EXHIBIT (13)


Appendix A to the Proxy Statement for the 2010 Annual Meeting of Shareholders




























APPENDIX A



























PEOPLES BANCORP OF NORTH CAROLINA, INC.
 
 General Description of Business
 Peoples Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”).  The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”).  The Company’s principal source of income is any dividends which are declared and paid by the Bank on its capital stock.  The Company has no operations and conducts no business of its own other than owning the Bank.  Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated.
 
 The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 22 banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory, Charlotte, Monroe, Cornelius, Mooresville and Raleigh North Carolina.  The Bank also operates a loan production office in Denver, North Carolina.  At December 31, 2009, the Company had total assets of $1.0 billion, net loans of $762.6 million, deposits of $809.3 million, total securities of $201.5 million, and shareholders’ equity of $99.2 million.
 
 The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans.  Real estate loans are predominately variable rate commercial property loans, which include residential development loans to commercial customers.  Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio.  The majority of the Bank's deposit and loan customers are individuals and small to medium-sized businesses located in the Bank's market area.  The Bank’s loan portfolio also includes Individual Taxpayer Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco de le Gente offices.  Additional discussion of the Bank’s loan portfolio and sources of funds for loans can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-31 of the Annual Report, which is included in this Form 10-K as Exhibit 13.
 
 The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the "Commissioner").
 
 At December 31, 2009, the Bank employed 267 full-time equivalent employees.
 
 Subsidiaries
 The Bank is a subsidiary of the Company.  The Bank has two subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank's customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services.  Real Estate Advisory Services, Inc. provides real estate appraisal and real estate brokerage services.
 
 In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used in December 2006 to repay the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.
 
 The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.
 
 These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
  A-1
 
 The Company established a new subsidiary, Community Bank Real Estate Solutions, LLC (“CBRES”), during second quarter 2009.  CBRES serves as a “clearing-house” for appraisal services for community banks.  Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property is located.  This type of service ensures that the appraisal process remains independent from the financing process within the bank.
 
 This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of Peoples Bancorp of North Carolina, Inc. (the “Company”).  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions.  Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements.  Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank (the “Bank”), (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission.  The Company undertakes no obligation to update any forward-looking statements.
 
  
  A-2
   SELECTED FINANCIAL DATADollars in Thousands Except Per Share Amounts2009
2008
2007
2006
2005Summary of OperationsInterest income
$
50,037

56,322

61,732

55,393

41,913Interest expense

17,187

23,526

27,585

23,110

15,429Net interest earnings

32,850

32,796

34,147

32,283

26,484Provision for loan losses

10,535

4,794

2,038

2,513

3,110Net interest earnings after provisionfor loan losses

22,315

28,002

32,109

29,770

23,374Non-interest income

11,823

10,495

8,816

7,554

6,668Non-interest expense

29,883

28,893

25,993

22,983

20,330Earnings before taxes

4,255

9,604

14,932

14,341

9,712Income taxes

1,339

3,213

5,340

5,170

3,381Net earnings

2,916

6,391

9,592

9,171

6,331Dividends and accretion of preferred stock

1,246

-

-

-

-Net earnings available to commonshareholders
$
1,670

6,391

9,592

9,171

6,331Selected Year-End BalancesAssets
$
1,048,494

968,762

907,262

818,948

730,280Available for sale securities

195,115

124,916

120,968

117,581

115,158Loans, net

762,643

770,163

713,174

643,078

559,239Mortgage loans held for sale

2,840

-

-

-

2,248Interest-earning assets

988,017

921,101

853,878

780,082

692,835Deposits

809,343

721,062

693,639

633,820

582,854Interest-bearing liabilities

826,838

758,334

718,870

650,364

576,681Shareholders' equity
$
99,223

101,128

70,102

62,835

54,353Shares outstanding*

5,539,056

5,539,056

5,624,234

5,745,951

5,677,328Selected Average BalancesAssets
$
1,016,257

929,799

846,836

772,585

706,843Available for sale securities

161,135

115,853

120,296

118,137

108,690Loans

782,464

747,203

665,379

604,427

550,545Interest-earning assets

956,680

876,425

801,094

732,244

668,614Deposits

772,075

720,918

659,174

605,407

570,997Interest-bearing liabilities

796,260

740,478

665,727

613,686

563,210Shareholders' equity
$
101,162

76,241

70,586

62,465

55,989Shares outstanding*

5,539,056

5,588,314

5,700,860

5,701,829

5,692,290Profitability RatiosReturn on average total assets

0.29%

0.69%

1.13%

1.19%

0.90%Return on average shareholders' equity

2.88%

8.38%

13.59%

14.68%

11.31%Dividend payout ratio**

86.22%

41.93%

24.30%

20.78%

22.34%Liquidity and Capital Ratios (averages)Loan to deposit

101.35%

103.65%

100.94%

99.84%

96.42%Shareholders' equity to total assets

9.95%

8.20%

8.34%

8.09%

7.92%Per share of Common Stock*Basic net income
$
0.30

1.14

1.68

1.61

1.11Diluted net income
$
0.30

1.13

1.65

1.58

1.09Cash dividends
$
0.26

0.48

0.41

0.33

0.25Book value
$
13.37

13.73

12.46

10.94

9.57*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividendduring first quarter 2005, a 10% stock dividend during second quarter 2006 and a 3-for-2 stock split duringsecond quarter 2007.**As a percentage of net earnings available to common shareholders.




A-3






MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
 AND RESULTS OF OPERATIONS
 
 The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-32  through A-66.
 
 Introduction
 Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company, for the years ended December 31, 2009, 2008 and 2007.  The Company is a registered bank holding company operating under the supervision of the Federal Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).
 
 Overview
 Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.
 
 Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and small businesses and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.
  Economic conditions in 2009 continued to deteriorate and had a negative impact on our financial condition and results of operations.  Unfavorable trends, such as increased unemployment, falling real estate prices, increased loan default and increased bankruptcy rates, demonstrate the difficult business conditions that are affecting the general economy and therefore our operating results.  The unemployment rates in our primary market area have been higher than state and national averages throughout 2009.
 
 Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.
 
 Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.
 
 The Federal Reserve has decreased the Federal Funds Rate 4.00% since December 31, 2007 with the rate set at 0.25% as of December 31, 2009.  These decreases had a negative impact on 2009 earnings and will continue to have a negative impact on the Bank’s net interest income in the future periods.  The negative impact from the decrease in the
 
 A-4
 
 
 Federal Funds Rate has been partially offset by the increase in earnings realized on interest rate contracts, including both an interest rate swap and interest rate floors, utilized by the Company.  Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”
 
 On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”).  Under  the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and warrants to purchase 357,234 shares of common stock associated with the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”).  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield.  As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock.  The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000.  The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate.  Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things.  Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.
 
 The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends.  Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital.  However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.
 
 The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.
 
 The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000.  There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.
 
 It is the intent of the Company to utilize CPP funds to provide capital to support making loans to qualified borrowers in the Bank’s market area.  The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.  The Bank is also working with its current builders and contractors to provide financing for potential buyers who may not be able to qualify for financing in the current mortgage market in order to help these customers sell existing single family homes.  The Company will also use the CPP capital infusion as additional Tier I capital to protect the Bank from potential losses that may be incurred during this current recessionary period.
 
 The Company continues to face challenges resulting from the impact of the current economy on the housing and real estate markets.  The Bank continues to monitor and evaluate all significant loans in its portfolio, and will continue to manage its credit risk exposure with the expectation that stabilization of the real estate market will not occur until late 2010 or 2011.  The CPP funds have enhanced our capital position as the Company infused the Bank with $8.0 million additional regulatory capital. The Company has $19.0 million available that can be infused into the Bank as additional capital if needed to maintain its position as a well capitalized bank.  We anticipate increased loan losses in the short run and have prepared for that expectation. We have quality individuals managing our past due loans and foreclosed properties to minimize our potential losses. As the economy recovers, we are positioned to take advantage of all opportunities that present themselves.  Over the remainder of the year we anticipate net interest margin improvement as repricing of deposits should exceed repricing of loans. The amount and timing of any future Federal Reserve rate adjustment remains uncertain, and may further impact the Bank if those adjustments are significant.
  A-5
 
 The Company established a new subsidiary, Community Bank Real Estate Solutions, LLC (“CBRES”), during second quarter 2009.  CBRES will serve as a “clearing-house” for appraisal services for community banks.  Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property is located.  This type of service ensures that the appraisal process remains independent from the financing process within the bank.
 
 The Bank opened a new office in Iredell County, in Mooresville, North Carolina in September 2009.  Management continues to look for branching opportunities in nearby markets although there are no additional offices planned in 2010.
 
 Summary of Significant Accounting Policies
 The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiaries, Peoples Bank and Real Estate Solutions, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.
 
 The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  The following is a summary of some of the more subjective and complex accounting policies of the Company.  A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2009 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 6, 2010 Annual Meeting of Shareholders.
 
 Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company’s internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to consolidated financial statements.
 
 There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards.  These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Generally Accepted Accounting Principles ("GAAP").  For a more complete discussion of policies, see the notes to consolidated financial statements.
 
 The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
 
 The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
  A-6
 
 The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  As of December 31, 2009, the Company had cash flow hedges with a notional amount of $50.0 million.  This derivative instrument consists of one interest rate swap contract.
 
 The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of December 31, 2009 and December 31, 2008.
  (Dollars in thousands)Asset DerivativesAs of December 31, 2009

As of December 31, 2008BalanceSheet

Location
FairValue

BalanceSheet

Location
FairValueInterest rate derivative contracts
Other assets
$         1,762

Other assets
$          4,981
  The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floor designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.  As of December 31, 2009, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.
 
 The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company recognized a hedge ineffectiveness gain of $1,000 in earnings during the year ended December 31, 2009.
 
 Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next twelve months, the Company estimates that $1.4 million will be reclassified as an increase to interest income.
 
 The tables below present the effect of the Company’s derivative financial instruments on the Income Statement for the years ended December 31, 2009 and 2008.
  (Dollars in thousands)Amount of Gain

(Loss) Recognized in

OCI on Derivatives

Location of Gain

(Loss) Reclassified

from Accumulated

OCI into Income

Amount of Gain

(Loss) Reclassified

from Accumulated

OCI into IncomeYears ended

December 31,



Years ended

December 31,2009


2008



2009

2008Interest rate derivative contracts
$      434

$
7,147

Interest income

$         3,114

$   3,403Non-interest income

$46

$           -
  Relating to the post retirement benefit plan, the Company is required to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years.  The Company made a $467,000 reduction to retained earnings in 2008 pursuant to the
 
 A-7
 
 
 guidance of the pronouncement to record the portion of this benefit earned by participants prior to adoption of the pronouncement.   In 2009 the Company made a $358,000 addition to retained earnings to reflect an adjustment of the cumulative effect due to amendments to the individual split-dollar plans implemented during 2009.
 
 GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements.  There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.  Level 3 inputs are unobservable inputs for the asset or liability.  The table below presents the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of December 31, 2009 and 2008.
  (Dollars in thousands)Fair Value

Measurements

December 31, 2009
Level 1

Valuation

Level 2

Valuation

Level 3

ValuationInvestment securities available for sale
$
195,115

861

193,004

1,250Mortgage loans held for sale
$
2,840

-

2,840

-Market value of derivatives (in other assets)
$
1,762

-

1,762

-Fair Value

Measurements

December 31, 2008
Level 1

Valuation

Level 2

Valuation

Level 3

ValuationInvestment securities available for sale
$
124,916

935

122,731

1,250Market value of derivatives (in other assets)
$
4,981

-

4,981

-
  Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available.  If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.  Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.
 
 The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2009:
 
 (Dollars in thousands)Investment Securities Available for SaleLevel 3 ValuationBalance, beginning of period
$
1,250Change in book value

-Change in gain/(loss) realized and unrealized

-Purchases/(sales)

-Transfers in and/or out of Level 3

-Balance, end of period
$
1,250Change in unrealized gain/(loss) for assets still held in Level 3
$
-
   A-8
  The Company’s December 31, 2009 and 2008 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:
 
 (Dollars in thousands)Fair Value

Measurements

December 31, 2009

Level 1

Valuation

Level 2

Valuation

Level 3

Valuation

Total Gains/(Losses) for

the Year Ended

December 31, 2009Impaired loans
$
15,958

-

14,174

1,784

(1,924)Other real estate
$
3,997

-

3,997

-

(100)Fair Value

Measurements

December 31, 2008

Level 1

Valuation

Level 2

Valuation

Level 3

Valuation

Total Gains/(Losses) for

the Year Ended

December 31, 2008Impaired loans
$
7,073

-

5,903

1,170

(345)Other real estate
$
1,867

-

1,867

-

(166)
  The Company has specific loan loss reserves for loans that management has determined to be impaired.  These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the expected cash flow or appraised value of any underlying collateral.  At December 31, 2009 and 2008, the recorded investment in loans that were considered to be impaired was approximately $16.6 million and $7.5 million, respectively. In addition, the Company had approximately $2.0 million and $514,000 in loans past due more than ninety days and still accruing interest at December 31, 2009 and 2008, respectively.  The Company had specific reserves on impaired loans of $673,000 and $462,000 at December 31, 2009 and 2008, respectively. The average recorded investment in impaired loans for the twelve months ended December 31, 2009 and 2008 was approximately $15.0 million and $8.8 million, respectively. For the years ended December 31, 2009, 2008 and 2007, the Company recognized approximately $53,000, $57,000 and $29,000, respectively, of interest income on impaired loans.
  At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which are generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by Management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.
  In April 2009, the Financial Accounting Standards Board (“FASB”) issued new authoritative guidance under the following two ASC's intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairment of securities:
  ASC Topic 820 (formerly FASB Staff Position (FSP) FAS 157-4), “Fair Value Measurements and Disclosures,” provides additional guidance for estimating fair value in accordance with ASC Topic 820 when the volume and level of activity for the asset or liability have decreased significantly.  ASC Topic 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly.  The provisions of ASC Topic 820 were effective for the period ended March 31, 2009 and did not have a significant effect on the Company's condensed consolidated financial statements.
  ASC Topic 320 (formerly FSP FAS 115-2 and FAS 124-2), “Investments – Debt and Equity Securities,” amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements.  This ASC Topic 320 does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities.  The Company adopted the provisions of ASC Topic 320 as of June 30, 2009 and it did not have a significant effect on the Company's condensed consolidated financial statements.
  In June 2009, the FASB issued new authoritative guidance under ASC Topic 860 (formerly Statement No. 166) “Transfers and Servicing,” to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. ASC Topic 860 eliminates the concept of a "qualifying special-purpose entity" and changes the requirements for derecognizing financial assets. ASC Topic 860 also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative guidance
 
 A-9
 
 
 under ASC Topic 860 will be effective January 1, 2010 and is not expected to have a significant impact on the Company's consolidated financial statements.
  In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” (SFAS 167)to amend certain requirements of FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements.  SFAS 167 will remain authoritative until integrated into FASB Codification.  SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  SFAS 167 has not had any effect on the Company's financial position, results of operations or disclosures.
 
 In June 2009, the FASB issued Accounting Standards Update No. 2009-01 (“ASU 2009-01”), “Topic 105 – Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards No. 168 – The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.”  ASU 2009-01 amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 168 (“SFAS 168”), “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.”  ASU 2009-1 includes SFAS 168 in its entirety, including the accounting standards update instructions contained in Appendix B of the Statement.  The FASB Accounting Standards Codification TM (“Codification”) became the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards.  All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement was effective for the Company’s financial statements beginning in the interim period ended September 30, 2009.
 
 Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts.  Instead, it will issue Accounting Standards Updates.  The FASB does not consider Accounting Standards Updates as authoritative in their own right.  Accounting Standards Updates serve only to update the Codification, provide background information about the guidance, and provide the basis for conclusions on the change(s) in the Codification.  FASB Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles”, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with GAAP.  Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly.  Upon becoming effective, all of the content of the Codification carries the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy has been modified to include only two levels of GAAP: authoritative and non-authoritative.  As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy.  The adoption of the Codification and ASU 2009-01 did not have any effect on the Company’s results of operations or financial position.  All references to accounting literature included in the notes to the financial statements have been changed to reference the appropriate sections of the Codification.
 
 In June 2009, the FASB issued Accounting Standards Update No. 2009-02 (“ASU 2009-02”), “Omnibus Update – Amendments to Various Topics for Technical Corrections.”  The adoption of ASU 2009-02 did not have a material effect on the Company’s results of operations, financial position or disclosures.
 
 In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (“ASU 2009-05”), “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value.”  ASU 2009-05 applies to all entities that measure liabilities at fair value within the scope of ASC Topic 820.  ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following techniques:
 
 1)  A valuation technique that uses:
 a.  The quoted price of the identical liability when traded as an asset
 b.  Quoted prices for similar liabilities or similar liabilities when traded as assets.
 2)  Another valuation technique that is consistent with the principles of ASC Topic 820.  Two examples would be an income approach, such as a technique
 that is based on the amount at the measurement date that the reporting entity would pay to transfer the identical liability or would receive to enter into the
 identical liability.
 
 The amendments in ASU 2009-5 also clarify that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability.  It also clarifies that both a quoted price in an active market for the identical liability
 
 A-10
 
 
 at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements.  The guidance provided in ASU 2009-5 became effective for the Company in the fourth quarter of 2009.  Because the Company does not currently have any liabilities that are recorded at fair value, the adoption of this guidance did not have any impact on results of operations, financial position or disclosures.
  ASU 2009-12, “Fair Value Measurements and Disclosures (Topic 820) - Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent),” issued in September, 2009, allows a company to measure the fair value of an investment that has no readily determinable fair market value on the basis of the investee's net asset value per share as provided by the investee. This allowance assumes that the investee has calculated net asset value in accordance with the GAAP measurement principles of Topic 946 as of the reporting entity's measurement date.   Examples of such investments include investments in hedge funds, private equity funds, real estate funds and venture capital funds. The update also provides guidance on how the investment should be classified within the fair value hierarchy based on the value for which the investment can be redeemed.  The amendment is effective for interim and annual periods ending after December 15, 2009 with early adoption permitted.  The Company does not have investments in such entities and, therefore, there is no impact to our financial statements.
 
 ASU 2009-13, “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force” was issued in October, 2009 and provides guidance on accounting for products or services (deliverables) separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable.  The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price.  The amendments in the Update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted.  The Company does not expect the update to have an impact on its financial statements.
 
 Issued October, 2009, ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance.  At the date of issuance, a share-lending arrangement entered into on an entity's own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital.  Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs.  The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement.  The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009.   The Company has no plans to issue convertible debt and, therefore, the update had no impact on its financial statements as of December 31, 2009.
 
 In December 2009, the FASB issued Accounting Standards Update No. 2009-16 (“ASU 2009-16”), “Accounting for Transfers of Financial Assets”.  ASU No. 2009-16 formally incorporates into the FASB Codification amendments to SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, made by SFAS No. 166 “Accounting for Transfers of Financial Assets”, an amendment of FASB Statement No. 140, primarily to 1.)  eliminate the concept of a qualifying special-purpose entity, 2.)  limit the circumstances under which a financial asset should be derecognized when the entire financial asset has not been transferred to a non-consolidated entity, 3.)  requires additional disclosures concerning a transferor’s continuing involvement with transferred financial assets and 4.)  requires that all servicing assets and liabilities be measured at fair value.  This guidance is effective as of the start of the first annual and interim reporting periods.  ASU No. 2009-19 is not expected to have a material impact on the Company’s results of operations, financial position or disclosures; however the Company will need to review future loan participation agreements and other transfers of financial assets for compliance with the new standard.
 
 In December 2009, the FASB issued Accounting Standards Update No. 2009-17 (“ASU 2009-17”), “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”.  ASU No. 2009-17 formally incorporates into the FASB Codification amendments to FASB Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities”, made by SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” to require that a comprehensive qualitative analysis be performed to determine whether a holder of variable interests in a variable interest entity also has a controlling financial interest in the entity.  In addition, the amendments require that the same type of analysis be applied to entities that were previously designated as qualified special-purpose entities.  This ASU is effective as of the start of the first annual reporting period beginning after November 15, 2009, for interim periods within the first annual reporting period and for all subsequent annual and interim reporting periods.  ASU No. 2009-17 is not expected to have a material impact on the Company’s financial position, results of operations or disclosures.
  A-11
 
 In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASU 2010-06”), “Improving Disclosures about Fair Value Measurements”.  ASU No. 2010-06 amends FASB Accounting Standards Codification topic 820-10-50, “Fair Value Measurements and Disclosures”, to require additional information to be disclosed principally regarding Level 3 measurements and transfers to Level 1 and 2.  In addition, enhanced disclosure is required concerning inputs and valuation techniques used to determine Level 2 and Level 3 measurements.  This guidance is generally effective for interim and annual reporting periods beginning with December 15, 2009; however requirements to disclose separately purchases, sales, issuances and settlements in the Level 3 reconciliation are effective for fiscal years beginning after December 15, 2010 (and for interim periods within such years).  ASU No. 2010-06 is not expected to have a material impact on the Company’s financial position or results of operations and will have a minimal impact on its disclosures.
 
 Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations or cash flows.
 
 Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP.  Actual results could differ from those estimates.
 
 The remainder of management’s discussion and analysis of the Company’s results of operations and financial position should be read in conjunction with the consolidated financial statements and related notes presented on pages A-32 through A-66.
 
 Results of Operations
 Summary.The Company reported earnings of $2.9 million in 2009, or $0.53 basic and diluted net earnings per common share before adjustment for preferred stock dividends and accretion as compared to $6.4 million, or $1.14 basic net earnings per common share and $1.13 diluted net earnings per common share for 2008.  After adjusting for $1.2 million in dividends and accretion on preferred stock, net earnings available to common shareholders for the year ended December 31, 2009 were $1.7 million or $0.30 basic and diluted net earnings per common share.  Net earnings from recurring operations for the year ended December 31, 2009 were $2.5 million, or $0.46 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, as compared to net earnings from recurring operations of $6.7 million, or $1.20 basic net earnings per share and $1.19 diluted net earnings per share, for the same period one year ago.  The Company’s decrease in net earnings for 2009 is primarily attributable to an increase in provision for loan losses and an increase in non-interest expense, which were partially offset by an increase in non-interest income.
 
 Net earnings for 2008 represented a decrease of 33% as compared to 2007 net earnings of $9.6 million or $1.68 basic net earnings per common share and $1.65 diluted net earnings per common share.  The decrease in 2008 net earnings was primarily attributable to a decrease in net interest income, an increase in the provision for loan losses and an increase in non-interest expense, which was partially offset by an increase in non-interest income.
 
 The return on average assets in 2009 was 0.29%, compared to 0.69% in 2008 and 1.13% in 2007. The return on average shareholders’ equity was 2.88% in 2009 compared to 8.38% in 2008 and 13.59% in 2007.
 
 Net Interest Income.Net interest income, the major component of the Company's net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them.  Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid.  Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.
 
 Net interest income for 2009 increased to $32.9 million compared to $32.8 million in 2008.  This increase is primarily attributable to a reduction in interest expense due to a decrease in the cost of funds for time deposits.  Net interest income decreased 4% in 2008 from $34.1 million in 2007.  The decrease in 2008 was primarily related to a reduction in the Bank’s prime commercial lending rate.  The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments.  Net income from derivative instruments was $3.4 million for the year ended December 31, 2008 compared to a net loss of $406,000 for the same period in 2007.
 
 Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2009, 2008 and 2007. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same
 
 A-12
 
 
 periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate of 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.  Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.
 
 Table 1- Average Balance TableDecember 31, 2009

December 31, 2008

December 31, 2007(Dollars in thousands)
Average

Balance

Interest
Yield /

Rate
Average

Balance
Interest
Yield /

Rate
Average

Balance
Interest
Yield /

RateInterest-earning assets:Loans
$
782,464


40,058

5.12%

747,203

46,808

6.26%

665,379

55,109

8.28%Interest rate derivative contracts

-


3,114

0.40%

-

3,403

0.45%

-

(406
)
-0.06%Loan fees

-


39

0.00%

-

393

0.05%

-

698

0.10%Total loans

782,464


43,211

5.52%

747,203

50,604

6.77%

665,379

55,401

8.33%Investments - taxable

81,642


3,477

4.26%

26,591

1,253

4.71%

20,305

868

4.27%Investments - nontaxable*

79,493


4,226

5.32%

89,262

4,924

5.52%

99,991

5,470

5.47%Federal funds sold

704


1

0.14%

3,050

55

1.80%

7,378

383

5.19%Other

12,377


53

0.43%

10,319

293

2.84%

8,041

444

5.52%Total interest-earning assets

956,680


50,968

5.33%

876,425

57,129

6.52%

801,094

62,566

7.81%Cash and due from banks

31,225






21,331





20,081Other assets

41,866






41,626





34,287Allowance for loan losses

(13,514
)





(9,583
)




(8,626
)Total assets
$
1,016,257






929,799





846,836Interest-bearing liabilities:NOW accounts
$
112,452


1,373

1.22%

92,612

1,269

1.37%

79,550

1,127

1.42%Regular savings accounts

35,762


368

1.03%

17,423

50

0.29%

18,685

54

0.29%Money market accounts

94,537


1,224

1.29%

93,564

1,930

2.06%

87,916

2,918

3.32%Time deposits

412,127


9,687

2.35%

406,127

15,008

3.70%

361,859

17,430

4.82%FHLB / FRB borrowings

84,547


3,596

4.25%

79,417

3,616

4.55%

80,058

3,759

4.70%Demand notes payable to U.S. Treasury

805


-

0.00%

859

14

1.63%

814

39

4.79%Trust preferred securities

20,619


546

2.65%

20,619

1,016

4.93%

20,619

1,476

7.16%Other

35,411


393

1.11%

29,857

624

2.09%

16,226

782

4.82%Total interest-bearing liabilities

796,260


17,187

2.16%

740,478

23,527

3.18%

665,727

27,585

4.14%Demand deposits

117,197






111,192





111,164Other liabilities

2,428






4,021





3,022Shareholders' equity

101,162






76,241





70,586Total liabilities and shareholders' equity
$
1,017,047






931,932





850,499Net interest spread



$
33,781

3.17%



33,602

3.34%



34,981

3.67%Net yield on interest-earning assets






3.53%





3.83%





4.37%Taxable equivalent adjustmentInvestment securities



$
931





806





834Net interest income



$
32,850





32,796





34,147*Includes U.S. government agency securities that are non-taxable for state income tax purposes of $45.5 million in 2009, $63.6 million in 2008 and $74.9 million in 2007. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities.
  Changes in interest income and interest expense can result from variances in both volume and rates.  Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated.  The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.
  A-13
   Table 2 - Rate/Volume Variance Analysis-Tax Equivalent BasisDecember 31, 2009

December 31, 2008(Dollars in thousands)
Changes in

average

volume
Changes in average

rates
Total

Increase (Decrease)

Changes in average

volume
Changes in average

rates
Total

Increase (Decrease)Interest income:Loans: Net of unearned income
$
2,168

(9,561
)
(7,393
)
6,177

(10,974
)
(4,797
)Investments - taxable

2,470

(246
)
2,224

282

102

384Investments - nontaxable

(529
)
(169
)
(698
)
(589
)
43

(546
)Federal funds sold

(23
)
(31
)
(54
)
(151
)
(177
)
(328
)Other

33

(273
)
(240
)
95

(246
)
(151
)Total interest income

4,119

(10,280
)
(6,161
)
5,814

(11,252
)
(5,438
)Interest expense:NOW accounts

257

(153
)
104

182

(40
)
142Regular savings accounts

121

197

318

(4
)
-

(4
)Money market accounts

16

(722
)
(706
)
152

(1,140
)
(988
)Time deposits

181

(5,502
)
(5,321
)
1,884

(4,306
)
(2,422
)FHLB / FRB Borrowings

226

(246
)
(20
)
(30
)
(113
)
(143
)Demand notes payable toU.S. Treasury

-

(14
)
(14
)
1

(27
)
(26
)Trust Preferred Securities

-

(470
)
(470
)
-

(459
)
(459
)Other

89

(320
)
(231
)
471

(630
)
(159
)Total interest expense

890

(7,230
)
(6,340
)
2,656

(6,716
)
(4,059
)Net interest income
$
3,229

(3,050
)
179

3,158

(4,536
)
(1,379
)
  Net interest income on a tax equivalent basis totaled $33.8 million in 2009 as compared to $33.6 million in 2008.  The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.17% in 2009, a decrease from the 2008 net interest spread of 3.34%.  The net yield on interest-earning assets in 2009 decreased to 3.53% from the 2008 net interest margin of 3.83%.
 
 Tax equivalent interest income decreased $6.2 million or 11% in 2009 primarily due to a reduction in the Bank’s prime commercial lending rate.  The yield on interest-earning assets decreased to 5.33% in 2009 from 6.52% in 2008 as a result of a decrease in the average yield received on loans resulting from Federal Reserve interest rate decreases, which were partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts.  Average interest-earning assets increased $80.3 million primarily as the result of a $35.3 million increase in average loans and a $45.3 million increase in average investment securities over 2008.  All other interest-earning assets including federal funds sold were $13.1 million in 2009 and $13.4 million in 2008.
 
 Interest expense decreased $6.3 million or 27% in 2009 due to a decrease in the average rate paid on interest-bearing liabilities.  The cost of funds decreased to 2.16% in 2009 from 3.18% in 2008.  This decrease in the cost of funds was primarily attributable to decreases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit.  The $55.8 million growth in average interest-bearing liabilities was primarily attributable to an increase in interest-bearing checking and savings accounts of $39.2 million to $242.8 million in 2009 from $203.6 million in 2008.
 
 In 2008 net interest income on a tax equivalent basis decreased $1.4 million or 4% to $33.6 million in 2008 from $35.0 million in 2007.  The interest rate spread was 3.34% in 2008, a decrease from the 2007 net interest spread of 3.67%.  The net yield on interest-earning assets in 2008 decreased to 3.83% from the 2007 net interest margin of 4.37%.
  A-14
 
 Provision for Loan Losses.Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Company’s loan portfolio, including the valuation of impaired loans, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.
 
 The provision for loan losses was $10.5 million, $4.8 million, and $2.0 million for the years ended December 31, 2009, 2008 and 2007, respectively.  The increase in the provision for loan losses for 2009 is primarily attributable to an increase in non-performing assets and a $3.3 million increase in net charge-offs.  Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.
  Non-Interest Income.  Non-interest income for 2009 totaled $11.8 million, an increase of $1.3 million or 13% from non-interest income of $10.5 million for 2008.  This increase in non-interest income is attributable to an increase in gains on sale of securities which were partially offset by an increase in write-downs of securities and a decrease in miscellaneous income and other service charges and fees when compared to the same period last year.  Recurring non-interest income increased 2% to $11.2 million for the year ended December 31, 2009, as compared to $11.0 million for the same period one year ago.  The increase in recurring non-interest income is primarily due to a $167,000 increase in mortgage banking income resulting from increased mortgage loan demand.  Net non-recurring gains of $574,000 for the year ended December 31, 2009 included a $1.8 million gain on sale of securities, which was partially offset by write-downs of three securities totaling $723,000.  This $1.1 million net gain on the sale and write-down of securities for the year ended December 31, 2009 was partially offset by a $498,000 net loss on the disposition of assets.  Net non-recurring losses of $456,000 for the year ended December 31, 2008 were due to a $167,000 loss on the sale of securities and a $289,000 net loss on the disposition of assets.
  Non-interest income for 2008 increased $1.7 million or 19% from non-interest income of $8.8 million for 2007. The increases in non-interest income for 2008 are primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in mortgage banking income and a decrease in the loss on sale and write-down of securities when compared to the same period in 2007.  These increases in non-interest income were partially offset by a decrease in insurance and brokerage commissions and a net increase in losses and write-downs on foreclosed property for the year ended 2008 when compared to 2007.
 
 Service charges on deposit accounts totaled $5.6 million during 2009, an increase of $370,000, or 7% over 2008.  Service charge income increased $925,000, or 22% in 2008 compared to 2007.  These increases are primarily attributable to growth in the deposit base coupled with normal pricing changes, which resulted in an increase in account maintenance fees.
 
 Other service charges and fees decreased to $2.1 million for the year ended December 31, 2009 as compared to $2.4 million for the same period one year ago.  This decrease is primarily attributable to a decrease in check cashing fees.
 
 The Company reported net gains on sale and write-downs of securities of $1.1 million in 2009 and net losses on sale and write-downs of securities of $167,000 and $562,000 in 2008 and 2007, respectively.The Company periodically evaluates its investments for any impairment which would be deemed other than temporary.   As part of its evaluation in 2009, the Company determined that the fair values of three investments were less than the original cost of the investments and that the decline in fair value was not temporary in nature.  As a result, the Company wrote down its original investments by $723,000.  The remaining fair value of the investments at December 31, 2009 was $11,000.  Similarly, as part of its evaluation in 2008, the Company wrote down one investment by $300,000.  The remaining fair value of the investments at December 31, 2008 was $22,000.
 
 During the year ended 2007, the Company wrote down two investments by $430,000.  The remaining fair value of the investments at December 31, 2007 was $348,000.
  Mortgage banking income increased to $827,000 in 2009 from $660,000 in 2008 primarily due to an increase in mortgage loan demand.  During 2008 mortgage banking income increased $100,000 from the $560,000 reported in 2007.  The increase in mortgage banking income for 2008 was primarily attributable to an increase in brokered loan activity.
 
 Net losses on other real estate and repossessed assets were $501,000, $287,000 and $118,000 for 2009, 2008 and 2007, respectively.  The increase in net losses on other real estate and repossessed assets during 2009 was primarily attributable to increased write-downs on foreclosed property for the year ended December 31, 2009 as compared to the same period last year.  Management determined that the market value of these assets had decreased significantly and charges were appropriate for 2009.
  A-15
 
 Miscellaneous income for 2009 totaled $2.4 million, an increase of 5% from $2.3 million for 2008.  During 2008, miscellaneous income increased 3% from $2.2 million for 2007.
 
 Table 3 presents a summary of non-interest income for the years ended December 31, 2009, 2008 and 2007.
  Table 3 - Non-Interest Income(Dollars in thousands)
2009

2008

2007Service charges
$
5,573

5,203

4,279Other service charges and fees

2,058

2,399

1,938Gain (loss) on sale of securities

1,072

(167
)
(562
)Mortgage banking income

827

660

560Insurance and brokerage commissions

414

426

521Loss on foreclosed and repossessed assets

(501
)
(287
)
(118
)Miscellaneous

2,380

2,261

2,198Total non-interest income
$
11,823

10,495

8,816
  Non-Interest Expense.  Total non-interest expense amounted to $29.9 million for 2009, an increase of 3% from 2008.  Non-interest expense for 2008 increased 11% to $28.9 million from non-interest expense of $26.0 million for 2007.
 
 Salary and employee benefit expense was $14.8 million in 2009, compared to $15.2 million during 2008, a decrease of $436,000 or 3%, following a $1.3 million or 9% increase in salary and employee benefit expense in 2008 over 2007.  The decrease in salary and employee benefits in 2009 is primarily due to a reduction in incentive expense.   The increase in salary and employee benefits in 2008 was primarily related to normal salary increases and expense associated with additional staff for new branches.
 
 The Company recorded occupancy expenses of $5.4 million in 2009, compared to $5.0 million during 2008, an increase of $380,000 or 8%, following an increase of $278,000 or 6% in occupancy expenses in 2008 over 2007.  The increases in 2009, 2008 and 2007 are primarily due to an increase in furniture and equipment expense and lease expense associated with new branches.
 
 The total of all other operating expenses increased $1.0 million or 12% to $9.7 million during 2009.  The increase in other expense for 2009 is primarily attributable to a $1.2 million increase in FDIC insurance expense due to an increase in 2009 FDIC insurance assessment rates combined with a $453,000 FDIC insurance special assessment paid in September 2009.  Other operating expense increased $1.3 million or 18% in 2008 over 2007.  The increase in other expense for 2008 is primarily attributable an increase of $407,000 in FDIC insurance expense, an increase of $309,000 in deposit program expense and an increase of $133,000 in foreclosure expense
 
 Table 4 presents a summary of non-interest expense for the years ended December 31, 2009, 2008 and 2007.
 
 Table 4 - Non-Interest Expense(Dollars in thousands)
2009

2008

2007Salaries and wages
$
11,530

11,591

10,276Employee benefits

3,228

3,603

3,612Total personnel expense

14,758

15,194

13,888Occupancy expense

5,409

5,029

4,751Office supplies

426

564

554FDIC deposit insurance

1,766

547

140Professional services

358

422

400Postage

342

360

320Telephone

616

476

405Director fees and expense

350

450

499Advertising

860

1,076

988Consulting fees

198

385

460Taxes and licenses

248

193

272Other operating expense

4,552

4,197

3,316Total non-interest expense
$
29,883

28,893

25,993
   A-16
  Income Taxes.Total income tax expense was $1.3 million in 2009 compared with $3.2 million in 2008 and $5.3 million in 2007.   The primary reason for the decrease in taxes for 2009 as compared to 2008 and 2007 was the decrease in pretax income.  The Company’s effective tax rates were 31.47%, 33.46% and 35.76% in 2009, 2008 and 2007, respectively.
 
 Liquidity.The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements.  Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities.  In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit.  As of December 31, 2009 such unfunded commitments to extend credit were $140.2 million, while commitments in the form of standby letters of credit totaled $3.3 million.
 
 The Company uses several sources to meet its liquidity requirements.  The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $100,000.  The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships.  As of December 31, 2009, the Company’s core deposits totaled $569.0 million, or 70% of total deposits.
 
 The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings.  The Bank is also able to borrow from the Federal Reserve on a short-term basis.  In third quarter 2008, the Bank significantly improved its funding capacity by pledging loans to the Federal Reserve Bank ("FRB").  The Bank’s policies include the ability to access wholesale funding up to 40% of total assets.  The Bank’s wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina.  The Company’s ratio of wholesale funding to total assets was 15.75% as of December 31, 2009.
 
 At December 31, 2009, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $84.0 million, which have an average maturity of 14 months.  The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits.   Access to the brokered deposit market could be restricted if the Bank were to fall below the well capitalized level.  For additional information, please see the section below entitled “Deposits.”
 
 The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $77.0 million at December 31, 2009.  At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $147.0 million.  As additional collateral, the Bank has pledged securities to FHLB.  At December 31, 2009, the market value of securities pledged to FHLB totaled $7.5 million.  The remaining availability at FHLB was $3.5 million at December 31, 2009.  The Bank had no borrowings from the FRB at December 31, 2009.  The FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At December 31, 2009, the carrying value of loans pledged as collateral to the FRB totaled approximately $428.2 million.  During 2009, the Bank increased its overall borrowing capacity by pledging commercial real estate loans to the FRB that were previously pledged to the FHLB.
 
 The Bank also had the ability to borrow up to $40.5 million for the purchase of overnight federal funds from four correspondent financial institutions as of December 31, 2009.
 
 The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 19.10% at December 31, 2009, 11.71% at December 31, 2008 and 13.93% at December 31, 2007.  The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy for on balance sheet liquidity is 10%.
 
 As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $4.6 million during 2009.  Net cash used in investing activities of $80.3 million consisted primarily of purchases of available-for-sale investments totaling $141.8 million which were partially offset by maturities, calls and sales of available-for-sale investments which totaled $71.4 million.  Net cash provided by financing activities amounted to $79.1 million, primarily from a $88.3 million net increase in deposits which was partially offset by a reduction in FRB borrowings of $5.0 million.
 
 Asset Liability and Interest Rate Risk Management.The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities.  This is
 
 A-17
 
 
 done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 5 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2009.
 
 Table 5 - Interest Sensitivity Analysis(Dollars in thousands)
Immediate
1-3

months
4-12

months

Total

Within One

Year
Over One

Year & Non-sensitive
TotalInterest-earning assets:Loans
$
506,108

7,751

27,801

541,660

236,396

778,056Mortgage loans held for  sale

2,840

-

-

2,840

-

2,840Investment securities

-

1,798

2,646

4,444

190,671

195,115Interest-bearing deposit accounts

1,458

249

-

1,707

-

1,707Certificates of deposit

-

-

3,345

3,345

-

3,345Other interest-earning assets

-

-

-

-

6,954

6,954Total interest-earning assets

510,406

9,798

33,792

553,996

434,021

988,017Interest-bearing liabilities:NOW, savings, and money market deposits

290,273

-

-

290,273

-

290,273Time deposits

42,465

107,827

142,271

292,563

108,871

401,434Other short term borrowings

636

-

-

636

-

636FHLB borrowings

-

5,000

2,000

7,000

70,000

77,000Securities sold underagreement to repurchase

36,876

-

-

36,876

-

36,876Trust preferred securities

-

20,619

-

20,619

-

20,619Total interest-bearing liabilities

370,250

133,446

144,271

647,967

178,871

826,838Interest-sensitive gap
$
140,156

(123,648
)
(110,479
)
(93,971
)
255,150

161,179Cumulative interest-sensitive gap
$
140,156

16,508

(93,971
)
(93,971
)
161,179Interest-earning assets as a percentage ofinterest-bearing liabilities

137.85%

7.34%

23.42%

85.50%

242.64%
  The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank.  The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company.  ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements.  The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.
 
 The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year.  Rate sensitive assets therefore include both loans and available for sale securities.  Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds.  As shown in Table 5, the Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits.  During periods of rising rates, this results in increased net interest income.  The opposite occurs during periods of declining rates.  Rate sensitive assets at December 31, 2009 totaled $956.7 million, exceeding rate sensitive liabilities of $796.3 million by $160.4 million.
 
 Included in the rate sensitive assets are $490.4 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”).  The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At December 31,
 
 A-18
 
 
 2009, the Bank had $317.8 million in loans with interest rate floors.  The floors were in effect on $315.5 million of these loans pursuant to the terms of the promissory notes on these loans.   The weighted average rate on these loans is 1.19% higher than the indexed rate on the promissory notes without interest rate floors.
 
 The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company. As of December 31, 2009, the Company had a cash flow hedge with a notional amount of $50.0 million.  This derivative instrument consists of one interest rate swap contract.  The interest rate swap contract is used to convert $50.0 million of variable rate loans to a fixed rate.  Under the swap contract, the Company receives a fixed rate of 6.245% and pays a variable rate based on the current prime rate (3.25% at December 31, 2009) on the notional amount of $50.0 million.  The swap agreement matures in June 2011.  The Company recognized $3.1 million in interest income, net of premium amortization, from interest rate derivative contracts during the year ended December 31, 2009.  Based on the current interest rate environment, it is expected the Company will continue to receive income on this interest rate contract throughout 2010.  The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company recognized a hedge ineffectiveness gain of $1,000 in earnings during the year ended December 31, 2009.
 
 Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next twelve months, the Company estimates that $1.4 million will be reclassified as an increase to interest income.
 
 Table 6 presents additional information on the Company’s derivative financial instruments as of December 31, 2009.
 
 Table 6 - Derivative Instruments(Dollars in thousands)Type of Derivative
Notional

Amount

Contract

Rate

Year-to-date Income

(Net of Premium Amortization)Interest rate floor contact*

-

-


106Interest rate floor contact*

-

-


623Interest rate floor contact*

-

-


912Interest rate swap contact expiring 06/01/11

50,000

6.245%


1,472$
50,000



$
3,114* Interest rate floor contracts expired during 2009
  An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities.  A discussion of these changes and trends follows.
 
 Analysis of Financial Condition
 Investment Securities.All of the Company’s investment securities are held in the available-for-sale (“AFS”) category.At December 31, 2009 the market value of AFS securities totaled $195.1 million, compared to $124.9 million and $121.0 million at December 31, 2008 and 2007, respectively.  The increase in 2009 investment securities is primarily due to $87.9 million in securities purchased to offset the cost of the Company’s CPP dividend.  Table 7 presents the market value of the AFS securities held at December 31, 2009, 2008 and 2007.
  A-19
  
 Table 7 - Summary of Investment Portfolio(Dollars in thousands)
2009

2008

2007Obligations of United States governmentsponsored enterprises
$
41,142

58,487

76,992Obligations of states and political subdivisions

44,336

26,973

25,905Mortgage-backed securities

107,526

37,271

16,271Trust preferred securities

1,250

1,250

250Equity securities

861

935

1,550Total securities
$
195,115

124,916

120,968
  The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income.  The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.
 
 The Company’s investment portfolio consists of U.S. government sponsored enterprise securities, municipal securities, U.S. government enterprise sponsored mortgage-backed securities, and trust preferred securities and equity securities.  AFS securities averaged $161.1 million in 2009, $115.9 million in 2008 and $120.3 million in 2007.  Table 8 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2009.   Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields are calculated on a tax equivalent basis.Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.
 
 Table 8 - Maturity Distribution and Weighted Average Yield on InvestmentsAfter One Year

After 5 YearsOne Year or Less

Through 5 Years

Through 10 Years

After 10 Years

Totals(Dollars in thousands)

Amount

Yield

Amount

Yield

Amount
Yield

Amount

Yield

Amount

YieldBook value:United States Governmentsponsored enterprises

$
-

-

11,998

5.25%

23,358
5.37%

4,903

5.81%

40,259

5.39%States and political subdivisions


2,566

2.83%

10,727

3.48%

10,303
4.29%

19,864

4.23%

43,460

3.97%Mortgage backed securities


-

-

1,924

4.55%

19,220
5.21%

84,771

5.48%

105,915

5.41%Trust preferred securities


-

-

-

-

500
5.09%

750

5.76%

1,250

5.49%Equity securities


-

-

-

-

-
-

1,233

0.00%

1,233

0.00%Total securities

$
2,566

2.83%

24,649

4.43%

53,381
5.10

111,521

5.21%

192,117

5.05%
  Loans.The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties in North Carolina.
  A-20
 
 Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Real estate mortgage loans include both commercial and residential mortgage loans.  At December 31, 2009, the Company had $116.1 million in residential mortgage loans, $99.1 million in home equity loans and $297.8 million in commercial mortgage loans, which include $231.2 million using commercial property as collateral and $66.6 million using residential property as collateral.  At December 31, 2009, real estate construction loans included $101.9 million in speculative construction and development loans.
 
 Residential mortgage loans include $55.4 million made to customers in the Company’s traditional banking offices and $60.7 million in mortgage loans originated in the Company’s Latino banking operations.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.
 
 The mortgage loans originated in the traditional banking offices are generally 15 to 30 year fixed rate loans with attributes that cause the loans to not be sellable in the secondary market.  These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type and are generally made to existing Bank customers.  These loans have been originated throughout the Company’s five county service area, with no geographic concentration.  At December 31, 2009 there were 21 loans with an outstanding balance of $2.1million that were 30 days or more past due and two loans more than 90 days past due totaling $369,000.
 
 The mortgage loans originated in the Company’s Latino operations are primarily adjustable rate mortgage loans that adjust annually after the end of the first five years of the loan.  The loans are tied to the one-year T-Bill index and, if they were to adjust at December 31, 2009, would have a reduction in the interest rate on the loan.  The underwriting on these loans includes both full income verification and no income verification, with loan-to-value ratios of up to 95% without private mortgage insurance.  A majority of these loans would be considered subprime loans, as they were underwritten using stated income rather than fully documented income verification.  No other loans in the Company’s portfolio would be considered subprime.  The majority of these loans have been originated within the Charlotte, NC metro area.  At this time, Charlotte has experienced a decline in values within the residential real estate market.  At December 31, 2009 there were 113 loans with an outstanding balance of $12.6 million 30 days or more past due and 12 loans more than 90 days past due totaling $1.3 million.  Total losses on this portfolio, since the first loans were originated in 2004, have amounted to approximately $706,000through December 31, 2009.
 
 As a recipient of CPP funds, the Bank will continue to work with delinquent borrowers in an attempt to mitigate foreclosure.  The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.
 
 The composition of the Company’s loan portfolio is presented in Table 9.
 
 Table 9 - Loan Portfolio2009

2008

2007

2006

2005(Dollars in thousands)
Amount

% of Loans

Amount

% of

Loans

Amount

% of Loans

Amount

% of Loans

Amount

% of LoansBreakdown of loan receivables:Commercial
$
67,487

8.67
%

76,945

9.85
%

82,190

11.38
%

85,064

13.06
%

79,902

14.10
%Real estate - mortgage

512,963

65.93
%

474,732

60.77
%

417,709

57.83
%

364,595

55.97
%

330,227

58.28
%Real estate - construction

169,680

21.81
%

216,188

27.67
%

209,644

29.03
%

187,960

28.86
%

141,420

24.96
%Consumer

27,926

3.59
%

13,323

1.71
%

12,734

1.76
%

13,762

2.11
%

15,115

2.66
%Total loans
$
778,056

100.00
%

781,188

100.00
%

722,277

100.00
%

651,381

100.00
%

566,664

100.00
%Less: Allowance for loan losses

15,413




11,025




9,103




8,303




7,425Net loans
$
762,643




770,163




713,174




643,078




559,239
  As of December 31, 2009, gross loans outstanding were $778.1 million, a decrease of $3.1 million from the December 31, 2008 balance of $781.2 million.  Commercial loans decreased $9.5 million in 2009.  Real estate mortgage loans grew $38.2 million when compared to 2008 due to an increase in non-conforming mortgage loans and commercial real estate loans. Real estate construction loans decreased $46.5 million in 2009 as a result of a decrease in real estate development loans.  Consumer loans increased $14.6 million in 2009.  Loans originated or renewed during the year ended December 31, 2009 amounting to approximately $135.2 million were offset by paydowns and payoffs of existing loans.  The Bank has modified terms on mortgage loans totaling $19.5 million during the year ended December 31, 2009.  Average loans represented 82% and 85% of total earning assets for the years ended December 31, 2009 and 2008, respectively.  The Company had $2.8 million in mortgage loans held for sale as of December 31, 2009 and no mortgage loans held for sale as of December 31, 2008.
  A-21
 
 Table 10 identifies the maturities of all loans as of December 31, 2009 and addresses the sensitivity of these loans to changes in interest rates.
 
 Table 10 - Maturity and Repricing Data for Loans(Dollars in thousands)

Within one

year or less
After one year through five

years
After five

years
Total loansCommercial

$
57,181

9,563

743

67,487Real estate - mortgage


307,750

147,484

57,729

512,963Real estate - construction


159,823

8,730

1,127

169,680Consumer


16,906

10,723

297

27,926Total loans

$
541,660

176,500

59,896

778,056Total fixed rate loans

$
30,329

135,847

59,896

226,072Total floating rate loans


511,331

40,653

-

551,984Total loans

$
541,660

176,500

59,896

778,056
  In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2009, outstanding loan commitments totaled $140.2 million.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Additional information regarding commitments is provided below in the section entitled “Contractual Obligations” and in Note 10 to the Consolidated Financial Statements.
 
 Allowance for Loan Losses.The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
 
 ·
the Bank’s loan loss experience;
 ·
the amount of past due and non-performing loans;
 ·
specific known risks;
 ·
the status and amount of other past due and non-performing assets;
 ·
underlying estimated values of collateral securing loans;
 ·
current and anticipated economic conditions; and
 ·
other factors which management believes affect the allowance for potential credit losses.
 
 Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of nine risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan as well as the level of reserves deemed appropriate for the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.
 
 As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million.  The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.
  A-22
 
 Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.
 
 Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.
 
 The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment.  When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.  At December 31, 2009 and 2008, the recorded investment in loans that were considered to be impaired was approximately $16.6 million and $7.5 million, respectively, with related allowance for loan losses of approximately $673,000 and $462,000 for December 31, 2009 and 2008, respectively.
 
 The general allowance reflects reserves established under GAAP for collective loan impairment.  These reserves are based upon historical net charge-offs using the last three years’ experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.
 
 The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.
 
 Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with GAAP and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions that adversely affect the operating results of the Company.
 
 There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2009 as compared to the year ended December 31, 2008. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.
 
 Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.  Also, a loan review process further assists with evaluating credit quality and assessing potential performance issues.
 
 Net charge-offs for 2009 were $6.1 million.  The ratio of net charge-offs to average total loans was 0.79%in 2009, 0.38% in 2008 and 0.19% in 2007.  Management expects the ratio of net charge-offs to average total loans to increase again in 2010 due to the recessionary economic conditions and the decline in real estate values and new home sales.   The allowance for loan losses increased to $15.4 million or 1.98% of total loans outstanding at December 31, 2009.  For December 31, 2008 and 2007, the allowance for loan losses amounted to $11.0 million or 1.41% of total loans outstanding and $9.1 million, or 1.26% of total loans outstanding, respectively.  Management would expect the percentage of the allowance for loan losses to total loans to increase in 2010 if non-performing loans continue to increase as a result of the current recessionary economic conditions.
  A-23
 
 Table 11 presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at December 31, 2009 and 2008.
  Table 11 - Loan Risk Grade AnalysisPercentage of LoansBy Risk Grade*Risk Grade
2009

2008Risk Grade 1 (Excellent Quality)
3.52%

4.08%Risk Grade 2 (High Quality)
16.34%

17.95%Risk Grade 3 (Good Quality)
51.12%

63.08%Risk Grade 4 (Management Attention)
17.16%

10.42%Risk Grade 5 (Watch)
7.43%

2.14%Risk Grade 6 (Substandard)
1.45%

0.80%Risk Grade 7 (Low Substandard)
0.04%

0.00%Risk Grade 8 (Doubtful)
0.00%

0.00%Risk Grade 9 (Loss)
0.00%

0.00%* Excludes non-accrual loans
  Table 12 presents an analysis of the allowance for loan losses, including charge-off activity.
 
 Table 12 - Analysis of Allowance for Loan Losses(Dollars in thousands)
2009

2008

2007

2006

2005Reserve for loan losses at beginning
$
11,025

9,103

8,303

7,425

8,049Loans charged off:Commercial

697

249

414

505

293Real estate - mortgage

3,384

1,506

471

568

2,141Real estate - construction

1,754

644

252

250

1,250Consumer

835

748

489

636

516Total loans charged off

6,670

3,147

1,626

1,959

4,200Recoveries of losses previously charged off:Commercial

111

87

86

64

144Real estate - mortgage

161

8

21

108

162Real estate - construction

36

30

102

2

-Consumer

215

150

179

150

160Total recoveries

523

275

388

324

466Net loans charged off

6,147

2,872

1,238

1,635

3,734Provision for loan losses

10,535

4,794

2,038

2,513

3,110Reserve for loan losses at end of year
$
15,413

11,025

9,103

8,303

7,425Loans charged off net of recoveries, asa percent of average loans outstanding

0.79%

0.38%

0.19%

0.27%

0.68%
  Non-performing Assets.Non-performing assets, comprised of non-accrual loans, other real estate owned, other repossessed assets and loans for which payments are more than 90 days past due totaled $28.8 million at December 31, 2009 compared to $14.2 million at December 31, 2008.   Non-accrual loans were $22.8 million at December 31, 2009, an increase of $11.0 million from non-accruals of $11.8 million at December 31, 2008.  As a percentage of loans outstanding, non-accrual loans were 2.93% and 1.51% at December 31, 2009 and 2008, respectively. The Bank had $2.0 million and $514,000 in loans 90 days past due and still accruing at December 31, 2009 and 2008, respectively.  Other real estate owned totaled $4.0 million and $1.9 million as of December 31, 2009 and 2008, respectively.  The Bank had no repossessed assets as of December 31, 2009 and 2008.
  A-24
 
 At December 31, 2009, the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $24.8 million or 3.18% of total loans.  Non-performing loans for 2008 were $12.3 million, or 1.58% of total loans and $8.0 million, or 1.11% of total loans for 2007.  Interest that would have been recorded on non-accrual loans for the years ended December 31, 2009, 2008 and 2007, had they performed in accordance with their original terms, amounted to approximately $1.6 million, $850,000 and $693,000, respectively. Interest income on impaired loans included in the results of operations for 2009, 2008, and 2007 amounted to approximately $53,000, $57,000 and $29,000, respectively.
 
 Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing.  Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans.  Management anticipates continued weakness in the housing market, which combined with the current recessionary economic conditions will, in all likelihood, result in higher levels of non-performing loans in 2010.
 
 It is the general policy of the Company to stop accruing interest income and place the recognition of interest on a cash basis when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income.  Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.
 
 A summary of non-performing assets at December 31 for each of the years presented is shown in Table 13.
 
 Table 13 - Non-performing Assets(Dollars in thousands)
2009

2008

2007

2006

2005Non-accrual loans
$
22,789

11,815

7,987

7,560

3,492Loans 90 days or more past due and still accruing

1,977

514

-

78

946Total non-performing loans

24,766

12,329

7,987

7,638

4,438All other real estate owned

3,997

1,867

483

344

531Total non-performing assets
$
28,763

14,196

8,470

7,982

4,969As a percent of total loans at year endNon-accrual loans

2.93%

1.51%

1.11%

1.16%

0.62%Loans 90 days or more past due and still accruing

0.25%

0.07%

0.00%

0.01%

0.17%Total non-performing assets

3.70%

1.82%

1.17%

1.23%

0.88%
 
 Deposits.The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2009, total deposits were $809.3 million, an increase of $88.3 million or 12% increase over the December 31, 2008 balance of $721.1 million. Core deposits, which include demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $100,000, increased to $569.0 million at December 31, 2009 from $497.2 million at December 31, 2008.
 
 Time deposits in amounts of $100,000 or more totaled $233.1 million, $220.4 million and $203.5 million at December 31, 2009, 2008 and 2007, respectively.  At December 31, 2009, brokered deposits amounted to $84.0 million as compared to $61.0 million at December 31, 2008.  This increase is primarily due to a $10.8 million increase in certificates of deposit issued through the Certificate of Deposit Account Registry Service (CDARS) as of December 31, 2009 compared to December 31, 2008.  Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market.  Brokered deposits outstanding as of December 31, 2009 have a weighted average rate of 1.90% with a weighted average original term of 14 months.
  A-25
 
 Table 14 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2009.
 
 Table 14 - Maturities of Time Deposits over $100,000(Dollars in thousands)
2009Three months or less
$
89,013Over three months through six months

57,696Over six months through twelve months

24,080Over twelve months

62,353Total
$
233,142
  Borrowed Funds.The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions.  At December 31, 2009 and 2008, FHLB borrowings totaled $77.0 million compared to $87.5 million at December 31, 2007. Average FHLB borrowings for 2009 were $77.3 million, compared to average balances of $79.2 million for 2008 and $80.1 million for 2007. The maximum amount of outstanding FHLB borrowings was $87.9 million in 2009, and $97.6 in 2008 and $95.0 in 2007.The FHLB borrowings outstanding at December 31, 2009 had fixed interest rates ranging from 3.71% to 6.49%.  At December 31, 2009, $70.0 million of the Bank’s FHLB borrowings had maturities exceeding one year.  The FHLB has the option to convert $72.0 million of the total borrowings to a floating rate and, if converted, the Bank may repay borrowings without a prepayment fee.  The Company also has an additional $5.0 million in an advance that has been converted to a fixed rate by the FHLB, which may be repaid with a prepayment fee.  Additional information regarding FHLB borrowings is provided in Note 6 to the Consolidated Financial Statements.
 
 The Bank had no borrowings from the FRB at December 31, 2009.  At December 31, 2008, FRB borrowings totaled $5.0 million.  This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009.
 
 Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from customers, amounted to approximately $636,000 and $1.6 million at December 31, 2009 and 2008, respectively.
 
 Securities sold under agreements to repurchase amounted to $36.9 million and $37.5 million as of December 31, 2009 and 2008, respectively.
 
 Junior Subordinated Debentures (related to Trust Preferred Securities).In June 2006 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2007 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.
 
 The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments.  The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.
 
 These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
  A-26
 
 Contractual Obligations and Off-Balance Sheet Arrangements.The Company’s contractual obligations and other commitments as of December 31, 2009 are summarized in Table 15 below.  The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements.  Other commitments include commitments to extend credit.  Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
 
 Table 15 - Contractual Obligations and Other Commitments(Dollars in thousands)
Within One

Year
One to

Three Years
Three to

Five Years
Five Years

or More
TotalContractual Cash ObligationsLong-term borrowings
$
7,000

5,000

15,000

50,000

77,000Junior subordinated debentures

-

-

-

20,619

20,619Operating lease obligations

653

1,056

498

1,652

3,859Total
$
7,653

6,056

15,498

72,271

101,478Other CommitmentsCommitments to extend credit
$
45,629

4,405

2,876

87,297

140,207Standby letters of creditand financial guarantees written

3,302

-

-

-

3,302Total
$
48,931

4,405

2,876

87,297

143,509
  The Company enters into derivative contracts to manage various financial risks.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date.  Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk.  Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts.  Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-19 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.
 
 Capital Resources.Shareholders’ equity at December 31, 2009 was $99.2 million compared to $101.1 million at December 31, 2008 and $70.1 million at December 31, 2007.  Unrealized gains and losses, net of taxes, at December 31, 2009, 2008 and 2007 amounted to gains of $2.9 million, $5.5 million and $1.7 million, respectively.  Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength.   Average shareholders’ equity as a percentage of total average assets was 9.95%, 8.20% and 8.34% for 2009, 2008 and 2007.   The return on average shareholders’ equity was 2.88% at December 31, 2009 as compared to 8.38% and 13.59% as of December 31, 2008 and December 31, 2007, respectively.  Total cash dividends paid on common stock during 2009 amounted to $1.4 million.  Cash dividends totaling $2.7 million and $2.3 million were paid during 2008 and 2007, respectively.  The Company paid dividends totaling $1.1 million on preferred stock during 2009.  There were no dividends paid on preferred stock during the years ended December 31, 2008 and 2007.
 
 In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008.  The Company repurchased 50,497 shares, or $873,000, of its common stock under this plan during 2007.  The Company repurchased 25,000 shares, or $350,000, of its common stock under this plan during 2008. The Board of Directors ratified the purchase of 497 additional shares in March 2008.
 
 In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009.  The Company repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008.  Because of the Company’s participation in the U.S. Treasury Department’s CPP, discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without UST approval.
  A-27
 
 The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.
 
 On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the UST.  Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the CPP under the TARP.  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield.  As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock.  The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000.  The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate.  Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things.  Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.
 
 The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends.  Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital.  However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.
 
 The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.
 
 The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000.  There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.
 
 Under regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater.  Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill.  Tier 1 capital at December 31, 2009, 2008 and 2007 includes $20.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 13.74%, 13.65% and 11.03% at December 31, 2009, 2008 and 2007, respectively.  Total risk-based capital is defined as Tier 1 capital plus supplementary capital.  Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets.  The Company’s total risk-based capital ratio was 15.00%, 14.90% and 12.16% at December 31, 2009, 2008 and 2007, respectively.  In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater.  The Company’s Tier 1 leverage capital ratio was 11.42%, 12.40% and 10.43% at December 31, 2009, 2008 and 2007, respectively.
 
 The Bank’s Tier 1 risk-based capital ratio was 11.22%, 9.85% and 9.80% at December 31, 2009, 2008 and 2007, respectively.  The total risk-based capital ratio for the Bank was 12.48%, 11.10% and 10.93% at December 31, 2009, 2008 and 2007, respectively.   The Bank’s Tier 1 leverage capital ratio was 9.33%, 8.94% and 9.26% at December 31, 2009, 2008 and 2007 respectively.
 
 A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be "well capitalized" at December 31, 2009, 2008 and 2007.
  A-28
 
 The Company’s key equity ratios as of December 31, 2009, 2008 and 2007 are presented in Table 16.
 
 Table 16 - Equity Ratios2009

2008

2007Return on average assets
0.29%

0.69%

1.13%Return on average equity
2.88%

8.38%

13.59%Dividend payout ratio *
86.22%

41.93%

24.30%Average equity to average assets
9.95%

8.20%

8.34%* As a percentage of net earnings available to common shareholders.
  Quarterly Financial Data.The Company’s consolidated quarterly operating results for the years ended December 31, 2009 and 2008 are presented in Table 17.
   Table 17 - Quarterly Financial Data2009

2008(Dollars in thousands, except per

share amounts)
First
Second
Third
Fourth

First
Second
Third
FourthTotal interest income
$
12,581

12,523

12,403

12,530

$
14,553

14,072

14,122

13,576Total interest expense

4,702

4,324

4,132

4,029


6,680

5,700

5,627

5,520Net interest income

7,879

8,199

8,271

8,501


7,873

8,372

8,495

8,056Provision for loan losses

1,766

2,251

3,139

3,379


391

681

1,035

2,687Other income

2,186

4,251

2,503

2,883


2,607

2,802

2,506

2,580Other expense

7,342

7,956

7,344

7,241


6,930

7,113

7,278

7,572Income before income taxes

957

2,243

291

764


3,159

3,380

2,688

377Income taxes

332

883

(9
)
133


1,103

1,188

942

(20
)Net earnings

625

1,360

300

631


2,056

2,192

1,746

397Dividends and accretion of preferredstock

201

349

348

348


-

-

-

-Net earnings (loss) availableto common shareholders
$
424

1,011

(48
)
283

$
2,056

2,192

1,746

397Basic earnings per common share
$
0.08

0.18

(0.01
)
0.05

$
0.37

0.39

0.31

0.07Diluted earnings per common share
$
0.08

0.18

(0.01
)
0.05

$
0.36

0.39

0.31

0.07
   A-29
  QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates.  This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.
 
 The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely (positively)impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off-balance sheet derivative instruments. During the years ended December 31, 2009, 2008 and 2007, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management.”
 
 Table 18 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments and the notional amount and estimated fair value of the Company’s off-balance sheet derivative instruments at their expected maturity dates for the period ended December 31, 2009. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2009.  All convertible FHLB advances are callable at the option of FHLB.  For core deposits without contractual maturity (i.e. interest bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.
 
 Table 18 - Interest Rate Risk(Dollars in thousands)Estimated Resulting Theoretical Net

Interest IncomeHypothetical rate change (ramp over 12 months)

Amount

% Change+2%

$
34,296

2.84%+1%

$
33,679

0.99%0%

$
33,348

0.00%-1%

$
33,119

-0.69%-2%

$
32,837

-1.53%Estimated Resulting Theoretical

Market Value of EquityHypothetical rate change (immediate shock)

Amount

% Change+2%

$
84,719

-9.97%+1%

$
90,621

-3.70%0%

$
94,098

0.00%-1%

$
99,547

5.79%-2%

$
105,540

12.16%
   A-30
  Table 19 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps.”  The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1% and 2% as compared to the estimated theoretical impact of rates remaining unchanged.  The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the theoretical impact of rates remaining unchanged.  The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates.  This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes.  Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.
 
 Table 19 - Market Risk Table(Dollars In Thousands)
Principal/Notional Amount Maturing in Year Ended December 31,Loans Receivable
2010
2011
2012
2013 &

2014
Thereafter
Total
Fair ValueFixed rate
$
40,661

21,164

36,311

81,016

46,920

226,072

227,368Average interest rate

6.71%

7.04%

7.07%

6.27%

7.19%Variable rate
$
248,988

49,482

35,462

61,846

156,206

551,984

551,984Average interest rate

4.53%

4.41%

4.49%

4.53%

5.40%778,056

779,352Investment SecuritiesInterest bearing cash
$
249

-

-

-

1,458

1,707

1,707Average interest rate

0.50%

-

-

-

-Securities available for sale
$
28,561

25,923

32,397

36,623

71,611

195,115

195,115Average interest rate

5.12%

5.31%

5.40%

5.00%

4.78%Nonmarketable equity securities
$
-

-

-

-

6,345

6,345

6,345Average interest rate

-

-

-

-

0.34%Certificates of Deposit
$
3,345

-

-

-

-

3,345

3,345Average interest rate

1.32%

-

-

-

-Debt ObligationsDeposits
$
292,247

39,069

66,784

3,322

407,921

809,343

809,081Average interest rate

1.76%

2.02%

2.28%

2.46%

0.89%Advances from FHLB
$
7,000

5,000

10,000

40,000

15,000

77,000

86,680Average interest rate

6.05%

4.21%

4.43%

4.66%

4.14%Demand notes payable to U.S. Treasury
$
636

-

-

-

-

636

636Average interest rate

-

-

-

-

-Securities sold under agreement to repurchase
$
36,876









36,876

36,876Average interest rate

1.09%Junior subordinated debentures
$
-

-

-

-

20,619

20,619

20,619Average interest rate

-

-

-

-

1.90%Derivative Instruments (notional amount)Interest rate swap contracts
$
-

50,000

-

-

-

50,000

1,762Average interest rate

-

6.25%

-

-

-
    A-31
   PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated Financial StatementsDecember 31, 2009, 2008 and 2007INDEXPAGE(S)Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements
A-33Financial StatementsConsolidated Balance Sheets at December 31, 2009 and December 31, 2008
A-34Consolidated Statements of Earnings for the years ended December 31, 2009, 2008 and 2007
A-35Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2009, 2008 and 2007
A-36Consolidated Statements of Comprehensive Income for the years ended December 31, 2009, 2008 and 2007
A-37Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007
A-38 - A-39Notes to Consolidated Financial Statements
A-40 - A-66
    A-32
 Porter Keadle Moore, LLP
  
 
 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 
 To the Board of Directors and Shareholders
 Peoples Bancorp of North Carolina, Inc.
 Newton, North Carolina
 
 We have audited the accompanying consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
 
 We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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 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 Peoples Bancorp of North Carolina and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.
  We were not engaged to examine management's assessment of the effectiveness of Peoples Bancorp of North Carolina, Inc’s. internal control over financial reporting as of December 31, 2009, included in the accompanying Management’s Report of Internal Controls Over Financial Reporting and, accordingly, we do not express an opinion thereon.
 
 
  /s/ Porter Keadle Moore, LLP
  
 
 Atlanta, Georgia
 February 25, 2010
        Certified Public AccountantsSuite 1800
●
235 Peachtree Street NE
●
Atlanta, Georgia 30303
●
Phone 404-588-4200
●
Fax 404-588-4222
●
www.pkm.com
 A-33
 
 PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated Balance SheetsDecember 31, 2009 and 2008(Dollars in thousands)Assets
2009

2008Cash and due from banks, including reserve requirements
$
29,633

19,743of $5,017,000 and $7,257,000Interest bearing deposits

1,707

1,453Federal funds sold

-

6,733Cash and cash equivalents

31,340

27,929Certificates of deposit

3,345

-Investment securities available for sale

195,115

124,916Other investments

6,346

6,303Total securities

201,461

131,219Mortgage loans held for sale

2,840

-Loans

778,056

781,188Less allowance for loan losses

(15,413
)
(11,025
)Net loans

762,643

770,163Premises and equipment, net

17,947

18,297Cash surrender value of life insurance

7,282

7,019Accrued interest receivable and other assets

21,636

14,135Total assets
$
1,048,494

968,762Liabilities and Shareholders' EquityDeposits:Non-interest bearing demand
$
117,636

104,448NOW, MMDA & savings

290,273

210,058Time, $100,000 or more

233,142

220,374Other time

168,292

186,182Total deposits

809,343

721,062Demand notes payable to U.S. Treasury

636

1,600Securities sold under agreement to repurchase

36,876

37,501Short-term Federal Reserve Bank borrowings

-

5,000FHLB borrowings

77,000

77,000Junior subordinated debentures

20,619

20,619Accrued interest payable and other liabilities

4,797

4,852Total liabilities

949,271

867,634Shareholders' equity:Series A preferred stock, $1,000 stated value; authorized5,000,000 shares; issued and outstanding25,054 shares in 2009 and 2008

24,476

24,350Common stock, no par value; authorized20,000,000 shares; issued and outstanding5,539,056 shares in 2009 and 2008

48,269

48,269Retained earnings

23,573

22,985Accumulated other comprehensive income

2,905

5,524Total shareholders' equity

99,223

101,128Total liabilities and shareholders' equity
$
1,048,494

968,762See accompanying notes to consolidated financial statements.
 A-34
 
  PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated Statements of EarningsFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)2009

2008

2007Interest income:Interest and fees on loans
$
43,211

50,604

55,401Interest on federal funds sold

1

55

383Interest on investment securities:U.S. Government sponsored enterprises

5,461

4,392

4,572States and political subdivisions

1,242

904

888Other

122

367

488Total interest income

50,037

56,322

61,732Interest expense:NOW, MMDA & savings deposits

2,965

3,249

4,099Time deposits

9,687

15,008

17,430FHLB borrowings

3,577

3,616

3,759Junior subordinated debentures

546

1,016

1,476Other

412

637

821Total interest expense

17,187

23,526

27,585Net interest income

32,850

32,796

34,147Provision for loan losses

10,535

4,794

2,038Net interest income after provision for loan losses

22,315

28,002

32,109Other income:Service charges

5,573

5,203

4,278Other service charges and fees

2,058

2,399

1,938Gain (loss) on sale and write-down of securities

1,072

(167
)
(562
)Mortgage banking income

827

660

561Insurance and brokerage commissions

414

426

521Loss on sale and write-down ofother real estate and  repossessed assets

(501
)
(287
)
(118
)Miscellaneous

2,380

2,261

2,198Total other income

11,823

10,495

8,816Other expense:Salaries and employee benefits

14,758

15,194

13,888Occupancy

5,409

5,029

4,751Other

9,716

8,670

7,354Total other expenses

29,883

28,893

25,993Earnings before income taxes

4,255

9,604

14,932Income taxes

1,339

3,213

5,340Net earnings

2,916

6,391

9,592Dividends and accretion of preferred stock

1,246

-

-Net earnings available to common shareholders
$
1,670

6,391

9,592Basic earnings per common share
$
0.30

1.14

1.68Diluted earnings per common share
$
0.30

1.13

1.65Cash dividends declared per common share
$
0.26

0.48

0.41See accompanying notes to consolidated financial statements.
 
  A-35
   PEOPLES BANCORP OF NORTH CAROLINA, INC.Consolidated Statements of Changes in Shareholders' EquityFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)AccumulatedOtherStock Shares

Stock Amount

Retained

ComprehensivePreferred

Common

Preferred

Common

Earnings

Income (Loss)
TotalBalance, December 31, 2006

-

3,830,634

$
-

51,122

12,484

(771
)
62,8353 for 2 stock split

-

1,915,147


-

-

-

-

-Cash paid in lieu offractional shares

-

-


-

-

(3
)
-

(3
)Cash dividends declared

-

-


-

-

(2,331
)
-

(2,331
)Repurchase and retirement ofcommon stock

-

(150,497
)

-

(2,811
)
-

-

(2,811
)Exercise of stock options

-

28,950


-

239

-

-

239Stock option tax benefit

-

-


-

92

-

-

92Restricted stock/stock optioncompensation expense

-

-


-

10

-

-

10Net earnings

-

-


-

-

9,592

-

9,592Change in accumulated othercomprehensive income(loss), net of tax

-

-


-

-

-

2,479

2,479Balance, December 31, 2007

-

5,624,234


-

48,652

19,742

1,708

70,102Cumulative effect ofadoption of EITF 06-4

-

-


-

-

(467
)
-

(467
)Issuance of Series Apreferred stock

25,054

-


24,350

704

-

-

25,054Cash dividends declared oncommon stock

-

-


-

-

(2,681
)
-

(2,681
)Repurchase and retirement ofcommon stock

-

(90,500
)

-

(1,126
)
-

-

(1,126
)Exercise of stock options

-

5,322


-

44

-

-

44Restricted stock/stock optioncompensation expense

-

-


-

(5
)
-

-

(5
)Net earnings

-

-


-

-

6,391

-

6,391Change in accumulated othercomprehensive income(loss), net of tax

-

-


-

-

-

3,816

3,816Balance, December 31, 2008

25,054

5,539,056


24,350

48,269

22,985

5,524

101,128Adjustment to thecumulative effect ofadoption of EITF 06-4

-

-


-

-

358

-

358Accretion of Series Apreferred stock

-

-


126

-

(126
)
-

-Cash dividends declared onSeries A preferred stock

-

-


-

-

(1,120
)
-

(1,120
)Cash dividends declared oncommon stock

-

-


-

-

(1,440
)
-

(1,440
)Net earnings

-

-


-

-

2,916

-

2,916Change in accumulated othercomprehensive income(loss), net of tax

-

-


-

-

-

(2,619
)
(2,619
)Balance, December 31, 2009

25,054

5,539,056

$
24,476

48,269

23,573

2,905

99,223See accompanying notes to consolidated financial statements.
   A-36
   PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated Statements of Comprehensive IncomeFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)2009

2008

2007Net earnings
$
2,916

6,391

9,592Other comprehensive income:Unrealized holding gains on securitiesavailable for sale

214

2,145

1,965Reclassification adjustment for losses (gains) on salesand write-downs of securities available for saleincluded in net earnings

(1,072
)
167

562Unrealized holding gains (losses) on derivativefinancial instruments qualifying as cash flowhedges

(2,726
)
3,744

1,245Reclassification adjustment for gains onderivative financial instruments qualifying ascash flow hedges included in net earnings

(1
)
-

-Total other comprehensive income (loss),before income taxes

(3,585
)
6,056

3,772Income tax expense (benefit) related to othercomprehensive income:Unrealized holding gains on securitiesavailable for sale

83

836

765Reclassification adjustment for losses (gains) on salesand write-downs of securities available for saleincluded in net earnings

(417
)
65

219Unrealized holding gains (losses) on derivativefinancial instruments qualifying as cash flowhedges

(632
)
1,339

309Total income tax expense (benefit) related toother comprehensive income

(966
)
2,240

1,293Total other comprehensive income (loss),net of tax

(2,619
)
3,816

2,479Total comprehensive income
$
297

10,207

12,071See accompanying notes to consolidated financial statements.
   A-37
   PEOPLES BANCORP OF NORTH CAROLINA, INC.Consolidated Statements of Cash FlowsFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)2009

2008

2007Cash flows from operating activities:Net earnings
$
2,916

6,391

9,592Adjustments to reconcile net earnings tonet cash provided by operating activities:Depreciation, amortization and accretion

2,931

1,679

1,553Provision for loan losses

10,535

4,794

2,038Deferred income taxes

(1,720
)
(485
)
(480
)Loss (gain) on sale of investment securities

(1,795
)
(133
)
132Write-down of investment securities

723

300

430Gain on ineffective portion of derivative financialinstruments

(1
)
-

-Loss (gain) on sale of premises and equipment

(3
)
1

(10
)Loss on sale of repossessed assets

24

47

83Write-down of other real estate and repossessions

477

240

35Restricted stock/stock option compensation expense

4

12

10Origination of mortgage loans held for sale

(2,840
)
-

-Change in:Cash surrender value of life insurance

(263
)
(243
)
(244
)Other assets

(6,578
)
(20
)
(1,014
)Other liabilities

300

(1,851
)
2,404Net cash provided by operating activities

4,710

10,732

14,529Cash flows from investing activities:Purchases of certificates of deposit

(3,345
)
-

-Purchases of investment securities available for sale

(141,770
)
(41,659
)
(15,858
)Proceeds from calls and maturities of investment securitiesavailable for sale

40,629

16,488

7,471Proceeds from sales of investment securities availablefor sale

30,743

23,448

8,363Purchases of other investments

(1,426
)
(4,180
)
(8,357
)Proceeds from sale of other investments

809

4,311

8,424Net change in loans

(7,916
)
(65,188
)
(72,816
)Purchases of premises and equipment

(1,614
)
(1,857
)
(7,672
)Proceeds from sale of premises and equipment

24

34

56Proceeds from sale of repossessed assets

3,435

2,868

425Purchases of derivative financial instruments

-

-

(634
)Net cash used by investing activities

(80,431
)
(65,735
)
(80,598
)Cash flows from financing activities:Net change in deposits

88,281

27,424

59,818Net change in demand notes payable to U.S. Treasury

(964
)
-

-Net change in securities sold under agreement to repurchase

(625
)
9,917

21,165Proceeds from FHLB borrowings

24,100

97,100

275,300Repayments of FHLB borrowings

(24,100
)
(107,600
)
(277,100
)Proceeds from FRB borrowings

45,000

5,000

-Repayments of FRB borrowings

(50,000
)
-

-Proceeds from issuance of Series A preferred stock

-

25,054

-Proceeds from exercise of stock options

-

44

331Common stock repurchased

-

(1,126
)
(2,811
)Cash paid in lieu of fractional shares

-

-

(3
)Cash dividends paid on Series A preferred stock

(1,120
)
-

-Cash dividends paid on common stock

(1,440
)
(2,681
)
(2,331
)Net cash provided by financing activities

79,132

53,132

74,369Net change in cash and cash equivalent

3,411

(1,871
)
8,300Cash and cash equivalents at beginning of period

27,929

29,800

21,500Cash and cash equivalents at end of period
$
31,340

27,929

29,800
   A-38
   PEOPLES BANCORP OF NORTH CAROLINA, INC.Consolidated Statements of Cash Flows, continuedFor the Years ended December 31, 2009, 2008 and 2007(Dollars in thousands)2009

2008

2007Supplemental disclosures of cash flow information:Cash paid during the year for:Interest
$
17,541

23,799

27,420Income taxes
$
2,230

4,166

5,690Noncash investing and financing activities:Change in unrealized gain on investment securitiesavailable for sale, net
$
(524
)
1,411

1,543Change in unrealized gain on derivative financialinstruments, net
$
(2,095
)
2,405

936Transfer of loans to other real estate and repossessions
$
6,067

4,539

682Financed portion of sale of other real estate
$
1,166

1,133

-Reclassification of an investment from other assetsto securities available for sale
$
-

-

500Reclassification of a security from other investmentsto securities available for sale
$
-

-

600Accretion of Series A preferred stock
$
126

-

-Deferred gain rolled into cost basis ofacquired building
$
-

-

540Cumulative effect and resulting adjustment ofadoption of EITF 06-4
$
(358
)
467

-See accompanying notes to consolidated financial statements.
   A-39
  PEOPLES BANCORP OF NORTH CAROLINA, INC.
 
 Notes to Consolidated Financial Statements
  (1)
Summary of Significant Accounting Policies
 Organization
 
 Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999.  Bancorp is primarily regulated by the Board of Governors of the Federal Reserve System, and serves as the one-bank holding company for Peoples Bank (the “Bank").  Bancorp established a new subsidiary, Community Bank Real Estate Solutions, LLC (“Real Estate Solutions”), in 2009.
 
 The Bank commenced business in 1912 upon receipt of its banking charter from the North Carolina State Banking Commission (the “SBC”). The Bank is primarily regulated by the SBC and the Federal Deposit Insurance Corporation and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg, Iredell, Union and Wake counties in North Carolina.
 
 Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.
 
 Real Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.
 
 Real Estate Solutions is a wholly owned subsidiary of Bancorp and will serve as a “clearing house” for appraisal services for community banks.  Other banks are able to contract with Real Estate Solutions to find and engage appropriate appraisal companies in the area where property is located.
 
 Principles of Consolidation
 The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiaries, the Bank and Real Estate Solutions, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”).  All significant intercompany balances and transactions have been eliminated in consolidation.
 
 Basis of Presentation
 The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.
  Cash and Cash Equivalents
 Cash and due from banks, interest bearing deposits and federal funds sold are considered cash and cash equivalents for cash flow reporting purposes. Generally, federal funds are sold for one-day periods.
 
 Investment Securities
 The Company classifies its securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2009 and 2008, the Company classified all of its investment securities as available for sale.
 
 Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.
 
 Management evaluates investment securities for other-than-temporary impairment on an annual basis.  A decline in the market value of any investment below cost that is deemed other-than-temporary is charged to earnings for
 
 A-40
 
 the decline in value deemed to be credit related.  The decline in value attributed to non-credit related factors is recognized in comprehensive income and or new cost basis in the security is established.
 
 Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to the yield.  Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.
 
 Other Investments
 Other investments include equity securities with no readily determinable fair value.  These investments are carried at cost.
 
 Mortgage Loans Held for Sale
 Mortgage loans held for sale are carried at lower of aggregate cost or market value.  At December 31, 2009, the cost of mortgage loans held for sale approximates the market value.  The Company did not have any mortgage loans held for sale at December 31, 2008.
 
 Loans
 Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding.   The recognition of certain loan origination fee income and certain loan origination costs is deferred when such loans are originated and amortized over the life of the loan.
 
 Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected.
 
 Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings and interest is recognized on a cash basis when such loans are placed on non-accrual status.
 
 Allowance for Loan Losses
 The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
 
 ·
the Bank’s loan loss experience;
 ·
the amount of past due and non-performing loans;
 ·
specific known risks;
 ·
the status and amount of other past due and non-performing assets;
 ·
underlying estimated values of collateral securing loans;
 ·
current and anticipated economic conditions; and
 ·
other factors which management believes affect the allowance for potential credit losses.
 
 The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment.  When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral.  Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.
 
 The general allowance reflects reserves established under GAAP for collective loan impairment.  These reserves are based upon historical net charge-offs using the last three years’ experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.
  A-41
 
 The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.
 
 Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with GAAP and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.
 
 There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2009 as compared to the year ended December 31, 2008. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.
 
 Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.  Also, a loan review process further assists with evaluation credit quality and assessing potential performance issues.
 
 Mortgage Banking Activities
 Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Company’s origination of single-family residential mortgage loans.
 
 Mortgage servicing rights (“MSR's”) represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee.  MSRs are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans.  The Company recognized no servicing assets during 2009, 2008 and 2007.
 
 Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $6.6 million, $9.3 million and $12.1 million at December 31, 2009, 2008 and 2007, respectively.
 
 The Company originates certain fixed rate mortgage loans and commits these loans for sale.  The commitments to originate fixed rate mortgage loans and the commitments to sell these loans to a third party are both derivative contracts.  The fair value of these derivative contracts is immaterial and has no effect on the recorded amounts in the financial statements.
 
 Premises and Equipment
 Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for the period. The cost of maintenance and repairs that do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:
  Buildings and improvements

10 - 50  yearsFurniture and equipment

3 - 10 years
  Foreclosed Assets
 Foreclosed assets include all assets received in full or partial satisfaction of a loan and include real and personal property. Foreclosed assets are reported at the lower of carrying amount or net realizable value, and are included in other assets on the balance sheet.  The balance of other real estate owned was $4.0 million and $1.9 million at December 31, 2009 and 2008, respectively.
  A-42
 
 Income Taxes
 Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that the realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.
 
 In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.
 
 Derivative Financial Instruments and Hedging Activities
 In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.
 
 On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.
 
 If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.
 
 The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.
 
 Advertising Costs
 Advertising costs are expensed as incurred.
 
 Accumulated Other Comprehensive Income
 At December 31, 2009, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $1.8 million and net unrealized gains on derivatives of $1.1 million.  At December 31, 2008, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $2.3 million and net unrealized gains on derivatives of $3.2 million.
 
 Stock-Based Compensation
 The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “1999 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  The 1999 Plan expired on May 13, 2009.
 
 Under the Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant.  The options granted in 1999 vested over a five-year period.  Options granted subsequent to 1999 vest over a three-year period.
  A-43
 
 All options expire after ten years.  A summary of the activity in the Plan is presented below:
 
 Stock Option ActivityFor the years ended December 31, 2009, 2008 and 2007Shares
Weighted

Average Option

Price Per Share
Weighted Average

Remaining

Contractual Term (in

years)Outstanding, December 31, 2006

221,674

$
8.24Granted during the period

-

$
-Forfeited during the period

-

$
-Exercised during the period

(28,949
)
$
8.26Outstanding, December 31, 2007

192,725

$
8.24Granted during the period

-

$
-Forfeited during the period

(2,458
)
$
8.02Exercised during the period

(5,322
)
$
8.26Outstanding, December 31, 2008

184,945

$
8.24Granted during the period

-

$
-Expired during the period

(15,483
)
$
9.02Exercised during the period

-

$
-Outstanding, December 31, 2009

169,462

$
8.17

2.30Exercisable, December 31, 2009

169,462

$
8.17

2.30
  Options outstanding at December 31, 2009 are exercisable at option prices ranging from $6.99 to $10.57.  As of December 31, 2009, the exercise price on options outstanding is more than the current market value; therefore, options outstanding as of December 31, 2009 have no intrinsic value.  Such options have a weighted average remaining contractual life of approximately two years.
 
 The Company recognized compensation expense for employee stock options and restricted stock awards of $4,000, $12,000 and $10,000 for the years ended December 31, 2009, 2008 and 2007, respectively.  As of December 31, 2009 and 2008, there was no unrecognized compensation cost related to nonvested employee stock options.
 
 No options were granted during the years ended December 31, 2009 and 2008.  There were no options exercised during the year ended December 31, 2009.  The total intrinsic value (amount by which the fair market value of the underlying stock exceeds the exercise price of an option on exercise date) of options exercised during the year ended December 31, 2008 was $26,000.  Cash received from option exercises for the year ended December 31, 2008 was $44,000.  There were no tax deductions from options exercised for the years ended December 31, 2009 and 2008.
 
 The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock at a grant date fair value of $12.80 per share during third quarter 2008 and 2,000 shares of restricted stock at a fair value of $11.37 per share during fourth quarter 2008. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date).  The amount of expense recorded each period reflects the changes in the Company’s stock price during the period.  As of December 31, 2009 and 2008, there was $14,000 and $47,000 of total unrecognized compensation cost related to restricted stock grants, respectively, which is expected to be recognized over a period of three years.
 
 The Company has a new Omnibus Stock Ownership and Long Term Incentive Plan, which was approved by shareholders’ on May 7, 2009 (the “2009 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  A total of 360,000 shares are currently reserved for possible issuance under the 2009 Plan.   All rights must be granted or awarded within ten years from the May 7, 2009 effective date of the 2009 Plan.  The Company has not granted any rights under this plan.
  A-44
 
 Net Earnings Per Share
 Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share. The average market price during the year is used to compute equivalent shares.
 
 The reconciliations of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the years ended December 31, 2009, 2008 and 2007 are as follows:
 
 For the year ended December 31, 2009:
Net Earnings Available to Common Shareholders (Dollars in thousands)

Common

Shares

Per Share

AmountBasic earnings per common share
$
1,670

5,539,056

$
0.30Effect of dilutive securities:Stock options

-

3,681Diluted earnings per common share
$
1,670

5,542,737

$
0.30For the year ended December 31, 2008:
Net Earnings Available to Common Shareholders (Dollars in thousands)

Common

Shares

Per Share

AmountBasic earnings per common share
$
6,391

5,588,314

$
1.14Effect of dilutive securities:Stock options

-

58,980Diluted earnings per common share
$
6,391

5,647,294

$
1.13For the year ended December 31, 2007:
Net Earnings Available to Common Shareholders (Dollars in thousands)

Common

Shares

Per Share

AmountBasic earnings per common share
$
9,592

5,700,860

$
1.68Effect of dilutive securities:Stock options

-

109,455Diluted earnings per common share
$
9,592

5,810,315

$
1.65
  Recent Accounting Pronouncements
 In April 2009, the Financial Accounting Standards Board (“FASB”) issued new authoritative guidance under the following two ASC's intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairment of securities:
  ASC Topic 820 (formerly FASB Staff Position (FSP) FAS 157-4), “Fair Value Measurements and Disclosures,” provides additional guidance for estimating fair value in accordance with ASC Topic 820 when the volume and level of activity for the asset or liability have decreased significantly.  ASC Topic 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly.  The provisions of ASC Topic 820 were effective for the period ended March 31, 2009 and did not have a significant effect on the Company's condensed consolidated financial statements.
  ASC Topic 320 (formerly FSP FAS 115-2 and FAS 124-2), “Investments – Debt and Equity Securities,” amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements.  This ASC Topic 320 does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities.   The Company adopted the provisions of ASC Topic 320 as of June 30, 2009 and it did not have a significant effect on the Company's condensed consolidated financial statements.
  A-45
  In June 2009, the FASB issued new authoritative guidance under ASC Topic 860 (formerly Statement No. 166) “Transfers and Servicing,” to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. ASC Topic 860 eliminates the concept of a "qualifying special-purpose entity" and changes the requirements for derecognizing financial assets. ASC Topic 860 also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative guidance under ASC Topic 860 will be effective January 1, 2010 and is not expected to have a significant impact on the Company's consolidated financial statements.
  In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” (SFAS 167)to amend certain requirements of FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements.  SFAS 167 will remain authoritative until integrated into FASB Codification.  SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  SFAS 167 has not had any effect on the Company's financial position, results of operations or disclosures.
 
 In June 2009, the FASB issued Accounting Standards Update No. 2009-01 (“ASU 2009-01”), “Topic 105 – Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards No. 168 – The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.”  ASU 2009-01 amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 168 (“SFAS 168”), “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.”  ASU 2009-1 includes SFAS 168 in its entirety, including the accounting standards update instructions contained in Appendix B of the Statement.  The FASB Accounting Standards Codification TM (“Codification”) became the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards.  All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement was effective for the Company’s financial statements beginning in the interim period ended September 30, 2009.
 
 Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts.  Instead, it will issue Accounting Standards Updates.  The FASB does not consider Accounting Standards Updates as authoritative in their own right.  Accounting Standards Updates serve only to update the Codification, provide background information about the guidance, and provide the basis for conclusions on the change(s) in the Codification.  FASB Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles”, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with GAAP.  Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly.  Upon becoming effective, all of the content of the Codification carries the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy has been modified to include only two levels of GAAP: authoritative and non-authoritative.  As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy.  The adoption of the Codification and ASU 2009-01 did not have any effect on the Company’s results of operations or financial position.  All references to accounting literature included in the notes to the financial statements have been changed to reference the appropriate sections of the Codification.
 
 In June 2009, the FASB issued Accounting Standards Update No. 2009-02 (“ASU 2009-02”), “Omnibus Update – Amendments to Various Topics for Technical Corrections.”  The adoption of ASU 2009-02 did not have a material effect on the Company’s results of operations, financial position or disclosures.
 
 In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (“ASU 2009-05”), “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value.”  ASU 2009-05 applies to all entities that measure liabilities at fair value within the scope of ASC Topic 820.  ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following techniques:
 
 1)  A valuation technique that uses:
 a.  The quoted price of the identical liability when traded as an asset
 b.  Quoted prices for similar liabilities or similar liabilities when traded as assets.
  A-46
 
 2)  Another valuation technique that is consistent with the principles of ASC Topic 820.  Two examples would be an income approach, such as a technique
 that is based on the amount at the measurement date that the reporting entity would pay to transfer the identical liability or would receive to enter into the
 identical liability.
 
 The amendments in ASU 2009-5 also clarify that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability.  It also clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements.  The guidance provided in ASU 2009-5 became effective for the Company in the fourth quarter of 2009.  Because the Company does not currently have any liabilities that are recorded at fair value, the adoption of this guidance did not have any impact on results of operations, financial position or disclosures.
 
 ASU 2009-12, “Fair Value Measurements and Disclosures (Topic 820) - Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent),” issued in September, 2009, allows a company to measure the fair value of an investment that has no readily determinable fair market value on the basis of the investee's net asset value per share as provided by the investee. This allowance assumes that the investee has calculated net asset value in accordance with the GAAP measurement principles of Topic 946 as of the reporting entity's measurement date.   Examples of such investments include investments in hedge funds, private equity funds, real estate funds and venture capital funds. The update also provides guidance on how the investment should be classified within the fair value hierarchy based on the value for which the investment can be redeemed.  The amendment is effective for interim and annual periods ending after December 15, 2009 with early adoption permitted.  The Company does not have investments in such entities and, therefore, there is no impact to our financial statements.
 
 ASU 2009-13, “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force” was issued in October, 2009 and provides guidance on accounting for products or services (deliverables) separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable.  The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price.  The amendments in the Update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted.  The Company does not expect the update to have an impact on its financial statements.
 
 Issued October, 2009, ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance.  At the date of issuance, a share-lending arrangement entered into on an entity's own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital.  Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs.  The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement.  The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009.   The Company has no plans to issue convertible debt and, therefore, the update to had no impact on its financial statements at December 31, 2009.
 
 In December 2009, the FASB issued Accounting Standards Update No. 2009-16 (“ASU 2009-16”), “Accounting for Transfers of Financial Assets”.  ASU No. 2009-16 formally incorporates into the FASB Codification amendments to SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, made by SFAS No. 166 “Accounting for Transfers of Financial Assets”, an amendment of FASB Statement No. 140, primarily to 1.)  eliminate the concept of a qualifying special-purpose entity, 2.)  limit the circumstances under which a financial asset should be derecognized when the entire financial asset has not been transferred to a non-consolidated entity, 3.)  requires additional disclosures concerning a transferor’s continuing involvement with transferred financial assets and 4.)  requires that all servicing assets and liabilities be measured at fair value.  This guidance is effective as of the start of the first annual and interim reporting periods.  ASU No. 2009-19 is not expected to have a material impact on the Company’s results of operations, financial position or disclosures; however the Company will need to review future loan participation agreements and other transfers of financial assets for compliance with the new standard.
  In December 2009, the FASB issued Accounting Standards Update No. 2009-17 (“ASU 2009-17”), “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”.  ASU No. 2009-
 
 A-47
 
 17 formally incorporates into the FASB Codification amendments to FASB Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities”, made by SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” to require that a comprehensive qualitative analysis be performed to determine whether a holder of variable interests in a variable interest entity also has a controlling financial interest in the entity.  In addition, the amendments require that the same type of analysis be applied to entities that were previously designated as qualified special-purpose entities.  This ASU is effective as of the start of the first annual reporting period beginning after November 15, 2009, for interim periods within the first annual reporting period and for all subsequent annual and interim reporting periods.  ASU No. 2009-17 is not expected to have a material impact on the Company’s financial position, results of operations or disclosures.
 
 In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASU 2010-06”), “Improving Disclosures about Fair Value Measurements”.  ASU No. 2010-06 amends FASB Accounting Standards Codification topic 820-10-50, “Fair Value Measurements and Disclosures”, to require additional information to be disclosed principally regarding Level 3 measurements and transfers to Level 1 and 2.  In addition, enhanced disclosure is required concerning inputs and valuation techniques used to determine Level 2 and Level 3 measurements.  This guidance is generally effective for interim and annual reporting periods beginning with December 15, 2009; however requirements to disclose separately purchases, sales, issuances and settlements in the Level 3 reconciliation are effective for fiscal years beginning after December 15, 2010 (and for interim periods within such years).  ASU No. 2010-06 is not expected to have a material impact on the Company’s financial position or results of operations, and will have a minimal impact on its disclosures.
 
 Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations or cash flows.
  (2)
Investment Securities
  Investment securities available for sale at December 31, 2009 and 2008 are as follows:
  (Dollars in thousands)December 31, 2009Amortized

Cost

Gross

Unrealized

Gains

Gross

Unrealized

Losses

Estimated Fair

ValueMortgage-backed securities
$
105,915

1,830

219

107,526U.S. governmentsponsored enterprises

40,259

934

51

41,142State and political subdivisions

43,460

1,065

189

44,336Trust preferred securities

1,250

-

-

1,250Equity securities

1,233

-

372

861Total
$
192,117

3,829

831

195,115December 31, 2008Amortized

Cost

Gross

Unrealized

Gains

Gross

Unrealized

Losses

Estimated Fair

ValueMortgage-backed securities
$
36,557

854

140

37,271U.S. governmentsponsored enterprises

55,223

3,266

2

58,487State and political subdivisions

26,648

460

135

26,973Trust preferred securities

1,250

-

-

1,250Equity securities

1,382

-

447

935Total
$
121,060

4,580

724

124,916
  The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2009 and 2008 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.
  A-48
   (Dollars in thousands)December 31, 2009Less than 12 Months

12 Months or More

TotalFair Value
Unrealized

Losses

Fair Value
Unrealized

Losses

Fair Value
Unrealized

LossesMortgage-backed securities
$
16,970

219

-

-

16,970

219U.S. governmentsponsored enterprises

8,683

51

-

-

8,683

51State and political subdivisions

9,249

182

153

7

9,402

189Equity securities

-

-

861

372

861

372Total
$
34,902

452

1,014

379

35,916

831December 31, 2008Less than 12 Months

12 Months or More

TotalFair Value
Unrealized

Losses

Fair Value
Unrealized

Losses

Fair Value
Unrealized

LossesMortgage-backed securities
$
10,017

140

-

-

10,017

140U.S. governmentsponsored enterprises

-

-

614

2

614

2State and political subdivisions

2,748

75

2,373

60

5,121

135Equity securities

528

72

407

375

935

447Total
$
13,293

287

3,394

437

16,687

724
   At December 31, 2009, unrealized losses in the investment securities portfolio relating to debt securities totaled $459,000.  The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary.  From the December 31, 2009 tables above, 17 out of 99 securities issued by state and political subdivisions contained unrealized losses and 13 out of 92 securities issued by U.S. government sponsored enterprises, including mortgage-backed securities, contained unrealized losses.  These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.
 
 The Company periodically evaluates its investments for any impairment which would be deemed other than temporary.   As part of its evaluation in 2009, the Company determined that the fair values of three investments were less than the original cost of the investments and that the decline in fair value was not temporary in nature.  As a result, the Company wrote down its original investments by $723,000.  The remaining fair value of the investments at December 31, 2009 was $11,000.  Similarly, as part of its evaluation in 2008, the Company wrote down one investment by $300,000.  The remaining fair value of the investments at December 31, 2008 was $22,000.
 
 The amortized cost and estimated fair value of investment securities available for sale at December 31, 2009, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
 A-49
   (Dollars in thousands)Amortized

Cost

Estimated Fair

ValueDue within one year
$
2,566

2,584Due from one to five years

22,725

23,396Due from five to ten years

34,161

34,824Due after ten years

25,517

25,924Mortgage-backed securities

105,915

107,526Equity securities

1,233

861Total
$
192,117

195,115
    Proceeds from sales of securities available for sale during 2009 were $30.7 million and resulted in a gross gain of $1.8 million.  During 2008 and 2007, the proceeds from sales of securities available for sale were $23.4 million and $8.4 million, respectively.  Gross gains of $160,000 for 2008 and gross losses of $132,000 for 2007 were realized on those sales.
 
 Securities with a fair value of approximately $69.6 million and $65.2 million at December 31, 2009 and 2008, respectively, were pledged to secure public deposits and for other purposes as required by law.
 
 GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is a three-level fair value hierarchy for fair value measurements.  Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability.  The table below presents the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of December 31, 2009 and 2008.
 
  (Dollars in thousands)Fair Value

Measurements

December 31, 2009

Level 1

Valuation

Level 2

Valuation

Level 3

ValuationInvestment securities available for sale
$
195,115

861

193,004

1,250Mortgage loans held for sale
$
2,840

-

2,840

-Market value of derivatives (in other assets)
$
1,762

-

1,762

-Fair Value

Measurements

December 31, 2008

Level 1

Valuation

Level 2

Valuation

Level 3

ValuationInvestment securities available for sale
$
124,916

935

122,731

1,250Market value of derivatives (in other assets)
$
4,981

-

4,981

-
 
 Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available.  If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.  Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.
  A-50
 
 The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2009:
 
  (Dollars in thousands)Investment Securities Available for SaleLevel 3 ValuationBalance, beginning of period
$
1,250Change in book value

-Change in gain/(loss) realized and unrealized

-Purchases/(sales)

-Transfers in and/or out of Level 3

-Balance, end of period
$
1,250Change in unrealized gain/(loss) for assets still held in Level 3
$
-
   (3)
Loans
 
 
 Major classifications of loans at December 31, 2009 and 2008 are summarized as follows:
 
 (Dollars in thousands)2009

2008Commercial
$
67,487

76,945Real estate - mortgage

512,963

474,732Real estate - construction

169,680

216,188Consumer

27,926

13,323Total loans

778,056

781,188Less allowance for loan losses

15,413

11,025Total net loans
$
762,643

770,163
  The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties of North Carolina.  Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.
  At each reporting period, the Company determines which loans are impaired.  Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis.  An allowance for each impaired loan, which are generally collateral-dependent, is calculated based on the fair value of its collateral.  The fair value of the collateral is based on appraisals performed by third-party valuation specialists.  Factors including the assumptions and techniques utilized by the appraiser are considered by Management.  If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.
 The Company’s December 31, 2009 and 2008 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:
 
 (Dollars in thousands)Fair Value Measurements December 31, 2009

Level 1

Valuation

Level 2

Valuation

Level 3

Valuation

Total Gains/(Losses) for

the Year Ended

December 31, 2009Impaired loans
$
15,958

-

14,174

1,784

(1,924)Other real estate
$
3,997

-

3,997

-

(100)Fair Value Measurements December 31, 2008

Level 1

Valuation

Level 2

Valuation

Level 3

Valuation

Total Gains/(Losses) for

the Year Ended

December 31, 2008Impaired loans
$
7,073

-

5,903

1,170

(345)Other real estate
$
1,867

-

1,867

-

(166)
   A-51
 
 The Company has specific loan loss reserves for loans that management has determined to be impaired.  These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the expected cash flow or appraised value of any underlying collateral.  At December 31, 2009 and 2008, the recorded investment in loans that were considered to be impaired was approximately $16.6 million and $7.5 million, respectively. In addition, the Company had approximately $2.0 million and $514,000 in loans past due more than ninety days and still accruing interest at December 31, 2009 and 2008, respectively.  The Company had specific reserves on impaired loans of $673,000 and $462,000 at December 31, 2009 and 2008, respectively. The average recorded investment in impaired loans for the twelve months ended December 31, 2009 and 2008 was approximately $15.0 million and $8.8 million, respectively. For the years ended December 31, 2009, 2008 and 2007, the Company recognized approximately $53,000, $57,000 and $29,000, respectively, of interest income on impaired loans.
  Changes in the allowance for loan losses were as follows:
 
 (Dollars in thousands)2009

2008

2007Balance at beginning of year
$
11,025

9,103

8,303Amounts charged off

(6,670
)
(3,147
)
(1,626
)Recoveries on amounts previously charged off

523

275

388Provision for loan losses

10,535

4,794

2,038Balance at end of year
$
15,413

11,025

9,103
   (4)
Premises and Equipment
  Major classifications of premises and equipment are summarized as follows:
 
 (Dollars in thousands)2009

2008Land
$
3,581

3,573Buildings and improvements

14,737

14,709Furniture and equipment

18,624

17,156Total premises and equipment

36,942

35,438Less accumulated depreciation

18,995

17,141Total net premises and equipment
$
17,947

18,297
  Depreciation expense was approximately $1.9 million for the year ended December 31, 2009.  The Company recognized approximately $1.8 and $1.7 million in depreciation expense for the years ended December 31, 2008 and 2007.
  (5)
Time Deposits
 
 
 At December 31, 2009, the scheduled maturities of time deposits are as follows:
 
 (Dollars in thousands)2010
$
292,5632011

38,8492012

66,7002013

1,0502014 and thereafter

2,272Total
$
401,434
  A-52
 
 At December 31, 2009 and 2008, the Company has approximately $84.0 million and $61.0 million, respectively, in time deposits purchased through third party brokers.  The weighted average rate of brokered deposits as of December 31, 2009 and 2008 was 1.90% and 3.25%, respectively.
  (6)
Federal Home Loan Bank and Federal Reserve Bank Borrowings
 
 
 The Bank has borrowings from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly or quarterly interest payments at December 31, 2009. The FHLB borrowings are collateralized by a blanket assignment on all residential first mortgage loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns.  At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $147.0 million.  As additional collateral, the Bank has pledged securities to FHLB.  At December 31, 2009, the market value of securities pledged to FHLB totaled $7.5 million.
 
 Borrowings from the FHLB outstanding at December 31, 2009 consist of the following:
 
 (Dollars in thousands)Maturity Date

Call Date

Rate

Rate Type

AmountMarch 30, 2010

September 30, 2000 and everythree months thereafter

5.880%

Convertible

$
5,000May 24, 2010

May 24, 2001 and every threemonths thereafter

6.490%

Convertible


2,000June 24, 2015

June 24, 2010

3.710%

Convertible


5,000March 25, 2019

N/A

4.260%

Fixed


5,000March 31, 2016

March 31, 2009 and every threemonths thereafter

4.620%

Convertible


5,000October 5, 2016

N/A

4.450%

Convertible


5,000December 12, 2011

December 12, 2007 and every

4.210%

Convertible


5,000three months thereafterJanuary 30, 2017

October 30, 2008 and every

4.500%

Convertible


5,000three months thereafterJune 8, 2017

December 8, 2008 and every

4.713%

Convertible


15,000three months thereafterJune 9, 2014

February 11, 2008 and every

4.685%

Convertible


15,000month thereafterJuly 11, 2017

January 11, 2008 and every

4.440%

Convertible


5,000three months thereafterJuly 24, 2017

April 24, 2008 and every

4.420%

Convertible


5,000month thereafter$
77,000
  The FHLB has the option to convert $72.0 million of the total borrowings to a floating rate and, if converted, the Bank may repay borrowings without payment of a prepayment fee.  The Company also has an additional $5.0 million in an advance that has been converted to a fixed rate by the FHLB, which may be repaid with a prepayment fee.
 
 The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. At December 31, 2009 and 2008, the Bank owned FHLB stock amounting to $5.5 million and $5.1 million, respectively.
 
 As of December 31, 2009, the Bank had no borrowings from the Federal Reserve Bank (“FRB”).  The Bank had $5.0 million in borrowings from the FRB at December 31, 2008. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009.  The FRB borrowings are collateralized
 
 A-53
 
 by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $428.2 million.
  (7)
Junior Subordinated Debentures
  In June 2006, the Company formed a second wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures.  All of the common securities of PEBK Trust II are owned by the Company.  The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points.  The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes.  The debentures represent the sole asset of PEBK Trust II.  PEBK Trust II is not included in the consolidated financial statements.
 
 The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points.  The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments.  The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.
 
 These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture.  The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011.  As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.
  (8)
Income Taxes
  The provision for income taxes in summarized as follows:
  (Dollars in thousands)2009


2008


2007Current
$
3,059


3,698


5,820Deferred

(1,720
)

(485
)

(480
)Total
$
1,339


3,213


5,340
  The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:
  (Dollars in thousands)2009

2008

2007Pre-tax income at statutory rates (34%)
$
1,447

3,265

5,077Differences:Tax exempt interest income

(429
)
(313
)
(307
)Nondeductible interest and other expense

38

60

56Cash surrender value of life insurance

(89
)
(83
)
(83
)State taxes, net of federal benefits

100

257

560Nondeductible capital losses

234

-

-Other, net

38

27

37Total
$
1,339

3,213

5,340
  The following summarized the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities.  The net deferred tax asset is included as a component of other assets at December 31, 2009 and 2008.
  A-54
 (Dollars in thousands)2009

2008Deferred tax assets:Allowance for loan losses
$
5,942

4,281Amortizable intangible assets

11

44Accrued retirement expense

987

1,184Income from non-accrual loans

14

37Other

112

-Total gross deferred tax assets

7,066

5,546Deferred tax liabilities:Deferred loan fees

1,404

1,654Premises and equipment

328

194Unrealized gain on available for sale securities

1,168

1,502Unrealized gain on cash flow hedges

686

1,319Other

-

84Total gross deferred tax liabilities

3,586

4,753Net deferred tax asset
$
3,480

793
  (9)
Related Party Transactions
 
 The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers are made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2009:
 
 (Dollars in thousands)Beginning balance
$
5,658New loans

5,217Repayments

4,935Ending balance
$
5,940
  At December 31, 2009 and 2008, the Company had deposit relationships with related parties of approximately $17.2 million and $20.0 million, respectively.
  
 (10)
Commitments and Contingencies
 
 The Company leases various office spaces for banking and operational facilities and equipment under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2009 are as follows:
 
 (Dollars in thousands)Year ending December 31,2010
$
6532011

5902012

4662013

2562014

242Thereafter

1,652Total minimum obligation
$
3,859
  Total rent expense was approximately $922,000, $1.0 million and $1.1 million for 2009, 2008 and 2007, respectively.
  A-55
 
 The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees.  Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.  The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
 
 The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
 
 In most cases, the Company requires collateral or other security to support financial instruments with credit risk.
 
 (Dollars in thousands)Contractual Amount2009

2008Financial instruments whose contract amount represent credit risk:Commitments to extend credit
$
140,207

158,939Standby letters of credit and financial guarantees written
$
3,302

4,316
  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $143.5 million does not necessarily represent future cash requirements.
 
 Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Company’s delineated market area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.
 
 In the normal course of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Bank or the Company.
 
 The Company has employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive stock option, and change in control provisions.
 
 The Company has $40.5 million available for the purchase of overnight federal funds from four correspondent financial institutions.
  (11)
Derivative Financial Instruments and Hedging Transactions
  Accounting Policy for Derivative Instruments and Hedging Activities
 The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
 
 The Company records all derivatives on the balance sheet at fair value.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the
 
 A-56
 
 hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.  The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
 
 Risk Management Objective of Using Derivatives
 The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  By using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company.  As of December 31, 2009, the Company had a cash flow hedge with a notional amount of $50.0 million.  This derivative instrument consists of one interest rate swap contract.
 
 Fair Values of Derivative Instruments on the Balance Sheet
 The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of December 31, 2009 and 2008.
 
 (Dollars in thousands)Asset DerivativesAs of December 31, 2009

As of December 31, 2008Balance Sheet

Location

Fair Value

Balance Sheet

Location

Fair ValueInterest rate derivative contracts
Other assets

$
1,762

Other assets

$
4,981
  Cash Flow Hedges of Interest Rate Risk
 The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy.  For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate loan assets, the interest rate floors designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium.  As of December 31, 2009, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.
 
 The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings.  During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings.  The Company recognized hedge ineffectiveness gains of $1,000 in earnings during the year ended December 31, 2009.
 
 Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next twelve months, the Company estimates that $1.4 million will be reclassified as an increase to interest income.
  A-57
 
 Effect of Derivative Instruments on the Income Statement
 The table below presents the effect of the Company’s derivative financial instruments on the Income Statement for the years ended December 31, 2009 and 2008.
 
  (Dollars in thousands)Amount of Gain

(Loss) Recognized in

OCI on Derivatives

Location of Gain

(Loss) Reclassified

from Accumulated

OCI into Income

Amount of Gain

(Loss) Reclassified

from Accumulated

OCI into IncomeYears ended

December 31,



Years ended

December 31,2009

2008



2009

2008Interest rate derivative contracts

$
434

$
7,147

Interest income

$
3,114

$
3,403Non-interest income

$
46

$
-
  (12)
Employee and Director Benefit Programs
  The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under this plan, the Company matches employee contributions to a maximum of five percent of annual compensation. The Company’s contribution pursuant to this formula was approximately $482,000, $483,000 and $424,000 for the years 2009, 2008 and 2007, respectively. Investments of the plan are determined by the compensation committee consisting of selected outside directors and senior executive officers. No investments in Company stock have been made by the plan. The vesting schedule for the plan begins at 20 percent after two years of employment and graduates 20 percent each year until reaching 100 percent after six years of employment.
 
 In December 2001, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries.  Under the plan, the Company purchased life insurance contracts on the lives of the key officers and each director.  The increase in cash surrender value of the contracts constitutes the Company’s contribution to the plan each year.  Plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to this plan were approximately $609,000, $365,000 and $258,000 during 2009, 2008 and 2007, respectively.
 
 The Company is currently paying medical benefits for certain retired employees. Postretirement benefits expense, including amortization of the transition obligation, as applicable, was approximately $23,000 for the years ended December 31, 2009, 2008 and 2007.
 
 The following table sets forth the change in the accumulated benefit obligation for the Company’s two postretirement benefit plans described above:
 
 (Dollars in thousands)2009Benefit obligation at beginning of period
$
1,779Service cost

500Interest cost

105Benefits paid

(29
)Benefit obligation at end of period
$
2,355
  The amounts recognized in the Company’s consolidated balance sheet as of December 31, 2009 are shown in the following two tables:
 
 (Dollars in thousands)2009Benefit obligation
$
2,355Fair value of plan assets

-
   A-58
   (Dollars in thousands)2009Funded status
$
(2,355
)Unrecognized prior service cost/benefit

-Unrecognized net actuarial loss

-Net amount recognized
$
(2,355
)Unfunded accrued liability
$
(2,355
)Intangible assets

-Net amount recognized
$
(2,355
)
  Net periodic benefit cost of the Company’s two post retirement benefit plans for the year ended December 31, 2009 consisted of the following:
 
 (Dollars in thousands)2009Service cost
$
500Interest cost

105Net periodic cost
$
605Weighted average discount rate assumption used todetermine benefit obligation

6.66%
  During the year ended December 31, 2009, the Company paid benefits totaling $46,000.  Information about the expected benefit payments for the Company’s two postretirement benefit plans is as follows:
 
 (Dollars in thousands)Year ending December 31,2010
$
492011
$
822012
$
1972013
$
2022014
$
226Thereafter
$
9,284
  Members of the Board of Directors are eligible to participate in the Company’s Omnibus Stock Ownership and Long Term Incentive Plan (the “Stock Benefits Plan”).  Each director has been awarded 9,737 book value shares (adjusted for stock dividends and stock splits) under the Stock Benefits Plan.  The book value of the shares awarded range from $6.31 to $8.64.  All book value shares were fully vested on May 6, 2009 and were exercised subsequently.  The Company recorded expenses of approximately $59,000, $136,000 and $159,000 associated with the benefits of this plan in the years ended December 31, 2009, 2008 and 2007, respectively.
  A-59
 
 A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2009, 2008 and 2007 is presented below.
 
 2009

2008

2007Shares


Weighted Average

Price of

Book Value Shares

Shares

Weighted Average

Price of

Book Value

Shares

Shares

Weighted Average

Price of

Book Value

SharesOutstanding, beginning of period
97,377


$
7.38

97,377

$
7.38

97,377

$
7.38Exercised during the period
(97,377
)

$
7.38

-

$
-

-

$
-Outstanding, end of period
-


$
-

97,377

$
7.38

97,377

$
7.38Number of shares exercisable
-


$
-

89,580

$
7.27

81,791

$
7.89
  The Company has a new Omnibus Stock Ownership and Long Term Incentive Plan, which was approved by shareholders’ on May 7, 2009 (the “2009 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees.  A total of 360,000 shares are currently reserved for possible issuance under the 2009 Plan.   All rights must be granted or awarded within ten years from the May 7, 2009 effective date of the 2009 Plan.  The Company has not granted any rights under this plan.
 
 Relating to the post retirement benefit plan, the Company is required to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years.  The Company made a $467,000 reduction to retained earnings in 2008 pursuant to the guidance of the pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement.   In 2009 the Company made a $358,000 addition to retained earnings to reflect an adjustment of the cumulative effect due to policy amendments to the individual split-dollar plans implemented during 2009.
  (13)
Regulatory Matters
 
 The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
 Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 Capital consists of the allowance for loan losses up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2009, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
 
 As of December 31, 2009, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
  A-60
 
 The Company’s and the Bank’s actual capital amounts and ratios are presented below:
 
 (Dollars in thousands)Actual

For Capital

Adequacy Purposes

To Be Well

Capitalized Under

Prompt Corrective

Action ProvisionsAmount

Ratio

Amount

Ratio

Amount

RatioAs of December 31, 2009:Total Capital (to Risk-Weighted Assets)Consolidated
$
126,689

15.00%

67,586

8.00%

N/A

N/ABank
$
105,217

12.48%

67,444

8.00%

84,305

10.00%Tier 1 Capital (to Risk-Weighted Assets)Consolidated
$
116,091

13.74%

33,793

4.00%

N/A

N/ABank
$
94,619

11.22%

33,722

4.00%

50,583

6.00%Tier 1 Capital (to Average Assets)Consolidated
$
116,091

11.42%

40,650

4.00%

N/A

N/ABank
$
94,619

9.33%

40,581

4.00%

50,726

5.00%As of December 31, 2008:Total Capital (to Risk-Weighted Assets)Consolidated
$
125,871

14.90%

67,589

8.00%

N/A

N/ABank
$
93,530

11.10%

67,411

8.00%

84,264

10.00%Tier 1 Capital (to Risk-Weighted Assets)Consolidated
$
115,332

13.65%

33,794

4.00%

N/A

N/ABank
$
82,991

9.85%

33,705

4.00%

50,558

6.00%Tier 1 Capital (to Average Assets)Consolidated
$
115,332

12.40%

37,192

4.00%

N/A

N/ABank
$
82,991

8.94%

37,137

4.00%

46,421

5.00%
   (14)
Shareholders' Equity
  In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008.  The Company repurchased 50,497 shares, or $873,000, of its common stock under this plan during 2007.  The Company repurchased 25,000 shares, or $350,000, of its common stock under this plan during 2008. The Board of Directors ratified the purchase of 497 additional shares in March 2008.
 
 In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009.  The Company repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008.  Because of the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”), discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without United States Department of the Treasury (“UST”) approval.
 
 The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.
 
 On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the UST.  Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the CPP under the Troubled Asset Relief Program (“TARP”).  Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale.  Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant.  The discount recorded on the preferred stock that resulted
 
 A-61
 
 from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield.  As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock.  The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000.  The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate.  Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things.  Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.
 
 The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter.  The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends.  Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital.  However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator.  The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.
 
 The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.
 
 The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000.  There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.
 
 The Board of Directors of the Bank may declare a dividend of all of its retained earnings as it may deem appropriate, subject to the requirements of the General Statutes of North Carolina, without prior approval from the requisite regulatory authorities. As of December 31, 2009, this amount was approximately $41.4 million.
  (15)
Other Operating Expense
 
 Other operating expense for the years ended December 31 included the following items that exceeded one percent of total revenues:
 
 (Dollars in thousands)2009

2008

2007Advertising
$
860

1,076

988FDIC insurance
$
1,766

547

140Visa debit card expense
$
1,064

761

666Telephone
$
616

476

405
  (16)
Fair Value of Financial Instruments
  The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.
  A-62
 
 Cash and Cash Equivalents
 For cash, due from banks, interest bearing deposits and federal funds sold, the carrying amount is a reasonable estimate of fair value.
 
 Certificates of Deposit
 The carrying amount of certificates of deposits is a reasonable estimate of fair value.
 
 Investment Securities Available for Sale
 Fair values for investment securities are based on quoted market prices.
 
 Other Investments
 For other investments, the carrying value is a reasonable estimate of fair value.
 
 Mortgage Loans Held for Sale
 Mortgage loans held for sale are carried at lower of aggregate cost or market value.  The cost of mortgage loans held for sale approximates the market value.
 
 Loans
 The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.
 
 Cash Surrender Value of Life Insurance
 For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.
 
 Derivative Instruments
 For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.
 
 Deposits and Demand Notes Payable
 The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.
 
 Securities Sold Under Agreements to Repurchase
 For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.
 
 FHLB and Short-term FRB Borrowings
 The fair value of FHLB and FRB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.
 
 Junior Subordinated Debentures
 Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.
 
 Commitments to Extend Credit and Standby Letters of Credit
 Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.
 
 Limitations
 Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
  A-63
 
 Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
 
 The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2009 and 2008 are as follows:
 
  December 31, 2009

December 31, 2008Carrying

Amount

Estimated

Fair Value

Carrying Amount

Estimated

Fair Value(dollars in thousands)Assets:Cash and cash equivalents
$
31,340

31,340

27,929

27,929Certificates of deposit
$
3,345

3,345

-

-Investment securities available for sale
$
195,115

195,115

124,916

124,916Other investments
$
6,346

6,346

6,303

6,303Mortgage loans held for sale
$
2,840

2,840

-

-Loans, net
$
762,643

763,939

770,163

773,256Cash surrender value of life insurance
$
7,282

7,282

7,019

7,019Derivative instruments
$
1,762

1,762

4,981

4,981Liabilities:Deposits and demand notes payable
$
809,979

809,717

722,662

718,278Securities sold under agreementsto repurchase
$
36,876

36,876

37,501

37,501Short-term FRB borrowings
$
-

-

5,000

4,999FHLB borrowings
$
77,000

86,680

77,000

83,038Junior subordinated debentures
$
20,619

20,619

20,619

20,619
   A-64
 (17)
Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements
  Balance SheetsDecember 31, 2009 and 2008(Dollars in thousands)Assets
2009

2008Cash
$
300

25,600Interest-bearing time deposit

19,000

5,000Investment in subsidiaries

98,455

89,407Investment securities available for sale

1,668

1,811Other assets

437

415Total assets
$
119,860

122,233Liabilities and Shareholders' EquityAccrued expenses
$
18

486Junior subordinated debentures

20,619

20,619Shareholders' equity

99,223

101,128Total liabilities and shareholders' equity
$
119,860

122,233
   Statements of EarningsFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)Revenues:
2009

2008

2007Dividends from subsidiaries
$
-

1,929

4,811Interest and dividend income

454

443

464Loss on sale of securities

(149
)
(327
)
(236
)Total revenues

305

2,045

5,039Expenses:Interest

546

1,016

1,476Other operating expenses

230

244

266Total expenses

776

1,260

1,742Earnings (loss) before income tax benefit and equity inundistributed earnings of subsidiaries

(471
)
785

3,297Income tax benefit

84

389

515Earnings (loss) before equity in undistributedearnings of subsidiaries

(387
)
1,174

3,812Equity in undistributed earnings of subsidiaries

3,303

5,217

5,780Net earnings
$
2,916

6,391

9,592
    A-65
    Statements of Cash FlowsFor the Years Ended December 31, 2009, 2008 and 2007(Dollars in thousands)2009

2008

2007Cash flows from operating activities:Net earnings
$
2,916

6,391

9,592Adjustments to reconcile net earnings to netcash provided (used) by operating activities:Book value shares accrual

(720
)
136

159Equity in undistributed earnings of subsidiaries

(3,303
)
(5,217
)
(5,780
)Deferred income tax benefit

278

(53
)
(62
)Loss on sale of investment securities

149

327

236Change in:Other assets

(319
)
(3
)
-Accrued income

17

(17
)
2Accrued expense

252

15

(254
)Net cash provided by operating activities

(730
)
1,579

3,893Cash flows from investing activities:Purchases of investment securities available for sale

(15,000
)
(1,000
)
-Proceeds from maturities of investment securities available for sale

15,000

-

-Proceeds from sales of investment securities available for sale

-

3

-Net change in interest-bearing time deposit

(14,000
)
3,000

-Payments for investments in subsidiaries

(8,010
)
-

-Net cash provided (used) by investing activities

(22,010
)
2,003

-Cash flows from financing activities:Proceeds from issuance of Series A preferred stock

-

25,054

-Cash dividends paid on Series A preferred stock

(1,120
)
-

-Cash dividends paid on common stock

(1,440
)
(2,680
)
(2,331
)Cash paid in lieu of fractional shares

-

-

(3
)Common stock repurchased

-

(1,126
)
(2,811
)Proceeds from exercise of stock options

-

44

331Net cash provided (used) by financing activities

(2,560
)
21,292

(4,814
)Net change in cash

(25,300
)
24,874

(921
)Cash at beginning of year

25,600

726

1,647Cash at end of year
$
300

25,600

726
   A-66
   DIRECTORS AND OFFICERS OF THE COMPANY
 
 DIRECTORS
 
 Robert C. Abernethy – Chairman
 Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;
 President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)
 
 James S. Abernethy
 Vice President, Carolina Glove Company, Inc. (glove manufacturer)
 President and Assistant Secretary, Midstate Contractors, Inc. (paving company)
 
 Douglas S. Howard
 Vice President, Howard Ventures, Inc. (private equity firm)
  
 John W. Lineberger, Jr.
 President, Lincoln Bonded Warehouse Company (commercial warehousing facility)
 
 Gary E. Matthews
 President and Director, Matthews Construction Company, Inc. (general contractor)
 
 Billy L. Price, Jr. MD
 Managing Partner and Practitioner of Internal Medicine, Catawba Valley Internal Medicine, PA
 
 Larry E. Robinson
 President and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and wine distributor)
  
 William Gregory (Greg) Terry
 Executive Vice President, Drum & Willis-Reynolds Funeral Homes and Crematory
 
 Dan Ray Timmerman, Sr.
 President and Chief Executive Officer, Timmerman Manufacturing, Inc. (wrought iron furniture, railings and gates manufacturer)
 
 Benjamin I. Zachary
 President, Treasurer, General Manager and Director, Alexander Railroad Company
 
 
 
 OFFICERS
 
 Tony W. Wolfe
 President and Chief Executive Officer
 
 A. Joseph Lampron
 Executive Vice President, Chief Financial Officer and Corporate Treasurer
 
 Joseph F. Beaman, Jr.
 Executive Vice President and Corporate Secretary
 
 Lance A. Sellers
 Executive Vice President and Assistant Corporate Secretary
 
 William D. Cable, Sr.
 Executive Vice President and Assistant Corporate Treasurer
  
 A-67