |        |       |
| One to five years                              |       | 4,406         |       | 4,312     |       | 4.18        |       |
| Five to ten years                              |       | 10,599        |       | 10,291    |       | 3.76        |       |
| After ten years                                |       | 127,197       |       | 124,511   |       | 4.76        |       |
| Total mortgage-backed securities               |       | 142,202       |       | 139,114   |       | 4.67        |       |
|                                           |       |          |       |      |       |        |       |
| Municipal securities                           |       |          |       |      |       |        |       |
| After ten years                                |       | 25,047        |       | 25,031    |       | 4.10        |       |
| Total municipal securities                     |       | 25,047        |       | 25,031    |       | 4.10        |       |
|                                           |       |          |       |      |       |        |       |
| U. S. treasury securities                      |       |          |       |      |       |        |       |
| One to five years                              |       | 489           |       | 489       |       | 5.14        |       |
| Total U.S. treasury securities                 |       | 489           |       | 489       |       | 5.14        |       |
| Total investment securities available-for-sale |       | $             | 235,231    |      | $          | 231,631     |       | 4.73 | % |

 
| ** **                                   | ** ** | **Amortized** | ** ** | **Fair**  | ** ** | **Average** | ** ** |
|----------------------------------------------|------------|---------------|------------|-----------|------------|-------------|------------|
| **Held-to-maturity at December 31, 2006**    | ** ** | **Cost**      | ** ** | **Value** | ** ** | **Yield**   | ** ** |
| U.S. government-sponsored agencies           |       |          |       |      |       |        |       |
| One to five years                            |       | $             | 8,967      |      | $          | 8,734       |       | 3.50 | % |
| Five to ten years                            |       | 13,018        |       | 12,777    |       | 4.44        |       |
| After ten years                              |       | 2,000         |       | 1,971     |       | 5.30        |       |
| Total U.S. government-sponsored agencies     |       | 23,985        |       | 23,482    |       | 4.16        |       |
|                                         |       |          |       |      |       |        |       |
| Mortgage-backed securities*                  |       |          |       |      |       |        |       |
| Five to ten years                            |       | 6,702         |       | 6,544     |       | 4.21        |       |
| After ten years                              |       | 58,974        |       | 57,560    |       | 4.35        |       |
| Total mortgage-backed securities             |       | 65,676        |       | 64,104    |       | 4.34        |       |
|                                         |       |          |       |      |       |        |       |
| Corporate bonds                              |       |          |       |      |       |        |       |
| After ten years                              |       | 8,004         |       | 7,864     |       | 4.21        |       |
| Total corporate bonds                        |       | 8,004         |       | 7,864     |       | 4.21        |       |
| Total investment securities held-to-maturity |       | 97,665        |       | 95,450    |       | 4.28        |       |
| Total investment securities                  |       | $             | 332,896    |      | $          | 327,081     |       | 4.60 | % |

----

* Based oncontractual maturities

 

 

38

----

 

 

*Loans*

 

Loans receivable, net ofdeferred fees and costs, increased by $128.1 million, or 15%, to $973.5 millionat September 30, 2007 from $845.4 million at December 31, 2006. See Table10 for details on the loans receivable portfolio. We experienced growth in allof our loan types within our loan portfolio. We expect continued growth for theremainder of 2007 due to our increased legal lending limit of $23.4 million atSeptember 30, 2007 and the volume of loans we have scheduled for funding.  In addition, we had $144.4 million in loansheld for sale, net at September 30, 2007, compared to $338.7 million atDecember 31, 2006, a decrease of $194.3 million. Loans that are held forsale, net are valued at the lower of cost or market value. The decrease inloans held for sale at September 30, 2007 compared to December 31, 2006 is dueto decreased loan origination volume as a result of the slowdown in theregional housing market and tightening credit conditions within the mortgageindustry.

 

Table10.

** **

**LoansReceivable**

At September 30, 2007 andDecember 31, 2006

(In thousands)

 
| ** **                      | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
|                            |       |                   |       |                  |       |   |   |   |   |
| Commercial and industrial       |       | $                      | 107,059    |                  | 10.99      | % | $ | 102,284 |   | 12.09 | % |
| Real estate - commercial        |       | 398,364                |       | 40.91                 |       | 317,201 |   | 37.50 |   |
| Real estate - construction      |       | 179,438                |       | 18.43                 |       | 154,525 |   | 18.27 |   |
| Real estate - residential       |       | 205,681                |       | 21.12                 |       | 201,320 |   | 23.80 |   |
| Home equity lines               |       | 75,098                 |       | 7.71                  |       | 65,557 |   | 7.75 |   |
| Consumer                        |       | 8,221                  |       | 0.84                  |       | 4,904 |   | 0.59 |   |
|                            |       |                   |       |                  |       |   |   |   |   |
| Gross loans                     |       | $                      | 973,861    |                  | 100.00     | % | $ | 845,791 |   | 100.00 | % |
|                            |       |                   |       |                  |       |   |   |   |   |
| Net deferred (fees) costs       |       | (343                   | )          |                  |       | (342 | ) |   |   |
| Less: allowance for loan losses |       | (10,857                | )          |                  |       | (9,638 | ) |   |   |
|                            |       |                   |       |                  |       |   |   |   |   |
| Loans receivable, net           |       | $                      | 962,661    |                  |       |   | $ | 835,811 |   |   |   |

 

 

*Deposits*

 

Total depositswere $1.14 billion at September 30, 2007 compared to $1.22 billion atDecember 31, 2006. We experienced increases in our non-interest bearingchecking and savings products and decreases in our interest checking, moneymarket and certificates of deposit products. The overall decrease in totaldeposits was primarily a result of losing high cost deposit balances to certaincustomers who were looking for increased yields on their funds.  As we saw our liquidity increase during thethird quarter due to the large decrease in loans held for sale originations, wechose not to set premium tier pricing for our deposit products.  See Table 11 for details on certificates ofdeposit with balances of $100,000 or more. Our savings deposits continue toincrease as a result of our Simply Savings product, which allows new customersto earn a yield of 4.51% on funds deposited with us.  We had brokered certificates of deposit of$10.0 million and $5.0 million at September 30, 2007 and December 31,2006, respectively.

 

Table11.

** **

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

At September 30, 2007

(In thousands)

 

 
| **Maturities:**                       | ** ** | **Fixed Term** | ** ** | **No-Penalty*** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|
| Three months or less                  |       | $              | 95,711     |            | $          | 12,908    |       | $ | 108,619 |   |
| Over three months through six months  |       | 51,525         |       | 11,582          |       | 63,107    |       |
| Over six months through twelve months |       | 20,451         |       | 10,960          |       | 31,411    |       |
| Over twelve months                    |       | 19,446         |       | 435             |       | 19,881    |       |
|                                  |       | $              | 187,133    |            | $          | 35,885    |       | $ | 223,018 |   |

----

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

 

39

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*Borrowings*

 

Other borrowed fundsincreased $127.8 million to $322.4 million at September 30, 2007, compared to$194.6 million at December 31, 2006. Treasury, Tax & Loan Note optionborrowings increased $9.0 million to $14.0 million at September 30, 2007compared to $5.0 million at December 31, 2006.  FHLB advances increased $76.9 million to$200.0 million at September 30, 2007 compared to $122.7 million at December 31,2006. Customer repurchase agreements increased $11.4 million to $57.8 millionat September 30, 2007 compared to $46.3 million at December 31, 2006.  In addition, we had federal funds purchasedof $10.0 million at September 30, 2007 compared to none at December 31,2006.  Broker dealer repurchaseagreements were $20.5 million at September 30, 2007 compared to none atDecember 31, 2006.  The overall increasein our other borrowed funds was a result of the funding needed to support thegrowth in our loans receivable and investment securities portfolios during2007.  Table 12 provides information onour borrowings.

 

Table12.

** **

**Short-TermBorrowings and Other Borrowed Funds**

At September 30, 2007

(In thousands)

** **
| **Short-term FHLB advances:**                                        | ** ** | ** **          | ** ** | **Maturity or** | ** **  | ** **        | ** ** | **Amount**      | ** ** |
|----------------------------------------------------------------------|------------|---------------------|------------|-----------------|-------------|-------------------|------------|-----------------|------------|
| **Advance Date**                                                     | ** ** | **Term of Advance** | ** ** | **Call Date**   | ** **  | **Interest Rate** | ** ** | **Outstanding** | ** ** |
| Dec-04                                                               |       | 3 years             |       | Dec-07          |        | 3.59              | %          | 7,500           |       |
| Sep-07                                                               |       | 5 years             |       | Mar-08          |        | 3.75              |       | 5,000           |       |
| Apr-05                                                               |       | 3 year              |       | Apr-08          |        | 4.31              |       | 5,000           |       |
| Apr-05                                                               |       | 3 year              |       | Apr-08          |        | 4.08              |       | 5,000           |       |
| Jul-03                                                               |       | 5 years             |       | Jul-08          |        | 2.29              |       | 2,083           |       |
| **Total short-term FHLB advances and weighted  average rate**        | ** ** | **3.76**            | **%**      | **$**           | **24,583**  | ** **        |
| ** **                                                           | ** ** | ** **          | ** ** | ** **      | ** **  | ** **        | ** ** | ** **      | ** ** |
| **Other short-term borrowed funds:**                                 | ** ** | ** **          | ** ** | ** **      | ** **  |
| TT&L Note option                                                 |       |                |       |            |        | 4.21              | %          | $               | 13,955     |   |
| Customer repurchase agreements                                       |       | 2.92                |       | 57,751          |        |
| Federal Funds Purchased                                              |       | 5.36                |       | 10,000          |        |
| Broker dealer repurchase agreements                                  |       | 5.37                |       | 20,480          |        |
| **Total other short-term borrowed funds and  weighted average rate** | ** ** | **3.83**            | **%**      | **$**           | **102,186** |              |
| ** **                                                           | ** ** | ** **          | ** ** | ** **      | ** **  | ** **        | ** ** | ** **      | ** ** |
| **Other  borrowed funds:**                                           | ** ** | ** **          | ** ** | ** **      | ** **  | ** **        | ** ** | ** **      | ** ** |
| Trust preferred                                                      |       |                |       |            |        | 7.88              | %          | $               | 20,619     |   |
| FHLB advances -  long term                                           |       |                |       |            |        | 4.37              |       | 175,000         |       |
| **Other borrowed funds and weighted average rate**                   | ** ** | **4.74**            | **%**      | **$**           | **195,619** | ** **        |
| ** **                                                           | ** ** | ** **          | ** ** | ** **      | ** **  | ** **        | ** ** | ** **      | ** ** |
| **Total other borrowed funds and weighted average  rate**            | ** ** | **4.38**            | **%**      | **$**           | **322,388** | ** **        |

 

 

**               **At September 30, 2007,mortgage funding checks decreased by $28.4 million to $17.8 million, comparedto $46.2 million at December 31, 2006. These liabilities are related toGeorge Mason and are used to fund the loans in process of being sold.

 

** **

**40**

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** **

 

*Shareholders’ Equity*

 

Shareholders’ equity atSeptember 30, 2007 was $156.1 million, an increase of $188,000, compared to$155.9 million at December 31, 2006. The increase in shareholders’ equitywas a result of accumulated net income over the past nine months of 2007.  During the second quarter of 2007, weinitiated our share repurchase plan and acquired 223,740 shares of our commonstock for a cost of $2.2 million, which offset most of the increase seen inretained earnings.  Accumulated losses inother comprehensive income for the nine months ended September 30, 2007 were$2.4 million compared to $2.3 million at December 31, 2006.  Book value per share at September 30, 2007was $6.43 compared to $6.37 at December 31, 2006. Tangible book value pershare (which is book value per share adjusted for changes in othercomprehensive income, less goodwill and other intangible assets) at September30, 2007 was $5.82 compared to $5.75 at December 31, 2006.

 

##### **Business Segment Operations**

 

We provide banking andnon-banking financial services and products through our subsidiaries. Weoperate in three business segments, commercial banking, mortgage banking andwealth management and trust services.

 

*Commercial Banking*

 

The Commercial Bankingsegment includes both commercial and consumer lending and provides customerssuch products as commercial loans, real estate loans, and other businessfinancing and consumer loans. In addition, this segment also provides customerswith various deposit products including demand deposit accounts, savingsaccounts and certificates of deposit.

 

For the three months endedSeptember 30, 2007, the Commercial Banking segment recorded net income of $1.8million compared to $2.2 million for the same period of 2006, a decrease of$394,000. For the nine months ended September 30, 2007, the Commercial Bankingsegment recorded net income of $5.4 million compared to $7.2 million for thesame nine month period of 2006.  Thedecreases in net income are primarily related to decreases in net interestmargin and increases in our provision for loan losses as a result of acharge-off of one nonaccrual loan totaling $417,000 during the third quarter of2007 and the overall net new loan growth during 2007.  Provision for loan losses increased $685,000to $915,000 for the three months ended September 30, 2007 compared to $230,000for the three months ended September 30, 2006. For the nine months ended September 30, 2007 and 2006, provision forloan losses was $1.7 million and $870,000, respectively.   In addition, non-interest expense hasincreased as a result of both the branch expansion that has occurred over thepast twelve months and the increase in our FDIC insurance premiums resultingfrom the change in the assessment calculation as part of the deposit insurancereform during 2007.  At September 30,2007, total assets for this segment were $1.64 billion, loans receivable, netof deferred fees and costs, were $973.5 million and total deposits were $1.14billion. At September 30, 2006, total assets were $1.48 billion, loansreceivable, net of deferred fees and costs, were $806.6 million and totaldeposits were $1.18 billion.

 

*Mortgage Banking*

 

The operations of theMortgage Banking segment are conducted through George Mason. George Masonengages primarily in the origination and acquisition of residential mortgagesfor sale into the secondary market on a best efforts basis.

 

 

 

41

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For the three months endedSeptember 30, 2007 and 2006, the Mortgage Banking segment recorded net incomeof $429,000 and $547,000, respectively. Year-to-date net income throughSeptember 30, 2007 was $1.5 million compared to $1.6 million for the same ninemonth period of 2006.  The decrease innet income is attributable to decreases in net interest income and non-interestincome due to decreased loan volume over the comparable periods offset bydecreases in non-interest expense. Non-interest expense decreased $2.6 million, or 22%, to $9.0 million forthe nine months ended September 30, 2007 compared to $11.6 million for the samenine month period of 2006.  At September30, 2007, total assets for this segment were $163.9 million; loans held forsale, net were $144.4 million and mortgage funding checks were $17.8 million.At September 30, 2006, total assets were $273.1 million; loans held for sale,net were $258.1 million and mortgage funding checks were $45.4 million.

 

*WealthManagement and Trust Services*

 

The Wealth Management andTrust Services segment provides investment and financial services to businessand individuals, including financial planning, retirement/estate planning,trusts, estates, custody, investment management, escrows, and retirement plans.Operations of the Bank’s trust division is included in this operating segmentsince the date we acquired certain fiduciary and other assets and assumedcertain liabilities on February 9, 2006.

 

For each of the three monthperiods ended September 30, 2007 and 2006, the Wealth Management and TrustServices segment recorded a net loss of $2.0 million. For the nine months endedSeptember 30, 2007, the net loss for this business segment was $1.7 million,compared to a net loss of $2.0 million for the same nine month period of2006.  The losses recorded were primarilya result of the aforementioned loss on the escrow arrangement during the thirdquarter of 2007 and the impairment charges recorded during the third quarter of2006.  For the three months endedSeptember 30, 2007 and 2006, non-interest income was $1.1 million and $849,000,respectively.  For the nine months endedSeptember 30, 2007 and 2006, non-interest income was $3.2 million and $2.5million, respectively.  The increases innon-interest income are primarily attributable to the trust division whoseoperations are included for the full three and nine months ended September 30,2007.  At September 30, 2007, totalassets were $4.2 million and managed and custodial assets were $6.2 billion. AtSeptember 30, 2006, total assets for this segment were $5.5 million and managedand custodial assets were $5.9 billion.

 

Information pertaining toour business segments can be found in Note 4 to the Notes to ConsolidatedFinancial Statements.

 

## **CapitalResources**

 

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

 

Regulatory agencies measurecapital adequacy utilizing a formula that takes into account the individualrisk profile of the financial institution. The guidelines define capital asboth Tier 1 (which includes common shareholders’ equity, defined to includecertain debt obligations) and Tier 2 (which includes certain other debtobligations, a portion of the allowance for loan losses, and 45% of anyunrealized gains in equity securities).

 

At September 30, 2007, ourTier 1 and total (Tier 1 and Tier 2) risk-based capital ratios were 12.49% and13.34%, respectively. At December 31, 2006, our Tier 1 and totalrisk-based

 

 

42

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capital ratios were 13.25% and 14.06%,respectively.  Our regulatory capitallevels for the Bank and bank holding company meet those established forwell-capitalized institutions. Table 13 provides additional informationpertaining to our capital ratios.

 

Table13.

** **

**CapitalComponents**

At September 30, 2007 andDecember 31, 2006

(In thousands)

 
| ** **                                                      | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **To Be Well**        | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| **Cardinal Financial Corporation**                              | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(Consolidated):**                                             | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** |
| **At September 30, 2007**                                       |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| Total risk-based capital/ Total capital to risk-weighted assets |       | $          | 171,944    |                  | 13.34      | %                     | $          | 103,088               | >  | 8.00                  | %          | $ | 128,860 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to risk-weighted assets          |       | 160,904    |       | 12.49                 | %          | 51,544                | >  | 4.00                  | %          | 77,316                | >  | 6.00 | % |
| Tier I capital/ Total capital to average assets                 |       | 160,904    |       | 9.80                  | %          | 65,684                | >  | 4.00                  | %          | 82,105                | >  | 5.00 | % |
|                                                            |       |       |       |                  |       |                  |       |                  |       |                  |       |   |   |
| **At December 31, 2006**                                        | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Total risk-based capital/ Total capital to risk-weighted assets |       | $          | 170,457    |                  | 14.06      | %                     | $          | 97,010                | >  | 8.00                  | %          | $ | 121,263 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to risk-weighted assets          |       | 160,656    |       | 13.25                 | %          | 48,505                | >  | 4.00                  | %          | 72,758                | >  | 6.00 | % |
| Tier I capital/ Total capital to average assets                 |       | 160,656    |       | 10.68                 | %          | 60,180                | >  | 4.00                  | %          | 75,225                | >  | 5.00 | % |

 
| ** **                                                      | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                               | ** ** | **To Be Well  Capitalized Under** | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------------------------------|------------|------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                      | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **Prompt Corrective  Action Provisions** | ** ** |
| **Cardinal Bank:**                                              | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                               | ** ** | **Ratio**                         | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **At September 30, 2007**                                       |       |       |       |                               |       |                                     |       |                              |       |   |   |   |   |
| Total risk-based capital/ Total capital to risk-weighted assets |       | $          | 155,816    |                               | 12.12      | %                                        | $          | 102,824                           | >  | 8.00 | % | $ | 128,531 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to risk-weighted assets          |       | 144,776    |       | 11.26                              | %          | 51,412                                   | >  | 4.00                              | %          | 77,118 | >  | 6.00 | % |
| Tier I capital/ Total capital to average assets                 |       | 144,776    |       | 8.83                               |       | 65,590                                   | >  | 4.00                              | %          | 81,988 | >  | 5.00 | % |
|                                                            |       |       |       |                               |       |                                     |       |                              |       |   |   |   |   |
| **At December 31, 2006**                                        | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                               | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total risk-based capital/ Total capital to risk-weighted assets |       | $          | 141,885    |                               | 11.73      | %                                        | $          | 96,742                            | >  | 8.00 | % | $ | 120,927 | >  | 10.00 | % |
| Tier I capital/ Tier I capital to risk-weighted assets          |       | 132,084    |       | 10.92                              | %          | 48,371                                   | >  | 4.00                              | %          | 72,556 | >  | 6.00 | % |
| Tier I capital/ Total capital to average assets                 |       | 132,084    |       | 8.80                               | %          | 60,038                                   | >  | 4.00                              | %          | 75,048 | >  | 5.00 | % |
|                                                                 |            |            |            |                                    |            |                                          |            |                                   |            |  |  |  |  |  |  |  |  |  |

 

 

43

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**Contractual Obligations**

 

                We have enteredinto a number of long-term contractual obligations to support our ongoingbusiness activities. These contractual obligations will be funded throughoperating revenues and liquidity sources held or available to us. The requiredpayments under such obligations are detailed in Table 14.

 

Table14.

** **

**ContractualObligations**

At September 30, 2007

(In thousands)

 
| ** **                                          | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------|------------|
| ** **                                          | ** ** | **Total**  | ** ** | **Less than  1 Year**      | ** ** | **1 - 2 Years** | ** ** | **3 - 5 Years** | ** ** | **More than  5 Years** | ** ** |
| Certificates of deposit                             |       | $          | 475,790    |                       | $          | 427,835 |   | $ | 32,479 |   | $ | 15,476 |   | $ | — |   |
|                                                |       |       |       |                       |       |   |   |   |   |   |   |
| Brokered certificates of deposit                    |       | 9,950      |       | 4,995                      |       | — |   | 4,955 |   | — |   |
|                                                |       |       |       |                       |       |   |   |   |   |   |   |
| Advances from the Federal Home Loan Bank of Atlanta |       | 199,583    |       | 24,583                     |       | — |   | 55,000 |   | 120,000 |   |
|                                                |       |       |       |                       |       |   |   |   |   |   |   |
| Trust preferred securities                          |       | 20,619     |       | —                     |       | — |   | — |   | 20,619 |   |
|                                                |       |       |       |                       |       |   |   |   |   |   |   |
| Operating lease obligations                         |       | 19,734     |       | 4,826                      |       | 4,475 |   | 6,227 |   | 4,206 |   |
| Total                                               |       | $          | 725,676    |                       | $          | 462,239 |   | $ | 36,954 |   | $ | 81,658 |   | $ | 144,825 |   |

 

 

**Commitments and Contingencies**

 

In the normal course ofbusiness, we are a party to financial instruments with off-balance sheet riskto meet the financing needs of our customers. These financial instrumentsinclude commitments to extend credit and standby letters of credit. Theseinstruments represent our obligation to extend credit or guarantee borrowingsthat are not recorded on the consolidated statements of financialcondition.  The rates and terms of theseinstruments are competitive with others in the market in which we operate.  The instruments involve, to varying degrees,elements of credit and interest rate risk in excess of the amount recognized inthe consolidated statements of financial condition.

 

The Bank’s maximum exposureto credit loss in the event of nonperformance by the other party to thefinancial instrument for commitments to extend credit and standby letters ofcredit is represented by the contractual amount of those instruments. The Bankuses the same credit policies in making commitments and conditional obligationsas it does for on-balance sheet instruments.

 

At September 30, 2007,commitments to extend credit were $339.9 million and standby letters of creditwere $10.1 million. The fair value of the liability associated with standbyletters of credit at September 30, 2007 was immaterial.

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the agreement. Commitments generally have expirationdates or other termination clauses and may require payment of a fee. Since manyof the commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future funding requirements. Weevaluate each customer’s credit worthiness on a case-by-case basis and requirecollateral to support financial instruments when deemed necessary. The amountof collateral obtained upon extension of credit is based on management’s creditevaluation of the counterparty. Collateral held varies but may include accountsreceivable, inventory, property and equipment, and income-producing commercialproperties.

 

Standby letters of creditare conditional commitments we issued to guarantee the performance of thecontractual obligations by a customer to a third party. Those guarantees areprimarily issued to support public and private borrowing arrangements,including commercial paper, bond financing, and similar transactions. Thecredit risk involved in issuing standby letters

 

44

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of credit is essentially the same as thatinvolved in extending loan facilities to customers. We hold certificates ofdeposit, deposit accounts, real estate or other appropriate forms of collateralsupporting those commitments when collateral is deemed necessary.  The majority of these guarantees extend untilsatisfactory completion of the customer’s contractual obligations.

 

George Mason maintains areserve for loans sold that pay off earlier than the contractual agreed uponperiod, thereby requiring that George Mason refund part of the service releasepremium and/or premium pricing received from the investor.  The reserve as of September 30, 2007 was$47,000.

 

We have counter-party riskthat may arise from the possible inability of George Mason’s third partyinvestors to meet the terms of their forward sales contracts.  George Mason works with third-party investorsthat are generally well-capitalized, are investment grade and exhibit strongfinancial performance to mitigate this risk. To date, none of our investors have failed to meet its obligations, nordo we expect any third-party investor to fail to meet its obligation.

 

## **Liquidity**

 

Liquidity in the bankingindustry is defined as the ability to meet the demand for funds of bothdepositors and borrowers. We must be able to meet these needs by obtainingfunding from depositors or other lenders or by converting non-cash items intocash.  The objective of our liquiditymanagement program is to ensure that we always have sufficient resources tomeet the demands of our depositors and borrowers. Stable core deposits and astrong capital position provide the base for our liquidity position. We believewe have demonstrated our ability to attract deposits because of our convenientbranch locations, personal service and pricing.

 

In addition to deposits, wehave access to various wholesale funding markets. These markets include thebrokered CD market, the repurchase agreement market and the federal fundsmarket. We also maintain secured lines of credit with the Federal Reserve Bankof Richmond and the Federal Home Loan Bank of Atlanta. Having diverse fundingalternatives reduces our reliance on any one source for funding.

 

Cash flow from amortizingassets or maturing assets can also provide funding to meet the needs ofdepositors and borrowers.

 

We have established a formalliquidity contingency plan which establishes a liquidity management team andprovides guidelines for liquidity management. For our liquidity managementprogram, we first determine our current liquidity position and then forecastliquidity based on anticipated changes in the balance sheet. In this forecast,we expect to maintain a liquidity cushion. We also stress test our liquidityposition under several different stress scenarios. Guidelines for theforecasted liquidity cushion and for liquidity cushions for each stressscenario have been established. In addition, one stress test combines all otherstress tests to see how liquidity would react to several negative scenariosoccurring at the same time. We believe that we have sufficient resources tomeet our liquidity needs.

 

In October 2007, GeorgeMason and the Bank cancelled its one year $150 million floating rate revolvingcredit and security agreement with a third party. The purpose of this creditfacility was to fund residential mortgage loans made by George Mason prior totheir sale into the secondary market. However, we determined that as a resultof the limited use of this credit facility and the available liquidity at theBank, this credit facility was no longer needed.  At September 30, 2007, none of this line wasutilized.

 

 

45

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In addition to thisfacility, this same lender had also provided a $100 million facility that wasutilized by George Mason to warehouse residential mortgage loans held for saleto this lender. Again, this credit facility was cancelled in October 2007 as aresult of the limited use by George Mason of this facility and the availableliquidity at the Bank.

 

Liquid assets, which includecash and due from banks, federal funds sold and investment securities availablefor sale, totaled $387.1 million at September 30, 2007 or 23% of total assets.We held investments that are classified as held-to-maturity in the amount of$82.7 million at September 30, 2007. To maintain ready access to the Bank’ssecured lines of credit, the Bank has pledged the majority of its investmentsecurities to the Federal Home Loan Bank of Atlanta with additional investmentsecurities pledged to the Federal Reserve Bank of Richmond. Additionalborrowing capacity at the Federal Home Loan Bank of Atlanta at September 30,2007 was $151.9 million. Borrowing capacity with the Federal Reserve Bank ofRichmond was $12.7 million at September 30, 2007. We anticipate maintainingliquidity at a level sufficient to protect depositors, provide for reasonablegrowth and fully comply with all regulatory requirements.

 

##### **Interest Rate Sensitivity**

 

                Weare exposed to various business risks including interest rate risk. Our goal isto maximize net interest income without incurring excessive interest rate risk.Management of net interest income and interest rate risk must be consistentwith the level of capital and liquidity that we maintain. We manage interestrate risk through an asset and liability committee (“ALCO”). ALCO isresponsible for managing the interest rate risk in conjunction with liquidityand capital management.

 

We employ an independentconsulting firm to model our interest rate sensitivity.  We use a net interest income simulation modelas our primary tool to measure interest rate sensitivity. Many assumptions aredeveloped based on expected activity in the balance sheet. For maturing assets,assumptions are created for the redeployment of these assets. For maturingliabilities, assumptions are developed for the replacement of these fundingsources. Assumptions are also developed for assets and liabilities that couldreprice during the modeled time period. These assumptions also cover how weexpect rates to change on non-maturity deposits such as NOW, Money Market,savings accounts and certificates of deposit. Based on inputs that include thecurrent balance sheet, the current level of interest rates and the developedassumptions, the model then produces an expected level of net interest incomeassuming that market rates remain unchanged. This is considered the base case.Next, the model determines what net interest income would be based on specificchanges in interest rates. The rate simulations are performed for a two yearperiod and include ramped rate changes of down 200 basis points and up 200basis points. In the ramped down rate change, the model moves rates graduallydown 200 basis points over the first year and then rates remain flat in thesecond year. For the up 200 basis point scenario, rates are gradually moved up200 basis points in the first year and then rates remain flat in the secondyear. In both the up and down scenarios, the model assumes a parallel shift inthe yield curve. The results of these simulations are then compared to the basecase.

 

At September 30, 2007, wewere liability sensitive for the entire two year simulation period.   Liability sensitive means that we had moreliabilities repricing than assets. We have more of our liabilities innon-maturity or short-term deposit products than we have in floating rateassets.  In a decreasing interest rateenvironment, net interest income would grow for a liability sensitivebank.  In the down 200 basis pointscenario, net interest income improves by not more than 10.8% for the one yearperiod and by not more than 13.9% over the two year time horizon.

 

 

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In the up 200 basis pointscenario, for a liability sensitive bank, net interest income should contractin a rising rate environment.  In the up200 basis point scenario, net interest income declines by not more than 6.2% inthe first year and declines by not more than 8.8% over the two year timehorizon.

 

**Item3.  Quantitative and QualitativeDisclosures 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. Interest rate risk arises because the assets of theBank and the liabilities of the Bank have different maturities andcharacteristics. In order to measure this interest rate risk, we use asimulation process that measures the impact of changing interest rates on netinterest income. This model is run for the Bank by an independent consultingfirm. The simulations incorporate assumptions related to expected activity inthe balance sheet. For maturing assets, assumptions are developed for theredeployment of these assets. For maturing liabilities, assumptions aredeveloped for the replacement of these funding sources. Assumptions are alsodeveloped for assets and liabilities that reprice during the modeled timeperiod. These assumptions also cover how we expect rates to change onnon-maturity deposits such as NOW, Money Market, savings accounts andcertificates of deposit. Based on inputs that include the most recent periodend balance sheet, the current level of interest rates and the developedassumptions, the model then produces an expected level of net interest incomeassuming that interest rates remain unchanged. This becomes the base case.Next, the model determines the impact on net interest income given specifiedchanges in interest rates. The rate simulations are performed for a two yearperiod and include ramped rate changes of down 200 basis points and up 200basis points. In the ramped down rate change, the model moves rates graduallydown 200 basis points over the first year and then rates remain flat in thesecond year. For the up 200 basis point scenario, rates are gradually increasedby 200 basis points in the first year and remain flat in the second year. Inboth the up and down scenarios, the model assumes a parallel shift in the yieldcurve. The results of these simulations are then compared to the base case.

 

At September 30, 2007, wewere liability sensitive for the entire two year simulation period.   Liability sensitive means that we had moreliabilities repricing than assets. We have more of our liabilities innon-maturity or short-term deposit products than we have in floating rateassets.  In a decreasing interest rateenvironment, net interest income would grow for a liability sensitivebank.  In the down 200 basis pointscenario, net interest income improves by not more than 10.8% for the one yearperiod and by not more than 13.9% over the two year time horizon.  In the up 200 basis point scenario, for aliability sensitive bank, net interest income should contract in a rising rateenvironment.  In the up 200 basis pointscenario, net interest income declines by not more than 6.2% in the first yearand declines by not more than 8.8% over the two year time horizon.

 

                Seealso “Interest Rate Sensitivity” in Item 2 above for a discussion of ourinterest rate risk.

 

 

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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. Therewere no changes in our internal control over financial reporting identified inconnection with our evaluation of it that occurred during our last fiscalquarter that materially affected, or are likely to materially affect, ourinternal control over financial reporting.

 

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**PART II — OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

In the ordinary course ofour operations, we may become party to legal proceedings.

 

On August 9, 2007, the Company filed a complaint against defendantsPhilip A. Seifert and Liberty Growth Fund, LP in the Circuit Court of FairfaxCounty, Virginia.  Additional informationon this proceeding, including the underlying facts, is set forth in Note 11 tothe consolidated financial statements and incorporated by reference into thisItem 1.

 

 

**Item1A.  Risk Factors**

 

Our operations aresubject to many risks that could adversely affect our future financialcondition and performance and, therefore, the market value of oursecurities.  The risk factors that areapplicable to us are outlined in our Annual Report on Form 10-K for the yearended December 31, 2006.  These riskfactors have not changed as of the date of this report.

 

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

 

(a)  None.

(b)  Notapplicable.

(c)  We did notpurchase any shares of our common stock during the three months ended September30, 2007.

 

**Item 3.  Defaults Upon Senior Securities**

 

(a)  None.

(b)  None.

 

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

 

(a)  None.

(b)  Notapplicable.

(c)  None.

(d)  None.

 

**Item 5.  Other Information**

 

(a)         On November 7, 2007, weentered into an Executive Employment Agreement with Kendal E. Carson, whoserves as our President and is Senior Executive Vice President of CardinalBank.  The initial term of his agreement, which is retroactively effectiveas of March 6, 2006, is three years commencing on that date, and the agreementautomatically renews for successive one year periods up until March 6,2011.  The agreement provides for an annual base salary, and he iseligible for an annual merit increase, performance bonus and stock optiongrants on the same basis as similarly situated executive officers of theCompany.   Mr. Carson may also receive severance paymentsin the event of a change in control of us or a termination ofhis employment by us for reasons other than cause, as provided in theagreement.  The agreement contains non-competition and non-solicitationcovenants.  A copy of Mr. Carson’s employment agreement is attached asExhibit 10.1 to this Form 10-Q and is incorporated by reference into this Item5.

 

Mr.Carson also participates in our supplemental executive retirement plan,effective as of June 5, 2007. Upon retirement at age 65 and based onhis period of service with us, Mr. Carson will be entitled to an annualretirement benefit as provided in the agreement.  Thebenefits in the plan vest incrementally based on his years of service tous.   A copy of the Supplemental Executive Retirement Plan that weentered into with Mr. Carson on November 7, 2007 is attached as Exhibit 10.2 tothis Form 10-Q and is incorporated by reference into this Item 5.

 

(b)  None.

 

**Item 6.  Exhibits**

 

| 10.1   |   | Executive Employment  Agreement, dated November 7, 2007, between Cardinal Financial Corporation and  Kendal E. Carson.        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                          |
| 10.2   |   | Supplemental Executive  Retirement Plan, dated November 7, 2007, between Cardinal Financial  Corporation and Kendal E. Carson |
|   |   |                                                                                                                          |
| 31.1   |   | Rule 13a-14(a)  Certification of Chief Executive Officer                                                                      |
|   |   |                                                                                                                          |
| 31.2   |   | Rule 13a-14(a)  Certification of Chief Financial Officer                                                                      |
|   |   |                                                                                                                          |
| 32.1   |   | Statement of Chief  Executive Officer Pursuant to 18 U.S.C. Section 1350                                                      |
|   |   |                                                                                                                          |
| 32.2   |   | Statement of Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350                                                      |

 

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**SIGNATURES**

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** **

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

** **
| ** **                 | **CARDINAL FINANCIAL CORPORATION**                | ** ** |
|----------------------------|---------------------------------------------------|------------|
| ** **                 | **(Registrant)**                                  | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| **Date: November 8, 2007** | **/s/**Bernard H. Clineburg                       | ** ** |
| ** **                 | **Bernard H. Clineburg**                          | ** ** |
| ** **                 | **Chairman and Chief Executive  Officer**         | ** ** |
| ** **                 | **(Principal Executive Officer)**                 | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| **Date: November 8, 2007** | **/s/ Mark A. Wendel**                            | ** ** |
| ** **                 | **Mark A. Wendel**                                | ** ** |
| ** **                 | **Executive Vice President and  Chief Financial** | ** ** |
| ** **                 | **Officer (Principal Financial  Officer)**        | ** ** |
| ** **                 | **Mark A. Wendel**                                | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| ** **                 | ** **                                        | ** ** |
| **Date: November 8, 2007** | **/s/ Jennifer L. Deacon**                        | ** ** |
| ** **                 | **Jennifer L. Deacon**                            | ** ** |
| ** **                 | **Senior Vice President and  Controller**         | ** ** |
| ** **                 | **(Principal Accounting Officer)**                | ** ** |

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