United
States


Securities
and Exchange Commission


Washington,
D.C. 20549





Form
10-K





(Mark
One)





[X]
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the fiscal year ended December 31,
2008





[  
]          TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES


EXCHANGE ACT OF 1934





For the transition period
from                                        to





Commission
File Number 000-51765




Bay National
Corporation


(Exact
name of registrant as specified in its charter)





Maryland
              52-2176710(State
      or other jurisdiction of
              (I.R.S.
      Employerincorporation
      or organization)
              Identification
      No.)





2328 West Joppa Road,
Lutherville,
Maryland              21093


(Address
of principal executive
offices)                   (Zip
Code)





Registrant's telephone
number, including area code: 410-494-2580





Securities
registered pursuant to Section 12(b) of the Act:


Title
      of each class
            Name
      of each exchange on which registeredCommon
      stock, par value $0.01 per share
            The
      NASDAQ Stock Market LLC





Securities
registered pursuant to Section 12(g) of the Act:  None





Indicate
by checkmark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.   Yes__No  X





Indicate
by checkmark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.    Yes __           No  X







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





Indicate
by checkmark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405 of this chapter) is not contained herein, and will not
be contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K.   ____





Indicate
by checkmark whether the registrant is a large accelerated filer, an accelerated
filer, a non-accelerated filer, or a smaller reporting company.  See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
      accelerated filer ____
                Accelerated
      filer ____Non-accelerated
      filer ____ (Do not check if a smaller reporting company)
                Smaller
      reporting company _X__


Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act):  Yes __   No  X





The aggregate market value of the
common equity held by non-affiliates was $13,210,126 as of June 30, 2008, based
on a sales price of $8.40 per share of Common Stock, which is the sales price at
which shares of Common Stock were last sold on the NASDAQ Stock Market on June
25, 2008 (the last date at which the common stock had traded as of June 30,
2008).





The
number of shares outstanding of the registrant's Common Stock was 2,153,101 as
of March 24, 2009.





DOCUMENTS
INCORPORATED BY REFERENCE





Portions
of the Proxy Statement for the 2009 Annual Meeting of Stockholders of Bay
National Corporation, to be filed with the Securities and Exchange Commission no
later than 120 days after the close of the fiscal year, are incorporated by
reference in Part III of this Annual Report on Form 10-K.














PART
I





Item
1.  Description of Business





BUSINESS
OF BAY NATIONAL CORPORATION AND BAY NATIONAL BANK





General





Bay
National Corporation was incorporated under the laws of the State of Maryland on
June 3, 1999, primarily to serve as a bank holding company for a proposed
federally chartered commercial bank to be named Bay National Bank.





Bay
National Bank commenced operations on May 12, 2000 with its main office in
Lutherville, Maryland and a branch office in Salisbury,
Maryland.  Subsequently, it added residential lending offices located
in Salisbury, Maryland and Baltimore, Maryland, in December 2007, a loan
production office was initiated in Columbia, Maryland that was subsequently
closed in March 2009, and in May 2008, a residential mortgage lending office in
Cambridge, Maryland.  Bay National Bank accepts checking and savings
deposits and offers a wide range of commercial and industrial, real estate,
consumer and residential mortgage loans.








Marketing
Focus





Bay
National Bank was formed by a group of individuals active in business,
professional, banking, financial and charitable activities in the Baltimore,
Maryland metropolitan area and the Eastern Shore of Maryland. These individuals
believed that the banking needs of certain segments of these communities were
not being served adequately by existing banks.  Specifically, as a
result of bank mergers in the 1990s, many banks in the Baltimore metropolitan
area and the Eastern Shore of Maryland became local branches of large regional
and national banks. Although size gave the larger banks some advantages in
competing for business from large corporations, including economies of scale and
higher lending limits, the organizers believed that these “mega banks” were
focused on a mass market approach which de-emphasized personal contact and
service.  The organizers also believed that the centralization of
decision-making power at these large institutions had resulted in a lack of
customer service. At many of these institutions, determinations were made at the
out-of-state “home office" by individuals who lacked personal contact with
customers as well as an understanding of the customers' needs and scope of the
relationship with the institution.





Bay
National Bank’s management believes that this trend is ongoing, and continues to
be particularly frustrating to owners of small and mid-sized businesses,
business professionals and high net worth individuals who traditionally have
been accustomed to dealing directly with a bank executive who had an
understanding of their banking needs with the ability to deliver a prompt
response.





Bay
National Bank targets its commercial banking services to small and mid-sized
businesses and targets its retail banking services to the owners of these
businesses and their employees, to business professionals and to high net worth
individuals.





Bay
National Bank seeks to distinguish itself by:





·
            Developing
      personal relationships with its
customers;





·
            Customizing
      its products to fit the needs of its customers instead of adopting a "one
      size fits all" mentality;





·
            Streamlining
      the decision-making process; and,





1


·
            Offering
      its customers additional complementary services, such as insurance and
      investment advice, through relationships with strategic
      partners.





Bay
National Bank’s offices are not organized in the traditional retail branch
structure, which is transaction and "bank teller" oriented.  Instead,
Bay National Bank emphasizes a "sit-down" model where customers can choose to be
greeted by a personal banker and taken to a private desk. Customers also have
the option to conduct their transactions using a more traditional teller
counter. Management believes that this approach makes service more
individualized and enhances the banker's understanding of each individual
customer's needs. Furthermore, Bay National Bank’s branch locations do not focus
on capturing every customer within the surrounding area. Instead, they are
strategically located in areas convenient to Bay National Bank’s target customer
base.





Market
Area and Facilities





Bay
National Bank’s headquarters and Baltimore branch office are located at 2328
West Joppa Road, Lutherville, Maryland 21093. Bay National Bank serves the
Baltimore metropolitan area from that location, with its primary service area
being Towson, Lutherville-Timonium, Cockeysville, Hunt Valley, Ruxton and Roland
Park.  Bay National Bank’s former loan production office at 8820
Columbia 100 Parkway, Columbia, Maryland 21045 primarily served the
Baltimore-Washington corridor.  Bay National Bank’s Salisbury,
Maryland branch office is located at 109 Poplar Hill Avenue, Salisbury, Maryland
21801, from which it serves Maryland’s lower Eastern Shore.  Bay
National Bank also has three residential real estate loan production offices
located in its Lutherville headquarters, in its Salisbury branch office and in
Cambridge, Maryland.





Products
and Services





Loan
Portfolio.





Bay
National Bank offers a full range of loans, including commercial and industrial
loans, real estate loans, consumer loans and residential mortgage and home
equity loans. Commercial business and commercial real estate loans for
owner-occupied properties are Bay National Bank's primary loan products,
accounting for approximately 77% of the loan portfolio as of December 31,
2008.





Generally,
Bay National Bank is subject to a lending limit to any one borrower of 15% of
Bay National Bank’s unimpaired capital and surplus.  However,
management is able to originate loans and to participate with other lenders with
respect to loans that exceed Bay National Bank's lending limits.





The
following is a description of the types of loans that Bay National Bank has
targeted in building its loan portfolio:





·
            Commercial
      and industrial loans for business purposes including working capital,
      equipment purchases, lines of credit and government contract
      financing.  Asset-based lending and accounts receivable
      financing are also available. As of December 31, 2008, these loans
      represented approximately 50% of Bay National Bank’s loan portfolio. In
      general, Bay National Bank targets small and mid-sized businesses in its
      market area with credit needs in the range of up to $5
      million.





·
            Commercial
      real estate loans, including mortgage loans on non-residential properties,
      and land development and construction loan financing, primarily for
      owner-occupied premises as well as first and second mortgage loans on
      commercially owned residential investment properties.  As of
      December 31, 2008, these loans represented approximately 27% of Bay
      National Bank’s loan





2


portfolio.  We
      are currently decreasing the number of land development and construction
      loans that we originate based on current market conditions.·
            Residential
      mortgage loans and construction loans secured by residential property,
      including first and second mortgage loans on owner-occupied and investment
      properties (1 to 4 family and multi-family) owned by individuals, and home
      equity loans secured by single-family owner-occupied residences. As of
      December 31, 2008, these loans represented approximately 21% of Bay
      National Bank’s loan portfolio. Like its consumer loans, Bay National
      Bank’s residential real estate loans are targeted to business owners and
      their employees, business professionals and high net worth
      individuals.





·
            Consumer
      loans include automobile and personal loans. In addition, Bay National
      Bank offers personal lines of credit. As of December 31, 2008, these loans
      represented approximately 2% of Bay National Bank’s loan portfolio. Bay
      National Bank’s consumer loans are targeted to business owners and their
      employees, business professionals and high net worth
      individuals.





Prior to
2007, Bay National Bank originated some of its Eastern Shore residential
mortgage loans through BNB Mortgage, LLC, a Maryland limited liability company,
which is a joint venture between Bay National Bank and an Ocean City, Maryland
real estate agent.  Bay National Bank was responsible for all of the
operations of BNB Mortgage, LLC. Bay National Bank’s share of net income from
this entity amounted to $2,682 for the year ended December 31, 2006 and no
income was generated from this entity during 2007 and 2008.  All loans
originated by BNB Mortgage, LLC were immediately sold to Bay National Bank.
These loans were then sold to third party investors in the same fashion as other
conventional first and second residential mortgage loans originated by Bay
National Bank.  While recently this joint venture has not been active
due to current market conditions, it is still operational and could potentially
be a source for origination of loans in the future should real estate market
conditions in the area improve.





Bay
National Bank’s conventional first and second residential mortgage loans adhere
to standards developed by Fannie Mae/Freddie Mac.  Bay National Bank
sells most of its first and second residential mortgage loans in the secondary
market. These loans essentially have a lower degree of risk and a lower yield
relative to the other types of loans that Bay National Bank makes. Since these
loans are typically sold, Bay National Bank offers these loans as well as
certain residential construction loans to a broader array of individuals than
its home equity loans and other consumer loan products. As of December 31, 2008,
mortgage loans held for sale totaled $1.2 million.





Deposits.





Bay
National Bank offers a wide range of interest-bearing and non-interest-bearing
accounts, including commercial and retail checking accounts, money market
accounts, individual retirement accounts, interest-bearing statement savings
accounts and certificates of deposit with fixed and variable rates and a range
of maturity date options.





Other Banking and Financial
Services.





Bay
National Bank offers cash management services such as sweep accounts, repurchase
agreements, commercial paper investments, account reconciliation, lockbox
services and wire transfers of funds to its commercial customers. Additionally,
Bay National Bank makes available telephone banking, ATM/debit cards, safe
keeping boxes, after-hours deposit services, travelers checks, direct deposit of
payroll and automatic drafts for various accounts. These services are provided
either directly by Bay National Bank or through correspondent banking
relationships.  Bay National Bank does not have its own network of ATM
machines. In most instances, Bay National Bank waives fees based upon a
predetermined number of ATM transactions per month, thereby allowing its
customers to use almost any ATM machine.





3


In
addition, Bay National Bank's customers are able to access information about
their accounts and view information about Bay National Bank's services and
products on Bay National Bank's website, which is located at http://www.baynational.com.
Bay National Bank’s website also permits customers to make transfers of funds
among accounts, pay bills, order checks and send e-mails to Bay National
Bank.





Bay
National Bank offers, through strategic partners, investment advisory, risk
management and employee benefit services. Through these affiliations, banking
clients can receive a full range of financial services, including investment
advice, personal and business insurance products and employee benefit products
such as pension and 401(k) plan administration. To the extent permitted by
applicable regulations, the strategic partners may share fees and commissions
with Bay National Bank.  As of December 31, 2008, Bay National Bank
had not entered into any such fee arrangements. When sufficient volume is
developed in any of these lines of business, Bay National Bank may provide these
services if permitted by applicable regulations.





Competition





In both
the Baltimore metropolitan area and on Maryland's Eastern Shore, Bay National
Bank faces strong competition from large banks headquartered within and outside
of Maryland.  Bay National Bank also competes with other community
banks, savings and loan associations, credit unions, mortgage companies, finance
companies and others providing financial services.  In addition,
insurance companies, securities brokers and other non-bank entities or their
affiliates may provide services, which historically have been considered banking
in nature.





Many of
Bay National Bank’s competitors can finance extensive advertising campaigns,
maintain extensive branch networks and technology investments, and offer
services, which Bay National Bank cannot offer or chooses not to offer. Also,
larger institutions have substantially higher lending limits than Bay National
Bank. Some of Bay National Bank’s competitors have other advantages, such as tax
exemption in the case of credit unions, and less stringent regulation in the
case of mortgage companies and finance companies.





Employees





As of
March 30, 2009, Bay National Bank employed forty-seven individuals including one
part-time employee.  Thirty-six people operate from Bay National
Bank’s headquarters and banking office in Lutherville, Maryland, ten people
operate from the Salisbury, Maryland office and one person is located in
Cambridge, Maryland. Bay National Corporation has no employees.





Recent
Developments





On
February 6, 2009, Bay National Bank voluntarily entered into a Consent Order
(the “Consent Order”) with the Office of the Comptroller of Currency (the
“OCC”), our primary banking regulator.





Among
other things, the Consent Order requires the Bank and/or its board of directors
(the "Board") to take certain actions, including developing and submitting
written plans to the OCC, and imposes restrictions on the Bank designed to
improve its financial strength, including the following: within 30 days provide
a written analysis of the Board’s decision whether to sell, merge or liquidate
the Bank or remain independent; if the Board decides the Bank should remain
independent and the OCC does not object to the written analysis, within 60 days
of the Consent Order, implement a three-year strategic plan for the Bank with
respect to certain financial objectives; by April 30, 2009 maintain a 12% total
risk-based ratio, an 11% Tier 1 risk-based ratio and a 9% leverage ratio;
develop a three-year capital program that, among other things, assesses current
and expected funding needs and ensures that sufficient funds or access to funds
exists to meet those needs; ensure that the




4


Bank has
competent management in its credit risk and asset liability risk management
functions, conduct management reviews and adopt a written education program for
officers as necessary; immediately take action to protect the Bank’s interest in
assets criticized by the OCC and adopt a written program designed to eliminate
the basis of such criticism; and develop written plans to address liquidity
improvement, loan portfolio management, asset diversification, the Bank’s
allowance for loan and lease losses, monitoring and review of problem loans and
leases, charged-off loans and related issues, and monitoring of portfolio
trends.





The Board
has appointed a compliance committee to monitor, coordinate and report to the
Board on the Bank’s compliance with the Consent Order.  In addition,
under the Consent Order the Bank may not pay dividends unless it is in
compliance with the capital program required by the Consent Order and applicable
regulatory requirements and receives the OCC’s written
non-objection.





The
Bank's Board and its compliance committee and have submitted a written
analysis to the OCC in which the Bank details its decision to remain independent
while continually evaluating other options.





The
Bank’s Board and executive management are adopting a Strategic Plan that
maps out a strategy for the Bank to restore its higher capitalization, strong
earnings, good asset quality and to also eliminate the concerns raised by the
OCC in the Consent Order.  Pursuant to the plan, the Bank will return
to its original business model, provide stronger risk controls and provide the
management and support items necessary to continue to grow and serve its
customer base.  We envision all the key elements of the plan being in
place by the end of 2009.





In order
to make the plan work, the Bank will focus on six goals that are the keys to its
success.  These are:





•           A
return to its original mission: The Bank’s original mission was to serve local
businesses and professionals through internally generated loans.  The
Bank has returned to that mission.





•           Improve
asset quality:  Asset quality must be raised to acceptable levels and
thereafter maintained as part of a high quality loan portfolio.  This
loan portfolio will consist of primarily internally-generated small business
loans that are fully within the Bank’s expertise and provide adequate yields
with manageable risk.





•           Increase
capitalization:  Capital must be raised to levels above the minimum
capital needed to meet regulatory requirements.  This higher level of
capital can be achieved by either shrinking the size of the balance sheet, by
raising additional contributions from present and new shareholders or by a
combination of these two approaches.  Increasing the Bank’s level of
capital will ensure that it not only remains viable through the present economic
downturn, but will have the ability to grow its assets and regain its former
earnings profile.





•           Improve
liquidity:   Liquidity must be increased and then maintained at a
level that is at least comparable with other local banks in terms of core
deposits.  More specifically, the Bank in solving its liquidity issues
has taken, or will take the following steps as well as others:


Primary
Sources of Liquidity


•   Develop
multiple lines of credit with other financial institutions.


•   Remain
a Federal Home Loan Bank (“FHLB”) member with the ability to take
advances.


•   Obtain
ability to borrow from the Federal Reserve discount window.


•   Continue
use of national market CDs which are not considered brokered CDs.


•   Maintain
and track collateral available to be pledged.  The availability of
this collateral will also periodically be validated by a secondary
source.


•   Develop
a traditional low-risk investment portfolio with laddered
maturities.





5


Secondary
Sources of Liquidity


•   Seek
to restore the ability to use brokered funds on a more limited basis than in the
past


•   Seek
to restore the ability to fully utilize the certificate of deposit account
registry service (“CDARS”), or other sweep programs.


•   Establish
relationships with other banks for standby participations


•   Track
a pool of loans that would be available for participation




•
              Return
      to Profitability:  Profitability must be restored as soon as
      possible and beyond that point earnings must show consistent and steady
      growth.  In the context of improving profitability and
      preserving capital, we have already made significant internal changes that
      we believe will reduce costs and lead to improved earnings or minimize
      losses.
 
 •
              Develop
      management depth:  We believe that the executive management team
      and management succession plan have the depth, experience and talent to
      maintain the confidence of the public, clients, directors, shareholders
      and regulators.  The Board will evaluate management on a regular
      basis.





SUPERVISION
AND REGULATION





General





Bay
National Corporation and Bay National Bank are subject to extensive regulation
under state and federal banking laws and regulations. These laws impose specific
requirements and restrictions on virtually all aspects of operations and
generally are primarily intended to protect depositors, not stockholders. The
following discussion is only a summary and readers should refer to particular
statutory and regulatory provisions for more detailed information. In addition,
management cannot predict the nature or the extent of the effect on our business
and earnings that new federal or state legislation may have in the
future.





Bay
National Corporation





Federal Bank Holding Company
Regulation.Bay National Corporation is a bank holding company
registered under the Bank Holding Company Act of 1956, as amended, and is
subject to supervision by the Board of Governors of the Federal Reserve System
(the “FRB”). As a bank holding company, Bay National Corporation is required to
file with the FRB an annual report and such other additional information as the
FRB may require by statute. The FRB may also examine Bay National Corporation
and each of its subsidiaries.





The FRB
must approve, among other things, the acquisition by a bank holding company of
control of more than 5% of the voting shares, or substantially all the assets,
of any bank or bank holding company or the merger or consolidation by a bank
holding company with another bank holding company. Under the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal Act”), the
restrictions on interstate acquisitions of banks by bank holding companies were
repealed as of September 29, 1995. The effect of the repeal of these
restrictions is that, subject to certain time and deposit base requirements, Bay
National Corporation may acquire a bank located in Maryland or any other state,
and a bank holding company located outside of Maryland can acquire any
Maryland-based bank holding company or bank.





Unless it
chooses to become a financial holding company, as further described below, a
bank holding company is prohibited from acquiring control of voting shares of
any company which is not a bank or bank holding company and from engaging
directly or indirectly in any activity other than banking, including managing or
controlling banks or furnishing services for its authorized
subsidiaries.  There are limited




6


exceptions.  A
bank holding company may, for example, engage in activities which the FRB has
determined by order or regulation to be so closely related to banking and/or
managing or controlling banks as to be "properly incident thereto." In making
such a determination, the FRB is required to consider whether the performance of
such activities can reasonably be expected to produce benefits to the public,
such as convenience, increased competition or gains in efficiency, which
outweigh possible adverse effects, such as undue concentration of resources,
decreased or unfair competition, conflicts of interest or unsound banking
practices. The FRB is also empowered to differentiate between activities
commenced de novo and activities commenced by the acquisition, in whole or in
part, of a going concern. Some of the activities that the FRB has determined by
regulation to be closely related to banking include servicing loans, performing
certain data processing services, acting as a fiduciary, investment or financial
advisor, and making investments in corporations or projects designed primarily
to promote community welfare.





Subsidiary
banks of a bank holding company are subject to certain restrictions imposed by
statute on any extensions of credit to the bank holding company or any of its
subsidiaries, investments in their stock or other securities, and taking such
stock or securities as collateral for loans to any borrower. Further, a bank
holding company and any subsidiary bank are prohibited from engaging in certain
tie-in arrangements in connection with the extension of credit. The FRB adopted
amendments to its Regulation Y, creating exceptions to the Bank Holding Company
Act's anti-tying prohibitions, which give bank subsidiaries of holding companies
greater flexibility in packaging products and services with their
affiliates.





In
accordance with FRB policy, Bay National Corporation is expected to act as a
source of financial strength to Bay National Bank and to commit resources to
support Bay National Bank in circumstances in which Bay National Corporation
might not otherwise do so. The FRB may require a bank holding company to
terminate any activity or relinquish control of a non-bank subsidiary (other
than a non-bank subsidiary of a bank) upon the Federal Reserve's determination
that such activity or control constitutes a serious risk to the financial
soundness or stability of any subsidiary depository institution of the bank
holding company. Further, federal bank regulatory authorities have additional
discretion to require a bank holding company to divest itself of any bank or
non-bank subsidiary if the agency determines that divestiture may aid the
depository institution's financial condition.





Pursuant
to authority granted under the Gramm-Leach-Bliley Act of 1999 (the “GLBA”), a
bank holding company may elect to become a financial holding company and thereby
engage in a broader range of financial and other activities than are permissible
for traditional bank holding companies.  In order to qualify for the
election, all of the depository institution subsidiaries of the bank holding
company must be well capitalized and well managed, as defined by regulation, and
all of its depository institution subsidiaries must have achieved a rating of
satisfactory or better with respect to meeting community credit
needs.





Pursuant
to the GLBA, financial holding companies are permitted to engage in activities
that are "financial in nature" or incidental or complementary thereto and not a
substantial risk to the safety and soundness of the depository institution or
the financial system in general, as determined by the FRB.  The GLBA
identifies several activities as "financial in nature," including, among others,
insurance underwriting and agency, investment advisory services, merchant
banking and underwriting, and dealing or making a market in securities. Being
designated a financial holding company allows insurance companies, securities
brokers and other types of financial companies to affiliate with and/or acquire
depository institutions.





As a bank
holding company with consolidated assets of more than $150 million, Bay National
Corporation also is subject to certain risk-based capital guidelines imposed on
bank holding companies by the FRB to ensure the holding company’s capital
adequacy.  See "Item 1. Description of Business - Supervision and
Regulation - Bay National Bank - Capital Adequacy Guidelines" below for
details.





7


The
status of Bay National Corporation as a registered bank holding company under
the Bank Holding Company Act does not exempt it from certain federal and state
laws and regulations applicable to corporations generally, including, without
limitation, certain provisions of the federal securities laws.





State Bank Holding Company
Regulation.  Bay National Corporation is a Maryland corporation
registered as a bank holding company under the Bank Holding Company Act of 1956,
as amended, and is subject to various restrictions on its activities as set
forth in Maryland law, in addition to those restrictions set forth in federal
law.





Under
Maryland law, a bank holding company that desires to acquire a Maryland
state-chartered bank or trust company, a federally chartered bank with its main
office in Maryland, or a bank holding company that has its principal place of
business in Maryland, must file an application with the Maryland Commissioner of
Financial Regulation (the "Commissioner"). In approving the application, the
Commissioner must consider whether the acquisition may be detrimental to the
safety and soundness of the entity being acquired or whether the acquisition may
result in an undue concentration of resources or a substantial reduction in
competition in Maryland. The Commissioner may not approve an acquisition if, on
consummation of the transaction, the acquiring company, together with all its
insured depository institution affiliates, would control 30% or more of the
total amount of deposits of insured depository institutions in Maryland. The
Commissioner has authority to adopt, by regulation, a procedure to waive this
requirement for good cause.  In a transaction for which the
Commissioner's approval is not required due to an exemption under Maryland law,
or for which federal law authorizes the transaction without application to the
Commissioner, the parties to the acquisition must provide written notice to the
Commissioner at least 15 days before the effective date of the
acquisition.





Bay
National Bank





General.Bay National Bank,
as a national banking association whose accounts are insured by the Deposit
Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC") up to the
maximum legal limits, is subject to regulation, supervision and regular
examinations by the OCC. Bay National Bank is a member of the Federal Reserve
System and, as such, is subject to certain regulations issued by the FRB. Bay
National Bank also is subject to applicable banking provisions of Maryland law
insofar as they do not conflict with or are not preempted by federal law. The
regulations of these various agencies govern most aspects of Bay National Bank's
business, including setting required reserves against deposits, loans,
investments, mergers and acquisitions, borrowing, dividends, and location and
number of branch offices.





The GLBA
authorizes expanded activities for national banks, but requires (with the
exception of underwriting municipal revenue bonds and other state and local
obligations) that any expanded activities be conducted in a new entity called a
“financial subsidiary” that is a subsidiary of the bank rather than the bank
itself.  A financial subsidiary may engage in any activities in which
a financial holding company or a financial holding company’s non-bank
subsidiaries can engage, except that a financial subsidiary cannot underwrite
most insurance, engage in real estate development or conduct merchant banking
activities.  A financial subsidiary may be established through
acquisition or de
novo.





In order
for a national bank to operate a financial subsidiary, it must be well
capitalized and well managed, have a satisfactory or better rating with respect
to meeting community credit needs and the aggregate assets of all of the bank’s
financial subsidiaries may not exceed 45% of the total assets of the bank,
subject to certain exceptions.  The OCC and the FDIC maintain
authority to review subsidiary activities.





Banking
is a business which depends on interest rate differentials. In general, the
differences between the interest paid by a bank on its deposits and its other
borrowings and the interest received by a bank on loans extended to its
customers and securities held in its investment portfolio constitute the major
portion of a bank's earnings. Thus, the earnings and growth of Bay National Bank
will be subject to the influence of




8


economic
conditions generally, both domestic and foreign, and also on the monetary and
fiscal policies of the United States and its agencies, particularly the FRB,
which regulates the supply of money. We cannot predict the nature and timing of
changes in such policies and their impact on Bay National Bank.





Branching and Interstate Banking.The federal banking agencies are authorized to approve interstate bank
merger transactions without regard to whether such a transaction is prohibited
by the law of any state, unless the home state of one of the banks has opted out
of the interstate bank merger provisions of the Riegle-Neal Act. Furthermore,
under the Riegle-Neal Act, interstate acquisitions of branches are permitted if
the law of the state in which the branch is located permits such acquisitions.
The Riegle-Neal Act also authorizes the OCC and FDIC to approve interstate
branching, de novo, by national and non-member banks, respectively, but only in
states which specifically allow for such branching.





The
District of Columbia, Maryland, Delaware and Pennsylvania have all enacted laws
which permit interstate acquisitions of banks and bank branches and permit
out-of-state banks to establish de novo branches.





Gramm-Leach-Bliley
Act.The GLBA substantially altered the statutory framework
for providing banking and other financial services in the United States of
America. The GLBA, among other things, eliminated many of the restrictions on
affiliations among banks and securities firms, insurance firms, and other
financial service providers.  The GLBA also provides protections
against the transfer and use by financial institutions of consumers’ nonpublic
personal information.  A financial institution must provide to its
customers, at the beginning of the customer relationship and annually
thereafter, the institution’s policies and procedures regarding the handling of
customers’ nonpublic personal financial information.  The privacy
provisions generally prohibit a financial institution from providing a
customer’s personal financial information to unaffiliated third parties unless
the institution discloses to the customer that the information may be so
provided and the customer is given the opportunity to opt out of such
disclosure.




Capital Adequacy
Guidelines.The FRB, the OCC and the FDIC have all adopted
risk-based capital adequacy guidelines by which they assess the adequacy of
capital in examining and supervising banks and bank holding companies and in
analyzing bank regulatory applications. Risk-based capital requirements
determine the adequacy of capital based on the risk inherent in various classes
of assets and off-balance sheet items.





National
banks and bank holding companies are expected to meet a minimum ratio of total
qualifying capital (the sum of core capital (Tier 1) and supplementary capital
(Tier 2)) to risk-weighted assets (a "Total Risk-Based Capital Ratio") of 8%. At
least half of this amount (4%) should be in the form of Tier 1 capital. These
requirements apply to Bay National Bank and Bay National
Corporation.





Tier 1
capital generally consists of the sum of common stockholders' equity and
perpetual preferred stock (subject in the case of the latter to limitations on
the kind and amount of such stock which may be included as Tier 1 capital), less
goodwill, without adjustment in accordance with Statement of Financial
Accounting Standards No. 115. Tier 2 capital consists of the following: hybrid
capital instruments, perpetual preferred stock which is not otherwise eligible
to be included as Tier 1 capital, term subordinated debt and intermediate-term
preferred stock, and, subject to limitations, general allowances for credit
losses. Assets are adjusted under the risk-based guidelines to take into account
different risk characteristics, with the categories ranging from 0% (requiring
no risk-based capital) for assets such as cash, to 100% for the bulk of assets
which are typically held by a commercial bank, including certain multi-family
residential and commercial real estate loans, commercial business loans and
consumer loans. Residential first mortgage loans on one-to-four-family
residential real estate and certain seasoned multi-family residential real
estate loans, which are not 90 days or more past-due or non-performing and which
have been made in accordance with prudent underwriting standards, are assigned a
50% level in the risk-weighing system, as are certain privately issued




9


mortgage-backed
securities representing indirect ownership of such loans. Off-balance sheet
items also are adjusted to take into account certain risk
characteristics.





In
addition to the risk-based capital requirements, the OCC and the FDIC have
established a minimum 3% Leverage Capital Ratio (Tier 1 capital to total
adjusted assets) requirement for the most highly-rated national banks, with an
additional cushion of at least 100 to 200 basis points for all other national
banks, which effectively increases the minimum Leverage Capital Ratio for such
other banks to 4% or 5% or more. Under the applicable regulations, highest-rated
banks and bank holding companies are those that the OCC and the FDIC determine
are not anticipating or experiencing significant growth and have well
diversified risk, including no undue interest rate risk exposure, excellent
asset quality, high liquidity, good earnings and, in general, those which are
considered a strong banking organization. A national bank or bank holding
company that has less than the minimum Leverage Capital Ratio requirement must
submit, to the applicable regulator for review and approval, a reasonable plan
describing the means and timing by which the bank will achieve its minimum
Leverage Capital Ratio requirement. A national bank or bank holding company
which fails to file such a plan is deemed to be operating in an unsafe and
unsound manner and could be subject to a cease-and-desist order.





The
OCC's  and FDIC’s regulations also provide that any insured depository
institution with a Leverage Capital Ratio less than 2% is deemed to be operating
in an unsafe or unsound condition. Operating in an unsafe or unsound manner
could lead the FDIC to terminate deposit insurance. However, such an institution
will not be subject to an enforcement proceeding solely on account of its
capital ratios if it has entered into and is in compliance with a written
agreement with the OCC and FDIC to increase its Leverage Capital Ratio to such
level as the OCC or FDIC deems appropriate and to take such other action as may
be necessary for the institution to be operated in a safe and sound manner. The
capital regulations also provide, among other things, for the issuance by the
OCC or the FDIC or their respective designee(s) of a capital directive, which is
a final order issued to a bank that fails to maintain minimum capital or to
restore its capital to the minimum capital requirement within a specified time
period. Such directive is enforceable in the same manner as a final
cease-and-desist order.





Prompt Corrective
Action.  Each federal banking agency is required to implement a
system of prompt corrective action for institutions which it regulates. Under
applicable regulations, a bank will be deemed to be: (i) "well capitalized" if
it has a Total Risk-Based Capital Ratio of 10% or more, a Tier 1 Risk-Based
Capital Ratio of 6% or more, a Leverage Capital Ratio of 5% or more and is not
subject to any written capital order or directive; (ii) "adequately capitalized"
if it has a Total Risk-Based Capital Ratio of 8% or more, a Tier 1 Risk-Based
Capital Ratio of 4% or more and a Leverage Capital Ratio of 4% or more (3% under
certain circumstances) and does not meet the definition of “well capitalized”;
(iii) "undercapitalized" if it has a Total Risk-Based Capital Ratio that is less
than 8%, a Tier 1 Risk-Based Capital Ratio that is less than 4% or a Leverage
Capital Ratio that is less than 4% (3.3% under certain circumstances); (iv)
"significantly undercapitalized" if it has a Total Risk-Based Capital Ratio that
is less than 6%, a Tier 1 Risk-Based Capital Ratio that is less than 3% or a
Leverage Capital Ratio that is less than 3%; and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2%.  Bay National Bank is "adequately
capitalized" as of December 31, 2008.  Bay National Bank has agreed to
achieve higher capital ratios by April 30, 2009, as further provided in Part I,
Subsection titled “Recent Developments.”





An
institution generally must file a written capital restoration plan which meets
specified requirements with an appropriate federal banking agency within 45 days
of the date the institution receives notice or is deemed to have notice that it
is undercapitalized, significantly undercapitalized or critically
undercapitalized. The federal banking agency must provide the institution with
written notice of approval or disapproval within 60 days after receiving the
capital restoration plan, subject to extensions by the applicable
agency.





10


An
institution which is required to submit a capital restoration plan must
concurrently submit a performance guaranty by each company that controls the
institution. Such guaranty is limited to the lesser of (i) an amount equal to 5%
of the institution's total assets at the time the institution was notified or
deemed to have notice that it was undercapitalized or (ii) the amount necessary
at such time to restore the relevant capital measures of the institution to the
levels required for the institution to be classified as adequately capitalized.
Such a guaranty expires after the federal banking agency notifies the
institution that it has remained adequately capitalized for each of four
consecutive calendar quarters. An institution which fails to submit a written
capital restoration plan within the requisite period, including any required
performance guaranty, or fails in any material respect to implement a capital
restoration plan, is subject to the restrictions in Section 38 of the Federal
Deposit Insurance Act which are applicable to significantly undercapitalized
institutions.





Immediately
upon becoming undercapitalized, an institution becomes subject to statutory
provisions which: (i) restrict payment of capital distributions and management
fees; (ii) require that the appropriate federal banking agency monitor the
condition of the institution and its efforts to restore its capital; (iii)
require submission of a capital restoration plan; (iv) restrict the growth of
the institution's assets; and (v) require prior approval of certain expansion
proposals. The appropriate federal banking agency for an undercapitalized
institution also may take any number of discretionary supervisory actions if the
agency determines that any of these actions is necessary to resolve the problems
of the institution at the least possible long-term cost to the deposit insurance
fund, subject, in certain cases, to specified procedures. These discretionary
supervisory actions include requiring the institution to raise additional
capital, restricting transactions with affiliates, requiring divestiture of the
institution or the sale of the institution to a willing purchaser, and any other
supervisory action that the agency deems appropriate. Significantly
undercapitalized and critically undercapitalized institutions are subject to
these and additional mandatory and permissive supervisory actions.





A
critically undercapitalized institution will be placed in conservatorship or
receivership within 90 days unless the FDIC formally determines that forbearance
from such action would better protect the deposit insurance fund. Unless the
FDIC or other appropriate federal banking regulatory agency makes specific
further findings and certifies that the institution is viable and is not
expected to fail, an institution that remains critically undercapitalized on
average during the four calendar quarters after the date it becomes critically
undercapitalized must be placed in receivership.  The general rule is
that the FDIC will be appointed as receiver within 90 days after a bank becomes
critically undercapitalized unless extremely good cause is shown and the federal
regulators agree to an extension.  In general, good cause is defined
as capital that has been raised and is immediately available for infusion into
the bank except for certain technical requirements that may delay the infusion
for a period of time beyond the 90 day time period.





Additionally,
under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed
for an institution where: (i) an institution’s obligations exceed its assets;
(ii) there is substantial dissipation of the institution’s assets or earnings as
a result of any violation of law or any unsafe or unsound practice; (iii) the
institution is in an unsafe or unsound condition; (iv) there is a willful
violation of a cease-and-desist order; (v) the institution is unable to pay its
obligations in the ordinary course of business; (vi) losses or threatened losses
deplete all or substantially all of an institution’s capital, and there is no
reasonable prospect of becoming “adequately capitalized” without assistance;
(vii) there is any violation of law or unsafe or unsound practice or condition
that is likely to cause insolvency or substantial dissipation of assets or
earnings, weaken the institution’s condition, or otherwise seriously prejudice
the interests of depositors or the insurance fund; (viii) an institution ceases
to be insured; (ix) the institution is undercapitalized and has no reasonable
prospect that it will become adequately capitalized, fails to become adequately
capitalized when required to do so, or fails to submit or materially implement a
capital restoration plan; or (x) the institution is critically undercapitalized
or otherwise has substantially insufficient capital.





11


Deposit
Insurance.  Bay National Bank’s deposits are insured by the
FDIC.  The FDIC has temporarily raised its coverage amounts through
December 31, 2009 from $100,000 to $250,000 per insured depositor (as defined by
law and regulation) and up to $250,000 for deposits held by individual
retirement accounts.





Deposit Insurance
Assessments.  Bay National Bank is a member of the Deposit
Insurance Fund (“DIF”) maintained by the FDIC. Through the DIF, the FDIC
insures the deposits of Bay National Bank up to prescribed limits for each
depositor, as indicated in the preceding paragraph. The DIF was formed
March 31, 2006, upon the merger of the Bank Insurance Fund and the Savings
Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of
2005 (the “Act’).  The Act established a range of 1.15% to 1.50%
within which the FDIC Board of Directors may set the Designated Reserve Ratio
(“DRR”). The current target DRR is 1.25%.  However, the Act has
eliminated the restrictions on premium rates based on the DRR and grants the
FDIC Board the discretion to price deposit insurance according to risk for all
insured institutions regardless of the level of the reserve ratio.





To
maintain the DIF, member institutions are assessed deposit insurance premiums
based on their current condition and the nature of their activities, and the
revenue needs of the DIF, as determined by the FDIC.  For institutions
that have long-term public debt rating, the risk assessment is based on its debt
rating and the components of its supervisory ratings.  For
institutions that do not have a long-term public debt rating, the risk
assessment is based on certain measurements of its financial condition and its
supervisory ratings.





Recent
failures have resulted in a decline in the reserve ratio to below 1.15%. Under
the Act the FDIC is required to establish and implement a restoration plan to
restore the reserve ratio to 1.15% within five years of the establishment of the
plan. The FDIC adopted a final rule effective January 1, 2009, raising
current rates uniformly by 7 basis points per $100 of domestic deposits for the
first quarter of 2009 only. Rates for first quarter 2009 will range from a
minimum of 12 basis points per $100 of deposits for well-managed,
well-capitalized banks with the highest credit ratings, to 50 basis points for
institutions posing the most risk to the DIF. Proposed rates beginning
April 1, 2009, range from a minimum initial assessment rate of 10
basis points per $100 of deposits to a maximum of 45 basis points per $100 of
deposits. Risk-based adjustments to the initial assessment rate may lower or
raise a depository institution’s rate to 8 basis points per $100 of deposits for
well-managed, well-capitalized banks with the highest credit ratings to
77.5 basis points for institutions posing the most risk to the
DIF.





In
addition to the increase in deposit insurance premiums, on February 27, 2009,
the FDIC announced that it plans to impose a emergency special assessment of 20
basis points on all banks and savings associations as a means to restore the
DIF, which will be assessed on June 30, 2009 and will be payable on September
30, 2009.  Subsequently, the Senate Banking Chairman, Christopher
Dodd, introduced legislation in the Senate that would permanently raise the
FDIC’s line of credit from Treasury to $100 billion and temporarily increase the
borrowing authority to $500 billion until December 31, 2020.  The FDIC
pledged to cut the 20 basis point emergency special assessment if Congress
approves legislation expanding the agency’s line of credit.





All
FDIC-insured depository institutions must also pay an annual assessment to
interest payments on bonds issued by the Financing Corporation, a federal
corporation chartered under the authority of the Federal Housing Finance Board.
The bonds (commonly referred to as FICO bonds) were issued to capitalize the
Federal Savings and Loan Insurance Corporation. FDIC-insured depository
institutions paid approximately 1.10 to 1.14 basis points per $100 of assessable
deposits in 2008. The FDIC established the FICO assessment rate effective for
the first quarter of 2009 at approximately 1.14 basis points annually per $100
of assessable deposits.





12


Additionally,
under the FDIC’s Temporary Liquidity Guarantee Program, in 2009 participating
depository institutions will pay a premium of 10 basis points per $100 to fully
insure noninterest-bearing transaction accounts. This additional assessment is
paid on account balances in excess of the insurance limits.





The FDIC
may terminate the deposit insurance of any insured depository institution,
including Bay National Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC.





Regulatory Enforcement
Authority.  The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 ("FIRREA") included substantial enhancement to the
enforcement powers available to federal banking regulators. This enforcement
authority included, among other things, the ability to assess civil money
penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions against banking organizations and institution-affiliated
parties, as defined in FIRREA. In general, these enforcement actions may be
initiated for violations of laws and regulations and unsafe or unsound
practices. Other actions or inactions may provide the basis for enforcement
action, including misleading or untimely reports filed with regulatory
authorities. FIRREA significantly increased the amount of and grounds for civil
money penalties and requires, except under certain circumstances, public
disclosure of final enforcement actions by the federal banking
agencies.





Transactions with Affiliates and
Insiders.Bay National Bank is subject to the provisions of
Section 23A and 23B of the Federal Reserve Act and Regulation W of the Federal
Reserve Bank, which place limits on the amount of loans or extensions of credit
to affiliates (as defined in the Federal Reserve Act), investments in or certain
other transactions with affiliates and on the amount of advances to third
parties collateralized by the securities or obligations of affiliates. The law
and regulation limit the aggregate amount of transactions with any individual
affiliate to 10% of the capital and surplus of Bay National Bank and also limit
the aggregate amount of transactions with all affiliates to 20% of capital and
surplus. Loans and certain other extensions of credit to affiliates are required
to be secured by collateral in an amount and of a type described in the
regulation.





Federal
law and Regulation W, among other things, prohibit an institution from engaging
in certain transactions with certain affiliates (as defined in the Federal
Reserve Act) unless the transactions are on terms substantially the same, or at
least as favorable to such institution and/or its subsidiaries, as those
prevailing at the time for comparable transactions with non-affiliated entities.
In the absence of comparable transactions, such transactions may only occur
under terms and circumstances, including credit standards that in good faith
would be offered to or would apply to non-affiliated companies.  In
addition, under Regulation W:





·
            a
      bank and its subsidiaries may not purchase a low-quality asset from an
      affiliate;


·
            covered
      transactions and other specified transactions between a bank or its
      subsidiaries and an affiliate must be on terms and conditions that are
      consistent with safe and sound banking practices;
  and


·
            with
      some exceptions, each loan or extension of credit by a bank to an
      affiliate must be secured by collateral with a market value ranging from
      100% to 130%, depending on the type of collateral, of the amount of the
      loan or extension of credit.





Regulation
W generally excludes all nonbank and nonsavings association subsidiaries of
banks from treatment as affiliates, except to the extent that the FRB decides to
treat these subsidiaries as affiliates.





13


Bay
National Bank also is subject to the restrictions contained in Section 22(h) of
the Federal Reserve Act and the FRB's Regulation O thereunder on loans to
executive officers, directors and principal stockholders. Under Section 22(h),
loans to a director, an executive officer or a greater-than-10% stockholder of a
bank as well as certain affiliated interests of any of the foregoing may not
exceed, together with all other outstanding loans to such person and affiliated
interests, the loans-to-one-borrower limit applicable to national banks
(generally 15% of the institution's unimpaired capital and surplus), and all
loans to all such persons in the aggregate may not exceed the institution's
unimpaired capital and unimpaired surplus. Regulation O also prohibits the
making of loans in an amount greater than $25,000 or 5% of capital and surplus
but in any event not over $500,000, to directors, executive officers and
greater-than-10% stockholders of a bank, and their respective affiliates, unless
such loans are approved in advance by a majority of the Board of Directors of
the bank with any "interested" director not participating in the voting.
Further, Regulation O requires that loans to directors, executive officers and
principal stockholders be made on terms substantially the same as those that are
offered in comparable transactions to unrelated third parties unless the loans
are made pursuant to a benefit or compensation program that is widely available
to all employees of the bank and does not give preference to insiders over other
employees. Regulation O also prohibits a depository institution from paying
overdrafts over $1,000 of any of its executive officers or directors unless they
are paid pursuant to written pre-authorized extension of credit or transfer of
funds plans.





All of
Bay National Bank’s loans to its and Bay National Corporation’s executive
officers, directors and greater-than-10% stockholders, and affiliated interests
of such persons, comply with the requirements of Regulation W and 22(h) of the
Federal Reserve Act and Regulation O.





Loans to One
Borrower.As a national bank, Bay National Bank is subject to
the statutory and regulatory limits on the extension of credit to one borrower.
Generally, the maximum amount of total outstanding loans that a national bank
may have to any one borrower at any one time is 15% of the bank's unimpaired
capital and surplus. A national bank may lend an additional 10% on top of the
15% if the amount that exceeds 15% of the bank's unimpaired capital and surplus
is fully secured by readily marketable collateral.





Liquidity.Bay National Bank
is subject to the reserve requirements of FRB Regulation D, which applies to all
depository institutions with transaction accounts or non-personal time deposits.
Specifically, amounts in transaction accounts above $10.3 million and up to
$44.4 million must have reserves held against them in the ratio of 3 percent of
the amount.  Amounts above $44.4 million require reserves of $1.332
million plus 10 percent of the amount in excess of $44.4 million.  Bay
National Bank is in compliance with the applicable liquidity
requirements.





Dividends.  The
amount of dividends that may be paid by Bay National Bank to Bay National
Corporation depends on its earnings and capital position and is limited by
statute, regulations and policies.  As a national bank, Bay National
Bank may not pay dividends from its paid-in surplus.  All dividends
must be paid out of undivided profits then on hand, after deducting expenses,
including provisions for credit losses and bad debts.  In addition, a
national bank is prohibited from declaring a dividend on its shares of common
stock until its surplus equals its stated capital, unless there has been
transferred to surplus no less than one-tenth of the bank’s net profits for the
preceding two consecutive half-year periods (in the case of an annual
dividend).  OCC approval is required if the total of all dividends
declared by a national bank in any calendar year exceeds the total of its net
profits for that year combined with its retained net profits for the preceding
two years, less any required transfers to surplus.  In addition, Bay
National Bank may not pay a dividend if, after paying the dividend, it would be
undercapitalized.  Furthermore, under the terms of the Consent Order,
the Bank may not pay dividends unless it is in compliance with the capital
program required by the Consent Order and applicable regulatory requirements and
receives the OCC’s written non-objection.





Community Reinvestment
Act.  The Community Reinvestment Act (the "CRA") requires that,
in connection with examinations of financial institutions within their
respective jurisdictions, the FRB, the




14


FDIC, the
OCC or the Office of Thrift Supervision shall evaluate the record of the
financial institutions in meeting the credit needs of their local communities,
including low and moderate income neighborhoods, consistent with the safe and
sound operation of those institutions. The CRA does not establish specific
lending requirements or programs for financial institutions nor does it limit an
institution's discretion to develop the types of products and services that it
believes are best suited to its particular community, consistent with the CRA.
An institution's CRA activities are considered in, among other things,
evaluating mergers, acquisitions and applications to open a branch or facility
as well as determining whether the institution will be permitted to exercise
certain of the powers allowed by the GLBA.  The CRA also requires all
institutions to make public disclosure of their CRA ratings. Bay National Bank
received a “satisfactory” rating in its latest CRA examination conducted in May
2003.





USA PATRIOT
Act.  Under the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act, commonly
referred to as the “USA Patriot Act” or the “Patriot Act,” financial
institutions are subject to prohibitions against specified financial
transactions and account relationships, as well as enhanced due diligence
standards intended to detect, and prevent, the use of the United States
financial system for money laundering and terrorist financing
activities.  The Patriot Act requires financial institutions,
including banks, to establish anti-money laundering programs, including employee
training and independent audit requirements, meet minimum standards specified by
the act, follow minimum standards for customer identification and maintenance of
customer identification records, and regularly compare customer lists against
lists of suspected terrorists, terrorist organizations and money
launderers.





The U.S.
Treasury Department (the “Treasury”) has issued a number of implementing
regulations that apply to various requirements of the USA Patriot Act to
financial institutions such as Bay National Bank.  Those regulations
impose new obligations on financial institutions to maintain appropriate
policies, procedures and controls to detect, prevent and report money laundering
and terrorist financing.




Failure of a financial institution to
comply with the USA Patriot Act’s requirements could have serious legal and
reputational consequences for the institution. The Company has adopted
appropriate policies, procedures and controls to address compliance with the
requirements of the USA Patriot Act under the existing regulations and will
continue to revise and update its policies, procedures and controls to reflect
changes required by the USA Patriot Act and Treasury’s
regulations.





The costs
or other effects of the compliance burdens imposed by the Patriot Act or future
anti-terrorist, homeland security or anti-money laundering legislation or
regulations cannot be predicted with certainty.





Consumer Credit
Reporting.The Fair and Accurate Credit Transactions Act
amended the federal Fair Credit Reporting Act.  These amendments to
the Fair Credit Reporting Act (the “FCRA Amendments”) include, among other
things:





·
            requirements
      for financial institutions to develop policies and procedures to identify
      relevant patterns, practices, and specific forms of activity that are “red
      flags” signaling potential identity theft and, upon the request of a
      consumer, place a fraud alert in the consumer's credit file stating that
      the consumer may be the victim of identity theft or other
      fraud;


·
            for
      entities that furnish information to consumer reporting agencies (which
      would include us), requirements to implement procedures and policies
      regarding the accuracy and integrity of the furnished information, and
      regarding the correction of previously furnished information that is later
      determined to be inaccurate; and


·
            a
      requirement for mortgage lenders to disclose credit scores to
      consumers.




15


The FCRA
Amendments also prohibit a business that receives consumer information from an
affiliate from using that information for marketing purposes unless the consumer
is first provided a notice and an opportunity to direct the business not to use
the information for such marketing purposes (the “opt-out”), subject to certain
exceptions.  We do not share consumer information among our affiliated
companies for marketing purposes, except as allowed under exceptions to the
notice and opt-out requirements.  Because none of our affiliates is
currently sharing consumer information with any other affiliate for marketing
purposes, the limitations on sharing of information for marketing purposes do
not have a significant impact on us.





Other
Regulations.Interest and other charges we collect or contract
for are subject to state usury laws and federal laws concerning interest
rates.  For example, under the Service Members Civil Relief Act, which
amended the Soldiers’ and Sailors’ Civil Relief Act of 1940, a lender is
generally prohibited from charging an annual interest rate in excess of 6% on
any obligation of a borrower who is on active duty with the United States
military.




Our loan
operations are also subject to federal laws applicable to credit transactions,
such as the following:




·
            The
      Federal Truth-In-Lending Act, governing disclosures of credit terms to
      consumer borrowers;




·
            The
      Home Mortgage Disclosure Act of 1975, requiring financial institutions to
      provide information to enable the public and public officials to determine
      whether a financial institution is fulfilling its obligation to help meet
      the housing needs of the community it
serves;




·
            The
      Equal Credit Opportunity Act, prohibiting discrimination on the basis of
      race, creed or other prohibited factors in extending
    credit;




·
            The
      Fair Debt Collection Act, governing the manner in which consumer debts may
      be collected by collection agencies;
and




·
            The
      rules and regulations of the various federal agencies charged with the
      responsibility of implementing these federal
  laws.




Our
deposit operations are subject to the following:




·
            The
      Right to Financial Privacy Act, which imposes a duty to maintain
      confidentiality of consumer financial records and prescribes procedures
      for complying with administrative subpoenas of financial records;
      and




·
            The
      Electronic Funds Transfer Act and Regulation E issued by the FRB to
      implement that Act, which govern automatic deposits to and withdrawals
      from deposit accounts and customers' rights and liabilities arising from
      the use of automated teller machines and other electronic banking
      services.




Proposed Legislation and Regulatory
Actions.New regulations and statutes are regularly proposed
that contain wide-ranging proposals for altering the structures, regulations,
and competitive relationships of the nation’s financial
institutions.  We cannot predict whether or in what form any proposed
regulation or statute will be adopted or the extent to which our business may be
affected by any new regulation or statute.




16


Recent Developments in Response to
Market Volatility.  Negative developments beginning in the
latter half of 2007 in the sub-prime mortgage market and the securitization
markets for such loans have resulted in uncertainty in the financial markets in
general and a related economic downturn, which continued through 2008 and are
expected to continue through 2009.  This resulted in significant
declines in re-sale values for residential and commercial real estate in certain
metropolitan areas such as Baltimore, Maryland.  Concerns over the
stability of the financial markets and the economy have resulted in decreased
lending by financial institutions to their customers and to each
other.  This market turmoil and tightening of credit has led to
increased commercial and consumer loan delinquencies, lack of customer
confidence, increased market volatility and widespread reduction in general
business activity.  Bank and bank holding company stock prices have
been negatively affected as has the ability of bank and bank holding companies
to raise capital or borrow in the debt markets.  The bank regulatory
agencies have been very aggressive in responding to concerns and trends
identified in examinations, and this has resulted in the increased issuance of
enforcement orders requiring action to address credit quality, liquidity and
risk management, and capital adequacy concerns, as well as other safety and
soundness concerns.




On
October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was
enacted to restore confidence and stabilize the volatility in the U.S. banking
system and to encourage financial institutions to increase their lending to
customers and to each other.  Initially introduced as the Troubled
Asset Relief Program (“TARP”), the EESA authorized the United States Department
of the Treasury (“U.S. Treasury”) to purchase from financial institutions and
their holding companies up to $700 billion in mortgage loans, mortgage-related
securities and certain other financial instruments, including debt and equity
securities issued by financial institutions and their holding companies in a
troubled asset relief program.




The FDIC
has implemented two temporary programs under the Temporary Liquidity Guaranty
Program (“TLGP”) to provide deposit insurance for the full amount of most
noninterest bearing transaction accounts through the end of 2009 and to
guarantee certain unsecured debt of financial institutions and their holding
companies through June 2012.  Financial institutions had until
December 5, 2008 to opt out of these two programs.  The Company has
elected not to opt out of these two programs.  The FDIC charges
“systemic risk special assessments” to depository institutions that participate
in the TLGP.  The FDIC has recently proposed that Congress give the
FDIC expanded authority to charge fees to the holding companies which benefit
from the FDIC guarantees.




Effect Of Governmental Monetary
Policies.Our earnings are affected by domestic economic conditions and
the monetary and fiscal policies of the United States government and its
agencies.  The FRB’s monetary policies have had, and are likely to
continue to have, an important impact on the operating results of commercial
banks through its power to implement national monetary policy in order, among
other things, to curb inflation or combat a recession.  The monetary
policies of the FRB affect the levels of bank loans, investments and deposits
through its control over the issuance of United States government securities,
its regulation of the discount rate applicable to member banks and its influence
over reserve requirements to which member banks are subject. We cannot predict
the nature or impact of future changes in monetary and fiscal
policies.




FORWARD
      LOOKING STATEMENTS





Some of
the matters discussed in this annual report including under the captions
“Business of Bay National Corporation and Bay National Bank,” and “Management’s
Discussion and Analysis of Financial Condition and Results of Operations”
include forward-looking statements.  These forward-looking statements
include statements regarding, among other things, statements in connection with
our description of the Company’s Strategic Plan and actions to be taken in
connection with the Consent Order, the Company’s expectations with respect to
resolving issues in its loan portfolio, future sources of revenue, liquidity
including anticipated sources of liquidity going forward, the allowance for
credit losses, interest rate sensitivity, payment of dividends, market risk,
hiring intentions and salary and benefit expenses, increasing




17


non-interest
income, competing for large certificates of deposit, subletting the space of our
former residential mortgage operation in Towson and former loan production
office in Columbia, investment strategies and expansion, financial and other
goals.  Forward-looking statements often use words such as “believe,”
“expect,” “plan,” “may,” “will,” “should,” “could,” “would,” “project,”
“contemplate,” “anticipate,” “forecast,” “intend”, or other words of similar
meaning.  You can also identify them by the fact that they do not
relate strictly to historical or current facts.When you read a
forward-looking statement, you should keep in mind the risk factors described
below and any other information contained in this annual report which identifies
a risk or uncertainty.  Bay National Corporation’s actual results and
the actual outcome of Bay National Corporation’s expectations and strategies
could be different from that described in this annual report because of these
risks and uncertainties and you should not put undue reliance on any
forward-looking statements.  All forward-looking statements speak only
as of the date of this filing, and Bay National Corporation undertakes no
obligation to make any revisions to the forward-looking statements to reflect
events or circumstances after the date of this filing or the occurrence of
unanticipated events.





Item
1A.  Risk Factors





You
should carefully consider the following risks, along with the other information
contained in this annual report.  The risks and uncertainties
described below are not the only ones that may affect Bay National
Corporation.  Additional risks and uncertainties may also adversely
affect our business and operations including those discussed in Item 7 –
Management’s Discussion and Analysis of Financial Condition and Results of
Operations and risks that we are currently unaware of or that we do not
currently consider material. If any of the following events actually occur, our
business and financial results could be materially adversely
affected.





Difficult economic and
market conditions have adversely affected, and may continue to adversely affect,
us and our industry.  Dramatic declines in the housing market,
with decreasing home prices and increasing delinquencies and foreclosures, have
negatively impacted the credit performance of mortgage and construction loans
and resulted in significant write downs of assets by many financial
institutions, including us.  Because a significant portion of our loan
portfolio is comprised of real estate related loans, continued decreases in real
estate values could adversely affect the value of property used as collateral
for loans in our portfolio.  General downward economic trends, reduced
availability of commercial credit and increasing unemployment have negatively
impacted the credit performance of commercial and consumer credit, resulting in
additional write downs.  Concerns over the stability of the financial
markets and the economy have resulted in decreased lending by financial
institutions.  This market turmoil has led to increased commercial and
consumer deficiencies, lack of customer confidence, increased market volatility
and reduction in general business activity.  The resulting economic
pressure on consumers and businesses and the lack of confidence in the financial
markets may continue to adversely affect our business, financial condition,
results of operation and stock price.  We do not expect that the
difficult conditions in the financial markets are likely to improve in the near
future.  A worsening of these conditions would likely exacerbate the
adverse effects of these difficult market conditions on us and others in the
financial institutions industry.





Because we currently serve
limited market areas, we could be more adversely affected by an economic
downturn in our market areas than our larger competitors who are more
geographically diverse.   Currently, our primary market
areas are limited to the Baltimore metropolitan area, the Baltimore-Washington
corridor and Maryland’s Eastern Shore.  Although the economic decline
has not impacted the suburban Maryland and Washington D.C. suburbs as adversely
as other areas of the United States, it has caused an increase in unemployment
and business failures and a significant decline in property values in the
metropolitan areas.  As a result, if any of these areas continues to
suffer an economic downturn, our business and financial condition may be more
severely affected than our larger bank competitors.  Our larger
competitors serve a more geographically diverse market area, parts of which may
not be affected by the same economic conditions that exist in our primary market
areas.  Further, unexpected changes in the national and local economy
may adversely affect our ability to attract deposits and to make loans. Such
risks are beyond




18


our
control and may have a material adverse effect on our financial condition and
results of operations and, in turn, the value of our securities.





Liquidity risk could impair
our ability to fund operations and jeopardize our financial
condition.Liquidity is essential to our
business.  An inability to raise funds through deposits, borrowings,
sale of loans and other sources could have a material adverse effect on our
liquidity.  Further, if U.S. markets and economic conditions continue
to deteriorate, our liquidity could be adversely affected.  For
example, further declines in the housing market could result in additional asset
write downs, which could reduce our liquidity below required levels and require
us to seek additional capital.  There can be no guarantee, however,
that such capital would be available when we require it or, if available, on
favorable terms, and if we raise capital via the sale of common stock, the
holdings of our current stockholders would be diluted.  Our access to
funding sources in amounts adequate to finance our activities could be impaired
by factors that affect us specifically or the financial services industry in
general.  Factors that could detrimentally impact our access to
liquidity sources include a decrease in the level of our business activity due
to a market downturn or adverse regulatory action against us.  Our
ability to acquire deposits or borrow could also be impaired by factors that are
not specific to us, such as a severe disruption of the financial markets or
negative views and expectations about the prospects for the financial services
industry.  Further, given that Bay National Bank is unable to issue
brokered CDs without prior approval from the FDIC, the Bank’s inability to
replace maturing brokered deposits with core deposits or cash flows from loan
repayments may require us to generate liquidity through other
means.  If we cannot raise additional capital when needed, our ability
to further expand operations through internal growth and deposit gathering could
be materially impaired.





Government regulation could
restrict Bay National Corporation’s or Bay National Bank’s growth or cause Bay
National Corporation or Bay National Bank to incur higher
costs.  Bay National Corporation and Bay National Bank operate
in a highly regulated environment and are subject to examination, supervision
and comprehensive regulation by several federal and state regulatory agencies.
Banking regulations, designed primarily for the safety of depositors, may limit
the growth of Bay National Bank and the return to investors by restricting
activities such as the payment of dividends; mergers with, or acquisitions by,
other institutions; investments; loans and interest rates; interest rates paid
on deposits; and the creation of branch offices. Laws and regulations could
change at any time, and changes could adversely affect Bay National
Corporation’s and Bay National Bank’s business. In addition, the cost of
compliance with regulatory requirements could adversely affect Bay National
Corporation’s and Bay National Bank’s ability to operate
profitably.





In
addition, the financial sector has recently been the focus on recent legislative
debate and government intervention, and we anticipate that additional laws and
regulations may be enacted in response to the current financial crises that
could have an impact on our operations.  Any changes in regulation and
oversight, including in the form of changes to statutes, regulations or
regulatory policies or changes in interpretation or implementation of statutes,
regulations or policies, could affect the service and products we offer,
increase our operating expenses, and otherwise adversely impact our financial
performance and condition. In addition, the burden imposed by these federal and
state regulations may place banks in general, and Bay National Bank
specifically, at a competitive disadvantage compared to less regulated
competitors.





Bay National Corporation and
Bay National Bank depend heavily on one key employee, Mr. Hugh W. Mohler, and
business would suffer if something were to happen to Mr. Mohler.  Mr. Mohler
is the Chairman, President and Chief Executive Officer of Bay National Bank. If
he were to leave for any reason, Bay National Corporation’s and Bay National
Bank’s business would suffer because he has banking experience and relationships
with clients and potential clients that would not be easy to replace. In
addition, because Bay National Bank’s business is relationship-driven, the loss
of an employee who has primary contact with one or more of Bay National Bank’s
clients could cause Bay National Bank to lose those clients' business, possibly
resulting in a decline in revenues.





19


If our allowance for credit
losses is not sufficient to cover actual loan losses, our earnings could
decrease.  We make various assumptions and judgments about the
collectability of our loan portfolio, including the creditworthiness of our
borrowers and the value of collateral for repayment.  In determining
the amount of the allowance for credit losses, we review and evaluate, among
other things, our loans and our loss and delinquency experience and current
economic conditions.  If our assumptions are incorrect, our allowance
for credit losses may not be sufficient to cover losses inherent in our loan
portfolio, resulting in additions to our allowance.





We are
particularly susceptible to this risk because we have experienced significant
growth in our residential real estate loan portfolio over the past few
years.  In general, loans do not begin to show signs of credit
deterioration or default until they have been outstanding for some period of
time, a process referred to as “seasoning.”  As a result, a portfolio
of older loans will usually behave more predictably than a newer
portfolio.  Because our residential real estate loan portfolio is not
significantly seasoned and there has been a downturn in the residential real
estate market, the current level of delinquencies and defaults may not be
representative of the level that will prevail when the portfolio becomes more
seasoned or if the condition of the residential real estate market does not
improve.  If delinquencies and defaults continue to increase, we may
be required to further increase our provision for credit losses.





Material
additions to our allowance would materially decrease our net
income.  In addition, bank regulators periodically review our
allowance for credit losses and may require us to increase our provision for
loan losses or recognize further loan charge-offs.  Any increase in
our allowance for credit losses or loan charge-offs may have a material adverse
effect on our results of operations and financial condition.





Bay National Bank’s lending
strategy involves risks resulting from the choice of loan
portfolio.  Bay National Bank's loan strategy emphasizes
commercial business loans and commercial real estate loans. At December 31,
2008, such loans accounted for approximately 77% of the loan portfolio.
Commercial business and commercial real estate loans may carry a higher degree
of credit risk than do residential mortgage loans because of several factors
including larger loan balances, dependence on the successful operation of a
business or a project for repayment, or loan terms with a balloon payment rather
than full amortization over the loan term.





Bay National Bank’s lending
limit may limit its growth and the growth of Bay National
Corporation.  Bay National Bank is limited in the amount it can
loan to a single borrower by the amount of its capital. Specifically, under
current law, Bay National Bank may lend up to 15% of its unimpaired capital and
surplus to any one borrower. Bay National Bank’s lending limit is significantly
less than that of many of its competitors and may discourage potential borrowers
who have credit needs in excess of Bay National Bank’s lending limit from
conducting business with Bay National Bank.





Bay National Bank faces
substantial competition which could adversely affect its ability to attract
depositors and borrowers.  Bay National Bank operates in a
competitive market for financial services and faces intense competition from
other institutions both in making loans and in attracting deposits. Many of
these institutions have been in business for numerous years, are significantly
larger, have established customer bases, have greater financial resources and
lending limits than Bay National Bank, and are able to offer certain services
that Bay National Bank is not able to offer. If Bay National Bank cannot attract
deposits and make loans at a sufficient level, its operating results will
suffer, as will its opportunities for growth.





Bay National Bank's ability
to compete may suffer if it cannot take advantage of technology to provide
banking services or if its customers fail to embrace that
technology.  Bay National Bank’s business strategy relies less
on customers' access to a large branch network and more on access to technology
and personal relationships. Further, the market for financial services is
increasingly affected by advances in technology, including developments in
telecommunications, data processing, computers, automation, Internet-based
banking and tele-banking.  Bay National Bank’s ability to compete
successfully may depend


20


on the
extent to which Bay National Bank can take advantage of technological changes
and the extent to which Bay National Bank’s customers embrace technology to
complete their banking transactions.




Our profitability depends on
interest rates and changes in monetary policy may impact
us.  Our results of operations depend to a large extent on our
“net interest income,” which is the difference between the interest expense
incurred in connection with our interest-bearing liabilities, such as interest
on deposit accounts, and the interest income received from our interest-earning
assets, such as loans.  Interest rates are influenced by, among other
things, expectations about future events, including the level of economic
activity, federal monetary and fiscal policy and geo-political stability, and as
a result, are not predictable or controllable.  In addition,
competitive factors heavily influence the interest rates we can earn on our loan
and investment portfolios and the interest rates we pay on our
deposits.  Community banks, in part, are often at a competitive
disadvantage in managing their cost of funds compared to the large regional,
super-regional or national banks that have access to the national and
international capital markets.  These factors influence our ability to
maintain a stable interest margin.





The costs of being a public
company are proportionately higher for small companies like us due to the
requirements of the Sarbanes-Oxley Act.  The Sarbanes-Oxley Act
of 2002 and the related rules and regulations promulgated by the Securities and
Exchange Commission have increased the scope, complexity, and cost of corporate
governance, reporting, and disclosure practices.  These regulations
are applicable to our company.  We expect to experience increasing
compliance costs, including costs related to internal controls, as a result of
the Sarbanes-Oxley Act.  These obligatory costs are proportionately
higher for a company of our size and will affect our profitability more than
that of some of our larger competitors.





Item
1B.  Unresolved Staff Comments





Not
applicable as the Company is not an accelerated filer or large accelerated
filer.




21


Item
2.  Properties





Baltimore





Our
Baltimore branch and administrative offices are located at 2328 West Joppa Road,
Lutherville, Maryland 21093.  Currently, we lease space in the
basement (1,429 square feet), the first floor (4,067 square feet) and the third
floor (6,206 square feet) of this building.  The basement space is
currently used for training and storage purposes of which approximately 400
square feet was sublet through August 2008 (we do not plan to sublet this space
going forward), 1,712 square feet of the first floor space is currently used for
administrative office space of which approximately 947 square feet will be
available to sublet as early as April 1, 2009, 2,355 square feet of the first
floor space is used for the Lutherville branch office and the third floor space
is used for Bay National Corporation and Bay National Bank’s executive, loan and
administrative offices.  The current lease expires on February 28,
2010, and we have the right to extend the lease for one five-year term to
February 28, 2015.





As of
December 31, 2008, Bay National Corporation was paying rent of $370,539 per
year, or $30,878 per month for all of the leased space in the
building.  For the March 2009 to February 2010 lease year, Bay
National Corporation will pay annual rent of $381,660, or $31,804 per
month.  If we extend the lease term, then for each lease year
thereafter, the yearly base rent will increase by 3%.  The rent
includes Bay National Corporation’s share of taxes and building operating
costs.





The
Landlord, Joppa Green II Limited Partnership, LLLP, is beneficially owned by the
MacKenzie Companies.  Gary T. Gill, who had been a director of Bay
National Corporation and Bay National Bank from January 2003 until May 2008, is
the president and chief executive officer of the MacKenzie
Companies.  See “Item 13 – Certain Relationships and Related
Transactions, and Director Independence.”





Towson





Bay
National Bank began leasing 4,317 square feet of space on the first floor of a
building located at 1122 Kenilworth Drive, Towson, Maryland 21204 for its
Baltimore residential mortgage operation on October 1, 2006. Pursuant to the
lease agreement, the Bank agreed to an initial lease term of five years and two
months, terminating on November 30, 2011. The Bank was also provided the right
to renew the lease
for one additional five-year term.  As part of this agreement, the
aggregate rent due under the lease is $8,969 monthly from December 2008 through
November 2009.  For each lease year thereafter, including any lease
years during any renewal term, the yearly base rent will increase by
3%.





In
November 2008, the Baltimore residential mortgage operation moved to available
space on the third floor of our headquarters located at 2328 West Joppa Road,
Lutherville, Maryland.  The Bank is currently paying the rent but
plans to sublet the space previously occupied by this group as part of its
continued emphasis on expense management.




Columbia





On
October 3, 2007, Bay National Bank agreed to lease 3,181 square feet of space on
the third floor of a building located at 8820 Columbia 100 Parkway, Suite 301,
Columbia, Maryland 21045.  This space was previously used for its
Baltimore-Washington corridor loan production office, which was closed effective
March 19, 2009.  Pursuant to the lease agreement, the Bank agreed to
an initial lease term of five years.  The Bank was also provided the
right to renew the lease for two additional five-year terms.  The
current rent under this agreement was $6,921 per month and increased by 3% for
each subsequent lease year thereafter, including any lease years during any
renewal term.  The Bank is currently paying the




22


rent but
plans to sublet the space previously occupied by this group as part of its
continued emphasis on expense management.





Salisbury





Bay
National Bank's Salisbury, Maryland branch office is located at 109 Poplar Hill
Avenue, Salisbury Maryland 21801 in a two-story building containing
approximately 2,500 square feet of office space.  The current lease
terminates on August 31, 2009, and we have the right to extend the lease for two
additional five-year terms. Under the current lease term, Bay National
Corporation is paying monthly rent of approximately $2,292, plus all real estate
taxes and utilities. Pursuant to this lease, Bay National Corporation has a
right of first refusal to purchase the building in the event the landlord
receives a bona fide offer to sell. This property is owned by John R. Lerch, who
has been a director of Bay National Corporation and Bay National Bank since
their formation.  See “Item 13 – Certain Relationships and Related
Transactions, and Director Independence.”





Through
October 2008, Bay National Bank's Salisbury, Maryland mortgage division office
was located at 318 East Main Street, Salisbury Maryland 21801. The leased space
consisted of two office suites totaling approximately 420 square
feet.  The original lease for this space expired on December 31, 2004
and Bay National Corporation rented the space on a month-to-month basis at a
cost of $700 per month. The landlord was responsible for all real estate taxes
and utilities.  The Company had leased an additional 200 square feet
in this building from January 1, 2005 through November 30, 2005 at an additional
cost of $300 per month.  During October 2008, the Salisbury mortgage
division moved to available space at the branch office located at 109 Poplar
Hill Avenue, Salisbury, Maryland 21801.





In August
2008, the Company began renting office space in Cambridge, Maryland on a
month-to-month basis at a cost of $350 per month for residential real estate
loan production.





Item
3.  Legal Proceedings





The
Company is party to legal actions that are routine and incidental to our
business.  In management’s opinion, the outcome of these matters,
individually or in the aggregate, will not have a material effect on our results
of operations or financial position. There are no proceedings known to Bay
National Corporation to be contemplated by any governmental
authority.  There are no material proceedings known to Bay National
Corporation, pending or contemplated, in which any director, officer or
affiliate or any principal security holder of Bay National Corporation is a
party adverse to Bay National Corporation or Bay National Bank or has a material
interest adverse to Bay National Corporation or Bay National Bank.





Item
4.  Submission of Matters to a Vote of Security Holders





No matter
was submitted during the fourth quarter of the year ended December 31, 2008 to a
vote of security holders of Bay National Corporation.




23


PART
II





Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities





As of
March 24, 2009, the number of holders of record of Bay National Corporation’s
common stock was approximately 339 as reported by the stock transfer agent,
Registrar and Transfer Company. Bay National Corporation’s common stock is
currently traded on the NASDAQ Capital Market under the symbol
"BAYN."





The
following table reflects the high and low sales information as reported on the
NASDAQ Capital Market for the periods presented. Quotations reflect inter-dealer
prices, without retail mark-up, mark-down, or commission and may not represent
actual transactions.  Amounts previously reported have been adjusted
to reflect a 1.1 to 1 stock split in the form of a stock dividend recorded on
June 29, 2007.





2008
              Sales
      Price Range
            
            
            2007
              Bid
      or Sales Price RangeQuarter
            
            Low
            
            
            High
            
            
            Low
            
            
            High1st
            $
            8.12
            
            $
            11.70
            
            $
            15.50
            
            $
            17.552nd
            
            7.80
            
            
            10.20
            
            
            14.77
            
            
            16.833rd
            
            4.26
            
            
            8.03
            
            
            14.50
            
            
            16.754th
            
            1.50
            
            
            5.96
            
            
            9.70
            
            
            18.00





Bay
National Corporation declared a 10% stock dividend in April 2007 payable on June
29, 2007 to stockholders of record on June 18, 2007 and all prior per share
amounts have been restated to reflect this dividend.  Bay National has
not paid any cash dividends during 2007 and 2008.  Management
anticipates that Bay National Corporation will retain all earnings, if any, in
order to provide more funds to operate and expand Bay National Corporation’s
business; therefore, Bay National Corporation has no plans to pay any cash
dividends at least until its profitability exceeds the level necessary to
support capital growth in excess of regulatory capital needs.  If Bay
National Corporation decides to pay dividends in the future, its ability to do
so will depend on the ability of Bay National Bank to pay dividends to Bay
National Corporation. In addition, management would consider a number of other
factors before deciding to pay dividends, including Bay National Corporation’s
earnings prospects, financial condition and cash needs.  In addition,
in February 2009, Bay National Corporation received notice from the Federal
Reserve Bank of Richmond that Bay National Corporation is expected to
immediately terminate future dividend payments, including payments on trust
preferred securities.  This order will remain in effect until Bay
National Corporation receives written approval from the Reserve Bank to resume
such payments.





The
amount of dividends that may be paid by Bay National Bank to Bay National
Corporation depends on Bay National Bank's earnings and capital position and is
limited by statute, regulations and regulatory policies.  As a
national bank, Bay National Bank may not pay dividends from its permanent
capital. All cash dividends must be paid out of undivided profits then on hand,
after deducting expenses, including provisions for credit losses and bad debts.
In addition, a national bank is prohibited from declaring a cash dividend on its
shares of common stock until its surplus equals its stated capital, unless there
has been transferred to surplus no less than one-tenth of the bank's net profits
for the preceding two consecutive half-year periods (in the case of an annual
dividend). OCC approval is required if the total of all cash dividends declared
by a national bank in any calendar year exceeds the total of its net profits for
that year combined with its retained net profits for the preceding two years,
less any required transfers to surplus. In addition, Bay National Bank may not
pay a dividend if, after paying the dividend, it would be “undercapitalized” as
defined in the applicable regulations.  Furthermore, under the terms
of the February 6, 2009 Consent Order, the Bank may not pay dividends unless it
is in compliance with the capital program required by the Consent Order and
applicable regulatory requirements and receives the OCC’s written
non-objection.





24


Item
6.  Selected Financial Data





SELECTED
FINANCIAL DATA


AS OF
DECEMBER 31, 2008, 2007, 2006, 2005 and 2004


(dollars
in thousands, except per share data)





2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Total
      assets
              
              $
              270,588
              
              
              $
              256,536
              
              
              $
              254,805
              
              
              $
              209,966
              
              
              $
              170,763Cash
      and due from banks
              
              
              7,263
              
              
              
              2,314
              
              
              
              2,348
              
              
              
              1,461
              
              
              
              1,403Federal
      funds sold and other overnight investments
              
              
              2,023
              
              
              
              4,859
              
              
              
              31,550
              
              
              
              6,033
              
              
              
              16,709Investment
      securities available for sale
              
              
              -
              
              
              
              400
              
              
              
              698
              
              
              
              1,540
              
              
              
              1,544Federal
      Reserve Bank stock
              
              
              704
              
              
              
              607
              
              
              
              607
              
              
              
              452
              
              
              
              313Federal
      Home Loan Bank stock
              
              
              535
              
              
              
              1,108
              
              
              
              510
              
              
              
              342
              
              
              
              243Loans,
      net
              
              
              242,676
              
              
              
              235,956
              
              
              
              214,841
              
              
              
              196,590
              
              
              
              149,217Deposits
              
              
              244,628
              
              
              
              201,981
              
              
              
              224,149
              
              
              
              182,573
              
              
              
              153,927Short-term
      borrowings
              
              
              1,864
              
              
              
              25,372
              
              
              
              1,545
              
              
              
              1,444
              
              
              
              1,381Note
      payable
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,250Subordinated
      debt
              
              
              8,000
              
              
              
              8,000
              
              
              
              8,000
              
              
              
              8,000
              
              
              
              -Stockholders’
      equity
              
              
              15,022
              
              
              
              19,921
              
              
              
              18,842
              
              
              
              16,214
              
              
              
              13,419Common
      shares outstanding*
              
              
              2,153,101
              
              
              
              2,137,633
              
              
              
              2,128,867
              
              
              
              2,116,841
              
              
              
              2,109,442Book
      value per share
              
              $
              6.98
              
              
              $
              9.32
              
              
              $
              8.85
              
              
              $
              7.66
              
              
              $
              6.36Ratio
      of interest earning assets to interest bearing liabilities
              
              
              127.07
              %
              
              
              121.35
              %
              
              
              126.40
              %
              
              
              126.38
              %
              
              
              124.95
              %Stockholders’
      equity as a percentage of assets
              
              
              5.55
              %
              
              
              7.77
              %
              
              
              7.39
              %
              
              
              7.72
              %
              
              
              7.86
              %





SELECTED
FINANCIAL RATIOS


FOR THE
YEARS ENDED DECEMBER 31, 2008, 2007, 2006, 2005 and 2004





Weighted
      average yield/rate on:
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Loans
      and loans held for sale
              
              
              6.15
              %
              
              
              8.79
              %
              
              
              9.12
              %
              
              
              7.46
              %
              
              
              5.89
              %Investments
      and interest bearing cash balances
              
              
              1.47
              %
              
              
              3.90
              %
              
              
              3.79
              %
              
              
              2.27
              %
              
              
              1.11
              %Deposits
      and borrowings
              
              
              3.20
              %
              
              
              4.45
              %
              
              
              4.31
              %
              
              
              2.96
              %
              
              
              2.17
              %Net
      interest spread
              
              
              2.71
              %
              
              
              3.95
              %
              
              
              4.40
              %
              
              
              4.12
              %
              
              
              3.14
              %Net
      interest margin
              
              
              3.30
              %
              
              
              4.82
              %
              
              
              5.27
              %
              
              
              4.74
              %
              
              
              3.60
              %





SELECTED
OPERATIONAL DATA


FOR THE
YEARS ENDED DECEMBER 31, 2008, 2007, 2006, 2005 and 2004


(dollars
in thousands, except per share data)





2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Interest
      income
                  
                  $
                  15,325
                  
                  
                  $
                  20,588
                  
                  
                  $
                  19,781
                  
                  
                  $
                  12,983
                  
                  
                  $
                  7,624Interest
      expense
                  
                  
                  6,763
                  
                  
                  
                  8,765
                  
                  
                  
                  7,823
                  
                  
                  
                  4,294
                  
                  
                  
                  2,464Net
      interest income
                  
                  
                  8,562
                  
                  
                  
                  11,823
                  
                  
                  
                  11,958
                  
                  
                  
                  8,689
                  
                  
                  
                  5,160Provision
      for credit losses
                  
                  
                  6,478
                  
                  
                  
                  2,126
                  
                  
                  
                  203
                  
                  
                  
                  1,179
                  
                  
                  
                  560Net
      interest income after provision for credit losses
                  
                  
                  2,084
                  
                  
                  
                  9,697
                  
                  
                  
                  11,755
                  
                  
                  
                  7,510
                  
                  
                  
                  4,600Non-interest
      income
                  
                  
                  763
                  
                  
                  
                  725
                  
                  
                  
                  777
                  
                  
                  
                  750
                  
                  
                  
                  539Non-interest
      expenses
                  
                  
                  11,106
                  
                  
                  
                  8,993
                  
                  
                  
                  8,424
                  
                  
                  
                  6,171
                  
                  
                  
                  4,337(Loss)
      Income before income taxes
                  
                  
                  (8,259
                  )
                  
                  
                  1,429
                  
                  
                  
                  4,108
                  
                  
                  
                  2,089
                  
                  
                  
                  802(Loss)
      Income tax benefit (expense)
                  
                  
                  3,194
                  
                  
                  
                  (492
                  )
                  
                  
                  (1,678
                  )
                  
                  
                  655
                  
                  
                  
                  -Net
      (loss) income
                  
                  $
                  (5,065
                  )
                  
                  $
                  937
                  
                  
                  $
                  2,430
                  
                  
                  $
                  2,744
                  
                  
                  $
                  802PER
      COMMON SHAREBasic
      net (loss) income per share*
                  
                  $
                  (2.37
                  )
                  
                  $
                  .44
                  
                  
                  $
                  1.14
                  
                  
                  $
                  1.30
                  
                  
                  $
                  .39Diluted
      net (loss) income per share*
                  
                  $
                  (2.37
                  )
                  
                  $
                  .42
                  
                  
                  $
                  1.09
                  
                  
                  $
                  1.24
                  
                  
                  $
                  .37Average
      shares outstanding (Basic)*
                  
                  
                  2,140,793
                  
                  
                  
                  2,133,174
                  
                  
                  
                  2,131,882
                  
                  
                  
                  2,114,809
                  
                  
                  
                  2,065,693Average
      shares outstanding (Diluted)*
                  
                  
                  2,140,793
                  
                  
                  
                  2,210,151
                  
                  
                  
                  2,219,989
                  
                  
                  
                  2,202,417
                  
                  
                  
                  2,130,333


*All periods have been adjusted to
reflect a 1.1 to 1 stock split in the form of a 10% dividend recorded on June
29, 2007.




25


Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations





The
following discussion of Bay National Corporation’s financial condition and
results of operations should be read in conjunction with Bay National
Corporation’s consolidated financial statements, the notes thereto and the other
information included in this annual report.





This
discussion and analysis provides an overview of the financial condition and
results of operations of Bay National Corporation ("Parent") and its national
bank subsidiary, Bay National Bank ("Bank"), (collectively
the  "Company"), as of December 31, 2008 and 2007 and for the years
ended December 31, 2008, 2007 and 2006.





Certain
reclassifications have been made to amounts previously reported to conform to
the classifications made in 2008.





General





The
Parent was incorporated on June 3, 1999 under the laws of the State of Maryland
to operate as a bank holding company of the Bank. The Bank commenced operations
on May 12, 2000.





The
principal business of the Company is to make loans and other investments and to
accept time and demand deposits. The Company’s primary market areas are the
Baltimore Metropolitan area, Baltimore-Washington corridor and Maryland’s
Eastern Shore, although the Company’s business development efforts generate
business outside of these areas. The Company offers a broad range of banking
products, including a full line of business and personal savings and checking
accounts, money market demand accounts, certificates of deposit, and other
banking services. The Company funds a variety of loan types including commercial
and residential real estate loans, commercial term loans and lines of credit,
consumer loans, and letters of credit with an emphasis on meeting the borrowing
needs of small businesses. The Company’s target customers are small and
mid-sized businesses, business owners, professionals, nonprofit institutions and
high net worth individuals.





Overview





The
Company’s growth moderated in 2008 and operating results declined due to
deterioration of the economic environment and industry-wide problems in
residential real estate lending. As such, management continues to emphasize
prudent asset/liability management and it has significantly tightened its
underwriting standards for residential real estate loans.  Key
measurements for the year ended December 31, 2008 include the
following:





·
            Total
      assets at December 31, 2008 increased by 5.5% to $270.6 million as
      compared to $256.5 million as of December 31,
  2007.





·
            Net
      loans outstanding increased by 2.8% from $ 235.9 million as of December
      31, 2007 to    $242.7 million as of December 31,
      2008.





·
            There
      was approximately $13.5 million in non-accrual loans as of December 31,
      2008.  In addition, the Company foreclosed on twenty-eight
      pieces of investor-owned residential real estate during 2008. These
      properties were placed into real estate acquired through foreclosure at an
      estimated net realizable value of approximately $8.6 million. As of
      December 31, 2008, fourteen properties remained with a net realizable
      value of $3.9 million.  Also, the Company had troubled debt
      restructures totaling $952,372 and approximately $2.0 million of loans 90
      days or more past due and still accruing.  There were no other
      non-performing assets as of December 31,
2008.





26


·
            Seventeen
      properties, held in real estate acquired through foreclosure, were sold
      during 2008. The amounts realized upon the sale of these properties
      closely approximated the value at which they were
  carried.





·
            Deposits
      at December 31, 2008 were $244.6 million, an increase of $42.6 million or
      21.1% from December 31, 2007.





·
            The
      Company realized a net loss of $5.1 million for the year ended December
      31, 2008. This compares to net income of $937,369 and $2.4 million for the
      years ended December 31, 2007 and 2006, respectively. Included in the
      results of the year ended December 31, 2008 was an income tax benefit of
      $3.2 million compared to income tax expense of $491,395 recorded in 2007.
      Net income for the year ended December 31, 2006 included income tax
      expense of $1.7 million.





·
            Net
      interest income, the Company’s main source of income, was $8.6 million for
      the year ended December 31, 2008 compared to $11.8 million and $12.0
      million for the years ended December 31, 2007 and 2006, respectively. This
      represents decreases of 27.6% and 28.4% from 2007 and 2006,
      respectively.





·
            Net
      loan charge-offs were $5.8 million for the year ended December 31, 2008,
      the majority of which were due to continued weaknesses in the Company’s
      portfolio of investor-owned residential construction and reconstruction
      loans resulting from problems in the housing market in its target
      markets.  Net loan charge-offs were $300,680 and $27,931 for the
      years ended December 31, 2007 and 2006,
  respectively.





·
            Non-interest
      income for the year ended December 31, 2008 increased by $38,362, or 5.3%,
      as compared to the year ended December 31, 2007 and decreased by $14,174,
      or 1.8%, as compared to the year ended December 31,
  2006.





·
            Non-interest
      expense increased by $2.1 million, or 23.5%, and $2.7 million, or 31.8%,
      for the year ended December 31, 2008, as compared to the years ended
      December 31, 2007 and 2006,
respectively.





·
            The
      market price of our common stock ended the year at $2.40, down 75.4% from
      the closing price of $9.75 on December 31,
2007.





·
            During
      2008, the Company eliminated seventeen positions and also reorganized its
      Baltimore-based residential lending operation by hiring new leadership
      that will focus on originating permanent residential mortgages to generate
      fee income by selling the loans to the secondary market. The Company has
      also tightened its construction lending underwriting to ensure that any
      loans written will be supported by appropriate primary and secondary
      sources of repayment.





A
detailed discussion of the factors leading to these changes can be found in the
discussion below.





Recent
Developments





On
February 6, 2009, pursuant to a Stipulation and Consent to the Issuance of a
Consent Order, the Bank consented to the issuance of a Consent Order by the OCC,
the Bank’s primary banking regulator.





Among
other things, the order requires the Bank and/or its Board to take




27


certain
actions, including developing and submitting certain written plans to the OCC,
and imposes certain restrictions on the Bank designed to improve its financial
strength, including the following: within 30 days provide a written analysis of
the Board’s decision whether to sell, merge or liquidate the Bank or remain
independent; if the Board decides the Bank should remain independent and the OCC
does not object to the written analysis, within 60 days of the Order implement a
three-year strategic plan for the Bank with respect to certain financial
objectives; by April 30, 2009 maintain a 12% total risk-based ratio, an 11% Tier
1 risk-based ratio and a 9% leverage ratio; develop a three-year capital program
that, among other things, assesses current and expected funding needs and
ensures that sufficient funds or access to funds exists to meet those needs;
ensure that the Bank has competent management in its credit risk and asset
liability risk management functions; conduct management reviews and adopt a
written education program for officers as necessary; immediately take action to
protect the Bank’s interest in assets criticized by the OCC and adopt a written
program designed to eliminate the basis of such criticism; and develop written
plans to address liquidity improvement, loan portfolio management, asset
diversification, the Bank’s allowance for loan and lease losses, monitoring and
review of problem loans and leases, charged-off loans and related issues, and
monitoring of  portfolio trends.





The Board
has appointed a compliance committee to monitor, coordinate and report to the
Board on the Bank’s compliance with the Consent Order.  In addition,
under the Consent Order the Bank may not pay dividends unless it is in
compliance with the capital program required by the Consent Order and applicable
regulatory requirements and receives the OCC’s written
non-objection.





The
foregoing description is only a summary of the material terms of the Order and
is qualified in its entirety by reference to the Order, which is filed as
exhibit 10.19 hereto.





The
Board and its compliance committee and have submitted a written analysis to
the OCC in which the Bank details its decision to remain independent while
continually evaluating other options.





Summary
of Key Items contained in the Board’s written response to the Consent
Order:





The
Bank's Board of Directors and Executive Management are adopting a Strategic
Plan that maps out the strategy for the Bank to restore its higher
capitalization, strong earnings, good asset quality and to also eliminate the
concerns raised by the OCC in the Consent Order.  The plan will return
the Bank to its original business model, provide stronger risk controls and
provide the management and support items necessary to continue to grow and serve
its customer base.  We envision all the key elements of the plan being
in place by the end of 2009.





There can
be no assurance that the OCC will accept our strategic plan to remain
independent and they could strictly enforce the terms of the
Order.  In such a situation there can be no assurance that the Company
will be able to raise the required amount of capital within the time frame
required in the Order and further regulatory actions could follow.





In order
to make the plan work, the Bank will focus on six goals that are the keys to its
success.  These are:





•           A
return to the original mission: The Bank's original mission was to serve local
businesses and professionals through internally generated loans.  The
Bank has returned to that mission.





•           Improve
asset quality:  Asset quality must be raised to acceptable levels and
thereafter maintained as part of a high quality loan portfolio.  This
loan portfolio will consist of primarily internally-generated small business
loans that are fully within the Bank's expertise and provide adequate
yields with manageable risk.





28


•           Increase
capitalization:  Capital must be raised to levels above the minimum
capital needed to meet regulatory requirements.  This higher level of
capital can be achieved by either shrinking the size of the balance sheet or by
raising additional contributions from present and new shareholders or by a
combination of these two approaches.  Increasing the Bank’s level of
capital will ensure that the Bank not only remains viable through the present
economic downturn, but will have the ability to grow its assets and regain its
former earnings profile.





•           Improve
liquidity:   Liquidity must be increased and then maintained at a
level that is at least comparable with other local banks in terms of core
deposits.  More specifically, the Bank in solving its liquidity issues
has taken, or will take the following steps as well as others:


Primary
Sources of Liquidity


•   Develop
multiple lines of credit with other financial institutions.


•   Remain
a FHLB member with the ability to take advances.


•   Obtain
ability to borrow from the Federal Reserve discount window.


•   Continue
use of national market CDs which are not considered brokered CDs.


•   Maintain
and track collateral available to be pledged.  The availability of
this collateral will also periodically be validated by a secondary
source.


•   Develop
a traditional low-risk investment portfolio with laddered
maturities.





Secondary
Sources of Liquidity


•   Seek
to restore the ability to use brokered funds on a more limited basis than in the
past.


•   Seek
to restore the ability to fully utilize CDARS, or other sweep
programs.


•   Establish
relationships with other banks for standby participations.


•   Track
a pool of loans that would be available for participation.





•         
Return to Profitability:  Profitability must be restored as soon
as possible and beyond that point earnings must show consistent and steady
growth.  In the context of improving profitability and preserving
capital, the Bank has already made the following internal changes that will
immediately improve earnings or minimize losses.





•   Significant
staff reductions that reduced the bank’s FTEs from 75 as of March 31, 2008 to 46
as of March 31, 2009.  This will result in cost savings of about $3.2
million in annual salary and benefits.


•   Across
the board salary reductions of 10% for all remaining officers except for the
chief executive officer who took a 20% reduction.  This will result in
annual savings of about $300,000.


•   Cancellation
of 2008 and 2009 year-end bonuses.


•   Board
of Directors have declined to be paid their fees for 2008 and 2009.


•   Closing
of loan production offices in Towson and Howard County.  The annual
savings from these two closures, excluding personnel costs, could be about
$130,000 in overhead if the Bank is successful at finding tenants to sub-lease
the two properties which have 3400 and 3200 of square feet,
respectively.





•           Develop
management depth:  The executive management team and management
succession plan have the depth, experience and talent to maintain the confidence
of the public, clients, directors, shareholders and regulators. The Board will
evaluate management on a regular basis.




29


Results
of Operations





OVERVIEW





The
Company recorded a net loss of $5.1 million for the year ended December 31,
2008. This compares to net income of $937,369 reported for the year ended
December 31, 2007, a decrease of $6.0 million.  The Company reported
net income of $2.4 million for the year ended December 31, 2006. The decrease in
year-over-year results is primarily due to a $6.5 million provision for credit
losses recorded during 2008 caused by the continued deterioration in the
residential real estate market, an increase in non-accrual loans, an increase in
non-interest expenses and a decline in the interest rate environment that has
made revenue growth difficult.





Bay
National Bank’s mortgage origination operations, located in Lutherville and
Salisbury, Maryland, originate conventional first and second lien residential
mortgage loans and construction and rehabilitation loans. Bay National Bank
sells most of its first and second lien residential mortgage loans in the
secondary market and typically recognizes a gain on the sale of these loans
after the payment of commissions to the loan origination officer. Since its
inception in February 2001, the Salisbury mortgage division has been a
significant contributor to operating results. The Towson mortgage operation was
initiated in February 2005 and began to contribute to the Company’s overall
profitability during the second half of 2006. For the years ended December 31,
2008, 2007 and 2006, gains on the sale of mortgage loans totaled $281,029,
$450,184, and $573,387, respectively.  Gains on the sale of mortgage
loans decreased for the year ended December 31, 2008 as compared to the same
period in 2007 due to a slowdown in the real estate markets in the Company’s
primary market areas.





In
2004, the Company introduced a loan program for conventional first lien and
second lien residential mortgage loans. Under this program, the Company
purchased a 100% participation in mortgage loans originated by a mortgage
company in the Baltimore metropolitan area. These participations are for loans
which a secondary market investor has committed to purchase. The participations
are typically held for a period of three to four weeks before being sold to the
secondary market investor. This holding period represents the amount of time
taken by the secondary market investor to review the loan files for completeness
and accuracy. During this holding period, the Company earns interest on these
loans at a rate indexed to the prime rate.





The
primary risk to the Company from this program is that the secondary market
investor may decline to purchase the loans due to documentary deficiencies or
errors. The Company attempts to manage this risk by conducting a thorough review
of the documentation prior to purchasing the participation. If the secondary
market investor declines to purchase the loan, the Company could attempt to sell
the loan to other investors or hold the loan in its loan portfolio. As of
December 31, 2008, the Company had no such loans outstanding under this program,
which are classified as held for sale. The Company earned $97,264 of interest on
this program during 2008, $416,851 during 2007 and $264,299 during 2006. The
Bank terminated the program in 2008 due to deterioration in the national
mortgage markets.





Earnings
and asset growth were a challenge in 2008 as a result of the slowing
economy.  Future results will be subject to the volatility of the
provision for credit losses, which is related to asset quality and loan growth
and the fluctuation of mortgage loan production, all of which are sensitive to
economic and interest rate instability, and other competitive pressures that
arise in a slowing economy.





NET
INTEREST INCOME / MARGINS





Net
interest income is the difference between income on earning assets and the cost
of funds supporting those assets. Earning assets are composed primarily of
loans, investments, and federal funds sold. Interest-bearing deposits and other
borrowings make up the cost of funds. Non-interest bearing deposits and




30


capital
are also funding sources. Changes in the volume and mix of earning assets and
funding sources along with changes in associated interest rates determine
changes in net interest income.





Interest
income from loans and investments for the year ended December 31, 2008 was $15.3
million compared to $20.6 million and $19.8 million for the years ended
December 31, 2007 and 2006, respectively. The 25.6% decrease from 2007 and the
22.5% decrease from 2006 were directly related to changes in average yields
caused by a declining interest rate environment in 2008 and 2007, an increasing
interest rate environment in 2006, and the impact of lost interest on increased
non-accrual loans over the periods.  If the non-accrual loans had been
current in accordance with their original terms, we would have recognized
additional interest income of approximately $401,000, $506,000, and $26,000 for
the periods ended December 31, 2008, 2007 and 2006, respectively.  The
yields on loans and investments declined from 8.71% for the year ended December
31, 2006 to 8.40% for the year ended December 31, 2007 and to 5.91% for the year
ended December 31, 2008.





The
percentage of average interest-earning assets represented by loans was 94.8%,
92.0% and 92.3% for the years ended December 31, 2008, 2007, and 2006,
respectively. For the year ended December 31, 2008, the average yield on the
loan portfolio was 6.15%, as compared to 8.79% for the year ended December 31,
2007 and 9.12% for the year ended December 31, 2006. Loan yields declined from
2007 and 2006 primarily due to eight reductions by the FRB in the target federal
funds rate during 2008, beginning with a 75 basis point reduction on January 22,
2008 to 3.50% and ending with a rate of 0% to 0.25% effective December 16,
2008.  As can be seen by the yields discussed above, these
fluctuations had a significant impact on the Company’s operating results. The
timing and amount of the impact on loan yields of changes to the federal funds
rates varies from period to period as a result of differences in the mix of
fixed rate loans to variable rate loans at any point in time.





The
average yield on the investment portfolio and other earning assets such as
federal funds sold was 1.5% for the year ended December 31, 2008 as
compared to 3.9% and 3.8% for the years ended December 31, 2007 and 2006,
respectively. The fluctuations in the average yields were a direct result of the
FRB actions discussed above.  The percentage of average
interest-earning assets represented by investments was 5.2%, 8.0% and 7.7% for
the years ended December 31, 2008, 2007 and 2006, respectively.





Interest
expense from deposits and borrowings for the year ended December 31, 2008 was $6.8
million compared to $8.8 million and $7.8 million for the years ended December
31, 2007 and 2006, respectively. The 22.8% decrease from 2007 and the 13.5%
decrease from 2006 are directly related to the changes in average rates
paid due to Federal Reserve actions discussed above. The average rates paid on
these liabilities changed from 4.31% for the year ended December 31, 2006 to
4.45% for the year ended December 31, 2007 to 3.20% for the year ended December
31, 2008.  During 2008, management observed ongoing pressure to pay
higher rates on deposits as the market for funds became more
competitive.  In addition, the market for loans has been very
competitive, which, as is typical, has created downward pressure on loan
pricing.





The
following tables set forth, for the periods indicated, information regarding the
average balances of interest-earning assets and interest-bearing liabilities,
the amount of interest income and interest expense, and the resulting yields on
average interest-earning assets and rates paid on average interest-bearing
liabilities. Average balances are also provided for non-interest-earning assets
and non-interest-bearing liabilities.





No tax
equivalent adjustments were made and no interest income was exempt from federal
income taxes.  All average balances are daily average
balances.  The average balances of non-accrual loans are included in
the average loan balances for the periods indicated.  The amortization
of loan fees is included in computing interest income; however, such fees are
not material.





31





Year
      Ended December 31, 2008Average
                  Balance
                
                
                Interestand fees
                
                
                Yield/
                  RateASSETSLoans
      and loans held for sale
                
                $
                245,877,726
                
                
                $
                15,127,186
                
                
                
                6.15
                %Investment
      securities
                
                
                1,311,027
                
                
                
                64,738
                
                
                
                4.94Federal
      funds sold and other overnight investments
                
                
                12,218,004
                
                
                
                133,615
                
                
                
                1.09Total
      Earning Assets
                
                
                259,406,757
                
                
                
                15,325,539
                
                
                
                5.91
                %Less:
      Allowance for credit losses
                
                
                (6,307,556
                )Cash
      and due from banks
                
                
                1,005,917Real
      estate acquired through foreclosure, net
                
                
                2,917,588Premises
      and equipment, net
                
                
                1,274,501Investment
      in bank owned life insurance
                
                
                5,146,932Accrued
      interest receivable and other assets
                
                
                5,229,586Total
      Assets
                
                $
                268,673,725LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
                
                $
                69,476,831
                
                
                
                1,137,624
                
                
                
                1.64
                %Regular
      savings deposits
                
                
                1,495,578
                
                
                
                3,924
                
                
                
                .26Time
      deposits
                
                
                120,100,747
                
                
                
                4,792,803
                
                
                
                3.99Short-term
      borrowings
                
                
                12,438,238
                
                
                
                225,985
                
                
                
                1.82Subordinated
      debt
                
                
                8,000,000
                
                
                
                603,039
                
                
                
                7.54Total
      interest-bearing liabilities
                
                
                211,511,394
                
                
                
                6,763,375
                
                
                
                3.20
                %Net
      interest income and spread
                
                
                
                
                
                $
                8,562,164
                
                
                
                2.71
                %Non-interest-bearing
      demand deposits
                
                
                38,573,550Accrued
      expenses and other liabilities
                
                
                1,028,966Stockholders’
      equity
                
                
                17,559,815Total
      Liabilities and Stockholders’ Equity
                
                $
                268,673,725Interest
      and fee income/earning assets
                
                
                5.91
                %Interest
      expense/earning assets
                
                
                2.61Net
      interest margin
                
                
                3.30
                %Return
      on Average Assets
                
                
                (1.89
                )
      %Return
      on Average Equity
                
                
                (28.84
                )
      %Average
      Equity to Average Assets
                
                
                6.54
                %





32





Year
      Ended December 31, 2007Average
                  Balance
                
                
                Interestand fees
                
                
                Yield/
                  RateASSETSLoans
      and loans held for sale
                
                $
                225,627,420
                
                
                $
                19,823,408
                
                
                
                8.79
                %Investment
      securities
                
                
                1,659,751
                
                
                
                93,630
                
                
                
                5.64Federal
      funds sold and other overnight investments
                
                
                17,924,113
                
                
                
                670,971
                
                
                
                3.74Total
      Earning Assets
                
                
                245,211,284
                
                
                
                20,588,009
                
                
                
                8.40
                %Less:
      Allowance for credit losses
                
                
                (3,221,583
                )Cash
      and due from banks
                
                
                2,467,696Real
      estate acquired through foreclosure, net
                
                
                273,588Premises
      and equipment, net
                
                
                1,122,160Investment
      in bank owned life insurance
                
                
                1,044,092Accrued
      interest receivable and other assets
                
                
                2,904,620Total
      Assets
                
                $
                249,801,857LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
                
                $
                75,969,362
                
                
                
                2,670,374
                
                
                
                3.52
                %Regular
      savings deposits
                
                
                3,858,771
                
                
                
                75,207
                
                
                
                1.95Time
      deposits
                
                
                103,139,490
                
                
                
                5,163,572
                
                
                
                5.01Short-term
      borrowings
                
                
                5,997,193
                
                
                
                253,956
                
                
                
                4.23Subordinated
      debt
                
                
                8,000,000
                
                
                
                602,096
                
                
                
                7.53Total
      interest-bearing liabilities
                
                
                196,964,816
                
                
                
                8,765,205
                
                
                
                4.45
                %Net
      interest income and spread
                
                
                
                
                
                $
                11,822,804
                
                
                
                3.95
                %Non-interest-bearing
      demand deposits
                
                
                31,164,810Accrued
      expenses and other liabilities
                
                
                1,576,342Stockholders’
      equity
                
                
                20,095,889Total
      Liabilities and Stockholders’ Equity
                
                $
                249,801,857Interest
      and fee income/earning assets
                
                
                8.40
                %Interest
      expense/earning assets
                
                
                3.58Net
      interest margin
                
                
                4.82
                %Return
      on Average Assets
                
                
                .38
                %Return
      on Average Equity
                
                
                4.66
                %Average
      Equity to Average Assets
                
                
                8.04
                %








33





Year
      Ended December 31, 2006Average
                  Balance
                
                
                Interestand fees
                
                
                Yield/
                  RateASSETSLoans
      and loans held for sale
                
                $
                209,637,043
                
                
                $
                19,117,244
                
                
                
                9.12
                %Investment
      securities
                
                
                2,151,124
                
                
                
                105,625
                
                
                
                4.91Federal
      funds sold and other overnight investments
                
                
                15,366,594
                
                
                
                557,970
                
                
                
                3.63Total
      Earning Assets
                
                
                227,154,761
                
                
                
                19,780,839
                
                
                
                8.71
                %Less:
      Allowance for credit losses
                
                
                (3,029,070
                )Cash
      and due from banks
                
                
                2,089,474Premises
      and equipment, net
                
                
                952,629Accrued
      interest receivable and other assets
                
                
                2,761,444Total
      Assets
                
                $
                229,929,238LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
                
                $
                61,312,209
                
                
                
                2,208,830
                
                
                
                3.60
                %Regular
      savings deposits
                
                
                6,327,802
                
                
                
                67,402
                
                
                
                1.07Time
      deposits
                
                
                103,935,678
                
                
                
                4,856,379
                
                
                
                4.67Short-term
      borrowings
                
                
                1,935,743
                
                
                
                86,522
                
                
                
                4.47Subordinated
      debt
                
                
                8,000,000
                
                
                
                603,567
                
                
                
                7.55Total
      interest-bearing liabilities
                
                
                181,511,432
                
                
                
                7,822,700
                
                
                
                4.31
                %Net
      interest income and spread
                
                
                
                
                
                $
                11,958,139
                
                
                
                4.40
                %Non-interest-bearing
      demand deposits
                
                
                29,145,397Accrued
      expenses and other liabilities
                
                
                1,701,423Stockholders’
      equity
                
                
                17,570,986Total
      Liabilities and Stockholders’ Equity
                
                $
                229,929,238Interest
      and fee income/earning assets
                
                
                8.71
                %Interest
      expense/earning assets
                
                
                3.44Net
      interest margin
                
                
                5.27
                %Return
      on Average Assets
                
                
                1.06
                %Return
      on Average Equity
                
                
                13.83
                %Average
      Equity to Average Assets
                
                
                7.64
                %





34





RATE/VOLUME
ANALYSIS





A
rate/volume analysis, which demonstrates changes in taxable-equivalent interest
income and expense for significant assets and liabilities, appears below. The
calculation of rate, volume and rate/volume variances is based on a procedure
established for bank holding companies by the Securities and Exchange
Commission. Rate, volume and rate/volume variances presented for each component
may not total to the variances presented on totals of interest income and
interest expense because of shifts from year to year in the relative mix of
interest-earning assets and interest-bearing liabilities.





Year
      ended December 31,2008
      vs. 2007
                            Due
      to variances inTotal
                          
                          
                          Rates
                          
                          
                          Volumes
                          
                          
                          Rate/
      VolumeInterest
      income on:Loans
      and loans held for sale
                          
                          $
                          (4,696,223
                          )
                          
                          $
                          (5,942,086
                          )
                          
                          $
                          1,779,172
                          
                          
                          $
                          (533,309
                          )Investment
      securities
                          
                          
                          (28,892
                          )
                          
                          
                          (11,672
                          )
                          
                          
                          (19,672
                          )
                          
                          
                          2,452Federal
      funds sold and other overnight investments
                          
                          
                          (537,355
                          )
                          
                          
                          (474,954
                          )
                          
                          
                          (213,602
                          )
                          
                          
                          151,201Total
      interest income
                          
                          
                          (5,262,470
                          )
                          
                          
                          (6,428,712
                          )
                          
                          
                          1,545,898
                          
                          
                          
                          (379,656
                          )Interest
      expense on:Interest-bearing
      demand deposits
                          
                          
                          (1,532,750
                          )
                          
                          
                          (1,426,440
                          )
                          
                          
                          (228,217
                          )
                          
                          
                          121,907Regular
      savings deposits
                          
                          
                          (71,283
                          )
                          
                          
                          (65,083
                          )
                          
                          
                          (46,058
                          )
                          
                          
                          39,858Time
      deposits
                          
                          
                          (370,769
                          )
                          
                          
                          (1,047,634
                          )
                          
                          
                          849,148
                          
                          
                          
                          (172,283
                          )Short-term
      borrowings
                          
                          
                          (27,972
                          )
                          
                          
                          (144,996
                          )
                          
                          
                          272,751
                          
                          
                          
                          (155,727
                          )Subordinated
      debt
                          
                          
                          943
                          
                          
                          
                          943
                          
                          
                          
                          -
                          
                          
                          
                          -Total
      interest expense
                          
                          
                          (2,001,831
                          )
                          
                          
                          (2,683,210
                          )
                          
                          
                          847,624
                          
                          
                          
                          (166,245
                          )Net
      interest income
                          
                          $
                          (3,260,639
                          )
                          
                          $
                          (3,745,502
                          )
                          
                          $
                          698,274
                          
                          
                          $
                          (213,411
                          )








Year
      ended December 31,2007
      vs. 2006
                            Due
      to variances inTotal
                          
                          Rates
                          
                          Volumes
                          
                          Rate/
      VolumeInterest
      income on:Loans
      and loans held for sale
                          
                          $
                          706,164
                          
                          
                          $
                          (698,735
                          )
                          
                          $
                          1,458,196
                          
                          
                          $
                          (53,297
                          )Investment
      securities
                          
                          
                          (11,995
                          )
                          
                          
                          15,724
                          
                          
                          
                          (24,127
                          )
                          
                          
                          (3,592
                          )Federal
      funds sold and other overnight investments
                          
                          
                          113,001
                          
                          
                          
                          17,263
                          
                          
                          
                          92,865
                          
                          
                          
                          2,873Total
      interest income
                          
                          
                          807,170
                          
                          
                          
                          (665,748
                          )
                          
                          
                          1,526,934
                          
                          
                          
                          (54,016
                          )Interest
      expense on:Interest-bearing
      demand deposits
                          
                          
                          461,544
                          
                          
                          
                          (53,665
                          )
                          
                          
                          528,038
                          
                          
                          
                          (12,829
                          )Regular
      savings deposits
                          
                          
                          7,805
                          
                          
                          
                          55,926
                          
                          
                          
                          (26,299
                          )
                          
                          
                          (21,822
                          )Time
      deposits
                          
                          
                          307,193
                          
                          
                          
                          347,054
                          
                          
                          
                          (37,202
                          )
                          
                          
                          (2,659
                          )Short-term
      borrowings
                          
                          
                          167,434
                          
                          
                          
                          (4,552
                          )
                          
                          
                          181,535
                          
                          
                          
                          (9,549
                          )Subordinated
      debt
                          
                          
                          (1,471
                          )
                          
                          
                          (1,471
                          )
                          
                          
                          -
                          
                          
                          
                          -Total
      interest expense
                          
                          
                          942,505
                          
                          
                          
                          343,292
                          
                          
                          
                          646,072
                          
                          
                          
                          (46,859
                          )Net
      interest income
                          
                          $
                          (135,335
                          )
                          
                          $
                          (1,009,040
                          )
                          
                          $
                          880,862
                          
                          
                          $
                          (7,157
                          )








PROVISION
FOR CREDIT LOSSES





The
provision for credit losses was $6.5 million for the year ended December 31,
2008, as compared to $2.1 million for the year ended December 31, 2007, and
$202,931 for the year ended December 31, 2006. The provision in 2008 was higher
than the same period in the prior year due to an increase in the level of risk
in the Company’s residential real estate portfolio resulting from a continued
slowdown in the real estate market in the Company’s markets.  This
slowdown resulted in an increase in loan extensions and




35


delinquencies
due to the inability of investors to resell properties as quickly as
anticipated.  More specifically, the Company experienced weaknesses in
its portfolio of investor-owned residential construction and reconstruction
loans, which totaled approximately $15.1 million of which $2.1 million was
classified as non-accrual as of December 31, 2008.  In addition, the
Company foreclosed on twenty-eight pieces of investor-owned residential real
estate during 2008.  For additional information on nonperforming
loans, see the Management Discussion and Analysis section entitled
“Nonperforming Loans and Other Delinquent Assets.”





Management
is aggressively addressing the problems in this portfolio; however, resolving
these issues will take time as the residential real estate market works through
its downturn and housing inventories return to normal levels.  As
such, there can be no assurance that management’s actions will result in
decreases in the levels of non-accrual and past-due loans.





For
additional information regarding the methodology used to determine the provision
for credit losses see the Management Discussion and Analysis section entitled
“Allowance for Credit Losses and Credit Risk Management.”





NON-INTEREST
INCOME





The
components of non-interest income were as follows:





Years Ended December 31,2008
            
            2007
            
            2006Service
      charges on deposit accounts
            $
            266,064
            $
            153,813
            $
            148,042Gain
      on sale of mortgage loans
            
            281,029
            
            450,184
            
            573,387Increase
      in cash surrender value of bank owned life
              insurance
            
            226,867
            
            41,662
            
            -Loss
      on sale of real estate acquired through foreclosure
            
            (59,688
            )
            -
            
            -Other
      income
            
            48,887
            
            79,138
            
            55,904Total
      non-interest income
            $
            763,159
            $
            724,797
            $
            777,333





Non-interest
income consists primarily of gains on the sale of mortgage loans, deposit
account service charges and increases in the cash surrender value of bank owned
life insurance. For the year ended December 31, 2008, the Company realized
non-interest income in the amount of $763,159 as compared to $724,797 and
$777,333 for the years ended December 31, 2007 and 2006,
respectively.





Service
charges on deposit accounts totaled $266,064 for the year ended December 31,
2008, as compared to $153,813 and $148,042 for the years ended December 31, 2007
and 2006, respectively. This represents an increase of 73.0% and 79.7% over 2007
and 2006, respectively.  The increases over the prior years were
attributable to an increase in overdraft fees charged on transaction accounts as
well as an increase in analysis fees charged on business checking accounts.
Although overdraft fees increased, the Company continues to maintain a very low
level of average overdrafts. Analysis fees have increased as a result of the
previously-discussed FRB actions, which reduced the rates used to calculate
credits available to customers to offset any analysis fees they
incurred.





Gains on
the sale of mortgage loans of $281,029 represented 36.8% of non-interest income
for the year ended December 31, 2008.  This compares to gains on the
sale of mortgage loans of $450,184, or 62.1%, of total non-interest income for
the year ended December 31, 2007 and $573,387, or 73.8%, of total non-interest
income for the year ended December 31, 2006. The decreases from the years ended
December 31, 2007 and 2006 were due to a general decline in home purchase and
refinance activity in the Company’s markets.





36





The
Company recognized increases in the cash surrender value of bank owned life
insurance (“BOLI”) of $226,867 for the year ended December 31, 2008 compared to
$41,662 recognized in the prior year.  The Company purchased this
investment during the fourth quarter of 2007 and the initial investment totaled
$5.0 million.





A loss on
the sale of real estate acquired through foreclosure, totaling $59,688,
resulting from the sale of seventeen residential real estate properties during
the year ended December 31, 2008, offset total non-interest income for the
year.





Other
income totaled $48,887 for the year ended December 31, 2008 as compared to
$79,138 and $55,904 for the years ended December 31, 2007 and 2006,
respectively.  These represent decreases of 38.2% and 12.6% over 2007
and 2006, respectively.  Other income primarily consists of cash
management fees and the decreases over the prior periods were attributed to a
decline in business activity.





The
Company will continue to seek ways to expand its sources of non-interest income.
In the future, the Company may enter into fee arrangements with strategic
partners that offer investment advisory services, risk management and employee
benefit services. No assurance can be given that such fee arrangements will be
obtained or maintained.





NON-INTEREST
EXPENSE





The components of non-interest expense
were as follows:





Years Ended December 31,2008
              
              
              2007
              
              
              2006Salaries
      and employee benefits
              
              $
              6,018,002
              
              
              $
              5,460,772
              
              
              $
              5,431,989Occupancy
      expenses
              
              
              763,336
              
              
              
              653,227
              
              
              
              506,323Furniture
      and equipment expenses
              
              
              426,190
              
              
              
              351,599
              
              
              
              342,261Legal
      and professional fees
              
              
              821,347
              
              
              
              285,434
              
              
              
              245,412Data
      processing and other outside services
              
              
              993,648
              
              
              
              870,404
              
              
              
              701,422Advertising
      and marketing related expenses
              
              
              509,939
              
              
              
              486,204
              
              
              
              512,709Provision
      for losses on real estate acquired through
                foreclosure
              
              
              569,350
              
              
              
              111,700
              
              
              
              -Other
      expenses
              
              
              1,004,594
              
              
              
              773,817
              
              
              
              684,239Total
      non-interest expenses
              
              $
              11,106,406
              
              
              $
              8,993,157
              
              
              $
              8,424,355





2008 compared to
2007





Non-interest
expense for the year ended December 31, 2008 totaled $11.1 million compared to
$9.0 million for the year ended December 31, 2007. The increase of $2.1 million,
or 23.5%, was primarily due to increases in salaries and employee benefits,
legal and professional fees, provisions for losses on real estate acquired
through foreclosure and other expenses.





Salaries
and employee benefit expenses represented 54.2% and 60.7% of non-interest
expenses for the years ended December 31, 2008 and 2007,
respectively.  Salaries and benefits increased by $557,230, or 10.2%,
over the prior year due to additions to staff during 2007 and then paying these
additional employees for the full year in 2008.  During 2007, we
increased the number of commercial account portfolio managers, commercial
lenders and other operations support and added four commercial bankers, a cash
management specialist and a commercial account manager to lead expansion into
the Baltimore-Washington corridor.  These additions were made to
continue to expand our market presence, as well as to manage the growth of the
loan and deposit portfolios and support increased operational
volume.  Although we ended 2008 with fewer employees than we had at
the beginning of the year, most of these employees left and/or were terminated
during the latter part of 2008, and as a result, did not have a significant
impact on changes to




37


salaries
and benefit expenses for 2008.  The increased expense related to this
staffing growth was offset by a decrease in accrued bonuses based on the
Company’s financial performance and a decrease in commissions based on the
industry-wide slow down in residential real estate lending.  As of
December 31, 2008, we had 54 full-time employees compared to 69 full-time
employees at December 31, 2007.  We terminated eight employees during
the first quarter of 2009 and do not intend to significantly expand or reduce
the number of employees in the immediate future.  Therefore, we expect
salaries and benefit expenses to decrease in 2009.





Occupancy
expenses increased by $110,109, or 16.9%, due in part to the acquisition of new
space obtained during the fourth quarter of 2007 for the Company’s Towson
residential lending operation, acquisition of space for the team hired to lead
expansion into the Baltimore-Washington corridor, assumption of first floor
space that had previously been sublet at the Bank’s Lutherville location as well
as scheduled rent increases.





Legal and
professional fees increased by $535,913, or 187.8%, during 2008 the majority of
which was related to increased legal fees incurred to help manage and workout
loans in the Company’s residential real estate portfolio.





The
Company recorded a $569,350 provision for losses on real estate acquired through
foreclosure during 2008 compared to $111,700 during the prior
year.  The $457,650, or 409.7%, increase from the prior year was
primarily driven by the deterioration in the residential real estate market,
which negatively impacted property values.





The
$123,244, or 14.2%, increase in data processing and other outside services
resulted from increased costs during 2008 for supporting a computer
infrastructure at an additional location, the costs associated with enhanced
security and preventive maintenance programs and an increase in outsourced data
and item processing costs that are a function of the growth of the Bank and the
number of customer accounts.





The
$74,591, or 21.2%, increase in furniture and equipment expenses during 2008 was
related to increased costs associated with expanded staffing and facilities.
Advertising and marketing related expenses increased $23,735, or 4.9%, and was
related to increased advertising for the Towson residential lending and
Baltimore-Washington corridor loan production offices.  The increase
of $230,776, or 29.8%, in all other expenses related to various costs associated
with the increased size and complexity of the Company.





The
banking industry utilizes an “efficiency ratio” as a key measure of expense
management and overall operating efficiency. This ratio is computed by dividing
non-interest expense by the sum of net interest income before the loan loss
provision and non-interest income. The Company’s efficiency ratio
was 119.1% for the year ended December 31, 2008 compared to 71.7% for the
year ending December 31, 2007. The increase in the efficiency ratio from the
prior year was primarily a result of the $5.3 million contraction in net
interest income as well as the $2.1 million increase in non-interest
expenses.





Approximately
52% of the occupancy costs in 2008 were paid to directors of Bay National
Corporation or entities controlled by directors of Bay National
Corporation.  Management believes that the terms of these leases are
at least as favorable as could be obtained from independent third
parties.  However, management has not conducted a recent market
analysis to confirm this. For a discussion of the terms of the leases with these
persons, see “Item 13 – Certain Relationships and Related Transactions, and
Director Independence.”





2007 compared to
2006





Non-interest
expense for the year ended December 31, 2007 totaled $9.0 million compared to
$8.4 million for the year ended December 31, 2006. The increase of $568,802, or
6.8%, was primarily due to increases in other expenses, data processing and
other outside services and occupancy expenses.





38


Salaries
and employee benefit expenses represented 60.7% and 64.5% of non-interest
expenses for the years ended December 31, 2007 and 2006,
respectively.  Salaries and benefits marginally increased by $28,783
or 0.5%.  The Bank experienced staffing growth during 2007 in
commercial account portfolio managers, commercial lenders and other operations
support.  In addition, the Company added four commercial bankers, a
cash management specialist and a commercial account manager during the second
half of the year to lead its expansion into the Baltimore-Washington
corridor.  These additions were made to continue to expand its market
presence, as well as to manage the growth of the loan and deposit portfolios and
support increased operational volume.  The increased expense related
to this staffing growth was offset by a decrease in accrued bonuses based on the
Company’s financial performance and a decrease in commissions based on the
industry-wide slow down in residential real estate lending.





Occupancy
expenses increased by $146,904, or 29.0%, due in part to the acquisition of new
space obtained during the fourth quarter of 2006 for the Company’s Towson
residential lending operation, assumption of first floor space that had
previously been sublet at the Bank’s Baltimore location as well as scheduled
rent increases.





Legal and
professional fees increased by $40,022, or 16.3%, during 2007.  The
increase was related to legal fees incurred in connection with the drafting of a
Stock Incentive Plan, increased costs associated with drafting the Annual Report
and Proxy materials, and increased legal fees incurred to help manage and
workout loans in the Company’s residential real estate portfolio. There was also
an increase in internal and external audit and other accounting fees related to
Company growth and implementation of provisions of the Sarbanes-Oxley Act of
2002 related to the documentation and testing of internal control over financial
reporting.





The
$168,982, or 24.1%, increase in data processing and other outside services
resulted from increased costs paid during 2007 for the cost of supporting a
computer infrastructure at an additional location, the costs associated with
enhanced security and preventive maintenance programs and an increase in
outsourced data and item processing costs that are a function of the growth of
the Bank and the number of customer accounts.





The
$9,338, or 2.7%, increase in furniture and equipment expenses during 2007 was
related to increased costs associated with expanded staffing and facilities.
Advertising and marketing related expenses decreased $26,505 or 5.2%, which was
related to a decline in charitable contributions offset by increased advertising
for the Towson residential lending and Howard County loan production
offices.  The increase of $201,278, or 29.4%, in all other expenses
relates to various costs associated with the increased size and complexity of
the Company and a provision for losses on real estate acquired through
foreclosure of $111,700 recorded during the fourth quarter of
2007.  In addition, the Company experienced an increase of $108,978 in
FDIC insurance expense due to the FDIC’s revision of its fee structure and
growth in our deposit base.





The
Company’s efficiency ratio was 71.7% for the year ended December 31, 2007
compared to 66.1% for the year ending December 31, 2006. The increase in the
efficiency ratio from the prior year was a result of management’s decision to
continue to invest in personnel to support the long-term growth of the
Company.





39


Approximately
73% of the occupancy costs in 2007 were paid to directors of Bay National
Corporation or entities controlled by directors of Bay National
Corporation.  Management believes that the terms of these leases are
at least as favorable as could be obtained from independent third
parties.  However, management has not conducted a recent market
analysis to confirm this. For a discussion of the terms of the leases with these
persons, see “Item 13 – Certain Relationships and Related Transactions, and
Director Independence.”





INCOME
TAXES





For the
year ended December 31, 2008, the Company recorded an income tax benefit of $3.2
million compared to income tax expense of $491,395 and $1.7 million recorded for
the year ended December 31, 2007 and 2006, respectively.  The decrease
is due to the significant pre-tax loss incurred for the year ended December 31,
2008.





At
December 31, 2008, the Company had approximately $3.0 million of cumulative
Maryland pre-tax net operating loss carryforwards (a possible net tax benefit of
$248 thousand) for the unconsolidated state tax return for Bay National
Corporation.  Unless Bay National Corporation generates income from
its own operations (i.e., unrelated to Bay National Bank), these operating loss
carryforwards will expire in 2019.  At December 31, 2008, the Company
had a valuation allowance offsetting 100% of the $248 thousand
receivable.




40


Financial
Condition





COMPOSITION
OF THE BALANCE SHEET





Total
assets of the Company were $270.6 million as of December 31, 2008, compared to
total assets of $256.5 million as of December 31, 2007. This represents growth
of approximately $14.0 million, or 5.5%, since December 31,
2007.  Deposits at December 31, 2008 were $244.6 million as compared
to deposits of $202.0 million at December 31, 2007.  The increase in
deposits was primarily attributed to an increase of $43.8 million in
certificates of deposit and an $18.9 million increase in non-interest bearing
deposits, which was offset by a $20.1 million decrease in other interest bearing
deposits.  As of December 31, 2008, loans including loans held for
sale (net of a $5.7 million allowance for credit losses), totaled $242.7
million.  This represents an increase of $6.7 million, or 2.8%, from
December 31, 2007.  Loan growth was particularly strong in the
Company’s Lutherville office and its former Baltimore-Washington Corridor
office. This growth resulted from the addition of experienced Commercial
Relationship Managers who were well positioned to take advantage of market
disruptions caused by turnover in the lending staffs of two institutions in the
Company’s markets.  A total of approximately $47.6 million in loans
outstanding as of December 31, 2007 were paid off during 2008. This activity,
combined with normal fluctuations in revolving credit balances and installment
payments on amortizing loans, offset the approximately $76.6 million in new
loans, excluding loans held for sale, funded during that same
period.  During 2008, the Company funded approximately $76 million in
mortgage loans held for sale and sold approximately $87 million in the secondary
market.





The
composition of the loan portfolio as of December 31, 2008 was approximately
$125.3 million of commercial loans (excluding real estate loans), $3.8 million
of consumer loans and $118.1 million of real estate loans excluding $1.2 million
of mortgage loans held for sale. The composition of the loan portfolio as of
December 31, 2007 was approximately $102.7 million of commercial loans
(excluding real estate loans), $4.1 million of consumer loans and $122.6 million
of real estate loans excluding $11.6 million of mortgage loans held for sale.
The overall growth in the loan portfolio and specifically the increased
concentration in commercial loans are a direct result of the expansion into the
Baltimore-Washington corridor as well as the marketing efforts of bank
employees, members of the Board of Directors and the Baltimore and Salisbury
Advisory Boards.





The
Company experienced weakness in its portfolio of investor-owned residential
construction and reconstruction loans. This total portfolio as of December 31,
2008 was approximately $15.1 million of which $2.1 million was classified as
non-accrual. Management is proactively and aggressively addressing the problems
in this portfolio by reviewing the specific credits more frequently, consulting
with legal counsel when necessary, working with borrowers for potential
restructure and/or working with potential investors to facilitate the sale of
the underlying property.  As a result of these efforts, this portfolio
declined by $13.4 million from a balance of $27.5 million as of December 31,
2007.  In addition, the Company has significantly tightened
underwriting standards for these types of loans and is currently originating
very few of these loans.  Resolving these issues will take time as the
residential real estate market works through its downturn and housing
inventories return to normal levels, and there can be no assurance that
management’s actions will result in decreases in the level of non-accrual and
past due loans.





During
2008, the Company foreclosed on twenty-eight pieces of residential real estate,
the majority of which were investor-owned properties. These properties were
recorded as real estate acquired through foreclosure at an estimated net
realizable value of approximately $8.6 million. The $4.7 million difference
between the related loan balances totaling approximately $13.3 million and the
net realizable value of $8.6 million was charged off to the allowance for credit
losses during that period. As of December 31, 2008, the net realizable value for
the remaining fourteen properties was $3.9 million.  During 2007, the
Company foreclosed on three pieces of investor-owned residential real
estate.  These properties were placed into real estate acquired
through foreclosure at an estimated net realizable value of approximately $1.05
million. The




41


approximate
$330 thousand difference between the related loan balances totaling
approximately $1.38 million and the $1.05 million net realizable value was
charged off to the allowance for credit losses during 2007.  As of
December 31, 2007, the net realizable value for these properties was
$946,431.  Prior to these foreclosures, the Company had no other real
estate acquired through foreclosure.  Based on review of estimates of
current market values for these properties, the Company recorded a provision of
$569,350 and $111,700 in December 2008 and 2007, respectively.





Funds not
extended in loans are held in cash and due from banks, and various investments
including federal funds sold and other overnight investments, United States
Treasury securities, Federal Reserve Bank stock and FHLB stock. These
investments totaled $10.5 million as of December 31, 2008 compared to $9.3
million as of December 31, 2007. Other than the investments in Federal Reserve
Bank stock and FHLB stock, totaling $1.2 million and $1.7 million at December
31, 2008 and 2007, respectively, all investments have maturities of 90 days or
less. The Treasury securities are used to collateralize municipal deposits and
repurchase agreements which are classified as short-term borrowings of which
$300,000 was outstanding as of December 31, 2007. There were no outstanding
repurchase agreements as of December 31, 2008.  Management reviews its
liquidity position daily to ensure that funds are readily available to fund the
growth of the loan portfolio or to fund the maturity of higher cost national
time deposits.





In March
2009, the Board of Directors approved a new investment policy and authorized
management of the Company to invest in a more traditional securities portfolio
in order to provide ongoing liquidity, income and a ready source of collateral
that can be pledged in order to access other sources of funds.





Total stockholder’s equity at December
31, 2008 was $15.0 million as compared to $19.9 million at December 31, 2007.
The decrease in stockholder’s equity is primarily a result of the negative
operating results for the year ended December 31, 2008.





COMPOSITION
OF LOAN PORTFOLIO





Because
yields on loans typically exceed the yields on investments, the Company’s
long-term business strategy is to continue to increase the overall level of
loans, as well as maintain a relatively high percentage of loans to total
earning assets.  Increasing loans and loans as a percentage of total
earning assets will maximize the net interest margin.  As of December
31, 2008 and 2007, loans represented 98.7% and 97.2% of total earning assets,
respectively.  However, in order to enhance liquidity, the Company is
willing to accept a slightly lower margin by creating an investment portfolio
that could result in a decrease in the percentage of loans to total earning
assets.





The
following table sets forth the composition of the principal balances of the
Company’s loan portfolio as of December 31, 2008, 2007, 2006, 2005, and 2004,
respectively.





2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Commercial
              
              $
              125,331,210
              
              
              $
              102,728,342
              
              
              $
              88,491,722
              
              
              $
              75,626,825
              
              
              $
              73,836,994Real
      Estate – Mortgage
              
              
              50,611,464
              
              
              
              36,210,905
              
              
              
              27,903,399
              
              
              
              34,542,931
              
              
              
              27,854,130Real
      Estate – Construction
              
              
              44,061,253
              
              
              
              67,775,883
              
              
              
              76,889,997
              
              
              
              47,933,768
              
              
              
              12,968,251Real
      Estate – Home Equity Line of Credit
              
              
              23,377,524
              
              
              
              18,585,641
              
              
              
              19,963,116
              
              
              
              21,067,964
              
              
              
              24,548,506Loans
      Held for Sale
              
              
              1,187,954
              
              
              
              11,601,070
              
              
              
              1,444,303
              
              
              
              17,509,064
              
              
              
              9,613,162Consumer
              
              
              3,781,316
              
              
              
              4,054,400
              
              
              
              3,323,141
              
              
              
              2,909,409
              
              
              
              2,205,556Total
      Loans
              
              $
              248,350,721
              
              
              $
              240,956,241
              
              
              $
              218,015,678
              
              
              $
              199,589,961
              
              
              $
              151,026,599





42


The
following table sets forth the percentages of loans in each category for the
Company’s loan portfolio as of December 31, 2008, 2007, 2006, 2005 and 2004,
respectively.





2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Commercial
              
              
              50.47
              %
              
              
              42.63
              %
              
              
              40.59
              %
              
              
              37.89
              %
              
              
              48.89
              %Real
      Estate – Mortgage
              
              
              20.38
              
              
              
              15.03
              
              
              
              12.80
              
              
              
              17.31
              
              
              
              18.44Real
      Estate – Construction
              
              
              17.74
              
              
              
              28.13
              
              
              
              35.27
              
              
              
              24.02
              
              
              
              8.59Real
      Estate – Home Equity Line of Credit
              
              
              9.41
              
              
              
              7.71
              
              
              
              9.16
              
              
              
              10.55
              
              
              
              16.25Loans
      Held for Sale
              
              
              0.48
              
              
              
              4.82
              
              
              
              0.66
              
              
              
              8.77
              
              
              
              6.37Consumer
              
              
              1.52
              
              
              
              1.68
              
              
              
              1.52
              
              
              
              1.46
              
              
              
              1.46Total
      Loans
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %





The
following table sets forth the maturity distribution for the Company’s loan
portfolio at December 31, 2008. Some of the loans may be renewed or repaid prior
to maturity.  Therefore, the following table should not be used as a
forecast of future cash flows.








Within
      one year
              
              
              One
      to
                three years
              
              
              Three
      to
                five years
              
              
              Over
      five years
              
              
              TotalCommercial
              
              $
              83,436,045
              
              
              $
              16,898,578
              
              
              $
              20,321,448
              
              
              $
              4,675,139
              
              
              $
              125,331,210Real
      Estate – Mortgage
              
              
              20,275,390
              
              
              
              12,404,935
              
              
              
              13,385,948
              
              
              
              4,545,191
              
              
              
              50,611,464Real
      Estate – Construction
              
              
              42,531,542
              
              
              
              1,260,842
              
              
              
              268,869
              
              
              
              -
              
              
              
              44,061,253Real
      Estate – Home Equity Line of Credit
              
              
              23,377,524
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              23,377,524Loans
      Held for Sale
              
              
              1,187,954
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,187,954Consumer
              
              
              3,659,193
              
              
              
              104,940
              
              
              
              17,183
              
              
              
              -
              
              
              
              3,781,316Total
              
              $
              174,467,648
              
              
              $
              30,669,295
              
              
              $
              33,993,448
              
              
              $
              9,220,330
              
              
              $
              248,350,721Fixed
      interest rate
              
              $
              38,780,472
              
              
              $
              30,669,295
              
              
              $
              33,993,448
              
              
              $
              9,220,330
              
              
              $
              112,663,545Variable
      interest rate
              
              
              134,499,222
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              134,499,222Loans
      Held for Sale
              
              
              1,187,954
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,187,954Total
              
              $
              174,467,648
              
              
              $
              30,669,295
              
              
              $
              33,993,448
              
              
              $
              9,220,330
              
              
              $
              248,350,721





The
scheduled repayments as shown above are reported in the maturity category in
which the payment is due, except for the adjustable (variable) rate loans, which
are reported in the period of repricing.





The
Company’s loan portfolio composition as of December 31, 2008 reflects a 54.2%
concentration in variable rate loans. Loans held for sale represented 0.5% of
the Company’s loan portfolio. Fixed rate loans totaled $112.7 million, or 45.4%,
of the Company’s loan portfolio. Interest rates on variable rate loans adjust to
the current interest rate environment, whereas fixed rates do not allow this
flexibility. Loans held for sale are expected to be sold in three months or less
and as a result are not materially impacted by interest rate fluctuations. If
interest rates were to increase in the future, the interest earned on the
variable rate loans would improve, and, if rates were to fall, the interest
earned would decline. See “Liquidity and Interest Rate
Sensitivity.”





The
officers and directors of the Company, including their related companies, had
outstanding loans from the Bank of $11.8 million at December 31, 2008 and $13.5
million at December 31, 2007. All loans made to officers and directors,
including their related companies, are made on substantially the same terms,
including interest rates and collateral, as those prevailing at the time for
comparable transactions with unaffiliated third parties and do not involve more
than the normal risk of repayment or present other unfavorable
features.





43


ALLOWANCE
FOR CREDIT LOSSES AND CREDIT RISK MANAGEMENT





Originating
loans involves a degree of risk that credit losses will occur in varying amounts
according to, among other factors, the type of loans being made, the
credit-worthiness of the borrowers over the term of the loans, the quality of
the collateral for the loan, if any, as well as general economic
conditions.  The Company charges the provision for credit losses to
earnings to maintain the total allowance for credit losses at a level considered
by management to represent its best estimate of the losses known and inherent in
the portfolio that are both probable and reasonable to estimate, based on, among
other factors, prior loss experience, volume and type of lending conducted,
estimated value of any underlying collateral, economic conditions (particularly
as such conditions relate to the Company’s market area), regulatory guidance,
peer statistics, management’s judgment, past due loans in the loan portfolio,
loan charge off experience and concentrations of risk (if any).  The
Company charges losses on loans against the allowance when it is believed that
collection of loan principal is unlikely.  Recoveries on loans
previously charged off are added back to the allowance.





Management
uses a loan grading system where all loans are graded based on management’s
evaluation of the risk associated with each loan. A factor, based on the loan
grading, is applied to the loan balance to reserve for potential losses. In
addition, management judgmentally establishes an additional nonspecific reserve.
The nonspecific portion of the allowance reflects management’s estimate of
probable inherent but undetected losses within the portfolio due to
uncertainties in economic conditions, delays in obtaining information about a
borrower’s financial condition and the difficulty of identifying other risk
factors and/or triggering events that have not yet manifested themselves in loss
allocation factors.





The
reserve factors used are based on management’s judgment as to appropriate
reserve percentages for various categories of loans, and management adjusts
those values based on the following: historical losses in each category,
historical and current delinquency in each category, underwriting standards in
each category, comparison of losses and delinquencies to peer group performance
and an assessment of the likely impact of economic and other external conditions
on the performance of each category.





A test of
the adequacy of the allowance for credit losses is performed and reported to the
Board of Directors on a monthly basis.  Management uses the
information available to make a determination with respect to the allowance for
credit losses, recognizing that the determination is inherently subjective and
that future adjustments may be necessary depending upon, among other factors, a
change in economic conditions of specific borrowers or generally in the economy
and new information that becomes available.  However, there are no
assurances that the allowance for credit losses will be sufficient to absorb
losses on nonperforming assets or that the allowance will be sufficient to cover
losses on nonperforming assets in the future.





The
allowance for credit losses as of December 31, 2008 and December 31, 2007 was
$5.7 million and $5.0 million, respectively. The amount equates to 2.29%
and 2.08% of outstanding loans, including loans held for sale, as of December
31, 2008 and 2007, respectively.  Bay National Corporation has no
exposure to foreign countries or foreign borrowers. Management believes that the
allowance for credit losses is adequate for each period presented.





44


The
following table represents an analysis of the activity in the allowance for
credit losses for the periods presented:





2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Balance
      at beginning of year
                  
                  $
                  5,000,000
                  
                  
                  $
                  3,175,000
                  
                  
                  $
                  3,000,000
                  
                  
                  $
                  1,810,000
                  
                  
                  $
                  1,266,500Provision
      for credit losses
                  
                  
                  6,478,200
                  
                  
                  
                  2,125,680
                  
                  
                  
                  202,931
                  
                  
                  
                  1,178,866
                  
                  
                  
                  559,596Loan
      charge-offsCommercial
                  
                  
                  (107,495
                  )
                  
                  
                  -
                  
                  
                  
                  (37,931
                  )
                  
                  
                  -
                  
                  
                  
                  (15,222
                  )Real
      Estate – Mortgage
                  
                  
                  (622,477
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Real
      Estate – Construction
                  
                  
                  (5,118,668
                  )
                  
                  
                  (343,919
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Real
      Estate – Home Equity Line of Credit
                  
                  
                  (36,572
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Consumer
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,134
                  )Loan
      recoveriesCommercial
                  
                  
                  1,700
                  
                  
                  
                  27,931
                  
                  
                  
                  10,000
                  
                  
                  
                  11,134
                  
                  
                  
                  1,260Real
      Estate – Mortgage
                  
                  
                  36,009
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Real
      Estate – Construction
                  
                  
                  44,338
                  
                  
                  
                  15,308
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      (charge-offs) recoveries
                  
                  
                  (5,803,165
                  )
                  
                  
                  (300,680
                  )
                  
                  
                  (27,931
                  )
                  
                  
                  11,134
                  
                  
                  
                  (16,096
                  )Balance
      at end of year
                  
                  $
                  5,675,035
                  
                  
                  $
                  5,000,000
                  
                  
                  $
                  3,175,000
                  
                  
                  $
                  3,000,000
                  
                  
                  $
                  1,810,000





The
following table presents the allocation of the allowance for credit losses,
reflecting use of the methodology presented above for the periods
presented:





Amount2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Commercial
                
                $
                1,978,854
                
                
                $
                1,206,946
                
                
                $
                1,281,491
                
                
                $
                2,046,219
                
                
                $
                1,279,472Real
      Estate – Mortgage
                
                
                1,072,779
                
                
                
                186,545
                
                
                
                177,116
                
                
                
                214,601
                
                
                
                179,798Real
      Estate – Construction
                
                
                2,235,729
                
                
                
                3,435,204
                
                
                
                1,482,349
                
                
                
                469,580
                
                
                
                150,346Real
      Estate – Home Equity Line of Credit
                
                
                358,890
                
                
                
                92,935
                
                
                
                100,811
                
                
                
                106,986
                
                
                
                122,918Loans
      Held for Sale
                
                
                5,940
                
                
                
                58,005
                
                
                
                7,222
                
                
                
                87,545
                
                
                
                48,066Consumer
                
                
                22,843
                
                
                
                19,562
                
                
                
                16,693
                
                
                
                10,275
                
                
                
                11,032Unallocated
                
                
                -
                
                
                
                803
                
                
                
                109,318
                
                
                
                64,794
                
                
                
                18,368Total
      Allowance
                
                $
                5,675,035
                
                
                $
                5,000,000
                
                
                $
                3,175,000
                
                
                $
                3,000,000
                
                
                $
                1,810,000





The
unallocated portion of the allowance for credit losses decreased in 2008. This
occurred because the Company calculates an overall reserve level while the
underlying portfolio experienced a moderate shift in the mix of loans by risk
grade and the real estate market softened in the Company’s primary market areas.
The shift in the mix of loans by risk grade is a normal result of the addition
of new loans, the decrease in balances of more mature loans and the ongoing
reassessment of all loans.





The
following table sets forth the percentages of loans in each category for the
Company's loan portfolio as of December 31, 2008, 2007, 2006, 2005, and 2004,
respectively.





2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Commercial
              
              
              50.47
              %
              
              
              42.63
              %
              
              
              40.59
              %
              
              
              37.89
              %
              
              
              48.89
              %Real
      Estate – Mortgage
              
              
              20.38
              
              
              
              15.03
              
              
              
              12.80
              
              
              
              17.31
              
              
              
              18.44Real
      Estate – Construction
              
              
              17.74
              
              
              
              28.13
              
              
              
              35.27
              
              
              
              24.02
              
              
              
              8.59Real
      Estate – Home Equity Line of Credit
              
              
              9.41
              
              
              
              7.71
              
              
              
              9.16
              
              
              
              10.55
              
              
              
              16.25Loans
      Held for Sale
              
              
              0.48
              
              
              
              4.82
              
              
              
              0.66
              
              
              
              8.77
              
              
              
              6.37Consumer
              
              
              1.52
              
              
              
              1.68
              
              
              
              1.52
              
              
              
              1.46
              
              
              
              1.46Total
      Loans
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %
              
              
              100.00
              %





45





NONPERFORMING
LOANS AND OTHER DELINQUENT ASSETS





Nonperforming
assets are comprised of nonaccrual loans, loans past due 90 days or more and
still accruing, troubled debt restructures and real estate acquired through
foreclosure.  Management will generally classify loans as non-accrual
when collection of full principal and interest under the original terms of the
loan is not expected or payment of principal or interest has become 90 days past
due.  In cases where management has additional information that leads
it to believe that we will still collect the full principal and interest due
under the loan, management will not classify such loan as non-accrual even
though payment of principal or interest on such loan has become 90 days past
due. Classifying a loan as non-accrual results in the Company no longer accruing
interest on such loan and reversing any interest previously accrued but not
collected. A non-accrual loan may be restored to accrual status when delinquent
principal and interest payments are brought current and future monthly principal
and interest payments are expected to be collected. As of December 31, 2008, the
Company had $13.5 million of non-accrual loans compared to $9.4 million as of
December 31, 2007.





Any
property acquired by the Company as a result of foreclosure on a mortgage loan
is classified as real estate acquired through foreclosure and recorded at the
lower of the unpaid principal balance or fair value at the date of acquisition
and subsequently carried at the lower of cost or net realizable value. Any
required write-down of the loan to its net realizable value will be charged
against the allowance for credit losses. Upon foreclosure, the Company generally
will require an appraisal of the property and, thereafter, appraisals of the
property on at least an annual basis with external inspections on at least a
quarterly basis. As of December 31, 2008 the Company held $3.9 million of
real estate acquired as a result of foreclosure, which was net of an allowance
of $645,322 for estimated losses in market value.  This compares to
$946,431 held at December 31, 2007, which was net of a provision of $111,700 for
estimated losses in market value.





Troubled
debt restructures, which are loans that have been restructured due to the
borrower’s inability to maintain a current status on the loan, totaled $952,372
as of December 31, 2008 and were comprised of three loans from the Company’s
residential real estate construction portfolio.  The Company had no
troubled debt restructures as of December 31, 2007.





The
Company applies the provisions of Statements of Financial Accounting Standards
No. 114 ("SFAS No. 114"), "Accounting by Creditors for Impairment of a Loan," as
amended by Statements of Financial Accounting Standards No. 118 ("SFAS No.
118"), "Accounting by Creditors for Impairment of a Loan-Income Recognition and
Disclosure." SFAS No. 114 and SFAS No. 118 require that impaired loans, which
consist of all modified loans and other loans for which collection of all
contractual principal and interest is not probable, be 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 repayment of the loan is collateral dependent. If the measure of
the impaired loan is less than the recorded investment in the loan, an
impairment is recognized through a valuation allowance and corresponding
provision for credit losses. The Company considers consumer loans as homogenous
loans and thus does not apply the SFAS No. 114 impairment test to these loans.
Impaired loans will be written off when collection of the loan is
doubtful.





As of
December 31, 2008, the Company had impaired loans totaling $16.4 million of
which $13.5 million represented non-accrual loans, $2.0 million represented
loans 90 days or more past due and accruing and $952,372 represented troubled
debt restructures.  Non-accrual loans as of December 31, 2008 were
comprised of commercial loans totaling $2.9 million, residential investment real
estate loans totaling $1.5 million, residential real estate construction loans
totaling $7.7 million, residential mortgage loans totaling $970,532 and home
equity lines of credit totaling $465,000.  Troubled debt restructures
were comprised of three loans in the Company’s commercial real estate
portfolio.  These nonperforming loans represented 6.6% of total
outstanding loans, including loans held for sale, as of December 31,
2008.  All of these loans were at least partially collateralized by
real estate. As of December 31, 2007, the Company had impaired loans




46


totaling
$9.4 million, all of which were included in its investor-owned residential real
estate construction loan portfolio, were classified as non-accrual loans and
were over 90 days past due.  Management will continue to closely
monitor these loans and the overall level of delinquencies; however, management
believes that the allowance for credit losses was adequate for these
loans.





For
troubled debt restructures, management establishes a specific reserve for those
loans that have an estimated fair value that is below the carrying
value.  Troubled debt restructures had a carrying amount of $952,372
as of December 31, 2008 with specific reserves of $39,551.





The
respective allowance for credit losses allocated to impaired loans was
approximately $2.9 million and $1.9 million as of December 31, 2008 and 2007,
respectively.  The average recorded investment in impaired loans was
approximately $13.7 million, $2.6 million and $508,000 for the years ended
December 31, 2008, 2007 and 2006, respectively, and no income had been accrued
or collected on those impaired loans classified as non-accrual loans while they
had been classified as impaired.  If the non-accrual loans had been
current in accordance with their original terms, the Company would have
recognized additional interest income of approximately $401,000, $506,000, and
$26,000 for the periods ended December 31, 2008, 2007 and 2006,
respectively.  Any losses on these loans will be charged off as soon
as the amount of loss is determinable.





As of
December 31, 2008, the Company had approximately $2.7 million of loans, where
known credit problems existed, that were subsequently classified as non-accrual
loans as the Company determined that collection of full principal and interest
under the original terms of the loans were not expected.  Management
believes that the allowance for credit losses was adequate for these loans as of
December 31, 2008.





INVESTMENT
PORTFOLIO





The
Company has chosen to invest its available funds primarily in federal funds sold
and other overnight investments. As a result, investment securities as of
December 31, 2008, consisted of $704,200 of Federal Reserve Bank stock and
$535,400 of FHLB stock.  Investment securities for the year ended
December 31, 2007, consisted of $607,300 of Federal Reserve Bank stock,
$1,107,700 of FHLB stock and $399,529 of U.S. Treasury securities which mature
within three months.





The
Company had no investments that were obligations of the issuer, or payable from
or secured by a source of revenue or taxing authority of the issuer, whose
aggregate book value exceeded 10% of stockholders' equity at December 31,
2008.





47


The
following table reflects the amortized cost, estimated fair value and weighted
average yield of the investment portfolio as of December 31:





2008Amortized
      Cost
              
              
              Estimated
      Fair Value
              
              
              Weighted
      Average YieldU.S.
      Treasury securitiesdue
      within one year
              
              $
              -
              
              
              $
              -
              
              
              
              -Other
      equity securities
              
              
              1,239,600
              
              
              
              1,239,600
              
              
              
              3.04
              %Total
      investments
              
              $
              1,239,600
              
              
              $
              1,239,600
              
              
              
              3.04
              %





2007Amortized
      Cost
              
              
              Estimated
      Fair Value
              
              
              Weighted
      Average YieldU.S.
      Treasury securitiesdue
      within one year
              
              $
              399,529
              
              
              $
              399,529
              
              
              
              3.91
              %Other
      equity securities
              
              
              1,715,000
              
              
              
              1,715,000
              
              
              
              6.00
              %Total
      investments
              
              $
              2,114,529
              
              
              $
              2,114,529
              
              
              
              5.61
              %





Management
has made the decision to maintain its available funds in highly-liquid assets
because it wants to ensure that funds are readily available to fund loan
commitments and maturing time deposits. Management believes that this strategy
will allow the Company to maximize interest margins while maintaining
appropriate levels of liquidity.





SOURCES
OF FUNDS





General





Deposits,
short-term borrowings in the form of repurchase agreements, short-term
borrowings under an overnight commercial paper program, short-term borrowings
under secured and unsecured lines of credit, borrowings under the subordinated
debt, scheduled amortization and prepayment of loans, funds provided by
operations and capital are the current sources of funds utilized by the Company
for lending and investment activities, and other general business
purposes.





Deposits





The
Company offers a variety of deposit products having a range of interest rates
and terms. The Company's deposits consist of checking accounts, savings
accounts, money market accounts and certificates of deposit.





The
following table sets forth the composition of the Company's deposits as of
December 31, 2008 and December 31, 2007:





2008
                                
                                
                                2007Demand
      Deposits
                                $
                                76,115,803
                                
                                31.12
                                %
                                
                                $
                                58,912,584
                                
                                
                                29.17
                                %Savings
                                
                                1,047,533
                                
                                0.43
                                
                                
                                
                                1,905,072
                                
                                
                                0.94Money
      Market and sweep
                                
                                23,763,974
                                
                                9.71
                                
                                
                                
                                41,277,267
                                
                                
                                20.44Certificates
      of deposit
                                
                                143,700,722
                                
                                58.74
                                
                                
                                
                                99,886,542
                                
                                
                                49.45Total
      deposits
                                $
                                244,628,032
                                
                                100.00
                                %
                                
                                $
                                201,981,465
                                
                                
                                100.00
                                %





The mix
of deposits shifted to a higher concentration of demand deposits and
certificates of deposit and a decreased concentration in savings and money
market and sweep accounts in 2008 compared to 2007. The increased concentration
in demand deposits was primarily a function of the movement of customers’




48


funds
into these accounts following the termination of the commercial paper program
due to the declining interest rate environment and the FDIC’s Temporary
Liquidity Guaranty Program, which provides deposit insurance for the full amount
of most non interest-bearing transaction accounts through December 31,
2009.  Certificates of deposit accounts increased by approximately
$43.8 million due to management’s decision to aggressively compete for national
market deposits during 2008 for liquidity management.





Of the
total deposits at December 31, 2008, $5.3 million, or 2.17%, was related to one
customer as compared to $6.2 million, or 3.08%, at December 31, 2007 for this
same customer. The deposits for this large customer tend to fluctuate
significantly; as a result, management monitors these deposits on a daily basis
to ensure that liquidity levels are adequate to compensate for these
fluctuations.





The
following table sets forth the maturity distribution for the Company's deposits
at December 31, 2008. Some of the deposits may be renewed or withdrawn prior to
maturity. Therefore, the following table should not be used as a forecast of
future cash flows.





Within
      one year
              
              
              One
      to three years
              
              
              Three
      to
                five years
              
              
              Over
      five years
              
              
              TotalDemand
      deposits
              
              $
              76,115,803
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              76,115,803Savings
              
              
              1,047,533
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              1,047,533Money
      Market and sweep
              
              
              23,763,974
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              23,763,974Certificates
      of deposit
              
              
              117,996,251
              
              
              
              23,868,719
              
              
              
              1,835,752
              
              
              
              -
              
              
              
              143,700,722Total
              
              $
              218,923,561
              
              
              $
              23,868,719
              
              
              $
              1,835,752
              
              
              $
              -
              
              
              $
              244,628,032





Certificates
of deposit in amounts of $100,000 or more, and their remaining maturities at
December 31, 2008, are as follows:





Three
      months or less
              
              $
              28,115,659Over
      three months through six months
              
              
              12,962,733Over
      six months through twelve months
              
              
              32,559,811Over
      twelve months
              
              
              13,951,518Total
              
              $
              87,589,721





The
market in which the Company operates is very competitive and the rates of
interest paid on deposits are affected by rates paid by other depository
institutions. Management closely monitors rates offered by other institutions
and seeks to be competitive within the market. The Company has chosen to
selectively compete for large certificates of deposits. The Company will choose
to pursue such deposits when expected loan growth provides for adequate spreads
to support the cost of those funds. As of December 31, 2008, the Company had
outstanding certificates of deposit of approximately $94.9 million that were
either obtained through the listing of certificate of deposit rates on two
Internet-based listing services (such deposits are sometimes referred to herein
as national market certificates of deposit) or to a lesser extent, acquired
through Promontory Financial Network’s CDARS program. The national market
certificates of deposit were issued with an average yield of 3.91% and an
average term of 27 months. Included in the $94.9 million are national
market certificates of deposit totaling $80.5 million that have been classified
as “Brokered Deposits” for bank regulatory purposes. These “Brokered Deposits”
were issued with an average yield of 3.91% and an average term of 6.5
months.  As of December 31, 2007, the total certificates of deposit
obtained through the listing of certificate of deposit rates on the
Internet-based listing services were approximately $31.6 million, and included
$199,000 of “Brokered Deposits.”  The Company has never paid broker
fees for deposits.





In the
first quarter of 2006, the Company began using brokered certificates of deposit
through Promontory Financial Network. Through this deposit matching network and
its CDARS program, the Company had the ability to offer its customers access to
FDIC-insured deposit products in aggregate amounts




49


exceeding
current insurance limits. When the Company places funds through CDARS on behalf
of a customer, it receives matching deposits through the network. The Company
also has the ability to raise deposits directly through the
network.  These deposits are also considered “Brokered Deposits” for
bank regulatory purposes. As of December 31, 2008, the Company had approximately
$3.1 million of CDARS deposits outstanding all of which was placed on behalf of
customers.  These deposits were issued with an average yield of 4.58%
and an average term of 5 months.





Effective
September 30, 2008, the Company was unable to accept additional brokered
deposits without prior FDIC approval.  This is a standard requirement
for banks that are deemed to be “adequately capitalized.”  As of
December 31, 2008, $30.8 million of the $80.5 million of brokered CDs will
mature during the first quarter of 2009.





Below is
a reconciliation of total deposits to core deposits as of December 31, 2008 and
2007, respectively:





December
      31,
                2008
              
              
              December
      31, 2007Total
      deposits
              
              $
              244,628,032
              
              
              $
              201,981,465Commercial
      paper sweep balances
              
              
              -
              
              
              
              7,309,507National
      market certificates of deposit
              
              
              (94,919,991
              )
              
              
              (32,661,081
              )Variable
      balance accounts (1 customer in 2008 and 2007)
              
              
              (5,311,720
              )
              
              
              (6,230,689
              )Portion
      of variable balance accounts considered to be core
              
              
              3,000,000
              
              
              
              3,000,000Core
      deposits
              
              $
              147,396,321
              
              
              $
              173,399,202





Core
deposits, which management categorizes as commercial paper sweep balances and
all deposits other than national market certificates of deposit, CDARS deposits
and $2.3 million of the $5.3 million deposits from the large customer described
above, stood at $147.4 million as of December 31, 2008, down 15.0% from $173.4
million as of December 31, 2007. Overall, the Company did not aggressively
compete for new local deposits during 2008, which essentially accounts for the
decrease in core deposits from 2007.  Core deposits are closely
monitored by management because they consider such deposits not only a
relatively stable source of funding but also reflective of the growth of
commercial and consumer depository relationships.





Borrowings.





Short-term
borrowings as of December 31, 2008 consist primarily of $1.9 million borrowed
under Federal Funds lines of credit. These borrowings are unsecured and are
subordinated to all deposits.  Short-term borrowings as of December
31, 2007 included $7.3 million borrowed under commercial paper, $3.6 borrowed
under Federal Funds lines of credit and $14.4 million borrowed under its secured
FHLB credit facility.





Subordinated
debt consists of $8 million of fixed interest rate trust preferred securities
(the “Trust Preferred Securities”), issued on December 12, 2005 through a
Delaware trust subsidiary, Bay National Capital Trust I (the “Trust”). The Trust
was formed for the purpose of issuing the Trust Preferred Securities and all of
its common securities are owned by the Company. The Company purchased the common
securities from the Trust for $248,000. In accordance with provisions of FIN46,
the financial position and results of operations are not included in the
Company’s consolidated financial position and results of
operations.





The Trust
used the proceeds of the sale of the Trust Preferred Securities and common
securities to purchase from the Company the aggregate principal amount of
$8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
Securities bear interest at the fixed annual rate of 7.20% until maturity. The
interest expense on




50


Trust
Preferred Securities, which include amortization of issuance costs, was
$603,039, $602,096 and $603,567 in 2008, 2007 and 2006, respectively. The Debt
Securities mature on February 23, 2036, but may be redeemed at the Company’s
option at any time on any February 23, May 23, August 23 or November 23 on or
after February 23, 2011, or at any time upon certain events, such as a change in
the regulatory capital treatment of Debt Securities, the Trust being deemed to
be an “investment company” under the Investment Company Act of 1940, as amended,
or the occurrence of certain adverse tax events.  Except upon the
occurrence of the events described above, which require a redemption premium for
redemptions prior to February 23, 2011, the Company may redeem the Debt
Securities at their aggregate principal amount, plus accrued interest, if
any.





The
Parent is required to retain $1,000,000 of the proceeds from the Debt Securities
for general corporate purposes (which may include making interest payments on
the Debt Securities) until the earlier of (i) the date on which the retained
funds are reduced to zero, or (ii) the date on which the Bank (or any successor)
meets the statutory requirements to pay dividends of at least $148,464 for each
of two consecutive quarters with positive retained earnings remaining after any
such dividend payment.  As of December 31, 2008, the Bank met the
retained earnings requirement.





The Debt
Securities are subordinated to the prior payment of other indebtedness of the
Company that, by its terms, is not similarly subordinated.  Although
the Debt Securities are recorded as a liability on the Company’s balance sheet,
the trust preferred securities qualify as Tier 1 capital, subject to regulatory
guidelines that limit the amount included to an aggregate of 25% of Tier 1
capital.





On
January 6, 2009, the Company provided notice under the Indenture of its election
to defer the interest payment due on February 23, 2009.  Under the
terms of the indenture for the Debt Securities dated December 12, 2005 (the
“Indenture”), the Company has the right to defer payments of interest on the
Debt Securities for up to 20 consecutive quarterly periods, provided that no
event of default (as defined in the Indenture) has occurred and is continuing at
the time of the deferral. The Company was not in default with respect to the
Indenture at the time the payments were deferred and such deferral did not cause
an event of default under the Indenture.  Although the Company has the
financial means to pay the interest on the Debt Securities, management elected
to defer payments of interest at this time to conserve cash.  In
addition, the Company had informal discussions with the FRB that led it to
believe that the FRB would instruct them to defer the future interest
payments.  In February 2009, the Company received formal notice from
the FRB instructing it to suspend its trust preferred interest
payments.





During
the period in which interest payments are being deferred, the Company may not,
subject to certain exceptions, (i) declare or pay any dividends or distributions
on, or redeem, purchase, acquire, or make a liquidation payment with respect to,
any of its capital stock, (ii) make any payments on, repay, repurchase or redeem
any debt securities other than those that rank senior to the Debt Securities, or
(iii) make any payment under any guarantees of the Company, other than those
that rank senior to the Company’s guarantee on the capital securities issued by
the Trust.  Interest on the Debt Securities continues to accrue during
the deferral period and interest on the deferred interest also accrues, both of
which must be paid at the end of the deferral period.  Prior to the
expiration of the deferral period, the Company has the right to further defer
interest payments, provided that no deferral period, together with all prior
deferrals, exceed 20 consecutive quarters.





As of
December 31, 2008, the Company had unused commitments for a total of $2.1
million of borrowing availability under an unsecured Federal Funds line of
credit with another institution.  This facility was terminated on
January 15, 2009 primarily based on the Company’s negative earnings
trend.





The
Company also had approximately $21.5 million of borrowing capacity with the FHLB
of Atlanta as of December 31, 2008.   This facility was suspended
on February 13, 2009.  The Company has




51


taken
steps to restore this line of credit and as of March 27, 2009, the Company has
available borrowing capacity of approximately $6.5 million.





For
additional information with respect to borrowings, please see Note 7 to the
Company’s audited financial statements, “Borrowings.”





INTEREST
RATE SENSITIVITY





The
primary objective of asset/liability management is to minimize interest rate
risk as net interest income can fluctuate with significant interest rate
movements. To minimize the risk associated with these rate swings, management
attempts to structure the Company’s balance sheet so that the ability exists to
adjust pricing on interest-earning assets and interest-bearing liabilities in
roughly equivalent amounts at approximately the same time intervals. Imbalances
in these repricing opportunities at any point in time constitute interest rate
sensitivity.





The
measurement of the Company’s interest rate sensitivity, or "gap," is one of the
principal techniques used in asset/liability management. The interest sensitive
gap is the dollar difference between assets and liabilities which are subject to
interest rate pricing within a given time period, including both floating rate
or adjustable rate instruments, and instruments which are approaching
maturity.





The
following table sets forth the amount of the Company's interest-earning assets
and interest-bearing liabilities as of December 31, 2008, which are expected to
mature or reprice in each of the time periods shown:


Maturity
      or repricing withinAmount
                                                  
                                                  
                                                  Percent
      of Total
                                                  
                                                  
                                                  0
      to 3Months
                                                  
                                                  
                                                  4
      to 12Months
                                                  
                                                  
                                                  1
      to 5Years
                                                  
                                                  
                                                  Over
      5YearsInterest-earning
      assetsFederal
      funds sold and other overnight investments
                                                  
                                                  $
                                                  2,023,478
                                                  
                                                  
                                                  
                                                  0.81
                                                  %
                                                  
                                                  $
                                                  2,023,478
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -Loans
      held for sale
                                                  
                                                  
                                                  1,187,954
                                                  
                                                  
                                                  
                                                  0.47
                                                  
                                                  
                                                  
                                                  1,187,954
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Loans
      – Variable rate
                                                  
                                                  
                                                  134,499,222
                                                  
                                                  
                                                  
                                                  53.45
                                                  
                                                  
                                                  
                                                  134,499,222
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Loans
      – Fixed rate
                                                  
                                                  
                                                  112,663,545
                                                  
                                                  
                                                  
                                                  44.78
                                                  
                                                  
                                                  
                                                  22,845,910
                                                  
                                                  
                                                  
                                                  15,934,561
                                                  
                                                  
                                                  
                                                  64,662,744
                                                  
                                                  
                                                  
                                                  9,220,330Other
      earning assets
                                                  
                                                  
                                                  1,239,600
                                                  
                                                  
                                                  
                                                  0.49
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  1,239,600Total
      interest-earning assets
                                                  
                                                  $
                                                  251,613,799
                                                  
                                                  
                                                  
                                                  100.00
                                                  %
                                                  
                                                  $
                                                  160,556,564
                                                  
                                                  
                                                  $
                                                  15,934,561
                                                  
                                                  
                                                  $
                                                  64,662,744
                                                  
                                                  
                                                  $
                                                  10,459,930Interest-bearing
      liabilitiesDeposits
      – Variable rate
                                                  
                                                  $
                                                  50,981,956
                                                  
                                                  
                                                  
                                                  24.93
                                                  %
                                                  
                                                  $
                                                  50,981,956
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -Deposits
      – Fixed rate
                                                  
                                                  
                                                  143,700,722
                                                  
                                                  
                                                  
                                                  70.25
                                                  
                                                  
                                                  
                                                  48,191,772
                                                  
                                                  
                                                  
                                                  69,804,479
                                                  
                                                  
                                                  
                                                  25,704,471
                                                  
                                                  
                                                  
                                                  -Short-term
      borrowings – variable rate
                                                  
                                                  
                                                  1,864,056
                                                  
                                                  
                                                  
                                                  0.91
                                                  
                                                  
                                                  
                                                  1,864,056
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Subordinated
      debt
                                                  
                                                  
                                                  8,000,000
                                                  
                                                  
                                                  
                                                  3.91
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  8,000,000Total
      interest-bearing liabilities
                                                  
                                                  $
                                                  204,546,734
                                                  
                                                  
                                                  
                                                  100.00
                                                  %
                                                  
                                                  $
                                                  101,037,784
                                                  
                                                  
                                                  $
                                                  69,804,479
                                                  
                                                  
                                                  $
                                                  25,704,471
                                                  
                                                  
                                                  $
                                                  8,000,000Periodic
      repricing differencesPeriodic
      gap
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  59,518,780
                                                  
                                                  
                                                  $
                                                  (53,869,918
                                                  )
                                                  
                                                  $
                                                  38,958,273
                                                  
                                                  
                                                  $
                                                  2,459,930Cumulative
      gap
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  59,518,780
                                                  
                                                  
                                                  $
                                                  5,648,862
                                                  
                                                  
                                                  $
                                                  44,607,135
                                                  
                                                  
                                                  $
                                                  47,067,065Ratio
      of rate sensitive assets to rate sensitive liabilities
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  158.91
                                                  %
                                                  
                                                  
                                                  22.83
                                                  %
                                                  
                                                  
                                                  2.52
                                                  %
                                                  
                                                  
                                                  130.75
                                                  %




52





The
Company has 53.45% of its interest-earning assets and 25.84% of its
interest-bearing liabilities in variable rate balances. The excess of
interest-earning assets over interest-bearing liabilities of $44.6
million in the categories of items maturing or repricing within 5 years
comprises the majority of the overall gap. This gap is generally reflective of
the Company’s emphasis on investing in short-term investments and originating
variable rate loans and the demand in the market for higher yielding fixed rate
deposits. This analysis indicates that the Company generally will benefit from
rising market rates of interest but will generally be adversely affected by
declining market rates of interest. However, since all interest rates and yields
do not adjust at the same pace, the gap is only a general indicator of interest
rate sensitivity. The analysis of the Company's interest-earning assets and
interest-bearing liabilities presents only a static view of the timing of
maturities and repricing opportunities, without taking into consideration the
fact that changes in interest rates do not affect all assets and liabilities
equally. Net interest income may be affected by other significant factors in a
given interest rate environment, including changes in the volume and mix of
interest-earning assets and interest-bearing liabilities.





Management
constantly monitors and manages the structure of the Company's balance sheet,
seeks to control interest rate exposure and evaluate pricing strategies while
maximizing earnings and net worth.  Strategies and policies to manage
the balance sheet are predicated upon the examination of how interest rate risk
affects overall business risk, capital risk, liquidity risk, and credit
risk.  The proper strategy will depend on the current level of risk,
the time frame, and the current and expected interest rate
environment.  The Company will attempt to extend fixed-rate
liabilities to longer maturities while purchasing variable rate assets to widen
the net interest margin if it determines that interest rates will more than
likely increase.  If the Company perceives that interest rates will
decline, an attempt will be made to shorten fixed rate liabilities while
securing longer term fixed rate assets.





In
theory, maintaining a nominal level of interest rate sensitivity can diminish
interest rate risk. In practice, this is made difficult by a number of factors,
including cyclical variation in loan demand, different impacts on interest
sensitive assets and liabilities when interest rates change and the availability
of funding sources. Management generally attempts to maintain a balance between
rate-sensitive assets and liabilities as the exposure period is lengthened to
minimize the overall interest rate risk to the Company.





LIQUIDITY





The
Company’s overall asset/liability management strategy takes into account the
need to maintain adequate liquidity to fund asset growth, deposit runoff and
ongoing operations.  Management monitors the liquidity position
daily.





The
Company’s primary sources of funds are deposits, commercial paper, borrowings
under the Federal funds and FHLB credit facilities, scheduled amortization and
prepayment of loans, funds provided by operations and capital.  The Company
also has access to national markets for certificates of
deposit.  While scheduled principal repayments on loans are a
relatively predictable source of funds, deposit flows and loan prepayments are
greatly influenced by market interest rates, economic conditions, and rates
offered by our competition.





The
Company's most liquid assets are cash and assets that can be readily converted
into cash, including investment securities maturing within one year. As of
December 31, 2008, the Company had $7.3 million in cash and due from banks and
$2.0 million in federal funds sold. As of December 31, 2007, the Company had
$2.3 million in cash and due from banks, $4.9 million in federal funds sold and
other overnight investments and $399,529 in three-month U.S. Treasury Securities
held in mutual funds.





The
increase in the overall level of liquid assets, other than loans expected to be
sold within 60 days, is the result of management’s decision to maintain margins
by using available liquidity to fund loan growth and allow non-core time
deposits to mature.





53


As of
December 31, 2008, the Company had unused commitments for a total of $2.1
million of borrowing availability under unsecured Federal Funds lines of credit
with one financial institution. This facility was terminated on January 15, 2009
primarily based on the Company’s negative earnings trend.  The Company
also had approximately $21.5 million of borrowing capacity with the FHLB of
Atlanta, which was subsequently suspended on February 13, 2009. The Company has
taken steps to restore this line of credit and as of March 27, 2009, the Company
has available borrowing capacity of approximately $6.5 million.  These
credit facilities can be used in conjunction with the normal deposit strategies,
which include pricing changes to increase deposits as necessary.  From time
to time, the Company may sell or participate out loans to create additional
liquidity as required.





Effective
with the filing of the September 30, 2008 Call Report, the Company was unable to
accept additional brokered deposits without prior approval of the
FDIC.  This is a standard requirement for banks that are deemed to be
“adequately capitalized.”  As of December 31, 2008, $30.8 million of
the $80.5 million of brokered CDs will mature during the first quarter of
2009.





As an
additional source of liquidity, management has also identified specific loans to
sell and has contacted several correspondent banks as potential purchasers of
such loans.  Some of those correspondents have expressed an interest and
have begun preliminary reviews of documentation provided by the Company. 
Since undertaking transactions of this nature could have an adverse impact on
the profitability of the Company (i.e., loss in interest income on the
participated loans) this is being considered only as a contingent source of
liquidity.





In early
2009, the Bank received notice of changes to its borrowing capacity with a
correspondent bank and the FHLB of Atlanta and of changes to its clearing
account maintained at the Federal Reserve Bank.  These changes were
primarily a result of the Bank’s negative earnings trends and its categorization
as adequately capitalized.





On
January 15, 2009, the Bank was notified that its $4 million unsecured line with
Fulton Bank was terminated.  This line had been used for short-term
liquidity needs.





On
February 13, 2009, the Federal Reserve Bank of Richmond notified the Company
that its Federal Reserve account would be placed on real-time monitoring and the
Company was responsible for providing $3 million in collateral.  With this
change, the Company is not allowed to initiate a funds transfer that exceeds its
available balance and the pledged collateral would be used to cover inadvertent
daylight overdrafts.  The required collateral has been pledged and as of
March 26, 2009, a daylight overdraft has not occurred in the account as
management closely monitors the position on a daily basis.





Also on
February 13, 2009, the Company was notified by the FHLB of Atlanta that it must
physically deliver specific loan documents for all pledged collateral and that
future borrowing capacity would be determined after FHLB’s review of those
files.  On March 12, 2009, management received the results of FHLB’s review
of the loan files and is currently organizing appropriate responses and/or
gathering additional documentation.  The Company currently has borrowing
capacity of approximately $6.5 million with FHLB and expects to increase the
available line pending submission of additional loan
documentation.





In
response to the termination of the line of credit by Fulton Bank and the
temporary revocation of borrowing capacity by FHLB, the Company immediately
sought to increase liquidity through issuance of national market certificates of
deposit.  The Company has been successful with generating cash from this
market while it works diligently to restore the lines of credit with FHLB and
where possible, obtain lines of credit from other institutions.





54


Because
management recognizes the importance of liquidity given the negative earnings
trends and the deterioration in the economy, the Company submitted an
application to the Federal Reserve’s Discount Window lending program.  This
program is a mechanism for implementing monetary policy and is also used as a
backup source of funds for individual depository
institutions.





The
primary credit program under the Discount Window aids the implementation of
monetary policy by making funds readily available at the primary credit rate
when there is a temporary shortage of liquidity in the banking system, making
the process of borrowing from the Discount Window administratively easier and
promoting consistency in the lending function across the Federal Reserve
System.  This program reduces depository institutions’ reluctance to
borrow, thus making the Discount Window a more effective policy
instrument.  The secondary credit program makes credit available, when
appropriate, to meet backup liquidity needs of depository institutions that do
not qualify for primary credit.





To
further aid in managing the Company’s liquidity, in a March 2009 meeting, the
Board approved the formation of an Investment Committee and the use of available
cash to establish an investment portfolio. The Investment Committee will meet to
review and discuss recommendations for the composition of the portfolio. By
limiting the maturity of securities and maintaining a conservative investment
posture, management can rely on the investment portfolio to help meet any
short-term funding needs.  Among the options available to the Company
is selling shares of common stock to raise capital and improve our liquidity
position.





Based on
the actions noted above, we believe that the Company has backup facilities in
place to meet a liquidity shortfall. Although the Company believes sufficient
liquidity exists, if economic conditions continue to deteriorate and consumer
confidence is not restored, this excess liquidity could be depleted, which would
then materially affect the Company’s ability to meet its operating needs and to
raise additional capital.





CONTRACTUAL
OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES, AND OFF-BALANCE SHEET
ARRANGEMENTS





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business.  These financial instruments primarily
include commitments to extend credit, lines of credit and standby letters of
credit.  The Company uses these financial instruments to meet the
financing needs of its customers.  These financial instruments
involve, to varying degrees, elements of credit, interest rate and liquidity
risk.  In addition, the Company also has operating lease obligations
and purchase commitments.





Outstanding
loan commitments and lines and letters of credit at December 31, 2008 and 2007
are as follows:





2008
            
            2007Loan
      commitments
            $
            14,981,584
            $
            35,114,676Unused
      lines of credit
            
            84,495,398
            
            85,999,686Letters
      of credit
            
            2,924,671
            
            3,564,927




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 interest rates fixed at current market amounts, fixed expiration
dates or other termination clauses, which may require payment of a
fee.  Unused lines of credit represent the unused portion of lines of
credit previously extended and available to the customer as long as there is no
violation of any contractual condition. These lines generally have variable
interest rates. Since many of the commitments are expected to expire without
being drawn upon, and since it is unlikely that customers will draw upon their
line of credit in full at any time, the total commitment amount




55


or line
of credit amount does not necessarily represent future cash
requirements.  The Company is not aware of any loss it would incur by
funding its commitments or lines of credit.





Standby
letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party.  The Company’s exposure to
credit loss in the event of nonperformance by the customer is the contract
amount of the commitment.





In
general, loan commitments, lines of credit and letters of credit are made on the
same terms, including with respect to collateral, as outstanding loans. Each
customer’s credit-worthiness and the collateral required are evaluated on a
case-by-case basis.





The
decline in the overall level of loan commitments and unused lines of credit as
of December 31, 2008 as compared to December 31, 2007, is reflective of
management’s decision to strictly manage loan growth and is also reflective of
the current global economic downturn.





The
Company has various financial obligations, including contractual obligations and
commitments that may require future cash payments.





The
following table presents, as of December 31, 2008, significant fixed and
determinable contractual obligations to third parties by payment
date:








Within
      one year
              
              
              One
      to three years
              
              
              Three
      to
                five years
              
              
              Over
      five years
              
              
              TotalDeposits
      without astated
      maturity(a)
              
              $
              100,927,389
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              100,927,389Certificates
      of deposit(a)
              
              
              118,619,318
              
              
              
              23,868,719
              
              
              
              1,835,752
              
              
              
              -
              
              
              
              144,323,789Other
      borrowings(a)
              
              
              1,923,624
              
              
              
              -
              
              
              
              -
              
              
              
              8,000,000
              
              
              
              9,923,624Operating
      leases
              
              
              572,639
              
              
              
              420,237
              
              
              
              98,549
              
              
              
              -
              
              
              
              1,091,425Purchase
      obligations
              
              
              360,013
              
              
              
              240,008
              
              
              
              -
              
              
              
              -
              
              
              
              600,021Total
              
              $
              222,402,983
              
              
              $
              24,528,964
              
              
              $
              1,934,301
              
              
              $
              8,000,000
              
              
              $
              256,866,248





(a)
            Includes
      accrued interest payable.





The
Company's operating lease obligations represent short and long-term lease and
rental payments for facilities. Purchase obligations represent estimated
obligations under agreements to purchase goods or services that are enforceable
and legally binding on the Company. The purchase obligation amounts presented
above primarily relate to estimated obligations under data and item processing
contracts and accounts payable for goods and services received through December
31, 2008.





CAPITAL
RESOURCES





The
Company had stockholders’ equity at December 31, 2008 of $15.0 million as
compared to $19.9 million at December 31, 2007. The decrease in capital is the
result of negative operating results. The Company has declared no cash dividends
since its inception.  Management is extremely focused on improving the
Company’s capital as required by the terms of the OCC’s Consent
Order.





Banking
regulatory authorities have implemented strict capital guidelines that directly
relate to the credit risk associated with an institution’s assets. Banks and
bank holding companies are required to maintain capital levels based on their
"risk adjusted” assets so that categories of assets with higher "defined” credit
risks will require more capital support than assets with lower risks. The Bank
has met its capital adequacy




56


requirements
to date and is presently evaluating alternative courses of action to improve its
capital position and to meet the higher risk-based capital ratios imposed by the
OCC in its Consent Order.





Banking
regulations also limit the amount of dividends that may be paid without prior
approval of the Bank's regulatory agencies.  Regulatory approval is
required to pay dividends that exceed the Bank’s net profits for the current
year plus its retained net profits for the preceding two years.  The
Bank could not have paid dividends to the Company without approval from bank
regulatory agencies at December 31, 2008 and no such payments are currently
planned.  Furthermore, under the terms of the Consent Order, the Bank
may not pay dividends unless it is in compliance with the capital program
required by the Order and applicable regulatory requirements and receives the
OCC’s written non-objection.





In
addition, in February 2009, Bay National Corporation received notice from the
Federal Reserve Bank of Richmond that it is expected to immediately terminate
future dividend payments, including payments on trust preferred
securities.  This order will remain in effect until Bay National
Corporation receives written approval from the Reserve Bank to resume such
payments.





The
tables below present the Bank's capital position relative to its various minimum
regulatory capital requirements as of December 31, 2008 and 2007. For a
discussion of these capital requirements, see "Item 1. Description of Business -
Supervision and Regulation - Bay National Bank - Capital Adequacy
Guidelines."





December
      31, 2008Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              Ratio
              
              
              Amount
              
              Ratio
              
              
              Amount
              
              RatioTotal
      Capital (to Risk Weighted Assets)*:
              $
              26,322,552
              
              9.57
              %
              $
              22,000,960
              
              8.00
              %
              $
              27,501,200
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets)*:
              
              22,857,283
              
              8.31
              %
              
              11,000,480
              
              4.00
              %
              
              16,500,720
              
              6.00
              %Tier
      I Capital (to Average Assets)*:
              
              22,857,283
              
              8.31
              %
              
              8,254,920
              
              3.00
              %
              
              13,758,200
              
              5.00
              %*In
      order to be in compliance with the terms of the Consent Order, the Bank
      must meet minimum Total Capital, Tier 1 Capital  (to Risk
      Weighted Assets) and Tier 1 Capital (to Average Assets) ratios of 12.00%,
      11.00% and 9.00%,
respectively.








December
      31, 2007Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              Ratio
              
              
              Amount
              
              Ratio
              
              
              Amount
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              $
              27,392,869
              
              10.41
              %
              $
              21,047,000
              
              8.00
              %
              $
              26,309,000
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              24,083,165
              
              9.15
              %
              
              10,523,000
              
              4.00
              %
              
              15,785,000
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              24,083,165
              
              9.63
              %
              
              7,504,000
              
              3.00
              %
              
              12,506,000
              
              5.00
              %





57


The
tables below present Bay National Corporation’s capital position relative to its
various minimum regulatory capital requirements as of December 31, 2008 and
2007.





December
      31, 2008Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              Ratio
              
              
              Amount
              
              Ratio
              
              
              Amount
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              $
              26,487,270
              
              9.96
              %
              $
              21,267,040
              
              8.00
              %
              $
              26,583,800
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              21,643,818
              
              8.14
              %
              
              10,633,520
              
              4.00
              %
              
              15,950,280
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              21,643,818
              
              7.87
              %
              
              8,254,920
              
              3.00
              %
              
              13,758,200
              
              5.00
              %





December
      31, 2007Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              Ratio
              
              
              Amount
              
              Ratio
              
              
              Amount
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              $
              31,230,256
              
              11.87
              %
              $
              21,054,000
              
              8.00
              %
              $
              26,317,000
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              27,728,115
              
              10.54
              %
              
              10,527,000
              
              4.00
              %
              
              15,790,000
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              27,728,115
              
              11.09
              %
              
              7,504,000
              
              3.00
              %
              
              12,506,000
              
              5.00
              %





Impact
of Inflation and Changing Prices





The
consolidated financial statements and notes thereto presented herein have been
prepared in accordance with accounting principles generally accepted in the
United States of America, which require the measurement of financial position
and operating results in terms of historical dollars without considering the
change in the relative purchasing power of money over time and due to inflation.
The impact of inflation is reflected in the increased cost of the Company's
operations. Unlike most industrial companies, nearly all the assets of the
Company are monetary in nature. As a result, interest rates have a greater
impact on the Company's performance than do the effects of general levels of
inflation. Interest rates do not necessarily move in the same direction or to
the same extent as the price of goods and services.





Application
of Critical Accounting Policies





The
Company’s consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and
follow general practices within the industries in which it operates. Application
of these principles requires management to make estimates, assumptions and
judgments that affect the amounts reported in the financial statements and
accompanying notes. These estimates, assumptions and judgments are based on
information available as of the date of the financial statements; accordingly,
as this information changes, the financial statements could reflect different
estimates, assumptions and judgments. Certain policies inherently have a greater
reliance on the use of estimates, assumptions and judgments and as such, have a
greater possibility of producing results that could be materially different than
originally reported. Estimates, assumptions and judgments are necessary when
assets and liabilities are required to be recorded at fair value, when a decline
in the value of an asset not carried on the financial statements at fair value
warrants an impairment write-down or valuation reserve to be established or when
an asset or liability must be recorded contingent upon a future event. Carrying
assets and liabilities at fair value inherently results in more financial
statement volatility. The fair values and the information used to record
valuation adjustments for certain assets and liabilities are based either on
quoted market prices or are provided by other third-party sources, when
available.





58


The most
significant accounting policies followed by the Company are presented in Note 1
to the consolidated financial statements. These policies, along with the
disclosures presented in the other financial statement notes and in this
financial review, provide information on how significant assets and liabilities
are valued in the financial statements and how those values are determined.
Based on the valuation techniques used and the sensitivity of financial
statement amounts to the methods, assumptions and estimates underlying those
amounts, management has identified the determination of the allowance for credit
losses as a critical accounting policy that requires the most subjective or
complex judgments, and, as such, could be most subject to revision as new
information becomes available.





The
allowance for credit losses represents management's best estimate of losses
known and inherent in the loan portfolio that are both probable and reasonable
to estimate, based on, among other factors: prior loss experience of the Company
and peer institutions; current economic conditions; review of the ongoing
financial conditions of borrowers; and the views of the Company’s regulators and
the firm that conducts an annual independent loan review. Determining the amount
of the allowance for credit losses is considered a critical accounting estimate
because it requires significant estimates, assumptions and judgments. The loan
portfolio also represents the largest asset type on the consolidated balance
sheets.





The
Company uses a loan grading system where loans are graded based on management's
evaluation of the risk associated with each loan. A factor, based on the loan
grading, is applied to the loan balance to reserve for losses. In addition,
management judgmentally establishes an additional nonspecific reserve. The
nonspecific portion of the allowance reflects management's estimate of probable
inherent but undetected losses within the portfolio due to uncertainties in
economic conditions, delays in obtaining information, including unfavorable
information about a borrower's financial condition, the difficulty in
identifying triggering events that correlate perfectly to subsequent loss rates
and risk factors that have not yet manifested themselves in loss allocation
factors.





Management
has significant discretion in making the judgments inherent in the determination
of the provision and allowance for credit losses, including the valuation of
collateral and the assessment of the financial condition of the borrower, and in
establishing allowance percentages and risk ratings.  The
establishment of allowance factors is a continuing exercise and allowance
factors may change over time, resulting in an increase or decrease in the amount
of the provision or allowance based upon the same volume and classification of
loans.





Changes
in allowance factors or in management’s interpretation of those factors will
have a direct impact on the amount of the provision and a corresponding effect
on income and assets.  Also, errors in management’s perception and
assessment of the allowance factors could result in the allowance not being
adequate to cover losses in the portfolio and may result in additional
provisions or charge-offs, which would adversely affect income and
capital.  For additional information regarding the allowance for loan
and lease losses, see the “Provision for Credit Losses and Credit Risk
Management” section of this financial review.





Recent
Accounting Pronouncements And Developments





Note 1 to
the consolidated financial statements discusses new accounting policies adopted
by the Company during 2008 and the expected impact of accounting policies,
recently issued or proposed, but not yet required to be adopted. To the extent
the adoption of new accounting standards materially affects the Company's
financial condition, results of operations or liquidity, the impact of these
changes are discussed in the applicable section(s) of this financial review and
notes to the consolidated financial statements.





Risk
Management





The Board
of Directors is the foundation for effective corporate governance and risk
management.




59


The Board
demands accountability of management, keeps stockholders' and other
constituencies' interests in focus and fosters a strong internal control
environment. Through its Executive, Asset/Liability and Audit Committees, the
Board actively reviews critical risk positions, including market, credit,
liquidity and operational risk. The Company's goal in managing risk is to reduce
earnings volatility, control exposure to unnecessary risk and ensure appropriate
returns for risk assumed. Senior management actively manages risk at the line of
business level, supplemented with corporate-level oversight through the
Asset/Liability Committee, the internal audit process and quality control
functions and other risk management groups within the Company. This risk
management structure is designed to uncover risk issues through a systematic
process, enabling timely and appropriate action to avoid and mitigate risk. The
risk management process establishes risk limits, and other measurement systems,
with a focus on risk reduction strategies and capital allocation
practices.




Item
7A.  Quantitative and Qualitative Disclosures About Market
Risk.





Not
applicable





Item
8.  Financial Statements and Supplementary Data





The
following consolidated financial statements are filed with this
report:





Management’s
Report On Internal Control Over Financial Reporting





Report of
Independent Registered Public Accounting Firm





Consolidated
Balance Sheets – December 31, 2008 and 2007





Consolidated
Statements of Operations – For the years ended December 31, 2008, 2007 and
2006





Consolidated
Statements of Changes in Stockholders’ Equity – For the years ended December 31,
2008, 2007 and 2006





Consolidated
Statements of Cash Flows – For the years ended December 31, 2008, 2007 and
2006





Notes to
Consolidated Financial Statements








60


Management’s
Report On Internal Control Over Financial Reporting





The
management of Bay National Corporation (“the Company”) is responsible for
establishing and maintaining adequate internal control over financial reporting.
The internal control over financial reporting has been designed under our
supervision to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of the Company’s consolidated financial
statements for external reporting purposes in accordance with accounting
principles generally accepted in the United States of America.




Management
has conducted an assessment of the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2008, utilizing the
framework established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on this assessment, management has determined that
the Company’s internal control over financial reporting as of December 31,
2008 is effective.




Our
internal control over financial reporting includes those policies and procedures
that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the Company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the Company’s assets that could have a
material effect on the financial statements.




Any
internal control system, no matter how well designed, will have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.




This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.




61


Report
of Independent Registered Public Accounting Firm








Board of
Directors and Stockholders


Bay
National Corporation





We have audited the accompanying
consolidated balance sheets of Bay National Corporation and subsidiary (the
“Company”) as of December 31, 2008 and 2007, and the related consolidated
statements of operations, changes in stockholders’ equity, and cash flows for
each of the three years in the period ended December 31, 2008.  The
Company’s management is responsible for these consolidated financial
statements.  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.  The Company is not required to have, nor
were we engaged to perform, an audit of its internal control over financial
reporting.  Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting.  Accordingly, we express no such opinion.  An
audit also includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation.  We believe that our audits
provide a reasonable basis for our opinion.





In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects,
the financial position of Bay National Corporation and subsidiary as of December
31, 2008 and 2007, and the results of their operations and cash flows for each
of the three years in the period ended December 31, 2008, in conformity with
accounting principles generally accepted in the United States of
America.





/s/
Stegman & Company


Baltimore,
Maryland


March 30,
2009


62




BAY NATIONAL
CORPORATION  CONSOLIDATED BALANCE
SHEETS


December
31, 2008 and 2007





2008
                  
                  
                  2007ASSETSCash and due from
      banks
                  
                  $
                  7,263,034
                  
                  
                  $
                  2,314,423Federal funds sold and other
      overnight investments
                  
                  
                  2,023,478
                  
                  
                  
                  4,859,248Investment securities available
      for sale (AFS) - at fair value
                  
                  
                  -
                  
                  
                  
                  399,529Other
      equity securities
                  
                  
                  1,239,600
                  
                  
                  
                  1,715,000Loans
      held for sale
                  
                  
                  1,187,954
                  
                  
                  
                  11,601,070Loans, net of unearned
      fees
                  
                  
                  247,162,767
                  
                  
                  
                  229,355,171Total
      Loans
                  
                  
                  248,350,721
                  
                  
                  
                  240,956,241Less: Allowance for credit
      losses
                  
                  
                  (5,675,035
                  )
                  
                  
                  (5,000,000
                  )Loans, net
                  
                  
                  242,675,686
                  
                  
                  
                  235,956,241Real
      estate acquired through foreclosure
                  
                  
                  3,873,405
                  
                  
                  
                  946,431Premises and equipment,
      net
                  
                  
                  1,151,246
                  
                  
                  
                  1,210,787Investment
      in bank owned life insurance
                  
                  
                  5,268,529
                  
                  
                  
                  5,041,662Income
      taxes receivable
                  
                  
                  3,276,739
                  
                  
                  
                  420,700Deferred
      tax asset
                  
                  
                  2,469,000
                  
                  
                  
                  1,942,000Accrued interest receivable and
      other assets
                  
                  
                  1,347,271
                  
                  
                  
                  1,729,838Total Assets
                  
                  $
                  270,587,988
                  
                  
                  $
                  256,535,859LIABILITIESNon-interest-bearing
      deposits
                  
                  $
                  49,945,354
                  
                  
                  $
                  31,044,172Interest-bearing
      deposits
                  
                  
                  194,682,678
                  
                  
                  
                  170,937,293Total deposits
                  
                  
                  244,628,032
                  
                  
                  
                  201,981,465Short-term
      borrowings
                  
                  
                  1,864,056
                  
                  
                  
                  25,371,508Subordinated
      debt
                  
                  
                  8,000,000
                  
                  
                  
                  8,000,000Accrued expenses and other
      liabilities
                  
                  
                  1,073,899
                  
                  
                  
                  1,262,334Total
    Liabilities
                  
                  
                  255,565,987
                  
                  
                  
                  236,615,307STOCKHOLDERS'
      EQUITYCommon stock - $.01 par value,
      authorized:9,000,000 shares authorized,
      2,153,101 and 2,137,633 issued and outstanding as of December 31, 2008 and
      2007, respectively:
                  
                  
                  21,531
                  
                  
                  
                  21,376Additional paid in
      capital
                  
                  
                  17,954,770
                  
                  
                  
                  17,788,833(Accumulated deficit) retained
      earnings
                  
                  
                  (2,954,300
                  )
                  
                  
                  2,110,343Total Stockholders'
      Equity
                  
                  
                  15,022,001
                  
                  
                  
                  19,920,552Total Liabilities and
      Stockholders' Equity
                  
                  $
                  270,587,988
                  
                  
                  $
                  256,535,859





See
accompanying notes to consolidated financial statements.


63


BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
OPERATIONS


For the
years ended December 31, 2008, 2007 and 2006





2008
                    
                    
                    2007
                    
                    
                    2006INTEREST
      INCOME:Interest and fees on
      loans
                    
                    $
                    15,127,186
                    
                    
                    $
                    19,823,408
                    
                    
                    $
                    19,117,244Interest on federal funds sold
      and other overnight
                      investments
                    
                    
                    133,615
                    
                    
                    
                    670,971
                    
                    
                    
                    557,970Taxable interest and dividends
      on investment securities
                    
                    
                    64,738
                    
                    
                    
                    93,630
                    
                    
                    
                    105,625Total interest
    income
                    
                    
                    15,325,539
                    
                    
                    
                    20,588,009
                    
                    
                    
                    19,780,839INTEREST
      EXPENSE:Interest
      on deposits
                    
                    
                    5,934,351
                    
                    
                    
                    7,909,153
                    
                    
                    
                    7,132,611Interest
      on short-term borrowings
                    
                    
                    225,985
                    
                    
                    
                    253,956
                    
                    
                    
                    86,522Interest
      on subordinated debt
                    
                    
                    603,039
                    
                    
                    
                    602,096
                    
                    
                    
                    603,567Total
      interest expense
                    
                    
                    6,763,375
                    
                    
                    
                    8,765,205
                    
                    
                    
                    7,822,700Net
      interest income
                    
                    
                    8,562,164
                    
                    
                    
                    11,822,804
                    
                    
                    
                    11,958,139Provision
      for credit losses
                    
                    
                    6,478,200
                    
                    
                    
                    2,125,680
                    
                    
                    
                    202,931Net
      interest income after provision for credit losses
                    
                    
                    2,083,964
                    
                    
                    
                    9,697,124
                    
                    
                    
                    11,755,208NON-INTEREST
      INCOME:Service charges on deposit
      accounts
                    
                    
                    266,064
                    
                    
                    
                    153,813
                    
                    
                    
                    148,042Gain
      on sale of mortgage loans
                    
                    
                    281,029
                    
                    
                    
                    450,184
                    
                    
                    
                    573,387Increase
      in cash surrender value of bank owned life
                      insurance
                    
                    
                    226,867
                    
                    
                    
                    41,662
                    
                    
                    
                    -Loss
      on sale of real estate acquired through foreclosure
                    
                    
                    (59,688
                    )
                    
                    
                    -
                    
                    
                    
                    -Other income
                    
                    
                    48,887
                    
                    
                    
                    79,138
                    
                    
                    
                    55,904Total non-interest
      income
                    
                    
                    763,159
                    
                    
                    
                    724,797
                    
                    
                    
                    777,333NON-INTEREST
      EXPENSE:Salaries and employee
      benefits
                    
                    
                    6,018,002
                    
                    
                    
                    5,460,772
                    
                    
                    
                    5,431,989Occupancy
    expenses
                    
                    
                    763,336
                    
                    
                    
                    653,227
                    
                    
                    
                    506,323Furniture and equipment
      expenses
                    
                    
                    426,190
                    
                    
                    
                    351,599
                    
                    
                    
                    342,261Legal and professional
      fees
                    
                    
                    821,347
                    
                    
                    
                    285,434
                    
                    
                    
                    245,412Data processing and other outside
      services
                    
                    
                    993,648
                    
                    
                    
                    870,404
                    
                    
                    
                    701,422Advertising
      and marketing related expenses
                    
                    
                    509,939
                    
                    
                    
                    486,204
                    
                    
                    
                    512,709Provision
      for losses on real estate acquired through
                      foreclosure
                    
                    
                    569,350
                    
                    
                    
                    111,700
                    
                    
                    
                    -Other expenses
                    
                    
                    1,004,594
                    
                    
                    
                    773,817
                    
                    
                    
                    684,239Total non-interest
      expenses
                    
                    
                    11,106,406
                    
                    
                    
                    8,993,157
                    
                    
                    
                    8,424,355(Loss)
      Income before income taxes
                    
                    
                    (8,259,283
                    )
                    
                    
                    1,428,764
                    
                    
                    
                    4,108,186Income
      tax (benefit) expense
                    
                    
                    (3,194,640
                    )
                    
                    
                    491,395
                    
                    
                    
                    1,678,358Net
      (Loss) Income
                    
                    $
                    (5,064,643
                    )
                    
                    $
                    937,369
                    
                    
                    $
                    2,429,828Per
      Share Data:Net (Loss) Income
      (Basic)
                    
                    $
                    (2.37
                    )
                    
                    $
                    .44
                    
                    
                    $
                    1.25Net
      (Loss) Income (Diluted)
                    
                    $
                    (2.37
                    )
                    
                    $
                    .42
                    
                    
                    $
                    1.20Average
      Shares Outstanding (Basic)
                    
                    
                    2,140,793
                    
                    
                    
                    2,133,174
                    
                    
                    
                    1,938,110Effect
      of dilution – Stock options and warrants
                    
                    
                    -
                    
                    
                    
                    76,977
                    
                    
                    
                    80,099Average
      Shares Outstanding (Diluted)
                    
                    
                    2,140,793
                    
                    
                    
                    2,210,151
                    
                    
                    
                    2,018,209





See
accompanying notes to consolidated financial statements.


64


BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS’ EQUITY


For the
years ended December 31, 2008, 2007 and 2006





Common
      Stock
              
              
              Additional
      Paid in Capital
              
              
              (Accumulated
                Deficit)
      Retained Earnings
              
              
              TotalBalances
      at January 1, 2006
              
              $
              19,244
              
              
              $
              17,451,201
              
              
              $
              (1,256,367
              )
              
              $
              16,214,078Stock-based
      compensation expense
              
              
              -
              
              
              
              115,714
              
              
              
              -
              
              
              
              115,714Issuance
      of common stock
              
              
              110
              
              
              
              82,763
              
              
              
              -
              
              
              
              82,873Net
      income
              
              
              -
              
              
              
              -
              
              
              
              2,429,828
              
              
              
              2,429,828Balances
      at December 31, 2006
              
              
              19,354
              
              
              
              17,649,678
              
              
              
              1,173,461
              
              
              
              18,842,493Stock-based
      compensation expense
              
              
              -
              
              
              
              122,539
              
              
              
              -
              
              
              
              122,539Stock
      options exercised
              
              
              27
              
              
              
              18,611
              
              
              
              -
              
              
              
              18,638Issuance
      of stock awards
              
              
              60
              
              
              
              (60
              )
              
              
              -
              
              
              
              -1.1
      to one stock split in the form of a stock dividend
              
              
              1,935
              
              
              
              (1,935
              )
              
              
              -
              
              
              
              -Cash
      paid in lieu of fractional shares on stock dividend
              
              
              -
              
              
              
              -
              
              
              
              (487
              )
              
              
              (487
              )Net
      income
              
              
              -
              
              
              
              -
              
              
              
              937,369
              
              
              
              937,369Balances
      at December 31, 2007
              
              
              21,376
              
              
              
              17,788,833
              
              
              
              2,110,343
              
              
              
              19,920,552Stock-based
      compensation expense
              
              
              -
              
              
              
              75,517
              
              
              
              -
              
              
              
              75,517Issuance
      of common stock
              
              
              66
              
              
              
              67,769
              
              
              
              -
              
              
              
              67,835Issuance
      of stock awards
              
              
              56
              
              
              
              (56
              )
              
              
              -
              
              
              
              -Stock
      options exercised
              
              
              33
              
              
              
              22,707
              
              
              
              -
              
              
              
              22,740Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              (5,064,643
              )
              
              
              (5,064,643
              )Balances
      at December 31, 2008
              
              $
              21,531
              
              
              $
              17,954,770
              
              
              $
              (2,954,300
              )
              
              $
              15,022,001










See
accompanying notes to consolidated financial statements.


65


BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
CASH FLOWS


For the
years ended December 31, 2008, 2007 and 2006





2008
              
              
              2007
              
              
              2006Cash
      Flows From Operating Activities:Net
      (Loss) Income
              
              $
              (5,064,643
              )
              
              $
              937,369
              
              
              $
              2,429,828Adjustments
      to reconcile net income to net cash provided (used) by operating
      activities:Depreciation
              
              
              337,368
              
              
              
              291,025
              
              
              
              250,494(Gain)
      loss on disposal of equipment
              
              
              (18,603
              )
              
              
              -
              
              
              
              19,798Accretion
      of investment discounts
              
              
              (471
              )
              
              
              (24,364
              )
              
              
              (50,556
              )Provision
      for credit losses
              
              
              6,478,200
              
              
              
              2,125,680
              
              
              
              202,931Provision
      for losses on real estate acquired through
                Foreclosure
              
              
              569,350
              
              
              
              111,700
              
              
              
              -Loss
      on sale of real estate acquired through foreclosure
              
              
              59,688
              
              
              
              -
              
              
              
              -Stock-based
      compensation
              
              
              75,517
              
              
              
              122,539
              
              
              
              115,714Increase
      in cash surrender of  bank owned life insurance
              
              
              (226,867
              )
              
              
              (41,662
              )
              
              
              -Deferred
      income taxes
              
              
              (527,000
              )
              
              
              (804,000
              )
              
              
              (55,000
              )Income
      taxes receivable
              
              
              (2,856,039
              )
              
              
              -
              
              
              
              -Gain
      on sale of loans held for sale
              
              
              (281,029
              )
              
              
              (450,184
              )
              
              
              (573,387
              )Origination
      of loans held for sale
              
              
              (76,205,941
              )
              
              
              (162,566,200
              )
              
              
              (110,309,174
              )Proceeds
      from sale of loans
              
              
              86,900,086
              
              
              
              152,859,617
              
              
              
              126,947,322Net
      decrease (increase) in accrued interest receivable and other
      assets
              
              
              382,567
              
              
              
              (137,419
              )
              
              
              (295,018
              )Net
      (decrease) increase in accrued expenses and other
    liabilities
              
              
              (188,435
              )
              
              
              (1,006,068
              )
              
              
              533,389Net
      cash provided by (used in) operating activities
              
              
              9,433,748
              
              
              
              (8,581,967
              )
              
              
              (19,216,341
              )Cash
      Flows From Investing Activities:Purchases
      of investment securities available for sale
              
              
              -
              
              
              
              (1,877,639
              )
              
              
              (5,106,584
              )Maturities
      of investment securities available for sale
              
              
              400,000
              
              
              
              2,200,000
              
              
              
              6,000,000Purchase
      of Federal Reserve Bank stock
              
              
              (96,900
              )
              
              
              -
              
              
              
              (154,960
              )Redemption
      (purchase) of Federal Home Loan Bank of Atlanta stock
              
              
              572,300
              
              
              
              (597,900
              )
              
              
              (167,700
              )Loan
      disbursements in excess of principal payments
              
              
              (32,178,466
              )
              
              
              (14,142,607
              )
              
              
              (34,518,409
              )Proceeds
      from sale of real estate acquired through foreclosure
              
              
              5,056,545
              
              
              
              -
              
              
              
              -Expenditures
      for real estate acquired through foreclosure
              
              
              (44,852
              )
              
              
              -
              
              
              
              -Purchase
      of bank owned life insurance
              
              
              -
              
              
              
              (5,000,000
              )
              
              
              -Expenditures
      for premises and equipment
              
              
              (259,224
              )
              
              
              (401,592
              )
              
              
              (623,686
              )Net
      cash used by investing activities
              
              
              (26,550,597
              )
              
              
              (19,819,738
              )
              
              
              (34,571,339
              )Cash
      Flows From Financing Activities:Net
      increase (decrease) in deposits
              
              
              42,646,567
              
              
              
              (22,167,487
              )
              
              
              41,575,866Net
      (decrease) increase in short-term borrowings
              
              
              (23,507,452
              )
              
              
              23,826,508
              
              
              
              100,842Net
      proceeds from issuance of common stock
              
              
              90,575
              
              
              
              18,638
              
              
              
              82,873Cash
      dividends paid in lieu of fractional shares
              
              
              -
              
              
              
              (487
              )
              
              
              -Net
      cash provided by financing activities
              
              
              19,229,690
              
              
              
              1,677,172
              
              
              
              41,759,581Net
      increase (decrease) in cash and cash equivalents
              
              
              2,112,841
              
              
              
              (26,724,533
              )
              
              
              26,404,583Cash
      and cash equivalents at beginning of year
              
              
              7,173,671
              
              
              
              33,898,204
              
              
              
              7,493,621Cash
      and cash equivalents at end of year
              
              $
              9,286,512
              
              
              $
              7,173,671
              
              
              $
              33,898,204




See
accompanying notes to consolidated financial statements.


66


BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
CASH FLOWS (CONT.)


For the
years ended December 31, 2008, 2007 and 2006





2008
              
              
              2007
              
              
              2006Supplemental
      information:Interest
      paid
              
              $
              6,652,564
              
              
              $
              8,858,813
              
              
              $
              7,399,278Income
      taxes paid
              
              $
              353,894
              
              
              $
              1,675,168
              
              
              $
              2,002,466Accrued
      director fees paid in common stock
              
              $
              67,835
              
              
              $
              -
              
              
              $
              -Amount
      transferred from loans to real estate acquired through
                foreclosure
              
              $
              8,575,010
              
              
              $
              1,058,131
              
              
              $
              -








See
accompanying notes to consolidated financial statements.





67
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


1.
            SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES





The
consolidated financial statements include the accounts of Bay National
Corporation and its subsidiary, Bay National Bank (the “Bank”), collectively
(the “Company”). All significant intercompany balances and transactions have
been eliminated in consolidation. The investment in subsidiary is recorded on
the parent's books on the basis of its equity in the net assets.  The
accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States of America and to general
practices in the banking industry.





Certain
reclassifications have been made to amounts previously reported to conform to
the classifications made in 2008.





Nature of
Business





Bay
National Corporation is incorporated under the laws of the State of Maryland to
operate as a bank holding company of a national bank with the name Bay National
Bank. The Company owns all the shares of common stock issued by the Bank. The
Bank is chartered by the Office of the Comptroller of the Currency (the "OCC")
to operate as a national bank. The Bank’s deposit accounts are eligible to be
insured by the Federal Deposit Insurance Corporation.





The
principal business of the Company is to make loans and other investments and to
accept time and demand deposits. The Company’s primary market areas are
Baltimore, the Baltimore-Washington corridor and Salisbury, Maryland, although
the Company’s business development efforts generate business outside of these
areas. The Company offers a broad range of banking products, including a full
line of business and personal savings and checking accounts, money market demand
accounts, certificates of deposit and other banking services. The Company funds
a variety of loan types including commercial and residential real estate loans,
commercial term loans and lines of credit, consumer loans and letters of credit.
The Company’s customers are primarily individuals and small
businesses.





Use of
Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.





Cash and Cash
Equivalents





The
Company has included cash and due from banks, and federal funds sold and other
overnight investments as cash and cash equivalents for the purpose of reporting
cash flows.





Investments
Available-for-Sale and Other Equity Securities





Marketable
equity securities and debt securities, not classified as held-to-maturity or
trading, are classified as available-for-sale. Securities available-for-sale are
acquired as part of the Company's




68
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


asset/liability
management strategy and may be sold in response to changes in interest rates,
loan demand, deposit maturities and/or withdrawals, changes in prepayment risk
and other factors. Securities available-for-sale are carried at fair value, with
unrealized gains or losses based on the difference between amortized cost and
fair value reported as accumulated other comprehensive income, a separate
component of stockholders' equity, net of deferred tax. Realized gains and
losses, using the specific identification method, are included as a separate
component of non-interest income. Related interest and dividends are included in
interest income.  Declines in the fair value of individual
available-for-sale securities below their cost, that are other than temporary,
result in write-downs of the individual securities to their fair
value.  Factors affecting the determination of whether an
other-than-temporary impairment has occurred include a downgrading of the
security by a rating agency, a significant deterioration in the financial
condition of the issuer, or the fact that management would not have the intent
and ability to hold a security for a period of time sufficient to allow for any
anticipated recovery in fair value.





Other
equity securities represented by Federal Reserve Bank and FHLB of Atlanta stock
are considered restricted as to marketability.  The Bank’s investment
in these securities is carried at cost.





Loans Held forSale





The
Company engages in sales of residential mortgage loans originated by the Bank
and at times, by a third party. Loans held for sale are carried at the lower of
aggregate cost or fair value. Fair value is derived from secondary market
quotations for similar instruments. Gains and losses on the sale of loans
originated by the Bank are recorded as a component of non-interest income in the
accompanying consolidated statements of operations. No gains or losses are
realized on the sale of loans originated by third parties. The Company's current
practice is to sell loans on a servicing released basis, and, therefore, it has
no intangible asset recorded for the value of such servicing at either December
31, 2008 or December 31, 2007. The Company earns interest on the outstanding
balances of all loans that are held for sale.





Loans





Loans are
stated at the principal amount outstanding net of any deferred fees and costs.
Interest income on loans is accrued at the contractual rate on the principal
amount outstanding.  It is the Company's policy to discontinue the
accrual of interest when circumstances indicate that collection is
doubtful.  Fees charged and costs capitalized for originating certain
loans are amortized on the interest method over the term of the
loan.





Loans are
considered impaired when, based on current information, it is improbable that
the Company will collect all principal and interest payments according to
contractual terms. Generally, loans are considered impaired once principal and
interest payments are 90 days past due and they are placed on non-accrual.
Management also considers the financial condition of the borrower, cash flows of
the loan and the value of the related collateral. Impaired loans do not include
large groups of smaller balance homogeneous credits such as residential real
estate, consumer installment loans and commercial leases, which are evaluated
collectively for impairment. Loans specifically reviewed for impairment are not
considered impaired during periods of "minimal delay" in payment (usually ninety
days or less) provided eventual collection of all amounts due is expected.
Impaired loans are measured based on the present value of expected future cash
flows discounted at the loan’s effective interest rate, except that as a
practical expedient, the Company may measure impairment based on a loan’s
observable market price or the fair value of the collateral, if repayment




69
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


of the
loan is collateral dependent.  The Company recognizes interest income
on impaired loans on a cash basis if the borrower demonstrates the ability to
meet the contractual obligation and collateral is sufficient.  If
there is doubt regarding the borrower’s ability to make payments, or if the
collateral is not sufficient, payments received are accounted for as a reduction
in principal.





Allowance for Credit
Losses





The
allowance for credit losses is established through a provision for credit losses
charged to expense.  Loans are charged against the allowance for
credit losses when management believes that the collectability of the principal
is unlikely.  The allowance, based on evaluations of the
collectability of loans, is an amount that management believes will be adequate
to absorb possible losses on existing loans that may become
uncollectible.  The evaluations take into consideration such factors
as changes in the nature and volume of the loan portfolio, overall portfolio
quality, review of specific problem loans and current economic conditions and
trends that may affect the borrowers' ability to pay.





The
allowance for credit losses represents an estimation done pursuant to Statement
of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies”
and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” The
Company uses a loan grading system where loans are graded based on management's
evaluation of the risk associated with each loan. A factor, based on the loan
grading, is applied to the loan balance to reserve for losses. In addition,
management judgmentally establishes an additional nonspecific reserve. The
nonspecific portion of the allowance reflects management's estimate of probable
inherent, but undetected, losses within the portfolio due to uncertainties in
economic conditions, delays in obtaining information, including unfavorable
information about a borrower's financial condition, the difficulty in
identifying triggering events that correlate perfectly to subsequent loss rates
and risk factors that have not yet manifested themselves in loss allocation
factors. The adequacy of the allowance is determined through careful and
continuous evaluation of the credit portfolio and involves consideration of a
number of factors to establish a prudent level.  Determination of the
allowance is inherently subjective and requires significant estimates, including
estimated losses on pools of homogeneous loans based on historical loss
experience and consideration of current economic trends, which may be
susceptible to significant change.





While
management believes it has established the allowance for credit losses in
accordance with generally accepted accounting principles and has taken into
account the views of its regulators and the current economic environment, there
can be no assurance that in the future the Company's regulators or the economic
environment will not require further increases in the allowance.





Real Estate Acquired Through
Foreclosure





The
Company records foreclosed real estate assets at the lower of cost or estimated
fair value on their acquisition dates and at the lower of such initial amount or
estimated fair value less selling costs thereafter.  Subsequent
write-downs are included in our noninterest expenses, along with operating
income, net of related expenses of such properties.  Gains or losses
realized upon disposition are included in non-interest income.





Rate Lock
Commitments





The
Company enters into commitments to originate residential mortgage loans with
interest rates determined prior to funding.  Such rate lock
commitments on mortgage loans to be sold in the secondary




70
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


market
are considered to be derivatives.  The period of time between issuance
of a loan commitment and closing and sale of the loan generally range from 15 to
90 days.  The Company protects itself from changes in interest rates
through the use of best efforts forward delivery commitments, whereby the
Company commits to sell a loan at the time the borrower commits to an interest
rate with the intent that the buyer has assumed interest rate risk on the
loan.  As a result, the Company is not exposed to losses nor will it
realize gains related to its rate lock commitments due to changes in interest
rates.





Premises and
Equipment





Premises
and equipment are stated at cost less accumulated depreciation and amortization
computed using the straight-line method.  Premises and equipment are
depreciated over the useful lives of the assets, except for leasehold
improvements which are amortized over the terms of the respective leases or the
estimated useful lives of the improvements, whichever is
shorter.  Useful lives range from: five to ten years for furniture,
fixtures and equipment; and three to five years for software, hardware and data
handling equipment. Leasehold improvements are amortized over the term of the
respective lease plus the first optional renewal period, if applicable.
Maintenance and repairs are charged to expense as incurred, while improvements,
which extend the useful life, are capitalized and depreciated over the estimated
remaining life of the asset.





Long-lived
depreciable assets are evaluated periodically for impairment when events or
changes in circumstances indicate the carrying amount may not be recoverable.
Impairment exists when the expected undiscounted future cash flows of a
long-lived asset are less than its carrying value. In that event, the Company
recognizes a loss for the difference between the carrying amount and the
estimated fair value of the asset based on a quoted market price, if applicable,
or a discounted cash flow analysis.





Bank Owned Life
Insurance





Bank
owned life insurance is carried at the aggregate cash surrender value of life
insurance policies owned where the Company or its subsidiaries are named
beneficiaries.  Increases in cash surrender value derived from
crediting rates for underlying insurance policies are credited to noninterest
income.





Transfers of Financial
Assets





Transfers
of financial assets are accounted for as sales, when control over the assets has
been surrendered.  Control over transferred assets is deemed to be
surrendered when: (1) the assets have been isolated from the Company; (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets; and (3)
the Company does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.





Stock-Based
Compensation





Effective
January 1, 2006, the Company adopted SFAS No. 123 (R), “Share-based Payment,”
for its equity awards vesting after the effective date.  SFAS No. 123
(R) was also adopted for shares available for issuance under the Bay National
Corporation 2007 Stock Incentive Plan (the “Incentive Plan”), which was
presented to and approved by the Company’s shareholders and is described in more
detail under Note 8.  SFAS No. 123 (R) requires an entity to recognize
compensation expense based on an estimate of the number


71
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


of awards
expected to actually vest, exclusive of awards expected to be
forfeited.




Advertising
Costs





Advertising
costs are generally expensed as incurred.





Income
Taxes





The
Company uses the liability method of accounting for income
taxes.  Under the liability method, deferred-tax assets and
liabilities are determined based on differences between the financial statement
carrying amounts and the tax bases of existing assets and liabilities (i.e.,
temporary differences) and are measured at the enacted rates in effect when
these differences reverse.





The
Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes” (“FIN 48”), as of January 1, 2007.  A tax position is
recognized as a benefit only if it is “more likely than not” that the tax
position would be sustained in a tax examination presuming that a tax
examination will occur.  The amount recognized is the largest amount
of tax benefit that is greater than 50% likely to be realized on
examination.  For tax positions not meeting the “more likely than not”
test, no tax benefit is recorded.  The adoption had no effect on the
Company’s financial statements.  The Company recognizes interest and
/or penalties related to income tax matters in income tax expense.





Earnings Per
Share





Earnings
per common share are computed by dividing net income by the weighted average
number of common shares outstanding during the period. Diluted net income per
common share is computed by dividing net income by the weighted average number
of common shares outstanding during the period, including any potential dilutive
common shares outstanding such as options and warrants.  Per share
data previously reported has been adjusted to reflect a 1.1 to 1 stock split in
the form of a stock dividend recorded on June 29, 2007.





Recent Accounting
Pronouncements and Developments





Adoption
of New Accounting Standards:





Staff Accounting Bulletin (“SAB”)
No. 110, “Certain Assumptions Used in Valuation Methods,”was issued in
December 2007 and extends the use of the “simplified” method, under certain
circumstances, in developing an estimate of the expected term of “plain vanilla”
share options in accordance with SFAS No. 123R.  Prior to SAB No. 110,
SAB No. 107 stated that the simplified method was only available for grants made
up to December 31, 2007.  The Company continues to use the simplified
method in developing an estimate of the expected term of stock
options.





SFAS No. 157, “Fair Value
Measurements.”SFAS No. 157 defines fair value, establishes a
framework for measuring fair value in generally accepted accounting principles,
and expands disclosures about fair value measurements. On February 12, 2008,
FASB Staff Position (“FSP”) 157-2, “Effective Date of FASB Statement No.
157,”was issued and it delays the effective date of SFAS No. 157 to
fiscal years beginning after November 15, 2008 for nonfinancial assets and
nonfinancial liabilities except for
  72
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006
 items
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually).  Then, FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset is Not Active,” was issued
on October 10, 2008 to clarify the application of SFAS No. 157 in a market that
is not active and to provide examples to illustrate key considerations in
determining fair value of a financial asset when the market for that financial
asset is not active.  The adoption of these pronouncements did not
have a material impact on the Company’s consolidated financial
statements.





SFAS No. 159, “The Fair Value
Option for Financial Assets and Financial Liabilities.”SFAS
No. 159 permits companies to elect on an instrument-by-instrument basis to
fair value certain financial assets and financial liabilities with changes in
fair value recognized in earnings as they occur. The election to fair value is
generally irrevocable. SFAS No. 157 and SFAS No. 159 are effective
January 1, 2008 for calendar year companies with the option to early adopt
as of January 1, 2007. The impact of adoption did not have a significant
impact on the Company’s consolidated financial statements.





SAB No. 109, “Written Loan
Commitments Recorded at Fair Value through
Earnings.”  Previously, SAB No. 105, “Application of Accounting
Principles to Loan Commitments,” stated that in measuring fair value of a
derivative loan commitment, a company should not incorporate the expected net
future cash flows related to the associated servicing of the
loan.  SAB No. 109 supersedes SAB No. 105 and indicates that the
expected net future cash flows related to the associated servicing of the loan
should be included in measuring fair value of all written loan commitments that
are accounted for at fair value through earnings.  SAB No. 105 also
indicated that internally-developed intangible assets should not be recorded as
part of the fair value of a derivative loan commitment, and SAB No. 109 retains
that view.  SAB No. 109 is effective for derivative loan commitments
issued or modified in fiscal quarters beginning after December 15,
2008.  The Company has no such investments, so the impact of adoption
in 2008 did not have a material impact on the Company’s consolidated financial
statements.





Newly
Issued But Not Yet Effective Accounting Standards:





SFAS No. 160, “Noncontrolling
Interests in Consolidated Financial Statements.”  SFAS No.
160’s objective is to improve the relevance, comparability, and transparency of
the financial information that a reporting entity provides in its consolidated
financial statements by establishing accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary.  SFAS 160 shall be effective for fiscal years and interim
periods within those fiscal years, beginning on or after December 15,
2008.  The Company does not expect the implementation of SFAS No. 160
to have a material impact on its consolidated financial
statements.





SFAS No. 141R, “Business
Combinations.”  This revises SFAS No. 141 and changes
multiple aspects of the accounting for business combinations. Under the guidance
in SFAS No. 141R, the acquisition method must be used, which requires the
acquirer to recognize most identifiable assets acquired, liabilities assumed,
and noncontrolling interests in the acquiree at their full fair value on the
acquisition date. Goodwill is to be recognized as the excess of the
consideration transferred plus the fair value of the noncontrolling interest
over the fair values of the identifiable net assets acquired. Subsequent changes
in the fair value of contingent consideration classified as a liability are to
be recognized in earnings, while contingent consideration classified as equity
is not to be remeasured. Costs such as transaction costs are to be excluded from
acquisition accounting, generally leading to recognizing expense and
additionally, restructuring costs that do not meet certain criteria at
acquisition date are to be
  73
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006
 subsequently
recognized as post-acquisition costs. SFAS No. 141R is effective for
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008.  The Company has not entered into any business
combinations, so it does not expect that adoption will have a material impact on
the Company’s consolidated financial statements.





SFAS No.
161, “Disclosures about
Derivative Instruments and Hedging Activities, an amendment of FASB Statement
No. 133.”SFAS No. 161 is intended to enhance the current
disclosure framework previously required for derivative instruments and hedging
activities under SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities,” to include how and why an entity
uses derivative instruments, how derivative instruments and related hedge items
are accounted for and their impact on an entity’s financial positions, result of
operations and cash flows.  This standard is effective for fiscal
years and interim periods beginning after November 15, 2008, with early adoption
encouraged.  While the Company does not currently utilize derivative
instruments, it is currently evaluating the impact of this new standard on its
consolidated financial statements.





SFAS No.
163, “Accounting for Financial
Guarantee Insurance Contracts-an interpretation of FASB Statement No.
60.”  SFAS No. 163 clarifies how Statement of Financial
Accounting Standards No. 60, “Accounting and Reporting by
Insurance Enterprises,” applies to financial guarantee insurance
contracts, including the recognition and measurement of premium revenue and
claim liabilities.  SFAS No. 163 also requires expanded disclosure
about financial guarantee insurance contracts.  SFAS No. 163 is
effective for financial statements issued for fiscal years and interim periods
beginning after December 15, 2008.  The Company does not have any
guarantee contracts, and therefore, we do not expect that SFAS No. 163 will have
a material impact on our consolidated financial statements.





FASB
Staff Position Emerging Issues Task Force 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions are Participating Securities
(“FSP-EITF 03-6-1”).”Under FSP-EITF 03-6-1, unvested share-based payment
awards that contain non-forfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be included in
the computation of earnings per share pursuant to the two-class
method.  FSP-EITF 03-6-1 is effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods within
those years and requires retrospective application.  We are currently
evaluating the impact, if any, that FSP-EITF 03-6-1 may have on our consolidated
financial statements.





FASB
Staff Position (“FSP”) FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities.”These pronouncements increase disclosure
requirements for public companies and are effective for reporting periods
(interim and annual) that end after December 15, 2008.  The purpose of
this FSP is to promptly improve disclosures by public entities and enterprises
until the pending amendments to FASB Statement No. 140, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities,” and
FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest
Entities,”are finalized by the Board.  The FSP amends
Statement No. 140 to require public entities to provide additional disclosures
about transferors’ continuing involvement with transferred financial
assets.  It also amends Interpretation 46(R) to require public
enterprises, including sponsors that have a variable interest in a variable
interest entity, to provide additional disclosures about their involvement with
variable interest entities.  This pronouncement is related to
disclosures only and will not have an impact on our consolidated financial
statements.
  74
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


2.       CONSENT
ORDER





On
February 6, 2009, pursuant to a Stipulation and Consent to the Issuance of a
Consent Order, the Bank consented to the issuance of a Consent Order by the OCC,
the Bank’s primary banking regulator.





Among
other things, the Consent Order requires the Bank and/or its Board to take
certain actions, including developing and submitting certain written plans to
the OCC, and imposes certain restrictions on the Bank designed to improve its
financial strength, including the following: within 30 days provide a written
analysis of the Board’s decision whether to sell, merge or liquidate the Bank or
remain independent; if the Board decides the Bank should remain independent and
the OCC does not object to the written analysis, within 60 days of the Consent
Order implement a three-year strategic plan for the Bank with respect to certain
financial objectives; by April 30, 2009 maintain a 12% total risk-based ratio,
an 11% Tier 1 risk-based ratio and a 9% leverage ratio; develop a three-year
capital program that, among other things, assesses current and expected funding
needs and ensures that sufficient funds or access to funds exists to meet those
needs; ensure that the Bank has competent management in its credit risk and
asset liability risk management functions; conduct management reviews and adopt
a written education program for officers as necessary; immediately take action
to protect the Bank’s interest in assets criticized by the OCC and adopt a
written program designed to eliminate the basis of such criticism; and develop
written plans to address liquidity improvement, loan portfolio management, asset
diversification, the Bank’s allowance for loan and lease losses, monitoring and
review of problem loans and leases, charged-off loans and related issues, and
monitoring of  portfolio trends.





The Board
has appointed a compliance committee to monitor, coordinate and report to the
Board on the Bank’s compliance with the Consent Order.  In addition,
under the Consent Order the Bank may not pay dividends unless it is in
compliance with the capital program required by the Consent Order and applicable
regulatory requirements and receives the OCC’s written
non-objection.





The Board
of the Bank and its compliance committee and have submitted a written analysis
to the OCC in which the Bank details its decision to remain independent while
continually evaluating other options.





The
Bank’s Board and executive management are adopting a Strategic Plan that maps
out a strategy for the Bank to restore its higher capitalization, strong
earnings, good asset quality and to also eliminate the concerns raised by the
OCC in the Consent Order.  Pursuant to the plan, the Bank will return
to its original business model, provide stronger risk controls and provide the
management and support items necessary to continue to grow and serve its
customer base.  We envision all the key elements of the plan being in
place by the end of 2009.





There can
be no assurance that the OCC will accept our strategic plan to remain
independent and they could strictly enforce the terms of the Consent
Order.  In such a situation there can be no assurance that the Company
will be able to raise the required amount of capital within the time frame
required in the Consent Order and further regulatory actions could
follow.





In order
to make the plan work, the Bank will focus on six goals that are the keys to its
success.  These are:





75
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


•           A
return to the original mission: The Bank’s original mission was to serve local
businesses and professionals through internally generated loans.  The
Bank has returned to that mission.





•           Improve
asset quality:  Asset quality must be raised to acceptable levels and
thereafter maintained as part of a high quality loan portfolio.  This
loan portfolio will consist of primarily internally-generated small business
loans that are fully within the Bank’s expertise and provide adequate yields
with manageable risk.





•           Increase
capitalization:  Capital must be raised to levels above the minimum
capital needed to meet regulatory requirements.  This higher level of
capital can be achieved by either shrinking the size of the balance sheet or by
raising additional contributions from present and new shareholders or by a
combination of these two approaches.  Increasing the Bank’s level of
capital will ensure that the Bank not only remains viable through the present
economic downturn, but will have the ability to grow its assets and regain its
former earnings profile.





•           Improve
liquidity:   Liquidity must be increased and then maintained at a
level that is at least comparable with other local banks in terms of core
deposits.





•           Return
to Profitability:  Profitability must be restored as soon as possible
and beyond that point earnings must show consistent and steady
growth.  In the context of improving profitability and preserving
capital, we have already made internal changes that we believe will reduce costs
and lead to improved earnings or minimize losses.





•           Develop
management depth:  We believe that the executive management team and
management succession plan have the depth, experience and talent to maintain the
confidence of the public, clients, directors, shareholders and regulators. The
Board will evaluate management on a regular basis.








76


BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006





3.
            INVESTMENT
      SECURITIES





Investments
available-for-sale





The
amortized cost and estimated fair values of investments available-for-sale at
December 31, 2007 were as follows:





Amortized
      Cost
                
                
                Gross
      Unrealized Gains
                
                
                Gross
      Unrealized Losses
                
                
                Estimated
      Fair ValueU.S.
      Treasury securities
                
                $
                399,529
                
                
                $
                -
                
                
                $
                -
                
                
                $
                399,529Total
      investments available-for-sale
                
                $
                399,529
                
                
                $
                -
                
                
                $
                -
                
                
                $
                399,529





The
Company held no such investments at December 31, 2008.  There were no
sales of investments available-for-sale during 2008, 2007 or 2006.





At
December 31, 2007, investments available-for-sale with a carrying value of
$300,000 were pledged as collateral for certain short-term
borrowings.  No investments were pledged as collateral as of December
31, 2008.





Other
equity securities





At
December 31, the Company’s investment in other equity securities was carried at
cost and consisted of:





2008
              
              
              2007Federal
      Reserve Bank stock
              
              $
              704,200
              
              
              $
              607,300Federal
      Home Loan Bank stock
              
              
              535,400
              
              
              
              1,107,700Total
      investments in other equity securities
              
              $
              1,239,600
              
              
              $
              1,715,000





4.            LOANS
AND ALLOWANCE FOR CREDIT LOSSES





Major
loan categories at December 31 are presented below:





2008
              
              
              2007Commercial
              
              $
              125,331,210
              
              
              $
              102,728,342Real
      Estate – Mortgage
              
              
              50,611,464
              
              
              
              36,210,905Real
      Estate – Construction
              
              
              44,061,253
              
              
              
              67,775,883Real
      Estate – Home Equity Line of Credit
              
              
              23,377,524
              
              
              
              18,585,641Loans
      Held for Sale
              
              
              1,187,954
              
              
              
              11,601,070Consumer
              
              
              3,781,316
              
              
              
              4,054,400Total
      Loans
              
              
              248,350,721
              
              
              
              240,956,241Less:
      Allowance for credit losses
              
              
              (5,675,035
              )
              
              
              (5,000,000
              )Net
      Loans
              
              $
              242,675,686
              
              
              $
              235,956,241





77
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


Activity
in the allowance for credit losses for the year endedDecember
31, 2008, 2007 and 2006 is shown below:





2008
                  
                  
                  2007
                  
                  
                  2006Balance
      at beginning of year
                  
                  $
                  5,000,000
                  
                  
                  $
                  3,175,000
                  
                  
                  $
                  3,000,000Provision
      for credit losses
                  
                  
                  6,478,200
                  
                  
                  
                  2,125,680
                  
                  
                  
                  202,931Loan
      charge-offsCommercial
                  
                  
                  (107,495
                  )
                  
                  
                  -
                  
                  
                  
                  (37,931
                  )Real
      Estate – Mortgage
                  
                  
                  (622,477
                  )
                  
                  
                  -
                  
                  
                  
                  -Real
      Estate - Construction
                  
                  
                  (5,118,668
                  )
                  
                  
                  (343,919
                  )
                  
                  
                  -Real
      Estate – Home Equity Line
                    Of
      Credit
                  
                  
                  (36,572
                  )
                  
                  
                  -
                  
                  
                  
                  -Loan
      recoveriesCommercial
                  
                  
                  1,700
                  
                  
                  
                  27,931
                  
                  
                  
                  10,000Real
      Estate - Mortgage
                  
                  
                  36,009
                  
                  
                  
                  -
                  
                  
                  
                  -Real
      Estate - Construction
                  
                  
                  44,338
                  
                  
                  
                  15,308
                  
                  
                  
                  -Net
      (charge-offs) recoveries
                  
                  
                  (5,803,165
                  )
                  
                  
                  (300,680
                  )
                  
                  
                  (27,931
                  )Balance
      at end of year
                  
                  $
                  5,675,035
                  
                  
                  $
                  5,000,000
                  
                  
                  $
                  3,175,000





As of
December 31, 2008, the Company had impaired loans totaling $16.4 million, of
which $13.5 million were classified as non-accrual loans, $2.0 million were 90
days or more past due and still accruing and $952,372 represented troubled debt
restructures.  As of December 31, 2007, the Company had impaired loans
totaling $9.4 million, all of which were included in its investor owned
residential real estate construction loan portfolio, were classified as
non-accrual loans and were over 90 days past due.  If the non-accrual
loans had been current in accordance with their original terms, we would have
recognized additional interest income of approximately $401,000, $506,000, and
$26,000 for the periods ended December 31, 2008, 2007 and 2006,
respectively.





The
following table sets forth information with respect to impaired loans and the
related valuation allowance as of December 31:





2008
              
              
              2007
              
              
              2006Impaired
      loans with valuation allowance
              
              $
              16,423,327
              
              
              $
              9,426,202
              
              
              $
              -Impaired
      loans with no valuation allowance
              
              
              -
              
              
              
              -
              
              
              
              -Total
      impaired loans
              
              $
              16,423,037
              
              
              $
              9,426,202
              
              
              $
              -Allowance
      for credit losses related to impaired loans
              
              $
              2,903,561
              
              
              $
              1,862,984
              
              
              $
              12,874Allowance
      for credit losses related to other than impaired
                loans
              
              
              2,771,474
              
              
              
              3,137,016
              
              
              
              3,162,126Total
      allowance for credit losses
              
              $
              5,675,035
              
              
              $
              5,000,000
              
              
              $
              3,175,000Interest
      income on impaired loans recorded on the cash basis
              
              $
              198,249
              
              
              $
              -
              
              
              $
              -Average
      recorded investment in impaired loans
              
              $
              13,672,271
              
              
              $
              2,537,535
              
              
              $
              507,640





78
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


5.      PREMISES
AND EQUIPMENT





Premises
and equipment at December 31 include the following:





2008
              
              
              2007Furniture
      and equipment
              
              $
              900,263
              
              
              $
              814,022Computer
      hardware and software
              
              
              903,076
              
              
              
              684,147Leasehold
      improvements
              
              
              772,737
              
              
              
              793,2992,576,076
              
              
              
              2,291,468Less
      accumulated depreciation
              
              
              (1,424,830
              )
              
              
              (1,080,681
              )Net
      premises and equipment
              
              $
              1,151,246
              
              
              $
              1,210,787





The
Company rents office space in five locations under four non-cancelable lease
arrangements and one monthly rental agreement accounted for as operating
leases.  The initial lease periods are five years and provide for one
or more five-year renewal options.  The lease for the Salisbury
location provides for percentage rent escalations upon renewal.  The
leases for the remaining locations provide for percentage annual rent
escalations.  The lease for the Salisbury location requires that the
lessee pay certain operating expenses applicable to the leased
space.





Rent
expense applicable to operating leases, for the periods ended December 31, was
as follows:





2008
              
              
              2007
              
              
              2006Minimum
      rentals
              
              $
              607,716
              
              
              $
              498,832
              
              
              $
              391,927Less:
      Sublease rentals
              
              
              (5,654
              )
              
              
              (1,197
              )
              
              
              (23,568
              )Net
      rent expense
              
              $
              602,062
              
              
              $
              497,635
              
              
              $
              368,359





At
December 31, 2008, future minimum lease payments under non-cancelable operating
leases having an initial term in excess of one year are as follows:





Years
      ending December 31:2009
              
              $
              572,6392010
              
              
              243,3842011
              
              
              176,8532012
              
              
              90,7592013
      and beyond
              
              
              7,790Total
      minimum lease payments
              
              $
              1,091,425





79
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


6.             DEPOSITS





The
following table sets forth the composition of the Company's deposits as of
December 31, 2008 and December 31, 2007:





2008
                    
                    2007Demand
      deposits
                    $
                    76,115,803
                    
                    31.12
                    %
                    
                    $
                    58,912,584
                    
                    
                    29.17
                    %Savings
                    
                    1,047,533
                    
                    0.43
                    
                    
                    
                    1,905,072
                    
                    
                    0.94Money
      market and sweep
                    
                    23,763,974
                    
                    9.71
                    
                    
                    
                    41,277,267
                    
                    
                    20.44Certificates
      of deposit
                    
                    143,400,722
                    
                    58.74
                    
                    
                    
                    99,886,542
                    
                    
                    49.45Total
      deposits
                    $
                    244,628,032
                    
                    100.00
                    %
                    
                    $
                    201,981,465
                    
                    
                    100.00
                    %





The
following table sets forth the maturity distribution for the Company's deposits
at December 31, 2008. Some of the deposits may be renewed or withdrawn prior to
maturity. Therefore, the following table should not be used as a forecast of
future cash flows.





Within
      one year
              
              
              One
      to three years
              
              
              Three
      to
                five years
              
              
              Over
      five yearsDemand
      deposits
              
              $
              76,115,803
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -Savings
              
              
              1,047,533
              
              
              
              -
              
              
              
              -
              
              
              
              -Money
      market and sweep
              
              
              23,763,974
              
              
              
              -
              
              
              
              -
              
              
              
              -Certificates
      of deposit
              
              
              117,996,251
              
              
              
              23,868,719
              
              
              
              1,835,752
              
              
              
              -Total
              
              $
              218,923,561
              
              
              $
              23,868,719
              
              
              $
              1,835,752
              
              
              $
              -





Certificates
of deposit in amounts of $100,000 or more and their remaining maturities at
December 31 are as follows:





2008
              
              
              2007Three
      months or less
              
              $
              28,115,659
              
              
              $
              19,303,042Over
      three months through six months
              
              
              12,962,733
              
              
              
              10,401,598Over
      six months through twelve months
              
              
              32,559,811
              
              
              
              5,838,645Over
      twelve months
              
              
              13,951,518
              
              
              
              11,639,910Total
              
              $
              87,589,721
              
              
              $
              47,183,195





Interest
expense on deposits, for the years ended December 31, is as
follows:





2008
              
              
              2007
              
              
              2006Interest-bearing
      transaction
              
              $
              374,434
              
              
              $
              889,635
              
              
              $
              873,622Savings
      and money market
              
              
              767,115
              
              
              
              1,855,946
              
              
              
              1,402,610Time,
      $100,000 or more
              
              
              2,724,645
              
              
              
              2,697,860
              
              
              
              2,097,542Other
      time
              
              
              2,068,157
              
              
              
              2,465,712
              
              
              
              2,758,837Total
      interest on deposits
              
              $
              5,934,351
              
              
              $
              7,909,153
              
              
              $
              7,132,611





80
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


7.       BORROWINGS





Information relating to short-term
borrowings, as of December 31, 2008 and 2007, is as follows:





Securities
      sold under agreements to repurchase2008
                
                
                2007Amount
                Rate
                
                
                Amount
                
                
                RateAs
      of year-end
                $
                -
                -
                %
                $
                -
                
                
                -
                %Average
      for the year
                $
                -
                -
                %
                $
                36,011
                
                
                4.52
                %Maximum
      month-end balance
                $
                -
                
                
                $
                300,000





Federal
      funds purchased2008
                
                
                2007Amount
                Rate
                
                
                Amount
                
                
                RateAs
      of year-end
                $
                1,864,000
                0.25
                %
                $
                3,637,000
                
                
                4.25
                %Average
      for the year
                $
                293,981
                3.32
                %
                $
                174,068
                
                
                3.73
                %Maximum
      month-end balance
                $
                1,938,000
                
                
                $
                3,637,000





Commercial
      paper2008
                
                
                2007Amount
                Rate
                
                
                Amount
                
                
                RateAs
      of year-end
                $
                56
                -
                %
                $
                7,309,508
                
                
                3.25
                %Average
      for the year
                $
                9,122,030
                1.27
                %
                $
                4,576,086
                
                
                4.15
                %Maximum
      month-end balance
                $
                14,798,374
                
                
                $
                9,015,951





81


BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006





Federal
      Home Loan Bank Borrowings2008
                
                
                2007Amount
                Rate
                
                
                Amount
                
                
                RateAs
      of year-end
                $
                -
                -
                %
                $
                14,425,000
                
                
                4.40
                %Average
      for the year
                $
                3,022,227
                3.33
                %
                $
                1,211,027
                
                
                4.63
                %Maximum
      month-end balance
                $
                8,150,000
                
                
                $
                16,000,000





In 2007,
the Company pledged U.S. Government Treasury Securities, based upon their market
values, as collateral for 100% of the principal and accrued interest of its
securities under agreement to repurchase.





The
Company maintained unused commitments for a total of $2.1 million of borrowing
availability under an unsecured federal funds line of credit with another
financial institution as of December 31, 2008.  This facility was
terminated on January 15, 2009 primarily based on the Company’s negative
earnings trend.   The Company also had approximately $21.5
million of additional borrowing capacity with the FHLB of Atlanta as of December
31, 2008. This facility was suspended on February 13, 2009.  The
Company has taken steps to restore this line of credit and as of March 27, 2009,
the Company has available borrowing capacity of approximately $6.5
million.  These borrowing facilities will be used, as necessary, to
supplement short-term liquidity needs.





Information
relating to subordinated debt as of December 31, 2008 and 2007 is as
follows:





2008
                
                
                2007Amount
                Rate
                
                
                Amount
                
                
                RateAs
      of year-end
                $
                8,000,000
                7.20
                %
                $
                8,000,000
                
                
                7.20
                %Average
      for the year
                $
                8,000,000
                7.54
                %
                $
                8,000,000
                
                
                7.53
                %Maximum
      month-end balance
                $
                8,000,000
                
                
                $
                8,000,000





On
December 12, 2006, the Company participated in a private placement of $8 million
of fixed interest rate trust preferred securities (the “Trust Preferred
Securities”), through a newly formed Delaware trust subsidiary, Bay National
Capital Trust I (the “Trust”). The Trust was formed for the purpose of issuing
the Trust Preferred Securities and all of its common securities are owned by the
Company. The Company purchased the common securities from the Trust for
$248,000. In accordance with provisions of FIN46, the financial position and
results of operations are not included in the Company’s consolidated financial
position and results of operations.





The Trust
used the proceeds of the sale of the Trust Preferred Securities and common
securities to purchase from the Company the aggregate principal amount of
$8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
Securities bear interest at the fixed annual rate of 7.20% until maturity. The
interest expense on Trust Preferred Securities was $603,039, $602,096 and
$603,567 in 2008, 2007 and 2006, respectively. The




82
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


Debt
Securities mature on February 23, 2036, but may be redeemed at the Company’s
option at any time on any February 23, May 23, August 23 or November 23 on or
after February 23, 2011, or at any time upon certain events, such as a change in
the regulatory capital treatment of Debt Securities, the Trust being deemed to
be an “investment company” under the Investment Company Act of 1940, as amended,
or the occurrence of certain adverse tax events.  Except upon the
occurrence of the events described above, which require a redemption premium for
redemptions prior to February 23, 2011, the Company may redeem the Debt
Securities at their aggregate principal amount, plus accrued interest, if
any.





The
parent was required to retain $1,000,000 of the proceeds from the Debt
Securities for general corporate purposes (which may include making interest
payments on the Debt Securities) until the earlier of (i) the date on which the
retained funds are reduced to zero, or (ii) the date on which Bay National Bank
(or any successor) meets the statutory requirements to pay dividends of at least
$148,464 for each of two consecutive quarters with positive retained earnings
remaining after any such dividend payment. As of December 31, 2008, the Bank
could not have paid dividends to the Parent Company without approval from bank
regulatory agencies.





The Debt
Securities are subordinated to the prior payment of other indebtedness of the
Company that, by its terms, is not similarly subordinated.  Although
the Debt Securities are recorded as a liability on the Company’s balance sheet,
for regulatory purposes, the Debt Securities are being treated as Tier 1 or Tier
2 capital under regulatory capital guidelines issued by the FRB.





On
January 6, 2009, the Company provided notice under the Indenture of its election
to defer the interest payment due on February 23, 2009.  Under the
terms of the indenture for the Debt Securities dated December 12, 2005 (the
“Indenture”), the Company has the right to defer payments of interest on the
Debt Securities for up to 20 consecutive quarterly periods, provided that no
event of default (as defined in the Indenture) has occurred and is continuing at
the time of the deferral. The Company was not in default with respect to the
Indenture at the time the payments were deferred and such deferral did not cause
an event of default under the Indenture.  Although the Company has the
financial means to pay the interest on the Debt Securities, management elected
to defer payments of interest at this time to conserve cash.  In
addition, the Company had informal discussions with the FRB that led it to
believe that the FRB would instruct them to defer the future interest
payments.  In February 2009, the Company received formal notice from
the FRB instructing it to suspend its trust preferred interest
payments.





8.      STOCK-BASED
COMPENSATION PLANS





Stock
Options





The Bay
National Corporation 2007 Stock Incentive Plan (the “Incentive Plan”) was
established effective May 22, 2007 and provides for the granting of incentive
stock options intended to comply with the requirements of Section 422 of the
Internal Revenue Code (“incentive stock options”), non-qualified stock options,
stock appreciation rights (“SARs”), restricted or unrestricted stock awards,
awards of phantom stock, performance awards, other stock-based awards, or any
combination of the foregoing (collectively “Awards”).  Awards will be
available for grant to officers, employees and directors of the Company and its
affiliates, including the Bank, except that non-employee directors will not be
eligible to receive awards of incentive stock options.




83
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


The
Incentive Plan authorizes the issuance of up to 200,000 shares of common stock
plus any shares that were available under the Company’s 2001 Stock Option Plan
(“Option Plan”) that terminated as of May 22, 2007 and shares subject to options
granted under the Option Plan that expire or terminate without having been fully
exercised.  The Incentive Plan has a term of ten years, and is
administered by the Compensation Committee of the Board of Directors. The
Compensation Committee consists of at least three non-employee directors
appointed by the Board of Directors. In general, the options have an exercise
price equal to 100% of the fair market value of the common stock on the date of
the grant.  As of December 31, 2008, thirteen Awards had been granted
under the Incentive Plan.  Five of these Awards included an
unrestricted stock grant of 550 shares to five employees in August 2007 based on
their 2006 performance.  The Awards vested immediately upon issuance
and the closing stock price on the grant date was $15.46.  The
remaining eight Awards represent restricted stock awards and are discussed in
more detail below in the section entitled “Restricted Stock Units.”





Effective
January 1, 2006 the Company adopted SFAS No. 123(R) and has included the
stock-based employee compensation cost in its income statements for the years
ended December 31, 2008 and 2007.  Prior periods have not been
restated.  Amounts recognized in the financial statements with respect
to stock-based compensation are as follows:





2008
              
              
              2007
              
              
              2006Amounts
      charged against income, before taxbenefit
              
              $
              75,517
              
              
              $
              122,539
              
              
              $
              115,714Amount
      of related income tax benefit recognized in income
              
              $
              13,812
              
              
              $
              31,130
              
              
              $
              12,444




The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used for grants during the year ended December 31:





2002Dividend
      yield
            
            
            
            
            -Expected
      volatility
            
            
            
            
            20.00
            %Risk-free
      interest rate
            
            
            
            
            4.17
            %Expected
      lives (in years)
            
            
            
            
            8





84
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


The
following is a summary of changes in shares under options for the years ended
December 31, 2008, 2007 and 2006 (amounts previously reported have been adjusted
to reflect a 1.1 to 1 stock split in the form of a stock dividend recorded on
June 29, 2007):





Number
      of Shares
              
              
              Weighted
      Average Exercise PriceBalance,
      January 1, 2006
              
              
              154,837
              
              
              $
              6.97Granted
              
              
              -
              
              
              
              -Cancelled
              
              
              (1,366
              )
              
              $
              6.89Exercised
              
              
              (12,025
              )
              
              $
              6.89Balance,
      December 31, 2006
              
              
              141,446
              
              
              $
              6.98Granted
              
              
              -
              
              
              
              -Cancelled
              
              
              -
              
              
              
              -Exercised
              
              
              (2,705
              )
              
              $
              6.89Balance,
      December 31, 2007
              
              
              138,741
              
              
              $
              6.99Granted
              
              
              -
              
              
              
              -Cancelled
              
              
              -
              
              
              
              -Exercised
              
              
              (3,300
              )
              
              $
              6.89Balance,
      December 31, 2008
              
              
              135,441
              
              
              $
              6.99Weighted
      average fair value of options granted during 2002
              
              $
              2.77





85
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


The
following table summarizes information about options outstanding at December 31,
2008:





Options
      Outstanding
                  
                  
                  Options
      ExercisableRange
      of Exercise Price
                  
                  Number
                  
                  Weighted
      Average Remaining Contractual Life
                    (in
      years)
                  
                  Weighted
      Average Exercise Price
                  
                  
                  Number
                  
                  Weighted
      Average Exercise Price$6.89
                  
                  116,945
                  
                  1
                  
                  $6.89
                  
                  
                  116,945
                  
                  $6.89$7.61
                  
                  18,496
                  
                  1
                  
                  $7.61
                  
                  
                  18,496
                  
                  $7.61135,441
                  
                  
                  
                  $6.99
                  
                  
                  135,441
                  
                  $6.99





Based
upon a closing stock price of $2.40 per share as of December 31, 2008, there was
no aggregate intrinsic value in options outstanding and
exercisable.





The
following table summarizes the changes in unvested option shares during the year
ended December 31, 2008 (amounts previously reported have been adjusted to
reflect a 1.1 to 1 stock split in the form of a stock dividend recorded on June
29, 2007):





Number
      of Shares
              
              Weighted
      Average Grant Date Fair ValueUnvested
      options at January 1, 2008
              
              4,624
              
              $2.77Granted
              
              -
              
              -Vested
              
              (4,624
              )
              $2.77Cancelled
              
              -
              
              -Unvested
      options at December 31, 2008
              
              -
              
              -





Restricted Stock
Units





During
the third quarter of 2007, a grant of 24,000 shares of the Company’s common
stock was awarded to four new employees.  Three of these awards vest
20% on each anniversary of the employee’s hiring date over 5 years and the
remaining grant vests 25% on each anniversary of the employee’s hiring date over
4 years.





Based on
2007 grants, 5,550 shares had vested during the year ended December 31,
2008.  During 2008, a total of 10,500 shares of the Company’s common
stock had been awarded to four employees.  These Awards vest 20% on
each anniversary of the employee’s hiring date over 5 years.  Two
recipients of these Awards granted during 2008 and one recipient under the 2007
grant are no longer employed with the Company.  As such, their
unvested grants, totaling 15,750 shares, were forfeited during the third quarter
of 2008.





The
Company incurred compensation expense of $70,891 and $62,589 associated with
restricted




86
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


stock for
the years ended December 31, 2008 and 2007, respectively.  The
unrecognized compensation cost related to restricted stock was $103,841 at
December 31, 2008 based upon a weighted average fair value of $13.24 and will be
recognized over the next five years based on the vesting schedule of the
Awards.





The
following table summarizes the changes in outstanding shares under restricted
stock grants for the year ended December 31, 2008.  Amounts have been
adjusted to reflect a 1.1 to 1 stock split in the form of a dividend recorded on
June 29, 2007.





Number
      of Shares
                
                
                Weighted
      Average Fair Value at Grant DateUnvested
      grants at January 1, 2008
                
                
                24,000
                
                
                $
                15.91Granted
                
                
                10,500
                
                
                
                10.21Vested
                
                
                (5,550
                )
                
                
                15.92Cancelled
                
                
                (15,750
                )
                
                
                -Unvested
      grants at December 31, 2008
                
                
                13,200
                
                
                $
                13.24





9.               RETIREMENT
PLAN





The
Company has a 401(k) profit sharing plan covering substantially all full-time
employees. The plan requires the Company to match 25% of employee contributions
of up to 3% of compensation as defined under the plan. The Company has also
elected to make a safe harbor contribution to the plan on behalf of all eligible
employees, as defined under the plan. The safe harbor contribution is equal to
3% of compensation as defined under the plan. The plan permits additional
contributions at the discretion of management.  Expenses under this
plan totaled $187,334, $179,626 and $171,224 for the years ended
December 31, 2008, 2007 and 2006, respectively.





87
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


10.             INCOME
TAXES





For the
year ended December 31, 2008, the Company recorded an income tax benefit of
$3,194,640 compared to income tax expense of $491,395 and $1,678,358 recorded
for the years ended December 31, 2007 and 2006, respectively.  The
decrease is due to the significant pre-tax loss incurred for the year ended
December 31, 2008.





At
December 31, 2008, the Company has approximately $3.0 million of cumulative
Maryland pre-tax net operating loss carryforward (which represents a possible
net tax receivable of $248 thousand) for the unconsolidated state tax
return for Bay National Corporation.  There is a valuation
allowance against 100% of the receivable since it cannot be determined that
this will be realized.  Unless Bay National Corporation generates
income from its own operations (i.e., unrelated to Bay National Bank), these net
operating loss carryforwards will begin to expire in 2019.





Federal
and state income tax (benefit) expense consists of the following for the
periods ended December 31:





2008
              
              
              2007
              
              
              2006Current
      federal income tax
              
              $
              (2,184,547
              )
              
              $
              1,160,434
              
              
              $
              1,391,380Current
      state income tax
              
              
              (483,093
              )
              
              
              134,961
              
              
              
              341,978Deferred
      federal income tax expense (benefit)
              
              
              (453,000
              )
              
              
              (707,000
              )
              
              
              (50,000
              )Deferred
      state income tax expense (benefit)
              
              
              (74,000
              )
              
              
              (97,000
              )
              
              
              (5,000
              )Total
      income tax (benefit) expense
              
              $
              (3,194,640
              )
              
              $
              491,395
              
              
              $
              1,678,358





The
following table is a summary of the tax effect of temporary differences that
give rise to a significant portion of deferred tax assets:





Deferred
      tax assets:
                        
                        2008
                        
                        
                        2007Net
      operating loss carryforwards (state)
                        
                        $
                        248,000
                        
                        
                        $
                        192,000Alternative
      Minimum Tax credit carryforward
                        
                        
                        147,000
                        
                        
                        
                        -Interest
      on nonaccrual loans
                        
                        
                        325,000
                        
                        
                        
                        -Contributions
                        
                        
                        1,000
                        
                        
                        
                        -Stock
      based compensation
                        
                        
                        39,000
                        
                        
                        
                        21,000Allowance
      for real estate acquired through foreclosure
                        
                        
                        255,000
                        
                        
                        
                        44,000Allowance
      for credit losses
                        
                        
                        1,747,000
                        
                        
                        
                        1,919,000Other
                        
                        
                        24,000
                        
                        
                        
                        -Total
      deferred tax assets
                        
                        
                        2,786,000
                        
                        
                        
                        2,176,000Less
      valuation allowance
                        
                        
                        (248,000
                        )
                        
                        
                        (192,000
                        )Deferred
      tax assets, net of valuation allowance
                        
                        
                        2,538,000
                        
                        
                        
                        1,984,000Deferred
      tax liabilities:Depreciation
      and amortization
                        
                        
                        (1
                        )
                        
                        
                        (13,000
                        )Deferred
      loan fees and costs, net
                        
                        
                        (68,000
                        )
                        
                        
                        (29,000
                        )
      )Net
      deferred tax assets
                        
                        $
                        2,469,000
                        
                        
                        $
                        1,942,000





For the
year ended December 31, 2008, the Company recorded a current income
tax benefit of $2,667,640 compared to a current expense of $1,295,395
for the year ended December 31, 2007.  The 2008 benefit was increased
by the recognition of a deferred tax benefit of $527,000, resulting
in total tax benefit of




88
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


$3,194,640
for the year ended December 31, 2008.  The 2007 expense was
offset by the recognition of a deferred tax benefit of $804,000, resulting
in a net tax expense of $491,395 for the year ended December 31,
2007.





Reported
income tax (benefit) expense differed from the amounts computed by applying
the U.S. federal statutory income tax rate of 34% to income before income taxes
as follows:





2008
              
              
              2007
              
              
              2006Amount
              
              
              Percentage
      of Pretax Income
              
              
              Amount
              
              
              Percentage
      of Pretax Income
              
              
              Amount
              
              
              Percentage
      of Pretax IncomeFederal
      income tax expense computed at the statutory rate
              
              $
              (2,808,156
              )
              
              
              (34.00
              )%
              
              $
              485,780
              
              
              
              34.00
              %
              
              $
              1,396,783
              
              
              
              34.00
              %State
      income tax expense (benefit), net
              
              
              (422,538
              )
              
              
              (5.12
              )
              
              
              64,888
              
              
              
              4.54
              
              
              
              222,405
              
              
              
              5.41Nondeductible
      expenses
              
              
              16,188
              
              
              
              (0.20
              )
              
              
              14,199
              
              
              
              0.99
              
              
              
              18,281
              
              
              
              0.45Non-taxable
      income
              
              
              (77,135
              )
              
              
              (0.93
              )
              
              
              (14,165
              )
              
              
              (0.99
              )
              
              
              (12,111
              )
              
              
              (0.30
              )Deferred
      tax benefit resulting from change in state income tax rate
              
              
              
              
              
              
              
              
              
              
              (90,743
              )
              
              
              (6.35
              )
              
              
              -
              
              
              
              -Other
              
              
              41,031
              
              
              
              0.50
              
              
              
              (45,564
              )
              
              
              (3.19
              )
              
              
              -
              
              
              
              -Adjustment
      to valuation allowance
              
              
              55,970
              
              
              
              0.68
              
              
              
              77,000
              
              
              
              5.39
              
              
              
              53,000
              
              
              
              1.29Income
      tax (benefit) expense, as reported
              
              $
              (3,194,640
              )
              
              
              (38.67
              )%
              
              $
              491,395
              
              
              
              34.39
              %
              
              $
              1,678,358
              
              
              
              40.85
              %








11.         RELATED
PARTY TRANSACTIONS





Certain
directors and executive officers have loan transactions with the Company. Such
loans were made in the ordinary course of business on substantially the same
terms, including interest rates and collateral, as those prevailing at the time
for comparable transactions with outsiders. The following schedule summarizes
changes in amounts of loans outstanding, both direct and indirect, to these
persons during 2008 and 2007.





2008
              
              
              2007Balance
      at beginning of period
              
              $
              13,520,043
              
              
              $
              11,245,284Additions
              
              
              31,430,692
              
              
              
              24,904,727Repayments
              
              
              (33,141,363
              )
              
              
              (22,629,968
              )Balance
      at December 31
              
              $
              11,809,372
              
              
              $
              13,520,043





An
individual, who was a director of the Company from 2003 until May 2008, is an
executive officer of the company which owns an office building in which the
Company had leased space under two separate operating leases.  The
leases were effectively combined during 2004 and extended to February 28,
2010.  Bay National Corporation has the right to extend the leases for
one additional five year term, to February 28, 2015. Rent expense under this
lease was $368,740, $358,000, and $347,573 for the periods ended December 31,
2008, 2007 and 2006, respectively. Management believes that the terms of the
foregoing leases are no more and no less favorable to Bay National Bank than
those which could have been received from unaffiliated parties.





89
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


12.               
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business.  These financial instruments may include
commitments to extend credit, standby letters of credit and purchase
commitments.  The Company uses these financial instruments to meet the
financing needs of its customers.  Financial instruments involve, to
varying degrees, elements of credit, interest rate and liquidity
risk.  These do not represent unusual risks and management does not
anticipate any losses which would have a material effect on the accompanying
financial statements.





Outstanding
loan commitments and lines and letters of credit at December 31 are as
follows:





2008
              
              
              2007Loan
      commitments
              
              $
              14,981,584
              
              
              $
              35,114,676Unused
      lines of credit
              
              
              84,495,398
              
              
              
              85,999,686Standby
      letters of credit
              
              
              2,924,671
              
              
              
              3,564,927





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.  The Company
generally requires collateral to support financial instruments with credit risk
on the same basis as it does for on-balance sheet instruments. The collateral is
based on management's credit evaluation of the counter party. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee.  Since many of the commitments are expected
to expire without being drawn upon, the total commitment amount does not
necessarily represent future cash requirements.  Each customer's
credit-worthiness is evaluated on a case-by-case basis.





Standby
letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party.  The credit risk involved
in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers.





13.  REGULATORY
MATTERS





As of
December 31, 2008, the Company was required to maintain a weekly average of
$25,000 of non-interest-bearing deposits with the Federal Reserve Bank. As of
December 31, 2007, the Company was required to maintain a weekly average of $1.9
million of non-interest-bearing deposits with the Federal Reserve
Bank.  The average weekly balance maintained with the Federal Reserve
Bank for the weekly period ending December 31, 2008 was $3.4 million. The
average weekly balance maintained with the Federal Reserve Bank for the weekly
period including December 31, 2007 was $2.0 million. The actual balances
maintained with the Federal Reserve Bank at December 31, 2008 and December 31,
2007 was $6.8 million and $1.8 million, respectively.





The
Company and the Bank are subject to various regulatory capital requirements
administered by 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 and the Bank's financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank's assets, liabilities
and certain off-balance sheet items as calculated under regulatory accounting
practices.  The Bank's capital amounts and classification are also
subject to qualitative




90
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


judgments
by the regulators about components, risk weightings and other
factors.





Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain amounts and ratios (set forth in the table below) of total and Tier
I capital (as defined in the regulations) to risk-weighted assets (as defined)
and Tier I capital (as defined) to average assets (as
defined).  Management believes, as of December 31, 2008, that the Bank
met all capital adequacy requirements to which it is subject.





The Bank
has been categorized as “adequately capitalized” by the OCC under the regulatory
framework for prompt corrective action. To be categorized as adequately
capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based
and Tier I leverage ratios. There are no conditions or events that management
believes would prevent the Bank from continuing to be categorized as adequately
capitalized.





The
Bank’s actual capital amounts and ratios as of December 31, 2008 and 2007 are
presented in the following tables:





December
      31, 2008Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Capital (to Risk Weighted Assets)*:
              
              $
              26,322,552
              
              
              
              9.57
              %
              
              $
              22,000,960
              
              
              
              8.00
              %
              
              $
              27,501,200
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets)*:
              
              
              22,857,283
              
              
              
              8.31
              %
              
              
              11,000,480
              
              
              
              4.00
              %
              
              
              16,500,720
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets)*:
              
              
              22,857,283
              
              
              
              8.31
              %
              
              
              8,254,920
              
              
              
              3.00
              %
              
              
              13,758,200
              
              
              
              5.00
              %*In
      order to be in compliance with the terms of the Consent Order, the Bank
      must meet minimum Total Capital, Tier 1 Capital (to Risk Weighted
      Assets) and Tier 1 Capital (to Average Assets) ratios of 12.00%, 11.00%
      and 9.00%, respectively.





December
      31, 2007Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              
              $
              27,392,869
              
              
              
              10.41
              %
              
              $
              21,047,000
              
              
              
              8.00
              %
              
              $
              26,309,000
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              
              24,083,165
              
              
              
              9.15
              %
              
              
              10,523,000
              
              
              
              4.00
              %
              
              
              15,785,000
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              
              24,083,165
              
              
              
              9.63
              %
              
              
              7,504,000
              
              
              
              3.00
              %
              
              
              12,506,000
              
              
              
              5.00
              %





91
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


Bay
National Corporation’s actual capital amounts and ratios as of December 31, 2008
and 2007 are presented in the following tables:





December
      31, 2008Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              
              $
              26,487,270
              
              
              
              9.96
              %
              
              $
              21,267,040
              
              
              
              8.00
              %
              
              $
              26,583,800
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              
              21,643,818
              
              
              
              8.14
              %
              
              
              10,633,520
              
              
              
              4.00
              %
              
              
              15,950,280
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              
              21,643,818
              
              
              
              7.87
              %
              
              
              8,254,920
              
              
              
              3.00
              %
              
              
              13,758,200
              
              
              
              5.00
              %





December
      31, 2007Actual
              
              
              For
      Capital
                Adequacy
      Purpose
              
              
              To
      Be Well
                Capitalized
      Under
                Prompt
      Corrective
                Action
      ProvisionsAmount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Capital (to Risk Weighted Assets):
              
              $
              31,230,256
              
              
              
              11.87
              %
              
              $
              21,054,000
              
              
              
              8.00
              %
              
              $
              26,317,000
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets):
              
              
              27,728,115
              
              
              
              10.54
              %
              
              
              10,527,000
              
              
              
              4.00
              %
              
              
              15,790,000
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets):
              
              
              27,728,115
              
              
              
              11.09
              %
              
              
              7,504,000
              
              
              
              3.00
              %
              
              
              12,506,000
              
              
              
              5.00
              %





Banking
regulations also limit the amount of dividends that may be paid without prior
approval of the Bank's regulatory agencies.  Regulatory approval is
required to pay dividends which exceed the Bank’s net profits for the current
year, plus its retained net profits for the preceding two
years.  Under the terms of the February 6, 2009 Consent Order, the
Bank may not pay dividends unless it is in compliance with the capital program
required by the Order and applicable regulatory requirements and receives the
OCC’s written non-objection.





In
addition, in February 2009, Bay National Corporation received notice from the
Federal Reserve Bank of Richmond that it is expected to immediately terminate
future dividend payments, including payments on trust preferred
securities.  This order will remain in effect until Bay National
Corporation receives written approval from the Reserve Bank to resume such
payments.





14.           FAIR
VALUE OF FINANCIAL INSTRUMENTS





Effective
January 1, 2008, the Company adopted SFAS No. 157 (SFAS 157), “Fair Value Measurements.”
SFAS 157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles and expands disclosures about fair
value measurements. SFAS 157 applies whenever other standards require (or
permit) assets or liabilities to be measured at fair value but does not expand
the use of fair value in any new circumstances. In this standard, the FASB
clarifies the principle that fair value should be based on the assumptions
market participants would use when pricing the asset or




92
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


liability.
In support of this principle, SFAS 157 establishes a fair value hierarchy that
prioritizes the information used to develop those assumptions. The fair value
hierarchy is as follows:





Level 1
inputs – Unadjusted quoted prices in active markets for identical assets or
liabilities that the entity has the ability to access at the measurement
date.





Level 2
inputs - Inputs other than quoted prices included in Level 1 that are observable
for the asset or liability, either directly or indirectly. These might include
quoted prices for similar assets and liabilities in active markets, and inputs
other than quoted prices that are observable for the asset or liability, such as
interest rates and yield curves that are observable at commonly quoted
intervals.





Level 3
inputs - Unobservable inputs for determining the fair values of assets or
liabilities that reflect an entity’s own assumptions about the assumptions that
market participants would use in pricing the assets or liabilities.





As of
December 31, 2008, the Company had no balance sheet categories that are required
by generally accepted accounting principles to be recorded at fair
value.





Loans
held for sale and loans held in the Company’s loan portfolio are valued at cost.
Any impairment of the value of these loans is reflected in the allowance for
credit losses.





Real
estate acquired through foreclosure (“OREO”) is valued at the time of
foreclosure and transferred to OREO from loans. Generally, the value of OREO is
based upon the lower of cost or net realizable value as determined by third
party real estate appraisals less the cost of disposal.





On a
nonrecurring basis, the Company may be required to measure certain assets at
fair value in accordance with generally accepted accounting
principles.  These adjustments usually result from application of
lower-of-cost-or-market accounting or write-downs of specific
assets.  The following table includes the assets measured at fair
value on a nonrecurring basis as of December 31, 2008 (in
thousands):





Carrying
      Value
              
              
              Level
      1
              
              
              Level
      2
              
              
              Level
      3Impaired
      Loans
              
              $
              16,423
              
              
              $
              -
              
              
              $
              16,423
              
              
              $
              -Real
      estate acquired through foreclosure
              
              
              3,873
              
              
              
              -
              
              
              
              3,873
              
              
              
              -Total
      assets at fair value
              
              $
              20,296
              
              
              $
              -
              
              
              $
              20,296
              
              
              $
              -





The
Company discloses fair value information about financial instruments, for which
it is practicable to estimate the value, whether or not such financial
instruments are recognized on the balance sheet.  Financial
instruments have been defined broadly to encompass 99.2% of the Company's assets
and 100% of its liabilities. Fair value is the amount at which a financial
instrument could be exchanged in a current transaction between willing parties,
other than in a forced sale or liquidation, and is best evidenced by a quoted
market price, if one exists.





93
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


Quoted
market prices, where available, are shown as estimates of fair market values.
Because no quoted market prices are available for a significant part of the
Company's financial instruments, the fair values of such instruments have been
derived based on the amount and timing of future cash flows and estimated
discount rates.





Present
value techniques used in estimating the fair value of many of the Company's
financial instruments are significantly affected by the assumptions used. In
that regard, the derived fair value estimates cannot be substantiated by
comparison to independent markets and, in many cases, could not be realized in
immediate cash settlement of the instrument. Additionally, the accompanying
estimates of fair values are only representative of the fair values of the
individual financial assets and liabilities and should not be considered an
indication of the fair value of the Company.





The
following disclosure of estimated fair values of the Company's financial
instruments at December 31 are made in accordance with the requirements of SFAS
No. 107 and are as follows:





2008
                  2007Estimated
                  
                  EstimatedCarrying
                  Fair
                  Carrying
                  FairAmount
                  Value
                  Amount
                  ValueFinancial
      AssetsCash
      and temporary investments (1)
                  $
                  9,286,512
                  $
                  9,286,512
                  $
                  7,173,671
                  
                  $
                  7,173,671Investments
      available-for-sale
                  -
                  -
                  399,529
                  
                  399,529Other
      equity securities
                  1,239,600
                  1,239,600
                  1,715,000
                  
                  1,715,000Bank
      owned life insurance
                  5,268,529
                  5,268,529
                  5,041,662
                  
                  5,041,662Loans,
      net of allowances (2)
                  242,675,686
                  244,909,172
                  235,956,241
                  
                  236,780,874Accrued
      interest receivable and other assets (3)
                  7,093,010
                  7,093,010
                  4,092,538
                  
                  4,092,538Financial
      LiabilitiesDeposits
                  $
                  244,628,032
                  $
                  245,085,887
                  $
                  201,981,465
                  
                  $
                  202,210,573Short-term
      borrowings
                  1,864,056
                  1,864,056
                  25,371,508
                  
                  25,371,508Subordinated
      debt
                  8,000,000
                  5,796,000
                  8,000,000
                  
                  7,703,819Accrued
      interest payable and other liabilities (3)
                  1,073,899
                  1,073,899
                  1,262,334
                  
                  1,262,334





(1)
            Temporary
      investments include federal funds sold and overnight
      investments.


(2)
            Loans,
      net of allowances, include loans held for
sale.


(3)
            Only
      financial instruments as defined in Statement of Financial Accounting
      Standards No. 107, “Disclosure about Fair Value of Financial Instruments,”
      are included in other assets and other
  liabilities.





The
following methods and assumptions were used to estimate the fair value of each
category of financial instruments for which it is practicable to estimate that
value:





Cash and due from banks, federal
funds sold and overnight investments. The carrying amount approximated
the fair value.





94
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


Investment Securities. The
fair value for U.S. Treasury securities was based upon quoted market
bids.





Other equity securities. The
fair value of Federal Reserve Bank and FHLB of Atlanta stock is not readily
determinable since these stocks are restricted as to marketability.





Loans. The fair value was
estimated by computing the discounted value of estimated cash flows, adjusted
for potential credit losses, for pools of loans having similar characteristics.
The discount rate was based upon the current loan origination rate for a similar
loan. Non-performing loans have an assumed interest rate of 0%.  The
fair value of residential mortgage loans held for sale was derived from
secondary market quotations for similar instruments.





Bank owned life
insurance.The carrying amount approximated the fair value due
to the variable interest rate.





Accrued interest receivable.
The carrying amount approximated the fair value of accrued interest, considering
the short-term nature of the receivable and its expected
collection.





Other assets. The carrying
amount approximated the fair value.





Deposit liabilities. The fair
value of demand, money market savings and regular savings deposits, which have
no stated maturity, were considered equal to their carrying amount, representing
the amount payable on demand.  These estimated fair values do not
include the intangible value of core deposit relationships, which comprise a
significant portion of the Bank’s deposit base.  Management believes
that the Bank’s core deposit relationships provide a relatively stable, low-cost
funding source that has a substantial intangible value separate from the value
of the deposit balances.





The fair
value of time deposits was based upon the discounted value of contractual cash
flows at current rates for deposits of similar remaining maturity.





Short-term borrowings. The
carrying amount approximated the fair value due to their variable interest
rates.





Subordinated Debt.Carrying values were
discounted using a cash flow approach based on market rates as of
December 31, 2008 and does not reflect the Company’s election in January of
2009 to defer interest payments.





Other liabilities. The
carrying amount approximated the fair value of accrued interest payable, accrued
dividends and premiums payable, considering their short-term nature and expected
payment.





Off-balance sheet instruments.
The Company charges fees for commitments to extend credit. Interest rates on
loans, for which these commitments are extended, are normally committed for
periods of less than one month. Fees charged on standby letters of credit and
other financial guarantees are deemed to be immaterial andthese guarantees are
expected to be settled at face amount or expire unused. It is impractical to
assign any fair value to these commitments.





95
 
 BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006


15.           PARENT
COMPANY FINANCIAL INFORMATION





Condensed
financial information for Bay National Corporation (Parent Only) is as
follows:





CONDENSED BALANCE
SHEETS


December
31, 2008 and 2007





2008
              
              
              2007ASSETSCash
      and cash equivalents
              
              $
              5,843
              
              
              $
              5,714Due
      from subsidiary
              
              
              162,244
              
              
              
              3,807,670Investment
      in subsidiary
              
              
              23,104,949
              
              
              
              24,331,166Other
      assets
              
              
              56,533
              
              
              
              82,786Total
      Assets
              
              $
              23,329,569
              
              
              $
              28,227,336LIABILITIESAccrued
      expenses and other liabilities
              
              $
              59,568
              
              
              $
              58,784Subordinated
      debt
              
              
              8,248,000
              
              
              
              8,248,000Total
      Liabilities
              
              
              8,307,568
              
              
              
              8,306,784STOCKHOLDERS'
      EQUITYCommon
      stock - $.01 par value, authorized:9,000,000
      shares authorized, 2,153,101 and 2,137,633 issued and outstanding as of
      December 31, 2008 and 2007, respectively:
              
              
              21,531
              
              
              
              21,376Additional
      paid in capital
              
              
              17,954,770
              
              
              
              17,788,833(Accumulated
      deficit) retained earnings
              
              
              (2,954,300
              )
              
              
              2,110,343Total
      Stockholders' Equity
              
              
              15,022,001
              
              
              
              19,920,552Total
      Liabilities and Stockholders' Equity
              
              $
              23,329,569
              
              
              $
              28,227,336





96


BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2008, 2007 and 2006





CONDENSED STATEMENTS OF
OPERATIONS


For the
years ended December 31, 2008, 2007 and 2006





2008
              
              
              2007
              
              
              2006Interest
      and dividends on investment securities
              
              $
              129
              
              
              $
              264
              
              
              $
              238Interest
      expense
              
              
              603,039
              
              
              
              602,096
              
              
              
              603,567Net
      interest expense
              
              
              (602,910
              )
              
              
              (601,832
              )
              
              
              (603,329
              )Non-interest
      expense
              
              
              75,517
              
              
              
              75,274
              
              
              
              162,966Loss
      before income taxes and equity in undistributed losses of
      subsidiary
              
              
              (678,427
              )
              
              
              (677,106
              )
              
              
              (766,295
              )Income
      tax (benefit) expense
              
              
              (230,665
              )
              
              
              (576,000
              )
              
              
              -Loss
      before equity in undistributed (losses) income of
    subsidiary
              
              
              (447,762
              )
              
              
              (101,106
              )
              
              
              (766,295Equity
      in undistributed (loss) income of subsidiary
              
              
              (4,616,881
              )
              
              
              1,038,475
              
              
              
              3,196,123Net
      (Loss) Income
              
              $
              (5,064,643
              )
              
              $
              937,369
              
              
              $
              2,429,828





CONDENSED STATEMENTS OF CASH
FLOWS


For the
years ended December 31, 2008, 2007 and 2006





2008
                
                
                2007
                
                
                2006Cash
      Flows From Operating ActivitiesNet
      (Loss) Income
                
                $
                (5,064,643
                )
                
                $
                937,369
                
                
                $
                2,429,828Adjustments
      to reconcile net (loss) income to net cashprovided
      by operating activities:Equity
      in undistributed loss (income) of subsidiary
                
                
                4,616,881
                
                
                
                (1,038,475
                )
                
                
                (3,196,123
                )Stock
      based compensation expense
                
                
                75,517
                
                
                
                122,539
                
                
                
                115,714Net
      decrease  in other assets
                
                
                3,671,679
                
                
                
                237,930
                
                
                
                1,438,739Net
      increase (decrease) in other liabilities
                
                
                784
                
                
                
                (47,250
                )
                
                
                79,207Net
      cash provided by operating activities
                
                
                3,300,218
                
                
                
                212,113
                
                
                
                867,365Cash
      Flows From Investing ActivitiesInvestment
      in subsidiary
                
                
                (3,390,664
                )
                
                
                (230,000
                )
                
                
                (950,000
                )Net
      cash used in investing activities
                
                
                (3,390,664
                )
                
                
                (230,000
                )
                
                
                (950,000
                )Cash
      Flows From Financing ActivitiesNet
      proceeds from issuance of common stock
                
                
                90,575
                
                
                
                18,638
                
                
                
                82,873Cash
      dividends paid in lieu of fractional shares
                
                
                -
                
                
                
                (487
                )
                
                
                -Net
      cash provided by financing activities
                
                
                90,575
                
                
                
                18,151
                
                
                
                82,873Net
      increase in cash and cash equivalents
                
                
                129
                
                
                
                264
                
                
                
                238Cash
      and cash equivalents at beginning of year
                
                
                5,714
                
                
                
                5,450
                
                
                
                5,212Cash
      and cash equivalents at end of year
                
                $
                5,843
                
                
                $
                5,714
                
                
                $
                5,450




97


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





There has
been no occurrence requiring a response to this Item.





Item
9A.  Controls and Procedures





As of the
end of the period covered by this annual report on Form 10-K, Bay National
Corporation’s Chief Executive Officer and Chief Financial Officer evaluated the
effectiveness of Bay National Corporation’s disclosure controls and
procedures.  Based upon that evaluation, Bay National Corporation’s
Chief Executive Officer and Chief Financial Officer concluded that Bay National
Corporation’s disclosure controls and procedures are effective as of December
31, 2008.  Disclosure controls and procedures are controls and other
procedures that are designed to ensure that information required to be disclosed
by Bay National Corporation in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission’s rules and
forms.





In
addition, there were no changes in Bay National Corporation’s internal control
over financial reporting (as defined in Rule 13a-15 under the Exchange Act)
during the quarter ended December 31, 2008, that have materially affected, or
are reasonably likely to materially affect, Bay National Corporation’s internal
control over financial reporting.





This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.




98





Item
9B.  Other Information







Hugh
Mohler’s annual base compensation was voluntarily decreased from $255,000 as of
January 1, 2008 to $229,500 as of September 5, 2008 and then decreased to
$206,000 effective January 23, 2009. Richard Oppitz earned an annual base
compensation of $157,500 until his termination effective January 7, 2009. Mark
Semanie earned an annual base compensation of $180,000 until his resignation
effective December 31, 2008.





99





PART
III





Item
10.   Directors, Executive Officers and Corporate
Governance





Code
of Ethics





Bay
National Corporation’s Board of Directors has adopted a code of conduct that
applies to all of its directors, officers and employees, including it principal
executive officer, principal financial officer, principal accounting officer or
controller and persons performing similar functions. That Code of Conduct is
posted on Bay National Bank’s internet website at
www.baynational.com.





The
remaining information required by this Item 10 is incorporated by reference
to the information appearing under the captions “Proposal 1. Election of
Directors,” “Board Meetings and Committees” and “Section 16(a) Beneficial
Ownership Reporting Compliance” in the Proxy Statement for the 2009 Annual
Meeting of Stockholders of Bay National Corporation.





Item
11.  Executive Compensation





The
information required by this Item 11 is incorporated by reference to the
information appearing under the captions “Director Compensation” and “Executive
Compensation” in the Proxy Statement for the 2009 Annual Meeting of Stockholders
of Bay National Corporation.





100


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





Securities
Authorized For Issuance Under Equity Compensation Plans





The
following table sets forth certain information as of December 31, 2008,
with respect to compensation plans under which equity securities of Bay National
Corporation are authorized for issuance.





Equity
      Compensation Plan InformationPlan
      category
              
              Number
      of securities to be issued(1)
                (a)
              
              
              Weighted-average
      exercise price of outstanding options and warrants(2)
                (b)
              
              
              Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))
                (c)Equity
      compensation plans approved by security holders
              
              148,641
              
              
              $6.99
              
              
              219,250Equity
      compensation plans not approved by security holders
              
              -
              
              
              -
              
              
              -Total
              
              148,641
              
              
              $6.99
              
              
              219,250


(1)
            Includes
      unvested restricted stock units


(2)
            Excludes
      unvested restricted stock units





The
remaining information required by this Item 12 is incorporated by reference
to the information appearing under the caption “Security Ownership of Management
and Certain Securityholders” in the Proxy Statement for the 2009 Annual Meeting
of Stockholders of Bay National Corporation.





Item
13.  Certain Relationships and Related Transactions, and Director
Independence





The
information required by this Item 13 is incorporated by reference to the
information appearing under the captions “Proposal 1.  Election of
Directors” and “Certain Relationships and Related Transactions” in the Proxy
Statement for the 2009 Annual Meeting of Stockholders of Bay National
Corporation.





Item
14.  Principal Accountant Fees and Services.





The
information required by this Item 14 is incorporated by reference to the
information appearing under the captions “Audit Committee Report – Audit and
Non-Audit Fees” and “Audit Committee Report – Policy on Audit Committee
Pre-Approval of Audit and Non-Audit Services of Independent Registered Public
Accounting Firm” in the Proxy Statement for the 2009 Annual Meeting of
Stockholders of Bay National Corporation.





101


Item
15.  Exhibits





The
following exhibits are filed with or incorporated by reference into this
report.








No.
              Description
      of Exhibit3.1*
              Articles
      of Incorporation of Bay National
Corporation


3.2%
            Amended
      and Restated Bylaws of Bay National
Corporation


4.1*
            Rights
      of Holders of Common Stock (as contained in Exhibit
  3.1)


4.2*
            Form
      of Common Stock Certificate


4.3@
            Indenture
      dated as of December 12, 2005 between Bay National Corporation and
      Wilmington Trust Company, as
Trustee.


4.4@
            Amended
      and Restated Declaration of Trust dated as of December 12, 2005 between
      Wilmington Trust Company, as the Trustees of Bay National Capital Trust I,
      Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark A. Semanie
      and Warren F. Boutilier, as the
Administrators.


4.5@
            Guarantee
      Agreement dated as of December 12, 2005 between Bay National Corporation
      and Wilmington Trust Company.


10.1+
            Amended
      and Restated Employment Agreement, dated as of June 1, 2006, between Bay
      National Bank and Hugh W. Mohler.


10.1.1
            Terms of January 2009 Amendment to Employment Agreement
      between Bay National Bank and Hugh W.
  Mohler.


10.2+
            Employment
      Agreement, dated as of June 1, 2006, between Bay National Bank and Richard
      C. Springer.


10.3
            Terms of Employment Arrangement between Bay National
      Bank and Richard J. Oppitz


10.4
            Terms of Employment Arrangement between Bay National
      Bank and Mark A. Semanie


10.5**
            Bay
      National Corporation Stock Option
Plan


10.6.1**
            Form
      of Incentive Stock Option Agreement for Stock Option
  Plan


10.6.2
            Form of Non-Qualified Stock Option Agreement for Stock
      Option Plan


10.7#
            Bay
      National Corporation and Bay National Bank Director Compensation
      Policy


10.8*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership


10.9*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership


10.10##
            Amendment
      to Lease Agreement dated February 12, 2004 between Bay National
      Corporation and Joppa Green II Limited
  Partnership


10.11##
            Amendment
      to Lease Agreement dated October 5, 2004 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.12##
            Amendment
      to Lease Agreement dated January 3, 2005 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.13##
            Amendment
      to Lease Agreement dated March 7, 2005 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.14*
            Lease
      Agreement dated September 16, 1999 between Bay National Corporation and
      John R. Lerch and Thomas C.
Thompson


10.15@@
            Lease
      Agreement dated July 19, 2006 between Bay National Bank and Riderwood
      Limited Partnership


10.16^
            Lease
      Agreement dated October 3, 2007 between Bay National Corporation and
      Columbia 100, LLC




102


10.17++
            Bay
      National Corporation 2007 Stock Incentive Plan and Forms of
      Agreement


10.18
            Stipulation and Consent to the Issuance of a Consent
      Order by the Office of the Comptroller of the
  Currency


10.19
              Consent Order issued by the Office of the Comptroller
      of the Currency21.1
              Subsidiaries of Bay National
Corporation23.1
              Consent of Stegman &
Company


31.1
              Rule 13a-14(a) Certification of Chief Executive
      Officer


31.2
              Rule 13a-14(a) Certification of Chief Financial
      Officer


32
              Section 1350 Certification of Chief Executive Officer and
      Chief Financial Officer





The
exhibits which are denominated with an asterisk (*) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form SB-2, as
amended, under the Securities Act of 1933, Registration Number
333-87781.





The
exhibit which is denominated with a percentage sign (%) was previously filed by
Bay National Corporation as a part of, and is hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on September
26, 2007.





The
exhibits which are denominated with an @ sign were previously filed by Bay
National Corporation as part of, and are hereby incorporated by reference from,
Bay National Corporation’s Annual Report on Form 10-K for the year ended
December 31, 2005, filed with the Commission on March 30, 2006.





The
exhibits which are denominated by the plus sign (+) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
2006.





The
exhibits which are denominated by two asterisks (**) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
under the Securities Act of 1933, Registration Number 333-69428.





The
exhibit which is denominated by the number sign (#) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on January 26,
2005.





The
exhibits which are denominated by two number signs (##) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
2005.





The
exhibit which is denominated by two @ signs (@@) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2006, filed on August 14, 2006.





The
exhibit which is denominated by a carrot sign (^) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on October 9,
2007.





103


The
exhibit which is denominated by two plus signs (++) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Registration Statement on Form S-8 under the
Securities Act of 1933, Registration Number 333-143544.





Note:
Exhibits 10.1 through 10.7 and 10.17 relate to management contracts or
compensatory plans or arrangements.





104


SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.










BAY
      NATIONAL CORPORATIONDate:  March
      31, 2009
                    By:
                    /s/ Hugh W. MohlerHugh
      W.
Mohler,   President





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.











Name
                                        Position
                                        Date/s/ Hugh W. Mohler
                                          Hugh
      W. Mohler
                                        Director
      and President (Principal Executive Officer)
                                        March
      31, 2009/s/ David E. Borowy
                                          David
      E. Borowy
                                        Senior
      Vice President and CFO
                                          (Principal
      Accounting and Financial Officer)
                                        March
      31, 2009/s/ R. Michael Gill
                                          R.
      Michael Gill
                                        Director
                                        March
      31, 2009/s/ John R. Lerch
                                          John
      R. Lerch
                                        Director
                                        March
      31, 2009/s/ Donald G. McClure, Jr.
                                          Donald
      G. McClure, Jr.
                                        Director
                                        March
      31, 2009/s/ Robert L. Moore
                                          Robert
      L. Moore
                                        Director
                                        March
      31, 2009/s/ James P. O’Conor
                                          James
      P. O’Conor
                                        Director
                                        March
      31, 2009/s/
      H. Victor Rieger, Jr.
                                          H.
      Victor Rieger, Jr.
                                        Director
                                        March
      31, 2009/s/ William B. Rinnier
                                          William
      B. Rinnier
                                        Director
                                        March
      31, 2009/s/ Edwin A. Rommel
                                          Edwin
      A. Rommel, III
                                        Director
                                        March
      31, 2009/s/Henry H. Stansbury
                                          Henry
      H. Stansbury
                                        Director
                                        March
      31,
2009





105


/s/ Eugene M. Waldron, Jr.
                    Eugene
      M. Waldron, Jr.
                  Director
                  March
      31, 2009/s/ Carl A. J. Wright
                    Carl
      A.J. Wright
                  Director
                  March
      31, 2009





106


EXHIBIT
INDEX








No.                      Description of
Exhibit





3.1*
            Articles
      of Incorporation of Bay National
Corporation


3.2%
            Amended
      and Restated Bylaws of Bay National
Corporation


4.1*
            Rights
      of Holders of Common Stock (as contained in Exhibit
  3.1)


4.2*
            Form
      of Common Stock Certificate


4.3@
            Indenture
      dated as of December 12, 2005 between Bay National Corporation and
      Wilmington Trust Company, as
Trustee.


4.4@
            Amended
      and Restated Declaration of Trust dated as of December 12, 2005 between
      Wilmington Trust Company, as the Trustees of Bay National Capital Trust I,
      Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark A. Semanie
      and Warren F. Boutilier, as the
Administrators.


4.5@
            Guarantee
      Agreement dated as of December 12, 2005 between Bay National Corporation
      and Wilmington Trust Company.


10.1+
            Amended
      and Restated Employment Agreement, dated as of June 1, 2006, between Bay
      National Bank and Hugh W. Mohler.


10.1.1
            Terms of January 2009 Amendment to Employment Agreement
      between Bay National Bank and Hugh W.
  Mohler.


10.2+
            Employment
      Agreement, dated as of June 1, 2006, between Bay National Bank and Richard
      C. Springer.


10.3
            Terms of Employment Arrangement between Bay National
      Bank and Richard J. Oppitz


10.4
            Terms of Employment Arrangement between Bay National
      Bank and Mark A. Semanie


10.5**
            Bay
      National Corporation Stock Option
Plan


10.6.1**
            Form
      of Incentive Stock Option Agreement for Stock Option
  Plan


10.6.2
            Form of Non-Qualified Stock Option Agreement for Stock
      Option Plan


10.7#
            Bay
      National Corporation and Bay National Bank Director Compensation
      Policy


10.8*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership


10.9*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership


10.10##
            Amendment
      to Lease Agreement dated February 12, 2004 between Bay National
      Corporation and Joppa Green II Limited
  Partnership


10.11##
            Amendment
      to Lease Agreement dated October 5, 2004 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.12##
            Amendment
      to Lease Agreement dated January 3, 2005 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.13##
            Amendment
      to Lease Agreement dated March 7, 2005 between Bay National Corporation
      and Joppa Green II Limited
Partnership


10.14*
            Lease
      Agreement dated September 16, 1999 between Bay National Corporation and
      John R. Lerch and Thomas C.
Thompson


10.15@@
            Lease
      Agreement dated July 19, 2006 between Bay National Bank and Riderwood
      Limited Partnership


10.16^
            Lease
      Agreement dated October 3, 2007 between Bay National Corporation and
      Columbia 100, LLC


10.17++
            Bay
      National Corporation 2007 Stock Incentive Plan and Forms of
      Agreement


10.18
            Stipulation and Consent to the Issuance of a Consent
      Order by the Office of the Comptroller of the
  Currency


10.19
            Consent Order issued by the Office of the Comptroller
      of the Currency




107


21.1
            Subsidiaries of Bay National
    Corporation


23.1
            Consent of Stegman &
  Company


31.1
            Rule 13a-14(a) Certification of Chief Executive
      Officer


31.2
            Rule 13a-14(a) Certification of Chief Financial
      Officer


32
            Section 1350 Certification of Chief Executive Officer and
      Chief Financial Officer





The
exhibits which are denominated with an asterisk (*) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form SB-2, as
amended, under the Securities Act of 1933, Registration Number
333-87781.





The
exhibit which is denominated with a percentage sign (%) was previously filed by
Bay National Corporation as a part of, and is hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on September
26, 2007.





The
exhibits which are denominated with an @ sign were previously filed by Bay
National Corporation as part of, and are hereby incorporated by reference from,
Bay National Corporation’s Annual Report on Form 10-K for the year ended
December 31, 2005, filed with the Commission on March 30, 2006.





The
exhibits which are denominated by the plus sign (+) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
2006.





The
exhibits which are denominated by two asterisks (**) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
under the Securities Act of 1933, Registration Number 333-69428.





The
exhibit which is denominated by the number sign (#) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on January 26,
2005.





The
exhibits which are denominated by two number signs (##) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
2005.





The
exhibit which is denominated by two @ signs (@@) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2006, filed on August 14, 2006.





The
exhibit which is denominated by a carrot sign (^) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on October 9,
2007.





The
exhibit which is denominated by two plus signs (++) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Registration Statement on Form S-8 under the
Securities Act of 1933, Registration Number 333-143544.





Note:
Exhibits 10.1 through 10.7 and 10.17 relate to management contracts or
compensatory plans or arrangements.