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U.S. Securities and Exchange Commission

Washington, D. C. 20549



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FORM 10-K



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



OR



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



For the transition period from  to



|                    |  |                     
|------------------- |  | --------------------
|For the year ended: |  | Commission File No.:
|December 31, 2003   |  | 0-22836             



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SOUTHERN FINANCIAL BANCORP, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                           
|-------------------------------------------------------------- |  | ------------------------------------------
|Virginia                                                       |  | 54-1779978                                
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer or Identification Number)



37 East Main Street,
Warrenton, Virginia 20186

(Address of principal executive office) (Zip Code)



(540) 349-3900

(Registrants telephone number, including area code)



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Securities Registered Pursuant to Section 12(b) of the
Act: None



Securities Registered Pursuant to Section 12
(g) of the Act:



Common Stock, par value $0.01 per share

(Title of Class)



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Indicate by check mark whether the registrant (1)
has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.    Yes  x    No ̈



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



The aggregate market value of the Common Stock held by non-affiliates of the registrant computed by reference to the last
reported bid price of such stock as of March 1, 2004 was $298,523,379 (6,428,152 shares @ $46.44 per share). For purposes of this computation, it is assumed that directors, executive officers and persons beneficially owning more than 5% of the
Common Stock of the registrant are affiliates. As of March 1, 2004, there were 7,437,380 shares of the registrants Common Stock outstanding.



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No ̈



The aggregate market value of the Common Stock held by non-affiliates of the registrant computed by reference to the last
reported bid price of such stock as of June 30, 2003, was $120,557,418 (4,390,292 shares @ $27.46 per share). For purposes of this computation, it is assumed that directors, executive officers and persons beneficially owning more than 5% of the
Common Stock of the registrant are affiliates. As of June 30, 2003, there were 5,491,433 shares of the registrants Common Stock outstanding.



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##### Table of Contents

INDEX



|         |  |                                                                                      |  |        
|-------- |  | ------------------------------------------------------------------------------------ |  | -------
|         |  |                                                                                      |  | Page   
|PART I   |  |                                                                                     
|Item 1.  |  | Business                                                                             |  |        
|         |  | Overview                                                                             |  | 3 - 4  
|         |  | Lending Activities                                                                   |  | 4 - 10 
|         |  | Investment Activities                                                                |  | 11 - 13
|         |  | Deposits                                                                             |  | 13 - 14
|         |  | Borrowings                                                                           |  | 14 - 15
|         |  | Supervision and Regulation                                                           |  | 15 - 18
|         |  | Competition                                                                          |  | 18     
|         |  | Employees                                                                            |  | 18     
|         |  | Available Information                                                                |  | 19     
|Item 2.  |  | Properties                                                                           |  | 20 - 21
|Item 3.  |  | Legal Proceedings                                                                    |  | 22     
|Item 4.  |  | Submission of Matters to Vote of Security Holders                                    |  | 22     
|PART II  |  |                                                                                     
|Item 5.  |  | Market for Registrants Common Equity and Related Stockholder Matters                |  | 23     
|Item 6.  |  | Selected Financial Data                                                              |  | 24 - 26
|Item 7.  |  | Managements Discussion and Analysis                                                 |  | 26 - 39
|Item 7a. |  | Quantitative and Qualitative Disclosure about Market Risk                            |  | 34 - 37
|Item 8.  |  | Financial Statements                                                                 |  | 40 - 67
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |  | 67     
|Item 9a. |  | Controls and Procedures                                                              |  | 67     
|PART III |  |                                                                                     
|Item 10. |  | Directors and Executive Officers of the Registrant                                   |  | 68 - 70
|Item 11. |  | Executive Compensation                                                               |  | 71 - 77
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management                       |  | 78 - 79
|Item 13. |  | Certain Relationships and Related Transactions                                       |  | 80     
|Item 14. |  | Principal Accountant Fees and Services                                               |  | 80     
|PART IV  |  |                                                                                     
|Item 15. |  | Exhibits, Financial Statements, Schedules and Reports on Form 10-K                   |  | 81 - 82
|         |  | Signatures and Certifications                                                        |  | 83 - 88



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##### Table of Contents

Part I.



Item 1. Business



Overview



We were formed in 1995
as a bank holding company for Southern Financial Bank (the Bank), which was chartered in 1986. Our financial performance has been characterized by steady asset growth, consistent core earnings and sound asset quality. We have grown through a
combination of internal growth, the opening of de novo branches and the acquisition of community banks and branches in our market. We have established 16 branches and acquired one branch in the last 17 years. Three acquisitions, The Horizon Bank of
Virginia (Horizon) in October 1999, First Savings Bank of Virginia in September 2000, and Metro-County Bank of Virginia in August 2002 added $303.8 million in assets, provided us with eleven additional branch locations and enhanced our core deposit
base. We currently operate 28 full-service banking locations, 19 of which are located in the northern Virginia cities of Warrenton, Herndon, Middleburg, Winchester, Leesburg, Fairfax, Sterling, Woodbridge, Manassas and Fredericksburg. In August 2001
we opened our twentieth branch in Georgetown in the District of Columbia and, in January 2002 we opened a branch in Charlottesville, Virginia. The five branches acquired from Metro-County Bank are located in the Richmond area, and in February 2003
we opened a new branch in Charlottesville, Virginia. In November 2003 we opened a new branch in Richmond, Virginia.



We have expanded from our roots in Fairfax County, where we maintain eight branches and 50% of our transactional deposits, to encompass a market area
extending from Winchester in northwest Virginia to Richmond, approximately 150 miles to the southeast. This area has been characterized by high growth and general affluence. As its economy has diversified away from a concentration in government and
government-related employment, northern Virginia has developed into a major center for technology and telecommunications activities and has a high concentration of small to medium-sized businesses representing a diverse array of industries. In the
process, Reston, Herndon, Tysons Corner and Fairfax have become important stand alone employment centers similar to Stamford, Connecticut and White Plains, New York, which have flourished outside of New York City. As a result, the bedroom
communities supporting business clusters have pushed west to Loudoun and Fauquier Counties and south and west to Stafford, Spotsylvania and Prince William Counties. We also believe that the high growth and general affluence in certain of the
areas adjoining our current market area provide the same attractive expansion opportunities. In addition to the District of Columbia, we believe that Montgomery County, Maryland and the Richmond, Virginia area are also attractive targets. Upon the
opening of our branch in Charlottesville, our market area expands to include Albemarle, Greene and Fluvanna Counties, all of which have experienced rapid population growth in the last decade.



On August 14, 2002, Southern Financial acquired all the outstanding common
stock of Metro-County Bank of Virginia for 354,711 shares of Southern Financial common stock and cash in the amount of $6,841,584. The merger was accounted for in accordance with Statement of Financial Standards No. 141 (SFAS No. 141), Business
Combinations, and the results of operations of Metro-County Bank have been included in our consolidated financial statements from August 15, 2002. The excess of the purchase price over the fair value of the net identifiable assets acquired has been
recorded as goodwill in the amount of $9,439,408 and core deposit intangible assets in the amount of $2,400,000. The core deposit intangible assets are being amortized over ten years. The factors considered in the decision to acquire Metro-County
Bank included the opportunity for future growth and an expanded geographic presence, as the acquisition of Metro-Countys locations in the greater Richmond area is a natural extension of our geographic area and fits well into our expansion
plans.



On September 1, 2000, we acquired all the outstanding
common stock of First Savings Bank of Virginia for 409,906 shares of our common stock. The acquisition has been accounted for by the purchase method, and accordingly, the results of operations of First Savings Bank have been included in our
consolidated financial statements from September 1, 2000. Goodwill of $1,646,651 was recorded, which was being amortized through December 31, 2001 on a straight-line basis over 15 years along with a core deposit premium of $1,566,163, which is being
amortized over 10 years. In connection with our adoption of SFAS No. 142, Goodwill and Other Intangible Assets, beginning January 1, 2002, this goodwill will no longer be amortized.



On December 28, 1999, we formed Southern Financial Capital Trust I, a wholly-owned subsidiary, for the purpose of issuing
redeemable capital securities. On May 24, 2000, a $5 million offering of redeemable capital securities was completed, and on September 7, 2000, $8 million of trust preferred securities were issued through a pooled underwriting totaling approximately
$300 million. On April 10, 2003, $10 million of trust preferred securities were issued through a pooled underwriting.



On October 1,1999, we completed our merger with Horizon. The merger qualified as a tax-free exchange and was accounted for as a pooling of interests. We
issued .63 shares of our common stock for each share of Horizon stock outstanding. A total of 1,045,523 shares (after adjustment for fractional shares) of our common stock were issued as a result of the merger. Horizon had no stock options
outstanding prior to the merger. Southern Financial and Horizon incurred $3,973,530 of merger-related costs that were charged to operations during the year ended December 31, 1999.



Our principal business is the acquisition of deposits from the general public through our home and branch offices and use of
these deposits to fund our loan and investment portfolios. We seek to be a full service community bank that provides a wide variety of financial services to our middle market corporate clients as well as to our retail clients. We are an active
commercial lender that often lends in conjunction with the Small Business Administration 7(a) and 504 loan programs. In addition, we are an active residential construction lender and offer our retail clients permanent residential mortgage loan
alternatives. We also invest funds in mortgage-backed securities, securities issued by agencies of the Federal Government, obligations of counties and municipalities and corporate obligations.



The principal sources of funds for our lending and investment activities are
deposits, amortization and repayment of loans, proceeds from the sales of loans, prepayments from mortgage-backed securities, repayments of maturing investment securities, Federal Home Loan Bank advances and other borrowed money.



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Principal sources of revenue are interest and fees on loans and investment securities, as well as fee
income derived from the maintenance of deposit accounts. Our principal expenses include interest paid on deposits and advances from the Federal Home Loan Bank and other borrowings, and operating expenses.



Lending Activities



Our primary
strategic objective is to serve the small to medium-sized business market with an array of unique and useful services, including a full array of commercial mortgage and nonmortgage loans. These loans include commercial real estate loans,
construction to permanent loans, development and builder loans, accounts receivable financing, lines of credit, equipment and vehicle loans, leasing options, commercial overdraft protection and corporate credit cards. We strive to do business in the
areas served by our branches, and all of our marketing and the vast majority of our loan customers are located within our existing market areas. The only significant exceptions to this local lending philosophy are loans made with an undertaking from
the Small Business Administration that may from time to time come to us because of our reputation and expertise as an SBA lender. Prior to making a loan, we obtain detailed loan applications to determine the borrowers ability to repay, and the
more significant items on these applications are verified through the use of credit reports, financial statements and confirmations. The following is a discussion of each of our major types of lending:



Commercial Real Estate Lending



Permanent. Commercial real estate lending includes loans for
permanent financing and construction. Commercial real estate lending typically involves higher loan principal amounts and the repayment of loans is dependent, in large part, on sufficient income from the properties securing the loans to cover
operating expenses and debt service. As a general practice, we require our commercial real estate loans to be secured by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. We look for
opportunities where cash flow from the collateral provides adequate debt service coverage and the guarantors net worth is centered on assets other than the project we finance. It has been our experience that borrowers whose assets consist
entirely of real estate, especially development projects, are particularly sensitive to real estate market cycles. In the event of a slowdown in the real estate market, real estate projects generally come under pressure at the same time and
liquidity of the borrower may be strained. As of December 31, 2003, our commercial real estate loans for permanent financing totaled $286.0 million.



Our underwriting guidelines for commercial real estate loans reflect all relevant credit factors, including, among other things, the income generated from
the underlying property to adequately service the debt, the availability of secondary sources of repayment and the overall creditworthiness of the borrower. In addition, we look to the value of the collateral, while maintaining the level of equity
invested by the borrower.



All valuations on property that will
secure loans are performed by independent outside appraisers who are reviewed by our Executive Vice President of Risk Management and reported annually to our Credit Committee. We retain a valid lien on real estate and obtain a title insurance policy
that insures the property is free of encumbrances.



Construction. We recognize that commercial, multifamily and other nonresidential properties can involve market risk due to the length of time it may take to bring a finished real estate product to market. As a result, we will only
make these types of loans when pre-leasing or pre-sales and or other credit factors suggest that the borrower can carry the debt if the anticipated market and property cash flow projections change during the construction phase. At December 31, 2003,
we had $60.7 million commercial construction loans.



Income
producing property loans are supported by evidence of the borrowers capacity to service the debt. The principals or general partners guarantee all of our commercial construction loans. Any interest reserves established on conventional
construction loans are not funded with the proceeds of the loan.



Construction loan borrowers are generally pre-qualified for the permanent loan by us. We obtain a copy of the contract with the general contractor who must be acceptable to us. All plans, specifications and surveys must include proposed
improvements. We review feasibility studies and sensitivity and risk analysis showing sensitivity of the project to variables such as interest rates, vacancy rates, lease rates and operating expenses for income producing properties and copies of any
previous environment site assessments if applicable.



Commercial Business
Lending



These loans consist of lines of credit, revolving
credit facilities, demand loans, term loans, equipment loans, SBA loans, stand-by letters of credit and unsecured loans. Commercial business loans are generally secured by accounts receivable, equipment and other collateral, such as readily
marketable stocks and bonds with adequate margins, cash value in life insurance policies and savings and time deposits at the Bank. At December 31, 2003, our commercial business loans totaled $163.0 million, including $20.7 million of debt
obligations.



In general, commercial business loans involve
more credit risk than residential mortgage loans and real estate-backed commercial loans and, therefore, usually yield a higher return to us. The increased risk for commercial business loans is due to the type of collateral securing these loans. The
increased risk also derives from the expectation that commercial loans generally will be serviced principally from the operations of the business, and those operations may not be successful. Historical trends have shown these types of loans to have
higher delinquencies than mortgage loans. Because of this, we often utilize the SBA 7(a) program to reduce the inherent risk associated with commercial business lending.



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Another way that we reduce risk in the commercial loan portfolio is by taking accounts receivable as
collateral. Our accounts receivable financing facilities, which provide a relatively high yield with considerable collateral control, are lines of credit under which a company can borrow up to the amount of a borrowing base which covers all of the
companys receivables. From our customers point of view, accounts receivable financing is an efficient way to finance expanding operations because borrowing capacity expands as sales increase. Customers can borrow from 75% to 90% of
qualified receivables placed in our system less accounts over 60 days past due. In most cases, the borrowers customers pay us directly. For borrowers with a good track record for earnings and quality receivables, we will consider pricing based
on the prime rate for transactions in which we lend up to a percentage of qualified outstanding receivables based on reported agings of the receivables portfolio.



We also actively pursue for our customers, equipment lease financing opportunities other than cars, trucks and other on-road
rolling stock. We provide financing and use a third party to service the leases. Payback is derived from the cash flow of the borrower, so credit quality may not be any lower than it would be in the case of an unsecured loan for a similar amount and
term.



SBA Lending



We have developed an expertise in the federally guaranteed SBA program. The
SBA program is an economic development program that finances the expansion of small businesses. We are a Preferred Lender in the Richmond District and a Certified Lender in the Washington D. C. District of the SBA. As an SBA Preferred and Certified
Lender, our preapproved status allows us to quickly respond to customers needs. Under the SBA program, we originate and fund SBA 7(a) loans that qualify for guarantees up to 85% of principal and accrued interest. We also originate 504 chapter
loans in which we generally provide 50% of the financing in the form of a first lien. At December 31, 2003, our total SBA loans were $56.4 million, which consisted of $35.2 million of 7(a) program loans and $21.2 million of 504 chapter loans.



We provide SBA loans to potential borrowers who are proposing
a business venture, often with existing cash flow and a reasonable chance of success. We do not treat the SBA guarantee as a substitute for a borrower meeting our credit standards, and except for minimum capital levels or maximum loan terms, the
borrower must meet our other credit standards as applicable to loans outside the SBA process.



Residential Mortgage Lending



Permanent. Residential mortgage loans are secured by single-family homes. We make fixed and adjustable rate first mortgage loans on residential properties with terms up to 30 years. We offer second mortgages in conjunction with our
own first mortgages or those of other lenders. In the case of conventional loans, we typically lend up to 80% of the appraised value of single-family residences and require private mortgage insurance for loans exceeding this amount. At December 31,
2003, we had $50.3 million of permanent residential mortgage loans.



We retain a valid lien on real estate and obtain a title insurance policy that insures that the property is free of encumbrances. We also require hazard insurance and flood insurance for all loans secured by real property if the property is
in a flood plain as designated by the Department of Housing and Urban Development. We also require most borrowers to advance funds on a monthly basis from which we make disbursements for items such as real estate taxes, private mortgage insurance
and hazard insurance.



Construction. We typically make
one to four family residential construction loans to builders/developers in our market areas. Construction loans generally have interest rates of prime plus one to two percent and fees of one to three points, loan-to-value ratios of 80% or less
based on current appraisals and terms of generally nine months or less. In substantially all cases, when we make a residential construction loan to a builder, the residence is pre-sold All plans, specifications and surveys must include proposed
improvements. Borrowers must evidence the capacity to service the debt. At December 31, 2003, we had $40.3 million of residential construction loans.



Consumer Lending



We offer various types of secured and unsecured consumer loans. We make consumer loans primarily for personal, family or household purposes as a
convenience to our customer base since these loans are not the focus of our lending activities. As a general guideline, a consumers total debt service should not exceed 40% of his gross income or 45% of net income. For purposes of this
calculation, debt includes house payment or rent, fixed installment payments, the estimated payment for the loan being requested and the minimum required payment on any revolving debt. At December 31, 2003, we had $7.7 million of consumer loans.



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Loan Portfolio Composition



The following table summarizes the composition of our loan portfolio as of December 31 for the years indicated:



|                                  |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|--------------------------------- |  | ---------------------- | ------- | ------- | ---- | - | ------ | ---- | ------- |  | ---- | ------ |  | ------- | ------- |  | ------ | - | ------- | - | ------- | ------ | --- | ------- |  | - | ------- |  | --- | -
|                                  |  | At December 31,        |        
|                                  |  | 2003                   |         |         | 2002 |   |        | 2001 |         |  | 2000 |        |  | 1999    |        
|                                  |  | Amount                 |         | Percent |      |   | Amount |      | Percent |  |      | Amount |  | Percent |         |  | Amount |   | Percent |   |         | Amount |     | Percent | 
|                                  |  | (amounts in thousands) |        
|Construction and land development |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|Residential                       |  | $                      | 40,329  |         | 7    | % |        | $    | 40,575  |  | 7    | %      |  | $       | 27,461  |  | 7      | % |         | $ | 14,929  |        | 5   | %       |  | $ | 9,468   |  | 4   | %
|Commercial                        |  |                        | 60,709  |         | 10   | % |        |      | 42,052  |  | 7    | %      |  |         | 16,850  |  | 4      | % |         |   | 20,597  |        | 6   | %       |  |   | 8,624   |  | 4   | %
|Mortgage                          |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|Residential                       |  |                        | 50,288  |         | 8    | % |        |      | 77,697  |  | 13   | %      |  |         | 61,741  |  | 15     | % |         |   | 53,165  |        | 17  | %       |  |   | 48,604  |  | 20  | %
|Multifamily residential           |  |                        | 6,872   |         | 1    | % |        |      | 9,438   |  | 2    | %      |  |         |        |  |       |   |         |   |        |        |    |         |  |   |        |  |    |  
|Commercial                        |  |                        | 286,028 |         | 46   | % |        |      | 253,958 |  | 41   | %      |  |         | 171,851 |  | 40     | % |         |   | 123,052 |        | 38  | %       |  |   | 107,902 |  | 45  | %
|Commercial and industrial         |  |                        | 163,042 |         | 27   | % |        |      | 170,776 |  | 28   | %      |  |         | 133,258 |  | 32     | % |         |   | 101,002 |        | 32  | %       |  |   | 54,175  |  | 23  | %
|Consumer                          |  |                        | 7,732   |         | 1    | % |        |      | 12,889  |  | 2    | %      |  |         | 9,272   |  | 2      | % |         |   | 7,617   |        | 2   | %       |  |   | 9,995   |  | 4   | %
|                                  |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|Total loans receivable            |  |                        | 615,000 |         | 100  | % |        |      | 607,385 |  | 100  | %      |  |         | 420,433 |  | 100    | % |         |   | 320,362 |        | 100 | %       |  |   | 238,768 |  | 100 | %
|                                  |  |                        |         |         |      |   |        |      |         | 
|Less:                             |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|Deferred loan fees, net           |  |                        | 3,384   |         |      |   |        |      | 2,805   |  |      |        |  |         | 2,106   |  |        |   |         |   | 1,670   |        |     |         |  |   | 1,230   |  |     |  
|Allowance for loan losses         |  |                        | 10,498  |         |      |   |        |      | 10,257  |  |      |        |  |         | 7,354   |  |        |   |         |   | 4,921   |        |     |         |  |   | 3,452   |  |     |  
|                                  |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  
|Loans receivable, net             |  | $                      | 601,118 |         |      |   |        | $    | 594,323 |  |      |        |  | $       | 410,973 |  |        |   |         | $ | 313,771 |        |     |         |  | $ | 234,086 |  |     |  
|                                  |  |                        |         |         |      |   |        |      |         |  |      |        |  |         |         |  |        |   |         |   |         |        |     |         |  |   |         |  |     |  



The following table
sets forth the contractual maturity ranges of the commercial and industrial loans and construction loans and the amount of those loans with predetermined and floating interest rates in each maturity range as of December 31, 2003:



|                          |  |                        |         |                             |   |               |  |            |        |               |   |       |  |   |        |  |   |        
|------------------------- |  | ---------------------- | ------- | --------------------------- | - | ------------- |  | ---------- | ------ | ------------- | - | ----- |  | - | ------ |  | - | -------
|                          |  |                        |         | Over 1 Year Through 5 Years |   | Over 5 years  |  |           
|                          |  | One Year or Less       |         | Fixed Rate                  |   | Floating Rate |  | Fixed Rate |        | Floating Rate |   | Total
|                          |  | (amounts in thousands)
|Construction:             |  |                        |         |                             |   |               |  |            |        |               |   |       |  |   |        |  |   |        
|Residential               |  | $                      | 32,343  |                             | $ | 1,075         |  | $          | 6,618  |               | $ | 90    |  | $ | 203    |  | $ | 40,329 
|Commercial                |  |                        | 37,550  |                             |   |              |  |            | 21,458 |               |   |      |  |   | 1,701  |  |   | 60,709 
|Commercial and Industrial |  |                        | 86,472  |                             |   | 15,662        |  |            | 22,407 |               |   | 9,688 |  |   | 28,813 |  |   | 163,042
|                          |  |                        |         |                             |   |               |  |            |        |               |   |       |  |   |        |  |   |        
|Total                     |  | $                      | 156,365 |                             | $ | 16,737        |  | $          | 50,483 |               | $ | 9,778 |  | $ | 30,717 |  | $ | 264,080
|                          |  |                        |         |                             |   |               |  |            |        |               |   |       |  |   |        |  |   |        



Credit Approval and Collection
Policies



Because long-term credit performance is so
closely associated with a banks underwriting policy, we have instituted what management believes is a stringent loan underwriting policy. Our underwriting guidelines are tailored for particular credit types, including lines of credit,
revolving credit facilities, demand loans, term loans, equipment loans, real estate loans, SBA loans, stand-by letters of credit and unsecured loans. We will make extensions of credit based on, among other factors, the potential borrowers
creditworthiness, likelihood of repayment and proximity to market areas served.



We have a standing Credit Committee comprised of certain of our officers, each of whom has a defined lending authority as an individual and in combination with other officers. These individual lending authorities are
determined by our Chief Executive Officer and certain directors and are based on the individuals technical ability and experience. These authorities must be approved by our board of directors and the Credit Committee. Our Credit Committee is
comprised of four levels of members: junior, regular, senior and executive, based on experience. Our executive members are our Chief Executive Officer, our President and two appointed Executive Vice Presidents. Under our loan approval process, the
sponsoring loan officers approval is required on all credit submissions. This approval must be included in or added to the individual and joining authorities outlined below. The sponsoring loan



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officer is primarily responsible for the customers relationship with us, including, among other things, obtaining
and maintaining adequate credit file information. We require each loan officer to maintain loan files in an order and detail that would enable a disinterested third party to review the file and determine the current status and quality of the credit.



In addition to approval of the sponsoring loan officer, we
require approvals from one or more members of the Credit Committee on all loans. The approvals required differ based on the size of the borrowing relationship. At least one senior or one executive member must approve all loans in the amount of
$100,000 or more. All three of the executive members of the Committee must approve all loans of $1 million or more. Regardless of the number of approvals needed, we encourage each member to treat his or her approval as if it were the only approval
necessary to approve the loan. Our legal lending limit to one borrower is limited to 15% of our unimpaired capital and surplus. As of December 31, 2003, our lending limit was approximately $13.9 million, although we had no loans to one borrower that
approached our legal lending limit at that date.



The following
collection actions are the minimal procedures which management believes are necessary to properly monitor past due loans and leases. When a borrower fails to make a payment, we contact the borrower in person, in writing and by telephone. At a
minimum, all borrowers are notified by mail when payments of principal and/or interest are five days past due and when payments are 10 days past due. In addition, consumer loan borrowers are assessed a late charge when payments are 10 days past due.
Real estate and commercial loan borrowers are assessed a late charge when payments are 15 days past due. Customers are contacted by a loan officer before the loan becomes 60 days delinquent. After 90 days, if the loan has not been brought current or
an acceptable arrangement is not worked out with the borrower, we will institute measures to remedy the default, including commencing foreclosure action with respect to mortgage loans and repossessions of collateral in the case of consumer loans.



If foreclosure is effected, the property is sold at a public
auction in which we may participate as a bidder. If we are the successful bidder, we include the acquired real estate property in our real estate owned account until it is sold. These assets are carried at the lower of cost or fair value net of
estimated selling costs. To the extent there is a decline in value, that amount is charged to operating expense.



Past Due Loans and Nonperforming Assets



Nonperforming assets were $5.8 million at December 31, 2003 compared with $2.3 million at December 31, 2002. Our ratio of nonperforming assets to total
loans and other real estate owned was 0.94% at December 31, 2003 and 0.37% at December 31, 2002.



Nonperforming assets were $2.3 million at December 31, 2002 compared with $1.5 million at December 31, 2001. The ratio of nonperforming assets to total
loans and other real estate owned was 0.37% at December 31, 2002 and 0.35% at December 31, 2001.



We generally place a loan on nonaccrual status when it becomes 90 days past due. Loans are also placed on nonaccrual status in cases where we are
uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Cash payments received while a loan is categorized as nonaccrual are recorded as a reduction of principal as long as doubt exists as to future collections.



We maintain appraisals on loans secured by real estate,
particularly those categorized as nonperforming loans and potential problem loans. In instances where appraisals reflect reduced collateral values, we make an evaluation of the borrowers overall financial condition to determine the need, if
any, for possible writedowns to their net realizable values. We record other real estate owned at the lower of our recorded investment in the loan or fair value less our estimated costs to sell.



7



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##### Table of Contents

The following table sets forth information regarding past due loans and nonperforming assets as of the
dates indicated:



|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|--------------------------------------------------------------- |  | ---------------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | - |  | ---- | ----- | - |  | - | ----- | -
|                                                                |  | At December 31,        |      
|                                                                |  | 2003                   |       |   | 2002 |   |       | 2001 |  |   | 2000  |   |  | 1999 |      
|                                                                |  | (amounts in thousands) |      
|Accruing loans 90 days or more delinquent(1):                   |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Mortgage-residential                                            |  | $                      | 1,458 |   |      | $ |      |      |  | $ |      |   |  | $    |      |   |  | $ |      |  
|Mortgage-commercial                                             |  |                        | 289   |   |      |   |      |      |  |   |      |   |  |      |      |   |  |   |      |  
|Commercial and industrial                                       |  |                        |      |   |      |   | 154   |      |  |   |      |   |  |      | 1     |   |  |   | 226   |  
|Consumer                                                        |  |                        |      |   |      |   |      |      |  |   |      |   |  |      | 8     |   |  |   | 9     |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Total                                                           |  |                        | 1,747 |   |      |   | 154   |      |  |   |      |   |  |      | 9     |   |  |   | 235   |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Nonperforming loans:                                            |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Construction-residential                                        |  |                        |      |   |      |   |      |      |  |   |      |   |  |      | 56    |   |  |   |      |  
|Construction-commercial                                         |  |                        | 3,486 |   |      |   |      |      |  |   |      |   |  |      |      |   |  |   |      |  
|Mortgage-residential                                            |  |                        |      |   |      |   | 159   |      |  |   | 343   |   |  |      | 499   |   |  |   | 413   |  
|Mortgage-commercial                                             |  |                        | 249   |   |      |   | 874   |      |  |   | 1,130 |   |  |      | 1,317 |   |  |   | 109   |  
|Commercial and industrial                                       |  |                        | 2,062 |   |      |   | 1,238 |      |  |   |      |   |  |      |      |   |  |   |      |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Subtotal                                                        |  |                        | 5,797 |   |      |   | 2,271 |      |  |   | 1,473 |   |  |      | 1,872 |   |  |   | 522   |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Troubled debt restructuring:                                    |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Mortgage-commercial                                             |  |                        |      |   |      |   |      |      |  |   |      |   |  |      | 49    |   |  |   | 68    |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Other real estate owned:                                        |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Mortgage-residential                                            |  |                        |      |   |      |   |      |      |  |   |      |   |  |      | 17    |   |  |   |      |  
|Mortgage-commercial                                             |  |                        |      |   |      |   |      |      |  |   |      |   |  |      |      |   |  |   | 2,296 |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Subtotal                                                        |  |                        |      |   |      |   |      |      |  |   |      |   |  |      | 17    |   |  |   | 2,296 |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Total nonperforming assets                                      |  | $                      | 5,797 |   |      | $ | 2,271 |      |  | $ | 1,473 |   |  | $    | 1,938 |   |  | $ | 2,886 |  
|                                                                |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |       |  
|Nonperforming assets to total assets                            |  |                        | 0.53  | % |      |   | 0.23  | %    |  |   | 0.19  | % |  |      | 0.32  | % |  |   | 0.71  | %
|Nonperforming assets to total loans and other real estate owned |  |                        | 0.94  | % |      |   | 0.37  | %    |  |   | 0.35  | % |  |      | 0.61  | % |  |   | 1.20  | %

---

|(1) | Accruing loans 90 days or more delinquent includes portions guaranteed by the Small Business Administration.
|--- | ------------------------------------------------------------------------------------------------------------



Our loss and delinquency experience on our residential real estate loan
portfolio has been limited by a number of factors, including our underwriting standards. Whether our loss and delinquency experience in this area of our portfolio will increase significantly depends upon the value of the real estate securing loans
and economic factors such as increases in unemployment as well as the overall economy of the region. Management believes that the allowance for loan losses at December 31, 2003 is a reasonable estimate of known and inherent losses in the loan
portfolio at that date.



At December 31, 2003, loans totaling
$14.9 million were considered potential problem loans and are not reported in the table above. These loans are subject to management attention and their classification is reviewed on a quarterly basis.



8



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##### Table of Contents

Allowance for Loan Losses



The following table summarizes activity in our allowance for loan losses during the periods indicated:



|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|----------------------------------------------------- |  | ------------------------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                      |  | As of and for the Years Ended December 31, |        
|                                                      |  | 2003                                       |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                                      |  | (dollars in thousands)                     |        
|Total loans at end of period, net of deferred fees    |  | $                                          | 611,616 |   |      | $ | 604,581 |      |  | $ | 418,328 |   |  | $    | 318,692 |   |  | $ | 237,539 |  
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Average loans outstanding                             |  | $                                          | 640,159 |   |      | $ | 524,271 |      |  | $ | 353,147 |   |  | $    | 267,186 |   |  | $ | 219,286 |  
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Allowance at beginning of period                      |  | $                                          | 10,257  |   |      | $ | 7,354   |      |  | $ | 4,921   |   |  | $    | 3,452   |   |  | $ | 3,062   |  
|Provision for losses                                  |  |                                            | 4,805   |   |      |   | 5,050   |      |  |   | 4,470   |   |  |      | 1,335   |   |  |   | 2,130   |  
|Allowance acquired from First Savings Bank            |  |                                            |        |   |      |   |        |      |  |   |        |   |  |      | 594     |   |  |   |        |  
|Allowance acquired from Metro-County Bank             |  |                                            |        |   |      |   | 1,350   |      |  |   |        |   |  |      |        |   |  |   |        |  
|Charge-offs:                                          |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Construction and land development                     |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Residential                                           |  |                                            |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Commercial                                            |  |                                            |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Mortgage                                              |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Residential                                           |  |                                            | (173    | ) |      |   | (80     | )    |  |   | (25     | ) |  |      | (232    | ) |  |   | (775    | )
|Commercial                                            |  |                                            |        |   |      |   |        |      |  |   | (105    | ) |  |      | (100    | ) |  |   | (480    | )
|Commercial and industrial                             |  |                                            | (6,053  | ) |      |   | (4,401  | )    |  |   | (2,175  | ) |  |      | (488    | ) |  |   | (736    | )
|Consumer                                              |  |                                            | (92     | ) |      |   | (45     | )    |  |   | (113    | ) |  |      | (54     | ) |  |   | (55     | )
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total charge-offs                                     |  |                                            | (6,318  | ) |      |   | (4,526  | )    |  |   | (2,418  | ) |  |      | (874    | ) |  |   | (2,046  | )
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Recoveries                                            |  |                                            | 1,754   |   |      |   | 1,029   |      |  |   | 381     |   |  |      | 414     |   |  |   | 306     |  
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Net charge-offs                                       |  |                                            | (4,564  | ) |      |   | (3,497  | )    |  |   | (2,037  | ) |  |      | (460    | ) |  |   | (1,740  | )
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Allowance at end of period                            |  | $                                          | 10,498  |   |      | $ | 10,257  |      |  | $ | 7,354   |   |  | $    | 4,921   |   |  | $ | 3,452   |  
|                                                      |  |                                            |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Ratio of allowance to end of period loans             |  |                                            | 1.72    | % |      |   | 1.70    | %    |  |   | 1.76    | % |  |      | 1.54    | % |  |   | 1.45    | %
|                                                      |  |                                            |         |   |     
|Ratio of net charge-offs to average loans outstanding |  |                                            | 0.71    | % |      |   | 0.67    | %    |  |   | 0.58    | % |  |      | 0.17    | % |  |   | 0.79    | %



Our allowance for loan
losses is established through charges to earnings in the form of a provision for loan losses. Management evaluates the allowance at least quarterly. In addition, on a quarterly basis our board of directors reviews our loan portfolio, conducts an
evaluation of the credit quality and reviews the loan loss provision, recommending changes as may be required. In evaluating the allowance, management considers the growth, composition and industry diversification of the portfolio, historical loan
loss experience, current delinquency levels and general economic conditions.



The allowance for loan losses represents managements estimate of an amount appropriate to provide for known and inherent losses in the loan portfolio in the normal course of business. We make specific allowances
for each loan based on its type and classification as discussed below. However, there are additional factors contributing to losses that cannot be quantified precisely or attributed to particular loans or categories of loans, including general
economic and business conditions and credit quality trends. We have established an unallocated portion of the allowance based on our evaluation of these factors, which management believes is prudent and consistent with regulatory requirements. Due
to the uncertainty of risks in the loan portfolio, managements judgement of the amount of the allowance necessary to absorb loan losses is approximate. The allowance is also subject to regulatory examinations and determination by the
regulatory agencies as to the appropriate level of the allowance.



We follow a loan review program designed to evaluate the credit risk in our loan portfolio. Through this loan review process, we maintain an internally classified watch list that helps management assess the overall quality of the loan
portfolio and the level of the allowance for loan losses. In establishing the appropriate classification for specific assets, management considers, among other factors, the estimated value of the underlying collateral, the borrowers ability to
repay, the borrowers payment history and the current delinquent status. As a result of this process, loans are categorized as substandard, doubtful, loss or special mention and reserves are allocated based on managements judgement and
historical experience.



Loans classified as
substandard are those loans with clear and defined weaknesses such as a highly-leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition which may jeopardize the liquidation of the debt.
They are characterized by the distinct possibility that we will sustain some losses if the deficiencies are not corrected.



Loans classified as doubtful are those loans which have characteristics similar to substandard loans but with an increased risk that
collection or liquidation in full is highly questionable and improbable.



9



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##### Table of Contents

Loans classified as loss are considered uncollectible and of such little value that their
continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer a loss on this asset even though partial recovery may
be effected in the future. Any loans considered to be impaired are accounted for in accordance with FAS 114.



In addition to the above classification categories, we also categorize certain loans as special mention. While special mention loans do not
have all the characteristics of a substandard or doubtful loan, they have one or more deficiencies which warrant special attention and which corrective management action, such as accelerated collection practices, may remedy.



During the evaluation of the loan portfolio, any loans that are not
classified or rated special mention are rated in accordance with the Banks risk rating. We also assign a general reserve allocation based on loan type.



The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the
dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur. With respect to investment securities underwritten as loans, the allowance is not available to
cover any impairment that is other than temporary. Because of this, in the event of other than temporary impairment of an investment security underwritten as a loan, such impairment must be charged to earnings in the same manner as an investment
security which is not underwritten as a loan.



|                                  |  |                        |        |                                                  |      |   |        |      |                                                  |  |      |        |  |                                                  |       |  |        |   |                                                  |   |       |        |     |                                                  |  |   |       |  |     |  
|--------------------------------- |  | ---------------------- | ------ | ------------------------------------------------ | ---- | - | ------ | ---- | ------------------------------------------------ |  | ---- | ------ |  | ------------------------------------------------ | ----- |  | ------ | - | ------------------------------------------------ | - | ----- | ------ | --- | ------------------------------------------------ |  | - | ----- |  | --- | -
|                                  |  | At December 31,        |       
|                                  |  | 2003                   |        |                                                  | 2002 |   |        | 2001 |                                                  |  | 2000 |        |  | 1999                                             |      
|                                  |  | Amount                 |        | Percent of Loans in Each Category to Total Loans |      |   | Amount |      | Percent of Loans in Each Category to Total Loans |  |      | Amount |  | Percent of Loans in Each Category to Total Loans |       |  | Amount |   | Percent of Loans in Each Category to Total Loans |   |       | Amount |     | Percent of Loans in Each Category to Total Loans | 
|                                  |  | (amounts in thousands) |       
|Construction and land development |  |                        |        |                                                  |      |   |        |      |                                                  |  |      |        |  |                                                  |       |  |        |   |                                                  |   |       |        |     |                                                  |  |   |       |  |     |  
|Residential                       |  | $                      | 742    |                                                  | 7    | % |        | $    | 1,032                                            |  | 7    | %      |  | $                                                | 602   |  | 7      | % |                                                  | $ | 65    |        | 5   | %                                                |  | $ | 54    |  | 4   | %
|Commercial                        |  |                        | 1,738  |                                                  | 10   | % |        |      | 1,047                                            |  | 7    | %      |  |                                                  | 657   |  | 4      | % |                                                  |   | 80    |        | 6   | %                                                |  |   | 35    |  | 4   | %
|Mortgage                          |  |                        |        |                                                  |      |   |        |      |                                                  |  |      |        |  |                                                  |       |  |        |   |                                                  |   |       |        |     |                                                  |  |   |       |  |     |  
|Residential                       |  |                        | 127    |                                                  | 8    | % |        |      | 293                                              |  | 13   | %      |  |                                                  | 306   |  | 15     | % |                                                  |   | 219   |        | 17  | %                                                |  |   | 256   |  | 20  | %
|Multifamily residential           |  |                        | 12     |                                                  | 1    | % |        |      | 20                                               |  | 2    | %      |  |                                                  |      |  | 0      | % |                                                  |   |      |        | 0   | %                                                |  |   |      |  | 0   | %
|Commercial                        |  |                        | 3,660  |                                                  | 46   | % |        |      | 3,998                                            |  | 41   | %      |  |                                                  | 3,076 |  | 40     | % |                                                  |   | 1,169 |        | 38  | %                                                |  |   | 1,020 |  | 45  | %
|Commercial and industrial         |  |                        | 3,811  |                                                  | 27   | % |        |      | 2,738                                            |  | 28   | %      |  |                                                  | 2,019 |  | 32     | % |                                                  |   | 2,377 |        | 32  | %                                                |  |   | 921   |  | 23  | %
|Consumer                          |  |                        | 206    |                                                  | 1    | % |        |      | 355                                              |  | 2    | %      |  |                                                  | 304   |  | 2      | % |                                                  |   | 116   |        | 2   | %                                                |  |   | 151   |  | 4   | %
|Unallocated                       |  |                        | 202    |                                                  | NA   |   |        |      | 774                                              |  | NA   |        |  |                                                  | 390   |  | NA     |   |                                                  |   | 895   |        | NA  |                                                  |  |   | 1,015 |  | NA  |  
|                                  |  |                        |        |                                                  |      |   |        |      |                                                  |  |      |        |  |                                                  |       |  |        |   |                                                  |   |       |        |     |                                                  |  |   |       |  |     |  
|Allowance for loan losses         |  | $                      | 10,498 |                                                  | 100  | % |        | $    | 10,257                                           |  | 100  | %      |  | $                                                | 7,354 |  | 100    | % |                                                  | $ | 4,921 |        | 100 | %                                                |  | $ | 3,452 |  | 100 | %
|                                  |  |                        |        |                                                  |      |   |        |      |                                                  |  |      |        |  |                                                  |       |  |        |   |                                                  |   |       |        |     |                                                  |  |   |       |  |     |  



Our loan loss
allowance is calculated by stratifying the loan portfolio by risk classifications and applying risk factors to each category. The risk factors are derived by considering relevant loss experience since 1992 of banks headquartered in Virginia, D.C.,
and Maryland, with $1 billion or more in assets as well as applying management judgment.



10



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##### Table of Contents

Investment Activities



Our
securities portfolio is managed by our President and our Senior Vice President/Treasurer, both of whom have significant experience in this area, with the concurrence of our Asset/Liability Committee. In addition to our President (chairman) and our
Senior Vice President/Treasurer, this committee is comprised of three outside directors. Investment management is performed in accordance with our investment policy, which is approved annually by the Asset/Liability Committee and the board of
directors. Our investment policy addresses our investment strategies, approval process, approved securities dealers and authorized investments.



Our investment policy authorizes us to invest in:



| |  | GNMA, FNMA and FHLMC mortgage-backed securities (MBS)
| | - | -----------------------------------------------------



| |  | Collateralized mortgage obligations
| | - | -----------------------------------



| |  | Municipal securities
| | - | --------------------



| |  | Corporate obligations
| | - | ---------------------



| |  | Interest-only mortgage-backed strips
| | - | ------------------------------------



| |  | Treasury securities
| | - | -------------------



| |  | Agency securities
| | - | -----------------



| |  | Asset-backed securities
| | - | -----------------------



| |  | Interest-rate caps
| | - | ------------------



| |  | Interest-rate swaps
| | - | -------------------



Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by
federal agencies such as the Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). These securities are deemed to have high credit ratings, and minimum
regular monthly cash flows of principal and interest are guaranteed by the issuing agencies.



Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal
prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a premium will generally suffer decreasing net yields as interest rates drop because homeowners tend to refinance their mortgages. Thus, the
premium paid must be amortized over a shorter period. Conversely, mortgage-backed securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be
true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal, and consequently the average life of these securities will be lengthened. If interest rates begin to
fall, prepayments will increase.



Collateralized mortgage
obligations (CMOs) are bonds that are backed by pools of mortgages. The pools can be GNMA, FNMA or FHLMC pools or they can be private-label pools. The CMOs are designed so that the mortgage collateral will generate a cash flow sufficient to provide
for the timely repayment of the bonds. The mortgage collateral pool can be structured to accommodate various desired bond repayment schedules, provided that the collateral cash flow is adequate to meet scheduled bond payments. This is accomplished
by dividing the bonds into classes to which payments on the underlying mortgage pools are allocated. The bonds cash flow, for example, can be dedicated to one class of bondholders at a time, thereby increasing call protection to bondholders.
In private-label CMOs, losses on underlying mortgages are directed to the most junior of all classes and then to the classes above in order of increasing seniority, which means that the senior classes have enough credit protection to be given the
highest credit rating by the rating agencies.





11



---

##### Table of Contents

The following table sets forth a summary of the investment securities portfolio as of the dates
indicated:



|                                                      |  |                        |         |                   |   |                   |  |   |        
|----------------------------------------------------- |  | ---------------------- | ------- | ----------------- | - | ----------------- |  | - | -------
|                                                      |  | December 31, 2003      |         | December 31, 2002 |   | December 31, 2001
|                                                      |  | (amounts in thousands)
|Available-for-sale securities (at fair value):        |  |                        |         |                   |   |                   |  |   |        
|FHLMC mortgage-backed securities                      |  | $                      | 6,278   |                   | $ | 13,035            |  | $ | 11,305 
|GNMA mortgage-backed securities                       |  |                        | 6,945   |                   |   | 11,122            |  |   | 4,603  
|FNMA mortgage-backed securities                       |  |                        | 52,005  |                   |   | 50,735            |  |   | 26,429 
|Collateralized mortgage obligations                   |  |                        | 31,499  |                   |   | 83,860            |  |   | 238,075
|Obligations of counties and municipalities            |  |                        |        |                   |   | 10,000            |  |   | 859    
|Corporate obligations                                 |  |                        | 23,735  |                   |   | 26,997            |  |   | 19,737 
|U.S. Treasury and other Government agency obligations |  |                        | 502     |                   |   | 2,282             |  |   | 515    
|FHLB stock                                            |  |                        | 3,850   |                   |   | 3,500             |  |   | 3,375  
|Federal Reserve Bank stock                            |  |                        | 2,034   |                   |   | 1,537             |  |   | 1,230  
|Other equity securities                               |  |                        | 484     |                   |   | 495               |  |   | 484    
|                                                      |  |                        |         |                   |   |                   |  |   |        
|Total classified as investment securities             |  |                        | 127,332 |                   |   | 203,563           |  |   | 306,612
|Debt obligations classified as loans                  |  |                        | 20,654  |                   |   | 32,543            |  |   | 37,213 
|                                                      |  |                        |         |                   |   |                   |  |   |        
|                                                      |  | $                      | 147,986 |                   | $ | 236,106           |  | $ | 343,825
|                                                      |  |                        |         |                   |   |                   |  |   |        
|Held-to-maturity securities (at amortized cost):      |  |                        |         |                   |   |                   |  |   |        
|FHLMC mortgage-backed securities                      |  | $                      | 3,787   |                   | $ |                  |  | $ |       
|FNMA mortgage-backed securities                       |  |                        | 188,451 |                   |   |                  |  |   |       
|Collateralized mortgage obligations                   |  |                        | 54,978  |                   |   |                  |  |   |       
|Corporate obligations                                 |  |                        | 2,985   |                   |   |                  |  |   |       
|                                                      |  |                        |         |                   |   |                   |  |   |        
|Total classified as investment securities             |  | $                      | 250,201 |                   | $ |                  |  | $ |       
|                                                      |  |                        |         |                   |   |                   |  |   |        



12



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##### Table of Contents

The following table summarizes the contractual maturity of investment securities and their weighted
average yields as of December 31, 2003:



|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|----------------------------------------- |  | -------------------- | ------- | -------------- | ---------------- | ---------------------- |  | ---- | -------------------- |  | -------------- | ------- | ---------------------- | - | ------- |  | ---- | -
|                                          |  | Available-for-sale   |         |                | Held-to-maturity |                       
|(dollars in thousands)                    |  | Estimated Fair Value |         | Amortized Cost |                  | Weighted Average Yield |  |      | Estimated Fair Value |  | Amortized Cost |         | Weighted Average Yield |  
|Debt obligations:                         |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|One year or less                          |  | $                    | 502     |                | $                | 499                    |  | 5.21 | %                    |  | $              |        |                        | $ |        |  |     |  
|After one through five years              |  |                      | 1,069   |                |                  | 997                    |  | 7.32 | %                    |  |                |        |                        |   |        |  |     |  
|After ten years                           |  |                      | 22,666  |                |                  | 22,859                 |  | 2.89 | %                    |  |                | 3,049   |                        |   | 2,985   |  | 6.22 | %
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|Total                                     |  |                      | 24,237  |                |                  | 24,355                 |  | 3.12 | %                    |  |                | 3,049   |                        |   | 2,985   |  | 6.22 | %
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|Mortgage-backed securities                |  |                      | 65,228  |                |                  | 65,793                 |  | 3.55 | %                    |  |                | 192,992 |                        |   | 192,238 |  | 4.44 | %
|Collateralized mortgage obligations       |  |                      | 31,499  |                |                  | 32,470                 |  | 5.86 | %                    |  |                | 55,144  |                        |   | 54,978  |  | 4.30 | %
|Equity securities                         |  |                      | 6,368   |                |                  | 6,368                  |  | 4.03 | %                    |  |                |        |                        |   |        |  |     |  
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|Total classified as investment securities |  |                      | 127,332 |                |                  | 128,986                |  | 4.07 | %                    |  |                | 251,185 |                        |   | 250,201 |  | 4.43 | %
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|Debt obligations classified as loans:     |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|After one through five years              |  |                      | 3,488   |                |                  | 3,461                  |  | 4.18 | %                    |  |                |        |                        |   |        |  |     |  
|After ten years                           |  |                      | 17,166  |                |                  | 17,116                 |  | 6.62 | %                    |  |                |        |                        |   |        |  |     |  
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|Total classified as loans                 |  |                      | 20,654  |                |                  | 20,577                 |  | 6.21 | %                    |  |                |        |                        |   |        |  |     |  
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  
|                                          |  | $                    | 147,986 |                | $                | 149,563                |  | 4.37 | %                    |  | $              | 251,185 |                        | $ | 250,201 |  | 4.43 | %
|                                          |  |                      |         |                |                  |                        |  |      |                      |  |                |         |                        |   |         |  |      |  



Contractual maturity
of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to prepay their obligations at any time.



Deposits



Deposits, which
represent 76% of our interest-rate sensitive liabilities as of December 31, 2003, have historically been the primary source of funding our asset growth. In addition to deposits, we obtain funds from loan repayments, maturing investments, loan sales,
cash flows generated from operations, capital trust borrowings, securities sold under agreements to repurchase and Federal Home Loan Bank advances. Borrowings may be used as an alternative source of lower cost funds or to fund the origination of
certain assets.



The following table sets forth the average
balances and weighted average rates paid, presented on a daily average basis, for our deposits for the periods indicated:



|                            |  |                         |         |              |      |   |                 |      |              |  |      |                 |  |              |         |  |      |  
|--------------------------- |  | ----------------------- | ------- | ------------ | ---- | - | --------------- | ---- | ------------ |  | ---- | --------------- |  | ------------ | ------- |  | ---- | -
|                            |  | Year Ended December 31, |        
|                            |  | 2003                    |         |              | 2002 |   |                 | 2001 |             
|                            |  | Average Balance         |         | Average Rate |      |   | Average Balance |      | Average Rate |  |      | Average Balance |  | Average Rate |        
|                            |  | (amounts in thousands)  |        
|Demand                      |  | $                       | 92,921  |              | 0.00 | % |                 | $    | 74,161       |  | 0.00 | %               |  | $            | 66,305  |  | 0.00 | %
|Interest checking           |  |                         | 44,119  |              | 0.40 | % |                 |      | 40,471       |  | 1.10 | %               |  |              | 31,398  |  | 1.22 | %
|Money market and savings    |  |                         | 107,800 |              | 0.66 | % |                 |      | 111,337      |  | 1.37 | %               |  |              | 84,410  |  | 2.97 | %
|Certificates of deposit (1) |  |                         | 498,183 |              | 1.80 | % |                 |      | 461,826      |  | 2.63 | %               |  |              | 377,680 |  | 4.96 | %
|                            |  |                         |         |              |      |   |                 |      |              |  |      |                 |  |              |         |  |      |  
|                            |  | $                       | 743,023 |              |      |   |                 | $    | 687,795      |  |      |                 |  | $            | 559,793 |  |      |  
|                            |  |                         |         |              |      |   |                 |      |              |  |      |                 |  |              |         |  |      |  
|Weighted average rate       |  |                         |         |              | 1.33 | % |                 |      |              |  | 2.05 | %               |  |              |         |  | 3.86 | %
|                            |  |                         |         |              |      |   |                 |      |              |  |      |                 |  |              |         |  |      |  

---

|(1) | Includes institutional CDs, some of which are callable and are tied to interest rate swaps. At December 31, 2003, we had $364.8 million in institutional CDs, $272.5
million of which are callable and tied to interest rate swaps.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

The following table sets forth by time remaining until maturity our certificates of deposit of $100,000
or more at December 31, 2003:



|                                        |  |                                   |        
|--------------------------------------- |  | --------------------------------- | -------
|Maturity Period                         |  | Time Deposits of $100,000 or More
|                                        |  | (amounts in thousands)           
|Three months or less                    |  | $                                 | 72,900 
|Over three months through twelve months |  |                                   | 25,064 
|Over twelve months                      |  |                                   | 290,761
|                                        |  |                                   |        
|Total                                   |  | $                                 | 388,725
|                                        |  |                                   |        



Borrowings



Borrowings consist of
the following:



|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|---------------------------------------------------- |  | ----------------- | ------- | ------------- | ----------------- | --------- | ------ | --------------------- | ----- | - | ------ | - | ------------- |  | --------- |  | --------------------- |  | ----- | -
|                                                     |  | December 31, 2003 |         |               | December 31, 2002 |          
|(dollars in thousands)                               |  | Amount            |         | Maturity Date |                   | Call Date |        | Weighted Average Rate |       |   | Amount |   | Maturity Date |  | Call Date |  | Weighted Average Rate | 
|Advances from FHLB of Atlanta:                       |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Overnight borrowings                                 |  | $                 | 7,000   |               |                   |           |        |                       | 1.15  | % |        | $ |              |  |           |  |                       |  | %     |  
|Term borrowings:                                     |  |                   | 5,000   |               | Sep-09            |           | Sep-04 |                       | 6.32  |   |        |   | 5,000         |  | Sep-09    |  | Sep-04                |  | 6.32  |  
|                                                     |  |                   | 5,000   |               | Sep-10            |           | Mar-04 |                       | 6.04  |   |        |   | 5,000         |  | Sep-10    |  | Sep-03                |  | 6.04  |  
|                                                     |  |                   | 5,000   |               | Sep-10            |           | Mar-04 |                       | 5.84  |   |        |   | 5,000         |  | Sep-10    |  | Mar-03                |  | 5.84  |  
|                                                     |  |                   | 25,000  |               | Oct-07            |           | Jan-04 |                       | 1.18  |   |        |   | 25,000        |  | Oct-07    |  | Jan-03                |  | 1.18  |  
|                                                     |  |                   |        |               |                   |           |        |                       |       |   |        |   | 25,000        |  | Oct-07    |  | Jan-03                |  | 1.10  |  
|                                                     |  |                   | 24,796  |               | Feb-05            |           |        |                       | 1.14  |   |        |   |              |  |           |  |                       |  |       |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Total advances from FHLB of Atlanta                  |  |                   | 71,796  |               |                   |           |        |                       | 2.18  |   |        |   | 65,000        |  |           |  |                       |  | 2.28  |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Callable long term debt                              |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|                                                     |  |                   | 5,000   |               | Jul-30            |           | Jul-05 |                       | 11.00 |   |        |   | 5,000         |  | Jul-30    |  | Jul-05                |  | 11.00 |  
|                                                     |  |                   | 8,000   |               | Sep-30            |           | Sep-10 |                       | 10.60 |   |        |   | 8,000         |  | Sep-30    |  | Sep-10                |  | 10.60 |  
|                                                     |  |                   | 10,000  |               | Apr-33            |           | Apr-08 |                       | 4.41  |   |        |   |              |  |           |  |                       |  |       |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Total callable long term debt                        |  |                   | 23,000  |               |                   |           |        |                       | 8.00  |   |        |   | 13,000        |  |           |  |                       |  | 10.75 |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Securities sold under agreements to repurchase:      |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Sweep accounts                                       |  |                   | 32,959  |               |                   |           |        |                       | 0.51  |   |        |   | 18,456        |  |           |  |                       |  | 0.94  |  
|Term repurchase agreement                            |  |                   | 5,000   |               | Jan-05            |           |        |                       | 1.43  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 25,000  |               | Jan-05            |           |        |                       | 1.22  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 25,000  |               | Jul-06            |           |        |                       | 2.30  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 15,000  |               | Aug-07            |           |        |                       | 3.18  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 15,000  |               | Aug-05            |           |        |                       | 1.89  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 10,000  |               | Feb-05            |           |        |                       | 1.80  |   |        |   |              |  |           |  |                       |  |       |  
|Term repurchase agreement                            |  |                   | 10,000  |               | Aug-08            |           |        |                       | 3.84  |   |        |   |              |  |           |  |                       |  |       |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Total securities sold under agreements to repurchase |  |                   | 137,959 |               |                   |           |        |                       | 1.77  |   |        |   | 18,456        |  |           |  |                       |  | 0.94  |  
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  
|Total borrowings                                     |  | $                 | 232,755 |               |                   |           |        |                       | 2.51  | % |        | $ | 96,456        |  |           |  |                       |  | 3.16  | %
|                                                     |  |                   |         |               |                   |           |        |                       |       |   |        |   |               |  |           |  |                       |  |       |  



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##### Table of Contents

The following table sets forth information regarding our short-term borrowings at and for the periods
indicated:



|                                                        |  |                         |        |   |      |   |        |      |  |   |         |  
|------------------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                        |  | Year Ended December 31, |       
|                                                        |  | 2003                    |        |   | 2002 |   |        | 2001 | 
|                                                        |  | (Dollars in thousands)  |       
|Ending Balance                                          |  | $                       | 39,959 |   |      | $ | 18,456 |      |  | $ | 40,500  |  
|Average Balance for the Period                          |  |                         | 48,111 |   |      |   | 39,579 |      |  |   | 81,098  |  
|Maximum Month-end Balance During the Period             |  |                         | 88,564 |   |      |   | 87,500 |      |  |   | 148,501 |  
|Average Interest Rate for the Period                    |  |                         | 0.90   | % |      |   | 2.01   | %    |  |   | 4.29    | %
|Weighted Average Interest Rate at the End of the Period |  |                         | 0.62   | % |      |   | 0.94   | %    |  |   | 2.27    | %



In May of 2000, we
formed a wholly-owned statutory business trust, Southern Financial Capital Trust I, which issued $5.0 million in trust preferred securities and in September of 2000, we formed a second wholly-owned statutory business trust, Southern Financial
Statutory Trust I, which issued $8.0 million in trust preferred securities. In April 2003, we formed a third wholly-owned statutory business trust, Southern Financial Capital Trust III which issued $10.0 million in trust preferred securities. Each
trust invested the proceeds in an equivalent amount of our junior subordinated debentures bearing an interest rate equal to the distribution rate on the respective issue of trust preferred securities. Each of the issuances of debentures will mature
in 2030 and 2033, which date may be shortened to a date not earlier than 2005 if certain conditions are met, including prior approval of the Federal Reserve. These debentures, which are the only assets of each trust, are subordinate and junior in
right of payment to all of our present and future senior indebtedness. We have fully and unconditionally guaranteed each trusts obligations under the trust preferred securities.



The debentures issued to Capital Trust I accrue interest at an annual rate of 11.0% of the aggregate liquidation amount,
payable quarterly, and the debentures issued to Statutory Trust I accrue interest at an annual rate of 10.60% of the liquidation preference, payable quarterly. The debentures issued to Capital Trust III accrue interest at a variable rate which is
based on LIBOR and adjusted quarterly and is currently 4.4125% of the aggregate liquidation amount, payable quarterly . The quarterly distributions on each issuance of trust preferred securities are paid at the same rate that interest is paid on the
corresponding debentures. Distributions to the holders of the trust preferred securities are included in interest expense, within the category entitled borrowings. Under the provisions of each issue of the debentures, we have the right to defer
payment of interest on the debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on either issue of the debentures are deferred, the distributions on the applicable trust preferred securities will
also be deferred.



For financial reporting purposes, the trusts
are not consolidated in our financial statements. The trust preferred securities are presented as a separate category of long-term debt on the balance sheet. Although the trust preferred securities are not included as a component of
stockholders equity in the balance sheet, for regulatory purposes the Federal Reserve Board treats a portion of the trust preferred securities as Tier 1 capital. The treatment of the trust preferred securities as Tier 1 or Tier 2 capital, in
addition to the ability to deduct the expense of the junior subordinated debentures for federal income tax purposes, provided us with a cost-effective method of raising capital to support the bank.



Supervision and Regulation



General



We are a bank holding company within the meaning of the
Bank Holding Company Act of 1956, as amended, and therefore are supervised and examined by the Board of Governors of the Federal Reserve System. We are also subject to Virginia laws that regulate banks and bank holding companies that are
administered by the Bureau of Financial Institutions of the State Corporation Commission of Virginia. Because of the insurance on our deposits, we are also affected by rules and regulations of the Federal Deposit Insurance Corporation. We are a
member of the Federal Reserve System and the Federal Home Loan Bank of Atlanta.



The supervision, regulation and examination of us and the bank are intended primarily for the protection of depositors rather than holders of our securities.



15



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##### Table of Contents

Bank Holding Company Regulation



We are required to file periodic reports and any additional information with the Federal Reserve. The Federal Reserve
examines us and may examine our subsidiaries. The State Corporation Commission also may examine us.



The Bank Holding Company Act requires prior Federal Reserve approval for, among other things, the acquisition of direct or indirect ownership or control
of more than 5% of the voting shares or substantially all of the assets of any bank, or a merger or consolidation of a bank holding company with another bank holding company. A bank holding company may acquire direct or indirect ownership or control
of voting shares of any company that is engaged directly or indirectly in banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company also may engage in or acquire an interest in a company
that engages in activities which the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident thereto.



The activities permissible to bank holding companies and their affiliates were substantially expanded by the
Gramm-Leach-Bliley Act which became effective on March 11, 2000. The Gramm-Leach-Bliley Act authorizes affiliations between commercial banks, investment banks and insurance companies and allows bank holding companies and state banks, if permitted by
state law, to engage in a variety of new activities. Under the Gramm-Leach-Bliley Act, a bank holding company can elect to be treated as a financial holding company. A financial holding company may engage in any activity and acquire and retain any
company that the Federal Reserve determines to be financial in nature. A financial holding company also may engage in any activity that is complementary to a financial activity and does not pose a substantial risk to the safety and soundness of
depository institutions or the financial system generally. The Federal Reserve must consult with the Secretary of the Treasury in determining whether an activity is financial in nature or incidental to a financial activity.



We are a legal entity separate and distinct from the bank and transactions
between the bank and any of its nonbanking subsidiaries, including us, and any of our nonbanking subsidiaries, are subject to Section 23A of the Federal Reserve Act. Section 23A of the Federal Reserve Act imposes limits on such transactions. Section
23A defines covered transactions, which include loans, and limits a banks covered transactions with any affiliate to 10% of the banks capital and surplus. It also requires that all of a banks loans to an affiliate be
secured by acceptable collateral, generally United States government or agency securities.



We and the bank also are subject to Section 23B of the Federal Reserve Act, which requires that transactions between the bank and any of its affiliates be on terms and under circumstances, including credit standards,
that are substantially the same or at least as favorable to the bank as those prevailing at the time for transactions with unaffiliated companies.



Federal Reserve policy requires a bank holding company to act as a source of financial strength and to take measures to preserve and protect bank
subsidiaries in situations where additional investments in a troubled bank may not otherwise be warranted. As a result, a bank holding company may be required to lend money to its subsidiaries in the form of capital notes or other instruments that
qualify as capital under regulatory rules. Any loans from the holding company to such subsidiary banks likely will be unsecured and subordinated to such banks depositors and perhaps to other creditors of its bank subsidiaries.



Bank Supervision



As a Virginia bank that is a member of the Federal Reserve System, the bank is regulated and examined by the State
Corporation Commission and by its primary federal regulator, the Federal Reserve. The State Corporation Commission and the Federal Reserve regulate and monitor all of the banks operations, including reserves, loans, mortgages, payments of
dividends and the establishment of branches.



Various statutes
limit the ability of the bank to pay dividends, extend credit or otherwise supply funds to us and our nonbanking subsidiaries. Dividends from the bank are expected to constitute our major source of funds.



Regulatory Capital Requirements



All banks and bank holding companies are required to maintain minimum levels
of regulatory capital. The federal bank regulatory agencies have established substantially similar risked based and leverage capital standards for banks that they regulate. These regulatory agencies also may impose capital requirements in excess of
these standards on a case-by-case basis for various reasons, including financial condition or actual or anticipated growth. Under the risk-based capital requirements of these regulatory agencies, we and the bank are required to maintain a minimum
ratio of total capital to risk-weighted assets of at least 8%. At least half of the total capital is required to be Tier 1 capital, which consists principally of common and certain qualifying preferred shareholders equity, less certain
intangibles and other adjustments. The remainder, Tier 2 capital, consists of a limited amount of subordinated and other qualifying debt and a limited amount of the general loan loss allowance. Based upon the applicable Federal Reserve regulations,
at December 31, 2003, the bank was considered to be well capitalized.



In addition, the federal regulatory agencies have established a minimum leverage capital ratio, Tier 1 capital divided by tangible assets. These guidelines provide for a minimum leverage capital ratio of 3% for banks
and their respective holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. All other institutions are expected to
maintain a leverage ratio above that minimum. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum
supervisory levels, without significant reliance on intangible assets.



16



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##### Table of Contents

Limits on Dividends and Other Payments



Virginia law restricts distributions of dividends to our shareholders. Our shareholders are entitled to receive dividends as
declared by our board of directors. However, no distribution to our shareholders may be made if, after giving effect to the distribution, we would not be able to pay our debts as they become due in the usual course of business or our total assets
would be less than our total liabilities. There are similar restrictions on stock repurchases and redemptions.



Banks have limits on all capital distributions, including cash dividends, payments to repurchase or otherwise acquire shares, payments to shareholders of
another institution in a cash-out merger, and other distributions charged against capital.



The bank may not make a capital distribution, including the payment of a dividend, if, after the distribution, it would become undercapitalized. The prior approval of the Federal Reserve is required if the total of
all dividends declared by the bank in any calendar year will exceed the sum of the banks net profits for that year and its retained net profits for the preceding two calendar years. The Federal Reserve also may limit the payment of dividends
by any state member bank if it considers the payment an unsafe or unsound practice. In addition, under Virginia law no dividend may be declared or paid that would impair a Virginia chartered banks paid-in capital. The State Corporation
Commission has general authority to prohibit payment of dividends by a Virginia chartered bank if it determines that the limit is in the public interest and is necessary to ensure the banks financial soundness.



FDIC Regulations



The Federal Deposit Insurance Corporation Improvement Act of 1991 required each federal banking agency to revise its
risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of non-traditional activities. Each federal banking agency has issued regulations, specifying the
levels at which a financial institution would be considered well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized, and
to take certain mandatory and discretionary supervisory actions based on the capital level of the institution. Those supervisory actions become increasingly severe for banks that are undercapitalized or worse.



Under the Federal Reserves regulations implementing the prompt
corrective action provisions, an institution is considered well capitalized if it has total risk-based capital of 10% or more, has a Tier I risk-based capital ratio of 6% or more, has a leverage capital ratio of 5% or more and is not subject to any
order or final capital directive to meet and maintain a specific capital level for any capital measure.



An adequately capitalized institution has a total risk-based capital ratio of 8% or more, a Tier I risk-based ratio of 4% or more and a leverage capital
ratio of 4% or more (3% under certain circumstances) and does not meet the definition of well capitalized.



An undercapitalized institution has a total risk-based capital ratio that is less than 8%, a Tier I risk-based capital ratio that is less than 4% or a
leverage capital ratio that is less than 4% (3% in certain circumstances). Undercapitalized banks are subject to growth limits and are required to submit a capital restoration plan for approval. For a capital restoration plan to be acceptable, the
banks parent holding company must guarantee that the bank will comply with the capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of 5% of the banks total assets at the time it became
undercapitalized and the amount necessary to bring the institution into compliance with applicable capital standards. If a bank fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. If the controlling holding
company fails to fulfill its obligations and files (or has filed against it) a petition under the federal Bankruptcy Code, the claim would be entitled to a priority in such bankruptcy proceeding over third-party creditors.



A significantly undercapitalized institution has a total risk-based capital
ratio that is less than 6%, a Tier I risk-based capital ratio that is less than 3% or a leverage capital ratio that is less than 3%. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions,
including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks.



A critically undercapitalized institution has a ratio of tangible equity to total assets that is equal to or less than 2%. A
critically undercapitalized bank is likely to be put in receivership and liquidated.



In addition, under certain circumstances, a federal banking agency may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized
institution to comply with supervisory actions as if it were in the next lower category.



The Federal Deposit Insurance Corporation Improvement Act also required federal banking regulators to draft standards in a number of other important areas to assure bank safety and soundness, including internal
controls, information systems and internal audit systems, credit underwriting, asset growth, compensation, loan documentation and interest rate exposure. The Federal Deposit Insurance Corporation Improvement Act also required the regulators to
establish maximum ratios of classified assets to capital, and minimum earnings sufficient to absorb losses without impairing capital. The legislation also contained other provisions which restricted the activities of state-chartered banks, amended
various consumer banking laws, limited the ability of undercapitalized banks to borrow from the Federal Reserves discount window and required federal banking regulators to perform annual onsite bank examinations.



Brokered Deposit Restrictions



Institutions that are only adequately capitalized (as defined
for purposes of the prompt corrective action rules described above) cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits.
Undercapitalized institutions may not accept, renew, or roll over brokered deposits.



17



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##### Table of Contents

Deposit Insurance Assessments



The banks deposits are currently insured to a maximum of $100,000 per depositor, subject to certain aggregation rules.
The FDIC has implemented a risk-related assessment system for deposit insurance premiums. All depository institutions have been assigned to one of nine risk assessment classifications based on certain capital and supervisory measures. The
banks deposits are subject to the rates of the Savings Associations Insurance Fund since it converted to a commercial bank from a federal savings bank on December 1, 1995. Based on its current risk classifications, the bank pays the minimum
Savings Associations Insurance Fund assessment and Bank Insurance Fund assessments.



Community Reinvestment Act



The Community
Reinvestment Act of 1977, as amended, (CRA) encourages banks consistent with their safe and sound operation, to help meet the credit needs for their entire communities, including low and moderate-income neighborhoods. The CRA does not
establish specific lending requirements or programs for financial institutions, nor does it limit an institutions discretion to develop the types of products and services that it believes are best suited to its particular community consistent
with the CRA.



A depository institutions primary federal
regulator, in connection with its examination of the institution, must assess the institutions record in assessing and meeting the credit needs of the community served by that institution, including low and moderate-income neighborhoods. The
regulatory agencys assessment of the institutions record is made available to the public. Further, such assessment is required of any institution which has applied to charter a national bank, obtain deposit insurance coverage for a newly
chartered institution, establish a new branch office that accepts deposits, relocate an office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. If a bank holding company
applies for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the records of each subsidiary depository institution of the applicant bank holding company, and such records may be the basis for denying the
application.



Fiscal and Monetary Policy



Banking is a business which depends on interest rate differentials. In
general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a banks earnings. Thus, our
earnings and growth and the earnings and growth of the bank will be subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies,
particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve,
and the reserve requirements on deposits. We cannot predict the ultimate effect of the nature and timing of any changes in such policies will have on our business or on the business of our subsidiaries.



Federal Home Loan Bank System



We are a member of the Federal Home Loan Bank System, which consists of 12
district Federal Home Loan Banks with each subject to supervision and regulation by the Federal Housing Finance Board. The Federal Home Loan Banks provide a central credit facility for member institutions. The bank, as a member of the Federal Home
Loan Bank of Atlanta, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank in an amount equal to at least 1% of the aggregate principal amount of their unpaid residential mortgage loans, home purchase contracts and
similar obligations at the beginning of each year, or 5% of their borrowings from the Federal Home Loan Bank of Atlanta, whichever is greater. At December 31, 2003, we had an investment of $3.9 million in the stock of the Federal Home Loan Bank of
Atlanta and were in compliance with these requirements.



Competition



The banking business
is highly competitive, and our profitability depends principally on our ability to compete in the market areas in which our banking operations are located. We experience substantial competition in attracting and retaining savings deposits and in
lending funds. The primary factors we encounter in competing for savings deposits are convenient office locations and rates offered. Direct competition for savings deposits comes from other commercial bank and thrift institutions, money market
mutual funds and corporate and government securities which may offer more attractive rates than insured depository institutions are willing to pay. The primary factors we encounter in competing for loans include, among others, interest rate and loan
origination fees and the range of services offered. Competition for origination of real estate loans normally comes from other commercial banks, thrift institutions, mortgage bankers, mortgage brokers and insurance companies. We have been able to
compete effectively with other financial institutions by emphasizing customer service and technology; by establishing long-term customer relationships and building customer loyalty; and by providing products and services designed to address the
specific needs of our customers.



Employees



At December 31, 2003,
we had 238 full-time equivalent employees, six of whom were executive officers. Management considers its relations with its employees to be good. Neither we nor the bank are a party to any collective bargaining agreement.



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##### Table of Contents

Available Information



Southern
Financials website address is www.southernfinancialbank.com. While we do not provide direct access through our website, we do make available free of charge through our website by a hyperlink to a third-party service our annual report on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable
after such material is electronically filed with or furnished to the Securities and Exchange Commission. We also provide paper copies of our filings free of charge upon request.



19



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##### Table of Contents

Item 2. Properties



Offices and Other
Material Properties



We conduct business from our main
office in Warrenton, Virginia and at 27 branch offices. Our headquarters are located at 37 E. Main Street, Warrenton, Virginia in an office building we lease. All of our leases are for terms of five years or more and the expiration dates range from
June 2004 to June 2018, not including any optional renewal periods which may be available.



The following table sets forth the date opened or acquired, ownership status and the total deposits, not including institutional deposits, for each of our banking locations:



|                                        |  |                         |  |                 |  |                               |       
|--------------------------------------- |  | ----------------------- |  | --------------- |  | ----------------------------- | ------
|Office Location                         |  | Date Opened or Acquired |  | Owned or Leased |  | Deposits at December 31, 2003
|Home Office:                            |  |                         |  |                 |  |                               |       
|                                        |  |                         | 
|37 E. Main Street Warrenton, VA         |  | February1989            |  | Leased          |  | $                             | 20,113
|                                        |  |                         | 
|Branch Offices:                         |  |                         |  |                 |  |                               |       
|                                        |  |                         | 
|362 Elden Street Herndon, VA            |  | April1986               |  | Leased          |  |                               | 29,669
|                                        |  |                         | 
|101 W. Washington Street Middleburg, VA |  | November1987            |  | Leased          |  |                               | 12,745
|                                        |  |                         | 
|25 W. Piccadilly Street Winchester, VA  |  | November1990            |  | Leased          |  |                               | 7,973 
|                                        |  |                         | 
|526 E. Market Street Leesburg, VA       |  | March1992               |  | Leased          |  |                               | 22,528
|                                        |  |                         | 
|4021 University Drive Fairfax, VA       |  | September1993           |  | Owned           |  |                               | 22,434
|                                        |  |                         | 
|322 Lee Highway Warrenton, VA           |  | August1994              |  | Leased          |  |                               | 17,383
|                                        |  |                         | 
|5245 Old Centreville Road Herndon, VA   |  | April1995               |  | Leased          |  |                               | 9,593 
|                                        |  |                         | 
|13542 Minnieville Road Woodbridge, VA   |  | April1995               |  | Leased          |  |                               | 9,237 
|                                        |  |                         | 
|1095 Millwood Pike Winchester, VA       |  | July1996                |  | Owned           |  |                               | 4,673 
|                                        |  |                         | 
|46910 Community Plaza Sterling, VA      |  | April1998               |  | Leased          |  |                               | 5,377 



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##### Table of Contents

|                                             |  |                         |  |                 |  |                              
|-------------------------------------------- |  | ----------------------- |  | --------------- |  | -----------------------------
|Office Location                              |  | Date Opened or Acquired |  | Owned or Leased |  | Deposits at December 31, 2003
|2062 Plank Road Fredericksburg, VA           |  | January1999             |  | Leased          |  | 8,293                        
|                                             |  |                         | 
|10175 Hastings Drive Manassas, VA            |  | March1999               |  | Leased          |  | 11,187                       
|                                             |  |                         | 
|7857 Heritage Drive (1) Annandale, VA        |  | October1999             |  | Leased          |  | 6,242                        
|                                             |  |                         | 
|9720 Lee Highway (1) Fairfax, VA             |  | October1999             |  | Leased          |  | 31,801                       
|                                             |  |                         | 
|527 Maple Avenue (1) Vienna, VA              |  | October1999             |  | Leased          |  | 22,644                       
|                                             |  |                         | 
|8414 Lee Highway (1) Merrifield, VA          |  | October1999             |  | Owned           |  | 45,186                       
|                                             |  |                         | 
|10693 Courthouse Road (2) Fredericksburg, VA |  | September2000           |  | Leased          |  | 21,737                       
|                                             |  |                         | 
|6354 Walker Lane (2) Alexandria, VA          |  | September2000           |  | Leased          |  | 13,789                       
|                                             |  |                         | 
|1055 Thomas Jefferson St., NW Washington, DC |  | August2001              |  | Leased          |  | 17,088                       
|                                             |  |                         | 
|300 E. Market Street Charlottesville, VA     |  | January2002             |  | Leased          |  | 5,021                        
|                                             |  |                         | 
|8206 Atlee Road (3) Mechanicsville, VA       |  | August2002              |  | Owned           |  | 33,172                       
|                                             |  |                         | 
|6401 Horsepen Road (3) Richmond, VA          |  | August2002              |  | Leased          |  | 3,785                        
|                                             |  |                         | 
|5419 Lakeside Avenue (3) Richmond, VA        |  | August2002              |  | Leased          |  | 16,315                       
|                                             |  |                         | 
|2801 Parham Road (3) Richmond, VA            |  | August2002              |  | Leased          |  | 7,313                        
|                                             |  |                         | 
|3124 West Broad Street (3) Richmond, VA      |  | August2002              |  | Owned           |  | 4,688                        
|                                             |  |                         | 
|2208 Ivy Road Charlottesville, VA            |  | February2003            |  | Owned           |  | 1,393                        
|                                             |  |                         | 
|1001 E. Main Street Richmond, VA             |  | November2003            |  | Leased          |  | 13                           

---

|(1) | Acquired from the Horizon Bank of Virginia
|--- | ------------------------------------------

|(2) | Acquired from First Savings Bank of Virginia
|--- | --------------------------------------------

|(3) | Acquired from Metro County Bank of Virginia
|--- | -------------------------------------------



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##### Table of Contents

Item 3. Legal Proceedings



We
and the bank from time to time are involved in legal proceedings arising in the normal course of business. Management believes that neither we nor the bank are a party to, nor is any of our property the subject of, any material pending or threatened
legal proceedings which, if determined adversely, would have a material adverse effect upon our consolidated position, results of operations or cash flows.



Item 4. Submission of Matters to Vote of Security Holders



None.



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##### Table of Contents

PART II.



Item 5. Market for Registrants Common Equity and Related Stockholder Matters



Corporate Address



37 East Main Street

Warrenton, Virginia 20186

540-349-3900

FAX: 540-349-3904



Form 10-K



The Banks Annual Report on Form 10-K to the Securities and Exchange Commission will be furnished without charge to stockholders upon written request to:



Investor Relations

37 East Main Street

Warrenton, Virginia 20186



Annual
Meeting



The Annual Meeting of stockholders of Southern Financial Bancorp,
Inc. will be held on April 29, 2004 at Fauquier Springs County Club, Springs Road, Warrenton, Virginia, commencing at 3:00 pm.



Stock Data



As of December 14, 1993, the Common Stock of Southern Financial Federal Savings Bank commenced trading on the NASDAQ Small Cap Stock Market under the symbol SFFB. On
February 21, 1995, the Common Stock commenced trading on the NASDAQ National Market under the symbol SFFB. On December 1, 1995, Southern Financial Federal Savings Bank merged into Southern Financial Bank, a wholly owned subsidiary of Southern
Financial Bancorp, Inc. The Bancorps Common Stock continues to be traded on the NASDAQ National Market under the symbol SFFB.



As of December 31, 2003, there were 1,218 stockholders of record, not including the number of persons or entities whose stock is held in nominee or street
name through various brokerage firms or banks. The following table sets forth the high and low stock prices, adjusted to reflect the 2003 10% stock dividend:



|            |  |      |       |      |   |      |  |      |       |      |   |       |  |      |       |     |   |       |  |   |       |  |   |      
|----------- |  | ---- | ----- | ---- | - | ---- |  | ---- | ----- | ---- | - | ----- |  | ---- | ----- | --- | - | ----- |  | - | ----- |  | - | -----
|            |  | 2000 |       | 2001 |   | 2002 |  | 2003
|            |  | HIGH |       | LOW  |   | HIGH |  | LOW  |       | HIGH |   | LOW   |  | HIGH |       | LOW
|1st Quarter |  | $    | 12.49 |      | $ | 9.70 |  | $    | 13.16 |      | $ | 9.25  |  | $    | 22.14 |     | $ | 17.91 |  | $ | 30.84 |  | $ | 23.16
|2nd Quarter |  |      | 11.41 |      |   | 8.98 |  |      | 18.33 |      |   | 12.22 |  |      | 25.61 |     |   | 19.50 |  |   | 31.30 |  |   | 26.82
|3rd Quarter |  |      | 11.68 |      |   | 9.34 |  |      | 19.05 |      |   | 15.92 |  |      | 25.56 |     |   | 21.03 |  |   | 36.22 |  |   | 27.28
|4th Quarter |  |      | 10.65 |      |   | 8.18 |  |      | 21.00 |      |   | 15.60 |  |      | 24.11 |     |   | 21.35 |  |   | 48.00 |  |   | 34.87



Transfer Agent & Registrar



Inquiries regarding stock
transfer, lost certificates or changes in name and/or address should be directed to the stock transfer agent and registrar:



Mellon Investor Services, L.L.C.

Overpeck Centre

83 Challenger Road

Ridgefield Park, NJ 07660

800-851-9677



Market Makers



Scott &
Stringfellow 800-552-7757

Ferris, Baker, Watts, Inc. 202-429-3545

Sandler ONeill 212-466-7800

Anderson & Strudwick, Inc. 800-767-2424

SunTrust Robinson-Humphrey 800-241-0460

Legg Mason  877-534-4627



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##### Table of Contents

Item 6. Selected Financial Data



|                                                                                                                                             |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|-------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------------------- | --------- | - | ---- | - | --------- | ---- |  | ---- | --------- |  | ---- | --------- | - |  | - | --------- | -
|                                                                                                                                             |  | As of and for the Year Ended December 31, |          
|                                                                                                                                             |  | 2003                                      |           |   | 2002 |   |           | 2001 |  | 2000 |           |  | 1999 |          
|(dollars in thousands, except per share data)                                                                                                |  |                                           |           |   |      |   |           |      |  |      |           |  |      |          
|Income statement data:                                                                                                                       |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|Interest income                                                                                                                              |  | $                                         | 54,270    |   |      | $ | 51,130    |      |  | $    | 54,179    |  | $    | 37,810    |   |  | $ | 29,756    |  
|Interest expense                                                                                                                             |  |                                           | 14,773    |   |      |   | 17,375    |      |  |      | 27,147    |  |      | 20,009    |   |  |   | 14,308    |  
|Net interest income                                                                                                                          |  |                                           | 39,497    |   |      |   | 33,755    |      |  |      | 27,032    |  |      | 17,801    |   |  |   | 15,448    |  
|Provision for loan losses                                                                                                                    |  |                                           | 4,805     |   |      |   | 5,050     |      |  |      | 4,470     |  |      | 1,335     |   |  |   | 2,130     |  
|Net interest income after provision for loan losses                                                                                          |  |                                           | 34,692    |   |      |   | 28,705    |      |  |      | 22,562    |  |      | 16,466    |   |  |   | 13,318    |  
|Non-interest income                                                                                                                          |  |                                           | 7,731     |   |      |   | 4,369     |      |  |      | 6,934     |  |      | 4,553     |   |  |   | 2,834     |  
|Non-interest expense                                                                                                                         |  |                                           | 22,861    |   |      |   | 18,401    |      |  |      | 16,992    |  |      | 13,440    |   |  |   | 14,589    |  
|Income before income taxes                                                                                                                   |  |                                           | 19,562    |   |      |   | 14,673    |      |  |      | 12,504    |  |      | 7,579     |   |  |   | 1,563     |  
|Income taxes                                                                                                                                 |  |                                           | 6,378     |   |      |   | 4,661     |      |  |      | 4,090     |  |      | 2,429     |   |  |   | 602       |  
|Net income                                                                                                                                   |  |                                           | 13,184    |   |      |   | 10,012    |      |  |      | 8,414     |  |      | 5,150     |   |  |   | 961       |  
|                                                                                                                                             |  |                                           |           |   |     
|Reconciliation to non-GAAP net income (excluding merger-related expense, gains (losses) on investment securities and other
assets):          |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|Income before taxes                                                                                                                          |  |                                           | 19,562    |   |      |   | 14,673    |      |  |      | 12,504    |  |      | 7,579     |   |  |   | 1,563     |  
|Merger-related expenses and provision (3)                                                                                                    |  |                                           | (770      | ) |      |   |          |      |  |      |          |  |      |          |   |  |   | (3,885    | )
|Gains (losses) on securities                                                                                                                 |  |                                           | (95       | ) |      |   | (1,603    | )    |  |      | 1,266     |  |      | (167      | ) |  |   |          |  
|Gains on other assets                                                                                                                        |  |                                           | 289       |   |      |   | (17       | )    |  |      | 962       |  |      | 380       |   |  |   |          |  
|Non-GAAP income before income taxes                                                                                                          |  |                                           | 20,138    |   |      |   | 16,293    |      |  |      | 10,276    |  |      | 7,366     |   |  |   | 5,448     |  
|Non-GAAP income taxes                                                                                                                        |  |                                           | 6,416     |   |      |   | 5,176     |      |  |      | 3,361     |  |      | 2,361     |   |  |   | 1,678     |  
|Non-GAAP net income                                                                                                                          |  |                                           | 13,722    |   |      |   | 11,117    |      |  |      | 6,915     |  |      | 5,005     |   |  |   | 3,770     |  
|                                                                                                                                             |  |                                           |           |   |     
|Per share data:                                                                                                                              |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|Reconciliation to non-GAAP earnings per share (excluding merger-related expenses, gains (losses) on investment securities and other
assets): |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|Earnings per basic share                                                                                                                     |  | $                                         | 2.19      |   |      | $ | 1.78      |      |  | $    | 1.90      |  | $    | 1.33      |   |  | $ | 0.26      |  
|Merger-related expenses and provision (3)                                                                                                    |  |                                           | (0.11     | ) |      |   |          |      |  |      |          |  |      |          |   |  |   | (0.77     | )
|Gains (losses) on securities and other assets                                                                                                |  |                                           | 0.02      |   |      |   | (0.20     | )    |  |      | 0.34      |  |      | 0.04      |   |  |   |          |  
|Non-GAAP earnings per basic share                                                                                                            |  |                                           | 2.27      |   |      |   | 1.98      |      |  |      | 1.56      |  |      | 1.29      |   |  |   | 1.03      |  
|Earnings per diluted share                                                                                                                   |  |                                           | 2.10      |   |      |   | 1.71      |      |  |      | 1.84      |  |      | 1.31      |   |  |   | 0.25      |  
|Gains (losses) on securities and other assets                                                                                                |  |                                           | 0.02      |   |      |   | (0.18     | )    |  |      | 0.33      |  |      | 0.05      |   |  |   | 0.02      |  
|Merger-related expenses and provision (3)                                                                                                    |  |                                           | (0.11     | ) |      |   |          |      |  |      |          |  |      |          |   |  |   | (0.76     | )
|Non-GAAP earnings per diluted share                                                                                                          |  |                                           | 2.19      |   |      |   | 1.89      |      |  |      | 1.51      |  |      | 1.26      |   |  |   | 0.99      |  
|                                                                                                                                             |  |                                           |           |   |     
|Book value per share                                                                                                                         |  |                                           | 14.96     |   |      |   | 13.58     |      |  |      | 11.93     |  |      | 9.46      |   |  |   | 7.81      |  
|Tangible book value per share                                                                                                                |  |                                           | 12.67     |   |      |   | 11.15     |      |  |      | 11.38     |  |      | 8.59      |   |  |   | 7.73      |  
|Weighted average shares outstanding                                                                                                          |  |                                           |           |   |      |   |           |      |  |      |           |  |      |           |   |  |   |           |  
|Basic:                                                                                                                                       |  |                                           | 6,032,566 |   |      |   | 5,614,255 |      |  |      | 4,428,700 |  |      | 3,877,539 |   |  |   | 3,685,586 |  
|Diluted:                                                                                                                                     |  |                                           | 6,269,387 |   |      |   | 5,868,093 |      |  |      | 4,590,156 |  |      | 3,946,832 |   |  |   | 3,788,012 |  
|Shares outstanding at end of period                                                                                                          |  |                                           | 6,208,589 |   |      |   | 5,985,298 |      |  |      | 5,420,011 |  |      | 4,194,983 |   |  |   | 3,696,097 |  



24



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|                                                                                                                           |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------------------- | --------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                                                                                           |  | As of and for the Year Ended December 31, |          
|                                                                                                                           |  | 2003                                      |           |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|(dollars in thousands, except per share data)                                                                              |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |        
|Period-end balance sheet data:                                                                                             |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total assets                                                                                                               |  | $                                         | 1,094,388 |   |      | $ | 970,630 |      |  | $ | 785,380 |   |  | $    | 610,339 |   |  | $ | 406,222 |  
|Total loans receivable, net of deferred fees                                                                               |  |                                           | 611,616   |   |      |   | 604,580 |      |  |   | 418,328 |   |  |      | 318,912 |   |  |   | 237,980 |  
|Allowance for loan losses                                                                                                  |  |                                           | 10,498    |   |      |   | 10,257  |      |  |   | 7,354   |   |  |      | 4,921   |   |  |   | 3,452   |  
|Loans held for sale                                                                                                        |  |                                           | 8,651     |   |      |   | 514     |      |  |   |        |   |  |      | 220     |   |  |   | 442     |  
|Total investment securities                                                                                                |  |                                           | 377,533   |   |      |   | 203,563 |      |  |   | 306,612 |   |  |      | 233,407 |   |  |   | 136,919 |  
|Total deposits                                                                                                             |  |                                           | 743,737   |   |      |   | 776,083 |      |  |   | 633,326 |   |  |      | 515,112 |   |  |   | 367,188 |  
|Other borrowings                                                                                                           |  |                                           | 209,755   |   |      |   | 83,456  |      |  |   | 55,500  |   |  |      | 34,000  |   |  |   | 5,000   |  
|Callable long-term debt                                                                                                    |  |                                           | 23,000    |   |      |   | 13,000  |      |  |   | 13,000  |   |  |      | 13,000  |   |  |   |        |  
|Total liabilities                                                                                                          |  |                                           | 1,001,531 |   |      |   | 889,327 |      |  |   | 720,712 |   |  |      | 570,650 |   |  |   | 377,358 |  
|Total stockholders equity                                                                                                 |  |                                           | 92,857    |   |      |   | 81,303  |      |  |   | 64,668  |   |  |      | 39,689  |   |  |   | 28,864  |  
|                                                                                                                           |  |                                           |           |   |     
|Selected performance ratios and other data:                                                                                |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Return on average assets                                                                                                   |  |                                           | 1.27      | % |      |   | 1.18    | %    |  |   | 1.16    | % |  |      | 1.09    | % |  |   | 0.24    | %
|Return on average equity                                                                                                   |  |                                           | 15.50     | % |      |   | 14.14   | %    |  |   | 18.00   | % |  |      | 15.96   | % |  |   | 3.12    | %
|Selected performance ratios (excluding merger-related expenses, gains (losses) on investment securities and other assets): |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Return on average assets:                                                                                                  |  |                                           | 1.32      | % |      |   | 1.31    | %    |  |   | 0.95    | % |  |      | 1.11    | % |  |   | 0.93    | %
|Return on average equity:                                                                                                  |  |                                           | 16.13     | % |      |   | 15.70   | %    |  |   | 14.80   | % |  |      | 16.21   | % |  |   | 12.24   | %
|Yield on earning assets                                                                                                    |  |                                           | 5.60      | % |      |   | 6.44    | %    |  |   | 7.97    | % |  |      | 8.60    | % |  |   | 7.82    | %
|Cost of funds                                                                                                              |  |                                           | 1.76      | % |      |   | 2.50    | %    |  |   | 4.51    | % |  |      | 5.37    | % |  |   | 4.71    | %
|Cost of funds including non-interest bearing deposits                                                                      |  |                                           | 1.58      | % |      |   | 2.26    | %    |  |   | 4.06    | % |  |      | 4.64    | % |  |   | 3.89    | %
|Net interest margin                                                                                                        |  |                                           | 4.08      | % |      |   | 4.25    | %    |  |   | 3.98    | % |  |      | 4.05    | % |  |   | 4.07    | %
|Efficiency ratio (1)                                                                                                       |  |                                           | 46.29     | % |      |   | 45.53   | %    |  |   | 53.54   | % |  |      | 60.70   | % |  |   | 64.04   | %
|Stockholders equity to total assets                                                                                       |  |                                           | 8.48      | % |      |   | 8.38    | %    |  |   | 8.23    | % |  |      | 6.50    | % |  |   | 7.11    | %
|Stockholders equity to total tangible assets                                                                              |  |                                           | 7.28      | % |      |   | 6.98    | %    |  |   | 7.98    | % |  |      | 8.95    | % |  |   | 7.11    | %
|Dividend payout ratio                                                                                                      |  |                                           | 25.05     | % |      |   | 21.12   | %    |  |   | 18.42   | % |  |      | 25.76   | % |  |   | 90.82   | %
|Intangible assets                                                                                                          |  | $                                         | 14,167    |   |      | $ | 14,558  |      |  | $ | 3,009   |   |  | $    | 3,639   |   |  | $ | 284     |  
|Amortization of intangibles                                                                                                |  |                                           | 320       |   |      |   | 306     |      |  |   | 371     |   |  |      | 152     |   |  |   |        |  
|Unrealized gains (losses)                                                                                                  |  |                                           | (1,409    | ) |      |   | 82      |      |  |   | 2,011   |   |  |      | 236     |   |  |   | (1,724  | )
|                                                                                                                           |  |                                           |           |   |     
|Selected average balances:                                                                                                 |  |                                           |           |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total loans receivable, net of deferred fees                                                                               |  | $                                         | 640,159   |   |      | $ | 524,271 |      |  | $ | 353,147 |   |  | $    | 267,186 |   |  | $ | 219,286 |  
|Total investment securities                                                                                                |  |                                           | 309,985   |   |      |   | 258,535 |      |  |   | 320,007 |   |  |      | 169,248 |   |  |   | 159,013 |  
|Overnight deposits                                                                                                         |  |                                           | 18,190    |   |      |   | 10,548  |      |  |   | 6,213   |   |  |      | 3,642   |   |  |   | 2,504   |  
|Earning assets                                                                                                             |  |                                           | 968,334   |   |      |   | 793,354 |      |  |   | 679,367 |   |  |      | 440,076 |   |  |   | 380,803 |  
|Total assets                                                                                                               |  |                                           | 1,038,764 |   |      |   | 851,118 |      |  |   | 724,119 |   |  |      | 473,126 |   |  |   | 404,373 |  
|Interest bearing deposits                                                                                                  |  |                                           | 650,101   |   |      |   | 613,634 |      |  |   | 493,488 |   |  |      | 338,435 |   |  |   | 303,729 |  
|Other debt                                                                                                                 |  |                                           | 190,411   |   |      |   | 80,769  |      |  |   | 108,209 |   |  |      | 34,505  |   |  |   | 13,159  |  
|Total interest bearing liabilities                                                                                         |  |                                           | 840,513   |   |      |   | 694,403 |      |  |   | 601,698 |   |  |      | 372,940 |   |  |   | 316,888 |  
|Non-interest bearing deposits                                                                                              |  |                                           | 92,921    |   |      |   | 74,161  |      |  |   | 66,304  |   |  |      | 58,188  |   |  |   | 50,501  |  
|Total deposits                                                                                                             |  |                                           | 743,022   |   |      |   | 687,795 |      |  |   | 559,793 |   |  |      | 396,623 |   |  |   | 354,230 |  
|Stockholders equity                                                                                                       |  |                                           | 85,047    |   |      |   | 70,812  |      |  |   | 46,739  |   |  |      | 32,268  |   |  |   | 30,810  |  



25



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|                                                       |  |                                           |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|------------------------------------------------------ |  | ----------------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------ | -
|                                                       |  | As of and for the Year Ended December 31, |       
|                                                       |  | 2003                                      |        |   | 2002 |   |        | 2001 |  |   | 2000   |   |  | 1999 |       
|(dollars in thousands, except per share data)          |  |                                           |        |   |      |   |        |      |  |   |        |   |  |      |       
|Allowance for loan losses:                             |  |                                           |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Balance-beginning of period                            |  | $                                         | 10,257 |   |      | $ | 7,354  |      |  | $ | 4,921  |   |  | $    | 3,452  |   |  | $ | 3,062  |  
|Provision for loan losses                              |  |                                           | 4,805  |   |      |   | 5,050  |      |  |   | 4,470  |   |  |      | 1,335  |   |  |   | 2,130  |  
|Balance acquired from Metro-County Bank of Virginia    |  |                                           |       |   |      |   | 1,350  |      |  |   |       |   |  |      |       |   |  |   |       |  
|Balance acquired from First Savings Bank of Virginia   |  |                                           |       |   |      |   |       |      |  |   |       |   |  |      | 594    |   |  |   |       |  
|Net charge-offs                                        |  |                                           | (4,564 | ) |      |   | (3,497 | )    |  |   | (2,037 | ) |  |      | (460   | ) |  |   | (1,740 | )
|                                                       |  |                                           |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Balance-end of period                                  |  | $                                         | 10,498 |   |      | $ | 10,257 |      |  | $ | 7,354  |   |  | $    | 4,921  |   |  | $ | 3,452  |  
|                                                       |  |                                           |        |   |     
|Asset quality:                                         |  |                                           |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Nonaccrual loans, including SBA guaranteed portion (2) |  | $                                         | 5,798  |   |      | $ | 2,271  |      |  | $ | 1,473  |   |  | $    | 1,872  |   |  | $ | 522    |  
|Other real estate owned                                |  |                                           |       |   |      |   |       |      |  |   |       |   |  |      | 17     |   |  |   | 2,296  |  
|Total nonperforming assets                             |  |                                           | 5,798  |   |      |   | 2,271  |      |  |   | 1,473  |   |  |      | 1,889  |   |  |   | 2,818  |  
|Provision for loan losses to net charge-offs           |  |                                           | 105.28 | % |      |   | 144.41 | %    |  |   | 219.44 | % |  |      | 290.22 | % |  |   | 122.41 | %
|Net charge-offs to average loans (annualized)          |  |                                           | 0.71   | % |      |   | 0.67   | %    |  |   | 0.58   | % |  |      | 0.17   | % |  |   | 0.79   | %
|Nonperforming assets to total assets                   |  |                                           | 0.53   | % |      |   | 0.23   | %    |  |   | 0.19   | % |  |      | 0.31   | % |  |   | 0.75   | %
|Allowance for loan losses to nonperforming assets      |  |                                           | 181.06 | % |      |   | 451.65 | %    |  |   | 499.25 | % |  |      | 262.87 | % |  |   | 661.30 | %
|Allowance for loan losses to total loans               |  |                                           | 1.72   | % |      |   | 1.70   | %    |  |   | 1.76   | % |  |      | 1.54   | % |  |   | 1.45   | %

---

|(1) | Calculated by dividing total other expense, net of amortization of goodwill and intangibles and merger-related expenses, by net interest income plus total other income, excluding
gains (losses) on securities and other assets.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The SBA guaranteed portion of nonaccrual loans totaling $2.0 million and $822 thousand at December 31, 2003 and 2002, respectively, are included in the total.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Certain merger-related expenses were not tax effected because they were not deductible for tax purposes.
|--- | --------------------------------------------------------------------------------------------------------



Item 7. Managements Discussion and Analysis



Managements Discussion and Analysis of Financial Condition and Results of Operations analyze the major elements of our balance sheets and statements of income. This section should be read in conjunction with the
audited consolidated financial statements and related notes as of December 31, 2003 and 2002 and for each of the years in the three-year period ended December 31, 2003 included in this annual report.



Overview



2003 versus 2002



Net income for the year ended December 31, 2003 was $13.2 million compared
with $10.0 million for the year ended December 31, 2002, an increase of 31.7%. Diluted earnings per share were $2.10 for the year ended December 31, 2003 compared with $1.71 for the year ended December 31, 2002, an increase of 22.8%. The increase in
net income was the result of several factors. During 2003, net interest income increased due to the spread on the average earning assets, particularly investment securities and commercial loans, which increased compared with average earning assets
in 2002. Further, non-interest income increased due to lower losses on investment securities during 2003 compared with net losses during 2002. Income from both traditional banking fees and commercial service fees as well as the decrease in the
provision for loan losses also contributed to the increased net income for the year ended December 31, 2003 compared with the prior year. Other factors, such as increased operating expenses and provision for income taxes negatively impacted net
income during 2003 compared with 2002.



Non-GAAP net income
excludes net gains and losses on investment securities and other assets and merger expenses related to the pending merger with Provident Bankshares Corporation. For the years ended December 31, 2003 and 2002, respectively, non-GAAP net income
increased 23.4% to $13.7 million ($2.19 diluted earnings per share) from $11.1 million ($1.89 diluted earnings per share). Non-GAAP net income for the years ended 2003 and 2002 excluded net losses on investment securities totaling $95 thousand, net
gains on other assets totaling $289 thousand and $770 thousand of merger-related expense, compared with $1.6 million of net losses on investment securities and $17 thousand of net losses on other assets, respectively. Net interest income and
non-interest income combined, excluding gains and losses on securities and other assets, increased 24.9% during 2002 compared with 2001, while non-interest expenses increased only 8.3% during the respective periods. We believe these Non-GAAP
financial measures are a meaningful presentation because they exclude those items that are not considered part of Southern Financials core operating activity.



Total assets increased to $1.1 billion at December 31, 2003, from $970.6 million at December 31, 2002, an increase of 12.7%.
Total loans receivable, including loans held for sale, increased $15.2 million, or 2.5% compared with December 31, 2002. Loan closings for 2003 totaled $260.7 million. Much of the growth from loan closings was offset by increased loan repayments.
Investment securities increased to $377.5 million, or by 85.5% from December 31, 2002 to December 31, 2003 and included $250.2 million of securities classified as held to maturity. The investment securities increased as part of managements
strategy to lever some of the $10 million in trust preferred securities issued during the second quarter of 2003. The increase in investment securities was funded by a series of borrowings with different terms to coincide with the estimated
prepayments of the securities.



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##### Table of Contents

For the years ended December 31, 2003 and 2002, returns on average equity were 15.5% and 14.1%, while
book values per share were $14.96 and $13.58 for the respective periods.



2002 versus 2001



Net
income for the year ended December 31, 2002 was $10.0 million compared with $8.4 million for the year ended December 31, 2001, an increase of 19.0%. The increase in net income was positively impacted by an increase in loans and deposits and net
interest margin. The increase was offset by an increase in the loan loss provision and by a change from net gains to net losses on investment securities and other assets and an increase in other expenses. Diluted earnings per share were $1.71 for
the year ended December 31, 2002 and compared with $1.84 for the year ended December 31, 2001. The diluted earnings per share was adversely impacted by additional shares issued in association with the Metro-County Bank acquisition in August 2002,
and from the secondary common stock offering in mid-October 2001. Management estimates that the incremental shares associated with the Metro acquisition and the 2002 secondary common stock offering reduced the 2002 earnings per share by $.39.
Non-GAAP net income excluding net gains and losses on investment securities and other assets was $11.1 million ($1.89 diluted earnings per share) and $6.9 million ($1.51 diluted earnings per share) for the years ended December 31, 2002 and 2001,
respectively, an increase of 60.8%. Net interest income and non-interest income combined, excluding gains and losses on securities and other assets, increased 24.9% during 2002 compared with 2001, while non-interest expenses increased only 8.3%
during the respective periods.



During the year ended December
31, 2002 and 2001, respectively, we recognized securities losses totaling $1.6 million compared with securities gains totaling $1.3 million, a negative change of $2.9 million. The negative change in gains and losses on investment securities was
largely attributable to the $4.5 million impairment write downs of residential interest-only strips included in investment securities which were partially offset by gains on sales of investment securities. The higher prepayments on residential
mortgages due to the low interest rate environment resulted in a decline in value of the residential interest only strips during 2002.



Total assets increased to $970.2 million at December 31, 2002, from $785.0 million at December 31, 2001, an increase of 23.6%. During 2002, loans
receivable increased 44.6% including the Metro-County loans totaling $71 million. Excluding the Metro-County acquisition, loans increased 27.6% and loans closed for the year totaled $240.3 million. For 2002, investment securities declined to $203.6
million, or 33.6% as we continued to shorten the duration of the investment securities portfolio. Deposits and borrowings combined with proceeds from investment security repayments and sales funded the loan growth.



The following table presents net income and return on average equity



|     |  |             |  |                           |  
|---- |  | ----------- |  | ------------------------- | -
|     |  | Net income* |  | Return on Average Equity* |  
|1994 |  | 1,605       |  | 8.83                      | %
|     |  |            
|1995 |  | 1,881       |  | 8.38                      |  
|1996 |  | 1,916       |  | 7.97                      |  
|1997 |  | 2,808       |  | 10.92                     |  
|1998 |  | 3,284       |  | 11.30                     |  
|1999 |  | 3,771       |  | 12.24                     |  
|2000 |  | 5,005       |  | 15.51                     |  
|2001 |  | 6,916       |  | 14.80                     |  
|2002 |  | 11,118      |  | 15.70                     |  
|2003 |  | 13,722      |  | 16.13                     |  

---

|* | Net income and return on average equity presented here are based on non-GAAP net income, which excludes gains and losses on securities and other assets. For the years 1999 to 2003,
the reconciliation from non-GAAP net income to pro forma net income is included in the financial highlights on page 2. From 1994 to 1998 there were no adjustments to GAAP net income except for 1996, in which the FSLIC charge of $556 thousand after
tax was added back to compute pro forma net income.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Results of Operations



Our operating results
depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings.
Operating results are also affected by the level of our non-interest income, including income or loss from the sale of loans and fees and service charges on deposit accounts, and by the level of our operating expenses, including compensation,
premises and equipment, deposit insurance assessments and income taxes.



27



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##### Table of Contents

Net Interest Income



2003 versus 2002



Net interest income before the provision for loan losses for the year ended December 31, 2003 was $39.5 million, an increase of 17.0% from $33.8 million
for the year ended December 31, 2002. The increase in net interest income was mainly due to the growth in earning assets resulting from purchases of investment securities and net loan originations, particularly in the commercial loan portfolio.
Average earning assets increased 22.0% to $968.3 million for the year ended December 31, 2003 compared with $793.4 million for the year ended December 31, 2002.



Our yield on total interest-earning assets was 5.60% for the year ended December 31, 2003; a decrease compared with 6.44% for the year ended December
31, 2002. Generally, the yields on new loan growth and investment securities purchases were lower relative the yields on repaid loans and investment securities, resulting in a declining yield through out 2003. The cost of funds also declined to
1.76% from 2.50% for the years ended December 31, 2003 and 2002, respectively. The reduction in the cost of funds was primarily due to maturities of certificates of deposit replaced with lower costing deposits. During 2003, Southern continued the
use of interest rate swaps as hedges on callable certificates of deposits, effectively converting the fixed rate debt into floating rate debt priced at LIBOR. The reduction in the cost of funds, however, was slowed compared to 2002, due to the
addition of fixed rate funding totaling $105 million during 2003. Southern Financial locked into fixed rate funding during the year to fund investment securities purchases and to protect against the potential for rise in interest rates.



The net interest margin was 4.08% for the year ended December 31, 2003,
down from 4.25% for the year ended December 31, 2002. The decline in the net interest margin is directly related to the decline in the yield on earning assets, which declined more rapidly than the cost of funds on the deposits and borrowings.



2002 versus 2001



Net interest income before the provision for loan losses for the year ended
December 31, 2002, was $33.8 million, an increase of 24.9% over the prior year. The increase in net interest income was primarily due to growth in earning assets resulting from loan originations and purchases and an increase in net interest margin.
Average earning assets increased 16.8% to $793.4 million for the year ended December 31, 2002 compared with 2001. The net interest margin was 4.25% and 3.98% for the years ended December 31, 2002 and 2001, respectively, as the cost of funds declined
more than the yield on earning assets due to the series of federal interest rate cuts which began in 2001.



Interest income decreased 5.6% to $51.1 million for the year ended December 31, 2002 compared with $54.2 million for the year ended December 31, 2001. The
yield on earning assets declined to 6.44% from 7.97% for the years ended December 31, 2002 and 2001, respectively. During 2002, the mix of earning assets shifted to a higher proportion of average loans than investment securities as evidenced by the
ratios of average loans to investment securities which improved to 51.3% from 92.4% for 2002 and 2001, respectively. The increase in average earning assets coupled with the change in the earning asset mix was more than offset by the impact of
reduction in interest rates which began in 2001, causing a decline in interest income. The reduction in the investment securities yield resulting from the lower interest rates compounded by increased amortization of premiums on mortgage-related
securities due to higher prepayments compared with the prior year, also contributed to the decline in interest income and the yield on earning assets.



Interest expense decreased by 36.0% to $17.4 million from $27.1 million for the years ended December 31, 2002 and 2001, respectively. The cost of funds
declined to 2.50% from 4.51% for the respective years due to the reduction in interest rates which began in 2001. Average deposits increased 24.4% to $613.6 million for the year ended December 31, 2002 compared with the prior year.



28



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##### Table of Contents

The following tables present for the periods indicated the average balances, the interest earned or paid
on such amounts and the weighted average yields for each major category of interest-earning assets and interest-bearing liabilities. Calculations for all periods have been made utilizing daily average balances. Loan balances do not include
nonaccrual loans.



|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|----------------------------------------------- |  | --------------------------- | --------- | --------------------- | ---- | ---------------------- |  | ----- | --------------------------- |  | --------------------- | ------- | ----------------------- | - | ------ | --------------------------- | ----- | --------------------- |  | ----------------------- | ------- |  | - | ------ |  | ----- | -
|                                                |  | Years Ended December 31,    |          
|                                                |  | 2003                        |           |                       | 2002 |                        |  | 2001  |                            
|                                                |  | Average Outstanding Balance |           | Interest Earned/ Paid |      | Average Yield/RateRate |  |       | Average Outstanding Balance |  | Interest Earned/ Paid |         | Average Yield/Rate Rate |   |        | Average Outstanding Balance |       | Interest Earned/ Paid |  | Average Yield/Rate Rate |        
|                                                |  | (dollars in thousands)      |          
|Assets:                                         |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Interest-earning assets:                        |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Loans                                           |  | $                           | 640,159   |                       | $    | 40,325                 |  | 6.30  | %                           |  | $                     | 524,271 |                         | $ | 37,111 |                             | 7.08  | %                     |  | $                       | 353,147 |  | $ | 30,760 |  | 8.71  | %
|Securities                                      |  |                             | 309,985   |                       |      | 13,757                 |  | 4.44  |                             |  |                       | 258,535 |                         |   | 13,877 |                             | 5.37  |                       |  |                         | 320,007 |  |   | 23,189 |  | 7.25  |  
|Investments                                     |  |                             | 18,190    |                       |      | 188                    |  | 1.03  |                             |  |                       | 10,548  |                         |   | 142    |                             | 1.35  |                       |  |                         | 6,213   |  |   | 230    |  | 3.69  |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total interest-earning assets                   |  |                             | 968,334   |                       |      | 54,270                 |  | 5.60  | %                           |  |                       | 793,354 |                         |   | 51,130 |                             | 6.44  | %                     |  |                         | 679,367 |  |   | 54,179 |  | 7.97  | %
|Less allowance for loan losses                  |  |                             | 10,832    |                       |      |                        |  |       |                             |  |                       | 8,948   |                         |   |        |                             |       |                       |  |                         | 5,696   |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total interest-earning assets, net of allowance |  |                             | 957,502   |                       |      |                        |  |       |                             |  |                       | 784,406 |                         |   |        |                             |       |                       |  |                         | 673,671 |  |   |        |  |       |  
|Noninterest-earning assets:                     |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Bank owned life insurance                       |  |                             | 22,837    |                       |      |                        |  |       |                             |  |                       | 20,870  |                         |   |        |                             |       |                       |  |                         | 15,639  |  |   |        |  |       |  
|Other noninterest-earning assets                |  |                             | 58,425    |                       |      |                        |  |       |                             |  |                       | 45,842  |                         |   |        |                             |       |                       |  |                         | 34,809  |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total assets                                    |  | $                           | 1,038,764 |                       |      |                        |  |       |                             |  | $                     | 851,118 |                         |   |        |                             |       |                       |  | $                       | 724,119 |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Liabilities and Stockholders Equity:           |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Interest-bearing liabilities:                   |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Interest-bearing demand deposits                |  | $                           | 44,119    |                       | $    | 175                    |  | 0.40  | %                           |  | $                     | 40,471  |                         | $ | 445    |                             | 1.10  | %                     |  | $                       | 31,398  |  | $ | 383    |  | 1.22  | %
|Savings and money market accounts               |  |                             | 107,800   |                       |      | 712                    |  | 0.66  |                             |  |                       | 111,337 |                         |   | 1,520  |                             | 1.37  |                       |  |                         | 84,410  |  |   | 2,507  |  | 2.97  |  
|Time deposits                                   |  |                             | 498,183   |                       |      | 8,955                  |  | 1.80  |                             |  |                       | 461,826 |                         |   | 12,137 |                             | 2.63  |                       |  |                         | 377,680 |  |   | 18,742 |  | 4.96  |  
|Other borrowings                                |  |                             | 170,244   |                       |      | 3,164                  |  | 1.86  |                             |  |                       | 67,769  |                         |   | 1,842  |                             | 2.72  |                       |  |                         | 95,209  |  |   | 4,084  |  | 4.29  |  
|Callable long term debt                         |  |                             | 5,000     |                       |      | 572                    |  | 11.44 |                             |  |                       | 5,000   |                         |   | 572    |                             | 11.44 |                       |  |                         | 5,000   |  |   | 572    |  | 11.44 |  
|Callable long term debt                         |  |                             | 8,000     |                       |      | 859                    |  | 10.74 |                             |  |                       | 8,000   |                         |   | 859    |                             | 10.74 |                       |  |                         | 8,000   |  |   | 859    |  | 10.74 |  
|Callable long term debt                         |  |                             | 7,167     |                       |      | 336                    |  | 4.69  |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total interest-bearing liabilities              |  |                             | 840,513   |                       |      | 14,773                 |  | 1.76  | %                           |  |                       | 694,403 |                         |   | 17,375 |                             | 2.50  | %                     |  |                         | 601,697 |  |   | 27,147 |  | 4.51  | %
|Noninterest-bearing liabilities:                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Demand deposits                                 |  |                             | 92,921    |                       |      |                        |  |       |                             |  |                       | 74,161  |                         |   |        |                             |       |                       |  |                         | 66,305  |  |   |        |  |       |  
|Other noninterest-bearing liabilities           |  |                             | 20,283    |                       |      |                        |  |       |                             |  |                       | 11,742  |                         |   |        |                             |       |                       |  |                         | 9,378   |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total liabilities                               |  |                             | 953,717   |                       |      |                        |  |       |                             |  |                       | 780,306 |                         |   |        |                             |       |                       |  |                         | 677,380 |  |   |        |  |       |  
|Stockholders equity                            |  |                             | 85,047    |                       |      |                        |  |       |                             |  |                       | 70,812  |                         |   |        |                             |       |                       |  |                         | 46,739  |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Total liabilities and stockholder equity       |  | $                           | 1,038,764 |                       |      |                        |  |       |                             |  | $                     | 851,118 |                         |   |        |                             |       |                       |  | $                       | 724,119 |  |   |        |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Net interest income                             |  |                             |           |                       | $    | 39,497                 |  |       |                             |  |                       |         |                         | $ | 33,755 |                             |       |                       |  |                         |         |  | $ | 27,032 |  |       |  
|                                                |  |                             |           |                       |      |                        |  |       |                             |  |                       |         |                         |   |        |                             |       |                       |  |                         |         |  |   |        |  |       |  
|Net interest spread                             |  |                             |           |                       |      |                        |  | 3.84  | %                           |  |                       |         |                         |   |        |                             | 3.94  | %                     |  |                         |         |  |   |        |  | 3.46  | %
|Net interest margin                             |  |                             |           |                       |      |                        |  | 4.08  | %                           |  |                       |         |                         |   |        |                             | 4.25  | %                     |  |                         |         |  |   |        |  | 3.98  | %



29



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##### Table of Contents

The following tables present information regarding changes in interest income and interest expense for
the periods indicated for each major category of interest-earning asset and interest-bearing liability which distinguishes between the changes attributable to changes in volume (changes in volume multiplied by old rate) and changes in rates (changes
in rates multiplied by old volume). The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) have been allocated between rate and volume variances
based on the percentage relationship of such variances to each other.



|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|--------------------------------------------- |  | --------------------------------------------------------------------- | ------ | ---- | --------------------------------------------------------------------- | ------ | ----- |  | - | ------ | - |  | ---- | ------ | - | ----- | - | ------- | - |  | - | ------ | -
|                                              |  | Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 |        |      | Year Ended December 31, 2002 Compared to Year Ended December 31, 2001 |       
|                                              |  | Increase (decrease) Due to Change in                                  |        |      | Increase (decrease) Due to Change in                                  |       
|                                              |  | Volume                                                                |        | Rate |                                                                       |        | Total |  |   | Volume |   |  | Rate |        |   | Total |  
|Interest-earning assets:                      |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Loans receivable                              |  | $                                                                     | 7,603  |      | $                                                                     | (4,389 | )     |  | $ | 3,214  |   |  | $    | 12,887 |   |       | $ | (6,536  | ) |  | $ | 6,351  |  
|Securities and investments                    |  |                                                                       | 2,769  |      |                                                                       | (2,843 | )     |  |   | (74    | ) |  |      | (3,662 | ) |       |   | (5,738  | ) |  |   | (9,400 | )
|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Total increase (decrease) in interest income  |  |                                                                       | 10,372 |      |                                                                       | (7,232 | )     |  |   | 3,140  |   |  |      | 9,225  |   |       |   | (12,274 | ) |  |   | (3,049 | )
|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Interest-bearing liabilities:                 |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Interest-bearing deposits                     |  |                                                                       | 802    |      |                                                                       | (5,062 | )     |  |   | (4,260 | ) |  |      | 4,406  |   |       |   | (11,936 | ) |  |   | (7,530 | )
|Other borrowings                              |  |                                                                       | 3,173  |      |                                                                       | (1,515 | )     |  |   | 1,658  |   |  |      | (1,237 | ) |       |   | (1,005  | ) |  |   | (2,242 | )
|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Total increase (decrease) in interest expense |  |                                                                       | 3,975  |      |                                                                       | (6,577 | )     |  |   | (2,602 | ) |  |      | 3,169  |   |       |   | (12,941 | ) |  |   | (9,772 | )
|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  
|Increase in net interest income               |  | $                                                                     | 6,397  |      | $                                                                     | (655   | )     |  | $ | 5,742  |   |  | $    | 6,056  |   |       | $ | 667     |   |  | $ | 6,723  |  
|                                              |  |                                                                       |        |      |                                                                       |        |       |  |   |        |   |  |      |        |   |       |   |         |   |  |   |        |  



Provision for Loan Losses



The provision for loan losses is a current
charge to earnings made in order to increase the allowance for loan losses to a level deemed appropriate by management based on an evaluation of the loan portfolio, current economic conditions, changes in the nature and volume of lending, historical
loan experience and other relevant factors. Our loan loss allowance is calculated by stratifying the loan portfolio by risk classifications and applying risk factors to each category. The risk factors are derived by considering relevant loss
experience since 1992 of banks headquartered in Virginia, D.C., and Maryland, with $1 billion or more in assets as well as applying management judgment. The provision for loan losses for the year ended December 31, 2003 was $4.8 million compared
with $5.1 million for the year ended December 31, 2002. As of and for the year ended December 31, 2003 the allowance for loan losses was $10.5 million, or 1.72% of total loans receivable, while net charge-offs to average loans receivable were .71%.
We continue to monitor the loan portfolio and make charge-offs we deem appropriate, particularly given the uncertainty in the U.S. economy. Due to the uncertainty of risks in the loan portfolio, managements judgment of the amount of the
allowance necessary to absorb loan losses is approximate; however, the allowance for loan losses at December 31, 2003 represents managements best estimate of inherent probable losses in the loan portfolio at that date.



The provision for loan losses for the year ended December 31, 2002 was $5.1
million compared with $4.5 million for the year ended December 31, 2001. The allowance for loan losses at December 31, 2002 was $10.3 million, or 1.70% of total loans receivable, net of deferred fees. The ratio of net charge-offs to average loans
receivable were .67%, while the ratio of nonperforming assets to total assets was .23% for the same period.



30



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##### Table of Contents

Other Income



2003 versus 2002



Total other income increased to $7.7 million from $4.4 million for the years ended December 31, 2003 and 2002, respectively, an increase of 75.0%. This
significant increase in other income is primarily the result of net losses on securities sales totaling $95 thousand during 2003 versus $1.6 million during 2002. During 2003, the net gains that resulted from sales of securities, including trust
preferred and mortgage-backed securities were largely offset by losses resulting from write-downs of interest-only strips incurred earlier in 2003. During 2002, the net losses on securities were primarily due to write-downs of interest-only strips
which were offset by gains on sales of securities. To a lesser extent, net gains on other assets totaling $289 thousand also contributed to the increased other income during 2003 compared with 2002, which included net losses on other assets of $17
thousand. Total other income excluding net losses on securities and net gains and losses on other assets, noted above increased to $7,537 from $5,989, or 25.8%. Fee income generated from our core banking services comprised 46% of the increase. These
fees include commercial service products are comprised of account maintenance and electronic banking fees, commercial service fees, other loan fees, and system maintenance and license fees. Southern Financial has invested in technology over recent
years to develop and support cash management and other web-based products to provide cash management solutions to small and medium sized businesses. Gains on sales of loans, which increased by $878 thousand in 2003, comprised most of the remaining
increase and are primarily comprised of loans generated through Small Business Administration (SBA) lending programs.



2002 versus 2001



Total other income decreased to $4.4 million from $6.9 million for the years ended December 31, 2002 and 2001, respectively. During the years 2002 and
2001, respectively, Southern Financial recognized net securities losses totaling $1.6 million and net gains of $1.3 million, respectively. Securities losses for 2002 are comprised of net securities gains on sales totaling $2.9 million offset by $4.5
million of write-downs of residential interest-only strips included in our investment securities portfolio. At December 31, 2002, the remaining balance of residential interest only strips was reduced to $2.6 million. Net gains on other assets
totaled $840 thousand in 2001 and included a gain on sale of real estate offset by write-downs of intangible assets associated with software development. Net losses on other assets in 2002 totaled $17 thousand. Excluding the impact of net gains and
losses on investment securities and other assets, non-interest income increased 27.2% for the years ended December 31, 2002 and 2001, respectively. Areas of increase during 2002 included account maintenance and electronic banking fees, and fees
generated from commercial service products including lockbox fees and gains on sale of loans.



Other Expense



2003 versus 2002



Total other expenses for the years ended December 31, 2003 and 2002 were $22.9 million and $18.4 million, respectively, an increase of 24.2%. Several
factors contributed to the increase. Included in other expenses for 2003 were $770 thousand of expenses associated with the Provident Bankshares Corporation merger expected to close during the second quarter of 2004. Excluding these merger-related
expenses, other expenses increased 20.0%. The increase resulted, in part, from the ongoing operating expenses related to the Metro-County Bank merger which closed in August 2002. Operating expenses relating to the Metro-County branches totaled
approximately $2.3 million and $752 thousand for the years ended December 31, 2003 and 2002, representing 42% of the increase before merger-related expenses. The remaining increase resulted from the addition of our second Charlottesville de novo
branch during the latter part of 2002 and our downtown Richmond branch which opened in late 2003. Compensation-related expenses and general operating expenses also increased to support the growing franchise. Overall, the efficiency ratio was 46.3%
compared with 45.5% for the years ended December 31, 2003 and 2002, respectively. The efficiency ratio excludes amortization from intangibles of $320 thousand and merger-related expenses of $770 thousand from total other expenses and net gains on
securities and other assets of $289 thousand from other income.



2002 versus 2001



Total other expenses for the
year ended December 31, 2002 were $18.4 million, an increase of 8.3% when compared with the year ended December 31, 2001. This increase was largely due to operating expenses associated with the Metro-County Bank acquisition. Excluding the operating
expenses associated with Metro-County, other expenses increased 3.9%. Compensation and benefits, which represents 54.4% of total other expenses, increased 14.0%. New employees from Metro-County Bank, as well as increased head count from the
Georgetown and Charlottesville branches that opened during the second half of 2001, contributed to the increase. The efficiency ratio, the ratio of non-interest expenses before amortization of intangibles divided by net interest income and
non-interest income less gains on securities and non-recurring items, was 46.3% for the year ended December 31, 2002; an improvement compared with 53.5% for the year ended December 31, 2001. The efficiency ratio remained below 50% for each of the
four quarters of 2002.



31



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##### Table of Contents

The following presents the efficiency ratio:





|     |  |                  
|---- |  | -----------------
|     |  | Efficiency Ratio*
|1999 |  | 64.04            
|2000 |  | 60.70            
|2001 |  | 53.54            
|     | 
|2002 |  | 45.53            
|     | 
|2003 |  | 46.29            

---

|* | Efficiency Ratio excludes gains/losses on securities and other assets for all years presented. Also excluded were merger-related charges and expenses during 2003 and 1999 associated
with the Provident Bankshares Corporation merger and the Horizon Bank of Virginia merger, respectively.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Financial Condition



Loan Portfolio



Our loan portfolio composition reflects our commercial business focus on small to medium sized businesses which we adopted when we become a commercial
bank in 1995. We continue to pursue our niche lending of small to medium-sized business clients and, as a result, the growth in the loan portfolio is primarily in the commercial loan product lines. While total loans receivable increased $7.6 million
or 1.3 % from $607.4 million at December 31, 2002 to $615 million at December 31, 2003, the commercial loan portfolio increased $43.0 million, or 9.2%.The commercial loan portfolio is comprised of commercial real estate loans, including
construction loans and non-mortgage commercial and industrial loans. Commercial mortgage loans increased 12.6 %, while commercial and industrial loans decreased $7.7 million, or 4.6%. Impacting this net decrease was an $11.8 million reduction in
debt obligations classified as loans, or trust preferred securities of other banking institutions, that are included in non-mortgage loans as we elected to reduce our concentration in this area. Excluding the impact of the reduction in trust
preferred securities, commercial and industrial loans showed a slight increase.



Our commercial real estate lending program includes construction and permanent loans closed both under the Small Business Administration (SBA) loan programs and loans closed outside of the SBA programs that serve both
the investor and owner occupied facility market. The 504 loan program is used to finance long-term fixed assets, primarily real estate and heavy equipment and gives borrowers access to 90% financing for a project. Another SBA loan product, 7(a),
includes loans that may be used for the purchase of real estate, construction, renovation or leasehold improvements, as well as machinery, equipment, furniture, fixtures, inventory and in some instances, working capital and debt refinancing. The SBA
guarantees up to 80% of the loan balance in the 7(a) program and start-up businesses are eligible.



At December 31, 2003, commercial real estate loans totaled $347.0 million; of which $286.0 million were permanent loans and $60.7 million were
construction loans compared with $296.0 million at December 31, 2002, of which $254.0 million were permanent loans and $42.1 million were construction loans. The construction loans included owner occupied commercial real estate, economy hotels and a
shopping center. Permanent and construction commercial real estate loans outstanding under the SBA 7(a) and 504 loan programs totaled $33.3 million at December 31, 2003.



At December 31, 2003, we had $163.0 million in commercial and industrial loans, which represented 26.5% of our total loans
receivable at that date compared with $170.8 million at December 31, 2002. Of the total commercial and industrial loans, 16.4% are loans made under the SBA 7(a) program. Commercial and industrial loans also include loans originated under our
Accounts Receivable Tracking System, or ARTS. At December 31, 2003, $54.8 million, or 33.6% of commercial business loans were part of this program.



New loan closings during 2003 totaled $260.7 million, which exceeded loan closings for the year ended December 31, 2002, which totaled $240.3 million. Our
higher level of loan closings reflects both our strategy to focus on our primary business customers and our ability to offer financing to them at loan amounts that exceed the smaller banks loan to one borrower limitations and are too small to be a
primary focus for banks that are much larger. Our commitment to technology and cash management products has also provided us with opportunities to provide financing to the small to medium-sized business clients. Despite the growth in new loan
closings, loan prepayments during 2003 were higher than during 2002, primarily due to the heavy refinance market resulting from the historically low interest rates. During the same period we also experienced higher builder construction loan
repayments, because of the builders ability to pay down loans with sales and we noted higher prepayments of loans purchased in prior years because of the low interest rate environment.



32



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##### Table of Contents

The following table presents commercial loan growth (in thousands):





|     |  |                        |        
|---- |  | ---------------------- | -------
|     |  | Commercial Loan Growth
|1998 |  | $                      | 137,152
|1999 |  | $                      | 172,316
|2000 |  | $                      | 239,230
|2001 |  | $                      | 331,974
|     | 
|2002 |  | $                      | 466,786
|     | 
|2003 |  | $                      | 509,779



Investment
Activities



Our securities portfolio is managed by our
President and our Senior Vice President/Treasurer, both of whom have significant experience in this area, with the concurrence of our Asset/Liability Committee. Investment management is performed in accordance with our investment policy, which is
approved annually by the Asset/Liability Committee and the board of directors. Our investment policy addresses our investment strategies, approval process, approved securities dealers and authorized investments. During 2003, investment securities
classified as available-for-sale were sold from time to time as part of our asset/liability management strategy in response to changes in interest rates and liquidity needs.



Total investment securities increased to $377.5 million, or 85.5% from 2003 to 2002, including securities classified as
held-to-maturity totaling $250.2 million, all of which were purchased during 2003. Investment securities classified as available-for-sale decreased 37.4% from December 31, 2003 to December 31, 2002. We decreased investment securities available for
sale through principal repayments and sales totaling $159.4 million combined, which was partially offset by investment securities purchases totaling $88 million during the year ended December 31, 2003, with the remaining change attribute to changes
in premiums and discounts on investment securities. The investment securities purchased consisted primarily of agency mortgage-backed securities and collateralized mortgage obligations. Investment securities totaling $105 million were purchased as
part of a leveraged transaction in coordination with a $10 million adjustable rate trust preferred issuance in April 2003.



Deposits



Deposits, which represent 76.2% of our interest-rate sensitive liabilities as of December 31, 2003, have historically been the primary source of funding
our asset growth. In addition to deposits, we obtain funds from loan repayments, maturing investments, loans and investment securities sales, cash flows generated from operations, callable long-term debt and both short-term and long-term Federal
Home Loan Bank advances. Short-term borrowings may be used as an alternative source of lower cost funds or to fund the origination of certain assets. In addition, during 2003, funding was obtained through long-term securities sold under agreements
to repurchase as part of a balance sheet strategy to lever the issuance of trust preferred securities earlier in the year.



Total deposits declined 4.2% to $743.7 million at December 31, 2003 from $776.1 million at December 31, 2002. Increases in demand deposits and time
deposits were offset by a decline in money market and savings accounts for the year ended December 31, 2003 compared with 2002. At December 31, 2003, we had $103.9 million of noninterest-bearing deposits compared with $92.6 million at December 31,
2002, an increase of 12.2%. Competition in the retail banking markets where Southern Financial maintains branches contributed, in part, to the decline money market and savings accounts as did the low interest rate environment and appeal of
alternative investments such as the stock market and mutual funds.



As of December 31, 2003, total interest rate swaps employed to hedge certificates of deposits, totaled $306.5 million compared with $287.5 million as of December 31, 2002. For both years, all but $20 million of the interest rate swaps were
in the form of fair value hedges. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on these interest rate swaps is generally tied to the three-month LIBOR, which approximates
the issuance rate on individual certificates of deposits. The level of callable certificates of deposits and the interest rate swaps are expected to decline in the future as the interest rate swaps and certificates of deposits are called and
replaced with alternative sources of funding.



33



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##### Table of Contents

Borrowings



Borrowings consist of overnight and term advances from the Federal Home Loan Bank of Atlanta, short-term and long-term
securities sold under agreements to repurchase and callable long-term debt. During 2003, term borrowings comprised a greater percentage of total deposits and borrowings compared with the prior year as part of a balance sheet strategy to lever the
balance sheet and reduce interest rate risk. Term borrowings excluding callable long-term debt totaled $169.7 million at December 31, 2003 and $65 million at December 31, 2002. Of the increase, $75 million represents long-term securities sold under
agreements to repurchase with staggered maturities to correspond with the expected prepayments of the funded investment securities. In addition, $25 million in long-term adjustable rate advances from the Federal Home Loan Bank of Atlanta were issued
during the year and hedged with an interest rate swap, converting the debt to a fixed rate borrowing as part of the overall balance sheet strategy to lock into some fixed rate funding and partially offset the interest rate sensitivity associated
with the callable certificates of deposit described above.



The
following table presents total assets and capital (in thousands):



|     |  |              |  |               
|---- |  | ------------ |  | --------------
|     |  | Total Assets |  | Total Capital*
|1998 |  | 404,254      |  | 30,626        
|1999 |  | 406,222      |  | 28,864        
|2000 |  | 609,936      |  | 52,689        
|2001 |  | 784,977      |  | 77,668        
|2002 |  | 970,630      |  | 94,303        
|2003 |  | 1,094,388    |  | 115,857       

---

|* | Total capital includes stockholders equity and callable long-term debt
|- | -----------------------------------------------------------------------



Interest Rate Sensitivity and Market Risk



We are engaged primarily in the business of investing funds obtained from deposits and borrowings into interest-bearing loans and investments.
Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between the interest income on loans and investments and the interest expense on deposits and borrowing. To the extent that our
interest-bearing liabilities do not reprice or mature at the same time as our interest-bearing assets, we are subject to interest rate risk and corresponding fluctuations in net interest income. We have employed asset/liability management policies
that attempt to manage our interest-earning assets and interest-bearing liabilities, thereby attempting to control the volatility of net interest income, without having to incur unacceptable levels of credit or investment risk.



We actively manage our overall exposure to changes in interest rates. In
managing our funding, we first attempt to gauge the direction of interest rates, which will determine how much sensitivity we are willing to take. If rates are decreasing, we seek to fund with liabilities that reprice in the near future. If rates
are rising, we attempt to do the opposite. When necessary, we will enter into interest rate swaps, financial options or forward delivery contracts for the purpose of reducing interest rate risk. Our interest rate sensitivity and market analysis
includes the effect of these interest rate swap hedges.



Management uses a duration gap of equity approach to manage our interest rate risk and reviews quarterly interest sensitivity reports. Beginning with the third quarter of 2002 these reports were prepared using a model created by a third
party. This approach uses a model which generates estimates of the change in our market value of portfolio equity (MVPE) over a range of interest rate scenarios. MVPE is the present value of expected cash flows from assets, liabilities
and off-balance sheet contracts using standard industry assumptions about estimated loan prepayment rates, reinvestment rates and deposit decay rates.



With respect to our residential mortgage loan portfolio, it is our policy to retain those mortgage loans which have an adjustable interest rate and to
sell most fixed rate mortgage loans originated into the secondary market. In addition, our commercial loans generally have rates that are tied to the prime rate, the one-year Constant Maturity Treasury (CMT) rate as reported by the
Federal Reserve Board, or the three-year CMT rate. Both of these actions help control our exposure to rising interest rates.



34



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##### Table of Contents

The following table prepared by a third party sets forth an analysis of our interest rate risk as
measured by the estimated change in MVPE resulting from instantaneous and sustained parallel shifts in the yield curve (plus or minus 300 basis points, measured in 100 basis point increments) as of December 31, 2003 and 2002:



Sensitivity of Market Value of Portfolio Equity

As of December 31, 2003

(amounts in thousands)



|                                                      |        |                                  |                    |  |                                            |                    |   |  |              |    |  |                             |   |  |        |  
|----------------------------------------------------- | ------ | -------------------------------- | ------------------ |  | ------------------------------------------ | ------------------ | - |  | ------------ | -- |  | --------------------------- | - |  | ------ | -
|Change in Interest
Rates In Basis Points (Rate
Shock) |        | Market Value of Portfolio Equity |                    |  | Market Value of Portfolio Equity as a % of |                   
|                                                      | Amount |                                  | $ Change From Base |  |                                            | % Change From Base |   |  | Total Assets |    |  | Portfolio Equity Book Value |  
|Up 300                                                |        | $                                | 86,144             |  | $                                          | (43,825            | ) |  | (33.72       | )% |  | 7.87                        | % |  | 92.77  | %
|Up 200                                                |        |                                  | 97,797             |  |                                            | (32,172            | ) |  | (24.75       | )  |  | 8.94                        |   |  | 105.32 |  
|Up 100                                                |        |                                  | 112,767            |  |                                            | (17,202            | ) |  | (13.24       | )  |  | 10.30                       |   |  | 121.44 |  
|Base                                                  |        |                                  | 129,969            |  |                                            |                   |   |  | 0.00         |    |  | 11.88                       |   |  | 139.97 |  
|Down 100                                              |        |                                  | 137,336            |  |                                            | 7,367              |   |  | 5.67         |    |  | 12.55                       |   |  | 147.90 |  
|Down 200                                              |        |                                  | 135,600            |  |                                            | 5,631              |   |  | 4.33         |    |  | 12.39                       |   |  | 146.03 |  
|Down 300                                              |        |                                  | 137,789            |  |                                            | 7,820              |   |  | 6.02         |    |  | 12.59                       |   |  | 148.39 |  



Sensitivity of Market
Value of Portfolio Equity

As of December 31, 2002

(amounts in thousands)



|                                                      |        |                                  |                   |  |                                            |                   |   |  |              |    |  |                            |   |  |        |  
|----------------------------------------------------- | ------ | -------------------------------- | ----------------- |  | ------------------------------------------ | ----------------- | - |  | ------------ | -- |  | -------------------------- | - |  | ------ | -
|Change in Interest
Rates In Basis Points (Rate
Shock) |        | Market Value of Portfolio Equity |                   |  | Market Value of Portfolio Equity as a % of |                  
|                                                      | Amount |                                  | $ Change FromBase |  |                                            | %Change From Base |   |  | Total Assets |    |  | Portfolio Equity BookValue |  
|Up 300                                                |        | $                                | 77,014            |  | $                                          | (19,033           | ) |  | (19.82       | )% |  | 7.94                       | % |  | 94.72  | %
|Up 200                                                |        |                                  | 85,031            |  |                                            | (11,016           | ) |  | (11.47       | )  |  | 8.76                       |   |  | 104.59 |  
|Up 100                                                |        |                                  | 93,808            |  |                                            | (2,239            | ) |  | (2.33        | )  |  | 9.67                       |   |  | 115.38 |  
|Base                                                  |        |                                  | 96,047            |  |                                            |                  |   |  | 0.00         |    |  | 9.90                       |   |  | 118.13 |  
|Down 100                                              |        |                                  | 100,057           |  |                                            | 4,010             |   |  | 4.18         |    |  | 10.31                      |   |  | 123.07 |  
|Down 200                                              |        |                                  | 99,367            |  |                                            | 3,320             |   |  | 3.46         |    |  | 10.24                      |   |  | 122.22 |  
|Down 300                                              |        |                                  | 97,493            |  |                                            | 1,446             |   |  | 1.51         |    |  | 10.05                      |   |  | 119.91 |  



Our interest rate
sensitivity is also monitored by management through the use of a model that generates estimates of the change in the adjusted net interest income over a range of interest rate scenarios. The Federal Home Loan Bank of Atlanta also prepares such
analysis for us. Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income also depends upon the relative amounts of interest-earning assets and
interest-bearing liabilities and the interest rate earned or paid on them. In this regard, the model assumes that the composition of our interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period
being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities.



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##### Table of Contents

Sensitivity of Net Interest Income

As of December 31, 2003

(amounts in thousands)



|                                                      |        |                              |                   |  |                     |         |  |      |                    |  |       |   
|----------------------------------------------------- | ------ | ---------------------------- | ----------------- |  | ------------------- | ------- |  | ---- | ------------------ |  | ----- | --
|Change in Interest
Rates In Basis Points (Rate
Shock) |        | Adjusted Net Interest Income |                   |  | Net Interest Margin |        
|                                                      | Amount |                              | % ChangeFrom Base |  |                     | Percent |  |      | % Change From Base | 
|Up 300                                                |        | $                            | 32,520            |  | (12.70              | )%      |  | 2.97 | %                  |  | (0.43 | )%
|Up 200                                                |        |                              | 34,225            |  | (8.13               | )       |  | 3.13 |                    |  | (0.27 | ) 
|Up 100                                                |        |                              | 35,796            |  | (3.91               | )       |  | 3.27 |                    |  | (0.13 | ) 
|Base                                                  |        |                              | 37,253            |  |                    |         |  | 3.40 |                    |  |      |   
|Down 100                                              |        |                              | 37,507            |  | 0.68                |         |  | 3.43 |                    |  | 0.03  |   
|Down 200                                              |        |                              | 34,234            |  | (8.10               | )       |  | 3.13 |                    |  | (0.27 | ) 
|Down 300                                              |        |                              | 30,658            |  | (17.70              | )       |  | 2.80 |                    |  | (0.60 | ) 



Sensitivity of Net
Interest Income

As of December 31, 2002

(amounts in thousands)



|                                                      |        |                              |                    |  |                     |         |  |      |                    |  |       |  
|----------------------------------------------------- | ------ | ---------------------------- | ------------------ |  | ------------------- | ------- |  | ---- | ------------------ |  | ----- | -
|Change in Interest
Rates In Basis Points (Rate
Shock) |        | Adjusted Net Interest Income |                    |  | Net Interest Margin |        
|                                                      | Amount |                              | % Change From Base |  |                     | Percent |  |      | % Change From Base | 
|Up 300                                                |        | $                            | 37,009             |  | 8.42                | %       |  | 3.81 | %                  |  | 0.29  | %
|Up 200                                                |        |                              | 37,613             |  | 10.19               |         |  | 3.88 |                    |  | 0.36  |  
|Up 100                                                |        |                              | 37,668             |  | 10.35               |         |  | 3.88 |                    |  | 0.36  |  
|Base                                                  |        |                              | 34,134             |  |                    |         |  | 3.52 |                    |  |      |  
|Down 100                                              |        |                              | 34,296             |  | 0.47                |         |  | 3.53 |                    |  | 0.02  |  
|Down 200                                              |        |                              | 32,449             |  | (4.94               | )       |  | 3.34 |                    |  | (0.17 | )
|Down 300                                              |        |                              | 28,868             |  | (15.43              | )       |  | 2.98 |                    |  | (0.54 | )



The market value of
portfolio equity and net interest income worsened in the up 100, 200 and 300 basis point rate shocks from December 31, 2002 to 2003 primarily due to the portfolio of residential mortgage-backed interest only strips, included in commercial mortgage
obligations in 2002 which prepaid by early 2003. We invested in interest only strips to hedge against an expected rise in interest rates. During 2002 and early 2003 the residential mortgage prepayments reached historical highs and the amortization
of the interest only strips accelerated, resulting in a complete write-down of the interest only strips by early 2003. Based on this experience, we elected not to replace this investment because they proved to be expensive when rates remained
unchanged.



Certain shortcomings are inherent in the
methodology used in the above interest rate risk measurements. Modeling changes in MVPE requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates.
Accordingly, although the MVPE table and Sensitivity of Net Interest Income table provide an indication of our interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of
the effect of changes in market interest rates on our worth and net interest income.



As part of our interest rate risk management, we use interest rate swaps that are accounted for as both cash flow and fair value hedges in accordance with Statement of Financial Accounting Standards No. 133. Cash flow
hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities. At the inception of the hedge, we determine and document the risk management objective and strategy, the
hedged risk, the derivative instrument, the hedged item and how hedge effectiveness will be assessed initially and on an ongoing basis. At the inception of the hedge and on an ongoing basis, the hedge must be deemed to be highly effective in hedging
the hedged risk in order to qualify for hedge accounting. Effectiveness is measured by comparing the change in London Inter Bank Offer Rate, or LIBOR (which the interest rate swap is priced from) to the change in the rate underlying the hedged asset
or liability. If high correlation is not achieved, the hedging designation is discontinued with the change in the fair value of the interest rate swap recorded as other income or expense. In the event that any derivative or hedged item is terminated
or sold, the gain or loss on the derivative will be amortized over the remaining life of the item hedged. Interest to be received or paid on the interest rate swap is accrued monthly. Of our $327.5 million in interest rate swaps, $307.5 million are
fair value hedges.



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##### Table of Contents

Liquidity and Funds Management



The objective of our liquidity management is to assure the ability to meet our financial obligations. These obligations
include the payment of deposits on demand or at maturity, the repayment of borrowings at maturity and the ability to fund loan commitments and other new business opportunities. We obtain funding from a variety of sources, including customer deposit
accounts, customer certificates of deposit and payments on our loans and investments. Historically, our level of core deposits has been insufficient to fully fund our lending activities. Therefore, we must seek funding from additional sources,
including brokered certificates of deposit, available-for-sale investment securities and maintaining lines of credit from the Federal Home Loan Bank of Atlanta and reverse repurchase agreement borrowings from approved securities dealers.



In addition, we use derivative products such as interest rate swaps which
enhance our liquidity through the issuance of long-term liabilities to match with our long-term assets. We also enhance our liquidity by monitoring unfunded loan commitments, which reduces unexpected funding requirements.



During the year ended December 31, 2003, we funded our financial obligations
with deposits, long-term and short-term borrowings and cash flows from loan and investment securities repayments and sales. At December 31, 2003, we had $48.2 million of unfunded lines of credit and undisbursed construction loan funds of $67
million. Approved loan commitments were $6.8 million at December 31, 2003. Management anticipates that funding requirements for these commitments can be met from the normal sources of funds.



Capital Resources



Capital management consists of providing equity to support both current and future operations. We and the bank are subject
to capital adequacy requirements imposed by the Federal Reserve. The Federal Reserve has adopted risk-based capital requirements for assessing bank holding company and member bank capital adequacy. Under current Federal Reserve Board regulations,
these requirements are (a) leverage capital of 4.0% of adjusted average total assets; (b) Tier I capital of 4% of risk-weighted assets; (c) Tier I and II capital of 8% of risk-weighted assets. At December 31, 2003, the Banks capital ratios
were 9.43% leverage capital; 13.80% Tier I capital; and 15.05% Tier I and Tier II capital.



Pursuant to FDICIA, each federal banking agency revised its risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentration of credit risk and the risks of
nontraditional activities. As a member of the Federal Reserve System, the bank is subject to capital adequacy guidelines of the Federal Reserve. Also pursuant to FDICIA, the Federal Deposit Insurance Corporation has promulgated regulations setting
the levels at which an insured institution such as the bank would be considered well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically
undercapitalized. The Bank is classified well capitalized for purposes of the FDICs prompt corrective action regulations.



Impact of Inflation and Changing Prices



Our financial statements and related notes included in this document have been prepared in accordance with generally accepted accounting principles. These
require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.



Unlike many industrial companies, substantially all of our assets and
virtually all of our liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or
in the same magnitude as the prices of goods and services. However, other expenses do reflect general levels of inflation.



Critical Accounting Policies



Our accounting and reporting policies are in accordance with the accounting principles generally accepted in the United States of America and conform with
general practices in the banking industry. The preparation of financial statements in conformity with these principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of
the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on information available at the date of the financial statements and could differ from actual results.
The more critical of the accounting policies involves the determination of the allowance for loan losses and accounting for derivative financial instruments.



Allowance for Loan Losses



The allowance for loan losses is established through a provision for loan losses, which is charged to expense. Loans are charged against the allowance for
loan losses when management believes that the collectibility of the principal is unlikely. The allowance is a current estimate of the known and inherent losses in the present portfolio based upon managements evaluation of the loan portfolio.
Estimates of losses inherent in the portfolio involve the exercise of judgment and the use of assumptions. The evaluations take into consideration such factors as changes in the nature, volume and quality of the loan portfolio, prior loss
experience, level of nonperforming loans, current and anticipated general economic conditions and the value and adequacy of collateral. Changes in the estimate of losses may occur due to changing economic conditions and the economic conditions of
borrowers.



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##### Table of Contents

A loan is considered impaired when, based on all current information and events, it is probable that we
will be unable to collect all amounts due according to the contractual terms of the agreement, including all scheduled principal and interest payments. Such impaired loans are measured based on the present value of expected future cash flows,
discounted at the loans effective interest rate or, impairment may be measured based on the loans observable market price, or if, the loan is collateral dependent, the fair value of the collateral. When the measure of the impaired loan
is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Loans for which foreclosure is probable continue to be accounted for as loans.



Each impaired loan is evaluated individually to determine the income recognition policy. Generally, payments received are
applied in accordance with the contractual terms of the note or as a reduction of principal.



Derivative Financial Instruments



As part of our interest rate risk management, we use interest rate swaps that are accounted for as both cash flow and fair value hedges in accordance with Statement of Financial Accounting Standards No. 133. Cash flow
hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities. At the inception of the hedge, the risk management objective and strategy, the hedged risk, the
derivative instrument, the hedged item and how hedge effectiveness will be assessed initially and on an ongoing basis are documented. At inception of the hedge and on an ongoing basis, the hedge must be deemed to be highly effective in hedging the
hedged risk in order to qualify for hedge accounting. Effectiveness is measured by comparing the change in LIBOR (which the interest rate swap is priced from) to the change in the rate underlying the hedged asset or liability. If high correlation is
not achieved, the hedging designation is discontinued with the change in the fair value of the interest rate swap recorded as other income or expense. In the event that any derivative that meets the requirements for hedge accounting or hedged item
is terminated or sold, the gain or loss on the derivative will be amortized over the remaining life of the item hedged. Interest to be received or paid on the interest rate swaps is accrued monthly.



We use interest rate swaps that are accounted for as cash flow hedges to
hedge the issuance of pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on
the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce long-term fixed rate deposits. The fair
value of the interest rate swap is recorded in other assets in the consolidated balance sheets with changes in the fair value included in other comprehensive income. To the extent that the hedge is not completely effective, the ineffective portion
is charged or credited to other income or expense in the consolidated statements of income. The amounts recorded in other comprehensive income are subsequently reclassified into interest expense as a yield adjustment in the same period in which the
related interest on the CDs affect earnings.



We also use
interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on
the interest rate swaps is generally tied to three-month LIBOR, which approximates the issuance rate on the individual CDs. The combination of the swaps and the issuance of the individual CDs operates to produce long-term floating rate
deposits. The CDs and the interest rate swaps have like terms and were committed to simultaneously. To the extent that the hedge is not completely effective, the ineffective portion is charged or credited to interest expense in the consolidated
statements of income. Both the interest rate swap (included in other assets in the consolidated balance sheets) and the CDs are recorded at fair value, with changes in fair value included in the statements of income as interest expense.



We incorporate all items from the consolidated balance sheet as well as
off-balance sheet items such as derivative items used to hedge balance sheet items in an overall assessment of its interest rate risk. All on-balance sheet items and off-balance sheet items are incorporated in a report that is generated quarterly by
the Federal Home Loan Bank of Atlanta that assesses the interest rate risk in different interest rate environments. The report shows how the market value of our portfolio value of equity changes when interest rates rise or fall 1%, 2%, and 3%. The
report also shows the change in net interest income in the same interest rate change scenarios.



Off Balance Sheet Arrangements



In May of 2000, we formed a wholly-owned statutory business trust, Southern Financial Capital Trust I, which issued $5.0 million in trust preferred securities and in September 2000, we formed a second wholly-owned statutory business trust,
Southern Financial Statutory Trust I, which issued $8.0 million in trust preferred securities. Finally, in April 2003, we formed a third wholly-owned statutory business, Southern Financial Capital Trust III, which issued $10.0 million in trust
preferred securities. Each trust invested the proceeds in an equivalent amount of our junior subordinated debentures bearing an interest rate equal to the distribution rate on the respective issue of trust preferred securities.



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##### Table of Contents

Contractual Obligations



The following table represents our contractual obligations due by period:



|                                                           |  |                        |         |                  |   |           |  |           |         |                   |   |        |  |   |       
|---------------------------------------------------------- |  | ---------------------- | ------- | ---------------- | - | --------- |  | --------- | ------- | ----------------- | - | ------ |  | - | ------
|                                                           |  | Payments due by period
|(dollars in thousands)                                     |  | Total                  |         | Less than 1 year |   | 1-3 years |  | 3-5 years |         | More than 5 years
|Contractual Obligations                                    |  |                        |         |                  |   |           |  |           |         |                   |   |        |  |   |       
|Advances from Federal Home Loan Bank - long term           |  | $                      | 64,736  |                  | $ |          |  | $         | 24,796  |                   | $ | 25,000 |  | $ | 15,000
|Securities sold under agreements to repurchase - long term |  |                        | 105,000 |                  |   |          |  |           | 80,000  |                   |   | 25,000 |  |   |      
|Callable long term debt                                    |  |                        | 23,000  |                  |   |          |  |           |        |                   |   |       |  |   | 23,000
|Operating lease obligations                                |  |                        | 9,288   |                  |   | 1,707     |  |           | 2,821   |                   |   | 2,317  |  |   | 2,443 
|                                                           |  |                        |         |                  |   |           |  |           |         |                   |   |        |  |   |       
|Total                                                      |  | $                      | 202,024 |                  | $ | 1,707     |  | $         | 107,617 |                   | $ | 52,317 |  | $ | 40,443
|                                                           |  |                        |         |                  |   |           |  |           |         |                   |   |        |  |   |       



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##### Table of Contents

Item 8. Financial Statements



INDEPENDENT AUDITORS REPORT



Southern
Financial Bancorp, Inc.



To the Board of
Directors and Stockholders of

Southern Financial Bancorp, Inc.:



We have audited the accompanying consolidated balance sheets of Southern
Financial Bancorp, Inc. and subsidiaries (Bancorp) as of December 31, 2003 and 2002, and the related consolidated statements of income, comprehensive income, changes in stockholders equity and cash flows for each of the years in the three-year
period ended December 31, 2003. These consolidated financial statements are the responsibility of Bancorps management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southern Financial Bancorp, Inc. and subsidiaries as of December 31, 2003 and
2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.



Richmond, VA,

February 27, 2004



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##### Table of Contents

CONSOLIDATED BALANCE SHEETS

AS OF DECEMBER 31, 2003 and 2002

(dollars in thousands except per share data)



|                                                                                                                                                                         |  |      |           |   |      |   |        
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---- | --------- | - | ---- | - | -------
|                                                                                                                                                                         |  | 2003 |           |   | 2002
|Assets                                                                                                                                                                   |  |      |           |   |      |   |        
|Cash and due from banks                                                                                                                                                  |  | $    | 24,859    |   |      | $ | 28,705 
|Overnight earning deposits                                                                                                                                               |  |      | 11,527    |   |      |   | 64,693 
|Investment securities, available-for-sale                                                                                                                                |  |      | 127,332   |   |      |   | 203,563
|Investment securities, held-to-maturity                                                                                                                                  |  |      | 250,201   |   |      |   |       
|Loans held for sale                                                                                                                                                      |  |      | 8,651     |   |      |   | 514    
|Loans receivable, net                                                                                                                                                    |  |      | 601,118   |   |      |   | 594,323
|Cash surrender value of life insurance                                                                                                                                   |  |      | 23,378    |   |      |   | 22,287 
|Premises and equipment, net                                                                                                                                              |  |      | 9,573     |   |      |   | 8,264  
|Intangible assets, net                                                                                                                                                   |  |      | 14,167    |   |      |   | 14,558 
|Other assets                                                                                                                                                             |  |      | 23,582    |   |      |   | 33,723 
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Total assets                                                                                                                                                             |  | $    | 1,094,388 |   |      | $ | 970,630
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Liabilities and Stockholders Equity                                                                                                                                     |  |      |           |   |      |   |        
|                                                                                                                                                                         |  |     
|Liabilities:                                                                                                                                                             |  |      |           |   |      |   |        
|Deposits                                                                                                                                                                 |  | $    | 743,737   |   |      | $ | 776,083
|Advances from Federal Home Loan Bank - short term                                                                                                                        |  |      | 7,000     |   |      |   |       
|Advances from Federal Home Loan Bank - long term                                                                                                                         |  |      | 64,796    |   |      |   | 65,000 
|Securities sold under agreements to repurchase - short term                                                                                                              |  |      | 32,959    |   |      |   | 18,456 
|Securities sold under agreements to repurchase - long term                                                                                                               |  |      | 105,000   |   |      |   |       
|Callable long term debt                                                                                                                                                  |  |      | 23,000    |   |      |   | 13,000 
|Other liabilities                                                                                                                                                        |  |      | 25,039    |   |      |   | 16,788 
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Total liabilities                                                                                                                                                        |  |      | 1,001,531 |   |      |   | 889,327
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Stockholders equity:                                                                                                                                                    |  |      |           |   |      |   |        
|Preferred stock, $.01 par value, 1,000,000 shares authorized, none in 2003 and 12,858 shares of 6% cumulative convertible preferred stock
issued and outstanding in 2002 |  |      |          |   |      |   |       
|Common stock, $.01 par value, 20,000,000 shares authorized, 6,208,589 and 5,441,180 shares issued and outstanding,
respectively                                          |  |      | 62        |   |      |   | 54     
|Capital in excess of par                                                                                                                                                 |  |      | 91,700    |   |      |   | 81,167 
|Retained earnings                                                                                                                                                        |  |      | 2,504     |   |      |   |       
|Accumulated other comprehensive income (loss)                                                                                                                            |  |      | (1,409    | ) |      |   | 82     
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Total stockholders equity                                                                                                                                               |  |      | 92,857    |   |      |   | 81,303 
|                                                                                                                                                                         |  |      |           |   |      |   |        
|Total liabilities and stockholders equity                                                                                                                               |  | $    | 1,094,388 |   |      | $ | 970,630
|                                                                                                                                                                         |  |      |           |   |      |   |        



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



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##### Table of Contents

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2003, 2002, and 2001

(dollars in thousands except per share data)



|                                                    |  |      |           |   |      |   |           |      |  |   |          
|--------------------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | ---- |  | - | ---------
|                                                    |  | 2003 |           |   | 2002 |   |           | 2001
|Interest income:                                    |  |      |           |   |      |   |           |      |  |   |          
|Loans                                               |  | $    | 40,325    |   |      | $ | 37,111    |      |  | $ | 30,760   
|Investment securities                               |  |      | 13,945    |   |      |   | 14,019    |      |  |   | 23,419   
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Total interest income                               |  |      | 54,270    |   |      |   | 51,130    |      |  |   | 54,179   
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Interest expense:                                   |  |      |           |   |      |   |           |      |  |   |          
|Deposits                                            |  |      | 9,842     |   |      |   | 14,102    |      |  |   | 21,632   
|Borrowings                                          |  |      | 4,931     |   |      |   | 3,273     |      |  |   | 5,515    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Total interest expense                              |  |      | 14,773    |   |      |   | 17,375    |      |  |   | 27,147   
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Net interest income                                 |  |      | 39,497    |   |      |   | 33,755    |      |  |   | 27,032   
|Provision for loan losses                           |  |      | 4,805     |   |      |   | 5,050     |      |  |   | 4,470    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Net interest income after provision for loan losses |  |      | 34,692    |   |      |   | 28,705    |      |  |   | 22,562   
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Other income:                                       |  |      |           |   |      |   |           |      |  |   |          
|Account maintenance and electronic banking fees     |  |      | 3,132     |   |      |   | 2,707     |      |  |   | 2,199    
|Commercial service fees                             |  |      | 691       |   |      |   | 544       |      |  |   | 330      
|Other loan fees                                     |  |      | 606       |   |      |   | 427       |      |  |   | 412      
|System maintenance and license fees                 |  |      | 211       |   |      |   | 254       |      |  |   | 213      
|Income from bank owned life insurance               |  |      | 1,091     |   |      |   | 1,126     |      |  |   | 943      
|Gain on sale of loans                               |  |      | 1,796     |   |      |   | 918       |      |  |   | 603      
|Gain (loss) on investment securities, net           |  |      | (95       | ) |      |   | (1,603    | )    |  |   | 1,266    
|Other                                               |  |      | 299       |   |      |   | (4        | )    |  |   | 968      
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Total other income                                  |  |      | 7,731     |   |      |   | 4,369     |      |  |   | 6,934    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Other expense:                                      |  |      |           |   |      |   |           |      |  |   |          
|Employee compensation and benefits                  |  |      | 12,008    |   |      |   | 10,001    |      |  |   | 8,775    
|Premises, equipment and data processing             |  |      | 6,028     |   |      |   | 5,295     |      |  |   | 4,477    
|Merger-related expenses                             |  |      | 770       |   |      |   |          |      |  |   |         
|Other                                               |  |      | 4,055     |   |      |   | 3,105     |      |  |   | 3,740    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Total other expense                                 |  |      | 22,861    |   |      |   | 18,401    |      |  |   | 16,992   
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Income before income taxes                          |  |      | 19,562    |   |      |   | 14,673    |      |  |   | 12,504   
|Provision for income taxes                          |  |      | 6,378     |   |      |   | 4,661     |      |  |   | 4,090    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Net income                                          |  | $    | 13,184    |   |      | $ | 10,012    |      |  | $ | 8,414    
|                                                    |  |      |           |   |      |   |           |      |  |   |          
|Earnings per common share:                          |  |      |           |   |      |   |           |      |  |   |          
|Basic                                               |  | $    | 2.19      |   |      | $ | 1.78      |      |  | $ | 1.90     
|Diluted                                             |  |      | 2.10      |   |      |   | 1.71      |      |  |   | 1.83     
|Dividends declared per common share                 |  |      | 0.59      |   |      |   | 0.38      |      |  |   | 0.35     
|Weighted average shares outstanding:                |  |      |           |   |      |   |           |      |  |   |          
|Basic                                               |  |      | 6,032,566 |   |      |   | 5,614,255 |      |  |   | 4,428,700
|Diluted                                             |  |      | 6,269,387 |   |      |   | 5,868,093 |      |  |   | 4,590,156



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



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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND
2001

(dollars in thousands)



|                                                                                   |  |      |        |   |      |   |        |      |  |   |        |  
|---------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                   |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Net income                                                                         |  | $    | 13,184 |   |      | $ | 10,012 |      |  | $ | 8,414  |  
|Other comprehensive income:                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Cash flow hedge:                                                                   |  |      |        |   |      |   |        |      |  |   |        |  
|Unrealized holding loss                                                            |  |      | (147   | ) |      |   | (1,370 | )    |  |   | (1,173 | )
|Reclassification adjustment for net interest expense included in net income        |  |      | 820    |   |      |   | 694    |      |  |   | 201    |  
|Available-for-sale securities:                                                     |  |      |        |   |      |   |        |      |  |   |        |  
|Unrealized holding gain/(loss)                                                     |  |      | (3,061 | ) |      |   | (3,894 | )    |  |   | 4,926  |  
|Reclassification adjustment for net (gains)/losses included in net income          |  |      | 95     |   |      |   | 1,603  |      |  |   | (1,266 | )
|                                                                                   |  |      |        |   |      |   |        |      |  |   |        |  
|Other comprehensive income (loss) before tax                                       |  |      | (2,293 | ) |      |   | (2,967 | )    |  |   | 2,688  |  
|Income tax expense (benefit) related to items of other comprehensive income (loss) |  |      | (802   | ) |      |   | (1,038 | )    |  |   | 913    |  
|                                                                                   |  |      |        |   |      |   |        |      |  |   |        |  
|Other comprehensive income (loss), net of tax                                      |  |      | (1,491 | ) |      |   | (1,929 | )    |  |   | 1,775  |  
|                                                                                   |  |      |       
|Comprehensive income                                                               |  | $    | 11,693 |   |      | $ | 8,083  |      |  | $ | 10,189 |  
|                                                                                   |  |      |        |   |      |   |        |      |  |   |        |  



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



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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2003, 2002, 2001

(dollars in thousands)



|                                                                                             |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------------------- |  | ------------------------- | - | ----------- | - | ---------------------------- |  | ---------------- | ------ |  | ------------------------------------------ | ------- | - | ------------------------ | - | ------ | - |  | - | ------ | -
|                                                                                             |  | ConvertiblePreferredStock |   | CommonStock |   | Capital in Excess ofParValue |  | RetainedEarnings |        |  | AccumulatedOtherComprehensiveIncome (Loss) |         |   | TotalStockholdersEquity |  
|Balance, December 31, 2000                                                                   |  | $                         |  |             | $ | 30                           |  | $                | 28,713 |  | $                                          | 10,710  |   |                          | $ | 236    |   |  | $ | 39,689 |  
|Dividends on preferred and common stock ($0.87 per preferred share) ($0.35 per common
share) |  |                           |   |             |   |                              |  |                  |        |  |                                            | (1,562  | ) |                          |   |        |   |  |   | (1,562 | )
|Stock dividend of 10%                                                                        |  |                           |   |             |   | 4                            |  |                  | 9,572  |  |                                            | (9,576  | ) |                          |   |        |   |  |   |       |  
|Issuance of common stock                                                                     |  |                           |   |             |   | 9                            |  |                  | 16,335 |  |                                            |         |   |                          |   |        |   |  |   | 16,344 |  
|Options exercised                                                                            |  |                           |   |             |   |                             |  |                  | 8      |  |                                            |         |   |                          |   |        |   |  |   | 8      |  
|Change in other comprehensive income                                                         |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   | 1,775  |   |  |   | 1,775  |  
|Net income                                                                                   |  |                           |   |             |   |                              |  |                  |        |  |                                            | 8,414   |   |                          |   |        |   |  |   | 8,414  |  
|                                                                                             |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   |        |   |  |   |        |  
|Balance, December 31, 2001                                                                   |  |                           |  |             |   | 43                           |  |                  | 54,628 |  |                                            | 7,986   |   |                          |   | 2,011  |   |  |   | 64,668 |  
|Dividends on preferred and common stock ($0.87 per preferred share) ($0.38 per common
share) |  |                           |   |             |   |                              |  |                  |        |  |                                            | (2,126  | ) |                          |   |        |   |  |   | (2,126 | )
|Stock dividend of 15%                                                                        |  |                           |   |             |   | 7                            |  |                  | 15,745 |  |                                            | (15,752 | ) |                          |   |        |   |  |   |       |  
|Issuance of common stock                                                                     |  |                           |   |             |   | 4                            |  |                  | 10,701 |  |                                            | (120    | ) |                          |   |        |   |  |   | 10,585 |  
|Options exercised                                                                            |  |                           |   |             |   |                             |  |                  | 93     |  |                                            |         |   |                          |   |        |   |  |   | 93     |  
|Change in other comprehensive loss                                                           |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   | (1,929 | ) |  |   | (1,929 | )
|Net income                                                                                   |  |                           |   |             |   |                              |  |                  |        |  |                                            | 10,012  |   |                          |   |        |   |  |   | 10,012 |  
|                                                                                             |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   |        |   |  |   |        |  
|Balance, December 31, 2002                                                                   |  |                           |  |             |   | 54                           |  |                  | 81,167 |  |                                            |        |   |                          |   | 82     |   |  |   | 81,303 |  
|Dividends on preferred and common stock ($0.87 per preferred share) ($0.59 per common
share) |  |                           |   |             |   |                              |  |                  |        |  |                                            | (3,305  | ) |                          |   |        |   |  |   | (3,305 | )
|Stock dividend of 10%                                                                        |  |                           |   |             |   | 6                            |  |                  | 7,369  |  |                                            | (7,375  | ) |                          |   |        |   |  |   |       |  
|Issuance of common stock                                                                     |  |                           |   |             |   |                             |  |                  | 200    |  |                                            |         |   |                          |   |        |   |  |   | 200    |  
|Options exercised                                                                            |  |                           |   |             |   | 2                            |  |                  | 2,964  |  |                                            |         |   |                          |   |        |   |  |   | 2,966  |  
|Change in other comprehensive loss                                                           |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   | (1,491 | ) |  |   | (1,491 | )
|Net income                                                                                   |  |                           |   |             |   |                              |  |                  |        |  |                                            | 13,184  |   |                          |   |        |   |  |   | 13,184 |  
|                                                                                             |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   |        |   |  |   |        |  
|Balance, December 31, 2003                                                                   |  | $                         |  |             | $ | 62                           |  | $                | 91,700 |  | $                                          | 2,504   |   |                          | $ | (1,409 | ) |  | $ | 92,857 |  
|                                                                                             |  |                           |   |             |   |                              |  |                  |        |  |                                            |         |   |                          |   |        |   |  |   |        |  



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



44



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##### Table of Contents

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 and 2001

(dollars in thousands)



|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|-------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                                                                   |  | 2003 |          |   | 2002 |   |          | 2001 | 
|Cash flows from operating activities:                                                              |  |      |          |   |      |   |          |      |  |   |          |  
|Net income                                                                                         |  | $    | 13,184   |   |      | $ | 10,012   |      |  | $ | 8,414    |  
|Adjustments to reconcile net income to net cash provided by operating activities:                  |  |      |          |   |      |   |          |      |  |   |          |  
|Depreciation and amortization                                                                      |  |      | 1,485    |   |      |   | 1,669    |      |  |   | 1,511    |  
|(Accretion) amortization of discounts or premiums on investment securities and loans, net          |  |      | 2,692    |   |      |   | 6,686    |      |  |   | (1,202   | )
|Provision for loan losses                                                                          |  |      | 4,805    |   |      |   | 5,050    |      |  |   | 4,470    |  
|Gain on sale of loans                                                                              |  |      | (1,796   | ) |      |   | (918     | )    |  |   | (603     | )
|(Gain) loss on sale of securities                                                                  |  |      | 95       |   |      |   | 1,603    |      |  |   | (1,266   | )
|Accretion of deferred loan fees                                                                    |  |      | (1,988   | ) |      |   | (1,770   | )    |  |   | (881     | )
|Loans originated - held for sale                                                                   |  |      | (14,488  | ) |      |   | (8,471   | )    |  |   | (7,224   | )
|Loans sold - held for sale                                                                         |  |      | 28,710   |   |      |   | 8,117    |      |  |   | 7,738    |  
|(Increase) decrease in other assets                                                                |  |      | 5,968    |   |      |   | (7,103   | )    |  |   | (1,292   | )
|Increase (decrease) in other liabilities                                                           |  |      | 5,754    |   |      |   | (6,165   | )    |  |   | 7,532    |  
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Net cash provided by operating activities                                                          |  |      | 44,421   |   |      |   | 8,710    |      |  |   | 17,197   |  
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Cash flows from investing activities:                                                              |  |      |          |   |      |   |          |      |  |   |          |  
|Increase in loans receivable                                                                       |  |      | (29,069  | ) |      |   | (115,410 | )    |  |   | (99,563  | )
|Purchase of investment securities, held-to-maturity                                                |  |      | (288,819 | ) |      |   |         |      |  |   |         |  
|Purchase of investment securities, available-for-sale                                              |  |      | (87,785  | ) |      |   | (244,872 | )    |  |   | (546,582 | )
|Sale of investment securities available-for-sale                                                   |  |      | 65,964   |   |      |   | 190,017  |      |  |   | 224,376  |  
|Paydowns of investment securities, held-to-maturity                                                |  |      | 38,326   |   |      |   |         |      |  |   |         |  
|Paydowns of investment securities, available-for-sale                                              |  |      | 93,446   |   |      |   | 147,998  |      |  |   | 253,736  |  
|Purchase of bank owned life insurance                                                              |  |      |         |   |      |   | (5,000   | )    |  |   |         |  
|Cash paid for merger                                                                               |  |      |         |   |      |   | (6,842   | )    |  |   |         |  
|Cash acquired from merger                                                                          |  |      |         |   |      |   | 13,719   |      |  |   |         |  
|Increase in premises and equipment, net                                                            |  |      | (2,732   | ) |      |   | (1,389   | )    |  |   | (1,232   | )
|Increase in other equity securities                                                                |  |      | (836     | ) |      |   | (443     | )    |  |   | (1,705   | )
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Net cash used in investing activities                                                              |  |      | (211,505 | ) |      |   | (22,222  | )    |  |   | (170,970 | )
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Cash flows from financing activities:                                                              |  |      |          |   |      |   |          |      |  |   |          |  
|Net increase (decrease) in deposits                                                                |  |      | (25,437  | ) |      |   | 52,527   |      |  |   | 121,426  |  
|Increase (decrease) in advances from FHLB - short term                                             |  |      | 7,000    |   |      |   | (40,500  | )    |  |   | 21,500   |  
|Increase in advances from FHLB - long term                                                         |  |      |         |   |      |   | 50,000   |      |  |   |         |  
|Proceeds from callable long term debt                                                              |  |      | 10,000   |   |      |   |         |      |  |   |         |  
|Increase in securities sold under agreements to repurchase - short term                            |  |      | 14,503   |   |      |   | 18,456   |      |  |   |         |  
|Increase in securities sold under agreements to repurchase - long term                             |  |      | 105,000  |   |      |   |         |      |  |   |         |  
|Proceeds from issuance of common stock                                                             |  |      | 2,311    |   |      |   | 94       |      |  |   | 16,352   |  
|Dividends on preferred and common stock                                                            |  |      | (3,305   | ) |      |   | (2,126   | )    |  |   | (1,562   | )
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Net cash provided by financing activities                                                          |  |      | 110,072  |   |      |   | 78,451   |      |  |   | 157,716  |  
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Net increase (decrease) in cash and cash equivalents                                               |  |      | (57,012  | ) |      |   | 64,939   |      |  |   | 3,943    |  
|Cash and cash equivalents, beginning of period                                                     |  |      | 93,398   |   |      |   | 28,459   |      |  |   | 24,516   |  
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Cash and cash equivalents, end of period                                                           |  | $    | 36,386   |   |      | $ | 93,398   |      |  | $ | 28,459   |  
|                                                                                                   |  |      |          |   |      |   |          |      |  |   |          |  
|Supplemental data:                                                                                 |  |      |          |   |      |   |          |      |  |   |          |  
|Cash payments for interest on deposits and borrowings, net of cash payments on interest rate swaps |  | $    | (4,183   | ) |      | $ | (1,838   | )    |  | $ | 6,988    |  
|Cash payments for income taxes                                                                     |  | $    | 1,900    |   |      | $ | 7,480    |      |  | $ | 5,325    |  
|Supplemental schedule of noncash investing and financing activities:                               |  |      |          |   |      |   |          |      |  |   |          |  
|Issuance of common stock for purchase accounting acquisition                                       |  | $    |         |   |      | $ | 10,246   |      |  | $ |         |  
|Common stock issued for stock dividend                                                             |  | $    | 7,375    |   |      | $ | 15,752   |      |  | $ | 9,576    |  
|Unrealized gain (loss) on investment securities available-for-sale                                 |  | $    | (2,966   | ) |      | $ | (2,291   | )    |  | $ | 3,660    |  
|Unrealized gain (loss) on interest rate swaps                                                      |  | $    | (7,444   | ) |      | $ | 8,371    |      |  | $ | (4,300   | )
|Transfer to loans held for sale from loans receivable                                              |  | $    | 22,216   |   |      | $ |         |      |  | $ |         |  



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



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##### Table of Contents

Notes to Consolidated Financial Statements

December 31, 2003, 2002 and 2001



1. Organization and Significant Accounting Policies



Southern Financial Bancorp, Inc. (the Bancorp or Southern
Financial) was incorporated in the state of Virginia on December 1, 1995. On December 1, 1995, the Bancorp acquired all of the outstanding shares of Southern Financial Bank (the Bank). The Bank, formerly Southern Financial Federal
Savings Bank, converted from a savings bank to a state chartered commercial bank effective December 1, 1995.



On August 14, 2002, Southern Financial acquired all the outstanding common stock of Metro-County Bank of Virginia for 354,711 shares of Southern Financial
common stock and cash in the amount of $6,841,584. The merger was accounted for in accordance with SFAS No. 141, Business Combinations, and the results of operations of Metro-County Bank have been included in our consolidated financial statements
from August 15, 2002. The excess of the purchase price over the fair value of the net identifiable assets acquired has been recorded as goodwill in the amount of $9,439,408 and core deposit intangible assets in the amount of $2,400,000. The core
deposit intangible assets are being amortized over ten years. The factors considered in the decision to acquire Metro-County Bank included the opportunity for future growth and an expanded geographic presence, as the acquisition of
Metro-Countys locations in the greater Richmond area is a natural extension of our geographic area and fits well into our expansion plans. The following table presents unaudited pro forma results of operations for the years ended December 31,
2002 and December 31, 2001 as though Southern Financial and Metro-County Bank of Virginia had combined at the beginning of the period. The pro forma financial information does not necessarily reflect the results of operations that would have
occurred had Southern Financial and Metro-County Bank constituted a single entity during both periods.



|                                             |  |                         |        |      |   |       
|-------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------
|                                             |  | Year Ended December 31,
|(dollars in thousands except per share data) |  | 2002                    |        | 2001
|Total revenue                                |  | $                       | 59,513 |      | $ | 68,216
|Net income                                   |  |                         | 8,404  |      |   | 8,668 
|                                             |  |                        
|Earnings per share:                          |  |                         |        |      |   |       
|Basic                                        |  | $                       | 1.02   |      | $ | 1.23  
|Diluted                                      |  |                         | 0.96   |      |   | 1.16  



The principal
activities of the Bank are to attract deposits, originate loans and conduct mortgage banking as permitted for state chartered banks by applicable regulations. The Bank conducts full-service banking operations in Fairfax, Herndon, Leesburg,
Middleburg, Warrenton, Winchester, Woodbridge, Sterling, Manassas, Fredericksburg, Fairfax City, Vienna, Annandale, Merrifield, Charlottesville, Richmond, and Springfield in Virginia, and Georgetown in the District of Columbia. All the branches are
managed as a single business segment.



The accounting and
reporting policies of Southern Financial are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. The more significant of these policies are
discussed below. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. The allowance for
loan losses is a material estimate that is particularly susceptible to changes in the near term.



Principles of Consolidation



The accompanying consolidated financial statements include the accounts of Southern Financial and subsidiaries as of December 31, 2003 and 2002, and for the years ended December 31, 2003, 2002 and 2001. All significant intercompany accounts
and transactions have been eliminated.



Cash and Cash Equivalents



Amounts represent actual cash balances held by or due to
Southern Financial. For purposes of the consolidated statements of cash flows, Southern Financial defines cash, due from banks, and overnight earning assets as cash and cash equivalents.



Investment Securities



Southern Financial accounts for its investment securities in three categories: held-to-maturity, available-for-sale, and trading. Investments in debt
securities are classified as held-to-maturity when Southern Financial has the positive intent and ability to hold those securities to maturity. Held-to-maturity securities are measured at amortized cost. The amortization of premiums and accretion of
discounts are computed using a method that approximates the level yield method. Investment securities classified as available-for-sale (including interest-only strips) are reported at fair value, with unrealized gains and losses excluded from
earnings and reported in a separate component of other comprehensive income (loss) in stockholders equity on an after-tax basis. Trading securities are reported at fair value with unrealized gains and losses included in earnings. The specific
identification method is used to determine gains or losses on sales of investment securities.



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Federal Home Loan Bank Stock



Southern Financial, as a member of the Federal Home Loan Bank (FHLB) of Atlanta, is required to hold shares of capital stock
in the FHLB in an amount equal to at least 1% of the aggregate principal amount of its residential mortgage loans or 5% of its borrowings from the FHLB, whichever is larger. This investment is recorded at cost, and it is pledged as collateral for
advances from the FHLB. The amount of FHLB stock was $3.9 million and $3.5 million at December 31, 2003 and 2002, respectively, and was included in investment securities, available-for-sale in the consolidated balance sheets.



Loans Held for Sale



Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market
value.



Loans Receivable



Interest income is accrued on loans as earned on the outstanding principal
balances. Nonrefundable loan fees and direct origination costs are deferred and recognized over the lives of the related loans as adjustments of yield. Accrual of interest is discontinued when management believes, after considering economic and
business conditions and collection efforts, that the borrowers financial condition is such that collection of interest is doubtful. Any accrued interest considered uncollectible is charged against current income.



The allowance for loan losses is established through a provision for loan
losses, which is charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is a current estimate of the losses inherent in the present
portfolio based upon managements evaluation of the loan portfolio. Estimates of losses inherent in the portfolio involve the exercise of judgment and the use of assumptions. The evaluations take into consideration such factors as changes in
the nature, volume and quality of the loan portfolio, prior loss experience, level of nonperforming loans, current and anticipated general economic conditions and the value and adequacy of collateral. Changes in the estimate of losses may occur due
to changing economic conditions and the economic conditions of borrowers.



A loan is considered impaired when, based on all current information and events, it is probable that the Bancorp will be unable to collect all amounts due according to the contractual terms of the agreement, including
all scheduled principal and interest payments. Such impaired loans are measured based on the present value of expected future cash flows, discounted at the loans effective interest rate or, as a practical expedient, impairment may be measured
based on the loans observable market price, or if, the loan is collateral  dependent, the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded
through a valuation allowance. Loans for which foreclosure is probable continue to be accounted for as loans.



Each impaired loan is evaluated individually to determine the income recognition policy. Generally, payments received are applied in accordance with the
contractual terms of the note or as a reduction of principal.



Premises and
Equipment



Premises and equipment are stated at cost less
accumulated depreciation and amortization. Expenditures for maintenance and repairs that do not materially prolong the useful lives of the assets are charged to expense as incurred.



Depreciation is computed using the straight-line method over estimated useful lives of three to ten years for furniture and
equipment and 30 years for buildings. Amortization of leasehold improvements is computed using the straight-line method over the shorter of ten years or the lease term.



Real Estate Acquired through Foreclosure



Southern Financial records and carries real estate acquired through foreclosure at the lower of the recorded investment in the loan or fair value less
estimated selling costs. Costs relating to development and improvement of property are capitalized, provided that the resulting carrying value does not exceed fair value less estimated selling costs. Costs relating to holding the assets are expensed
as incurred.



Goodwill and Other Intangible Assets



Statement of Financial Accounting Standards No. 142 (SFAS 142),
Goodwill and Other Intangible Assets was issued in June 2001. It discontinues amortization of intangible assets unless they have finite useful lives, and, instead, requires that they be tested at least annually for impairment by
comparing their fair values with their recorded amounts. SFAS No. 142 also requires disclosure of the changes in the carrying amounts of goodwill from period to period, the carrying amounts of intangible assets by major intangible asset class for
those subject to and not subject to amortization, and the estimated intangible asset amortization expense for the next five years. Southern Financial adopted SFAS No. 142 as of January 1, 2002, and therefore, discontinued the amortization of
goodwill on January 1, 2002. The core deposit intangible assets are amortized over ten years. An evaluation of impairment of goodwill under SFAS No. 142 as of June 30, 2003 determined there was no impairment of the goodwill.



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Derivative Financial Instruments



As part of our interest rate risk management, we make extensive use of interest rate swaps. Some of them are accounted for
as cash flow hedges and some are accounted for as fair value hedges in accordance with SFAS 133. Cash flow hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or
liabilities.



We use interest rate swaps that are accounted for
as cash flow hedges to hedge the interest rate risk associated with pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the
floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce
long-term fixed rate deposits. Changes in the fair value of cash flow hedges are accounted for in other comprehensive income. To the extent that the hedge is not completely effective, the ineffective portion is charged or credited to interest
expense in the consolidated statements of income. The ineffectivess charged (credited) to interest expense during the years ended December 31, 2003, 2002 and 2001 was $256, ($18,853), and $107,890, respectively. The amounts recorded in other
comprehensive income are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the CDs affect earnings. The estimated net amount of the existing gains or losses that are expected to
be reclassified into earnings within the next 12 months is approximately $252,000 based upon interest rates in effect during December 2003.



We also use interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these
interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is generally tied to three-month LIBOR, which approximates the issuance rate on the individual CDs. The combination of the
swaps and the issuance of individual CDs operates to produce long-term floating rate deposits. The CDs and the interest rate swaps have like terms and were committed to simultaneously. To the extent that the hedge is not completely effective, the
ineffective portion is charged or credited to interest expense in the consolidated statements of income. Both the interest rate swap (included in other assets in the consolidated balance sheets) and the CDs are recorded at fair value, with changes
in fair value included in the statements of income as interest expense.



We also use interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the Federal Home Loan Bank of Atlanta (FHLB). Under the terms of these interest rate swaps, we are the fixed rate payer and
the floating rate receiver. The floating rate on the interest rate swaps is equal to three-month LIBOR. The combination of the swaps and the borrowing from FHLB operates to produce long-term fixed rate borrowings. The terms of the borrowings and the
interest rate swaps mirror each other and were committed simultaneously. Changes in the fair value of the fair value hedges are accounted for in the income statement, as are changes in the fair value of the borrowings.



Southern Financial incorporates all items from its consolidated balance sheet
as well as off-balance sheet items such as derivative items used to hedge balance sheet items in an overall assessment of its interest rate risk. All on-balance sheet items and off-balance sheet items are incorporated in a report that is generated
quarterly by a third party that assesses the interest rate risk in different interest rate environments. The report shows how the market value of Southern Financials portfolio value of equity changes when interest rates rise or fall 1%, 2%,
and 3%. The report also shows the change in net interest income in the same interest rate change scenarios.



Income Taxes



Deferred
tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes.



Earnings Per Share



Basic earnings per common
share is computed by dividing net income, less dividends on preferred stock, by the weighted average number of shares of common stock outstanding during the periods. Diluted earnings per common share is computed by dividing net income by the
weighted average number of shares of common stock and dilutive common stock equivalents outstanding during the periods. Common stock equivalents include the number of shares issuable on exercise of outstanding options less the number of shares that
could have been purchased with the proceeds from the exercise of the options based on the average price of common stock during the period plus the number of shares issuable on conversion of the convertible preferred shares to common shares.



Financial Instruments with Off-Balance Sheet Risk



Southern Financial is a party to financial instruments with off-balance
sheet risk in the normal course of business primarily to meet the financing needs of its customers. These financial instruments involve, to varying degrees, elements of credit risk that are not recognized in the balance sheet.



Exposure to credit loss in the event of nonperformance by the other party to
the financial instrument for commitments to extend credit and letters of credit written is represented by the contractual amount of those instruments. Southern Financial generally requires collateral to support such financial instruments in excess
of the contractual amount of those instruments and essentially uses the same credit policies in making commitments as it does for on-balance sheet instruments.



We are exposed to credit and market risk as a result of our use of derivative instruments. If the fair value of the derivative contract is positive,
the counterparty owes us and, hence, a repayment risk exists. If the fair value of the derivative contract is negative, we owe the counterparty and, therefore, there



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is no repayment risk. We minimize repayment risk by entering into transactions with financially stable counterparties
that are specified by our policy and reviewed periodically by our credit committee. When we have multiple derivative transactions with the same counterparty, the net mark-to-market exposure represents the netting of positive and negative exposures
with the same counterparty. The net mark-to-market exposure with a counterparty is a measure of credit risk when there is a legally enforceable master netting agreement between us and the counterparty. We use master netting agreements with the
majority of our counterparties.



Recently Issued Accounting Pronouncements



In January 2003, the FASB issued FASB Interpretation No.
46 (FIN 46), Consolidation of Variable Interest Entities, which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should
consolidate the entity. FIN 46 Revised (FIN 46R), issued in December 2003, replaces FIN 46. FIN 46R requires public entities to apply FIN 46 or FIN 46R to all entities that are considered special-purpose entities in practice and under the FASB
literature that was applied before the issuance of FIN 46 by the end of the first reporting period that ends after December 15, 2003. For any variable interest entities (VIE) that must be consolidated under FIN 46R, the assets, liabilities and
noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an
accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and noncontrolling interest of the VIE.



Southern Financial adopted FIN 46R as of December 31, 2003. Currently,
Southern Financial has no variable interest entities that require consolidation of previously unconsolidated entities or disclosure in the consolidated financial statements, however, the standard affected how our trust preferred securities are
reported in the consolidated financial statements. The trust formed to issue the trust preferred securities can no longer be consolidated because the economic risks associated with the trust are held by the holders of the trust preferred securities
rather than Southern Financial, which has a controlling equity interest. This means that Southern Financial no longer consolidates the trust preferred securities as minority interest but, rather, holds callable long term debt to a related party.
This change may also impact regulatory capital in the future as further described in Regulatory Capital Requirements in Managements Discussion and Analysis. The overall adoption of FIN 46R did not have a material impact on Southern
Financials operations, equity, or financial condition.



In May 2003, the Financial Accounting Standards Board (FASB) issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This Statement establishes standards for classifying and
measuring certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The provisions of SFAS 150 became effective June 1, 2003, for all financial instruments created or modified after
May 31, 2003, and otherwise became effective as of July 1, 2003. The adoption of this standard did not have a material impact on financial condition, the results of operations, or liquidity.



In December 2003, the FASB deferred for an indefinite period the application
of the guidance in SFAS 150 to noncontrolling interests that are classified as equity in the financial statements of a subsidiary but would be classified as a liability in the parents financial statements under SFAS 150. The deferral is
limited to mandatorily redeemable noncontrolling interests associated with finite-lived subsidiaries. Management does not believe any such applicable entities exist as of December 31, 2003.



Stock-Based Compensation



Southern Financial adopted the disclosure only provisions of Statement of
Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation and Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation  Transition and
Disclosure. These statements allow an entity to continue to measure compensation cost for these plans using the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (APB 25),
Accounting for Stock Issued to Employees. Southern Financial has elected to follow APB 25 and related interpretations in accounting for its employee stock options.



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Pro forma information regarding net income and earnings per share as required by SFAS 123 AND SFAS 148
has been determined as if Southern Financial had accounted for its employee stock options under the fair value method. The fair value of all currently outstanding options was estimated at the date of the grant using a Black-Scholes option pricing
model. Pro forma results are presented in the following table:



|                                          |  |      |        |   |      |   |        |      |  |   |       |  
|----------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                          |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Net income:                               |  |      |        |   |      |   |        |      |  |   |       |  
|As reported                               |  | $    | 13,184 |   |      | $ | 10,012 |      |  | $ | 8,414 |  
|Pro forma                                 |  |      | 12,599 |   |      |   | 9,452  |      |  |   | 7,857 |  
|                                          |  |      |        |   |      |   |        |      |  |   |       |  
|Basic earnings per share:                 |  |      |        |   |      |   |        |      |  |   |       |  
|As reported                               |  |      | 2.19   |   |      |   | 1.78   |      |  |   | 1.90  |  
|Pro forma                                 |  |      | 2.09   |   |      |   | 1.68   |      |  |   | 1.77  |  
|Diluted earnings per share:               |  |      |        |   |      |   |        |      |  |   |       |  
|As reported                               |  |      | 2.10   |   |      |   | 1.71   |      |  |   | 1.83  |  
|Pro forma                                 |  |      | 2.01   |   |      |   | 1.61   |      |  |   | 1.71  |  
|                                          |  |      |        |   |      |   |        |      |  |   |       |  
|Weighted-average assumptions:             |  |      |        |   |      |   |        |      |  |   |       |  
|Expected lives (years)                    |  |      | 10     |   |      |   | 10     |      |  |   | 10    |  
|Risk-free interest rate (%)               |  |      | 4.27   | % |      |   | 4.51   | %    |  |   | 5.02  | %
|Expected volatility (%)                   |  |      | 22.00  | % |      |   | 25.00  | %    |  |   | 27.00 | %
|Expected dividends (%) (annual per share) |  |      | 0.15   | % |      |   | 0.13   | %    |  |   | 0.13  | %
|                                          |  |      |        |   |      |   |        |      |  |   |       |  



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2. Investment Securities



The portfolio consists of the following securities:



|                                          |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|----------------------------------------- |  | ----------------- | ------- | -------------------- | - | --------------------- |  | ------------------- | ----- |  | - | -------
|                                          |  | December 31, 2003
|(dollars in thousands)                    |  | AmortizedCost     |         | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Estimated FairValue
|Available-for-sale:                       |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|FHLMC mortgage-backed securities          |  | $                 | 6,205   |                      | $ | 73                    |  | $                   |      |  | $ | 6,278  
|GNMA mortgage-backed securities           |  |                   | 6,993   |                      |   | 16                    |  |                     | 64    |  |   | 6,945  
|FNMA mortgage-backed securities           |  |                   | 52,595  |                      |   | 196                   |  |                     | 786   |  |   | 52,005 
|Collateralized mortgage obligations       |  |                   | 32,470  |                      |   | 365                   |  |                     | 1,336 |  |   | 31,499 
|Corporate obligations                     |  |                   | 23,856  |                      |   | 152                   |  |                     | 273   |  |   | 23,735 
|U.S. Treasury and agency securities       |  |                   | 499     |                      |   | 3                     |  |                     |      |  |   | 502    
|Federal Home Loan Bank stock              |  |                   | 3,850   |                      |   |                      |  |                     |      |  |   | 3,850  
|Federal Reserve Bank stock                |  |                   | 2,034   |                      |   |                      |  |                     |      |  |   | 2,034  
|Other equity securities                   |  |                   | 484     |                      |   |                      |  |                     |      |  |   | 484    
|                                          |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|Total classified as investment securities |  |                   | 128,986 |                      |   | 805                   |  |                     | 2,459 |  |   | 127,332
|Debt obligations classified as loans      |  |                   | 20,577  |                      |   | 467                   |  |                     | 390   |  |   | 20,654 
|                                          |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|                                          |  | $                 | 149,563 |                      | $ | 1,272                 |  | $                   | 2,849 |  | $ | 147,986
|                                          |  |                   |         |                      |   |                       |  |                     |       |  |   |        



|                                           |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|------------------------------------------ |  | ----------------- | ------- | -------------------- | - | --------------------- |  | ------------------- | ----- |  | - | -------
|                                           |  | December 31, 2002
|(dollars in thousands)                     |  | AmortizedCost     |         | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Estimated FairValue
|Available-for-sale:                        |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|FHLMC mortgage-backed securities           |  | $                 | 12,932  |                      | $ | 106                   |  | $                   | 4     |  | $ | 13,035 
|GNMA mortgage-backed securities            |  |                   | 11,041  |                      |   | 80                    |  |                     |      |  |   | 11,121 
|FNMA mortgage-backed securities            |  |                   | 50,366  |                      |   | 417                   |  |                     | 47    |  |   | 50,736 
|Collateralized mortgage obligations        |  |                   | 83,073  |                      |   | 1,221                 |  |                     | 434   |  |   | 83,860 
|Obligations of counties and municipalities |  |                   | 9,900   |                      |   | 100                   |  |                     |      |  |   | 10,000 
|Corporate obligations                      |  |                   | 28,047  |                      |   | 199                   |  |                     | 1,249 |  |   | 26,997 
|U.S. Treasury and agency securities        |  |                   | 2,258   |                      |   | 24                    |  |                     |      |  |   | 2,282  
|Federal Home Loan Bank stock               |  |                   | 3,500   |                      |   |                      |  |                     |      |  |   | 3,500  
|Federal Reserve Bank stock                 |  |                   | 1,537   |                      |   |                      |  |                     |      |  |   | 1,537  
|Other equity securities                    |  |                   | 495     |                      |   |                      |  |                     |      |  |   | 495    
|                                           |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|Total classified as investment securities  |  |                   | 203,149 |                      |   | 2,147                 |  |                     | 1,734 |  |   | 203,563
|Debt obligations classified as loans       |  |                   | 31,567  |                      |   | 1,293                 |  |                     | 317   |  |   | 32,543 
|                                           |  |                   |         |                      |   |                       |  |                     |       |  |   |        
|                                           |  | $                 | 234,716 |                      | $ | 3,440                 |  | $                   | 2,051 |  | $ | 236,106
|                                           |  |                   |         |                      |   |                       |  |                     |       |  |   |        



|                                          |  |                   |         |                      |   |                       |  |                     |     |  |   |        
|----------------------------------------- |  | ----------------- | ------- | -------------------- | - | --------------------- |  | ------------------- | --- |  | - | -------
|                                          |  | December 31, 2003
|(dollars in thousands)                    |  | AmortizedCost     |         | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | Estimated FairValue
|Held-to-maturity:                         |  |                   |         |                      |   |                       |  |                     |     |  |   |        
|FHLMC mortgage-backed securities          |  | $                 | 3,787   |                      | $ |                      |  | $                   | 95  |  | $ | 3,692  
|FNMA mortgage-backed securities           |  |                   | 188,451 |                      |   | 1,422                 |  |                     | 573 |  |   | 189,300
|Collateralized mortgage obligations       |  |                   | 54,978  |                      |   | 385                   |  |                     | 219 |  |   | 55,144 
|Corporate obligations                     |  |                   | 2,985   |                      |   | 64                    |  |                     |    |  |   | 3,049  
|                                          |  |                   |         |                      |   |                       |  |                     |     |  |   |        
|Total classified as investment securities |  | $                 | 250,201 |                      | $ | 1,871                 |  | $                   | 887 |  | $ | 251,185
|                                          |  |                   |         |                      |   |                       |  |                     |     |  |   |        



There were no
held-to-maturity investment securities as of December 31, 2002.



Gross gains of $2.1 million and no gross losses were realized on the sale of investment securities during the year ended December 31, 2003. Interest-only strips and one collaterized mortgage obligation, with a total fair value of $630
thousand, included in the investment securities portfolio as



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collateralized mortgage obligations were written down in the amount of $2.2 million during the year ended December 31,
2003. Gross gains of $3.9 million and gross losses of $943 thousand were realized on the sale of investment securities during the year ended December 31, 2002. Interest-only strips, with a total fair value of $2.8 million, included in the investment
securities portfolio as collateralized mortgage obligations were written down in the amount of $4.5 million during the year ended December 31, 2002. Gross gains of $3.2 million and gross losses of $1.9 million were realized on the sale of investment
securities during the year ended December 31, 2001.



As of
December 31, 2003 and December 31, 2002, securities having a book value of $319.4 million and $128.6 million, respectively, were pledged as collateral for advances from the FHLB and as collateral for deposits in accordance with Federal and state
requirements.



The following table sets forth
information regarding contractual maturity of the investment security portfolio:



|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|----------------------------------------- |  | ------------------- | ------- | ---------------- | - | ------------------- |  | ------------- | ------- |  | - | -------
|                                          |  | December 31, 2003  
|                                          |  | Available-for-sale  |         | Held-to-maturity
|(dollars in thousands)                    |  | EstimatedFair Value |         | AmortizedCost    |   | EstimatedFair Value |  | AmortizedCost
|Debt obligations:                         |  |                     |         |                  |   |                     |  |               |         |  |   |        
|One year or less                          |  | $                   | 502     |                  | $ | 499                 |  | $             |        |  | $ |       
|After one through five years              |  |                     | 1,069   |                  |   | 997                 |  |               |        |  |   |       
|After ten years                           |  |                     | 22,666  |                  |   | 22,859              |  |               | 3,049   |  |   | 2,985  
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|Total                                     |  |                     | 24,237  |                  |   | 24,355              |  |               | 3,049   |  |   | 2,985  
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|Mortgage-backed securities                |  |                     | 65,228  |                  |   | 65,793              |  |               | 192,992 |  |   | 192,238
|Collateralized mortgage obligations       |  |                     | 31,499  |                  |   | 32,470              |  |               | 55,144  |  |   | 54,978 
|Equity securities                         |  |                     | 6,368   |                  |   | 6,368               |  |               |        |  |   |       
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|Total classified as investment securities |  |                     | 127,332 |                  |   | 128,986             |  |               | 251,185 |  |   | 250,201
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|Debt obligations classified as loans:     |  |                     |         |                  |   |                     |  |               |         |  |   |        
|After one through five years              |  |                     | 3,488   |                  |   | 3,461               |  |               |        |  |   |       
|After ten years                           |  |                     | 17,166  |                  |   | 17,116              |  |               |        |  |   |       
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|Total classified as loans                 |  |                     | 20,654  |                  |   | 20,577              |  |               |        |  |   |       
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        
|                                          |  | $                   | 147,986 |                  | $ | 149,563             |  | $             | 251,185 |  | $ | 250,201
|                                          |  |                     |         |                  |   |                     |  |               |         |  |   |        



Contractual maturity
of mortgage-backed securities and collateralized mortgage obligations is not a reliable indicator of their expected life because borrowers have the right to repay their obligations at any time.



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There are $44.4 million of available-for-sale mortgage-backed securities and $85.7 million of
held-to-maturity securities that are considered temporarily impaired at December 31, 2003. These securities are all guaranteed by either GNMA, FNMA or FHLMC, which are agencies of the Federal Government, and therefore carry actual guarantees of the
Federal Government in the case of GNMA securities, and implied guarantees of the Federal Government in the case of FNMA and FHLMC securities. For this reason we do not consider impairment of these securities as other than temporary. The impairment
is caused by higher interest rates since the purchase of the securities and will reverse if interest rates decline in the future; conversely it will get worse if interest rates rise more. The same is true of most of the available-for-sale
collateralized mortgage obligations that are impaired, as well as $15.3 million of held-to-maturity collateralized mortgage obligations that are impaired. $2.6 million of the available-for-sale collateralized mortgage obligations that are impaired
are not backed by any of the Federal Agencies, but we do not consider them other than temporarily impaired, as they carry an AA rating from Fitch and are guaranteed by Commercial Guaranty Assurance Ltd. There are $8.2 million of debt obligations
classified as loans that are impaired; none of these have ratings; they are all obligations of special-purpose subsidiaries of banks. The credit qualities of these banks have not changed since we purchased the securities; therefore, we do not
consider that the impairment is other than temporary; it is due to rising interest rates. Except for one security in the amount of $1.7 million, all of the available-for-sale corporate obligations have ratings of BBB- or better. Based on these
ratings and our own analysis, we do not believe that any of the impairments on these securities is other than temporary. The one security that has a below-investment-grade rating has a split rating and is a strong competitor in its business. For
this reason, we do not believe that the impairment is other than temporary. The following table presents information regarding temporarily impaired investment securities as of December 31, 2003:



|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|----------------------------------------- |  | ------------------- | ------- | ------------------- | - | --------- |  | ---------------- | ------ | ---------- | - | ---------------- |  | - | ------- |  | - | -----
|                                          |  | Less Than 12 Months |         | 12 Months or Longer |   | Total    
|(dollars in thousands)                    |  | Fair Value          |         | UnrealizedLosses    |   | FairValue |  | UnrealizedLosses |        | Fair Value |   | UnrealizedLosses
|Available-for-sale:                       |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|Mortgage-backed securities                |  | $                   | 40,212  |                     | $ | 834       |  | $                | 4,166  |            | $ | 16               |  | $ | 44,378  |  | $ | 850  
|Collateralized mortgage obligations       |  |                     | 6,575   |                     |   | 385       |  |                  | 7,167  |            |   | 951              |  |   | 13,742  |  |   | 1,336
|Corporate obligations                     |  |                     | 9,053   |                     |   | 47        |  |                  | 6,640  |            |   | 226              |  |   | 15,693  |  |   | 273  
|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|Total classified as investment securities |  |                     | 55,840  |                     |   | 1,266     |  |                  | 17,973 |            |   | 1,193            |  |   | 73,813  |  |   | 2,459
|Debt obligations classified as loans      |  |                     | 1,010   |                     |   | 58        |  |                  | 7,214  |            |   | 332              |  |   | 8,224   |  |   | 390  
|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|                                          |  | $                   | 56,850  |                     | $ | 1,324     |  | $                | 25,187 |            | $ | 1,525            |  | $ | 82,037  |  | $ | 2,849
|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|                                          |  |                     |        
|                                          |  | Less Than 12 Months |         | 12 Months or Longer |   | Total    
|(dollars in thousands)                    |  | Fair Value          |         | UnrealizedLosses    |   | FairValue |  | UnrealizedLosses |        | Fair Value |   | UnrealizedLosses
|Held-to-maturity:                         |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|Mortgage-backed securities                |  | $                   | 85,695  |                     | $ | 668       |  | $                |       |            | $ |                 |  | $ | 85,695  |  | $ | 668  
|Collateralized mortgage obligations       |  |                     | 15,262  |                     |   | 219       |  |                  |       |            |   |                 |  |   | 15,262  |  |   | 219  
|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      
|Total classified as investment securities |  | $                   | 100,957 |                     | $ | 887       |  | $                |       |            | $ |                 |  | $ | 100,957 |  | $ | 887  
|                                          |  |                     |         |                     |   |           |  |                  |        |            |   |                  |  |   |         |  |   |      



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3. Loans Receivable



Loans receivable consist of the following:



|                                  |  |                        |         |      |   |        
|--------------------------------- |  | ---------------------- | ------- | ---- | - | -------
|                                  |  | December 31,          
|                                  |  | 2003                   |         | 2002
|                                  |  | (dollars in thousands)
|Construction and land development |  |                        |         |      |   |        
|Residential                       |  | $                      | 40,329  |      | $ | 40,575 
|Commercial                        |  |                        | 60,709  |      |   | 42,052 
|                                  |  |                       
|Mortgage                          |  |                        |         |      |   |        
|Residential                       |  |                        | 50,288  |      |   | 77,697 
|Multifamily residential           |  |                        | 6,872   |      |   | 9,438  
|Commercial                        |  |                        | 286,028 |      |   | 253,958
|                                  |  |                       
|Commercial and industrial         |  |                        | 163,042 |      |   | 170,776
|Consumer                          |  |                        | 7,732   |      |   | 12,889 
|                                  |  |                        |         |      |   |        
|Total loans receivable            |  |                        | 615,000 |      |   | 607,385
|Less:                             |  |                        |         |      |   |        
|Deferred loan fees, net           |  |                        | 3,384   |      |   | 2,805  
|Allowance for loan losses         |  |                        | 10,498  |      |   | 10,257 
|                                  |  |                        |         |      |   |        
|Loans receivable, net             |  | $                      | 601,118 |      | $ | 594,323
|                                  |  |                        |         |      |   |        



The following sets
forth information regarding the allowance for loan losses for the years ended December 31,



|                                            |  |                        |        |   |      |   |        |      |  |   |        |  
|------------------------------------------- |  | ---------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                            |  | 2003                   |        |   | 2002 |   |        | 2001 | 
|                                            |  | (dollars in thousands) |       
|Allowance at beginning of period            |  | $                      | 10,257 |   |      | $ | 7,354  |      |  | $ | 4,921  |  
|                                            |  |                        |       
|Provisions for losses charged to income     |  |                        | 4,805  |   |      |   | 5,050  |      |  |   | 4,470  |  
|Acquired from Metro County Bank of Virginia |  |                        |       |   |      |   | 1,350  |      |  |   |       |  
|Recoveries                                  |  |                        | 1,754  |   |      |   | 1,029  |      |  |   | 381    |  
|Charge-offs                                 |  |                        | (6,318 | ) |      |   | (4,526 | )    |  |   | (2,418 | )
|                                            |  |                        |        |   |      |   |        |      |  |   |        |  
|Allowance at end of period                  |  | $                      | 10,498 |   |      | $ | 10,257 |      |  | $ | 7,354  |  
|                                            |  |                        |        |   |      |   |        |      |  |   |        |  



Southern
Financials loan portfolio is concentrated in the Northern Virginia area. The amount of loans being serviced for others was $57.1 million and $27.9 million at December 31, 2003 and 2002, respectively. At December 31, 2003, there were two loans
with balances totaling $1.7 million that had payments ninety days or more past due on which interest was still accruing. At December 31, 2002, there was one loan with a balance of $154 thousand that had payments ninety days or more past due on which
interest was still accruing. There were no loan balances transferred to foreclosed properties for the years ended December 31, 2003 and 2002. Loan balances transferred to foreclosed properties were $138 thousand for the year ended December 31, 2001.
Southern Financial had no real estate owned at December 31, 2003 and 2002. Debt obligations classified as loans totaling $20.7 million and $32.5 million as of December 31, 2003 and 2002, respectively, are included in commercial and industrial loans.



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Nonaccruing loans, all of which were impaired, were as follows:



|                              |  |                        |       |      |   |      
|----------------------------- |  | ---------------------- | ----- | ---- | - | -----
|                              |  | December 31,          
|                              |  | 2003                   |       | 2002
|                              |  | (dollars in thousands)
|Carrying value                |  | $                      | 3,832 |      | $ | 1,449
|Allocation of general reserve |  |                        | 656   |      |   | 335  



The average carrying
balances and interest income earned on impaired loans were as follows:



|                                                  |  |                         |       |      |   |       |  |   |      
|------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | -----
|                                                  |  | Year Ended December 31,
|                                                  |  | 2003                    |       | 2002 |   | 2001 
|                                                  |  | (dollars in thousands) 
|Average carrying value                            |  | $                       | 2,639 |      | $ | 1,577 |  | $ | 1,701
|Income anticipated under original loan agreements |  |                         | 110   |      |   | 110   |  |   | 115  
|Income recorded                                   |  |                         |      |      |   | 81    |  |   | 107  



4. Premises and Equipment



Premises and equipment consists of the following:



|                                                |  |                        |        |   |      |   |        |  
|----------------------------------------------- |  | ---------------------- | ------ | - | ---- | - | ------ | -
|                                                |  | December 31,           |       
|                                                |  | 2003                   |        |   | 2002 |  
|                                                |  | (dollars in thousands) |       
|Land                                            |  | $                      | 1,867  |   |      | $ | 1,255  |  
|Building and improvements                       |  |                        | 4,285  |   |      |   | 3,513  |  
|Furniture and equipment                         |  |                        | 7,494  |   |      |   | 6,841  |  
|Leasehold improvements                          |  |                        | 4,631  |   |      |   | 3,926  |  
|                                                |  |                        |        |   |      |   |        |  
|                                                |  |                        | 18,277 |   |      |   | 15,535 |  
|                                                |  |                       
|Less: Accumulated depreciation and amortization |  |                        | (8,704 | ) |      |   | (7,271 | )
|                                                |  |                        |        |   |      |   |        |  
|Premises and equipment, net                     |  | $                      | 9,573  |   |      | $ | 8,264  |  
|                                                |  |                        |        |   |      |   |        |  



Depreciation and
amortization expense aggregated $1.4 million, $1.3 million, and $1.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.



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5. Intangible Assets



Data concerning various intangible assets is presented in the following tables:



|                                     |  |                        |        |                         |                   |      |                     |  |                         |        |  |   |      |  
|------------------------------------ |  | ---------------------- | ------ | ----------------------- | ----------------- | ---- | ------------------- |  | ----------------------- | ------ |  | - | ---- | -
|                                     |  | December 31, 2003      |        |                         | December 31, 2002 |     
|                                     |  | Gross CarryingValue    |        | AccumulatedAmortization |                   |      | Gross CarryingValue |  | AccumulatedAmortization |       
|                                     |  | (dollars in thousands) |       
|Amortizable core deposit intangibles |  | $                      | 2,996  |                         | $                 | (747 | )                   |  | $                       | 3,966  |  | $ | (447 | )
|Amortizable other intangibles        |  |                        | 361    |                         |                   | (239 | )                   |  |                         | 361    |  |   | (219 | )
|Unamortizable goodwill               |  |                        | 11,941 |                         |                   | (145 | )                   |  |                         | 11,042 |  |   | (145 | )



Amortization expense:



|                                  |  |                        |    |                          |   |          |  |   |    
|--------------------------------- |  | ---------------------- | -- | ------------------------ | - | -------- |  | - | ---
|                                  |  | Other                  |    | Core Deposit Intangibles |   | Goodwill
|                                  |  | (dollars in thousands)
|12 months ended December 31, 2003 |  | $                      | 20 |                          | $ | 300      |  | $ |   
|12 months ended December 31, 2002 |  |                        | 69 |                          |   | 237      |  |   |   
|12 months ended December 31, 2001 |  |                        | 92 |                          |   | 175      |  |   | 104



Estimated amortization
expense:



|                        |  |       |    |                          |   |    
|----------------------- |  | ----- | -- | ------------------------ | - | ---
|                        |  | Other |    | Core Deposit Intangibles
|Year ended December 31, |  |       |    |                          |   |    
|2004                    |  | $     | 20 |                          | $ | 300
|2005                    |  |       | 20 |                          |   | 300
|2006                    |  |       | 20 |                          |   | 300
|2007                    |  |       | 20 |                          |   | 300
|2008                    |  |       | 20 |                          |   | 300



|                                           |  |                                              |        |      |   |        |  |   |      
|------------------------------------------ |  | -------------------------------------------- | ------ | ---- | - | ------ |  | - | -----
|                                           |  | Year ended December 31,                     
|                                           |  | 2003                                         |        | 2002 |   | 2001  
|                                           |  | (dollars in thousands except per share data)
|Reported net income                        |  | $                                            | 13,184 |      | $ | 10,012 |  | $ | 8,414
|Add back - goodwill amortization           |  |                                              |       |      |   |       |  |   | 104  
|                                           |  |                                              |        |      |   |        |  |   |      
|Adjusted net income                        |  | $                                            | 13,184 |      | $ | 10,012 |  | $ | 8,518
|                                           |  |                                              |        |      |   |        |  |   |      
|Reported basic earnings per share          |  | $                                            | 2.19   |      | $ | 1.78   |  | $ | 1.90 
|Add back - goodwill amortization per share |  |                                              |       |      |   |       |  |   | 0.03 
|                                           |  |                                              |        |      |   |        |  |   |      
|Adjusted basic earnings per share          |  | $                                            | 2.19   |      | $ | 1.78   |  | $ | 1.93 
|                                           |  |                                              |        |      |   |        |  |   |      
|Reported diluted earnings per share        |  | $                                            | 2.10   |      | $ | 1.71   |  | $ | 1.83 
|Add back - goodwill amortization per share |  |                                              |       |      |   |       |  |   | 0.02 
|                                           |  |                                              |        |      |   |        |  |   |      
|Adjusted diluted earnings per share        |  | $                                            | 2.10   |      | $ | 1.71   |  | $ | 1.85 
|                                           |  |                                              |        |      |   |        |  |   |      



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6. Deposits



Deposits consist of the following:



|                                  |  |              |         |      |   |        
|--------------------------------- |  | ------------ | ------- | ---- | - | -------
|                                  |  | December 31,
|(dollars in thousands)            |  | 2003         |         | 2002
|Demand accounts                   |  | $            | 103,932 |      | $ | 92,621 
|Interest checking accounts        |  |              | 46,554  |      |   | 46,096 
|Money market and savings accounts |  |              | 101,657 |      |   | 162,043
|Certificates of deposit           |  |              | 491,594 |      |   | 475,323
|                                  |  |              |         |      |   |        
|                                  |  | $            | 743,737 |      | $ | 776,083
|                                  |  |              |         |      |   |        



As of December 31,
2003, certificates of deposit mature as follows:



|           |  |   |        
|---------- |  | - | -------
|2004       |  | $ | 180,271
|2005       |  |   | 15,477 
|2006       |  |   | 4,469  
|2007       |  |   | 5,310  
|2008       |  |   | 55,233 
|Thereafter |  |   | 230,834
|           |  |   |        
|           |  | $ | 491,594
|           |  |   |        



Deposits with
balances greater than $100 thousand totaled $523.7 million and $516.0 million at December 31, 2003 and 2002, respectively, of which $364.5 million and $320.5 million represented certificates of deposit.



Southern Financial uses interest rate swaps that are accounted for as cash
flow hedges to hedge the issuance of pools of certificates of deposit(CDs) which reprice with changes in market interest rates. As of December 31, 2003 and 2002, the notional amount of these swaps was $20 million. Under the terms of these interest
rate swaps, Southern Financial is the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. Southern Financial pays fixed
rates ranging between 5.23% and 5.45%, and swaps totaling $15 million expire in January 2004 while the remaining $5 million expires in February 2009. The fair value of the interest rate swaps accounted for as cash flow hedges was a loss of $637
thousand and $1.3 million at December 31, 2003 and 2002, respectively.



Southern Financial also uses interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. As of December 31, 2003 and 2002, the notional amount of these swaps was $282.5 million and
$267.5 million, respectively. Under the terms of these interest rate swaps, Southern Financial is the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is generally tied to three-month LIBOR, which
approximates the issuance rate on the individual CDs. Southern Financial receives fixed rates ranging between 2.00% and 6.50%, and the swaps expire at varying dates through April 2023. The fair value of the interest rate swaps accounted for as fair
value hedges was a loss of $1.2 million at December 31, 2003 and a gain of $6.7 million at December 31, 2002.



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##### Table of Contents

7. Borrowings



Borrowings consist of the following:



|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|---------------------------------------------------- |  | ----------------- | ------- | ------------ | ----------------- | -------- | ------ | ------------------- | ----- | - | ------ | - | ------------ |  | -------- |  | ------------------- |  | ----- | -
|                                                     |  | December 31, 2003 |         |              | December 31, 2002 |         
|(dollars in thousands)                               |  | Amount            |         | MaturityDate |                   | CallDate |        | WeightedAverageRate |       |   | Amount |   | MaturityDate |  | CallDate |  | WeightedAverageRate | 
|Advances from FHLB of Atlanta:                       |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Overnight borrowings                                 |  | $                 | 7,000   |              |                   |          |        |                     | 1.15  | % |        | $ |             |  |          |  |                     |  |       | %
|Term borrowings:                                     |  |                   | 5,000   |              | Sep-09            |          | Sep-04 |                     | 6.32  |   |        |   | 5,000        |  | Sep-09   |  | Sep-04              |  | 6.32  |  
|                                                     |  |                   | 5,000   |              | Sep-10            |          | Mar-04 |                     | 6.04  |   |        |   | 5,000        |  | Sep-10   |  | Sep-03              |  | 6.04  |  
|                                                     |  |                   | 5,000   |              | Sep-10            |          | Mar-04 |                     | 5.84  |   |        |   | 5,000        |  | Sep-10   |  | Mar-03              |  | 5.84  |  
|                                                     |  |                   | 25,000  |              | Oct-07            |          | Jan-04 |                     | 1.18  |   |        |   | 25,000       |  | Oct-07   |  | Jan-03              |  | 1.18  |  
|                                                     |  |                   |        |              |                   |          |        |                     |       |   |        |   | 25,000       |  | Oct-07   |  | Jan-03              |  | 1.10  |  
|                                                     |  |                   | 24,796  |              | Feb-05            |          |        |                     | 1.14  |   |        |   |             |  |          |  |                     |  |       |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Total advances from FHLB of Atlanta                  |  |                   | 71,796  |              |                   |          |        |                     | 2.18  |   |        |   | 65,000       |  |          |  |                     |  | 2.28  |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Callable long term debt                              |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|                                                     |  |                   | 5,000   |              | Jul-30            |          | Jul-05 |                     | 11.00 |   |        |   | 5,000        |  | Jul-30   |  | Jul-05              |  | 11.00 |  
|                                                     |  |                   | 8,000   |              | Sep-30            |          | Sep-10 |                     | 10.60 |   |        |   | 8,000        |  | Sep-30   |  | Sep-10              |  | 10.60 |  
|                                                     |  |                   | 10,000  |              | Apr-33            |          | Apr-08 |                     | 4.41  |   |        |   |             |  |          |  |                     |  |       |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Total callable long term debt                        |  |                   | 23,000  |              |                   |          |        |                     | 8.00  |   |        |   | 13,000       |  |          |  |                     |  | 10.75 |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Securities sold under agreements to repurchase:      |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Sweep accounts                                       |  |                   | 32,959  |              |                   |          |        |                     | 0.51  |   |        |   | 18,456       |  |          |  |                     |  | 0.94  |  
|Term repurchase agreement                            |  |                   | 5,000   |              | Jan-05            |          |        |                     | 1.43  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 25,000  |              | Jan-05            |          |        |                     | 1.22  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 25,000  |              | Jul-06            |          |        |                     | 2.30  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 15,000  |              | Aug-07            |          |        |                     | 3.18  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 15,000  |              | Aug-05            |          |        |                     | 1.89  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 10,000  |              | Feb-05            |          |        |                     | 1.80  |   |        |   |             |  |          |  |                     |  |       |  
|Term repurchase agreement                            |  |                   | 10,000  |              | Aug-08            |          |        |                     | 3.84  |   |        |   |             |  |          |  |                     |  |       |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Total securities sold under agreements to repurchase |  |                   | 137,959 |              |                   |          |        |                     | 1.77  |   |        |   | 18,456       |  |          |  |                     |  | 0.94  |  
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  
|Total borrowings                                     |  | $                 | 232,755 |              |                   |          |        |                     | 2.51  | % |        | $ | 96,456       |  |          |  |                     |  | 3.16  | %
|                                                     |  |                   |         |              |                   |          |        |                     |       |   |        |   |              |  |          |  |                     |  |       |  



Southern Financial
also uses interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the Federal Home Loan Bank of Atlanta (FHLB). As of December 31, 2003, the notional amount of these swaps was $25 million. There were
none as of December 31, 2002. Under the terms of these interest rate swaps, Southern Financial is the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is equal to three-month LIBOR. Southern Financial
pays a fixed rate of 1.82%, and the swaps expire in February 2005. The fair value of these interest rate swaps was a loss of $204 thousand at December 31, 2003.



8. Stockholders Equity



In September 2003, Southern Financial announced a 10% stock dividend. In January 2003, we announced a 15% stock dividend, and during 2001 announced and
issued a 10% stock dividend to stockholders. All share amounts and per share data are adjusted to reflect these stock dividends.



In 1987, Southern Financials stockholders approved an incentive stock option plan under which options to purchase up to 83,660 shares of common
stock could be granted. During each of the years 1994 and 1997, this plan was amended to allow an additional 100,000 shares of common stock to be granted. In 1999 and 2001, the plan was amended to allow an additional 150,000 and 70,000 shares,
respectively, of common stock to be granted. In accordance with the plan agreement, the exercise price for stock options equals the stocks market price on the date of grant. The maximum term of all options granted under the plans is ten years
and vesting occurs after one year.



In 2003, Southern
Financials stockholders approved the 2003 Stock Incentive Plan under which options to purchase up to 150,000 shares of common stock could be granted.



Southern Financial did not record any compensation costs in 2003, 2002 or 2001 related to its stock option plan. In addition, no significant modifications
to the plan were made during these periods. The fair values of the stock options outstanding used to determine the pro forma impact of the options were calculated using an acceptable option pricing model using the key assumptions detailed above.



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A summary of the status of Southern Financials stock option plan as of December 31, 2003, 2002 and
2001, and changes during the years ended December 31, 2003, 2002, and 2001 is presented below. Average prices and shares subject to options have been adjusted to reflect stock dividends.



|                                                                 |  |         |  |                              |       |        |         |                              |   |        |  |                              |  |   |      
|---------------------------------------------------------------- |  | ------- |  | ---------------------------- | ----- | ------ | ------- | ---------------------------- | - | ------ |  | ---------------------------- |  | - | -----
|                                                                 |  | 2003    |  | 2002                         |       | 2001  
|                                                                 |  | Shares  |  | WeightedAverageExercisePrice |       | Shares |         | WeightedAverageExercisePrice |   | Shares |  | WeightedAverageExercisePrice
|Outstanding at beginning of period                               |  | 528,495 |  | $                            | 13.96 |        | 525,824 |                              | $ | 12.09  |  | 460,656                      |  | $ | 11.75
|Granted                                                          |  | 72,616  |  |                              | 26.42 |        | 77,355  |                              |   | 20.16  |  | 100,466                      |  |   | 13.55
|Exercised                                                        |  | 177,401 |  |                              | 12.77 |        | 74,684  |                              |   | 5.96   |  | 18,174                       |  |   | 6.67 
|Expired                                                          |  |        |  |                              |      |        |        |                              |   |       |  | 17,124                       |  |   | 16.33
|                                                                 |  |         |  |                              |       |        |         |                              |   |        |  |                              |  |   |      
|Outstanding at end of period                                     |  | 423,710 |  |                              | 15.61 |        | 528,495 |                              |   | 13.96  |  | 525,824                      |  |   | 12.21
|                                                                 |  |         |  |                              |       |        |         |                              |   |        |  |                              |  |   |      
|Options exercisable at end of period                             |  | 351,094 |  |                              | 14.22 |        | 451,140 |                              |   | 12.93  |  | 425,358                      |  |   | 11.90
|                                                                 |  |         |  |                              |       |        |         |                              |   |        |  |                              |  |   |      
|Weighted average fair value of options granted during the period |  |         |  | $                            | 12.71 |        |         |                              | $ | 10.65  |  |                              |  | $ | 10.68
|                                                                 |  |         |  |                              |       |        |         |                              |   |        |  |                              |  |   |      



The following table
summarizes information about stock options outstanding at December 31, 2003:



|               |  |                    |  |                              |       |                    |         |                              |   |                                                 |  |    
|-------------- |  | ------------------ |  | ---------------------------- | ----- | ------------------ | ------- | ---------------------------- | - | ----------------------------------------------- |  | ---
|Exercise Price |  | OptionsOutstanding |  | WeightedAverageExercisePrice |       | OptionsExercisable |         | WeightedAverageExercisePrice |   | WeightedAverageRemainingContractualLife(months)
|$ 6.35 - $9.15 |  | 8,978              |  | $                            | 7.48  |                    | 8,978   |                              | $ | 7.48                                            |  | 10 
|9.80 - 14.55   |  | 157,045            |  |                              | 11.81 |                    | 157,045 |                              |   | 11.81                                           |  | 62 
|14.82 - 19.96  |  | 185,071            |  |                              | 17.14 |                    | 185,071 |                              |   | 17.14                                           |  | 77 
|25.30 - 29.77  |  | 72,616             |  |                              | 25.35 |                    |        |                              |   | 25.35                                           |  | 112
|               |  |                    |  |                              |       |                    |         |                              |   |                                                 |  |    
|               |  | 423,710            |  | $                            | 15.61 |                    | 351,094 |                              | $ | 14.22                                           |  |    
|               |  |                    |  |                              |       |                    |         |                              |   |                                                 |  |    



There were 40 option
holders at December 31, 2003. Options exercised during 2003 had exercise prices ranging from $7.60 to $19.96. Options exercised during 2002 had exercise prices ranging from $6.30 to $11.77. Options exercised during 2001 had exercise prices ranging
from $6.91 to $13.00. The closing price of Southern Financials stock at December 31, 2003 was $43.07 per share.



9. Regulatory Matters



Southern Financials primary supervisory agent is the Federal Reserve Bank. The Federal Reserve Bank has mandated certain minimum capital standards
for the industry. In addition, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) outlines various levels of capital adequacy for the industry.



Failure to meet minimum capital requirements can initiate certain mandatory  and possibly additional discretionary
 actions by regulation that, if undertaken, could have a direct material effect on Southern Financials financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Southern Financial
must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Southern Financials capital amounts and
classification are also subject to qualitative judgements by the regulators about components, risk weightings, and other factors.



Quantitative measures established by regulation to ensure capital adequacy require Southern Financial to maintain minimum amounts and ratios (set forth in
the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).



As of December 31, 2003, the most recent notification from the Federal Reserve Bank categorized Southern Financial as well
capitalized under the regulatory framework for prompt corrective action. To be categorized as adequately capitalized Southern Financial must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table.
There are no conditions or events since that notification that management believes have changed the institutions category.



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Southern Financials actual capital amounts and ratios are also presented in the tables below. (All
dollar amounts are in thousands.)



|                                         |  |        |         |       |                             |   |        |                                                                |        |  |      |        |  |       |        |  |       |  
|---------------------------------------- |  | ------ | ------- | ----- | --------------------------- | - | ------ | -------------------------------------------------------------- | ------ |  | ---- | ------ |  | ----- | ------ |  | ----- | -
|                                         |  | Actual |         |       | For CapitalAdequacyPurposes |   |        | To Be Well CapitalizedUnder Prompt CorrectiveAction Provisions |       
|                                         |  | Amount |         | Ratio |                             |   | Amount |                                                                | Ratio  |  |      | Amount |  | Ratio |       
|As of December 31, 2003                  |  |        |         |       |                             |   |        |                                                                |        |  |      |        |  |       |        |  |       |  
|Total Capital (to risk-weighted assets)  |  | $      | 112,358 |       | 15.05                       | % |        | $                                                              | 59,712 |  | 8.00 | %      |  | $     | 74,640 |  | 10.00 | %
|Tier I Capital (to risk-weighted assets) |  |        | 103,027 |       | 13.80                       |   |        |                                                                | 29,856 |  | 4.00 |        |  |       | 44,784 |  | 6.00  |  
|Tier I Capital (to average assets)       |  |        | 103,027 |       | 9.43                        |   |        |                                                                | 43,724 |  | 4.00 |        |  |       | 54,655 |  | 5.00  |  
|As of December 31, 2002                  |  |        |         |       |                             |   |        |                                                                |        |  |      |        |  |       |        |  |       |  
|Total Capital (to risk-weighted assets)  |  | $      | 88,438  |       | 12.52                       | % |        | $                                                              | 56,499 |  | 8.00 | %      |  | $     | 70,623 |  | 10.00 | %
|Tier I Capital (to risk-weighted assets) |  |        | 79,611  |       | 11.27                       |   |        |                                                                | 28,249 |  | 4.00 |        |  |       | 42,374 |  | 6.00  |  
|Tier I Capital (to average assets)       |  |        | 79,611  |       | 8.39                        |   |        |                                                                | 37,957 |  | 4.00 |        |  |       | 47,446 |  | 5.00  |  



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10. Parent Company Activity



The Bancorp owns all of the outstanding shares of the Bank. Summary financial statements of the Bancorp follow:



BALANCE SHEETS

(dollars in thousands)



|                                           |  |              |         |      |   |       
|------------------------------------------ |  | ------------ | ------- | ---- | - | ------
|                                           |  | December 31,
|                                           |  | 2003         |         | 2002
|Assets:                                    |  |              |         |      |   |       
|Cash                                       |  | $            | 1,149   |      | $ | 387   
|Investment in subsidiaries                 |  |              | 113,090 |      |   | 93,200
|Other assets                               |  |              | 2,802   |      |   | 1,507 
|                                           |  |              |         |      |   |       
|Total assets                               |  | $            | 117,041 |      | $ | 95,094
|                                           |  |              |         |      |   |       
|Liabilities:                               |  |              |         |      |   |       
|Callable long term debt                    |  | $            | 23,000  |      | $ | 13,000
|Other liabilities                          |  |              | 1,184   |      |   | 791   
|                                           |  |              |         |      |   |       
|Total liabilities                          |  |              | 24,184  |      |   | 13,791
|                                           |  |              |         |      |   |       
|Total stockholders equity                 |  |              | 92,857  |      |   | 81,303
|                                           |  |              |         |      |   |       
|Total liabilities and stockholders equity |  | $            | 117,041 |      | $ | 95,094
|                                           |  |              |         |      |   |       



STATEMENTS OF INCOME

(dollars in thousands)



|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|---------------------------------------------- |  | ----------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ----- | -
|                                               |  | Year Ended December 31, |       
|                                               |  | 2003                    |        |   | 2002 |   |        | 2001 | 
|Income:                                        |  |                         |        |   |      |   |        |      |  |   |       |  
|Equity in earnings of Southern Financial Bank  |  | $                       | 14,398 |   |      | $ | 11,002 |      |  | $ | 9,828 |  
|Equity in earnings (loss) of Southern Web Tech |  |                         | 79     |   |      |   | (24    | )    |  |   | (456  | )
|Other                                          |  |                         | 4      |   |      |   | 12     |      |  |   | 25    |  
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|Total income                                   |  |                         | 14,481 |   |      |   | 10,990 |      |  |   | 9,397 |  
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|Expense:                                       |  |                         |        |   |      |   |        |      |  |   |       |  
|Interest expense                               |  |                         | 1,767  |   |      |   | 1,431  |      |  |   | 1,431 |  
|Other                                          |  |                         | 227    |   |      |   | 126    |      |  |   | 127   |  
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|Total expense                                  |  |                         | 1,994  |   |      |   | 1,557  |      |  |   | 1,558 |  
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|Income before income taxes                     |  |                         | 12,487 |   |      |   | 9,433  |      |  |   | 7,839 |  
|Income tax benefit                             |  |                         | (697   | ) |      |   | (579   | )    |  |   | (575  | )
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  
|Net income                                     |  | $                       | 13,184 |   |      | $ | 10,012 |      |  | $ | 8,414 |  
|                                               |  |                         |        |   |      |   |        |      |  |   |       |  



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STATEMENTS OF CASH FLOWS

(dollars in thousands)



|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|--------------------------------------------------------------------------------- |  | ----------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                                                  |  | Year Ended December 31, |        
|                                                                                  |  | 2003                    |         |   | 2002 |   |        | 2001 | 
|Operating activities:                                                             |  |                         |         |   |      |   |        |      |  |   |         |  
|Net income                                                                        |  | $                       | 13,184  |   |      | $ | 10,012 |      |  | $ | 8,414   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                         |         |   |      |   |        |      |  |   |         |  
|Equity in undistributed income of subsidiaries                                    |  |                         | (11,371 | ) |      |   | (2,943 | )    |  |   | (6,824  | )
|Other operating activities                                                        |  |                         | (605    | ) |      |   | (224   | )    |  |   | (322    | )
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Net cash provided by operating activities                                         |  |                         | 1,208   |   |      |   | 6,845  |      |  |   | 1,268   |  
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Investing activities:                                                             |  |                         |         |   |      |   |        |      |  |   |         |  
|Investment in subsidiaries                                                        |  |                         | (9,700  | ) |      |   | (6,841 | )    |  |   | (14,000 | )
|Repayment from (advance to) subsidiary                                            |  |                         | 100     |   |      |   | 275    |      |  |   | (275    | )
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Net cash used by investing activities                                             |  |                         | (9,600  | ) |      |   | (6,566 | )    |  |   | (14,275 | )
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Financing activities:                                                             |  |                         |         |   |      |   |        |      |  |   |         |  
|Increase in borrowings                                                            |  |                         | 9,700   |   |      |   |       |      |  |   |        |  
|Issuance of common stock                                                          |  |                         | 2,759   |   |      |   | 431    |      |  |   | 16,352  |  
|Dividends on preferred and common stock                                           |  |                         | (3,305  | ) |      |   | (2,126 | )    |  |   | (1,562  | )
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Net cash provided (used) by financing activities                                  |  |                         | 9,154   |   |      |   | (1,695 | )    |  |   | 14,790  |  
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Increase (decrease) in cash                                                       |  |                         | 762     |   |      |   | (1,416 | )    |  |   | 1,783   |  
|Cash, beginning of period                                                         |  |                         | 387     |   |      |   | 1,803  |      |  |   | 20      |  
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|Cash, end of period                                                               |  | $                       | 1,149   |   |      | $ | 387    |      |  | $ | 1,803   |  
|                                                                                  |  |                         |         |   |      |   |        |      |  |   |         |  
|SUPPLEMENTAL DATA                                                                 |  |                         |         |   |      |   |        |      |  |   |         |  
|Cash payments for interest on borrowings                                          |  | $                       | 1,643   |   |      | $ | 1,398  |      |  | $ | 1,431   |  
|Cash payments for income taxes                                                    |  |                         | 1,900   |   |      |   | 7,480  |      |  |   | 5,325   |  



11. Estimated Fair Value of
Financial Instruments



The assumptions used and the
estimates disclosed represent managements best judgment of appropriate valuation methods. These estimates are based on pertinent information available to management as of December 31, 2003. In certain cases, fair values are not subject to
precise quantification or verification and may change as economic and market factors, and managements evaluation of those factors change.



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Although management uses its best judgment in estimating the fair value of these financial instruments,
there are inherent limitations in any estimation technique. Therefore, these fair value estimates are not necessarily indicative of the amounts that Southern Financial would realize in a market transaction. Because of the wide range of valuation
techniques and the numerous estimates which must be made, it may be difficult to make reasonable comparisons of Southern Financials fair value information to that of other financial institutions. It is important that the many uncertainties
discussed above be considered when using the estimated fair value disclosures and to realize that because of these uncertainties, the aggregate fair value amount should in no way be construed as representative of the underlying value of Southern
Financial. The estimated fair values of Southern Financials financial instruments at December 31, 2003 and 2002 are as follows (all dollar amounts are in thousands):



|                                                            |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|----------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------- | --------------- |  | ---------- | ------- |  | - | -------
|                                                            |  | December 31, 2003 |         |   | December 31, 2002
|                                                            |  | Carrying Amount   |         |   | Fair Value        |   |         | Carrying Amount |  | Fair Value
|Financial assets:                                           |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|Cash and cash equivalents                                   |  | $                 | 36,386  |   |                   | $ | 36,386  |                 |  | $          | 93,398  |  | $ | 93,398 
|Available-for-sale securities                               |  |                   | 127,332 |   |                   |   | 127,332 |                 |  |            | 203,563 |  |   | 203,563
|Held-to-maturity securities                                 |  |                   | 250,201 |   |                   |   | 251,185 |                 |  |            |        |  |   |       
|Loans receivable, net of allowance                          |  |                   | 601,118 |   |                   |   | 615,667 |                 |  |            | 594,323 |  |   | 599,340
|Loans held for sale                                         |  |                   | 8,651   |   |                   |   | 8,651   |                 |  |            | 514     |  |   | 514    
|Other                                                       |  |                   | 3,838   |   |                   |   | 3,838   |                 |  |            | 4,884   |  |   | 4,884  
|Financial liabilities:                                      |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|Deposits:                                                   |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|Checking accounts                                           |  |                   | 150,486 |   |                   |   | 150,486 |                 |  |            | 138,717 |  |   | 138,717
|Money market and savings accounts                           |  |                   | 101,657 |   |                   |   | 101,657 |                 |  |            | 162,043 |  |   | 162,043
|Certificates of deposit                                     |  |                   | 491,594 |   |                   |   | 492,401 |                 |  |            | 475,323 |  |   | 480,522
|Borrowings:                                                 |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|FHLB advances - short term                                  |  |                   | 7,000   |   |                   |   | 7,000   |                 |  |            |        |  |   |       
|FHLB advances - long term                                   |  |                   | 64,796  |   |                   |   | 70,824  |                 |  |            | 65,000  |  |   | 67,428 
|Callable long term debt                                     |  |                   | 23,000  |   |                   |   | 23,854  |                 |  |            | 13,000  |  |   | 13,238 
|Securities sold under agreements to repurchase - short term |  |                   | 32,959  |   |                   |   | 32,959  |                 |  |            | 18,456  |  |   | 18,456 
|Securities sold under agreements to repurchase - long term  |  |                   | 105,000 |   |                   |   | 104,766 |                 |  |            |        |  |   |       
|Off balance sheet instruments:                              |  |                   |         |   |                   |   |         |                 |  |            |         |  |   |        
|Interest rate swaps                                         |  |                   | (2,084  | ) |                   |   | (2,084  | )               |  |            | 5,359   |  |   | 5,359  



The following methods
and assumptions were used to estimate the fair value amounts at December 31, 2003 and 2002:



Cash and Cash Equivalents



Carrying amount approximates fair value.



Available-for-Sale and
Held-to-Maturity Securities



Fair value is based on quoted
market prices.



Loans Receivable, Net of Allowance



Fair value of loans is estimated using discounted cash flow analyses based
on contractual repayment schedules. The discount rates used in these analyses are based on the interest rates currently offered by Southern Financial for loans with similar terms to borrowers of similar credit quality.



Loans Held for Sale



Fair value is based on selling prices arranged by arms-length contracts with third parties.



Other



Other financial assets consist of accrued interest receivable. Carrying amount approximates fair value.



Deposits



The carrying amount of deposit liabilities payable on demand, consisting of NOW accounts, money market deposits, statement
savings and other deposit accounts approximates fair value. Fair value of fixed-rate certificates of deposit is estimated based on discounted cash flow analyses using the remaining maturity of the underlying accounts and interest rates currently
offered on certificates of deposit with similar maturities.



Borrowings



The carrying amount of short-term FHLB advances
approximates fair value. Fair value of all other borrowings is estimated based on discounted cash flow analyses using the remaining maturity of the borrowings and interest rates currently in effect on borrowings with similar maturities.



Off-Balance Sheet Instruments



Fair value of the interest rate swaps reflects the estimated current
replacement cost of the instrument as determined by a third party.



The difference between the original fees charged by the Bank for commitments to extend credit and letters of credit and the current fees charged to enter into similar agreements is immaterial.



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12. Savings Plan



Southern Financial has an employee savings plan (the Savings Plan) that qualifies as a deferred salary arrangement under Section 401(k) of the
Internal Revenue Code. Under the Savings Plan, participating employees may defer a portion of their pretax earnings, up to the Internal Revenue Service annual contribution limit. Southern Financial matches one half of each employees
contributions on a discretionary basis based on its profit; such match is not to exceed 3 percent of the employees earnings. Southern Financials matching contributions to the Savings Plan were $167 thousand, $147 thousand, and $119
thousand for the years ended December 31, 2003, 2002 and 2001, respectively.



13. Provision for Income Taxes



The provision
for income taxes consists of the following:



|                              |  |                         |       |      |   |       |  |   |       |  
|----------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | ----- | -
|                              |  | Year Ended December 31, |      
|(dollars in thousands)        |  | 2003                    |       | 2002 |   | 2001  | 
|Current provision:            |  |                         |       |      |   |       |  |   |       |  
|Federal                       |  | $                       | 5,623 |      | $ | 3,155 |  | $ | 4,981 |  
|                              |  |                         |       |      |   |       |  |   |       |  
|Deferred (benefit) provision: |  |                         |       |      |   |       |  |   |       |  
|Federal                       |  |                         | 755   |      |   | 1,506 |  |   | (891  | )
|                              |  |                         |       |      |   |       |  |   |       |  
|                              |  | $                       | 6,378 |      | $ | 4,661 |  | $ | 4,090 |  
|                              |  |                         |       |      |   |       |  |   |       |  



Deferred income taxes
reflect temporary differences in the recognition of revenue and expenses for tax reporting and financial statement purposes, principally because certain items, such as the allowance for loan losses and loan fees, are recognized in different periods
for financial reporting and tax return purposes. A valuation allowance has not been established for deferred tax assets. Realization of the deferred tax asset is dependent on generating sufficient taxable income. Although realization is not assured,
management believes it is more likely than not that all of the deferred tax asset will be realized.



Deferred tax assets and liabilities were comprised of the following significant components as of December 31, 2003 and 2002:



|                                       |  |                        |       |      |   |      
|-------------------------------------- |  | ---------------------- | ----- | ---- | - | -----
|                                       |  | 2003                   |       | 2002
|                                       |  | (dollars in thousands)
|Assets:                                |  |                        |       |      |   |      
|Provision for losses on loans          |  | $                      | 1,264 |      | $ | 1,694
|Net operating loss carryforward        |  |                        | 388   |      |   | 691  
|Depreciation                           |  |                        | 259   |      |   | 215  
|Unrealized loss on interest rate swaps |  |                        | 694   |      |   | 459  
|Nonaccrual interest                    |  |                        | 128   |      |   | 126  
|Lease                                  |  |                        | 14    |      |   | 14   
|Real estate owned                      |  |                        | 53    |      |   | 53   
|Other                                  |  |                        | 63    |      |   | 60   
|                                       |  |                        |       |      |   |      
|Gross deferred tax assets              |  |                        | 2,863 |      |   | 3,312
|                                       |  |                        |       |      |   |      
|Liabilities:                           |  |                        |       |      |   |      
|Deferred loan fees                     |  |                        | 621   |      |   | 517  
|Stock based compensation               |  |                        |      |      |   | 63   
|Other                                  |  |                        | 191   |      |   | 161  
|                                       |  |                        |       |      |   |      
|Gross deferred tax liabilities         |  |                        | 812   |      |   | 741  
|                                       |  |                        |       |      |   |      
|Net deferred tax assets                |  | $                      | 2,051 |      | $ | 2,571
|                                       |  |                        |       |      |   |      



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The provision for income taxes differs from the amount of income tax determined by applying the
applicable U.S. statutory Federal income tax rate to pretax income as a result of the following differences:



|                                  |  |                         |   |  |      |   |  |      |  
|--------------------------------- |  | ----------------------- | - |  | ---- | - |  | ---- | -
|                                  |  | Year Ended December 31, |  
|                                  |  | 2003                    |   |  | 2002 |   |  | 2001 |  
|Statutory Federal income tax rate |  | 35                      | % |  | 35   | % |  | 35   | %
|Life insurance                    |  | -2                      |   |  | -3   |   |  | -3   |  
|Other                             |  |                        |   |  |     |   |  | 1    |  
|                                  |  |                         |   |  |      |   |  |      |  
|Effective tax rate                |  | 33                      | % |  | 32   | % |  | 33   | %
|                                  |  |                         |   |  |      |   |  |      |  



14. Commitments



The Bank leases its corporate headquarters and most of its branch facilities
under non-cancelable lease agreements. Most of these leases provide for the payment of property taxes and other costs by the Bank and include one or more renewal options ranging up to ten years. Annual rental commitments under all long-term
non-cancelable operating lease agreements consist of the following at December 31, 2003:



|                    |  |                        |       |                |   |       |  |   |      
|------------------- |  | ---------------------- | ----- | -------------- | - | ----- |  | - | -----
|                    |  | RealPropertyLeases     |       | SubleaseIncome |   | Total
|                    |  | (dollars in thousands)
|2004                |  | $                      | 1,850 |                | $ | 143   |  | $ | 1,707
|2005                |  |                        | 1,479 |                |   | 19    |  |   | 1,460
|2006                |  |                        | 1,361 |                |   |       |  |   | 1,361
|2007                |  |                        | 1,221 |                |   |       |  |   | 1,221
|2008                |  |                        | 1,096 |                |   |       |  |   | 1,096
|2009 and Thereafter |  |                        | 2,443 |                |   |       |  |   | 2,443
|                    |  |                        |       |                |   |       |  |   |      
|                    |  | $                      | 9,450 |                | $ | 162   |  | $ | 9,288
|                    |  |                        |       |                |   |       |  |   |      



Rent expense
aggregated $1.8 million, $1.6 million, and $1.3 million for the years ended December 31, 2003, 2002 and 2001, respectively.



Outstanding loan commitments amounted to $6.8 million (of which $1.1 million had fixed interest rates) and $23.7 million (of which $820 thousand had fixed
interest rates) at December 31, 2003 and 2002, respectively. The Bank had commitments from investors of $1.3 million to purchase loans from the Bank at both December 31, 2003 and 2002.



The Bank issues financial standby letters of credit and performance standby letters of credit. A financial standby letter of
credit obligates the Bank to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument. A performance standby letter of credit obligates the Bank to pay a third-party beneficiary when a customer fails to
perform some contractual non-financial obligation. Both types of standby letters of credit are generally issued for terms ranging from six months to three years. The Bank generally requires collateral to support the letters of credit in excess of
the contractual amount of the instruments and essentially uses the same credit policies in issuing letters of credit as it does for on-balance sheet instruments. At December 31, 2003, the Bank had performance standby letters of credit outstanding in
the amount of $11.1 million and financial standby letters of credit outstanding in the amount of $6.3 million. At December 31, 2002, the Bank had performance standby letters of credit outstanding in the amount of $5.9 million and financial standby
letters of credit outstanding in the amount of $3.2 million. At December 31, 2003, a liability of $91 thousand existed for letters of credit, and there was no liability recorded as of December 31, 2002.



At December 31, 2003, the Bank had unfunded lines of credit of $48.2 million
and undisbursed construction loan funds of $67 million.



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15. Earnings Per Share



The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of
shares of potential dilutive common stock (dollars in thousands except per share data):



|                               |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     
|------------------------------ |  | ------ | ------ | ---- | ------ | --------- | -------------- | - | ------ |  | - | ------ | - | -------------- | --------- |  | - | ----
|                               |  | 2003   |        | 2002
|                               |  | Amount |        |      | Shares |           | PerShareAmount |   | Amount |  |   | Shares |   | PerShareAmount
|Net income                     |  | $      | 13,184 |      |        |           |                |   |        |  | $ | 10,012 |   |                |           |  |   |     
|Preferred dividends            |  |        | (3     | )    |        |           |                |   |        |  |   | (11    | ) |                |           |  |   |     
|                               |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     
|Basic earnings per share       |  | $      | 13,181 |      |        | 6,032,566 |                | $ | 2.19   |  | $ | 10,001 |   |                | 5,614,255 |  | $ | 1.78
|                               |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     
|Effect of dilutive securities: |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     
|Stock options                  |  |        |        |      |        | 219,040   |                |   |        |  |   |        |   |                | 224,091   |  |   |     
|Convertible preferred stock    |  |        |        |      |        | 17,781    |                |   |        |  |   |        |   |                | 29,748    |  |   |     
|                               |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     
|Diluted earnings per share     |  | $      | 13,184 |      |        | 6,269,387 |                | $ | 2.10   |  | $ | 10,012 |   |                | 5,868,093 |  | $ | 1.71
|                               |  |        |        |      |        |           |                |   |        |  |   |        |   |                |           |  |   |     



|                               |  |        |       |   |        |           |                  |   |     
|------------------------------ |  | ------ | ----- | - | ------ | --------- | ---------------- | - | ----
|                               |  | 2001  
|                               |  | Amount |       |   | Shares |           | Per Share Amount
|Net income                     |  | $      | 8,414 |   |        |           |                  |   |     
|Preferred dividends            |  |        | (12   | ) |        |           |                  |   |     
|                               |  |        |       |   |        |           |                  |   |     
|Basic earnings per share       |  | $      | 8,402 |   |        | 4,428,700 |                  | $ | 1.90
|                               |  |        |       |   |        |           |                  |   |     
|Effect of dilutive securities: |  |        |       |   |        |           |                  |   |     
|Stock options                  |  |        |       |   |        | 130,877   |                  |   |     
|Convertible preferred stock    |  |        |       |   |        | 30,579    |                  |   |     
|                               |  |        |       |   |        |           |                  |   |     
|Diluted earnings per share     |  | $      | 8,414 |   |        | 4,590,156 |                  | $ | 1.83
|                               |  |        |       |   |        |           |                  |   |     



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16. Quarterly Financial Information (Unaudited  in thousands, except share data)



|                           |  |                            |        |                            |   |                            |  |                            |        |  |   |       
|-------------------------- |  | -------------------------- | ------ | -------------------------- | - | -------------------------- |  | -------------------------- | ------ |  | - | ------
|                           |  | Quarter EndedDec. 31, 2003 |        | Quarter EndedSep. 30, 2003 |   | Quarter EndedJun. 30, 2003 |  | Quarter EndedMar. 31, 2003
|Interest income            |  | $                          | 14,342 |                            | $ | 13,807                     |  | $                          | 13,188 |  | $ | 12,933
|Net interest income        |  |                            | 10,555 |                            |   | 10,031                     |  |                            | 9,508  |  |   | 9,403 
|Provision for loan losses  |  |                            | 1,250  |                            |   | 1,235                      |  |                            | 1,105  |  |   | 1,215 
|Income before income taxes |  |                            | 5,459  |                            |   | 5,136                      |  |                            | 5,069  |  |   | 3,898 
|Net income                 |  |                            | 3,552  |                            |   | 3,476                      |  |                            | 3,448  |  |   | 2,708 
|Earnings per share:        |  |                            |        |                            |   |                            |  |                            |        |  |   |       
|Basic                      |  |                            | 0.58   |                            |   | 0.58                       |  |                            | 0.58   |  |   | 0.45  
|Diluted                    |  |                            | 0.56   |                            |   | 0.55                       |  |                            | 0.55   |  |   | 0.43  
|                           |  |                            |        |                           
|                           |  | Quarter EndedDec. 31, 2002 |        | Quarter EndedSep. 30, 2002 |   | Quarter EndedJun. 30, 2002 |  | Quarter EndedMar. 31, 2002
|Interest income            |  | $                          | 13,376 |                            | $ | 12,639                     |  | $                          | 12,295 |  | $ | 12,820
|Net interest income        |  |                            | 9,214  |                            |   | 8,160                      |  |                            | 8,252  |  |   | 8,129 
|Provision for loan losses  |  |                            | 1,040  |                            |   | 950                        |  |                            | 1,560  |  |   | 1,500 
|Income before income taxes |  |                            | 3,661  |                            |   | 3,922                      |  |                            | 3,822  |  |   | 3,268 
|Net income                 |  |                            | 2,501  |                            |   | 2,675                      |  |                            | 2,608  |  |   | 2,228 
|Earnings per share:        |  |                            |        |                            |   |                            |  |                            |        |  |   |       
|Basic                      |  |                            | 0.42   |                            |   | 0.47                       |  |                            | 0.48   |  |   | 0.41  
|Diluted                    |  |                            | 0.40   |                            |   | 0.45                       |  |                            | 0.46   |  |   | 0.39  



|17. | Proposed Mergers
|--- | ----------------



Southern Financial signed a definitive merger agreement on July 24, 2003 providing for the merger of Essex Bancorp, Inc. (Essex) into Southern Financial
Bancorp, Inc. Southern Financial will issue up to 896,178 shares of its common stock for all the issued and outstanding common stock of Essex. Immediately prior to the merger, the agreement affects a spin-off of Essexs wholly-owned subsidiary,
Essex Home Mortgage Servicing Corporation (LoanCare). Following the merger Southern Financial will own 24.9% of LoanCare. The transaction closed on February 27, 2004.



On November 3, 2003, Southern Financial and Provident Bankshares Corporation (Provident) announced the signing of a
definitive agreement for Southern Financial to be merged into Provident. The shareholders of Southern Financial will receive 1.0875 shares of Provident common stock and $11.125 in cash for each Southern Financial share held. The merger, which is
subject to regulatory and shareholder approval, is expected to be completed in the second quarter of 2004.



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



None



Item 9a. Controls and Procedures



Our management, including the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of our
disclosure controls and procedures as of the end of the period covered by this annual report, and, based on their evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that these disclosure controls and procedures
are effective. There were no significant changes in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting.



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PART III.



Item 10. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act



The following table provides information regarding each of the directors of Southern Financial:



|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  |                               
|---------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------
|Name                   |  | Age; Principal Occupation for Past Five Years; and Directorships in Public Corporations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  | Year First Elected as Director
|John C. Belotti        |  | 67; President and CEO of Bee & H Electric Company in Fairfax, Virginia. He served as a founding director of Horizon from 1989 to 1999 and Vice Chairman of the Board of Horizon from 1998
to 1999.                                                                                                                                                                                                                                                                                                                                                                                                                                               |  | 1999                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Fred L. Bollerer       |  | 61; Senior partner and investment director at Venture Philanthropy Partners. Since 1998 he has served as a Management Advisor to the Morino Institute. He previously served as President and
Chief Executive Officer of the Morino Institutes Potomac KnowledgeWay Project, a non-profit leadership organization in Herndon, Virginia from 1998 to 2000. From 1993 to 1997, he was President and Chief Executive Officer of Riggs Bank, N.A. and
prior to that he was Chairman of the Board and Chief Executive Officer of First American Bank of Virginia.                                                                                     |  | 1999                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Neil J. Call           |  | 70; Executive Vice President of MacKenzie Partners, Inc., a New York financial consulting company, since 1990. From 1986 to 1990 he served as Executive Vice President of D.F. King & Co.,
Inc. and prior to that he was Executive Vice President, Finance, Gulf and Western Industries.                                                                                                                                                                                                                                                                                                                                                         |  | 1986                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|David de Give          |  | 61; Senior Vice President of the Company since 1992. For the last nine years he has been responsible for obtaining wholesale funding for us on a daily basis and for the managing our
investment portfolio. Prior to that he served as President of Newmarket Capital Corp., a mortgage company. Prior to that he worked for 15 years at Chemical Bank, where he was Vice President and Head of the Funding Department. For the last five years
of his tenure at Chemical, Mr. de Give reported to Mr. Porter and was responsible for raising wholesale funds on a daily basis and for managing the Chemicals United States balance sheet risk. |  | 1986                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Georgia S. Derrico     |  | 59; Chairman of the Board and Chief Executive Officer of the Company since 1986. Prior to this she served as Senior Vice President, Chief Administrative and Credit Officer of the
Multinational Division of Chemical Bank. She also served at Chemical as the Vice President and District Head of the Mid-Atlantic region of the United States for the Corporate Banking Division. Ms. Derrico is a director of Oneida, Ltd., a New York
Stock Exchange company. Ms. Derrico is the wife of Mr. R. Roderick Porter.                                                                                                                             |  | 1986                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Alfonso G. Finocchiaro |  | 71; Mr. Finocchiaro served as Executive Vice President, Regional General Manager and CEO (Americas) of Banco Portugues do Atlantico from 1978 to 1997. Prior to that, from 1977 to 1978 he was
President and Chief Executive Officer of Connecticut Bank International and from 1966 to 1977 he served as Vice President of Chemical Bank. Mr. Finocchiaro served as a director of BPD International Bank, New York, New York, from1997 to 2003 and as a
director of Banif Securities, Inc. since 2002.                                                                                                                                          |  | 1999                          
|                       |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Barbara J. Fried       |  | 68; Chairman of the Fried Companies, Inc., a real estate development and management company based in Springfield, Virginia, since 1995. Ms. Fried was also Chairman of the Board of First
Savings Bank of Virginia.                                                                                                                                                                                                                                                                                                                                                                                                                              |  | 2000                          



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|                   |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  |     
|------------------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|Virginia Jenkins   |  | 56; Owner, V. Jenkins Interiors and Antiques for more than the past five years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  | 1988
|                   |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|R. Roderick Porter |  | 58; President and Chief Operating Officer of the Company since April 1998. From 1994 to 1998 he was President of FX Concepts, Ltd., an international money management firm, Prior to that, he
served as Managing Director of West Capital, Inc., a real estate advising firm; Chairman of Newmarket Capital Corp., a mortgage company and a Principal of Morgan Stanley. Mr. Porter spent 15 years at Chemical, where he was a Senior Vice President.
In Chemicals treasury, Mr. Porter was responsible for asset liability management, the U.S. government and municipal security portfolio, all U.S. dollar denominated funding for the bank and holding company, money market trading and discount
brokerage. Prior experience at Chemical included tours as Vice President and General Manager for northern Europe based in London and for Chemical Japan based in Tokyo. Mr. Porter is the husband of Ms. Georgia S. Derrico. |  | 1986
|                   |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Michael P. Rucker  |  | 63; Retired. Mr. Rucker previously served as an executive with Caterpillar, Inc., a manufacturing company in Peoria, Illinois. He also serves as Chairman of the Board of George H. Rucker
Realty Corp., a real estate development company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | 1999
|                   |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Richard E. Smith   |  | 78; Retired Colonel, U.S. Marine Corps and CEO and Chairman of MANNA Financial Services, a broker-dealer/investment advisory company that he founded in 1961. He is also the owner of Reed
Insurance Agency. He served as a founding director and Chairman of the Board for Horizon Bank of Virginia. From 1989 to 1999, he served as a director of Guaranty Bank & Trust Co. and Riggs National Bank of Virginia.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  | 2000
|                   |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Robert P. Warhurst |  | 65, President and co-owner of Merrifield Garden Center in Merrifield and Fairfax, Virginia. He served as a founding director of Horizon from 1989 to 1999.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  | 1999



The Board of Directors
held eight meetings during 2003. During 2003, each director attended at least 75% of the aggregate of (i) the total number of meetings of the Board held during the period for which the director was on the Board and (ii) the total number of meetings
held by all committees of the Board on which the director then served.



Committees of the Board



The Board of
Directors presently has three committees, consisting of the Audit Committee, the Compensation Committee and the Asset/Liability Management Committee.



Audit Committee. The Audit Committee assists the board in fulfilling its fiduciary responsibilities relating to the Companys corporate
accounting and reporting practices. The Audit Committee reviews the reports of the independent auditors, the Companys internal control system, the audit process and the Companys process for monitoring compliance with laws and regulations
and the Companys code of conduct. In addition, the Audit Committee function includes loan review. The Audit Committee consists of Messrs. Call (chairman), Bollerer, Finocchiaro, Rucker and Ms. Jenkins, each of whom is an independent
director as defined in Rule 4200(a)(14) of the National Association of Securities Dealers, Inc. listing standards. The Audit Committee held four meetings during 2003. Southern Financials Board of Directors has determined that Neil J.
Call qualifies as an audit committee financial expert as defined in Item 401(h) of Regulation S-K, and that Mr. Call is independent as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act.



Compensation Committee. The Compensation Committee
reviews the performance, and establishes the compensation, of the Companys executive officers. The Companys executive compensation programs are designed to retain and reward executives based upon their individual performance and ability
to lead the Company to achieving its performance goals. The Compensation Committee consists of Messrs. Finocchiaro (chairman), Call and Warhurst and Ms. Jenkins. The Compensation Committee held two meetings during 2003.



Asset/Liability Management Committee. The Asset/Liability Management
Committee administers and formulates the Companys asset/liability management policies. The Asset/Liability Management Committee, which consists of Ms. Derrico, Ms. Fried and Messrs. Porter (chairman), Belotti, de Give and Smith, reports
periodically to the Board on the Companys interest sensitivity, including an analysis of the duration of its assets, liabilities and contingent liabilities as well as the mortgage pipeline and a calculation of the duration of its equity.



69



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Compensation Committee Interlocks and Insider Participation



The Compensation Committee is comprised of Messrs. Finocchiaro (chairman),
Call and Warhurst and Ms. Jenkins. No member of the Compensation Committee is or has ever been an employee of the Company or an employee of our subsidiary, Southern Financial Bank (the Bank). Furthermore, none of the executive officers
has served on the board of directors of any company of which a Compensation Committee member is an employee.



Senior Officers of the Company



Richard P. Steele, 56, joined the Company in June 1999 as Senior Vice President and was named Executive Vice President in January 2002. From 1993 to 1999, Mr. Steele was Senior Vice President of FX Concepts Inc., an international
money management firm based in New York City. From 1989 to 1993, Mr. Steele was Director of Finance for Eli Lilly and Company, Geneva, Switzerland where he was responsible for all financial activities in Greece, the Near and Middle East, Northern
Africa and Pakistan. Prior to that he held various financial assignments with Eli Lilly and Company, including the design and implementation of the companys currency and interest rate risk management program in the early 1980s.



William Stevens, 59, joined the Company in September 1999 as Executive
Vice President/Risk Management. From 1991 to 1999, Mr. Stevens served as a Senior Analyst in the Office of the Inspector General of the Federal Deposit Insurance Corporation. Prior to that he was an Executive Vice President at Riggs Bank, N.A. in
Washington, D.C. where he managed the banks commercial real estate and single family lending activities. He served for three years as President and COO of Anchor Mortgage Services. His background also includes 18 years at Chemical, where he
was a Senior Vice President, Real Estate.



Patricia A.
Ferrick, 41, joined the Company in March 2000 as Senior Vice President/Chief Financial Officer. Ms. Ferrick most recently served as Managing Director, Controller of National Cooperative Bank. At National Cooperative she managed the accounting
department of 13 people and oversaw all corporate and loan accounting as well as budgeting and financial reporting. Prior to that, she was Vice President/Controller for First Commonwealth Savings Bank and its subsidiary, James Madison Mortgage.
Before that she served as Vice President, Controller for NVR Savings Bank. From 1985 to 1989 she was an auditor at KPMG LLP where she audited financial institutions.



Section 16(a) Beneficial Ownership Reporting Compliance



Section 16(a) of the Exchange Act requires the Companys directors and executive officers, and any persons who own more
than 10% of the outstanding shares of Common Stock, to file with the Securities and Exchange Commission (SEC) reports of ownership and changes in ownership of Common Stock. Officers and directors are required by SEC regulations to
furnish the Company with copies of all Section 16(a) reports that they file. To the Companys knowledge, based solely on the Companys review of the copies of such reports furnished to it or written representations from certain reporting
persons that they have complied with the relevant filing requirements, during the year ended December 31, 2003, all Section 16(a) filing requirements applicable to the Companys officers, directors and more than 10% shareholders were complied
with, except that Messrs. Belotti, Smith and Warhurst and Ms. Fried each failed to timely report the receipt of Common Stock in lieu of Board fees on Form 4 on one occasion.



Code of Ethics



Southern Financial has adopted a code of ethics that applies to all officers and employees. The code of ethics is available to the public free of charge
by written request to:



Patricia A. Ferrick

Chief Financial Officer and Senior Vice President

37 East Main Street

Warrenton, Virginia 20186



70



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##### Table of Contents

Item 11. Executive Compensation



Summary
Compensation Table



The following table presents certain
summary information relating to total compensation of the Companys Chief Executive Officer and the other most highly compensated executive officers (determined as of the end of the last fiscal year) (collectively, the named executive
officers) for the fiscal years ended December 31, 2003, 2002 and 2001:



SUMMARY COMPENSATION TABLE



|                                                                      |  |              |  |                     |                       |                        |   |                                 |  |                               |  |           |                                   |  |                           |  |   |                
|--------------------------------------------------------------------- |  | ------------ |  | ------------------- | --------------------- | ---------------------- | - | ------------------------------- |  | ----------------------------- |  | --------- | --------------------------------- |  | ------------------------- |  | - | ---------------
|                                                                      |  |              |  | Annual Compensation |                       | Long-Term Compensation
|Name and Principal
Position                                           |  | Year         |  | Salary              |                       | Bonus                  |   | Other Annual Compensa- tion (1) |  | Restricted Stock Awards($)(4) |  |           | SecuritiesUnderlyingOptions(#)(2) |  | All Other Compensation(3)
|Georgia S. Derrico Chairman of the Board and
Chief Executive Officer  |  | 200320022001 |  | $                   | 266,000250,000225,000 |                        | $ | 385,000325,000280,000           |  |                            |  | 344,328 | (5)                               |  | 17,25015,813             |  | $ | 5,5005,1005,100
|                                                                      |  |              |  |                     |                       |                        |  
|David de Give Senior Vice President                                   |  | 200320022001 |  | $                   | 97,00095,00090,000    |                        | $ | 18,00018,00018,000              |  |                            |  |        |                                   |  | 2,8753,163               |  | $ | 3,3003,2483,250
|                                                                      |  |              |  |                     |                       |                        |  
|Patricia A. Ferrick Senior Vice President and
Chief Financial Officer |  | 200320022001 |  | $                   | 116,000110,000104,000 |                        | $ | 25,00020,00016,000              |  |                            |  |        |                                   |  | 2,3002,530               |  | $ | 3,5003,002690  
|                                                                      |  |              |  |                     |                       |                        |  
|R. Roderick Porter President and Chief Operating
Officer              |  | 200320022001 |  | $                   | 234,000220,000195,000 |                        | $ | 290,000225,000200,000           |  |                            |  | 344,328 | (5)                               |  | 17,25015,813             |  | $ | 5,5005,1005,100
|                                                                      |  |              |  |                     |                       |                        |  
|Richard P. Steele Executive Vice
President                            |  | 200320022001 |  | $                   | 140,000135,000125,000 |                        | $ | 32,00030,00022,000              |  |                            |  |        |                                   |  | 3,4503,795               |  | $ | 5,1004,3154,200
|                                                                      |  |              |  |                     |                       |                        |  
|William Stevens Executive Vice President                              |  | 200320022001 |  | $                   | 163,000160,000154,000 |                        | $ | 21,00027,00015,000              |  |                            |  |        |                                   |  | 2,3002,530               |  | $ | 5,5005,0323,200

---

|(1) | None of the named executive officers received Other Annual Compensation in excess of the lesser of $50,000 or 10% of combined salary and bonus for the years indicated.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes the effect of a 10% stock dividend issued by the Company effective October 2003, a 15% stock dividend issued by the Company effective February 2003 and a 10% stock dividend
issued by the Company effective December 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Consists of matching contributions made by the Company to the Southern Financial Bancorp, Inc. 401(k) Plan for the benefit of each respective executive officer.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | The unvested stock awards referenced in footnote (5) below were accelerated by the Board of Directors in November 2003 in connection with the proposed merger of the Company into
Provident Bankshares Corporation.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Represents the value of 14,666 shares of Common Stock awarded to each of Ms. Derrico and Mr. Porter on July 25, 2002. The awards are issuable in 50% increments in July 2004 and July
2005. At December 31, 2002, after giving effect to the 15% stock dividend in February 2003, each of Ms. Derrico and Mr. Porter held 16,866 unvested stock awards pursuant to this grant with an aggregate value of $441,383, based on the closing price
of the Common Stock on such date of $26.17 per share (as adjusted for the stock dividend).
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Option Grants in Last Fiscal Year



The following table sets forth certain information concerning option grants to each of the named executive officers for the
year ended December 31, 2003, adjusted to reflect the 10% stock dividend effective October 31, 2003 and the 15% stock dividend effective February 20, 2003:



OPTION GRANTS IN YEAR ENDED DECEMBER 31, 2003



|                    |  |                                             |  |                                                             |    |  |                                |       |                |           |                                                                                                 |   |         |  |   |        
|------------------- |  | ------------------------------------------- |  | ----------------------------------------------------------- | -- |  | ------------------------------ | ----- | -------------- | --------- | ----------------------------------------------------------------------------------------------- | - | ------- |  | - | -------
|                    |  | Individual Grants (1)                       |  |                                                            
|Name                |  | Number ofSecuritiesUnderlyingOptionsGranted |  | Percent ofTotal OptionsGranted toEmployees inFiscalYear (2) |    |  | Exercise orBase Price($/Share) |       | ExpirationDate |           | Potential Realizable Valueat Assumed Annual Ratesof
Stock Price Appreciationfor Option Term (3)
|                    |  |                                             |  |                                                             | 5% |  | 10%                           
|Georgia S. Derrico  |  | 18,975                                      |  | 25.4                                                        | %  |  | $                              | 25.30 |                | 1/23/2013 |                                                                                                 | $ | 301,869 |  | $ | 764,996
|                    |  |                                             |  |                                                             |    | 
|David de Give       |  | 3,613                                       |  | 4.8                                                         |    |  |                                | 25.30 |                | 1/23/2013 |                                                                                                 |   | 50,312  |  |   | 127,499
|                    |  |                                             |  |                                                             |    | 
|Patricia A. Ferrick |  | 2,530                                       |  | 3.4                                                         |    |  |                                | 25.30 |                | 1/23/2013 |                                                                                                 |   | 40,249  |  |   | 102,000
|                    |  |                                             |  |                                                             |    | 
|R. Roderick Porter  |  | 18,975                                      |  | 25.4                                                        |    |  |                                | 25.30 |                | 1/23/2013 |                                                                                                 |   | 301,869 |  |   | 764,996
|                    |  |                                             |  |                                                             |    | 
|Richard P. Steele   |  | 3,775                                       |  | 5.1                                                         |    |  |                                | 25.30 |                | 1/23/2013 |                                                                                                 |   | 60,374  |  |   | 152,999
|                    |  |                                             |  |                                                             |    | 
|William Stevens     |  | 2,530                                       |  | 3.4                                                         |    |  |                                | 25.30 |                | 1/23/2013 |                                                                                                 |   | 40,249  |  |   | 102,000

---

|(1) | All stock option grants reported in this table were awarded at the fair market value of the shares of our common stock at the date of award and are exercisable after January 24,
2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Options to purchase 74,635 shares of common stock were granted to the Companys employees during the year ended December 31, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------------

|(3) | These amounts represent certain assumed rates of appreciation based on the actual option term and annual compounding from the date of the grant. Actual gains, if any, on stock
option exercises and common stock holdings are dependent on future performance of the Companys Common Stock and overall stock market conditions. There can be no assurance that the stock appreciation amounts reflected in this table will be
achieved.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Option Exercises and Fiscal Year-End Option Values



The following table sets forth certain information concerning each stock option exercise during the fiscal year ended
December 31, 2003 by each of the named executive officers and the year end value of unexercised options, adjusted to reflect the 10% stock dividend effective October 31, 2003 and the 15% stock dividend effective February 20, 2003:



AGGREGATED OPTION EXERCISES IN YEAR ENDED DECEMBER 31, 2003

AND FISCAL YEAR END OPTION VALUES



|                    |  |                          |             |                  |               |                                                                          |             |                                                                  |               |  |   |           |  |   |        
|------------------- |  | ------------------------ | ----------- | ---------------- | ------------- | ------------------------------------------------------------------------ | ----------- | ---------------------------------------------------------------- | ------------- |  | - | --------- |  | - | -------
|Name                |  | SharesAcquiredonExercise |             | ValueRealized(1) |               | Number of Securities Underlying Unexercised Options at December 31, 2003 |             | Value of Unexercised In-The-Money Options atDecember 31, 2003(2)
|                    |  |                          | Exercisable |                  | Unexercisable |                                                                          | Exercisable |                                                                  | Unexercisable
|Georgia S. Derrico  |  | 132,002                  |             | $                | 3,706,209     |                                                                          | 19,534      |                                                                  | 4,348         |  | $ | 521,340   |  | $ | 77,279 
|                    |  |                          |             |                  |               |                                                                         
|David de Give       |  | 25,895                   |             |                  | 404,610       |                                                                          |            |                                                                  | 3,163         |  |   |          |  |   | 56,209 
|                    |  |                          |             |                  |               |                                                                         
|Patricia A. Ferrick |  |                         |             |                  |              |                                                                          | 10,879      |                                                                  | 2,530         |  |   | 327,547   |  |   | 44,967 
|                    |  |                          |             |                  |               |                                                                         
|R. Roderick Porter  |  | 17,028                   |             |                  | 458,329       |                                                                          | 71,522      |                                                                  | 18,975        |  |   | 1,976,474 |  |   | 337,253
|                    |  |                          |             |                  |               |                                                                         
|William Stevens     |  |                         |             |                  |              |                                                                          | 15,034      |                                                                  | 2,530         |  |   | 425,094   |  |   | 67,451 
|                    |  |                          |             |                  |               |                                                                         
|Richard P. Steele   |  |                         |             |                  |              |                                                                          | 13,536      |                                                                  | 3,795         |  |   | 380,896   |  |   | 67,451 

---

|(1) | The value realized represents the difference between the exercise price of the option and the market price of the option shares on the date of exercise without
considering any taxes which may have been owed.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The value of the unexercised options is calculated based on the closing price of common stock as reported on the Nasdaq National Market on December 31, 2003 of $43.07.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



Stock Option Plans



1993 Stock Option Plan.



On August 18, 1993, the Board of Directors approved the 1993 Stock Option
and Incentive Plan, which was approved by the shareholders on September 29, 1993. The 1993 Stock Option Plan was subsequently assumed by the Company after its formation as a holding company for the Bank. The Stock Option Plan was amended and
restated by the Board in March 2001 to increase the number of shares available for issuance by 70,000 and provide for stock option grants to non-employee directors. The Companys shareholders approved the amended and restated stock option plan
at its 2001 Annual Meeting of Shareholders. The 1993 Stock Option Plan expired on August 18, 2003 and no additional options will be granted under the plan after such date. Options outstanding under the 1993 Stock Option Plan will continue to be
governed by that plan.



The 1993 Stock Option Plan is intended
to provide a means for the Companys selected key employees and directors to increase their personal financial interest in the Company, thereby stimulating the efforts of these employees and directors and strengthening their desire to remain
employed with the Company.



As amended, the 1993 Stock Option
Plan authorizes the issuance of up to 529,100 shares of the Companys Common Stock pursuant to the grant of incentive and nonqualified options to employees and nonqualified options to directors. In addition to options granted at the discretion
of the Companys Compensation Committee, each non-employee director was granted options to acquire 1,000 shares of the Common Stock annually. However, the Compensation Committee, in its discretion, may reduce the number of shares automatically
granted. Unless otherwise provided in the stock option agreement, each automatic grant will vest in full one year from the grant date. As of December 31, 2002, nine non-employee directors were eligible to receive automatic grants.



As of December 31, 2003, options to purchase an aggregate of 365,721 shares
of Common Stock were outstanding under the 1993 Stock Option Plan.



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##### Table of Contents

2003 Stock Incentive Plan.



On February 20, 2003, the Board of directors approved the Southern Financial Bancorp, Inc. 2003 Stock Incentive Plan, which
was approved by the shareholders on April 24, 2003.



The 2003
Stock Incentive Plan is intended to provide a means to attract additional personnel, if needed, and to retain and reward exceptional performance by employees through additional option grants and other forms of incentive compensation. The Company
believes that this will have a direct impact on the future success and profitability of the Company.



The 2003 Stock Incentive Plan authorizes the issuance of up to 165,000 shares (adjusted for 10% stock dividend effective October 31, 2003) of the
Companys Common Stock pursuant to the exercise of options granted under the 2003 Stock Incentive Plan or upon the grant or exercise, as the case may be, of awards granted under the 2003 Stock Incentive Plan. If an award expires or is
terminated, the shares that were subject to the unexercised portion of the award will be available for future awards granted under the 2003 Stock Incentive Plan. The number of shares covered by each outstanding award and the exercise price of
outstanding awards shall be proportionately adjusted for any increase or decrease in the number of the Companys outstanding shares resulting from various changes in the Companys capitalization, such as stock splits or stock dividends.



As of December 31, 2003, options to purchase an aggregate of
57,989 shares of Common Stock were outstanding under the 2003 Stock Incentive Plan.



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##### Table of Contents

Securities Authorized for Issuance Under Equity Compensation Plans



The following table provides information as of December 31, 2003 regarding
the Companys equity compensation plans (including individual compensation arrangements) under which the Companys equity securities are authorized for issuance:



EQUITY COMPENSATION PLAN INFORMATION



|                                                           |  |                                                                                                 |  |                                                                                 |       |                                                                                                                                                 |       
|---------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------- | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------- | ------
|Plan category                                              |  | Number of securities to be issued upon exercise of outstanding options, warrants and rights (a) |  | Weighted-average exercise price of outstanding options, warrants and rights (b) |       | Number of securities remaining available for future issuance under equity compensation plans
(excluding securities reflected in column (a)) (c)
|Equity compensation plans approved by security holders     |  | 423,710                                                                                         |  | $                                                                               | 15.61 |                                                                                                                                                 | 92,384
|                                                           |  |                                                                                                 | 
|Equity compensation plans not approved by security holders |  |                                                                                                 |  |                                                                                 |       |                                                                                                                                                 |       
|                                                           |  |                                                                                                 | 
|Total                                                      |  |                                                                                                |  |                                                                                 | N/A   |                                                                                                                                                 | N/A   



Benefit Plan



The Company has established an employee savings plan pursuant to Section
401(k) of the Internal Revenue Code covering substantially all employees. Under the 401(k) plan, participating employees may contribute a portion of their pretax earnings and allocate the contributions among one or more investment options, including
an investment in the Common Stock. The Company matches 50% of each employees contributions on a discretionary basis depending on its profit, up to 3% of the employees annual compensation. The Companys expense for matching
contributions was $167,000, $147,000 and $119,000 for the years ended December 31, 2003, 2002, and 2001, respectively.



Compensation of Directors



During 2003, each member of the Companys Board of Directors who is not an employee of the Company or the Bank was paid $750 for attendance at each
Board meeting and $250 for attendance at each meeting of a committee of the Board of which he or she is a member. The same board fees were paid for meetings attended by teleconferencing. In addition, each director was paid an annual fee of $5,000.
Members of the Board who are officers are not paid separately for their service on the Board or its committees.



Directors may elect to receive their Board fees in Company Common Stock. A director must make such election at the beginning of each calendar year and the
election will remain in effect for that calendar year. Any shares issued to a director pursuant to his or her election to receive Board fees in Common Stock are acquired on the open market by the Companys transfer agent on a quarterly basis.
Neither the Company nor any director control the date on which such shares are purchased.



In addition to Board fees, the Companys Amended and Restated 1993 Stock Option Plan provides for an automatic grant of options annually to each of the Companys non-employee directors. Pursuant to the 1993
Stock Option Plan, each non-employee director will receive options to acquire 1,000 shares of the Companys Common Stock annually at an exercise price equal to fair market value on the grant date. The Compensation Committee has the discretion
to reduce the number of shares automatically granted. Unless otherwise provided, each option will vest one full year from the date of grant. Nine directors each received a grant of options to acquire 550 shares of Common Stock in January 2002. The
Companys 1993 Stock Option Plan remains in effect through September 2003, unless terminated earlier by the Board of Directors.



Pre-Existing Employment and Change in Control Agreements



The Company has a pre-existing employment agreement with Georgia S. Derrico, Chairman and Chief Executive Officer, and a pre-existing change in control
agreement with R. Roderick Porter, President and Chief Operating Officer. The terms of these pre-existing arrangements are discussed below. In connection with the proposed merger of the Company into Provident Bankshares Corporation new agreements,
also described below, now supersede the pre-existing agreements.



Ms. Derricos employment agreement provided that, upon her termination of employment following a change in control of Southern Financial, she would receive her base salary and any accrued but unpaid bonus through her termination date.
Ms. Derrico would also receive: (1) a pro-rated bonus payment, calculated by multiplying the last bonus paid prior to her termination of employment by a fraction, the numerator of which was the number of days between January 1 and the termination
date, and the denominator of which was 365; (2) base salary for the remaining term of the agreement; (3) three times



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her highest annual bonus during the preceding three calendar years; (4) continued health and welfare benefits for the
remaining agreement term; and (5) the costs of professional services (up to a maximum of 20% of base salary). Southern Financial also agreed to provide Ms. Derrico with tax indemnification in the event the aggregate value of payments and benefits
payable upon a change in control under existing compensation arrangements constituted an excess parachute payment for purposes of Sections 280G and 4999 of the Internal Revenue Code.



Mr. Porters change in control agreement provided that, upon his
termination of employment in connection with a change in control, he would receive: (1) his base salary and any earned but unpaid bonus through his termination date; (2) two times his base salary, in the event his termination occurred prior to a
change in control, or his base salary for the remaining term of the agreement, in the event termination occurred after a change in control; (3) two times his last annual bonus paid before termination; (4) any previously deferred compensation and any
accrued but unpaid vacation pay; and (5) any vested benefits under benefit plans or arrangements of Southern Financial, including health and welfare benefit continuation and fringe benefits. Southern Financial also agreed to indemnify Mr. Porter for
purposes of Sections 280G and 4999 of the Internal Revenue Code.



Pre-Existing Salary Continuation Agreements



In 2003, Southern Financial Bank established salary continuation agreements with Ms. Derrico and Messrs. Porter, David de Give, Richard P. Steele and William H. Stevens. Under the salary continuation agreements, each
individual would have received certain benefits following their termination of employment within one year after a change in control. Ms. Derricos annual benefit, payable over a 15-year period beginning at age 65, was 44.3% of her base salary,
inflated by 4% for each year between her termination date and attainment of age 65. The rest of the individuals annual benefit, also payable over 15 years upon their attainment of age 65, was 39.8% of their base salary, increased by 4% per
year between their termination date and their 65thbirthday. As discussed below, payments provided for under the new
agreements with Ms. Derrico and Mr. Porter satisfy in full any obligation of the Company under the salary continuation agreements. The salary continuation agreements for Messrs. de Give, Steele and Stevens will become the obligations of Provident
Bank after the proposed merger.



New Compensation Agreements with
Ms. Derrico and Mr. Porter



Concurrently with
entering into the merger agreement, Provident Bankshares, the Company and Southern Financial Bank entered into agreements with Ms. Derrico and Mr. Porter, which generally become effective upon completion of the merger but, effective upon signing,
supersede their pre-existing employment and change in control agreements, as described above. In the event the parties fail to complete the merger, the agreements with Provident Bankshares become null and void and the superseded agreements again
become effective. The terms of the new agreements are discussed below.



The new agreement with Ms. Derrico provides that, in exchange for the termination of her employment agreement with the Company, Provident Bankshares will pay her $2.2 million at the effective time of the merger. Under the new agreement, Ms.
Derrico also will receive a payment of $1.1 million in full satisfaction of any obligation under her salary continuation agreement with Southern Financial Bank. In exchange for the termination of Mr. Porters change in control agreement,
Provident Bankshares will pay him $1.1 million at the effective time of the merger. Provident Bankshares also will pay Mr. Porter $849,000 as full payment for any obligation under his salary continuation agreement with Southern Financial Bank.



In the event that any payments or benefits provided under the
new agreements become subject to excise taxes under Section 4999 of the Internal Revenue Code, Ms. Derrico and Mr. Porter will be entitled to additional amounts that will place them in the same financial positions they occupied prior to the
imposition of the excise taxes.



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PERFORMANCE GRAPH



The following Performance Graph compares the cumulative total shareholder return on the Companys Common Stock for the
period from December 31, 1998 to December 31, 2003 with the cumulative total return of the Nasdaq Composite Index and the Nasdaq Bank Index for the same period. The Performance Graph assumes $100 invested on December 31, 1998 in the Companys
Common stock, the Nasdaq Composite Index and the Nasdaq Bank Index and assumes reinvestment of dividends through December 31, 2003. The historical stock price performance for the Companys Common stock shown on the graph below is not
necessarily indicative of future stock performance.



The
Performance Graph and related description shall not be deemed incorporated by reference by any general statement incorporating by reference this Proxy Statement into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934,
except to the extent the Company specifically incorporates this Performance Graph by reference, and shall not otherwise be deemed filed under such acts.



[GRAPHIC APPEARS HERE]



|                           |  |                         |  |        |  |        |  |        |  |        |  |       
|-------------------------- |  | ----------------------- |  | ------ |  | ------ |  | ------ |  | ------ |  | ------
|                           |  | Cumulative Total Return
|                           |  | Dec-98                  |  | Dec-99 |  | Dec-00 |  | Dec-01 |  | Dec-02 |  | Dec-03
|SOUTHERN FINANCIAL BANCORP |  | 100.00                  |  | 80.43  |  | 64.14  |  | 149.83 |  | 173.37 |  | 319.02
|NASDAQ STOCK MARKET (U.S.) |  | 100.00                  |  | 186.2  |  | 126.78 |  | 96.96  |  | 68.65  |  | 108.18
|NASDAQ BANK                |  | 100.00                  |  | 96.15  |  | 109.84 |  | 118.92 |  | 121.74 |  | 156.62



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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Principal Shareholders



The following table sets forth as of March 1, 2004 certain information regarding those persons (including any group as that term is used in
Section 13(d)(3) of the Securities Exchange Act of 1934) who the Company knows were the beneficial owners of 5% or more of the outstanding shares of the Companys Common Stock:



|                                                                   |  |                                           |  |                                          |  
|------------------------------------------------------------------ |  | ----------------------------------------- |  | ---------------------------------------- | -
|Name and Address of Beneficial
Owners                              |  | Amount and Nature of Beneficial Ownership |  | Percent of Shares Beneficially Owned (1) |  
|Georgia S. Derrico (2) 37 E. Main Street Warrenton, Virginia 20186 |  | 483,223                                   |  | 6.5                                      | %
|                                                                   |  |                                          
|R. Roderick Porter (2) 37 E. Main Street Warrenton, Virginia 20186 |  | 483,223                                   |  | 6.5                                      | %

---

|(1) | The percentage beneficially owned was calculated based on 7,437,380 shares of common stock issued and outstanding as of March 1, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------

|(2) | Georgia S. Derrico and R. Roderick Porter are married to each other and the number and percentage of beneficial ownership of each represents their combined ownership. See the table
on the following page for additional information regarding Ms. Derricos and Mr. Porters beneficiary ownership of common stock.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Management



The following table sets forth as of March 1, 2004 the beneficial ownership of the Companys Common Stock by all
(1) directors, (2) named executive officers and (3) directors and named executive officers as a group. Unless otherwise indicated, based on information furnished by such shareholders, management believes that each person has sole voting
and investment power with respect to all shares beneficially owned by such person and the address of each shareholder is the same as the Companys address.



|                                                             |  |                                           |        |  |                                                                            |  |                                          |   
|------------------------------------------------------------ |  | ----------------------------------------- | ------ |  | -------------------------------------------------------------------------- |  | ---------------------------------------- | --
|Name of Beneficial Owner                                     |  | Amount and Nature of Beneficial Ownership |        |  | Number of Shares that may be Acquired Within 60 Days by Exercising Options |  | Percent of Shares Beneficially Owned (1) |   
|John C. Belotti                                              |  | 42,246                                    | (2)    |  | 2,783                                                                      |  |                                          | *%
|Fred L. Bollerer                                             |  | 6,082                                     |        |  | 2,783                                                                      |  |                                          | * 
|Neil J. Call                                                 |  | 65,958                                    |        |  | 2,783                                                                      |  |                                          | * 
|David de Give                                                |  | 120,296                                   | (3)    |  | 3,162                                                                      |  | 1.7                                      |   
|Georgia S. Derrico                                           |  | 483,223                                   |        |  |                                                                           |  | 6.5                                      |   
|Patricia A. Ferrick                                          |  | 17,673                                    |        |  |                                                                           |  |                                          | * 
|Barbara J. Fried                                             |  | 217,706                                   | (6)    |  | 2,783                                                                      |  | 3.0                                      |   
|Alfonso G. Finocchiaro                                       |  | 21,102                                    |        |  | 2,783                                                                      |  |                                          | * 
|Virginia Jenkins                                             |  | 3,361                                     |        |  | 2,783                                                                      |  |                                          | * 
|R. Roderick Porter                                           |  | 483,223                                   | (4)(7) |  |                                                                           |  | 6.5                                      |   
|Michael P. Rucker                                            |  | 33,653                                    | (8)    |  | 2,783                                                                      |  |                                          |   
|Richard E. Smith                                             |  | 44,716                                    | (9)    |  | 2,783                                                                      |  |                                          | * 
|Richard P. Steele                                            |  | 16,455                                    |        |  | 7,591                                                                      |  |                                          | * 
|William H. Stevens                                           |  | 1,458                                     |        |  | 17,583                                                                     |  |                                          | * 
|Robert P. Warhurst                                           |  | 21,261                                    |        |  | 2,783                                                                      |  |                                          | * 
|All directors and executive officers as a group (15 persons) |  | 1,095,190                                 |        |  | 53,383                                                                     |  | 15.3                                     | % 

---

|* | Indicates ownership of less than 1.0%.
|- | --------------------------------------

|(1) | The percentage beneficially owned was calculated based on 7,437,380 shares of common stock issued and outstanding as of March 1, 2004 and assumes the exercise by the shareholder or
group named in each row of all options for the purchase of our common stock held by such shareholder or group and exercisable within 60 days.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes 4,387 shares owned by Mr. Belottis spouse.
|--- | ----------------------------------------------------

|(3) | Includes 3,574 shares owned by Mr. de Gives spouse over which she has sole voting and investment power.
|--- | --------------------------------------------------------------------------------------------------------

|(4) | Georgia S. Derrico and R. Roderick Porter are married to each other and the number and percentage of beneficial ownership of each represents their combined ownership.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Includes (i) 43,053 shares owned individually by Ms. Derrico over which she has sole voting and investment power, (ii) 34,360 shares of common stock owned individually by Mr.
Porter, (iii) 334,594 shares held jointly with Mr. Porter, (iv) 4,605 shares owned by Marblehead, Inc., which is jointly owned by Ms. Derrico and Mr. Porter and (v) 3,797 shares owned jointly by Mr. Porter and his son. Ms.
Derrico disclaims beneficial ownership of the 34,360 shares beneficially owned solely by Mr. Porter and the 3,797 shares beneficially owned jointly by Mr. Porter and his son
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Includes 180,899 shares owned individually by Ms. Frieds spouse over which he has sole voting and investment power.
|--- | --------------------------------------------------------------------------------------------------------------------

|(7) | Includes (i) 34,360 shares of common stock owned individually by Mr. Porter over which he has sole voting and investment power, (ii) 43,053 shares owned individually by Ms.
Derrico, (iii) 334,594 shares held jointly with Ms. Derrico, (iv) 4,605 shares owned by Marblehead, Inc., which is jointly owned by Ms. Derrico and Mr. Porter, and (v) 3,797 shares owned jointly by Mr. Porter and his son. Mr. Porter
disclaims beneficial ownership of the 43,053 shares beneficially owned solely by Ms. Derrico.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Includes 2,783 shares held by the Jack R. Jones, Sr. Trust, of which Mr. Rucker is trustee and 7,649 shares held by the Estate of Henry C. Rucker, of which Mr. Rucker is
trustee.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Includes 11,786 shares owned by Reed Insurance Agency, Inc., of which Mr. Smith is President.
|--- | ---------------------------------------------------------------------------------------------



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Item 13. Certain Relationships and Related Transactions



Some of the directors and officers of the Company and the Bank are at present, as in the past, customers of the Bank and management has had, and expects to have in the future, banking transactions in the ordinary
course of business with the Companys directors, officers, principal shareholders and their associates, on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable
transactions with others. These transactions do not involve more than the normal risk of collectibility or present other unfavorable features. The balance of loans to directors, executive officers and their associates totaled $1.2 million at
December 31, 2003.



Item 14. Principal Accountant Fees and Services



The following table presents fees, including reimbursement for expenses, for professional audit services rendered by KPMG LLP for the audit of the Companys annual financial statements for the years ended
December 31, 2003 and December 31, 2002 and fees billed for other services rendered by KPMG LLP during those periods.



|                       |  |             |         |             |   |        
|---------------------- |  | ----------- | ------- | ----------- | - | -------
|                       |  | Fiscal 2003 |         | Fiscal 2002
|Audit Fees (1)         |  | $           | 119,000 |             | $ | 114,600
|Audit Related Fees (2) |  |             | 48,000  |             |   | 37,293 
|Tax Fees (3)           |  |             | 77,750  |             |   | 50,519 
|All Other Fees (4)     |  |             |        |             |   |       
|                       |  |             |         |             |   |        
|Total                  |  |             | 244,750 |             |   | 202,412
|                       |  |             |         |             |   |        

---

|(1) | Audit Fees consist of fees billed for professional services rendered for the audit of the
Companys consolidated annual financial statements and review of the interim consolidated financial statements included in quarterly reports and services that are normally provided by KPMG LLP in connection with statutory and regulatory filings
or engagements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Audit-Related Fees consist of fees billed for assurance and related services that are
reasonably related to the performance of the audit or review of the Companys consolidated financial statements and are not reported under Audit Fees. This category includes fees related to employee benefit plan audits and issuances
of letters to underwriters, review of registration statements and issuance of consents by KPMG LLP.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Tax Fees consist of fees billed for professional services rendered for tax compliance, tax
advice and tax planning. These services include assistance regarding federal and state tax compliance.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | All Other Fees consist of fees for products and services other than the services reported
above. There were no such fees in fiscal 2003 or 2002.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------



The Audit Committee has considered whether the provision of these non-audit services is compatible with maintaining the independence of KPMG LLP.



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PART IV.



|Item | 15. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K
|---- | ----------------------------------------------------------------------



| | (1) | The following consolidated financial statements and report of independent auditors of Southern Financial and its subsidiaries are in Part II, item 8 on the following pages:
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                                                                        |  |        
|------------------------------------------------------------------------------------------------------- |  | -------
|                                                                                                        |  | Page   
|Independent Auditors Report                                                                            |  | 40     
|Consolidated Balance Sheets:
December 31, 2003 and December 31, 2002                                    |  | 41     
|Consolidated Statements of Income:Years Ended December 31, 2003, 2002 and 2001                          |  | 42     
|Consolidated Statements of Comprehensive Income:Years Ended December 31, 2003, 2002 and 2001            |  | 43     
|Consolidated Statements of Changes in Stockholders Equity:Years Ended December 31, 2003, 2002 and 2001 |  | 44     
|Consolidated Statements of Cash Flows:Years Ended December 31, 2003, 2002 and 2001                      |  | 45     
|Notes to Consolidated Financial Statements                                                              |  | 46 - 67



| | (2) | All other schedules have been omitted as the required information is either inapplicable or included in the Notes to Consolidated Financial Statements.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | Exhibits (listed numbers correspond to item 601 of Regulation S-K)
| | --- | ------------------------------------------------------------------



| | (3) | Articles of Incorporation of Southern Financial Bancorp, Inc., by reference to the Form S-4 Registration Statement filed with the Securities and Exchange Commission on August 4,
1995, and By-Laws, by reference to Form S-4 Registration Statement filed with the Securities and Exchange Commission on August 4, 1995
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (4) | Instruments Defining the Rights of Security Holders, Including IndenturesReference is made to Exhibit (3) above
| | --- | ----------------------------------------------------------------------------------------------------------------



| | (9) | Voting Trust AgreementNot applicable
| | --- | -------------------------------------



| | (21) | Subsidiaries of the registrant:
| | ---- | -------------------------------



|                                     |  |                              |  |                                                     |  
|------------------------------------ |  | ---------------------------- |  | --------------------------------------------------- | -
|Name                                 |  | Jurisdiction ofIncorporation |  | Percentage of Voting Securities Owned by the Parent |  
|Southern Financial Bank              |  | Virginia                     |  | 100                                                 | %
|Southern WebTech.com, Inc.           |  | Virginia                     |  | 100                                                 | %
|Southern Financial Capital Trust I   |  | Delaware                     |  | 100                                                 | %
|Southern Financial Statutory Trust I |  | Delaware                     |  | 100                                                 | %
|Southern Financial Capital Trust III |  | Delaware                     |  | 100                                                 | %



| | (23) | Consent of Independent Auditors
| | ---- | -------------------------------



| | (31.1) | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)
| | ------ | -----------------------------------------------------------------------



| | (31.2) | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)
| | ------ | -----------------------------------------------------------------------



| | (32.1) | Certifications of the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002
| | ------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Reports on Form 8-K



We filed a report on Form 8-K on October 23, 2003 to file as an exhibit a copy of our press release dated October 23, 2003
announcing our earnings for the three months ended September 30, 2003.



We filed a report on Form 8-K on November 4, 2003 to file as an exhibit a copy of the Agreement and Plan of Reorganization dated November 3, 2003 between Provident Bankshares Corporation and Southern Financial.



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SIGNATURES



Pursuant to the
requirement of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



SOUTHERN FINANCIAL BANCORP, INC.By:

/s/ Georgia S. DerricoGeorgia S. DerricoChairman of the Board and Chief Executive Officer




Dated: March 9, 2004



Pursuant to the requirements of
the Securities Exchange Act of 1934, this report has been signed below on the dates indicated.



|                           |  |                                                                 |  |              
|-------------------------- |  | --------------------------------------------------------------- |  | -------------
|Name                       |  | Title                                                           |  | Date         
|/s/ Georgia S. Derrico     |  | Director and Chairman of the Board and Chief Executive Officer  |  | March 9, 2004
|Georgia S. Derrico         |  |                                                                
|                           |  |                                                                
|/s/ R. Roderick Porter     |  | Director and President and Chief Operating Officer              |  | March 9, 2004
|R. Roderick Porter         |  |                                                                
|                           |  |                                                                
|/s/ David de Give          |  | Director and Senior Vice President/Treasurer                    |  | March 9, 2004
|David de Give              |  |                                                                
|                           |  |                                                                
|/s/ Patricia A. Ferrick    |  | Senior Vice President and Chief Financial Officer               |  | March 9, 2004
|Patricia A. Ferrick        |  |                                                                
|                           |  |                                                                
|/s/ William H. Lagos       |  | Senior Vice President/Controller (Principal Accounting Officer) |  | March 9, 2004
|William H. Lagos           |  |                                                                
|                           |  |                                                                
|/s/ Virginia Jenkins       |  | Director                                                        |  | March 9, 2004
|Virginia Jenkins           |  |                                                                 |  |              
|                           |  |                                                                
|/s/ Neil J. Call           |  | Director                                                        |  | March 9, 2004
|Neil J. Call               |  |                                                                 |  |              
|                           |  |                                                                
|/s/ Michael P. Rucker      |  | Director                                                        |  | March 9, 2004
|Michael P. Rucker          |  |                                                                 |  |              
|                           |  |                                                                
|/s/ Alfonso G. Finocchiaro |  | Director                                                        |  | March 9, 2004
|Alfonso G. Finocchiaro     |  |                                                                 |  |              



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##### Table of Contents

|                       |  |          |  |              
|---------------------- |  | -------- |  | -------------
|/s/ Robert P. Warhurst |  | Director |  | March 9, 2004
|Robert P. Warhurst     |  |          |  |              
|                       |  |         
|/s/ John C. Belotti    |  | Director |  | March 9, 2004
|John C. Belotti        |  |          |  |              
|                       |  |         
|/s/ Fred L. Bollerer   |  | Director |  | March 9, 2004
|Fred L. Bollerer       |  |          |  |              
|                       |  |         
|/s/ Richard E. Smith   |  | Director |  | March 9, 2004
|Richard E. Smith       |  |          |  |              
|                       |  |         
|/s/ Barbara J. Fried   |  | Director |  | March 9, 2004
|Barbara J. Fried       |  |          |  |              



84



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##### Table of Contents

INDEX TO EXHIBITS



Number and Descriptions



|     |  |                                                                                                                                                                                
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|23   |  | Consent of Independent Auditors                                                                                                                                                
|     | 
|31.1 |  | Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)                                                                                                        
|     | 
|31.2 |  | Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)                                                                                                        
|     | 
|32.1 |  | Certifications of the Chief Executive Officer and the Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of
2002



85