**Exhibit13**

** **

**HCSBFINANCIAL CORPORATION**

 

****

 

**HORRYCOUNTY STATE BANK**

** **

Loris, SouthCarolina

 

Annual Report

 

2007

 

www.hcsbaccess.com

----

# ** **

**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

# **Contents**

# ** **

| ** **                                                                                  | **Page** |
|---------------------------------------------------------------------------------------------|----------|
|                                                                                        |     |
| Message to Shareholders                                                                     | 2        |
|                                                                                        |     |
| Ten Year History                                                                            | 4        |
|                                                                                        |     |
| Selected Financial Data                                                                     | 5        |
|                                                                                        |     |
| Description of Company’s Business                                                      | 6        |
|                                                                                        |     |
| Market for Common Share and Dividends                                                       | 7        |
|                                                                                        |     |
| Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 8-25     |
|                                                                                        |     |
| Report of Independent Registered Public Accounting  Firm                                    | 26       |
|                                                                                        |     |
| Consolidated Balance Sheets                                                                 | 27       |
|                                                                                        |     |
| Consolidated Statements of Income                                                           | 28       |
|                                                                                        |     |
| Consolidated Statements of Changes in Shareholders’  Equity and Comprehensive Income   | 29       |
|                                                                                        |     |
| Consolidated Statements of Cash Flows                                                       | 30       |
|                                                                                        |     |
| Notes to Consolidated Financial Statements                                                  | 31-55    |
|                                                                                        |     |
| Board of Directors                                                                          | 56       |
|                                                                                        |     |
| Corporate Officers                                                                          | 57       |
|                                                                                        |     |
| Branch Locations                                                                            | 57       |

 

# **Headquarters**

# ** **

| 5201 Broad  Street           |   | Mailing Address:             |
|------------------------------|--------|------------------------------|
| Loris, South  Carolina 29569 |   | Post Office Box  218         |
| (843) 756-6333               |   | Loris, South  Carolina 29569 |

 

Certain statements inthis annual report contain “forward-looking statements” within the meaning ofthe Private Securities Litigation Reform Act of 1995, such as statementsrelating to the future plans and expectations, and are thus prospective. Suchforward-looking statements are subject to risks, uncertainties and otherfactors that could cause actual results to differ materially from futureresults expressed or implied by such forward-looking statements.  Please see our annual report filed on Form 10-KSBfor further discussion of these risks.

 

**HCSB Financial Corporation willfurnish, free of charge, copies of the Annual Report and the Company’s Reportto the Securities and Exchange Commission (Form 10-KSB) upon writtenrequest to James R. Clarkson, President and C.E.O., HCSB Financial Corporation,Post Office Box 218, Loris, South Carolina 29569.**

 

----

 

**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**MESSAGETO SHAREHOLDERS**

 

December 31, 2007concluded the first twenty years of the operation of HCSB Financial Corporationand its subsidiary, Horry County State Bank. A brief reflection will illustrate just how far we have come  . . . from a bank with one office in Loris,$2 million in assets, and eight employees in January 1988 to a bank with14 offices throughout most of Horry County, $438 million in assets, and 156employees at the end of 2007.

 

The year 2007 presentedsome excellent opportunities for our bank to position itself for future growthand to strengthen our management team and support services staff.  Our Board of Directors elected to takeadvantage of these opportunities which we realized would likely result in asacrifice of short-term profitability in exchange for the long-range welfare ofHCSB.

 

We opened our thirteenthfull-service office in June in The Plaza at Gator Hole at OceanDrive.  And in November we movedinto our new facility at 1300 2nd Avenue in Conway.  In addition to the staffing of these newbranches, we added a significant number of employees to support our sales staffin these new offices and our other branches, which continue to experiencegrowth.

 

As we expected, thesestrategic decisions resulted in a reduction of earnings from $2.8 million in2006 to $2.0 million in 2007.  We didexperience significant growth in other areas, however.  In fact, total assets increased by 21.9% in2007 to $438.4 million.  The biggestcomponent of this growth was our loan portfolio, which grew by 38.4% to $348.7million net of our reserve for loan losses. Also, in 2007, our deposits grew by 23.9% to $340.9 million, andshareholders’ equity rose by 9.3% to $31.0 million.

 

While we’re quite proudof many of our accomplishments in 2007 and over our first 20 years, we need toemphasize our future.  In the near termof 2008, our company faces some serious challenges, as do most other segmentsof the economy, both local and national. Oil prices are projected to continue to rise in 2008, which has negativeimplications on agricultural profit margins, the tourism industry and householdfinancial situations in general.  And, too,real estate values have begun to decline as developers take a wait-and-seeapproach and as the availability of residential mortgage products has beensubstantially reduced in the aftermath of the sub-prime mortgage situation.  Furthermore, it seems that presidentialelection years always create additional anxiety.

 

Despite the doom andgloom being portrayed by the media, however, we at HCSB have reason to be veryexcited over our future.  First of all,we do not have a sub-prime mortgage portfolio or an adjustable rate residentialmortgage portfolio such as those that have captured media headlines in recentmonths.  And quite frankly, while ourlocal economy is admittedly not nearly as robust as it was a couple of yearsago, we believe financial conditions and opportunities in Horry County arestill far stronger than those of neighboring inland counties.

 

In addition, we have maderecent additions to our services, and we have still more services to beintroduced in 2008 which will enable us to utilize our technology in providingthe convenience that the public desires. The trend in banking today is to enable the customer base to have readyaccess to their accounts and the flexibility to perform banking functions wheneverand wherever

 

2

----

 

it may be most convenientto them.  We at HCSB are committed tooffering these service delivery channels just as the big banks do.

 

As the chief executiveofficer of your community banking company, what really excites me most aboutour future, however, is the quality of the workforce that we have at HCSB.  Regardless of whether our economy is strongor moderate and despite the growing dependence upon technology for bankingservices, the two primary traits that will set us apart from other bankinginstitutions is the quality and experience of our staff and the level ofservice that we provide to our customers. While I recognize that a seemingly increasing number of people areputting maximum emphasis now on pricing, I still steadfastly believe in thequote that “the bitterness of poor quality remains long after the sweetness oflow price.”  As mentioned earlier, lastyear we were fortunate to be able to employ a significant number of outstandingpeople to add to and supplement the fine staff that we already had.  As employees at HCSB, we are committed toproviding a quality of service second to none in a manner which will enable usto continue to add new relationships to our bank and build upon those which wehave developed over these last twenty years.

 

So, again, as noted inthe first paragraph above, a lot has changed with HCSB since our inception 20years ago.  And while we can all agreethat each and every change is not at times perceived to be better, we can surelyalso agree that we may undoubtedly expect much more change to come.  In fact, our ability to anticipate, keep upwith, and manage change will be a key to our continued success.

 

And while we undoubtedlymust look to the changing future and the challenges and opportunities it willsurely bring, we must not forget that our underlying reason for growth inassets and profitability has been and will continue to be primarilyattributable to the quality of banking services that we offer and the manner inwhich we provide them.  In short, we mustcontinue to do “the little things that make a little bank . . . BIG!” and totreat our customers the way that we as employees desire to be treated.

 

We continue to appreciateour shareholders and remind you that you, too, can help to support thecontinued growth in the value of your investment by recommending Horry CountyState Bank at your every opportunity.

 

Most respectfully,

 

 
| James R. Clarkson         |   |
|---------------------------|--------|
| President &  CEO |   |

 

3

----

 

**Ten YearHistory**

*(Omit 000’s)*

 
| **Year** | ** ** | **Assets** | ** ** | **Deposits** | ** ** | **Loans (net)** | ** ** | **Capital** | ** ** | **Earnings** | ** ** |
|----------|------------|------------|------------|--------------|------------|----------------------|------------|-------------|------------|--------------|------------|
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 1998     |       | $          | 83,586     |         | $          | 69,970               |       | $           | 55,061     |         | $          | 8,024 |   | $ | 511 |   |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 1999     |       | 114,326    |       | 94,829       |       | 74,871               |       | 8,341       |       | 994          |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2000     |       | 143,718    |       | 123,500      |       | 90,300               |       | 9,781       |       | 1,037        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2001     |       | 148,651    |       | 120,073      |       | 116,596              |       | 10,895      |       | 996          |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2002     |       | 211,598    |       | 164,161      |       | 161,381              |       | 19,850      |       | 1,161        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2003     |       | 269,714    |       | 209,931      |       | 190,055              |       | 21,509      |       | 1,568        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2004     |       | 296,807    |       | 222,389      |       | 210,649              |       | 23,454      |       | 2,055        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2005     |       | 331,662    |       | 254,137      |       | 232,509              |       | 25,303      |       | 2,408        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2006     |       | 359,357    |       | 275,151      |       | 251,849              |       | 28,350      |       | 2,805        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2007     |       | 438,353    |       | 340,851      |       | 348,671              |       | 30,983      |       | 2,040        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
|          |            |            |            |              |            |                      |            |             |            |              |            |  |  |  |  |  |

 

4

----

 

**SelectedFinancial Data**

 

The following table setsforth certain selected financial data concerning the Company.  The selected financial data has been derivedfrom the financial statements.  Thisinformation should be read in conjunction with the financial statements of theCompany, including the accompanying notes, included elsewhere herein.

 
| **Year Ended December 31,**         | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars  in thousands, except per share)**      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Financial Condition:**                           |       |       |       |       |       |       |       |       |       |       |       |
| Investment securities, available for sale          |       | $          | 49,609     |       | $          | 50,830     |       | $          | 38,233     |       | $          | 42,597 |   | $ | 28,115 |   |
| Allowance for loan losses                          |       | 3,535      |       | 2,718      |       | 2,569      |       | 2,155      |       | 1,774      |       |
| Net loans                                          |       | 348,671    |       | 251,849    |       | 232,509    |       | 210,649    |       | 190,055    |       |
| Premises and equipment, net                        |       | 16,051     |       | 16,139     |       | 11,681     |       | 11,803     |       | 9,377      |       |
| Total assets                                       |       | 438,353    |       | 359,537    |       | 331,662    |       | 296,807    |       | 269,714    |       |
| Noninterest-bearing deposits                       |       | 32,407     |       | 26,428     |       | 25,418     |       | 27,973     |       | 23,149     |       |
| Interest-bearing deposits                          |       | 308,444    |       | 248,723    |       | 228,719    |       | 194,416    |       | 186,782    |       |
| Total deposits                                     |       | 340,851    |       | 275,151    |       | 254,137    |       | 222,389    |       | 209,931    |       |
| Advances from the Federal HomeLoan Bank            |       | 52,300     |       | 43,390     |       | 43,390     |       | 43,390     |       | 36,690     |       |
| Total liabilities                                  |       | 407,370    |       | 331,187    |       | 306,359    |       | 273,353    |       | 248,205    |       |
| Total shareholders’ equity                    |       | 30,983     |       | 28,350     |       | 25,303     |       | 23,454     |       | 21,509     |       |
|                                               |       |       |       |       |       |       |       |       |       |       |       |
| **Results of Operations:**                         |       |       |       |       |       |       |       |       |       |       |       |
| Interest income                                    |       | $          | 28,536     |       | $          | 23,680     |       | $          | 19,164     |       | $          | 15,172 |   | $ | 14,237 |   |
| Interest expense                                   |       | 14,222     |       | 11,114     |       | 7,456      |       | 4,936      |       | 5,540      |       |
|                                               |       |       |       |       |       |       |       |       |       |       |       |
| Net interest income                                |       | 14,314     |       | 12,566     |       | 11,708     |       | 10,236     |       | 8,697      |       |
| Provision for loan losses                          |       | 985        |       | 770        |       | 1,070      |       | 1,285      |       | 857        |       |
| Net interest income after provisionfor loan losses |       | 13,329     |       | 11,796     |       | 10,638     |       | 8,951      |       | 7,840      |       |
| Other income                                       |       | 2,696      |       | 2,604      |       | 1,931      |       | 2,156      |       | 2,002      |       |
| Other expense                                      |       | 12,933     |       | 10,308     |       | 8,903      |       | 7,961      |       | 7,436      |       |
|                                               |       |       |       |       |       |       |       |       |       |       |       |
| Income before income taxes                         |       | 3,092      |       | 4,092      |       | 3,666      |       | 3,146      |       | 2,406      |       |
| Income tax expense                                 |       | 1,052      |       | 1,287      |       | 1,258      |       | 1,091      |       | 838        |       |
|                                               |       |       |       |       |       |       |       |       |       |       |       |
| Net income                                         | ** ** | **$**      | **2,040**  | ** ** | **$**      | **2,805**  | ** ** | **$**      | **2,408**  | ** ** | **$**      | **2,055** | ** ** | **$** | **1,568** | ** ** |
|                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per Share Data (1):**                            |       |       |       |       |       |       |       |       |       |       |       |
| Net income                                         |       | $          | 0.55       |       | $          | 0.77       |       | $          | 0.66       |       | $          | 0.57 |   | $ | 0.44 |   |
|                                               |       |       |       |       |       |       |       |       |       |       |       |
| Period end book value                              |       | $          | 8.42       |       | $          | 7.70       |       | $          | 6.87       |       | $          | 6.40 |   | $ | 5.88 |   |

 

----

(1)     Adjusted for 5% stock dividends declaredin February 2001, February 2002 and February 2003, and the 7.5%stock dividend declared in January 2004. Adjustments have also been made for the 3% stock dividends declared in January 2005,January 2006, and February 2008, as well as the two-for-one stocksplit in the form of a 100% stock dividend declared in January 2007.

 

5

----

 

**Descriptionof Company’s Business**

 

HCSB FinancialCorporation (the Company) was incorporated on June 10, 1999 to become aholding company for Horry County State Bank. The Company’s only significant asset is its wholly owned subsidiary,Horry County State Bank (the Bank).  TheBank is a state-chartered bank incorporated on December 18, 1987 andlocated at 5201 Broad Street, Loris, South Carolina.  The Company’s primary market includes HorryCounty in South Carolina and Columbus and Brunswick Counties in NorthCarolina.  From its 14 branch locations,the Company offers a full range of deposit services, including checkingaccounts, savings accounts, certificates of deposit, money market accounts, andIRAs, as well as a broad range of non-deposit investment services.

 

The Company isprimarily engaged in the business of attracting deposits from the generalpublic and using these deposits together with other funds to make agricultural,commercial, consumer, and real estate loans. The Company’s operating results depend to a substantial extent on thedifference between interest and fees earned on loans and investments and theCompany’s interest expense, consisting principally of interest paid on depositsand borrowings.  Unlike most industrialcompanies, virtually all of the assets and liabilities of financialinstitutions are monetary.  As a result,interest rates have a greater effect on the financial institution’sperformance.  In addition to competingwith other traditional financial institutions, the Company also competes forsavings dollars with nontraditional financial intermediaries, such as mutualfunds.  This has resulted in a highlycompetitive market area.  The Companyattempts to compete in this highly competitive market by focusing on providingpersonal service and attention to its customers.

 

In 1995 theCompany opened its first branch office in the Mt. Olive community of HorryCounty and has since expanded its branch network to 14 banking offices locatedthroughout Horry County, as well as an Operations Center in Loris, SouthCarolina which houses the Company’s support services.  This expansion of its branch system hasenabled the Company to more effectively compete for deposits and loans.  By expanding into different communities, theCompany has been able to substantially diversify its market place from one of apredominantly agricultural  flavor to onewhich blends residential developments of retirees and others, tourism, majoremployment areas, central county government and the market’s most activeoverall growth areas.  In so doing, theCompany has reduced considerably the seasonality in its loan portfolio as wellas the risks that are at times inherent with concentration of loans in oneparticular segment of the economy.

 

In order tosupport this growth in its branch network, the Company has undertaken severalsecondary common stock offerings.  Priorto its reorganization from a bank into the holding company, Horry County StateBank undertook three such secondary offerings of its common stock in efforts tostrengthen the Bank’s regulatory capital position to support projected futuregrowth in assets.  Since thereorganization was consummated in 1999, the Company committed to anothersecondary offering in 2002 whereby the Company issued an additional 365,712shares of common stock at a price per share of $22.00, resulting in over$8,000,000 in added capital.

 

In December, 2004,the Company participated in the issuance of $6,000,000 of trust preferredsecurities through its non-consolidated subsidiary HCSB Financial Trust I (theTrust) to enable the company to pursue its growth goals and yet maintain a “well-capitalized”status as defined by banking regulatory agencies.   This method of raising capital only recentlybecame available to companies such as HCSB Financial Corporation in incrementsthat the Company could utilize.  Itallows the Company to continue its growth trends without issuing additionalcommon stock, and thus there is no dilution of ownership among the Company’sshareholders.

 

During the year2006, the Company relocated some of its executive offices temporarily to thesecond floor of its branch bank at 1701 N. Oak Street, Myrtle Beach, S.C. dueto the need for additional space in its Operations Center.  The Company purchased a 5-acre tract of landin the Loris Commerce Center in 2006 and expects to begin construction of a newOperations Center on this site in 2008 in order to accommodate its executiveoffices and all support services in this new facility.  The Company intends to offer its presentOperations Center for sale.

 

Also in 2006 the Companyacquired a lot and 25,710 square foot building thereon at 1300 Second Avenue,Conway, South Carolina as well as the adjacent lots which front on Third Avenuein Conway, South Carolina.  In February 2007,the Company sold an interest in a portion of these properties to TLF MyrtleBeach Properties, LLC, (TLF), the real estate ownership partnership for the lawfirm of Thompson & Henry, P.A. During 2007 the Company and TLF completed construction of the interiorof the Second Avenue and the parking lot on Third Avenue, and the Companycompleted construction of its drive-up banking facility on Third Avenue aswell.  Thompson & Henry, P.A.moved

 

6

----

 

into their offices on thethird floor in October, 2007 and the Company opened its branch and drive-upfacility in November, 2007.  TLF and theCompany have secured two tenants who are presently leasing the entire secondfloor.

 

Also in June, 2007 theCompany opened a new branch in The Plaza at Gator Hole on Highway 17 in OceanDrive Beach.  The Company entered into atwo-year lease on this facility with an option for a one-year renewal, ifnecessary.  The Company expects topurchase or lease a lot in Ocean Drive Beach in 2008 and construct a permanentfull-service branch into which it will relocate its present branch.

 

# **Market for Common Share andDividends**

# ** **

As of December 31, 2007, there were 3,677,974 shares of our commonstock outstanding held by approximately 2,341 shareholders of record.  There is currently no established publictrading market in our common stock and trading and quotations of our commonstock have been limited and sporadic. Most of the trades of which the Company is aware have been privatelynegotiated by local buyers and sellers. In addition to these trades, the Company is aware of a small number oftrades reported on Yahoo! that occurred on the OTC Bulletin Board betweenSeptember, 2007 and December 31, 2007. These trades ranged from $20.15 to $21.36.  We have included these trades in thefollowing table.  Because there has notbeen an established market for our common stock, we may not be aware of allprices at which our common stock has been traded.  We have not determined whether the trades ofwhich we are aware were the result of arm’s-length negotiations between theparties.  Based on information availableto us, we believe transactions in our common stock can be fairly summarized asfollows for the periods indicated:

 
| ** **     | ** ** | **Low**    | ** ** | **High**   | ** ** |
|----------------|------------|------------|------------|------------|------------|
| **2007**       |       |       |       |       |       |
|           |       |       |       |       |       |
| Fourth Quarter |       | $          | 21.36      |       | $          | 25.22 |   |
| Third Quarter  |       | $          | 20.15      |       | $          | 25.22 |   |
| Second Quarter |       | $          | 20.37      |       | $          | 25.22 |   |
| First Quarter  |       | $          | 19.89      |       | $          | 23.28 |   |
|           |       |       |       |       |       |
| **2006**       | ** ** | ** ** | ** ** | ** ** | ** ** |
|           |       |       |       |       |       |
| Fourth Quarter |       | $          | 19.89      |       | $          | 19.89 |   |
| Third Quarter  |       | $          | 18.43      |       | $          | 19.40 |   |
| Second Quarter |       | $          | 15.52      |       | $          | 19.40 |   |
| First Quarter  |       | $          | 17.95      |       | $          | 17.95 |   |

 

All share and per sharedata in this report has been adjusted to reflect all stock dividends and splitsdeclared by the Company.

 

No cash dividendshave ever been declared or paid by the Company. However, the Board of Directors approved a 10% stock dividend for eachof the five years ending December 31, 1996.  The Company also paid a two-for-one stocksplit in the form of a 100% stock dividend in 2000, a 5% stock dividend in eachof the years 2001, 2002, and 2003, a 7.5% stock dividend in 2004, a 3% stockdividend in 2005 and 2006, and a two-for-one stock split in the form of a 100%stock dividend in January 2007.  TheCompany also paid a 3% stock dividend on February 15, 2008 to shareholdersof record February 5, 2008.

 

Management doesnot expect the Company to pay cash dividends in the foreseeable future.  The Company’s ability to pay dividendsdepends on the ability of its subsidiary, Horry County State Bank, to paydividends to the Company.  As a SouthCarolina state bank, the Bank may only pay dividends out of its net profits,after deducting expenses, including losses and bad debts.  In addition, the Bank is prohibited fromdeclaring a dividend on its shares of common stock until its surplus equals itsstated capital.

 

7

----

# ** **

# **MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION**

# ** **

# **INTRODUCTION**

# ** **

The following discussiondescribes our results of operations for 2007 as compared to 2006 and alsoanalyzes our financial condition as of December 31, 2007 as compared to December 31,2006.  Like most community banks, wederive most of our income from interest we receive on our loans andinvestments.  Our primary source of fundsfor making these loans and investments is our deposits, both interest-bearingand noninterest-bearing.  Consequently,one of the key measures of our success is our amount of net interest income, orthe difference between the income on our interest-earning assets, such as loansand investments, and the expense on our interest-bearing liabilities, such asdeposits and borrowed funds.  In order tomaximize our net interest income, we must not only manage the volume of thesebalance sheet items, but also the yields that we earn on our interest-earningassets and the rates that we pay on interest-bearing liabilities.

 

We have included a numberof tables to assist in our description of these measures.  For example, the “Average Balances” tableshows the average balance during 2007, 2006, and 2005 of each category of ourassets and liabilities, as well as the yield we earned or the rate we paid withrespect to each category.  A review ofthis table shows that our loans typically provide higher interest yields thando other types of interest earning assets, which is why we direct a substantialpercentage of our earning assets into our loan portfolio.  Similarly, the “Rate/Volume Analysis” tablehelps demonstrate the impact of changing interest rates and changing volume ofassets and liabilities during the years shown. We also track the sensitivity of our various categories of assets andliabilities to changes in interest rates, and we have included an “InterestRate Sensitivity Analysis” table to help explain this.  Finally, we have included a number of tablesthat provide details about our investment securities, our loans, and ourdeposits and other borrowings.

 

Of course, there arerisks inherent in all loans, so we maintain an allowance for loan losses toabsorb probable losses on existing loans that may become uncollectible.  We establish and maintain this allowance bycharging a provision for loan losses against our operating earnings.  In the Loan Portfolio section we haveincluded a detailed discussion of this process, as well as several tablesdescribing our allowance for loan losses and the allocation of this allowanceamong our various categories of loans.

 

In addition toearning interest on our loans and investments, we earn income through fees thatwe charge to our customers. Likewise, we incur other operating expenses aswell.  We describe the various componentsof this noninterest income, as well as our noninterest expense, in the OtherIncome and Other Expense section.

 

**GENERAL**

 

The Companycontinued to grow throughout 2007.  Totalassets increased by $78,816,000, or 21.92 %, and net loans increased by$96,822,000, or 38.44 %.  Much of thisgrowth is attributable to the success of our branch network, especially theoffice in Myrtle Beach and North Myrtle Beach, and the employment of additionallenders and other personnel who were seeking to change employment from CoastalFederal Bank as a result of that bank’s decision to be merged into BB&T.

 

Profitabilitydeclined in 2007 by 27.27 %, from $2,805,000 in 2006 to $2,040,000 in 2007,primarily as a result of an increase in salaries and employee benefits fromemployment of additional personnel and the expenses associated with opening newbranches.  The growth of the loanportfolio resulted in a loan to deposit ratio of 103.33%.  The Company will need to attract additionaldeposits, borrow more money, or a combination of the two to continue expansionof the loan portfolio.  A more detaileddiscussion of the factors contributing to growth and challenges is presentedbelow.

 

8

----

 

**RESULTSOF OPERATIONS**

 

The Companyexperienced an increase of $4,858,000, or 23.79%, in interest income on loansand related fees for the year ended December 31, 2007.  Because of the increase in growth ininterest-bearing deposits, total interest expense increased $3,108,000, or27.96%, to $14,222,000.  Although netinterest income increased significantly during 2007, the Company alsoexperienced a significant increase in noninterest expense.  The primary factor contributing to theincrease of noninterest expense was salaries and employee benefits, whichincreased $1,687,000, or 28.11%, from $6,002,000 for the year ended December 31,2006.  This increase was primarily theresult of the employment of additional lenders and other personnel who webelieve will contribute to the Bank’s future growth and success.  Overall, the Company had net income for theyear ended December 31, 2007 of $2,040,000, compared to $2,805,000 for theyear ended December 31, 2006.  Thisrepresents a decrease in net income of $765,000, or 27.27%.

 

# **ASSETS, LIABILITIES, ANDSHAREHOLDERS’ EQUITY**

# ** **

During the twelve months ended December 31, 2007, total assetsincreased $78,816,000, or 21.92%, when compared to December 31, 2006.  The primary reason for the increase in totalassets was an increase in net loans of $96,822,000, or 38.44%, during 2007 from$251,849,000 at December 31, 2006. Total deposits increased $65,700,000, or 23.88%, from the December 31, 2006 amount of$275,151,000.  Within the deposit area,interest-bearing deposits increased $59,721,000, or 24.01%, andnoninterest-bearing deposits increased $5,979,000, or 22.62%, during 2007.  The increase in deposits was primarily due tothe increase in our time deposits which increased $46,061,000, or 43.48%, from$105,941,000 at December 31, 2006 to $152,002,000 at December 31,2007.

 

# **DISTRIBUTION OF ASSETS,LIABILITIES, AND SHAREHOLDERS’ EQUITY**

# ** **

The Company has sought tomaintain a conservative approach in determining the distribution of its assetsand liabilities. The following table presents the percentage relationships ofsignificant components of the Company’s average balance sheets for the lastthree fiscal years.

 

9

----

 

**Balance Sheet Categories as aPercent of Average Total Assets**

 
| ** **                                      | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **Assets:**                                     |       |       |       |       |       |       |       |
| Interest earning assets:                        |       |       |       |       |       |       |       |
| Federal funds sold                              |       | 2.83       | %          | 5.86       | %          | 6.67       | %          |
| Time deposits with other banks                  |       | —     |       | —     |       | 0.06       |       |
| Investment  securities                          |       | 13.48      |       | 14.36      |       | 13.84      |       |
| Loans                                           |       | 76.86      |       | 71.72      |       | 70.87      |       |
|                                            |       |       |       |       |       |       |       |
| Total interest earning assets                   |       | 93.17      |       | 91.94      |       | 91.44      |       |
|                                            |       |       |       |       |       |       |       |
| Cash and due from banks                         |       | 2.00       |       | 3.06       |       | 3.79       |       |
| Allowance for loan losses                       |       | (0.78      | )          | (0.77      | )          | (0.73      | )          |
| Premises and equipment                          |       | 3.84       |       | 3.75       |       | 3.51       |       |
| Other assets                                    |       | 1.77       |       | 2.02       |       | 1.99       |       |
|                                            |       |       |       |       |       |       |       |
| Total assets                                    | ** ** | **100.00** | **%**      | **100.00** | **%**      | **100.00** | **%**      |
|                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities and shareholders’ equity:**  |       |       |       |       |       |       |       |
| Interest-bearing  liabilities:                  |       |       |       |       |       |       |       |
| Interest-bearing deposits                       |       | 70.08      | %          | 68.82      | %          | 68.17      | %          |
| Federal funds purchased                         |       | 0.09       |       | —     |       | —     |       |
| Advances from the Federal Home Loan Bank        |       | 11.59      |       | 12.57      |       | 13.57      |       |
| Notes Payable                                   |       | 0.43       |       | 0.25       |       | —     |       |
| Debt due to trust                               |       | 1.57       |       | 1.79       |       | 1.94       |       |
|                                            |       |       |       |       |       |       |       |
| Total interest-bearing liabilities              |       | 83.76      |       | 83.43      |       | 83.68      |       |
|                                            |       |       |       |       |       |       |       |
| Noninterest-bearing  deposits                   |       | 8.00       |       | 7.94       |       | 7.95       |       |
| Accrued interest and other liabilities          |       | 0.78       |       | 0.87       |       | 0.71       |       |
|                                            |       |       |       |       |       |       |       |
| Total  liabilities                              |       | 92.54      |       | 92.24      |       | 92.34      |       |
|                                            |       |       |       |       |       |       |       |
| Shareholders’ equity                       |       | 7.46       |       | 7.76       |       | 7.66       |       |
|                                            |       |       |       |       |       |       |       |
| Total liabilities and shareholders’ equity | ** ** | **100.00** | **%**      | **100.00** | **%**      | **100.00** | **%**      |

 

**NETINTEREST INCOME**

 

Earnings are dependent toa large degree on net interest income. Net interest income represents the difference between gross interestearned on earning assets, primarily loans and investment securities, andinterest paid on deposits and borrowed funds. Net interest income is affectedby the interest rates earned or paid and by volume changes in loans, investmentsecurities, deposits, and borrowed funds. The interest rate spread and the net yield on earning assets are twosignificant elements in analyzing the Company’s net interest income.  The interest rate spread is the differencebetween the yield on average earning assets and the rate on averageinterest-bearing liabilities.  The netyield on earning assets is computed by dividing net interest income by theaverage earning assets.

 

For the year ended December 31,2007, net interest income was $14,314,000, an increase of $1,748,000, or13.91%, over net interest income of $12,566,000 in 2006.  Interest income from loans, including fees,was $25,275,000, an increase of $4,858,000, or 23.79%, from 2006 to 2007 asemployment of additional lenders resulted in an increase in loans.    Interest expense for the year ended December 31,2007 was $14,222,000, compared to $11,114,000 for 2006.  This represents a increase of $3,108,000, or27.96%, compared to the prior year.  Theinterest rate spread and net yield on earning assets reflected the pressurecreated by the higher interest rate environment when compared to the previousyear as our customers began to move more of their money out of interest-bearingdemand deposits into time deposit accounts, which increased $46,061,000, or43.48%, throughout 2007.  Our timedeposit accounts have become very attractive to our customers in the currentinterest rate environment.  The net yieldrealized on earning

 

10

----

 

assets was 3.90% for2007, compared to 3.96% in 2006.  Theinterest rate spread was 3.46% and 3.60% in 2007 and 2006, respectively.

 

The following table setsforth, for the periods indicated, the weighted-average yields earned, theweighted-average yields paid, the interest rate spread, and the net yield onearning assets.  The table also indicatesthe average daily balance and the interest income or expense by specificcategories.

 

**AverageBalances, Income and Expenses, and Rates**

 
| ** **                                       | ** ** | **2007**    | ** **  | **2006**    | ** ** | **2005**   | ** ** |
|--------------------------------------------------|------------|-------------|-------------|-------------|------------|------------|------------|
| **Year ended December 31,**       | ** ** | **Average** | ** **  | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Balance** | ** **  | **Expense** | ** ** | **Rate**   | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets:**                                      |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earning Assets:                                  |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities,  taxable                             |       | $           | 42,538      |        | 2,212      |       | 5.20       | % | $ | 39,395 |   | $ | 1,869 |   | 4.74 | % | $ | 35,499 |   | $ | 1,391 |   | 3.92 | % |
| Securities,  nontaxable                          |       | 7,571       |        | 290         |       | 3.83       |       | 7,273 |   | 274 |   | 3.77 |   | 5,897 |   | 225 |   | 3.82 |   |
| Loans (1)                                        |       | 302,965     |        | 25,275      |       | 8.34       |       | 247,614 |   | 20,417 |   | 8.25 |   | 226,528 |   | 16,743 |   | 7.39 |   |
| Federal funds  sold                              |       | 11,161      |        | 586         |       | 5.25       |       | 20,230 |   | 964 |   | 4.77 |   | 21,330 |   | 694 |   | 3.25 |   |
| Time deposits  with other banks                  |       | —      |        | —      |       | —     |       | — |   | — |   | — |   | 183 |   | 4 |   | 2.19 |   |
| Nonmarketable  equity securities                 |       | 3,035       |        | 173         |       | 5.70       |       | 2,933 |   | 156 |   | 5.32 |   | 2,830 |   | 107 |   | 3.78 |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total earning  assets                            |       | 367,270     | ** **  | **$**       | **28,536** |       | 7.77       | % | 317,445 | ** ** | **$** | **23,680** |   | 7.46 | % | 292,267 | ** ** | **$** | **19,164** |   | 6.56 | % |
|                                             |       |        | ** **  | ** **  |       |       |       |   | ** ** | ** ** |   |   |   |   | ** ** | ** ** |   |   |   |
| Cash and due from  banks                         |       | 7,869       |        |        |       |       |       | 10,572 |   |   |   |   |   | 12,113 |   |   |   |   |   |
| Allowance for  loan losses                       |       | (3,069      | )           |        |       |       |       | (2,673 | ) |   |   |   |   | (2,328 | ) |   |   |   |   |
| Premises and  equipment                          |       | 15,157      |        |        |       |       |       | 12,966 |   |   |   |   |   | 11,224 |   |   |   |   |   |
| Other assets                                     |       | 6,962       |        |        |       |       |       | 6,961 |   |   |   |   |   | 6,356 |   |   |   |   |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     | ** ** | **$**       | **394,189** | ** **  | ** ** | ** ** | ** ** |   | **$** | **345,271** | ** ** |   |   |   |   | **$** | **319,632** |   |   |   |   |   |
| ** **                                       |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities:**                                 |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing  Liabilities:                   |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                       |       | $           | 276,269     |        | 11,268     |       | 4.08       | % | $ | 237,599 |   | $ | 8,391 |   | 3.53 | % | $ | 217,905 |   | $ | 5,271 |   | 2.42 | % |
| Other borrowings                                 |       | 53,925      |        | 2,954       |       | 5.48       |       | 50,446 |   | 2,723 |   | 5.40 |   | 49,576 |   | 2,185 |   | 4.41 |   |
| Total  interest-bearing liabilities              |       | 330,194     |        | 14,222      |       | 4.31       | %          | 288,045 |   | 11,114 |   | 3.86 | % | 267,481 |   | 7,456 |   | 2.79 | % |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  deposits                    |       | 31,545      |        |        |       |       |       | 27,415 |   |   |   |   |   | 25,402 |   |   |   |   |   |
| Accrued interest  and other liabilities          |       | 3,060       |        |        |       |       |       | 3,006 |   |   |   |   |   | 2,265 |   |   |   |   |   |
| Shareholders’  equity                       |       | 29,390      |        |        |       |       |       | 26,805 |   |   |   |   |   | 24,484 |   |   |   |   |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | **$**       | **394,189** |        |       |       |       |   | **$** | **345,271** |   |   |   |   |   | **$** | **319,632** |   |   |   |   |   |
|                                             |       | ** **  |        |        |       |       |       | ** ** |   |   |   |   |   | ** ** |   |   |   |   |   |
| Net interest  income/spread                      | ** ** | ** **  |        | **$**       | **14,314** |       | 3.46       | % |   | ** ** | **$** | **12,566** |   | 3.60 | % |   |   | **$** | **11,708** |   | 3.77 | % |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin                             |       |        |        |        |       | 3.90       | %          |   |   |   |   | 3.96 | % |   |   |   |   | 4.01 | % |

 

----

(1)   The effects of loans in nonaccrual status andfees collected are not significant to the computations.

 

11

----

 

**RATE/VOLUMEANALYSIS**

 

Net interestincome can also be analyzed in terms of the impact of changing rates and changingvolume.  The following table describesthe extent to which changes in interest rates and changes in the volume ofearning assets and interest-bearing liabilities have affected the Company’sinterest income and interest expense during the periods indicated. Informationon changes in each category attributable to (i) changes due to volume(change in volume multiplied by prior period rate), (ii) changes due torates (changes in rates multiplied by prior period volume), and (iii) changesin rate and volume (change in rate multiplied by the change in volume) isprovided as follows:

 
| ** **                           | ** ** | **2007 compared to 2006**              | ** ** |
|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **Due to increase (decrease) in** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume(1)**                                         | ** ** | **Rate (1)** | ** ** | **Volume/Rate** | ** ** | **Total** | ** ** |
| Interest income:                     |       |                                                  |       |   |   |   |   |   |   |
| Taxable securities                   |       | $                                                     | 149        |   | $ | 180 |   | $ | 14 |   | $ | 343 |   |
| Nontaxable securities                |       | 11                                                    |       | 5 |   | — |   | 16 |   |
| Loans                                |       | 4,564                                                 |       | 240 |   | 54 |   | 4,858 |   |
| Federal funds sold                   |       | (432                                                  | )          | 98 |   | (44 | ) | (378 | ) |
| Time deposits with other banks       |       |                                                  |       |   |   |   |   |   |   |
| Nonmarketable equity securities      |       | 6                                                     |       | 11 |   | — |   | 17 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest income                |       | 4,298                                                 |       | 534 |   | 24 |   | 4,856 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Interest expense:                    |       |                                                  |       |   |   |   |   |   |   |
| Interest-bearing deposits            |       | 1,366                                                 |       | 1,300 |   | 211 |   | 2,877 |   |
| Other borrowings                     |       | 188                                                   |       | 40 |   | 3 |   | 231 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest expense               |       | 1,554                                                 |       | 1,340 |   | 214 |   | 3,108 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Net interest income                  | ** ** | **$**                                                 | **2,744**  | ** ** | **$** | **(806** | **)** | **$** | **(190** | **)** | **$** | **1,748** | ** ** |

 
| ** **                           | ** ** | **2006 compared to 2005**              | ** ** |
|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **Due to increase (decrease) in** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume(1)**                                         | ** ** | **Rate (1)** | ** ** | **Volume/Rate** | ** ** | **Total** | ** ** |
| Interest income:                     |       |                                                  |       |   |   |   |   |   |   |
| Taxable securities                   |       | $                                                     | 153        |   | $ | 293 |   | $ | 32 |   | $ | 478 |   |
| Nontaxable securities                |       | 53                                                    |       | (3 | ) | (1 | ) | 49 |   |
| Loans                                |       | 1,558                                                 |       | 1,935 |   | 181 |   | 3,674 |   |
| Federal funds sold                   |       | (36                                                   | )          | 323 |   | (17 | ) | 270 |   |
| Time deposits with other banks       |       | (4                                                    | )          | — |   | — |   | (4 | ) |
| Nonmarketable equity securities      |       | 4                                                     |       | 43 |   | 2 |   | 49 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest income                |       | 1,728                                                 |       | 2,591 |   | 197 |   | 4,516 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Interest expense:                    |       |                                                  |       |   |   |   |   |   |   |
| Interest-bearing deposits            |       | 476                                                   |       | 2,424 |   | 219 |   | 3,119 |   |
| Other borrowings                     |       | 38                                                    |       | 491 |   | 9 |   | 538 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest expense               |       | 514                                                   |       | 2,915 |   | 228 |   | 3,657 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Net interest income                  | ** ** | **$**                                                 | **1,214**  | ** ** | **$** | **(324** | **)** | **$** | **(31** | **)** | **$** | **859** | ** ** |

 

----

(1) Volume-rate changes have been allocated to each category based on a consistentbasis between rate and volume.

 

12

----

 

**RATESENSITIVITY**

 

Interest ratespaid on deposits and borrowed funds and interest rates earned on loans andinvestments have generally followed the fluctuations in market rates in 2007and 2006.  However, fluctuations inmarket interest rates do not necessarily have a significant impact on netinterest income, depending on the Company’s interest rate sensitivity position.A rate-sensitive asset or liability is one that can be repriced either up ordown in interest rate within a certain time interval. When a proper balanceexists between rate-sensitive assets and rate-sensitive liabilities, marketinterest rate fluctuations should not have a significant impact on liquidityand earnings.  The larger the imbalance,the greater the interest rate risk assumed and the greater the positive ornegative impact of interest fluctuations on liquidity and earnings.

 

Interest rate sensitivitymanagement is concerned with the management of both the timing and themagnitude of repricing characteristics of interest-earning assets andinterest-bearing liabilities and is an important part of asset/liabilitymanagement.  The objectives of interestrate sensitivity management are to ensure the adequacy of net interest incomeand to control the risks to net interest income associated with movements ininterest rates.  The following table, “InterestRate Sensitivity Analysis,” indicates that, on a cumulative basis, after threethrough twelve months, rate-sensitive liabilities exceeded rate-sensitiveassets, resulting in a twelve-month liability sensitive position.  For a bank with a liability-sensitiveposition, or negative gap, falling interest rates would generally be expectedto have a positive effect on net interest income, and rising interest rateswould generally be expected to have the opposite effect.  The following table presents the Company’srate sensitivity at each of the time intervals indicated as of December 31,2007 and may not be indicative of the Company’s rate-sensitivity position atother points in time:

 

**Interest Rate SensitivityAnalysis**

 
| ** **                                       | ** ** | ** **          | ** ** | **After One** | ** ** | **After Three** | ** ** | ** **          | ** **   | **Greater**       | ** ** | ** **   | ** ** |
|--------------------------------------------------|------------|---------------------|------------|--------------------|------------|----------------------|------------|---------------------|--------------|-------------------|------------|--------------|------------|
| ** **                                       | ** ** | ** **          | ** ** | **Through**        | ** ** | **Through**          | ** ** | ** **          | ** **   | **Than One** | ** ** | ** **   | ** ** |
| **December 31, 2007**                  | ** ** | **Within One** | ** ** | **Three**          | ** ** | **Twelve**           | ** ** | **Within One** | ** **   | **Year or**  | ** ** | ** **   | ** ** |
| **(Dollars in thousands)**             | ** ** | **Month**           | ** ** | **Months**         | ** ** | **Months**           | ** ** | **Year**            | ** **   | **Non-Sensitive** | ** ** | **Total**    | ** ** |
| **Assets**                                       |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Interest-earning  assets                         |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Federal fund  sold                               |       | $                   | 3,655      |               | $          | —               |       | $                   | —       |              | $          | 3,655        |       | $ | — |   | $ | 3,655 |   |
| Loans                                            |       | 172,640             |       | 8,227              |       | 38,341               |       | 219,208             |         | 135,006           |       | 354,214      |       |
| Securities                                       |       | —              |       | —             |       | 187                  |       | 187                 |         | 52,749            |       | 52,936       |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total earning  assets                            |       | 176,295             |       | 8,227              |       | 38,528               |       | 223,050             |         | 187,755           |       | 410,805      |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| **Liabilities**                                  |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Interest-bearing  liabilities:                   |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Interest-bearing  deposits:                      |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Demand deposits                                  |       | 43,299              |       | —             |       | —               |       | 43,299              |         | —            |       | 43,299       |       |
| Savings deposits                                 |       | 113,143             |       | —             |       | —               |       | 113,143             |         | —            |       | 113,143      |       |
| Time deposits                                    |       | 13,969              |       | 47,571             |       | 76,671               |       | 138,211             |         | 13,791            |       | 152,002      |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total  interest-bearing deposits                 |       | 170,411             |       | 47,571             |       | 76,671               |       | 294,653             |         | 13,791            |       | 308,444      |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Other borrowings                                 |       | 15,000              |       | 24,600             |       | 7,700                |       | 47,300              |         | 10,000            |       | 57,300       |       |
| Junior  subordinated debentures                  |       | —              |       | 6,186              |       | —               |       | 6,186               |         | —            |       | 6,186        |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total  interest-bearing liabilities              |       | 185,411             |       | 78,357             |       | 84,371               |       | 348,139             |         | 23,791            |       | 371,930      |       |
|                                             |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Period gap                                       | ** ** | **$**               | **(9,116** | **)**              | **$**      | **(70,130**          | **)**      | **$**               | **(45,843**  | **)**             | **$**      | **(125,089** | **)**      | **$** | **163,964** |   |   |   |
|                                             | ** ** | ** **          | ** ** | ** **         | ** ** | ** **           | ** ** | ** **          | ** **   | ** **        |       |         |       |
| Cumulative gap                                   | ** ** | **$**               | **(9,116** | **)**              | **$**      | **(79,246**          | **)**      | **$**               | **(125,089** | **)**             | **$**      | **(125,089** | **)**      | **$** | **38,875** |   |   |   |
|                                             | ** ** | ** **          | ** ** | ** **         | ** ** | ** **           | ** ** | ** **          | ** **   | ** **        |       |         |       |
| Ratio of  cumulative gap to total earning assets |       | (2.22               | )%         | (19.29             | )%         | (30.45               | )%         | (30.45              | )%           | 9.46              | %          |         |       |
|                                                  |            |                     |            |                    |            |                      |            |                     |              |                   |            |              |            |  |  |  |  |  |  |

 

13

----

 

**PROVISIONFOR LOAN LOSSES**

 

The provision for loanlosses is charged to earnings based upon management’s evaluation of specificloans in its portfolio and general economic conditions and trends in themarketplace.  The 2007 and 2006provisions for loan losses and their related effect of increasing the allowancefor loan losses are related to growth in the loan portfolio.  Please refer to the section “Loan Portfolio”for a discussion of management’s evaluation of the adequacy of the allowancesfor loan losses. In 2007 and 2006, the provisions for loan losses were $985,000and $770,000, respectively.

 

# **NONINTEREST INCOME**

# ** **

Noninterest income was$2,696,000 for the year ended December 31, 2007, an increase of $92,000,or 3.53%, when compared with the year ended December 31, 2006.  The increase is primarily a result of feeincome of $628,000 from residential mortgage loans sold in the secondary marketfor the year ended December 31, 2007 as compared to $542,000 for the sameperiod in 2006, an increase of $86,000, or 15.87%.  This trend may continue as the Bank expandsits branch network, but it could be negatively affected by the recent generaldownturn in the local housing market. This increase in noninterest income is also a result of an increase of$26,000, or 9.00%, in brokerage commissions related to the sale of non-depositinvestment products from $289,000 for the year ended December 31, 2006 to$315,000 for the year ended December 31, 2007.  In addition, service charges on depositaccounts increased $18,000, or 1.26%, from $1,429,000 for the year ended December 31,2006 to $1,447,000 for the year ended December 31, 2007.  Also, other fees and commissions increased$57,000, or 27.67%, from $206,000 for the year ended December 31, 2006 to$263,000 for the year ended December 31, 2007.  We incurred a loss of $92,000 from the saleof several securities available-for-sale early in the year ended December 31,2007, but we were able to recoup this loss during the year in additionalinterest income earned on new securities, which we purchased at higher yields.

 

# **NONINTEREST EXPENSES**

# ** **

Most categories ofnoninterest expenses increased during 2007 due to continued growth of theCompany.  Salaries and employee benefitsincreased $1,687,000, or 28.11%, due to the employment of additional lendersand other personnel needed for the continued growth and success of theBank.  Also, marketing and advertisingexpenses increased $125,000, or 34.15%, from $366,000 for the year ended December 31,2006 to $491,000 for the year ended December 31, 2007.  In addition, furniture and equipment expensesalso increased $188,000, due mainly to the opening of a new branch in the NorthMyrtle Beach area in June, 2007 and a new branch in the Conway area inNovember, 2007.  Other operating expenseswere $2,574,000 for the year ended December 31, 2007, compared to$2,160,000for the year ended December 31, 2006.

 

## **INCOME TAXES**

## ** **

The Company’s income taxexpense for 2007 was $1,052,000, a decrease of $235,000 from the 2006 expenseof $1,287,000. The decrease in the expense results from the decrease in incomebefore taxes in 2007 compared to 2006. The Company’s effective tax rates for the years ended December 31,2007 and 2006 were 34.02% and 31.45%, respectively.

 

# **LIQUIDITY**

# ** **

Liquidity is the abilityto meet current and future obligations through liquidation or maturity ofexisting assets or the acquisition of additional liabilities.  The Company manages both assets andliabilities to achieve appropriate levels of liquidity.  Cash and federal funds sold are the Company’sprimary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cashflow from both deposits and loans.  Theinvestment securities portfolio is the Company’s principal source of secondaryasset liquidity.  However, theavailability of this source of funds is influenced by market conditions.  Individual and commercial deposits are theCompany’s primary source of funds for credit activities.  Although not historically used as principalsources of liquidity, federal funds purchased from correspondent banks andadvances from the Federal Home Loan Bank are other options available tomanagement.

 

14

----

 

As of December 31,2007, the Company had unused lines of credit to purchase federal funds fromunrelated banks totaling $25,800,000. These lines of credit are available on a one to fourteen day basis forgeneral corporate purposes.  The lendershave reserved the right not to renew their respective lines.  Unpledged securities available-for-sale, which totaled $2,644,000 at December 31,2007, also serve as a ready source of liquidity. Management believes that theCompany’s liquidity sources are adequate to meet its operating needs.  The level of liquidity is measured by theloans-to-total borrowed funds ratio, which was at 87.11% and 77.56% at December 31,2007 and 2006, respectively.

 

# **IMPACT OF OFF-BALANCE-SHEETINSTRUMENTS**

# ** **

The Company is aparty to financial instruments with off-balance-sheet risk in the normal courseof business to meet the financing needs of its customers.  These financial instruments consist of commitmentsto extend credit and standby letters of credit. Commitments to extend credit are legally binding agreements to lend to acustomer at predetermined interest rates as long as there is no violation ofany condition established in the contract. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit andinterest rate risk in excess of the amount recognized in the balance sheets.  The Company’s exposure to credit loss in theevent of nonperformance by the other party to the instrument is represented bythe contractual notional amount of the instrument.  Since certain commitments are expected toexpire without being drawn upon, the total commitment amounts do notnecessarily represent future cash requirements. Letters of credit are conditional commitments issued to guarantee acustomer’s performance to a third party and have essentially the same creditrisk as other lending facilities. Standby letters of credit often expire without being used.  Management believes that through varioussources of liquidity, the Company has the necessary resources to meet obligationsarising from these financial instruments.

 

The Company usesthe same credit underwriting procedures for commitments to extend credit andstandby letters of credit as for on-balance-sheet instruments.  The credit worthiness of each borrower isevaluated and the amount of collateral, if deemed necessary, is based on thecredit evaluation.  Collateral held forcommitments to extend credit and standby letters of credit varies but mayinclude accounts receivable, inventory, property, plant, equipment, andincome-producing commercial properties, as well as liquid assets such as timedeposit accounts, brokerage accounts, and cash value of life insurance.

 

The Company is notinvolved in off-balance-sheet contractual relationships, other than thosedisclosed in this report, which it believes could result in liquidity needs orother commitments or that could significantly impact earnings.

 

As of December 31, 2007, commitments to extend credit totaled$66,575,000 and standby letters of credit totaled $761,000.

 

The following table sets forth the length of time until maturity forunused commitments to extend credit and standby letters of credit at December 31,2007.

 
| ** **                           | ** ** | ** ** | ** ** | **After One** | ** ** | **After Three** | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|--------------------|------------|----------------------|------------|------------|------------|-------------------|------------|------------|------------|
| ** **                           | ** ** | **Within** | ** ** | **Through**        | ** ** | **Through**          | ** ** | **Within** | ** ** | **Greater**       | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **One**    | ** ** | **Three**          | ** ** | **Twelve**           | ** ** | **One**    | ** ** | **Than**          | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Month**  | ** ** | **Months**         | ** ** | **Months**           | ** ** | **Year**   | ** ** | **One Year** | ** ** | **Total**  | ** ** |
|                                 |       |       |       |               |       |                 |       |       |       |              |       |       |       |
| Unused  commitments to extend credit |       | $          | 1,363      |               | $          | 6,886                |       | $          | 30,249     |              | $          | 38,498     |       | $ | 28,077 |   | $ | 66,575 |   |
| Standby letters  of credit           |       | —     |       | 114                |       | 645                  |       | 759        |       | 2                 |       | 761        |       |
|                                 |       |       |       |               |       |                 |       |       |       |              |       |       |       |
| Totals                               | ** ** | **$**      | **1,363**  | ** **         | **$**      | **7,000**            | ** ** | **$**      | **30,894** | ** **        | **$**      | **39,257** | ** ** | **$** | **28,079** | ** ** | **$** | **67,336** | ** ** |

 

The Company entered into interest rate swap agreements associated withFederal Home Loan Bank advances during the third quarter of 2003.  The interest rate swaps effectively convertedthe fixed interest rates on the advances to a variable rate. The notionalamount of advances involved in this transaction totaled $14,600,000.  The unrealized loss related to the interestrate swaps was $339,000 at December 31, 2007 and a cumulative negativeeffect of $89,453 to

 

15

----

 

earnings.  The Company believesthat the hedging of such debt was very effective as management protectedagainst further declines in interest rates as well as a continuation ofinterest rates at or near their low levels at the time the transaction wasconsummated.

 

# **IMPACT OF INFLATION ANDCHANGING PRICES**

# ** **

The financial statementsand related financial data presented herein have been prepared in accordancewith generally accepted accounting principles which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering changes in relative purchasing power over time due toinflation.  Unlike most industrialcompanies, virtually all of the assets and liabilities of a financialinstitution are monetary in nature.  As aresult, interest rates generally have a more significant impact on a financialinstitution’s performance than does the effect of inflation.

 

While the effect ofinflation on a bank is normally not as significant as its influence on thosebusinesses that have large investments in plant and inventories, it does havean effect.  Interest rates generallyincrease as the rate of inflation increases, but the magnitude of the change inrates may not be the same.  Whileinterest rates have traditionally moved with inflation, the effect on income isdiminished because both interest earned on assets and interest paid onliabilities vary directly with each other unless the Company is in a highliability sensitive position.  Also,general increases in the price of goods and services will result in increasedoperating expenses.

 

# **CAPITAL RESOURCES**

# ** **

The Company usesseveral indicators of capital strength. The most commonly used measure is average common equity to average assets,which was 7.46% in 2007 compared to 7.76% in 2006.  The change in this ratio reflects an increasein the Company’s assets and a decrease in earnings in 2007 as compared to 2006.

 

The Company and the Bankare subject to various regulatory capital requirements administered by thefederal banking agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea material effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany and the Bank must meet specific capital guidelines that involvequantitative measures of their assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accountingpractices.  The capital amounts andclassifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

The Federal Reserveguidelines contain an exemption from the capital requirements for “small bankholding companies” which in 2006 were amended to cover most bank holdingcompanies with less than $500 million in total assets that do not have amaterial amount of debt or equity securities outstanding registered with theSEC.  Although our class of common stockis registered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the Federal Reserve Board will interpret its new guidelines to meanthat we qualify as a small bank holding company.  Nevertheless, our Company remains subject tothese capital requirements.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company must meetspecific capital guidelines that involve quantitative measures of the Company’sassets, liabilities, and certain off-balance-sheet items as calculated underregulatory accounting practices.  TheCompany’s capital amounts and classifications are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.  Regardless, our Company is “wellcapitalized” under these minimum capital requirements as set per bankregulatory agencies.

 

16

----

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum ratios of Tier 1 and total capital as a percentageof assets and off-balance-sheet exposures, adjusted for risk weights rangingfrom 0% to 100%.  Tier 1 capital consistsof common shareholders’ equity, excluding the unrealized gain or loss onsecurities available-for-sale, minus certain intangible assets.  Tier 2 capital consists of the allowance forloan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists ofthe sum of Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 and 8% for totalrisk-based capital.

 

The Company and the Bankare also required to maintain capital at a minimum level based on quarterlyaverage assets, which is known as the leverage ratio.  Only the strongest banks are allowed tomaintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios1% to 2% above the minimum.

 

As of December 31,2007, the most recent notifications from the Bank’s primary regulatorcategorized the Bank as well-capitalized under the regulatory framework forprompt corrective action.  There are noconditions or events that management believes have changed the Bank’s category.

 

# **The Company and the Bank are required to maintain certain risk-basedand leverage ratios.  The Company and theBank exceeded these regulatory capital ratios at December 31, 2007, 2006,and 2005 as set forth in the following tables.**

# ** **

| **December 31,**                                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
|---------------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| **(Dollars in thousands)**                                          | ** ** | **2007**   | ** **  | **2006**   | ** ** | **2005**    | ** ** |
| **The  Company**                                                    |       |       |        |       |       |        |       |
| Tier 1 capital                                                      |       | $          | 36,423      |       | $          | 34,773      |       | $ | 31,855 |   |
| Tier 2 capital                                                      |       | 3,323      |        | 2,718      |       | 2,569       |       |
|                                                                |       |       |        |       |       |        |       |
| Total qualifying  capital                                           | ** ** | **$**      | **39,746**  | ** ** | **$**      | **37,491**  | ** ** | **$** | **34,424** | ** ** |
|                                                                | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
| Risk-adjusted  total assets (including off-balance-sheet exposures) |       | **$**      | **361,051** | ** ** | **$**      | **270,498** | ** ** | **$** | **249,307** | ** ** |
|                                                                |       | ** ** |        | ** ** |       | ** **  |       |
| Tier 1  risk-based capital ratio                                    |       | 10.88      | %           | 12.86      | %          | 12.78       | %          |
| Total risk-based  capital ratio                                     |       | 11.87      | %           | 13.86      | %          | 13.81       | %          |
| Tier 1 leverage  ratio                                              |       | 9.45       | %           | 10.07      | %          | 9.61        | %          |
|                                                                |       |       |        |       |       |        |       |
| **The  Bank**                                                       |       |       |        |       |       |        |       |
| Tier 1 capital                                                      |       | $          | 36,100      |       | $          | 33,885      |       | $ | 30,664 |   |
| Tier 2 capital                                                      |       | 3,534      |        | 2,718      |       | 2,569       |       |
|                                                                |       |       |        |       |       |        |       |
| Total qualifying  capital                                           | ** ** | **$**      | **39,634**  | ** ** | **$**      | **36,603**  | ** ** | **$** | **33,233** | ** ** |
|                                                                | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
| Risk-adjusted  total assets (including off-balance-sheet exposures) |       | **$**      | **360,346** | ** ** | **$**      | **266,373** | ** ** | **$** | **248,743** | ** ** |
|                                                                |       | ** ** |        | ** ** |       | ** **  |       |
| Tier 1  risk-based capital ratio                                    |       | 10.02      | %           | 12.72      | %          | 12.33       | %          |
| Total risk-based  capital ratio                                     |       | 11.00      | %           | 13.74      | %          | 13.36       | %          |
| Tier 1 leverage  ratio                                              |       | 8.55       | %           | 9.71       | %          | 9.25        | %          |

 

The Company does notexpect to pay cash dividends to shareholders during 2008.

 

17

----

 

# **INVESTMENT PORTFOLIO**

# ** **

Management classifiesinvestment securities as either held-to-maturity or available-for-sale based ontheir intentions and the Company’s ability to hold them until maturity.  In determining such classifications,securities that management has the positive intent and the Company has theability to hold until maturity are classified as held-to-maturity and carriedat amortized cost.  All other securitiesare designated as available-for-sale and carried at estimated fair value withunrealized gains and losses included in shareholders’ equity on an after-taxbasis.  As of December 31, 2007 and2006, all securities were classified as available-for-sale.

 

The followingtables summarize the carrying value of investment securities as of theindicated dates and the weighted-average yields of those securities at December 31,2007.

 

**Investment Securities PortfolioComposition**

 
| **December 31,**                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars in thousands)**                 | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
| Government-Sponsored Enterprises           |       | $          | 20,447     |       | $          | 19,092     |       | $ | 8,437 |   |
| Obligations of state and local governments |       | 7,730      |       | 7,435      |       | 5,734      |       |
| Mortgage-backed securities                 |       | 21,432     |       | 23,449     |       | 23,242     |       |
| Equity securities available-for-sale       |       | —     |       | 854        |       | 820        |       |
| Nonmarketable equity securities            |       | 3,327      |       | 2,948      |       | 2,867      |       |
|                                       |       |       |       |       |       |       |       |
| Total securities                           | ** ** | **$**      | **52,936** | ** ** | **$**      | **53,778** | ** ** | **$** | **41,100** | ** ** |

 

**Investment Securities PortfolioMaturity Schedule**

 
| ** **                                       | ** ** | **Available-for-Sale** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| **December 31, 2007**                            | ** ** | **Carrying**           | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**                       | ** ** | **Amount**             | ** ** | **Yield** | ** ** |
| Government-Sponsored Enterprises due:            |       |                   |       |   |   |
| After one year but within five years             |       | 1,591                  |       | 5.650 | % |
| After five years but within ten years            |       | 6,318                  |       | 5.710 | % |
| After ten years                                  |       | 12,538                 |       | 5.538 | % |
|                                             |       |                   |       |   |   |
| Obligations of states and local governments due: |       |                   |       |   |   |
| Less than one year                               |       | 187                    |       | 3.052 | % |
| After one year but within five years             |       | 1,474                  |       | 3.944 | % |
| After five years but within ten years            |       | 4,150                  |       | 4.024 | % |
| After ten years                                  |       | 1,919                  |       | 3.681 | % |
|                                             |       |                   |       |   |   |
|                                             |       | 7,730                  |       | 3.900 | % |
|                                             |       |                   |       |   |   |
| Mortgage-backed securities                       |       | 19,660                 |       | 5.037 | % |
|                                             |       |                   |       |   |   |
| Collateralized Mortgage Obligation (CMOs)        |       | 1,772                  |       | 5.289 | % |
|                                             |       |                   |       |   |   |
| Equities available-for-sale                      |       | —                 |       | — |   |
| ** **                                       | ** ** | **$**                  | **49,609** |   | **5.102** | **%** |
|                                                  |            |                        |            |  |  |  |

 

18

----

 

# **LOAN PORTFOLIO**

# ** **

Management believes theloan portfolio is adequately diversified. There are no foreign loans, and agricultural loans as of December 31,2007 are limited.  There are no significantconcentrations of loans in any particular individuals or industry or group ofrelated individuals or industries.

 

The Company hasexperienced continued growth of its loan portfolio throughout 2007 and 2006,resulting in increases of $97,639,000 and $19,489,000, respectively.  Management has concentrated on maintainingquality in the loan portfolio. The loan-to-deposit ratio is used to monitor afinancial institution’s potential profitability and efficiency of assetdistribution and utilization.  Generally,a higher loan-to-deposit ratio is indicative of higher interest income sinceloans typically yield a higher return than other interest-earning assets.  The loan-to-deposit ratios were 103.33% and92.52% at December 31, 2007 and 2006, respectively.  The loans-to-total borrowed funds ratio was87.11% and 77.56% at December 31, 2007 and 2006, respectively.  Management intends to deploy available fundsto loans to the extent it deems prudent to achieve its targeted ratio of loansto deposits; however, there can be no assurance that management will be able toexecute its strategy or that loan demand will continue to support growth.

 

## **Loan Portfolio Composition**

## ** **

| **December 31,**                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
|------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|------------|-------------|------------|------------|
| **(Dollars in thousands)**                     | ** ** | **2007**   | ** **  | **2006**   | ** ** | **2005**    | ** ** | **2004**   | ** **  | **2003**   | ** ** |
| Real estate - construction andland development |       | $          | 59,084      |       | $          | 28,124      |       | $          | 18,686      |       | $          | 8,026 |   | $ | 13,845 |   |
| Real estate - mortgage andcommercial           |       | 201,448    |        | 147,156    |       | 133,527     |       | 110,584    |        | 89,801     |       |
| Agricultural                                   |       | 7,221      |        | 6,099      |       | 5,141       |       | 6,136      |        | 6,891      |       |
| Commercial and industrial                      |       | 64,019     |        | 54,313     |       | 55,909      |       | 62,991     |        | 48,479     |       |
| Consumer                                       |       | 18,535     |        | 18,267     |       | 21,168      |       | 22,881     |        | 27,325     |       |
| All other loans (includingoverdrafts)          |       | 1,899      |        | 608        |       | 647         |       | 2,186      |        | 5,488      |       |
|                                           |       |       |        |       |       |        |       |       |        |       |       |
| Total gross loans                              | ** ** | **$**      | **352,206** | ** ** | **$**      | **254,567** | ** ** | **$**      | **235,078** | ** ** | **$**      | **212,804** | ** ** | **$** | **191,829** | ** ** |

 

## **Credit Risk Management**

## ** **

Credit risk entails bothgeneral risk, which is inherent in the process of lending, and risk that isspecific to individual borrowers.  Themanagement of credit risk involves the processes of loan underwriting and loanadministration.  The Company seeks tomanage credit risk through a strategy of making loans within the Company’sprimary marketplace and within the Company’s limits of expertise.  Although management seeks to avoidconcentrations of credit by loan type or industry through diversification, asubstantial portion of the borrowers’ ability to honor the terms of their loansis dependent on the business and economic conditions in Horry and MarionCounties in South Carolina and Columbus and Brunswick Counties in NorthCarolina.  Additionally, since realestate is considered by the Company as the most desirable nonmonetarycollateral, a significant portion of the Company’s loans are collateralized byreal estate; however, the cash flow of the borrower or the business enterpriseis generally considered as the primary source of repayment.  Generally, the value of real estate is notconsidered by the Company as the primary source of repayment for performingloans.  The Company also seeks to limittotal exposure to individual and affiliated borrowers.  The Company seeks to manage risk specific toindividual borrowers through the loan underwriting process and through anongoing analysis of the borrower’s ability to service the debt as well as thevalue of the pledged collateral.

 

The Company’s loanofficers and loan administration staff are charged with monitoring the Company’sloan portfolio and identifying changes in the economy or in a borrower’scircumstances which may affect the ability to repay the debt or the value ofthe pledged collateral.  In order toassess and monitor the degree of risk in the Company’s loan portfolio, severalcredit risk identification and monitoring processes are utilized.  The Company assesses credit risk initially throughthe assignment of a risk grade to each loan based upon an assessment of theborrower’s financial capacity to service the debt and the presence and value ofany collateral.

 

19

----

# ** **

Credit grading is adjusted during the life of the loan to reflecteconomic and individual changes having an impact on the borrowers’ abilities tohonor the terms of their commitments. Management uses the risk grades as a tool for identifying known and inherentlosses in the loan portfolio and for determining the adequacy of the allowancefor loan losses.

 

**Maturities and Sensitivity of Loans to Changes in Interest Rates:**

 

The following table summarizes the loan maturity distribution, by type,at December 31, 2007 and related interest rate characteristics:

 
| ** **                                       | ** ** | ** **        | ** **  | **Over**            | ** ** | ** **         | ** ** | ** ** | ** **  |
|--------------------------------------------------|------------|-------------------|-------------|---------------------|------------|--------------------|------------|------------|-------------|
| ** **                                       | ** ** | ** **        | ** **  | **One Year**   | ** ** | ** **         | ** ** | ** ** | ** **  |
| **December 31, 2007**                  | ** ** | **One Year** | ** **  | **Through**         | ** ** | **Over Five** | ** ** | ** ** | ** **  |
| **(Dollars in thousands)**             | ** ** | **or Less**  | ** **  | **Five Years** | ** ** | **Years**          | ** ** | **Total**  | ** **  |
| Real estate - construction and land  development |       | $                 | 33,560      |                | $          | 23,854             |       | $          | 1,670       |   | $ | 59,084 |   |
| Real estate - other                              |       | 68,527            |        | 85,235              |       | 47,686             |       | 201,448    |        |
| Agricultural                                     |       | 2,487             |        | 2,789               |       | 1,945              |       | 7,221      |        |
| Commercial and industrial                        |       | 33,229            |        | 24,324              |       | 6,466              |       | 64,019     |        |
| Consumer                                         |       | 5,994             |        | 11,675              |       | 866                |       | 18,535     |        |
| All other loans (including overdrafts)           |       | 841               |        | 604                 |       | 454                |       | 1,899      |        |
| ** **                                       | ** ** | **$**             | **144,638** | ** **          | **$**      | **148,481**        | ** ** | **$**      | **59,087**  | ** ** | **$** | **352,206** |   |
| ** **                                       | ** ** | ** **        | ** **  | ** **          | ** ** | ** **         | ** ** | ** ** |        |
| Loans maturing after one year with:              |       |              |        |                |       |               |       |       |        |
| Fixed interest rates                             |       |              |        |                |       |               |       | $          | 133,946     |   |
| Floating interest rates                          |       |              |        |                |       |               |       | 73,623     |        |
| ** **                                       |       | ** **        |        | ** **          |       | ** **         |       | **$**      | **207,569** |   |

## ** **

## **Risk Elements**

## ** **

Loans are defined as impaired when it is probable that a creditor willbe unable to collect all amounts due according to the contractual terms of theloan agreement.  Impairment of a loan isbased on the present value of the expected future cash flows discounted at theloan’s effective interest rate or at the fair value of the collateral if theloan is collateral dependent.

 

Loans on the Company’s problem loan watch list are consideredpotentially impaired loans.  These loansare evaluated in determining whether all outstanding principal and interest areexpected to be collected.  Loans are notconsidered impaired if a minimal delay occurs and all amounts due, includingaccrued interest at the contractual interest rate for the period of delay, areexpected to be collected.

 

The following table sets forth our nonperforming assets for the datesindicated.

 
| **Nonperforming Assets**                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **(Dollars in thousands)**                        | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
| Nonaccrual loans (includes impaired loans)                  |       | $          | 2,696      |       | $          | 760        |       | $          | 2,044      |       | $          | 4,295 |   | $ | 1,641 |   |
| Restricted                                                  |       | —     |       | —     |       | —     |       | —     |       | —     |       |
| Total nonperforming loans                                   |       | 2,696      |       | 760        |       | 2,044      |       | 4,295      |       | 1,641      |       |
| Other real estate owned                                     |       | 338        |       | 95         |       | 485        |       | 964        |       | 390        |       |
| Total nonperforming assets                                  | ** ** | **$**      | **3,034**  | ** ** | **$**      | **855**    | ** ** | **$**      | **2,529**  | ** ** | **$**      | **5,259** | ** ** | **$** | **2,031** | ** ** |
|                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans 90 days or more past due and still  accruing interest |       | $          | —     |       | $          | 1,714      |       | $          | 843        |       | $          | 378 |   | $ | 2,315 |   |
|                                                        |       |       |       |       |       |       |       |       |       |       |       |   |   |   |   |   |
| Nonperforming assets to period end loans                    |       | 0.86       | %          | 0.33       | %          | 1.08       | %          | 2.47       | %          | 1.06       | %          |

 

20

----

 

For loans to be inexcess of 90 days delinquent and still accruing interest, the borrowers must beeither remitting payments although not able to get current, liquidation onloans deemed to be well secured must be near completion, or the Company musthave a reason to believe that correction of the delinquency status by theborrower is near.  The amount of bothnonaccrual loans and loans past due 90 days or more were considered incomputing the allowance for loan losses as of December 31, 2007.  During the year 2007 management made thedecision to place all loans which are in excess of 90 days delinquent onnonaccrual status.  If the borrower isable to bring the account current, the loan is then placed back on regularaccrual status.  This decision resultedin an increase in the ratio of nonperforming assets to period end loans as of December 31,2006, although the ratio of loans in excess of 90 days delinquent to totalloans actually declined on December 31, 2007 as compared to December 31,2006.  Management does not expect toincur significant losses from the nonperforming loans.  Management expects that future nonaccrualloan balances should more closely mirror the balances as of December 31,2007.

 

**Summary of Loan Loss Experience**

 
| **(Dollars in thousands)**                         | ** ** | **2007**   | ** **  | **2006**   | ** ** | **2005**    | ** ** | **2004**   | ** **  | **2003**   | ** ** |
|--------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|------------|-------------|------------|------------|
|                                                         | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
| Total loans outstanding at end of period                     | ** ** | **$**      | **354,214** | ** ** | **$**      | **256,800** | ** ** | **$**      | **235,669** | ** ** | **$**      | **212,808** | ** ** | **$** | **192,304** | ** ** |
| Average loans outstanding                                    | ** ** | **$**      | **302,965** | ** ** | **$**      | **247,614** | ** ** | **$**      | **226,528** | ** ** | **$**      | **211,028** | ** ** | **$** | **182,445** | ** ** |
|                                                         | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
| Balance of allowance for loan losses at  beginning of period |       | $          | 2,718       |       | $          | 2,569       |       | $          | 2,155       |       | $          | 1,774 |   | $ | 1,452 |   |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Charge-offs:                                                 |       |       |        |       |       |        |       |       |        |       |       |
| Real estate                                                  |       | —     |        | 4          |       | 122         |       | 354        |        | 27         |       |
| Commercial                                                   |       | 54         |        | 418        |       | 382         |       | 286        |        | 368        |       |
| Consumer and credit card                                     |       | 165        |        | 289        |       | 287         |       | 328        |        | 175        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Total charge-offs                                            |       | 219        |        | 711        |       | 791         |       | 968        |        | 570        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Recoveries of loans previous charged-off                     |       | 51         |        | 90         |       | 135         |       | 64         |        | 35         |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Net charge-offs                                              |       | 168        |        | 621        |       | 656         |       | 904        |        | 535        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Provision charged to operations                              |       | 985        |        | 770        |       | 1,070       |       | 1,285      |        | 857        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Balance of allowance for loan losses at end  of period       | ** ** | **$**      | **3,535**   | ** ** | **$**      | **2,718**   | ** ** | **$**      | **2,569**   | ** ** | **$**      | **2,155** | ** ** | **$** | **1,774** | ** ** |
|                                                         | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
| Ratios:                                                      |       |       |        |       |       |        |       |       |        |       |       |
| Net charge-offs to average loans  outstanding                |       | 0.06       | %           | 0.25       | %          | 0.29        | %          | 0.43       | %           | 0.30       | %          |
| Net charge-offs to loans at end of year                      |       | 0.05       | %           | 0.24       | %          | 0.28        | %          | 0.42       | %           | 0.28       | %          |
| Allowance for loan losses to average loans                   |       | 1.17       | %           | 1.10       | %          | 1.13        | %          | 1.02       | %           | 0.97       | %          |
| Allowance for loan losses to loans at end  of year           |       | 1.00       | %           | 1.06       | %          | 1.09        | %          | 1.01       | %           | 0.92       | %          |
| Net charge-offs to allowance for loan  losses                |       | 4.75       | %           | 22.85      | %          | 25.54       | %          | 41.95      | %           | 30.16      | %          |
| Net charge-offs to provisions for loan  losses               |       | 17.06      | %           | 80.65      | %          | 61.31       | %          | 70.35      | %           | 62.43      | %          |

 

21

----

 

Management has established an allowance for loan losses through aprovision for loan losses charged to expense. The allowance represents an amount which management believes will beadequate to absorb probable losses on existing loans that may becomeuncollectible.  Management does notallocate specific percentages of our allowance for loan losses to the variouscategories of loans but evaluates the adequacy on an overall portfolio basisutilizing several factors.  The primaryfactor considered is the credit risk grading system, which is applied to eachloan.  The amount of both nonaccrualloans and loans past due 90 days or more is also considered.  The historical loan loss experience, the sizeof our lending portfolio, and current and anticipated economic conditions isalso considered in determining the provision for loan losses. The amount of theallowance is adjusted periodically based on changing circumstances.  Recognized losses are charged to theallowance for loan losses, while subsequent recoveries are added to theallowance.

 

Management regularly monitors past due and classified loans.  However, it should be noted that noassurances can be made that future charges to the allowance for loan losses orprovisions for loan losses may not be significant to a particular accountingperiod.  At December 31, 2007 and2006, management considers the allowances for loan losses adequate based on itsjudgments, evaluations, and analysis of the loan portfolio.

 

Management’s judgment as to the adequacy of the allowance is based upona number of assumptions about future events which it believes to be reasonable,but which may or may not prove to be accurate. Because of the inherent uncertainty of assumptions made during theevaluation process, there can be no assurance that loan losses in futureperiods will not exceed the allowance for loan losses or that additionalallocations will not be required.  Ourlosses will undoubtedly vary from our estimates, and there is a possibilitythat charge-offs in future periods will exceed the allowance for loan losses asestimated at any point in time.

 

# **AVERAGE DAILY DEPOSITS**

# ** **

The followingtable summarizes the Company’s average daily deposits during the years ended December 31,2007, 2006, and 2005.  These totalsinclude time deposits $100,000 and over, which at December 31, 2007totaled $64,044,000.  Of this total,scheduled maturities within three months were $32,711,000; over three throughtwelve months were $31,014,000; and over twelve months were $319,000.

 
| ** **                            | ** ** | **2007**    | ** **  | **2006**    | ** ** | **2005**    | ** ** |
|---------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| ** **                            | ** ** | ** **  | ** **  | **Average** | ** ** | ** **  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                            | ** ** | **Average** | ** **  | **Rate**    | ** ** | **Average** | ** ** | **Rate** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| ** **                            | ** ** | **Amount**  | ** **  | **Paid**    | ** ** | **Amount**  | ** ** | **Paid** | ** ** | **Amount** | ** ** | **Paid** | ** ** |
|                                  |       |        |        |        |       |        |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand            |       | 31,545      |        | 0.00        | %          | $           | 27,415     |   | 0.00 | % | $ | 25,402 |   | 0.00 | % |
| Interest-bearing transaction accounts |       | 47,171      |        | 1.19        |       | 65,145      |       | 1.73 |   | 88,477 |   | 1.88 |   |
| Money market savings account          |       | 102,532     |        | 4.54        |       | 67,634      |       | 4.51 |   | 29,308 |   | 2.74 |   |
| Other savings accounts                |       | 5,402       |        | 1.22        |       | 5,846       |       | 1.27 |   | 6,146 |   | 0.86 |   |
| Time deposits                         |       | 121,164     |        | 4.94        |       | 98,974      |       | 4.19 |   | 93,974 |   | 2.93 |   |
|                                  |       |        |        |        |       |        |       |   |   |   |   |   |   |
| Total deposits                        | ** ** | **$**       | **307,814** | ** **  | ** ** | ** **  | **$**      | **265,014** |   |   |   | **$** | **243,307** |   |   |   |
|                                       |            |             |             |             |            |             |            |  |  |  |  |  |  |  |  |  |

 

22

----

 

**ADVANCES FROM THE FEDERAL HOME LOAN BANK**

 

The following table summarizes the Company’sshort-term borrowings for the years ended December 31, 2007, 2006 and2005.

 
| ** **                           | ** ** | **Maximum**        | ** ** | ** **  | ** ** | **Weighted** | ** ** | ** **            | ** ** |
|--------------------------------------|------------|--------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|
| ** **                           | ** ** | **Outstanding**    | ** ** | ** **  | ** ** | **Average**  | ** ** | ** **            | ** ** |
| ** **                           | ** ** | **at any**    | ** ** | **Average** | ** ** | **Interest** | ** ** | **Balance**           | ** ** |
| **(Dollars in thousands)** | ** ** | **Month End** | ** ** | **Balance** | ** ** | **Rate**     | ** ** | **December 31,** | ** ** |
| **2007**                             |       |               |       |        |       |         |       |                  |       |
| Advances from Federal Home Loan Bank |       | $                  | 52,300     |        | $          | 45,674       |       | 4.46                  | %          | $ | 52,300 |   |
|                                 |       |               |       |        |       |         |       |                  |       |
| **2006**                             |       |               |       |        |       |         |       |                  |       |
| Advances from Federal Home Loan Bank |       | $                  | 43,390     |        | $          | 43,390       |       | 4.37                  | %          | $ | 43,390 |   |
|                                 |       |               |       |        |       |         |       |                  |       |
| **2005**                             |       |               |       |        |       |         |       |                  |       |
| Advances from Federal Home Loan Bank |       | $                  | 43,390     |        | $          | 43,390       |       | 4.27                  | %          | $ | 43,390 |   |

 

Advances from the FederalHome Loan Bank are collateralized by one-to-four family residential mortgageloans, certain commercial real estate loans, certain securities in the Bank’sinvestment portfolio and the Company’s investment in Federal Home Loan Bankstock.  Although we expect to continueusing Federal Home Loan Bank advances as a secondary funding source, core depositswill continue to be our primary funding source. Of the $52,300,000 advances from Federal Home Loan Bank outstanding at December 31,2007, $6,700,000 have scheduled principal reductions in 2008, $14,600,000 in2010, $5,000,000 in 2011 and the remainder after five years.

 

# **Asdiscussed in the notes to the financial statements, the Company has enteredinto interest rate swap agreements associated with Federal Home Loan Bankadvances maturing on March 1, 2010, May 24, 2010 and March 22,2011.  The interest rate swapseffectively converted the fixed interest rates on the advances to a variablerate.  The variable rate was 5.21% at December 31,2007**andis based on the three month LIBOR index.

# ** **

**JUNIORSUBORDINATED DEBENTURES**

 

On December 21,2004, HCSB Financial Trust I (the “ Trust”), a non-consolidated subsidiary ofthe Company, issued and sold a total of 6,000 trust preferred securities, with$1,000 liquidation amount per capital security (the “Capital Securities”), toinstitutional buyers in a pooled trust preferred issue.  The Capital Securities, which are reported onthe consolidated balance sheet as junior subordinated debentures, generatedproceeds of $6 million.  The Trust loanedthese proceeds to the Company to use for general corporate purposes.  The junior subordinated debentures qualify asTier 1 capital under Federal Reserve Board guidelines, subject tolimitations.  See Note 11 to theconsolidated financial statements for more information about the terms of thejunior subordinated debentures.

 

Debt issuancecosts, net of accumulated amortization, from junior subordinated debenturestotaled $98,694 and $102,361 at December 31, 2007 and 2006, respectively,and are included in other assets on the consolidated balance sheet.  Amortization of debt issuance costs fromjunior subordinated debentures totaled $3,667 for the years ended December 31,2007, and December 31, 2006, and are reported in other expenses on theconsolidated income statement for the years ended December 31, 2007, and December 31,2006.

 

# **RETURN ON EQUITY AND ASSETS**

# ** **

The following table shows the return on average assets (net incomedivided by average total assets), return on average equity (net income dividedby average daily equity), and equity to assets ratio (average daily equitydivided by average total assets) for the period indicated.  Since its inception, the Company has not paidcash dividends.

 
| ** **               | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Return on average assets |       | 0.52       | %          | 0.81       | %          | 0.75       | %          |
| Return on average equity |       | 6.94       | %          | 10.46      | %          | 9.83       | %          |
| Equity to assets ratio   |       | 7.46       | %          | 7.77       | %          | 7.66       | %          |

 

23

----

 

# **ACCOUNTING AND FINANCIALREPORTING ISSUES**

# ** **

We have adopted various accounting policies which govern theapplication of accounting principles generally accepted in the United States inthe preparation of our financial statements. Our significant accounting policies are described in the footnotes tothe consolidated financial statements at December 31, 2007, as filed onour annual report on Form 10-KSB. Certain accounting policies involvesignificant judgments and assumptions by us which have a material impact on thecarrying value of certain assets and liabilities.  We consider these accounting policies to becritical accounting policies. The judgments and assumptions we use are based onhistorical experience and other factors, which we believe to be reasonableunder the circumstances.  Because of thenature of the judgments and assumptions we make, actual results could differfrom these judgments and estimates which could have a material impact on ourcarrying values of assets and liabilities and our results of operations.

 

We believe the allowance for loan losses is a critical accountingpolicy that requires the most significant judgments and estimates used inpreparation of our consolidated financial statements.  Refer to the portion of this discussion thataddresses our allowance for loan losses for a description of our processes andmethodology for determining our allowance for loan losses.

 

# **INDUSTRY DEVELOPMENTS**

# ** **

**Sarbanes-OxleyAct of 2002**

The Congress of theUnited States of America passed the Sarbanes-Oxley Act in 2002 in the aftermathof corporate scandals among several major publicly traded corporations.  The intent of the Act was to legislatecorporate governance and better ascertain the accuracy of financial reportingby companies regulated by the Securities and Exchange Commission.

 

Section 404 of theSarbanes-Oxley Act, which becomes effective for the Company in 2008, requiresthat the Company adopt and maintain effective internal controls that will, amongother things, permit the preparation of financial statements in conformity withaccounting principles generally accepted in the United States of America.  Management of the Company has theresponsibility to adopt sound accounting policies, maintain an adequate andefficient accounting system, safeguard assets and devise policies to ensurethat the Company complies with applicable laws and regulations.

 

To assist in this processthe company has purchased software from the national accounting firm of CroweChizek and retained the services of Elliott Davis, LLC and Co Source, LLC towork with management and participate in the Section 404 process.  Elliott Davis, LLC will perform only thoseservices in this regard that are acceptable by the Public Company AccountingOversight Board (PCAOB).  Compliance withSection 404 of the Sarbanes-Oxley Act will certainly add to the Company’soperating expenses due to requirements for additional technology, recordkeeping, and professional assistance that is necessary.

 

From time to time,various bills are introduced in the United States Congress with respect to theregulation of financial institutions. Certain of these proposals, if adopted, could significantly change theregulation of banks and the financial services industry.  The Company cannot predict whether any ofthese proposals will be adopted or, if adopted, how these proposals wouldaffect the Company.

 

24

----

# ** **

# **MANAGEMENT’S ANNUAL REPORTON INTERNAL CONTROL OVER FINANCIAL REPORTING**

# ** **

Management of HCSB Financial Corporation and its subsidiary HorryCounty State Bank is responsible for establishing and maintaining adequateinternal control over financial reporting. The Company’s internal controlsystem was designed to provide reasonable assurance to management and the Boardof Directors regarding the preparation and fair presentation of publishedfinancial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

 

The Company’s management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2007. Basedon this assessment management believes that as of December 31, 2007, theCompany’s internal control over financial reporting was effective.

 

This annual report does not include an attestation report of theCompany’s registered public accounting firm regarding internal control overfinancial reporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to temporary rules of theSecurities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report.

 

25

----

 

## **REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

## ** **

The Board of Directors

HCSB Financial Corporation and Subsidiary

Loris, South Carolina

 

We have audited the accompanying consolidated balance sheets of HCSBFinancial Corporation and its subsidiary as of December 31, 2007 and 2006,and the related consolidated statements of income, changes in shareholders’equity and comprehensive income, and cash flows for the years then ended.  These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and the significant estimates made by management aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position of HCSBFinancial Corporation and its subsidiary as of December 31, 2007 and 2006,and the consolidated results of their operations and their cash flows for theyears then ended, in conformity with U. S. generally accepted accountingprinciples.

 

We were not engaged to examine management’s assertion about theeffectiveness of HCSB Financial Corporation’s internal control over financialreporting as of December 31, 2007 included in Management’s Report onInternal Control over Financial Reporting and, accordingly, we do not expressan opinion thereon.

 

/s/ Elliott Davis, LLC

Elliott Davis, LLC

Columbia, South Carolina

March 10, 2008

 

26

----

# ** **

# **HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

# ** **

# **ConsolidatedBalance Sheets**

# ** **

| ** **                                                                                                                                          | ** ** | **December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| **(Dollars in thousands)**                                                                                                                | ** ** | **2007**              | ** **  | **2006** | ** ** |
| **Assets:**                                                                                                                                         |       |                  |        |   |   |
| Cash and cash equivalents:                                                                                                                          |       |                  |        |   |   |
| Cash and due from banks                                                                                                                             |       | $                     | 7,958       |   | $ | 9,463 |   |
| Federal funds sold                                                                                                                                  |       | 3,655                 |        | 19,238 |   |
| Total cash and cash equivalents                                                                                                                     |       | 11,613                |        | 28,701 |   |
|                                                                                                                                                |       |                  |        |   |   |
| Investment securities:                                                                                                                              |       |                  |        |   |   |
| Securities available-for-sale                                                                                                                       |       | 49,609                |        | 50,830 |   |
| Nonmarketable equity securities                                                                                                                     |       | 3,327                 |        | 2,948 |   |
| Total investment securities                                                                                                                         |       | 52,936                |        | 53,778 |   |
| Loans held for sale                                                                                                                                 |       | 2,008                 |        | 2,233 |   |
| Loans receivable                                                                                                                                    |       | 352,206               |        | 254,567 |   |
| Less allowance for loan losses                                                                                                                      |       | (3,535                | )           | (2,718 | ) |
| Loans, net                                                                                                                                          |       | 348,671               |        | 251,849 |   |
|                                                                                                                                                |       |                  |        |   |   |
| Premises, furniture and equipment, net                                                                                                              |       | 16,051                |        | 16,139 |   |
| Accrued interest receivable                                                                                                                         |       | 3,473                 |        | 2,880 |   |
| Other assets                                                                                                                                        |       | 3,601                 |        | 3,957 |   |
| Total assets                                                                                                                                        | ** ** | **$**                 | **438,353** | ** ** | **$** | **359,537** |   |
|                                                                                                                                                | ** ** | ** **            | ** **  | ** ** |   |
| **Liabilities:**                                                                                                                                    |       |                  |        |   |   |
| Deposits:                                                                                                                                           |       |                  |        |   |   |
| Noninterest-bearing transaction accounts                                                                                                            |       | 32,407                |        | $ | 26,428 |   |
| Interest-bearing transaction accounts                                                                                                               |       | 43,299                |        | 53,693 |   |
| Money market savings accounts                                                                                                                       |       | 104,310               |        | 83,795 |   |
| Other savings accounts                                                                                                                              |       | 8,833                 |        | 5,294 |   |
| Time deposits $100 and over                                                                                                                         |       | 64,044                |        | 47,369 |   |
| Other time deposits                                                                                                                                 |       | 87,958                |        | 58,572 |   |
| Total deposits                                                                                                                                      |       | 340,851               |        | 275,151 |   |
|                                                                                                                                                |       |                  |        |   |   |
| Repurchase Agreements                                                                                                                               |       | 5,000                 |        | — |   |
| Advances from the Federal Home Loan Bank                                                                                                            |       | 52,300                |        | 43,390 |   |
| Notes Payable                                                                                                                                       |       | —                |        | 3,478 |   |
| Junior subordinated debentures                                                                                                                      |       | 6,186                 |        | 6,186 |   |
| Accrued interest payable                                                                                                                            |       | 982                   |        | 772 |   |
| Other liabilities                                                                                                                                   |       | 2,051                 |        | 2,210 |   |
| Total liabilities                                                                                                                                   |       | 407,370               |        | 331,187 |   |
|                                                                                                                                                |       |                  |        |   |   |
| **Commitments and Contingencies (Notes 4, 12  and 13)**                                                                                             |       |                  |        |   |   |
| ** **                                                                                                                                          |       |                  |        |   |   |
| **Shareholders’ Equity:**                                                                                                                      |       |                  |        |   |   |
| Common stock, $0.01 par value, 10,000,000  shares authorized; 3,677,974 and 3,569,874 shares issued and outstanding in  2007 and 2006, respectively |       | 37                    |        | 36 |   |
| Capital surplus                                                                                                                                     |       | 28,689                |        | 25,756 |   |
| Nonvested restricted stock                                                                                                                          |       | (645                  | )           | (645 | ) |
| Retained earnings                                                                                                                                   |       | 2,908                 |        | 3,626 |   |
| Accumulated other comprehensive loss                                                                                                                |       | (6                    | )           | (423 | ) |
| Total shareholders’ equity                                                                                                                     |       | 30,983                |        | 28,350 |   |
| Total liabilities and shareholders’ equity                                                                                                     | ** ** | **$**                 | **438,353** | ** ** | **$** | **359,537** |   |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

27

----

 

# **HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Consolidated Statements of Income**

 
| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands except share amounts)** | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Interest income:**                                                     |       |                                        |       |   |   |
| Loans, including fees                                                    |       | $                                           | 25,275     |   | $ | 20,417 |   |
| Investment securities:                                                   |       |                                        |       |   |   |
| Taxable                                                                  |       | 2,212                                       |       | 1,869 |   |
| Tax-exempt                                                               |       | 290                                         |       | 274 |   |
| Nonmarketable equity securities                                          |       | 173                                         |       | 156 |   |
| Federal funds sold and other                                             |       | 586                                         |       | 964 |   |
| Total                                                                    |       | 28,536                                      |       | 23,680 |   |
|                                                                     |       |                                        |       |   |   |
| **Interest expense:**                                                    |       |                                        |       |   |   |
| Deposits                                                                 |       | 11,268                                      |       | 8,391 |   |
| Borrowings                                                               |       | 2,954                                       |       | 2,723 |   |
| Total                                                                    |       | 14,222                                      |       | 11,114 |   |
|                                                                     |       |                                        |       |   |   |
| **Net interest income**                                                  |       | 14,314                                      |       | 12,566 |   |
| ** **                                                               |       |                                        |       |   |   |
| Provision for loan losses                                                |       | 985                                         |       | 770 |   |
| **Net interest income after provision for  loan losses**                 |       | 13,329                                      |       | 11,796 |   |
| ** **                                                               |       |                                        |       |   |   |
| **Noninterest income:**                                                  |       |                                        |       |   |   |
| Service charges on deposit accounts                                      |       | 1,447                                       |       | 1,429 |   |
| Credit life insurance commissions                                        |       | 57                                          |       | 48 |   |
| Gain on sale of residential mortgage loans                               |       | 628                                         |       | 542 |   |
| Brokerage commissions                                                    |       | 315                                         |       | 289 |   |
| Other fees and commissions                                               |       | 263                                         |       | 206 |   |
| Losses on sales of securities                                            |       | (92                                         | )          | — |   |
| Other                                                                    |       | 78                                          |       | 90 |   |
| Total                                                                    |       | 2,696                                       |       | 2,604 |   |
|                                                                     |       |                                        |       |   |   |
| **Noninterest expenses:**                                                |       |                                        |       |   |   |
| Salaries and employee benefits                                           |       | 7,689                                       |       | 6,002 |   |
| Net occupancy                                                            |       | 868                                         |       | 668 |   |
| Marketing and advertising                                                |       | 491                                         |       | 366 |   |
| Loss on sale of assets                                                   |       | 11                                          |       | — |   |
| Furniture and equipment                                                  |       | 1,300                                       |       | 1,112 |   |
| Other operating                                                          |       | 2,574                                       |       | 2,160 |   |
| Total                                                                    |       | 12,933                                      |       | 10,308 |   |
|                                                                     |       |                                        |       |   |   |
| **Income before income taxes**                                           |       | 3,092                                       |       | 4,092 |   |
| ** **                                                               |       |                                        |       |   |   |
| Income tax provision                                                     |       | 1,052                                       |       | 1,287 |   |
| **Net income**                                                           | ** ** | **$**                                       | **2,040**  | ** ** | **$** | **2,805** |   |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** |   |
| **Net income per common share**                                          |       |                                        |       |   |   |
| Basic                                                                    | ** ** | **$**                                       | **0.55**   | ** ** | **$** | **0.77** |   |
| Diluted                                                                  | ** ** | **$**                                       | **0.55**   | ** ** | **$** | **0.77** |   |
|                                                                     | ** ** | ** **                                  | ** ** | ** ** |   |
| **Average common shares outstanding**                                    |       |                                        |       |   |   |
| Basic                                                                    | ** ** | **3,677,467**                               | ** ** | **3,648,335** |   |
| Diluted                                                                  | ** ** | **3,704,934**                               | ** ** | **3,665,065** |   |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

28

----

 

# **HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Consolidated Statements of Changes inShareholders’ Equity and Comprehensive Income**

**Years ended December 31, 2007 and 2006**

 
| ** **                                                     | ** ** | ** **            | ** ** | ** **     | ** ** | ** **    | ** ** | ** **   | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|---------------|------------|--------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                     | ** ** | ** **            | ** ** | ** **     | ** ** | ** **    | ** ** | ** **   | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                     | ** ** | ** **            | ** ** | ** **     | ** ** | **Nonvested** | ** ** | ** **   | ** ** | ** **   | ** ** | **compre-**            | ** ** | ** ** | ** ** |
| **(Dollars in thousands,**                           | ** ** | **Common Stock** | ** ** | **restricted** | ** ** | **Capital**   | ** ** | **Retained** | ** ** | **hensive**  | ** ** | ** **             | ** ** |
| **except share amounts)**                            | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **stock**     | ** ** | **surplus**  | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
| ** **                                                     | ** ** | ** **            | ** ** | ** **     | ** ** | ** **    | ** ** | ** **   | ** ** | ** **   | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Balance, December 31, 2005**                            |       | 1,788,201             |       | $              | 18         |          | $          | (703         | )          | $            | 25,685     |                   | $          | 865        |       | $ | (562 | ) | $ | 25,303 |   |
| ** **                                                     |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Net income                                                     |       |                  |       |           |       |          |       |         |       | 2,805        |       |                   |       | 2,805      |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Other comprehensive income, (loss) net of tax  expense of $81  |       |                  |       |           |       |          |       |         |       |         |       | 139                    |       | 139        |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Comprehensive income                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       | 2,944      |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Payment for fractional shares                                  |       | (1,247                | )          |           |       |          |       |         |       | (44          | )          |                   |       | (44        | )          |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Forfeiture of restricted stock                                 |       | (2,017                | )          |           |       | 58            |       | (58          | )          |         |       |                   |       |       |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Stock option expense                                           |       | 147                   |       |           |       |          |       | 147          |       |         |       |                   |       |       |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Declaration of 2 for 1 stock split on January 18,  2007   |       | 1,784,937             |       | 18             |       |          |       | (18          | )          |         |       |                   |       | —     |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| **Balance, December 31, 2006**                            |       | 3,569,874             |       | 36             |       | (645          | )          | 25,756       |       | 3,626        |       | (423                   | )          | 28,350     |       |
| ** **                                                     |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Net income                                                     |       |                  |       |           |       |          |       |         |       | 2,040        |       |                   |       | 2,040      |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Other comprehensive income, (loss) net of tax  expense of $245 |       |                  |       |           |       |          |       |         |       |         |       | 417                    |       | 417        |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Comprehensive income                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       | 2,457      |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Exercise of stock options                                      |       | 1,986                 |       |           |       |          |       | 29           |       |         |       |                   |       | 29         |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Stock option expense                                           |       |                  |       |           |       |          |       | 147          |       |         |       |                   |       | 147        |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| Declaration of 3% stock dividend on January 17,  2008     |       | 106,114               |       | 1              |       |          |       | 2,757        |       | (2,758       | )          |                   |       | —     |       |
|                                                           |       |                  |       |           |       |          |       |         |       |         |       |                   |       |       |       |
| **Balance, December 31, 2007**                            | ** ** | **3,677,974**         | ** ** | **$**          | **37**     | ** **    | **$**      | **(645**     | **)**      | **$**        | **28,689** | ** **             | **$**      | **2,908**  | ** ** | **$** | **(6** | **)** | **$** | **30,983** | ** ** |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

29

----

 

 

 

** **

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Consolidated Statements of Cash Flows**

 
| ** **                                                                                    | ** ** | **Years  Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)**                                                                    | ** ** | **2007**                      | ** ** | **2006** | ** ** |
| **Cash flows from operating activities:**                                                     |       |                          |       |   |   |
| Net income                                                                                    |       | $                             | 2,040      |   | $ | 2,805 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:            |       |                          |       |   |   |
| Provision for loan losses                                                                     |       | 985                           |       | 770 |   |
| Deferred income tax benefit                                                                   |       | (252                          | )          | (269 | ) |
| Depreciation expense                                                                          |       | 728                           |       | 636 |   |
| Premium amortization less discount  accretion                                                 |       | 33                            |       | 86 |   |
| Amortization of net deferred loan costs                                                       |       | 14                            |       | 10 |   |
| Loss on sale of securities  available-for-sale                                                |       | 92                            |       | — |   |
| (Gain) loss on sale of other real estate  owned                                               |       | 10                            |       | (26 | ) |
| Gain on disposal of premises and equipment                                                    |       | —                        |       | (20 | ) |
| Increase in interest receivable                                                               |       | (593                          | )          | (642 | ) |
| Increase in interest payable                                                                  |       | 210                           |       | 223 |   |
| (Increase) decrease in other assets                                                           |       | 605                           |       | (21 | ) |
| Stock compensation expense                                                                    |       | 147                           |       | 147 |   |
| Increase (decrease) in other liabilities                                                      |       | (159                          | )          | 113 |   |
|                                                                                          |       |                          |       |   |   |
| Net cash provided by operating activities                                                     |       | 3,860                         |       | 3,812 |   |
|                                                                                          |       |                          |       |   |   |
| **Cash flows from investing activities:**                                                     |       |                          |       |   |   |
| Purchases of securities available-for-sale                                                    |       | (21,265                       | )          | (17,350 | ) |
| Maturities of securities available-for-sale                                                   |       | 12,077                        |       | 4,887 |   |
| Proceeds from sales of securities  available-for-sale                                         |       | 10,947                        |       | — |   |
| Net increase in loans to customers                                                            |       | (97,934                       | )          | (22,221 | ) |
| Purchase of premises, furniture and  equipment                                                |       | (2,347                        | )          | (5,094 | ) |
| Proceeds from sale of premises, furniture  and equipment                                      |       | 1,707                         |       | 20 |   |
| Proceeds from sale of other real estate  owned                                                |       | 85                            |       | 875 |   |
| Purchase of nonmarketable equity securities                                                   |       | (379                          | )          | (81 | ) |
|                                                                                          |       |                          |       |   |   |
| Net cash used by investing activities                                                         |       | (97,109                       | )          | (38,964 | ) |
|                                                                                          |       |                          |       |   |   |
| **Cash flows from financing activities:**                                                     |       |                          |       |   |   |
| Net increase in demand deposits,  interest-bearing transaction accounts and savings  accounts |       | 19,639                        |       | 11,122 |   |
| Net increase in time deposits                                                                 |       | 46,061                        |       | 9,892 |   |
| Net increase in notes payable                                                                 |       | (3,478                        | )          | 3,478 |   |
| Net increase in FHLB borrowings                                                               |       | 8,910                         |       | — |   |
| Net increase in repurchase agreements                                                         |       | 5,000                         |       | — |   |
| Exercise of stock options                                                                     |       | 29                            |       | — |   |
| Cash paid for fractional shares                                                               |       | —                        |       | (44 | ) |
|                                                                                          |       |                          |       |   |   |
| Net cash provided by financing activities                                                     |       | 76,161                        |       | 24,448 |   |
|                                                                                          |       |                          |       |   |   |
| **Net decrease in cash and cash equivalents**                                                 |       | (17,088                       | )          | (10,704 | ) |
|                                                                                          |       |                          |       |   |   |
| **Cash and cash equivalents, beginning of  year**                                             |       | 28,701                        |       | 39,405 |   |
|                                                                                          |       |                          |       |   |   |
| **Cash and cash equivalents, end of year**                                                    | ** ** | **$**                         | **11,613** | ** ** | **$** | **28,701** | ** ** |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

30

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES**

 

**Basis of Presentation and Consolidation** -The accompanying consolidated financial statements include the accounts of HCSBFinancial Corporation and Subsidiary (the Company) and its wholly ownedsubsidiary, Horry County State Bank (the Bank) and all of the stock of HCSBFinancial Trust I (the Trust).  TheCompany was incorporated on June 10, 1999. The Bank was incorporated on December 18,1987, and opened for operations on January 4, 1988.  The principal business activity of theCompany is to provide commercial banking services in Horry County, SouthCarolina, and in Columbus and Brunswick Counties, North Carolina.  The Bank is a state-chartered bank, and itsdeposits are insured by the Federal Deposit Insurance Corporation.  The Trust is a special purpose subsidiaryorganized for the sole purpose of issuing trust preferred securities.  The operations of the Trust have not beenconsolidated in these financial statements.

 

**Management’s Estimates** - In preparing theconsolidated financial statements, management is required to make estimates andassumptions that affect the reported amounts of assets and liabilities as ofthe balance sheet date and income and expenses for the period.  Actual results could differ significantlyfrom those estimates.

 

Material estimates that are particularly susceptible to significantchange relate to the determination of the allowance for loan losses, includingvaluation allowances for impaired loans, and the carrying amount of real estateacquired in connection with foreclosures or in satisfaction of loans.  Management must also make estimates indetermining the estimated useful lives and methods for depreciating premisesand equipment.

 

While management uses available information to recognize losses onloans and foreclosed real estate, future additions to the allowance may benecessary based on changes in local economic conditions.  In addition, regulatory agencies, as anintegral part of their examination process, periodically review the Company’sallowances for losses on loans and foreclosed real estate.  Such agencies may require the Company torecognize additions to the allowances based on their judgments about informationavailable to them at the time of their examination.  Because of these factors, it is reasonablypossible that the allowances for losses on loans and foreclosed real estate maychange materially in the near term.

 

**Investment Securities** - Investment securitiesavailable-for-sale by the Company are carried at amortized cost and adjusted totheir estimated fair value.  Theunrealized gain or loss is recorded in shareholders’ equity net of the deferredtax effects.  Management does notactively trade securities classified as available-for-sale, but intends to holdthese securities for an indefinite period of time and may sell them prior tomaturity to achieve certain objectives. Reductions in fair value considered by management to be other thantemporary are reported as a realized loss and a reduction in the cost basis inthe security.  The adjusted cost basis ofsecurities available-for-sale is determined by specific identification and isused in computing the realized gain or loss from a sales transaction.

 

**Nonmarketable Equity Securities** -Nonmarketable equity securities include the Company’s investments in the stockof the Federal Home Loan Bank and Silverton Bank.  The stocks are carried at cost because theyhave no quoted market value and no ready market exists.  Investment in Federal Home Loan Bank stock isa condition of borrowing from the Federal Home Loan Bank, and the stock ispledged to collateralize the borrowings. Dividends received on Federal Home Loan Bank stock and CommunityFinancial Services stock are included as a separate component in interestincome.

 

At December 31,2007 and 2006, the investment in Federal Home Loan Bank stock was $2,994,000and $2,615,000, respectively.  Theinvestment in Silverton Bank stock was $122,000 at December 31, 2007 and2006.  The Company also had a $25,000investment in the holding company of a community bank at December 31, 2007and 2006.  Also included in nonmarketableequities is investment in the Trust, which totaled $186,000 at December 31,2007 and 2006.

 

31

----

** **

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

**Loans held for Sale** - Loans held for saleconsist of residential mortgage loans the Company originates for sale tosecondary market investors.  They arecarried at the lower of aggregate cost or market value.  Net unrealized losses, if any, are recognizedthrough a valuation allowance by charges to income.  Fees collected in conjunction withorigination activities are deferred as part of the cost basis of the loan andrecognized when the loan is sold.  Gainsor losses on sales are recognized when the loans are sold and are determined asthe difference between the sales price and the carrying value of the loans.

 

The Company issues rate lock commitments to borrowers based on pricesquoted by secondary market investors. When rates are locked with borrowers, a sales commitment is immediatelyentered (on a best efforts basis) at a specified price with a secondary marketinvestor.  Accordingly, any potentialliabilities associated with rate lock commitments are offset by salescommitments to investors.

 

**Loans Receivable** - Loans receivable arestated at their unpaid principal balance. Interest income on loans is computed based upon the unpaid principalbalance.  Interest income is recorded inthe period earned.

 

The accrual of interest income is generally discontinued when a loanbecomes contractually 90 days past due as to principal or interest.  Management may elect to continue the accrualof interest when the estimated net realizable value of collateral exceeds theprincipal balance and accrued interest.

 

Loan origination and commitment fees and certain direct loanorigination costs (principally salaries and employee benefits) are deferred andamortized to income over the contractual life of the related loans orcommitments, adjusted for prepayments, using the straight-line method.

 

Under Statement ofFinancial Accounting Standards (SFAS) No. 114, *Accountingby Creditors for the Impairment of a Loan,*and SFAS No. 118, *Accounting by Creditors for Impairment of a Loan - Income Recognitionand Disclosures,* loans are defined as impaired when it is probablethat a creditor will be unable to collect all amounts due according to thecontractual terms of the loan agreement. All loans are subject to this criteria except for smaller balancehomogeneous loans that are collectively evaluated for impairment and loans measuredat fair value or at the lower of cost or fair value.  The Company considers its consumerinstallment portfolio, credit card loans, and home equity lines as suchexceptions.  Therefore, the real estateand commercial loan portfolios are primarily affected by these statements.

 

Impairment of a loan is measured based on the present value of expectedfuture cash flows discounted at the loan’s effective interest rate or the fairvalue of the collateral if the loan is collateral dependent.  When management determines that a loan isimpaired, the difference between the Company’s investment in the related loanand the present value of the expected future cash flows, or the fair value ofthe collateral, is charged to bad debt expense with a corresponding entry tothe allowance for loan losses.  Theaccrual of interest is discontinued on an impaired loan when managementdetermines the borrower may be unable to meet payments as they become due.  As discussed in Note 4,  nonaccrual loans comprise a substantial majorityof loans classified as impaired at December 31, 2007 and 2006.

 

**Concentrations of Credit Risk**- Financial instruments, which potentially subject the Company toconcentrations of credit risk, consist principally of loans receivable,investment securities, federal funds sold and amounts due from banks.

 

The Company makes loans to individuals and small businesses for variouspersonal and commercial purposes primarily throughout Horry county in SouthCarolina and Columbus and Brunswick counties of North Carolina.  The Company’s loan portfolio is notconcentrated in loans to any single borrower or a relatively small number ofborrowers. Additionally, management is not aware of any concentrations of loansto classes of borrowers or industries that would be similarly affected byeconomic conditions except for loans secured by residential and commercial realestate and commercial and industrial non-real estate loans.  These concentrations of residential andcommercial real estate loans and commercial and industrial non-real estateloans totaled $260,531,000 and

 

32

----

** **

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

$64,019,000, respectively, at December 31, 2007, representing840.89% and 206.63%, respectively, of total equity and 73.97% and 18.18%,respectively, of net loans receivable.

 

**Concentrations of Credit Risk***(continued)* - In addition to monitoringpotential concentrations of loans to particular borrowers or groups ofborrowers, industries and geographic regions, management monitors exposure tocredit risk from concentrations of lending products and practices such as loansthat subject borrowers to substantial payment increases (e.g. principaldeferral periods, loans with initial interest-only periods, etc.), and loanswith high loan-to-value ratios. Management has determined that there is noconcentration of credit risk associated with its lending policies or practices.Additionally, there are industry practices that could subject the Company toincreased credit risk should economic conditions change over the course of aloan’s life.  For example, the Companymakes variable rate loans and fixed rate principal-amortizing loans withmaturities prior to the loan being fully paid (i.e. balloon paymentloans).  These loans are underwritten andmonitored to manage the associated risks. Therefore, management believes that these particular practices do notsubject the Company to unusual credit risk.

 

The Company’s investment portfolio consists principally of obligationsof the United States, its agencies or its corporations and general obligationmunicipal securities.  In the opinion ofmanagement, there is no concentration of credit risk in its investmentportfolio.  The Company places itsdeposits and correspondent accounts with and sells its federal funds to highquality institutions.  Managementbelieves credit risk associated with correspondent accounts is not significant.

 

**Allowance for Loan Losses** – Managementbelieves that the allowance is adequate to absorb inherent losses in the loanportfolio; however, assessing the adequacy of the allowance is a process thatrequires considerable judgment. Management’s judgments are based on numerous assumptions about currentevents, which management believes to be reasonable, but which may or may not bevalid.  Thus there can be no assurancethat loan losses in future periods will not exceed the current allowance amountor that future increases in the allowance will not be required.  No assurance can be given that management’songoing evaluation of the loan portfolio in light of changing economicconditions and other relevant circumstances will not require significant futureadditions to the allowance, thus adversely affecting the operating results ofthe Company.

 

The allowance is subject to examination by regulatory agencies, whichmay consider such factors as the methodology used to determine adequacy and thesize of the allowance relative to that of peer institutions, and other adequacytests.  In addition, such regulatoryagencies could require the Company to adjust its allowance based on informationavailable to them at their examination.

 

The methodology used to determine the reserve for unfounded lendingcommitments, which is included in other liabilities, is inherently similar tothat used to determine the allowance for loan losses adjusted for factorsspecific to binding commitments, including the probability of funding andhistorical loss ratio.

 

**Premises, Furniture and Equipment** -Premises, furniture and equipment are stated at cost less accumulateddepreciation.  The provision fordepreciation is computed by the straight-line method.  Rates of depreciation are generally based onthe following estimated useful lives: buildings - 40 years; furniture and equipment - 3 to 25 years.  The cost of assets sold or otherwise disposedof and the related accumulated depreciation is eliminated from the accounts,and the resulting gains or losses are reflected in the income statement.

 

Maintenance and repairs are charged to current expense as incurred, andthe costs of major renewals and improvements are capitalized.

 

**Other Real Estate Owned** - Other realestate owned includes real estate acquired through foreclosure.  Other real estate owned is initially recordedat the lower of cost (principal balance of the former loan plus costs ofimprovements) or fair value, less estimated costs to sell.

 

Any write-downs at the dates of acquisition are charged to theallowance for loan losses.  Expenses tomaintain such assets, subsequent write-downs, and gains and losses on disposalare included in other expenses.

 

33

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

**Derivative Financial Instruments** - TheCompany has entered into certain interest rate swap agreements which arederivative financial instruments (“derivatives”).  The derivatives are recognized as otherassets on the balance sheet at their fair value. On the date the derivativecontract is entered into, the Company designates the derivative as a hedge offair value of a recognized asset or liability (“fair value hedge”).  Changes in the fair value of a derivativethat is highly effective as - and that is designated and qualifies - as a fairvalue hedge, along with the loss or gain on the hedged asset or liability thatis attributable to the hedged risk, are recorded in current-period earnings.

 

The Company formally documents all relationships between hedginginstruments and hedged items, as well as its risk-management objective andstrategy for undertaking hedged transactions. This process includes linking all derivatives that are designated asfair value hedges to specific assets and liabilities on the balance sheet.  The derivatives in which the Company is acounterparty qualify for the “shortcut” method of assessing the ongoingeffectiveness of its hedging relationship with the underlying hedged item.  The Company discontinues hedge accountingprospectively when (1) the derivative expires or is sold, terminated, orexercised; (2) management determines that designation of the derivative asa hedge instrument is no longer appropriate; or (3) the underlying hedgeditem is liquidated.  When hedgeaccounting is discontinued, the derivative is carried at its fair value on thebalance sheet, with changes in its fair value recognized in current-periodearnings.

 

**Income and Expense Recognition** - Theaccrual method of accounting is used for all significant categories of incomeand expense.  Immaterial amounts ofinsurance commissions and other miscellaneous fees are reported when received.

 

**Income Taxes** - Amounts provided for incometaxes are based on income reported for financial statement purposes. Deferredincome taxes are provided for the temporary differences between the financialreporting basis and the tax basis of the Company’s assets and liabilities.  Deferred tax assets are reduced by avaluation allowance when, in the opinion of management, it is more likely thannot that some portion or all of the deferred tax assets will not be realized.Management has determined that it is more likely than not that the entiredeferred tax asset at December 31, 2007, will be realized, andaccordingly, has not established a valuation allowance.  Deferred tax assets and liabilities areadjusted for the effects of changes in tax laws and rates on the date ofenactment.

 

**Advertising Expense** - Advertising andpublic relations costs are generally expensed as incurred.  External costs incurred in producing mediaadvertising are expensed the first time the advertising takes place.  External costs relating to direct mailingcosts are expensed in the period in which the direct mailings are sent.  Advertising and public relations costs of$491,000 and $366,000, were included in the Company’s results of operations for2007 and 2006, respectively.

 

**Net Income Per Share** - Basic income pershare is calculated by dividing net income by the weighted-average number ofshares outstanding during the year. Diluted net income per share is computed based on net income divided bythe weighted average number of common and potential common shares.  Retroactive recognition has been given forthe effects of all stock dividends and splits in computing the weighted-averagenumber of shares.  The only potentialcommon share equivalents are those related to stock options and restrictedstock awards.  Stock options which areanti-dilutive are excluded from the calculation of diluted net income pershare.

 

**Stock-Based Compensation** - On January 1,2006, the Company adopted the fair value recognition provisions of FinancialAccounting Standards Board (“FASB”) Statement of Financial Accounting Standards(“SFAS”) No. 123(R), *Share-BasedPayment*, to account for compensation costs under its stock optionplans.

 

34

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

Notes to Consolidated Financial Statements

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

**Comprehensive Income** - Accountingprinciples generally require recognized income, expenses, gains, and losses tobe included in net income.  Althoughcertain changes in assets and liabilities, such as unrealized gains and losseson available-for-sale securities, are reported as a separate component of theequity section of the balance sheet, such items, along with net income, arecomponents of comprehensive income.

 

The components of other comprehensive income and related tax effectsare as follows:

 
| ** **                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                   | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| Unrealized gains (losses) on securities  available-for-sale            |       | $                                           | 570        |   | $ | 220 |   |
|                                                                   |       |                                        |       |   |   |
| Reclassification adjustment for (gains) losses  realized in net income |       | 92                                          |       | — |   |
|                                                                   |       |                                        |       |   |   |
| Net unrealized losses on securities                                    |       | 662                                         |       | 220 |   |
|                                                                   |       |                                        |       |   |   |
| Tax effect                                                             |       | (245                                        | )          | (81 | ) |
|                                                                   |       |                                        |       |   |   |
| Net-of-tax amount                                                      | ** ** | **$**                                       | **417**    | ** ** | **$** | **139** | ** ** |

 

**Statements of Cash Flows**- For purposes ofreporting cash flows, the Company considers certain highly liquid debtinstruments purchased with a maturity of three months or less to be cashequivalents.  Cash equivalents includeamounts due from banks, federal funds sold, and time deposits with other bankswith maturities of three months or less.

 

The following summarizes supplemental cash flow information:

 
| ** **                                                | ** ** | **Years ended December 31,** |       |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                      | ** ** | **2007**                                    | ** ** | **2006** |   |
| Cash paid for interest                                    |       | $                                           | 14,012     |   | $ | 10,539 |   |
|                                                      |       |                                        |       |   |   |
| Cash paid for income taxes                                |       | 1,232                                       |       | 1,716 |   |
|                                                      |       |                                        |       |   |   |
| Supplemental noncash investing and  financing activities: |       |                                        |       |   |   |
| Foreclosures on loans                                     |       | 338                                         |       | 459 |   |
|                                                           |            |                                             |            |  |  |  |  |

 

**Off-Balance-Sheet Financial Instruments** -In the ordinary course of business, the Company enters into off-balance-sheetfinancial instruments consisting of commitments to extend credit and letters ofcredit.  These financial instruments arerecorded in the financial statements when they become payable by the customer.

 

**Recently Issued Accounting Pronouncements** – Thefollowing is a summary of recent authoritative pronouncements that affectaccounting, reporting, and disclosure of financial information by the Company.

 

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS 157”). SFAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements. This standard eliminatesinconsistencies found in various prior pronouncements but does not require anynew fair value measurements. SFAS 157 is effective for the Company on January 1,2008 and will not impact the Company’s accounting measurements but it isexpected to result in additional disclosures.

 

In September 2006, The FASB ratified the consensuses reached bythe FASB’s Emerging Issues Task Force (“EITF”) relating to EITF 06-4,“Accounting for the Deferred Compensation and Postretirement Benefit Aspects ofEndorsement Split-Dollar Life Insurance Arrangements” (“EITF 06-4”).  Entities purchase life insurance for variousreasons including protection against loss of key employees and to fundpostretirement benefits. The two most common types of life insurancearrangements are endorsement split dollar life and collateral assignment splitdollar

 

35

----

** **

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

life. EITF 06-4 covers the former and EITF 06-10 (discussed below)covers the latter. EITF 06-4 states that entities with endorsement split-dollarlife insurance arrangements that provide a benefit to an employee that extendsto postretirement periods should recognize a liability for future benefits inaccordance with SFAS No. 106, “**Employers’Accounting for Postretirement Benefits Other Than Pensions,” (if, in substance,a postretirement benefit plan exists)**or AccountingPrinciples Board (“APB”) Opinion No. 12, “**Omnibus Opinion—1967” (if the arrangement is, in substance, anindividual deferred compensation contract).* *Entities should recognize the effects ofapplying this Issue through either (a) a change in accounting principlethrough a cumulative-effect adjustment to retained earnings or to othercomponents of equity or net assets in the statement of financial position as ofthe beginning of the year of adoption or (b) a change in accountingprinciple through retrospective application to all prior periods. EITF 06-4 iseffective for the Company on January 1, 2008. The Company does not believethe adoption of EITF 06-4 will have a material impact on its financialposition, results of operations or cash flows.

 

In September 2006, the FASB ratified the consensus reached on EITF06-5,**“Accounting for Purchases of Life Insurance—Determining the Amount ThatCould Be Realized in Accordance with FASB Technical Bulletin No. 85-4,Accounting for Purchases of Life Insurance” (“EITF 06-5”).  EITF06-5 states that a policyholder should consider any additional amounts includedin the contractual terms of the insurance policy other than the cash surrendervalue in determining the amount that could be realized under the insurancecontract.  EITF 06-5 also states that a policyholder should determine theamount that could be realized under the life insurance contract assuming thesurrender of an individual-life by individual-life policy (or certificate bycertificate in a group policy). EITF 06-5 is

 

effective for the Company on January 1, 2008.  The Companydoes not believe the adoption of EITF 06-5 will have a material impact on itsfinancial position, results of operations or cash flows.

 

In March 2007, the FASB ratified the consensus reached on EITF06-10, “Accounting for Collateral Assignment Split-Dollar Life InsuranceArrangements” (“EITF 06-10”). The postretirement aspect of this EITF issubstantially similar to EITF 06-4 discussed above and requires that anemployer recognize a liability for the postretirement benefit related to acollateral assignment split-dollar life insurance arrangement in accordancewith either FASB Statement No. 106 or APB Opinion No. 12, asappropriate, if the employer has agreed to maintain a life insurance policyduring the employee’s retirement or provide the employee with a death benefitbased on the substantive agreement with the employee.  In addition, a consensus was reached that anemployer should recognize and measure an asset based on the nature andsubstance of the collateral assignment split-dollar life insurance arrangement.EITF 06-10 is effective for the Company on January 1, 2008. The Companydoes not believe the adoption of EITF 06-10 will have a material impact on itsfinancial position, results of operations or cash flows.

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115” (“SFAS 159”). This statement permits,but does not require, entities to measure many financial instruments at fairvalue. The objective is to provide entities with an opportunity to mitigatevolatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accountingprovisions. Entities electing this option will apply it when the entity firstrecognizes an eligible instrument and will report unrealized gains and losseson such instruments in current earnings.  This statement 1) applies to all entities, 2) specifies certain electiondates, 3) can be applied on an instrument-by-instrument basis with someexceptions, 4) is irrevocable and 5) applies only to entire instruments. Oneexception is demand deposit liabilities which are explicitly excluded asqualifying for fair value. With respect to SFAS 115, available-for-sale andheld-to-maturity securities at the effective date are eligible for the fairvalue option at that date. If the fair value option is elected for thosesecurities at the effective date, cumulative unrealized gains and losses atthat date shall be included in the cumulative-effect adjustment and thereafter,such securities will be accounted for as trading securities. SFAS 159 iseffective for the Company on January 1, 2008. The Company is currentlyanalyzing the fair value option that is permitted, but not required, under SFAS159.

 

In June 2007, the FASB ratified theconsensus reached by the EITF with respect to EITF 06-11, “Accounting forIncome Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF 06-11”).Under EITF 06-11, a realized income tax benefit from dividends ordividend equivalents that are charged to retained earnings and are paid toemployees for equity-classified nonvested equity shares, nonvested equity shareunits and outstanding equity share options should be recognized as an increasein additional paid-in capital.  This EITFis to be applied prospectively to the income tax benefits that result fromdividends on equity-classified employee share-based payment awards that are

 

36

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

declared beginning in 2008, and interim periods within those fiscalyears.  Early application is permitted.The Company does not believe the adoption of EITF 06-11 will have a materialimpact on its financial position, results of operations or cash flows.

 

In November 2007, the Securities and Exchange Commission (“SEC”)issued Staff Accounting Bulletin No. 109, “Written Loan CommitmentsRecorded at Fair Value Through Earnings” (“SAB 109”). SAB 109 expresses thecurrent view of the SEC staff that the expected net future cash flows relatedto the associated servicing of the loan should be included in the measurementof all written loan commitments that are accounted for at fair value throughearnings.   SEC registrants areexpected to apply this guidance on a prospective basis to derivative loan commitmentsissued or modified in the first quarter of 2008 and thereafter. The Company iscurrently analyzing the impact of this guidance, which relates to the Company’smortgage loans held for sale.

 

In December 2007, the FASB issued SFAS No. 141(R), “BusinessCombinations,” (“SFAS 141(R)”) which replaces SFAS 141. SFAS 141(R) establishesprinciples and requirements for how an acquirer in a business combinationrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any controlling interest; recognizes andmeasures goodwill acquired in the business combination or a gain from a bargainpurchase; and determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusiness combination. FAS 141(R) is effective for acquisitions by theCompany taking place on or after January 1, 2009. Early adoption isprohibited. Accordingly, a calendar year-end company is required to record anddisclose business combinations following existing accounting guidance until January 1,2009. The Company will assess the impact of SFAS 141(R) if and when afuture acquisition occurs.

 

In December 2007, the FASB issued SFAS No. 160,“Noncontrolling Interests in Consolidated Financial Statements – an amendmentof ARB No. 51” (“SFAS 160”). SFAS 160 establishes new accounting andreporting standards for the noncontrolling interest in a subsidiary and for thedeconsolidation of a subsidiary. Before this statement, limited guidanceexisted for reporting noncontrolling interests (minority interest). As aresult, diversity in practice exists. In some cases minority interest isreported as a liability and in others it is reported in the mezzanine sectionbetween liabilities and equity. Specifically, SFAS 160 requires the recognitionof a noncontrolling interest (minority interest) as equity in the consolidatedfinancials statements and separate from the parent’s equity. The amount of netincome attributable to the noncontrolling interest will be included in consolidatednet income on the face of the income statement. SFAS 160 clarifies that changesin a parent’s ownership interest in a subsidiary that do not result indeconsolidation are equity transactions if the parent retains its controllingfinancial interest. In addition, this statement requires that a parentrecognize gain or loss in net income when a subsidiary is deconsolidated. Suchgain or loss will be measured using the fair value of the noncontrolling equityinvestment on the deconsolidation date. SFAS 160 also includes expandeddisclosure requirements regarding the interests of the parent and itsnoncontrolling interests. SFAS 160 is effective for the Company on January 1,2009.   Earlier adoption is prohibited.The Company is currently evaluating the impact, if any, the adoption of SFAS160 will have on its consolidated financial statements.

 

**Risks and Uncertainties** - In the normalcourse of its business, the Company encounters two significant types of risks:economic and regulatory.  There are threemain components of economic risk: interest rate risk, credit risk and market risk.  The Company is subject to interest rate riskto the degree that its interest-bearing liabilities mature or reprice atdifferent speeds, or on different basis, than its interest-earning assets.  Credit risk is the risk of default on theCompany’s loan portfolio that results from borrower’s inability orunwillingness to make contractually required payments.  Market risk reflects changes in the value ofcollateral underlying loans receivable and the valuation of real estate held bythe Company.

 

The Company is subject to the regulations of various governmentalagencies.  These regulations can and dochange significantly from period to period. The Company also undergoes periodic examinations by the regulatoryagencies, which may subject it to further changes with respect to assetvaluations, amounts of required loss allowances and operating restrictions fromthe regulators’ judgments based on information available to them at the time oftheir examination.

 

37

----

** **

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

**Reclassifications** - Certain captions andamounts in the 2006 financial statements were reclassified to conform with the2007 presentation.

 

#### **NOTE2 - CASH AND DUE FROM BANKS**

 

The Bank isrequired by regulation to maintain an average cash reserve balance based on apercentage of deposits.  At December 31,2007 and 2006, the requirements were satisfied by amounts on deposit with theFederal Reserve Bank and cash on hand.

 

#### **NOTE3 - INVESTMENT SECURITIES**

 

Securities available-for-sale consisted of the following:

 
| ** **                                 | ** ** | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|--------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------|------------|
| **(Dollars in thousands)**       | ** ** | **Cost**      | ** ** | **Gains**                 | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| **December 31, 2007**                 |       |          |       |                      |       |          |       |   |   |
| Government-sponsored enterprises           |       | $             | 20,208     |                      | $          | 246           |       | $ | 7 |   | $ | 20,447 |   |
| Mortgage-backed securities                 |       | 21,650        |       | 60                        |       | 278           |       | 21,432 |   |
| Obligations of state and local governments |       | 7,760         |       | 44                        |       | 74            |       | 7,730 |   |
|                                       |       |          |       |                      |       |          |       |   |   |
| Total                                      | ** ** | **$**         | **49,618** | ** **                | **$**      | **350**       | ** ** | **$** | **359** | ** ** | **$** | **49,609** | ** ** |
|                                       |       |          |       |                      |       |          |       |   |   |
| **December 31, 2006**                 |       |          |       |                      |       |          |       |   |   |
| Government-sponsored enterprises           |       | $             | 19,216     |                      | $          | 31            |       | $ | 155 |   | $ | 19,092 |   |
| Mortgage-backed securities                 |       | 23,943        |       | 25                        |       | 519           |       | 23,449 |   |
| Equity securities                          |       | 835           |       | 19                        |       | —        |       | 854 |   |
| Obligations of state and local governments |       | 7,508         |       | 39                        |       | 112           |       | 7,435 |   |
|                                       |       |          |       |                      |       |          |       |   |   |
| Total                                      | ** ** | **$**         | **51,502** | ** **                | **$**      | **114**       | ** ** | **$** | **786** | ** ** | **$** | **50,830** | ** ** |

 

The following is a summary of maturities of securitiesavailable-for-sale as of December 31, 2007.  The amortized cost and estimated fair valuesare based on the contractual maturity dates. Actual maturities may differ from contractual maturities becauseborrowers may have the right to call or prepay obligations with or withoutpenalty.

 
| ** **                                | ** ** | **Securities**         | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **Available-For-Sale** | ** ** |
| ** **                                | ** ** | **Amortized**          | ** ** | **Estimated** | ** ** |
| **(Dollars in thousands)**      | ** ** | **Cost**               | ** ** | **Fair Value** | ** ** |
| Due in less than one year                 |       | $                      | 187        |   | $ | 187 |   |
| Due after one year but within five years  |       | 4,273                  |       | 4,283 |   |
| Due after five years but within ten years |       | 12,813                 |       | 12,902 |   |
| Due after ten years                       |       | 32,345                 |       | 32,237 |   |
|                                      |       |                   |       |   |   |
| Total                                     | ** ** | **$**                  | **49,618** | ** ** | **$** | **49,609** | ** ** |

 

38

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

#### **NOTE3 - INVESTMENT SECURITIES** - *continued*

 

The following table shows gross unrealized losses and fair value,aggregated by investment category, and length of time that individualsecurities have been in a continuous unrealized loss position, at:

 

**Securities Available for Sale**

 
| ** **                                 | ** ** | ** **             | ** ** | ** **             | ** ** | **December 31, 2007** | ** ** | ** **     | ** ** | ** **          | ** ** |
|--------------------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                                 | ** ** | **Less than**     | ** ** | **Twelve months** | ** ** | ** **                      | ** ** | ** **     | ** ** |
| ** **                                 | ** ** | **twelve months** | ** ** | **or more**       | ** ** | **Total**                       | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Unrealized**         | ** ** | ** **                      | ** ** | **Unrealized** | ** ** | ** **          | ** ** | **Unrealized** | ** ** |
| **(Dollars in thousands)**       | ** ** | **Fair value**    | ** ** | **losses**             | ** ** | **Fair value**             | ** ** | **losses**     | ** ** | **Fair value** | ** ** | **losses** | ** ** |
|                                       |       |                   |       |                   |       |                            |       |           |       |                |       |   |   |
| Government-sponsored enterprises           |       | $                      | 4,724      |                   | $          | 7                               |       | $              | —     |                | $          | — |   | $ | 4,724 |   | $ | 7 |   |
| Mortgage-backed securities                 |       | —                 |       | —                 |       | 15,301                          |       | 278            |       | 15,301              |       | 278 |   |
| Obligations of state and local governments |       | 606                    |       | 1                      |       | 1,829                           |       | 73             |       | 2,435               |       | 74 |   |
|                                       |       |                   |       |                   |       |                            |       |           |       |                |       |   |   |
| Total                                      | ** ** | **$**                  | **5,330**  | ** **             | **$**      | **8**                           | ** ** | **$**          | **17,130** | ** **          | **$**      | **351** | ** ** | **$** | **22,460** | ** ** | **$** | **359** | ** ** |

 
| ** **                                 | ** ** | ** **             | ** ** | ** **             | ** ** | **December 31, 2006** | ** ** | ** **     | ** ** | ** **          | ** ** |
|--------------------------------------------|------------|------------------------|------------|------------------------|------------|---------------------------------|------------|----------------|------------|---------------------|------------|
| ** **                                 | ** ** | **Less than**     | ** ** | **Twelve months** | ** ** | ** **                      | ** ** | ** **     | ** ** |
| ** **                                 | ** ** | **twelve months** | ** ** | **or more**       | ** ** | **Total**                       | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Unrealized**         | ** ** | ** **                      | ** ** | **Unrealized** | ** ** | ** **          | ** ** | **Unrealized** | ** ** |
| **(Dollars in thousands)**       | ** ** | **Fair value**    | ** ** | **losses**             | ** ** | **Fair value**             | ** ** | **losses**     | ** ** | **Fair value** | ** ** | **losses** | ** ** |
|                                       |       |                   |       |                   |       |                            |       |           |       |                |       |   |   |
| Government-sponsored enterprises           |       | $                      | 5,892      |                   | $          | 23                              |       | $              | 5,860      |                | $          | 132 |   | $ | 11,752 |   | $ | 155 |   |
| Mortgage-backed securities                 |       | 2,399                  |       | 19                     |       | 18,222                          |       | 499            |       | 20,621              |       | 518 |   |
| Obligations of state and local governments |       | 2,721                  |       | 104                    |       | 1,634                           |       | 9              |       | 4,355               |       | 113 |   |
|                                       |       |                   |       |                   |       |                            |       |           |       |                |       |   |   |
| Total                                      | ** ** | **$**                  | **11,012** | ** **             | **$**      | **146**                         | ** ** | **$**          | **25,716** | ** **          | **$**      | **640** | ** ** | **$** | **36,728** | ** ** | **$** | **786** | ** ** |
|                                            |            |                        |            |                        |            |                                 |            |                |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Managementevaluates its investment portfolio periodically to identify any impairment thatis other than temporary.  At December 31,2007, the Company had thirteen individual securities, or 34.53% of the securityportfolio, that have been in an unrealized loss position for more than twelvemonths.  Management believes these lossesare temporary and are a result of the current interest rate environment.

 

At December 31,2007 and 2006, investment securities with a book value of $46,951,000 and$29,978,000, respectively, and a market value of $46,966,000 and $29,501,000,respectively, were pledged to secure deposits.

 

Gross realizedlosses on sales of available-for-sale securities were $92,000 in 2007.

 

#### **NOTE4 - LOANS RECEIVABLE**

 

Loans consisted of the following:

 
| ** **                                       | ** ** | **December 31,** | ** **  |
|--------------------------------------------------|------------|-----------------------|-------------|
| **(Dollars in thousands)**             | ** ** | **2007**              | ** **  | **2006** | ** ** |
| Real estate - construction and land  development |       | $                     | 59,084      |   | $ | 28,124 |   |
| Real estate - mortgage and commercial            |       | 201,448               |        | 147,156 |   |
| Agricultural                                     |       | 7,221                 |        | 6,099 |   |
| Commercial and industrial                        |       | 64,019                |        | 54,313 |   |
| Consumer                                         |       | 18,535                |        | 18,267 |   |
| All other loans (including overdrafts)           |       | 1,899                 |        | 608 |   |
|                                             |       |                  |        |   |   |
| Total gross loans                                | ** ** | **$**                 | **352,206** | ** ** | **$** | **254,567** | ** ** |

 

39

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

** **

**NOTE 4 -LOANS RECEIVABLE** – *continued*

** **

Certain parties(principally certain directors and officers of the Company, their immediatefamilies, and business interests) were loan customers and had othertransactions in the normal course of business with the Company.  Related party loans are made on substantiallythe same terms, including interest rates and collateral, as those prevailing atthe time for comparable transactions with unrelated persons and do not involvemore than normal risk of collectibility. The aggregate dollar amounts of loans to related parties were$13,790,000 and $12,354,000 at December 31, 2007 and 2006,respectively.  During 2007, advances onrelated party loans totaled $6,711,000, and repayments were $1,949,000.

 

Transactions inthe allowance for loan losses are summarized below:

 
| ** **                                 | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**       | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                                       |       |                                        |       |   |   |
| Balance, beginning of year                 |       | $                                           | 2,718      |   | $ | 2,569 |   |
| Provision charged to operations            |       | 985                                         |       | 770 |   |
| Recoveries on loans previously charged off |       | 51                                          |       | 90 |   |
| Loans charged off                          |       | (219                                        | )          | (711 | ) |
|                                       |       |                                        |       |   |   |
| Balance, end of year                       | ** ** | **$**                                       | **3,535**  | ** ** | **$** | **2,718** | ** ** |

 

Loans on the Company’s problem loan watch list are considered potentiallyimpaired loans.  These loans areevaluated in determining whether all outstanding principal and interest areexpected to be collected.  Loans are notconsidered impaired if a minimal delay occurs and all amounts due, includingaccrued interest at the contractual interest rate for the period of the delay,are expected to be collected.

 

As of December 31,2007 and 2006, the Company had nonaccrual loans of approximately $2,696,000 and$760,000, respectively.  These loanscomprise a substantial majority of loans classified as impaired.  At December 31, 2006, the Company had aloan secured by commercial real estate that was contractually past due 90 daysor more and still accruing interest of $1,714,000, for which impairment had notbeen recognized.  This loan was repaid infull on January 9, 2007 through the liquidation of a portion of the Bank’scollateral.  At December 31, 2007,the Company did not have any loans that were contractually past due 90 days ormore and still accruing interest.  Theadditional interest income, which would have been recognized into earnings ifthe Company’s nonaccrual loans had been current in accordance with theiroriginal terms, was $267,000 and $133,000 during 2007 and 2006,respectively.  Average impaired loans asof December 31, 2007 and 2006 were $1,195,000 and $2,926,000,respectively.

 

The Company is a party to financial instruments with off-balance-sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These financial instrumentsinclude commitments to extend credit and standby letters of credit.  These instruments involve, to varyingdegrees, elements of credit and interest rate risk in excess of the amountrecognized in the balance sheets.

 

The Company’s exposure to credit loss in the event of nonperformance bythe other party to the financial instrument for commitments to extend creditand standby letters of credit is represented by the contractual or notionalamount of those instruments.  The Companyuses the same credit policies in making commitments and conditional obligationsas it does for on-balance-sheet instruments.

 

Standby letters of credit are conditional commitments issued by theCompany to guarantee the performance of a customer to a third party.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loans tocustomers.  The fair value of standbyletters of credit is insignificant.

 

Commitments to extend credit are agreements to lend to a customer aslong as there is no violation of any condition established in thecontract.  Commitments generally havefixed expiration dates or other termination clauses and may require payment ofa fee.  Since some of the commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future cash requirements.  The Company evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Companyupon extension of credit, is based on management’s credit evaluation of thecounter-party.

 

40

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 4 -LOANS RECEIVABLE –***continued*

** **

Collateral heldfor commitments to extend credit and standby letters of credit varies but mayinclude accounts receivable, inventory, property, plant, equipment, andincome-producing commercial properties. The following table summarizes the Company’s off-balance-sheet financialinstruments whose contract amounts represent credit risk:

 
| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                 |       |                  |       |   |   |
| Commitments to extend credit         |       | $                     | 66,575     |   | $ | 37,852 |   |
| Standby letters of credit            |       | 761                   |       | 814 |   |
|                                      |            |                       |            |  |  |  |  |

 

**NOTE 5 -PREMISES, FURNITURE AND EQUIPMENT**

** **

Premises, furniture and equipment consisted of the following:

 
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**   | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                   |       |                  |       |   |   |
| Land                                   |       | $                     | 4,219      |   | $ | 4,202 |   |
| Buildings and land improvements        |       | 7,931                 |       | 7,683 |   |
| Furniture and equipment                |       | 5,579                 |       | 4,757 |   |
| Leasehold improvements                 |       | 58                    |       | 41 |   |
| Construction in progress               |       | 3,073                 |       | 3,537 |   |
|                                   |       |                  |       |   |   |
|                                   |       | 20,860                |       | 20,220 |   |
| Less accumulated depreciation          |       | (4,809                | )          | (4,081 | ) |
|                                   |       |                  |       |   |   |
| Premises, furniture and equipment, net | ** ** | **$**                 | **16,051** | ** ** | **$** | **16,139** | ** ** |

 

Depreciation expensefor the years ended December 31, 2007 and 2006 was $728,000 and $637,000,respectively.

 

The Company had $91,000 and $4,000 in capitalized interest duringconstruction in 2007 and 2006, respectively.

 

In 2006 the Company purchased an interest in four parcels of realestate in Conway, S.C. together with four buildings thereon.  The Company then initiated action in 2007 forthe removal of three of these buildings and for the completion of theconstruction of the fourth for use as a branch bank.  The amounts shown as construction in progressfor the years ended December 31, 2007 and 2006 reflect the Company’sinvestment in this property.  The Companyexpects to complete all phases of the construction process during the firstquarter of 2008 and at that time allocate the balance in construction inprogress among land, buildings and land improvements, furniture and fixturesand equipment.

 

**NOTE 6 -OTHER ASSETS**

** **

Other assets consisted of the following:

 
| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                 |       |                  |       |   |   |
| Cash value of life insurance         |       | $                     | 962        |   | $ | 929 |   |
| Other real estate owned              |       | 338                   |       | 95 |   |
| Prepaid expenses and insurance       |       | 491                   |       | 304 |   |
| Unamortized software                 |       | 143                   |       | 472 |   |
| Net deferred tax asset               |       | 768                   |       | 765 |   |
| Other                                |       | 899                   |       | 1,392 |   |
|                                 |       |                  |       |   |   |
| Total                                | ** ** | **$**                 | **3,601**  | ** ** | **$** | **3,957** | ** ** |

 

41

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 7 - DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES**

 

The Company maintains an overall interest-rate risk-management strategythat incorporates the use of derivatives to minimize significant unplannedfluctuations in earnings that are caused by interest-rate volatility.  As part of this strategy, the Company enteredcertain interest rate swap agreements, which remain in place.  Such interest rate swaps are derivativefinancial instruments (“derivatives”). Interest rate swaps generally involve the exchange of fixed and variablerate interest payments between two parties, based on a common notional amountand maturity date.  The Company’s goal isto manage interest-rate sensitivity by modifying the repricing or maturitycharacteristics of specific balance-sheet assets and liabilities so that thenet-interest margin is not, on a material basis, adversely affected bymovements in interest rates. The interest-rate swaps entered by the Companyconverted certain nonprepayable fixed rate long term debt to floating rates. Asa result of interest-rate fluctuations, hedged assets and liabilities willappreciate or depreciate in market value. The effect of this unrealized appreciation or depreciation willgenerally be offset by income or loss on the derivatives that are linked to thehedged assets and liabilities.  TheCompany views this strategy as a prudent management of interest-ratesensitivity, such that earnings are not exposed to undue risk presented bychanges in interest rates.

 

By using derivative instruments, the Companyis exposed to credit and market risk.  Ifthe counterparty fails to perform, credit risk is equal to the extent of thefair-value gain in a derivative.  Whenthe fair value of a derivative contract is positive, this generally indicatesthat the counterparty owes the Company, and, therefore, creates a repaymentrisk for the Company.  When the fairvalue of a derivative contract is negative, the Company owes the counterpartyand, therefore, it has no repayment risk. The Company minimizes the credit (or repayment) risk in derivativeinstruments by entering into transactions with high-quality counterparties thatare reviewed by the Company’s credit committee.

 

Market risk is the adverse effect that achange in interest rates, currency, or implied volatility rates has on thevalue of a financial instrument.  TheCompany manages the market risk associated with interest rate swap contracts byestablishing and monitoring limits as to the types and degree of risk that maybe undertaken.  The Company periodicallymeasures this risk by using a value-at-risk methodology.

 

The Company’s derivatives activities aremonitored by its risk-management committee as part of that committee’soversight of the Company’s asset/liability and treasury functions.  The Company’s asset/liability committee isresponsible for implementing various hedging strategies that are developedthrough its analysis of data from financial simulation models and otherinternal and industry sources.  Theresulting hedging strategies are then incorporated into the Company’s overallinterest-rate risk-management and trading strategies.

 

The interest rate swap agreements provide forthe Company to make payments at a variable rate determined by a specified index(three month LIBOR) in exchange for receiving payments at a fixed rate of3.4%.  During 2007 and 2006, the Companyrecognized $273,000 and $233,000, respectively, as an increase in interestexpense on Federal Home Loan Bank Advances as a result of its interest rateswaps.

 

At December 31, 2007 and 2006, the information pertaining tooutstanding interest rate swap agreements used to hedge fixed rate debt is asfollows:

 
| **(Dollars in thousands)**             | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |
| Notional amount                                  |       | $        | 14,600     |     | $          | 14,600 |   |
| Weighted average fixed (receive) rate            |       | 3.43     | %          | 3.43     | %          |
| Weighted average variable (pay) rate             |       | 5.40     | %          | 5.07     | %          |
| Weighted average maturity in years               |       | 2.6      |       | 3.6      |       |
|                                             |       |     |       |     |       |
| Unrealized loss relating to interest rate  swaps |       | $        | 339        |     | $          | 788 |   |

 

At December 31, 2007 and 2006, theunrealized loss of $339,000 and $788,000, respectively, related to interestrate swaps were recorded in derivative assets and other liabilities at the sameamount.

 

42

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 7 - DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES** - *continued*

 

Risk management results for the year ended December 31,2007 and 2006 related to the balance sheet hedging of long-term debt indicatethat the hedges were 100% effective and that there was no component of thederivative instruments’ gain or loss which was excluded from the assessment ofhedge effectiveness.

 

**NOTE 8 - NOTE PAYABLE**

 

On September 22, 2006, the Companyexecuted a line of credit with Nexity Bank to borrow up to $3,600,000.  The entire principal balance of the note wasdue September 30, 2007.  Theinterest rate on the note was a variable rate equal to the Wall Street JournalPrime Rate less 1%.  The note was securedby a first real estate mortgage on the four properties that were acquired withthe loan proceeds.  At December 31,2006, the Company had borrowed $3,478,000 on this line of credit.  This line of credit was paid in full on January 12,2007.  The line of credit was not renewedwhen it expired on September 30, 2007.

 

**NOTE 9 -DEPOSITS**

** **

At December 31, 2007, the scheduledmaturities of time deposits were as follows:

 
| **(Dollars in thousands)** | ** ** | **Amount** | ** **  |
|--------------------------------------|------------|------------|-------------|
| **Maturing In**                 |       |       |        |
|                                 |       |       |        |   |
| 2008                                 |       | $          | 138,211     |   |
| 2009                                 |       | 12,563     |        |
| 2010                                 |       | 701        |        |
| 2011                                 |       | 314        |        |
| 2012 and thereafter                  |       | 213        |        |
|                                 |       |       |        |
| Total                                | ** ** | **$**      | **152,002** | ** ** |

 

Overdrawn transaction accounts in the amount of $157,000 and $130,000were classified as loans as of December 31, 2007 and 2006, respectively.

 

Deposits by directors including their affiliates and executive officerstotaled approximately $2,766,000 and $2,671,000 at December 31, 2007 and2006, respectively.

 

**NOTE 10 -ADVANCES FROM THE FEDERAL HOME LOAN BANK**

** **

Advances from theFederal Home Loan Bank consisted of the following:

 
| ** **                                       | ** ** | **Interest** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------|------------|-----------------------|------------|
| **(Dollars in thousands)**             | ** ** | **Rate**     | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Advances maturing on:**                        |       |         |       |                  |       |   |   |
| March 11, 2008 (converted to fixed  rate)   |       | 3.09         | %          | $                     | 5,000      |   | $ | 5,000 |   |
| December 8, 2008 (converted to fixed  rate) |       | 3.87         | %          | 1,700                 |       | 1,700 |   |
| March 1, 2010                               |       | 5.92         | %          | 5,000                 |       | 5,000 |   |
| May 24, 2010                                |       | 6.49         | %          | 4,600                 |       | 4,600 |   |
| October 15, 2010                            |       | 4.59         | %          | 5,000                 |       | — |   |
| March 22, 2011                              |       | 4.88         | %          | 5,000                 |       | 5,000 |   |
| January, 17, 2012 (converted to variable  rate)  |       | 5.21         | %          | 5,000                 |       | 5,000 |   |
| July 23, 2012                               |       | 3.81         | %          | 5,000                 |       | 5,000 |   |
| September 4, 2012                           |       | 3.56         | %          | —                |       | 2,090 |   |
| September 4, 2012                           |       | 4.42         | %          | 5,000                 |       | — |   |
| September 7, 2012                           |       | 4.05         | %          | 1,000                 |       | — |   |
| January 30, 2013                            |       | 3.36         | %          | 5,000                 |       | 5,000 |   |
| December 8, 2014                            |       | 3.24         | %          | 5,000                 |       | 5,000 |   |
|                                             |       |         |       |                  |       |   |   |
| Total                                            | ** ** | ** **   | ** ** | **$**                 | **52,300** |   | **$** | **43,390** |   |

 

Interest is payable quarterly. Initially all advances bear interest at a fixed rate; however, at acertain date for each of the advances, at the Federal Home Loan Bank’s option,the rates can be converted to floating. Also on these dates

 

43

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 10 -ADVANCES FROM THE FEDERAL HOME LOAN BANK -***continued*

** **

the Federal Home Loan Bank has the option to call the advances.  As of December 31, 2007, $6,700,000 werefixed rate credits; $26,000,000 were convertible advances; and $19,600,000 wereadjustable rate credits.

 

As of December 31, 2007, scheduled principal reductions include$6,700,000 in 2008, $14,600,000 in 2010, $5,000,000 in 2011, $16,000,000 in2012, and $10,000,000 in the years thereafter.

 

As collateral, the Company has pledged its portfolio of first mortgageone-to-four family residential loans aggregating $27,584,000 at December 31,2007, as well as half of its commercial real estate loan portfolio, totaling$4,138,000 at December 31, 2007. Also, the Company has pledged half of its portfolio of HELOCS and second mortgage loans totaling $6,497,000, andits investment in Federal Home Loan Bank stock with a carrying value of$2,993,000.  The Company also has pledgedsecurities with a market value of $22,523,000 against its FHLB borrowings.  The Company has $1,114,000 in excess with theFederal Home Loan Bank that is available if liquidity needs should arise.

 

As discussed in Note 7, the Company has entered into interest rate swapagreements associated with Federal Home Loan Bank advances maturing on March 1,2010, May 24, 2010 and March 22, 2011.  The interest rate swaps effectively convertedthe fixed interest rates on the advances to a variable rate.  The variable rate of the swap payable was5.21% at December 31, 2007 and is based on the three month LIBOR index.

 

**NOTE 11 - JUNIOR SUBORDINATED DEBENTURES**

 

On December 21, 2004, HCSB Financial Trust I, (a non-consolidatedsubsidiary) issued $6.0 million floating rate trust preferred securities with amaturity of December 31, 2034.  Therate is adjusted quarterly and was 7.34% at December 31, 2007.  In accordance with the revised FIN 46, thetrust has not been consolidated in these financial statements.  The Company received from the Trust the $6.0million proceeds from the issuance of the securities and the $186,000 initialproceeds from the capital investment in the Trust, and accordingly has shownthe funds due to the trust as a $6,186,000 junior subordinated debenture.  The current regulatory rules allow certainamounts of junior subordinated debentures to be included in the calculation ofregulatory capital.  The debentureissuance costs, net of accumulated amortization, totaled $99,000 at December 31,2007 and is included in other assets on the consolidated balance sheet.  Amortization of debt issuance costs totaled$3,667 for each of the years ended December 31, 2007 and 2006.

 

The Company invested $5,880,000 in the Company’s wholly-ownedsubsidiary, Horry County State Bank.  Theremaining balance is being maintained by the Company to fund operations.

 

**NOTE 12 -LEASE COMMITMENTS**

** **

On January 1, 2008, the Company renewed a lease agreement for landon which to operate its Tabor City branch. The lease has a five-year term that expires December 31, 2012.  The Company has an option for nine additionalfive-year renewal periods thereafter. The lease has a rental amount of $1,000 per month through December 31,2012.  The lease gives the Company thefirst right of refusal to purchase the property at an unimproved value if theowners decide to sell.  The Company alsopays applicable property taxes on the property.

 

On January 1,2008, the Company entered into a lease agreement for a building located at 4720Highway 17 Bypass South, Myrtle Beach, South Carolina 29577.  This building is being used to operate atemporary bank location during a short period of construction and remodeling atour permanent Socastee branch location. The term of the lease is six months commencing February 1, 2008,and the monthly lease payments are $2,966.66.

 

On April 23, 2007, the Company entered into an annual leaseagreement for office space located at The Plaza at Gator Hole in North MyrtleBeach, South Carolina.  The term of thislease is two years with an option to renew the lease for an additional threeyear term are $4,666.67.  The leasedpremises are being used to operate a bank branch location.

 

44

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 12 -LEASE COMMITMENTS –***continued*

** **

Expected future minimum lease payments as of December 31, 2007 areas follows:

 
| **(Dollars in thousands)** | ** ** | **Amount** | ** **  |
|--------------------------------------|------------|------------|-------------|
|                                 |       |       |        |
| 2008                                 |       | 86,363     |        |
| 2009                                 |       | 31,229     |        |
| 2010                                 |       | 12,563     |        |
| 2011                                 |       | 12,563     |        |
| 2012                                 |       | 12,563     |        |
|                                 |       |       |        |
| Total                                | ** ** | **$**      | **155,281** | ** ** |
|                                      |            |            |             |  |

 

**NOTE 13 -COMMITMENTS AND CONTINGENCIES**

** **

In the ordinary course of business, the Company may, from time to time,become a party to legal claims and disputes. At December 31, 2007, management was not aware of any pending orthreatened litigation or unasserted claims that could result in losses, if any,that would be material to the financial statements.  On January 1, 2008 the Company enteredinto two new lease agreements.  Thedetails for these leases are disclosed in Note 12 – Lease Commitments.

 

**NOTE 14 -SHAREHOLDERS’ EQUITY**

** **

**Stock Dividends** - In January 2007,the Board of Directors declared a 2 for 1 stock split payable on February 13,2007, to shareholders of record at January 30, 2007.  As a result of the stock split in the form ofa 100% stock dividend, 1,784,937 shares were issued.  In January 2008, the Board of Directorsdeclared a 3.0% stock dividend payable on February 15, 2008, toshareholders of record on February 5, 2008.  As a result of the dividend, 106,114 shareswere issued.  All share and per shareamounts have been adjusted to reflect these dividends.

 

**Restrictions on Dividends** - South Carolinabanking regulations restrict the amount of dividends that can be paid toshareholders.  All of the Bank’sdividends to HCSB Financial Corporation and Subsidiary are payable only fromthe undivided profits of the Bank.  At December 31,2007, the Bank’s undivided profits were $15,938,608.  The Bank is authorized to pay cash dividendsup to 100% of net income in any calendar year without obtaining the priorapproval of the Commissioner of Banking provided that the Bank received acomposite rating of one or two at the last Federal or State regulatoryexamination.  Under Federal Reserve Boardregulations, the amounts of loans or advances from the Bank to the parentcompany are also restricted.

 

**NOTE 15 -CAPITAL REQUIREMENTS**

** **

The Company and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a material effect on the Company’sfinancial statements.  Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Bank must meet specific capital guidelines that involve quantitativemeasures of the Company’s and the Bank’s assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accountingpractices.  The Company’s and the Bank’scapital amounts and classifications are also subject to qualitative judgmentsby the regulators about components, risk-weightings, and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Company and the Bank to maintain minimum ratios (set forthin the table below) of Tier 1 and total capital as a percentage of assets andoff-balance-sheet exposures, adjusted for risk-weights ranging from 0% to100%.  Tier 1 capital of the Bankconsists of common shareholders’ equity, excluding the unrealized gain or losson securities available for sale, minus certain intangible assets.  Tier 2 capital consists of the allowance forloan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists ofthe sum of Tier 1 and Tier 2 capital.

 

45

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 15 -CAPITAL REQUIREMENTS -***continued*

** **

The Company and the Bank are also required to maintain capital at aminimum level based on quarterly average assets (as defined), which is known asthe leverage ratio.  Only the strongestinstitutions are allowed to maintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios1% to 2% above the minimum.

 

As of the most recent regulatory examination, the Bank was deemed wellcapitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, theBank must maintain total risk-based, Tier 1 risk-based, and Tier 1 leverageratios as set forth in the table below. There are no conditions or events that management believes have changedthe Company’s or the Bank’s categories.

 

The following table summarizes the capital ratios and the regulatoryminimum requirements for the Company and the Bank.

 
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | ** **                   | ** ** | ** **                 | ** ** | **To Be Well-** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------|------------|------------------------------|------------|----------------------------|------------|---------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | **Minimum Requirement** | ** ** | **Capitalized Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **             | ** ** | **For Capital**         | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** |       | **Adequacy  Purposes** |       | **Action  Provisions**       |       |
| **(Dollars in thousands)**     | ** ** | **Amount** | ** ** | **Ratio**              | ** ** | **Amount**                   | ** ** | **Ratio**                  | ** ** | **Amount**                | ** ** | **Ratio** | ** ** |
| **December 31, 2007**               |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| **The Company**                          |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 39,746     |                   | 11.87      | %                            | $          | 26,793                     |       | 8.00                      | %          | N/A |   | N/A |   |
| Tier 1 capital (to risk-weighted assets) |       | 36,423     |       | 10.88                  | %          | 13,396                       |       | 4.00                       | %          | N/A                       |       | N/A |   |
| Tier 1 capital (to average assets)       |       | 36,423     |       | 9.45                   | %          | 15,422                       |       | 4.00                       | %          | N/A                       |       | N/A |   |
|                                     |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| **The Bank**                             |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 39,634     |                   | 11.00      | %                            | $          | 28,828                     |       | 8.00                      | %          | $ | 36,035 |   | 10.00 | % |
| Tier 1 capital (to risk-weighted assets) |       | 36,100     |       | 10.02                  | %          | 14,414                       |       | 4.00                       | %          | 21,621                    |       | 6.00 | % |
| Tier 1 capital (to average assets)       |       | 36,100     |       | 8.55                   | %          | 16,883                       |       | 4.00                       | %          | 21,103                    |       | 5.00 | % |
|                                     |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| **December 31, 2006**               |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| **The Company**                          |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 37,491     |                   | 13.86      | %                            | $          | 21,640                     |       | 8.00                      | %          | N/A |   | N/A |   |
| Tier 1 capital (to risk-weighted assets) |       | 34,773     |       | 12.86                  | %          | 10,820                       |       | 4.00                       | %          | N/A                       |       | N/A |   |
| Tier 1 capital (to average assets)       |       | 34,773     |       | 10.07                  | %          | 13,811                       |       | 4.00                       | %          | N/A                       |       | N/A |   |
|                                     |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| **The Bank**                             |       |       |       |                   |       |                         |       |                       |       |                      |       |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 36,603     |                   | 13.74      | %                            | $          | 21,310                     |       | 8.00                      | %          | $ | 26,637 |   | 10.00 | % |
| Tier 1 capital (to risk-weighted assets) |       | 33,885     |       | 12.72                  | %          | 10,655                       |       | 4.00                       | %          | 15,982                    |       | 6.00 | % |
| Tier 1 capital (to average assets)       |       | 33,885     |       | 9.71                   | %          | 13,956                       |       | 4.00                       | %          | 17,445                    |       | 5.00 | % |

 

**NOTE 16 -RETIREMENT AND BENEFITS**

** **

##### **TrusteedRetirement Savings Plan**  - The Bankhas a trustee retirement savings plan which provides retirement benefits tosubstantially all officers and employees who meet certain age and servicerequirements.  The plan includes a“salary reduction” feature pursuant to Section 401(k) of the InternalRevenue Code.  Under the plan and presentpolicies, participants are permitted to contribute up to 15% of their annualcompensation.  At its discretion, theBank can make matching contributions up to 4% of the participants’compensation.  The Company charged$183,000 and $153,000 to earnings for the retirement savings plan in 2007 and2006, respectively.

##### ** **

**Directors Deferred Compensation Plan** - TheCompany has a deferred compensation plan whereby directors may elect to deferthe payment of their fees.  Under theterms of the plan, the Company accrues an expense equal to the amount deferredplus an interest component based on the prime rate of interest at the beginningof each year.  The Company has alsopurchased life insurance contracts on each of the participating directors.  At December 31, 2007 and 2006, $787,000and $645,000, respectively, of directors’ fees were deferred and are includedin other liabilities.

 

46

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 16 -RETIREMENT AND BENEFITS -***continued*

** **

**Performance Compensation for Incentive Plan**- The Company implemented an employee bonus program in 2003 which it refers toas its Performance Compensation Plan. The plan pays employees based on a schedule of key performanceindicators they are required to meet in order to be rewarded.  The plan accrues for its employee bonusesbased on a percentage of each employee’s annual salary.  The plan has a fiscal year ending on December 31,and pays out on January 30 of the following year.   The Company charged $167,000 and $88,000 toearnings for the stakeholder plan in 2007 and 2006, respectively.

 

**NOTE 17 - EARNINGS PER SHARE**

 

Earnings per share - basic is computed bydividing net income by the weighted average number of common sharesoutstanding.  Earnings per share -diluted is computed by dividing net income by the weighted average number ofcommon shares outstanding and dilutive common share equivalents using thetreasury stock method.  Dilutive commonshare equivalents include common shares issuable upon exercise of outstandingstock options.  All share amounts havebeen adjusted for stock splits and dividends.

 
| **(Dollars in thousands, except**                                                        | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **per share amounts)**                                                         | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Basic earnings per share:**                                                            |       |                                        |       |   |   |
|                                                                                     |       |                                        |       |   |   |
| Net income available to common shareholders                                              | ** ** | **$**                                       | **2,040**  | ** ** | **$** | **2,805** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Average common shares outstanding - basic                                                | ** ** | **3,677,467**                               | ** ** | **3,648,335** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Basic earnings per share                                                                 | ** ** | **$**                                       | **0.55**   | ** ** | **$** | **0.77** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| **Diluted earnings per share:**                                                          |       |                                        |       |   |   |
|                                                                                     |       |                                        |       |   |   |
| Net income available to common shareholders                                              |       | $                                           | 2,040      |   | $ | 2,805 |   |
|                                                                                     |       |                                        |       |   |   |
| Average common shares outstanding - basic                                                |       | 3,677,467                                   |       | 3,542,073 |   |
|                                                                                     |       |                                        |       |   |   |
| Incremental shares from assumed conversion  of stock options and restricted stock awards |       | 27,467                                      |       | 16,243 |   |
|                                                                                     |       |                                        |       |   |   |
| Average common shares outstanding - diluted                                              | ** ** | **3,704,934**                               | ** ** | **3,665,065** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Diluted earnings per share                                                               | ** ** | **$**                                       | **0.55**   | ** ** | **$** | **0.77** | ** ** |

** **

**NOTE 18 - STOCK COMPENSATION PLAN**

 

In 2004, upon shareholderapproval, the Company adopted an Omnibus Stock Ownership and Long TermIncentive Plan (the “Stock Plan”).  TheStock Plan authorizes the grant of options and awards of restricted stock tocertain of our employees for up to 400,000 shares of the Company’s common stockfrom time to time during the term of the Stock Plan, subject to adjustments uponchange in capitalization.  The Stock Planis administered by the Compensation Committee of the Board of Directors of theCompany.

 

47

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 18 - STOCK COMPENSATION PLAN**- *continued*

 

Options granted under the StockPlan are incentive stock options, and they are vested over a five year periodwith none vesting at the time of the grant. All unexercised incentive stock options expire ten years after the dateof the grant.  A summary of the Company’sincentive stock options as of December 31, 2007 and 2006 is as follows *(with adjustments for the 3% stock dividend and the 2-for1stock splitfor each period):*

** **
| ** **                       | ** ** | **2007**   | ** ** | **2006**     | ** ** |
|----------------------------------|------------|------------|------------|--------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Exercise** |       |   |   | **Exercise** |   |
| ** **                       | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** |   |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding at beginning of year |       | 85,272     |       | $            | 14.49      |   | 89,427 |   | $ | 13.94 |   |
| Granted                          |       | —     |       |         |       | — |   | — |   |
| Exercised                        |       | (1,986     | )          | 13.86        |       | — |   | — |   |
| Forfeited                        |       | —     |       |         |       | (4,155 | )  | 14.10 |   |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding at end of year       | ** ** | **83,286** |       | $            | 14.40      | ** ** | **85,272** |   | $ | 14.49 |   |

 

The Company had no optionsexercised during 2006.

** **

Restricted stock awardsincluded in the Stock Plan vest after the first three consecutive periodsduring which the Bank’s return on average assets (ROAA) averages 1.15%.  At December 31, 2007 and 2006, none ofthe restricted stock had vested; therefore, no compensation expense related tothe vesting was recognized.  Allungranted restricted stock awards expire. A summary of the Company’s unrestricted stock awards as ofDecember 31, 2007 and 2006 is as follows *(withadjustments for3% stock dividend and the 2-for-1 stock split for each period):*

** **
| ** **                       | ** ** | **2007**   | ** ** | **2006**     | ** ** |
|----------------------------------|------------|------------|------------|--------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | **Exercise** |       |   |   | **Exercise** |   |
| ** **                       | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** |   |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding at beginning of year |       | 47,584     |       | $            | 14.94      |   | 51,739 |   | $ | 14.00 |   |
| Granted                          |       | —     |       | —       |       | — |   | — |   |
| Exercised                        |       | —     |       | —       |       | — |   | — |   |
| Forfeited                        |       | —     |       | —       |       | (4,155 | ) | 14.54 |   |
|                             |       |       |       |         |       |   |   |   |   |
| Outstanding at end of year       | ** ** | **47,584** |       | $            | 14.85      | ** ** | **47,584** |   | 14.94 |   |
|                                  |            |            |            |              |            |  |  |  |  |  |  |

 

The following table summarizes information about stock optionsoutstanding under the Company’s plans at December 31, 2007 *(with adjustments for the 2-for-1stock split for the two periods):*

 
| ** **                      | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|---------------------------------|------------|-----------------|------------|-----------------|------------|
|                            |       |            |       |            |       |
| Number of options               |       | 128,764         |       | 40,301          |       |
| Weighted average remaining life |       | 5 years         |       | 2 years         |       |
| Weighted average exercise price |       | $               | 14.85      |            | $          | 14.85 |   |
|                                 |            |                 |            |                 |            |  |  |

 

The aggregate intrinsic value of sharesoutstanding at December 31, 2007 was $1,436,000.

 

The Company measures the fair value of eachoption award on the date of grant using the Black-Scholes option-pricingmodel.  The Company determines theassumptions used in the Black-Scholes option pricing model as follows:  the risk-free interest rate is based on theU.S. Treasury yield curve in effect at the time of the grant; the dividendyield is based on the Company’s dividend yield at the time of the grant (subjectto adjustment if the dividend yield on the grant date is not expected toapproximate the dividend yield over the expected life of the options); thevolatility factor is based on the historical volatility of the Company’s stock(subject to adjustment if historical volatility is reasonably expected todiffer from the past); the weighted-average expected life is based on thehistorical behavior of employees related to exercises, forfeitures andcancellations.

 

48

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 18 - STOCK COMPENSATION PLAN** - *continued*

 

There were no stock options granted in 2007or 2006.  The Company received $29,000 asa result of stock option exercises during the year ended December 31, 2007.  In accordance with Statement 123(R), thisbenefit is included as a financing activity in the accompanying Statements ofCash Flows.

 

A summary of the status of the nonvestedshares as of December 31, 2007, and changes during the year ended December 31,2007, is presented below:
| ** **                          | ** ** | ** ** | ** ** | **Weighted-**   | ** ** |
|-------------------------------------|------------|------------|------------|-----------------|------------|
| ** **                          | ** ** | ** ** | ** ** | **Average**     | ** ** |
|                                |       |       |       | **Grant-Date**  |       |
| **Nonvested  Shares**               | ** ** | **Shares** | ** ** | **Fair  Value** | ** ** |
|                                |       |       |       |            |       |
| Nonvested at January 1, 2007   |       | 38,911     |       | $               | 18.88      |   |
| Granted                             |       | —     |       | —          |       |
| Vested                              |       | —     |       | —          |       |
| Forfeited                           |       | —     |       | —          |       |
|                                |       |       |       |            |       |
| Nonvested at December 31, 2007 | ** ** | **38,911** | ** ** | **$**           | **19.77**  | ** ** |

 

As of December 31,2007, there was $113,908 of total unrecognized compensation cost related tononvested share-based compensation arrangements granted under the plans.  That cost is expected to be recognized over aweighted-average period of 3.0 years. The total fair value of shares vested during the years ended December 31,2007 and 2006 was $417,018 and $319,226, respectively.

 

**NOTE 19 -OTHER EXPENSES**

** **

Other expenses aresummarized as follows:

 
| ** **                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                                 |       |                                        |       |   |   |
| Stationery, printing, and postage    |       | $                                           | 477        |   | $ | 363 |   |
| Telephone                            |       | 232                                         |       | 199 |   |
| Director and advisory fees           |       | 141                                         |       | 154 |   |
| Insurance                            |       | 67                                          |       | 130 |   |
| ATM services                         |       | 116                                         |       | 101 |   |
| Courier services                     |       | 194                                         |       | 126 |   |
| Other                                |       | 1,347                                       |       | 1,087 |   |
|                                 |       |                                        |       |   |   |
| Total                                | ** ** | **$**                                       | **2,574**  | ** ** | **$** | **2,160** | ** ** |

 

49

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

** **

#### **NOTE 20 - INCOME TAXES**

 

Income tax expense issummarized as follows:

 
| ** **                                  | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                                        |       |                                        |       |   |   |
| Currently payable:                          |       |                                        |       |   |   |
| Federal                                     |       | $                                           | 1,021      |   | $ | 913 |   |
| State                                       |       | 83                                          |       | 145 |   |
|                                        |       |                                        |       |   |   |
| Total current                               |       | 1,104                                       |       | 1,058 |   |
|                                        |       |                                        |       |   |   |
| Deferred income taxes                       |       | 194                                         |       | 310 |   |
|                                        |       |                                        |       |   |   |
| Income tax expense                          | ** ** | **$**                                       | **1,298**  | ** ** | **$** | **1,368** | ** ** |
|                                        |       |                                        |       |   |   |
| Income tax expense is allocated as follows: |       |                                        |       |   |   |
| To continuing operations                    |       | $                                           | 1,052      |   | $ | 1,287 |   |
| To shareholders’ equity                |       | 246                                         |       | 81 |   |
|                                        |       |                                        |       |   |   |
| Total                                       | ** ** | **$**                                       | **1,298**  | ** ** | **$** | **1,368** | ** ** |

 

The components of the netdeferred tax asset are as follows:

 
| ** **                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**                  | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                                  |       |                  |       |   |   |
| Deferred tax assets:                                  |       |                  |       |   |   |
| Allowance for loan losses                             |       | $                     | 939        |   | $ | 690 |   |
| Net capitalized loan costs                            |       | 168                   |       | 146 |   |
| State net operating loss                              |       | 59                    |       | 42 |   |
| Deferred directors’ fees                         |       | 267                   |       | 219 |   |
| Valuation Allowance                                   |       | (59                   | )          | — |   |
| Nonaccruing interest                                  |       | 95                    |       | 60 |   |
| Net unrealized loss on securities  available-for-sale |       | 3                     |       | 249 |   |
| Other                                                 |       | 24                    |       | 12 |   |
|                                                  |       |                  |       |   |   |
| Total deferred tax assets                             |       | 1,496                 |       | 1,418 |   |
|                                                  |       |                  |       |   |   |
| Deferred tax liabilities:                             |       |                  |       |   |   |
| Accumulated depreciation                              |       | 698                   |       | 640 |   |
| Gain on sale of real estate                           |       | 73                    |       | 73 |   |
| Prepaid expenses                                      |       | 100                   |       | 62 |   |
|                                                  |       |                  |       |   |   |
| Total deferred tax liabilities                        |       | 871                   |       | 775 |   |
|                                                  |       |                  |       |   |   |
| Net deferred tax asset                                | ** ** | **$**                 | **625**    | ** ** | **$** | **643** | ** ** |

 

50

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

#### **NOTE 20 - INCOME TAXES** -*continued*

 

Deferred tax assetsrepresent the future tax benefit of future deductible differences and, if it ismore likely than not that a tax asset will not be realized, a valuationallowance is required to reduce the recorded deferred tax assets to netrealizable value.  Management hasdetermined that it is more likely than not that the entire deferred tax assetat December 31, 2007 and 2006 will be realized and, accordingly, has notestablished a valuation allowance.  Deferredtax assets are included in other assets.

 

A reconciliation betweenthe income tax expense and the amount computed by applying the Federalstatutory rates of 34% to income before income taxes follows:

 
| ** **                                           | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                                                 |       |                                        |       |   |   |
| Tax expense at statutory rate                        |       | $                                           | 1,051      |   | $ | 1,391 |   |
| State income tax, net of federal income tax  benefit |       | 55                                          |       | 95 |   |
| Tax-exempt interest income                           |       | (105                                        | )          | (98 | ) |
| Stock compensation expense                           |       | 50                                          |       | 50 |   |
| Other                                                |       | 1                                           |       | (151 | ) |
|                                                 |       |                                        |       |   |   |
| Income tax provision                                 | ** ** | **$**                                       | **1,052**  | ** ** | **$** | **1,287** | ** ** |

 

#### **NOTE 21 - UNUSED LINES OF CREDIT**

 

As of December 31, 2007,the Company had unused lines of credit to purchase federal funds from unrelatedbanks totaling $25,800,000. These lines of credit are available on a one tofourteen day basis for general corporate purposes.  The lenders have reserved the right not torenew their respective lines.  TheCompany may also utilize its unpledged securities, which totaled $2,644,000 at December 31,2007, if liquidity needs should arise.

 

51

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

#### **NOTE 22 - FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

The fair value of afinancial instrument is the amount at which the asset or obligation could beexchanged in a current transaction between willing parties, other than in aforced or liquidation sale.  Fair valueestimates are made at a specific point in time based on relevant marketinformation and information about the financial instruments.  Because no market value exists for asignificant portion of the financial instruments, fair value estimates arebased on judgments regarding future expected loss, current economic conditions,risk characteristics of various financial instruments, and other factors.

 

The following methods andassumptions were used to estimate the fair value of significant financialinstruments:

 

***Cash and Due from Banks***- The carrying amount is a reasonable estimate of fair value.

 

***Federal Funds Sold**and Purchased***- Federal funds soldand purchased are for a term of one day and the carrying amount approximatesthe fair value.

 

***Time Deposits with Other Banks***- Time deposits with other banks have a term less than 90 days and the carryingamount approximates the fair value.

 

***Investment SecuritiesAvailable-for-Sale***- For securitiesavailable-for-sale, fair value equals the carrying amount, which is the quotedmarket price.  If quoted market pricesare not available, fair values are based on quoted market prices of comparablesecurities.

 

***Nonmarketable Equity Securities***- The carrying amount is a reasonable estimate of fair value since no readymarket exists for these securities.

 

***Loans Held-for-Sale***- Fair values of mortgage loans held for sale are based on commitments on handfrom investors or market prices.

 

***Loans Receivable***- For certain categories of loans, such as variable rate loans which arerepriced frequently and have no significant change in credit risk and creditcard receivables, fair values are based on the carrying amounts.  The fair value of other types of loans isestimated by discounting the future cash flows using the current rates at whichsimilar loans would be made to the borrowers with similar credit ratings andfor the same remaining maturities.

 

***Deposits***- The fair value of demand deposits, savings, and money market accounts isthe amount payable on demand at the reporting date.  The fair values of certificates of depositare estimated using a discounted cash flow calculation that applies currentinterest rates to a schedule of aggregated expected maturities.

 

***Advances from the Federal HomeLoan Bank***- For the portion of borrowingsimmediately callable, fair value is based on the carrying amount.  The fair value of the portion maturing at alater date is estimated using a discounted cash flow calculation that appliesthe interest rate of the immediately callable portion to the portion maturingat the future date.

 

***Junior Subordinated Debentures***- The carrying value of junior subordinated debentures is a reasonable estimateof fair value since the debentures were issued at a floating rate.

 

***Note Payable-***The fair value of the note payableapproximates its carrying value because it reprices periodically.

 

52

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

#### **NOTE 22 - FAIR VALUE OF FINANCIAL INSTRUMENTS***- continued*

 

***Accrued Interest Receivable andPayable***- The carrying value of these instrumentsis a reasonable estimate of fair value.

 

***Commitments to Extend Creditand Standby Letters of Credit***- The contractualamount is a reasonable estimate of fair value for the instruments becausecommitments to extend credit and standby letters of credit are issued on a short-termor floating rate basis and include no unusual credit risks.

 

***Interest Rate Swaps***- Fair values are based on the present value of future cash flows based on theinterest rate spread between the fixed rate and the floating rate.

 

The carrying values andestimated fair values of the Company’s financial instruments were as follows:

 
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **(Dollars in thousands)**                                | ** ** | **Carrying  Amount**  | ** ** | **Estimated  Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Estimated  Fair Value** | ** ** |
| **Financial Assets:**                                               |       |                  |       |   |   |   |   |   |   |
| Cash and due from banks                                             |       | $                     | 7,958      |   | $ | 7,958 |   | $ | 9,463 |   | $ | 9,463 |   |
| Federal funds sold                                                  |       | 3,655                 |       | 3,655 |   | 19,238 |   | 19,238 |   |
| Investment securities available-for-sale                            |       | 49,609                |       | 49,609 |   | 50,830 |   | 50,830 |   |
| Nonmarketable equity securities                                     |       | 3,327                 |       | 3,327 |   | 2,948 |   | 2,948 |   |
| Loans and loans held-for-sale                                       |       | 354,214               |       | 353,194 |   | 256,800 |   | 253,146 |   |
| Accrued interest receivable                                         |       | 3,473                 |       | 3,473 |   | 2,880 |   | 2,880 |   |
| Other assets - interest rate swaps                                  |       | 339                   |       | 339 |   | 788 |   | 788 |   |
|                                                                |       |                  |       |   |   |   |   |   |   |
| **Financial Liabilities:**                                          |       |                  |       |   |   |   |   |   |   |
| Demand deposit, interest-bearing transaction,  and savings accounts |       | $                     | 188,849    |   | $ | 188,849 |   | $ | 169,210 |   | $ | 169,210 |   |
| Certificates of deposit                                             |       | 152,002               |       | 151,278 |   | 105,941 |   | 106,124 |   |
| Repurchase agreements                                               |       | 5,000                 |       | 5,000 |   |   |   |   |   |
| Advances from the Federal Home Loan Bank                            |       | 52,300                |       | 52,395 |   | 43,390 |   | 42,006 |   |
| Notes Payable                                                       |       | —                |       | — |   | 3,478 |   | 3,478 |   |
| Junior subordinated debentures                                      |       | 6,186                 |       | 6,186 |   | 6,186 |   | 6,186 |   |
| Accrued interest payable                                            |       | 982                   |       | 982 |   | 772 |   | 772 |   |
| Other liabilities - interest rate swaps                             |       | 339                   |       | 339 |   | 788 |   | 788 |   |

 
| ** **                      | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** |
|---------------------------------|------------|----------------------|------------|--------------------------------|------------|----------------------|------------|--------------------------------|------------|
|                            |       |                 |       |                           |       |                 |       |                           |       |
| **Off-Balance Sheet Financial** |       |                 |       |                           |       |                 |       |                           |       |
| **Instruments:**                |       |                 |       |                           |       |                 |       |                           |       |
| Commitments to extend credit    |       | $                    | 66,575     |                           | N/A        |                 | $          | 37,852                         |       | N/A |   |
| Standby letters of credit       |       | 761                  |       | N/A                            |       | 814                  |       | N/A                            |       |
| Interest rate swaps             |       | 14,600               |       | 339                            |       | 14,600               |       | 788                            |       |
|                                 |            |                      |            |                                |            |                      |            |                                |            |  |  |

 

53

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 23 -HCSB FINANCIAL CORPORATION (*PARENT COMPANY ONLY*)**

 

Presented below are thecondensed financial statements for HCSB Financial Corporation and Subsidiary(Parent Company Only).

 

**Condensed Balance Sheets**

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**             | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Assets**                                       |       |                  |       |   |   |
| Cash                                             |       | $                     | 16         |   | $ | 183 |   |
| Investment in banking subsidiary                 |       | 36,095                |       | 33,462 |   |
| Investment in trust                              |       | 186                   |       | 186 |   |
| Nonmarketable equity securities                  |       | 25                    |       | 25 |   |
| Premises, furniture, and equipment, net          |       | —                |       | 3,529 |   |
| Other assets                                     |       | 867                   |       | 661 |   |
|                                             |       |                  |       |   |   |
| Total assets                                     | ** ** | **$**                 | **37,189** | ** ** | **$** | **38,046** | ** ** |
|                                             | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Liabilities and shareholders’ equity**    |       |                  |       |   |   |
| Interest payable-notes payable                   |       | $                     | —     |   | $ | 11 |   |
| Interest payable-junior subordinated  debentures |       | 20                    |       | 21 |   |
| Notes payable                                    |       | —                |       | 3,478 |   |
| Junior subordinated debentures                   |       | 6,186                 |       | 6,186 |   |
|                                             |       |                  |       |   |   |
| Total liabilities                                |       | 6,206                 |       | 9,696 |   |
|                                             |       |                  |       |   |   |
| Shareholders’ equity                        |       | 30,983                |       | 28,350 |   |
|                                             |       |                  |       |   |   |
| Total liabilities and shareholder’s equity  | ** ** | **$**                 | **37,189** | ** ** | **$** | **38,046** | ** ** |

 

**Condensed Statements of Income**

 
| ** **                                                                                        | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                                              | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Income**                                                                                        |       |                                        |       |   |   |
| Dividends from banking subsidiary                                                                 |       | $                                           | 239        |   | $ | — |   |
| Dividend from trust preferred securities                                                          |       | 15                                          |       | 14 |   |
| Other Income                                                                                      | ** ** | **—**                                  |       | 2 |   |
|                                                                                              |       | 254                                         |       | 16 |   |
| **Expenses**                                                                                      |       |                                        |       |   |   |
| Interest expense on notes payable                                                                 |       | 8                                           |       | 27 |   |
| Interest expense on junior subordinated  debentures                                               |       | 490                                         |       | 465 |   |
| Other expenses                                                                                    |       | 183                                         |       | 200 |   |
|                                                                                              |       |                                        |       |   |   |
| **Income (loss) before income taxes and  equity in undistributed earnings of banking subsidiary** |       | (427                                        | )          | (676 | ) |
|                                                                                              |       |                                        |       |   |   |
| Income tax benefit                                                                                |       | (252                                        | )          | (269 | ) |
|                                                                                              |       |                                        |       |   |   |
| Equity in undistributed earnings of banking  subsidiary                                           |       | 2,215                                       |       | 3,212 |   |
|                                                                                              |       |                                        |       |   |   |
| **Net income**                                                                                    | ** ** | **$**                                       | **2,040**  | ** ** | **$** | **2,805** | ** ** |

 

54

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes to Consolidated Financial Statements**

 

**NOTE 23 -HCSB FINANCIAL CORPORATION (*PARENT COMPANY ONLY*)***- continued*

 

# **CondensedStatements of Cash Flows**

# ** **

| ** **                                                                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Cash flows from operating activities:**                                          |       |                                        |       |   |   |
| Net income                                                                         |       | $                                           | 2,040      |   | $ | 2,805 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                        |       |   |   |
| Equity in undistributed earnings of banking  subsidiary                            |       | (2,215                                      | )          | (3,212 | ) |
| Increase in other assets                                                           |       | (206                                        | )          | (309 | ) |
| Increase in other liabilities                                                      |       | (12                                         | )          | 14 |   |
| Stock compensation expense                                                         |       | 147                                         |       | 147 |   |
|                                                                               |       |                                        |       |   |   |
| Net cash used by operating activities                                              |       | (246                                        | )          | (555 | ) |
|                                                                               |       |                                        |       |   |   |
| **Cash flows from investing activities:**                                          |       |                                        |       |   |   |
| Purchase of land and building                                                      |       | —                                      |       | (3,528 | ) |
| Proceeds from sale of land and building                                            |       | 3,529                                       |       | — |   |
|                                                                               |       |                                        |       |   |   |
| Net cash provided (used) from investing  activities                                |       | 3,529                                       |       | (3,528 | ) |
|                                                                               |       |                                        |       |   |   |
| **Cash flows from financing activities:**                                          |       |                                        |       |   |   |
| Proceeds from stock issuance                                                       |       | 28                                          |       | — |   |
| Proceeds from notes payable                                                        |       | (3,478                                      | )          | 3,478 |   |
| Cash paid for fractional shares                                                    |       | —                                      |       | (44 | ) |
|                                                                               |       |                                        |       |   |   |
| Net cash provided (used) by financing  activities                                  |       | (3,450                                      | )          | 3,434 |   |
|                                                                               |       |                                        |       |   |   |
| **Increase (decrease) in cash**                                                    | ** ** | **(167**                                    | )          | (649 | ) |
|                                                                               |       |                                        |       |   |   |
| **Cash and cash equivalents, beginning of  year**                                  | ** ** | **183**                                     |       | 832 |   |
|                                                                               |       |                                        |       |   |   |
| **Cash and cash equivalents, end of year**                                         | ** ** | **$**                                       | **16**     | ** ** | **$** | **183** | ** ** |

 

55

----

# ** **

# **HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

# ** **

# **BOARDOF DIRECTORS**

# ** **

| Michael S. Addy               |   | President, Addy’s  Harbor Dodge, Inc.                          |
|-------------------------------|--------|--------------------------------------------------------------------------|
|                          |   |                                                                     |
| Johnny C.  Allen              |   | Retired, Horry County Treasurer                                          |
|                          |   |                                                                     |
| D. Singleton  Bailey          |   | President, Loris Drug Store, Inc.                                   |
|                          |   |                                                                     |
| Franklin C.  Blanton          |   | President, Blanton Supplies, Inc.                                   |
|                          |   | President, Blanton Supplies of Little River, Inc.                   |
|                          |   |                                                                     |
| Clay D.  Brittain, III   |   | Attorney, Thompson & Henry, P.A.                                |
|                          |   |                                                                     |
| Rachel B.  Broadhurst         |   | President, Century 21 – Broadhurst & Associates, Inc. |
|                          |   |                                                                     |
| Russell R.  Burgess, Jr. |   | Owner, Aladdin Realty Company                                            |
|                          |   | Owner and Broker-In-Charge                                               |
|                          |   | Burgess Realty & Appraisal Service                              |
|                          |   |                                                                     |
| James R.  Clarkson            |   | President and CEO                                                        |
|                          |   | HCSB Financial Corporation                                               |
|                          |   | and Horry County State Bank                                              |
|                          |   |                                                                     |
| J. Lavelle  Coleman           |   | Retired, Tabor City Oil, Inc.                                       |
|                          |   |                                                                     |
| Larry G.  Floyd               |   | Retired, Floyd’s Insulation, Inc.                              |
|                          |   | & Cherry Grove Sales, Inc.                                      |
|                          |   |                                                                     |
| Boyd R.  Ford, Jr.       |   | Retired, Ford’s Fuel Services, Inc.                            |
|                          |   | & Ford’s Propane Gas, Inc.                                 |
|                          |   |                                                                     |
| Tommie W.  Grainger           |   | President, Coastal Timber Co., Inc.                                 |
|                          |   |                                                                     |
| Gwyn G.  McCutchen            |   | Dentist                                                                  |
|                          |   |                                                                     |
| T. Freddie  Moore             |   | Retired, Gateway Drug Store, Inc.                                   |
|                          |   |                                                                     |
| Carroll D.  Padgett, Jr. |   | Attorney, Carroll D. Padgett, Jr., P.A.                             |

 

# **OFFICERSOF THE BOARD OF DIRECTORS**

 
| Clay D. Brittain, III |   | Johnny C. Allen                |
|----------------------------|--------|--------------------------------|
| Chairman                   |   | Vice Chairman                  |
|                       |   |                           |
| James R. Clarkson          |   | D.  Singleton Bailey |
| President and CEO          |   | Secretary                      |

 

56

----

 

**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**HORRY COUNTY STATE BANK CORPORATE OFFICERS**

 

James R. Clarkson, President/CEO

Glenn R. Bullard, Senior Executive Vice President

Jerry J. Cox, Jr., Senior Executive Vice President/Inland Region

Denise Floyd, Senior Vice President/Personnel Officer

Margaret H. Fowler, Senior Vice President/Operations Officer

Loretta B. Gerald, Senior Vice President/Cashier/Internal Auditor

Edward L. Loehr, Jr., Vice President/CFO

Ron L. Paige, Senior Executive VicePresident/Myrtle Beach Region

Douglas E. Shaffer, Senior Executive VicePresident/North Strand Region

 

**HORRY COUNTY STATE BANK BRANCHES AND ATM LOCATIONS**

 
| **Broad Street, Loris  Office***    | ** ** | **Windy Hill Office***     | ** ** | **Homewood Office***             |
|-------------------------------------|------------|----------------------------|------------|----------------------------------|
| **5009 Broad Street**               | ** ** | **4400 Hwy. 17 South**     | ** ** | **3201 Hwy. 701 North**          |
| Loris, SC 29569                     |       | N. Myrtle Beach, SC 29582  |       | Conway, SC 29526                 |
| 843-756-6333                        |       | 843-663-5600               |       | 843-369-4272                     |
|                                |       |                       |       |                             |
| **Mt. Olive Office***               | ** ** | **Socastee Office***       | ** ** | **Meeting Street, Loris Office** |
| **5264 Hwy. 9**                     | ** ** | **4600 Hwy. 17 Bypass S.** | ** ** | **4011 Meeting Street**          |
| **Green Sea, SC 29545**             | ** ** | **Myrtle Beach, SC 29577** | ** ** | **Loris, SC 29569**              |
| **843-392-6333**                    | ** ** | **843-293-7595**           | ** ** | **843-756-7168**                 |
| ** **                          | ** ** | ** **                 | ** ** | ** **                       |
| **Little River Office***            | ** ** | **Myrtle Beach Office***   | ** ** | **Carolina Forest Office***      |
| **3**187 Hwy. 9 E.                  | ** ** | **1701 N. Oak Street**     | ** ** | **273 Carolina Forest Blvd.**    |
| **Little River, SC 29566**          | ** ** | **Myrtle Beach, SC 29577** | ** ** | **Myrtle Beach, SC 29579**       |
| **843-399-9523**                    | ** ** | **843-839-9339**           | ** ** | **843-903-3223**                 |
| ** **                          | ** ** | ** **                 | ** ** | ** **                       |
| **Highway 501 Office***             | ** ** | **Tabor City Office***     | ** ** | **Ocean Drive Office**           |
| **1627-A Church Street (Hwy. 501)** | ** ** | **3210 Hwy. 701 Bypass**   | ** ** | **596 Highway 17 North**         |
| **Conway, SC 29526**                | ** ** | **Loris, SC 29569**        | ** ** | **North Myrtle Beach, SC 29582** |
| **843-248-8250**                    | ** ** | **910-653-3222**           | ** ** | **843-663-1396**                 |
| ** **                          | ** ** | ** **                 | ** ** | ** **                       |
| **Downtown Conway Office***         | ** ** | ** **                 | ** ** | **Covenant Towers Office**       |
| **1300 2nd Avenue**                 | ** ** | ** **                 | ** ** | **5001 Little River Road**       |
| Conway, SC  29526                   |       |                       |       | Myrtle  Beach, SC 29577          |
| **843-488-5510**                    | ** ** | ** **                 | ** ** | **843-449-2484**                 |

 

###### **Investment Services**

 

| 4400 Hwy. 17  South          |   |   |   | 1300 2nd  Avenue  |
|------------------------------|--------|--------|--------|-------------------|
| N. Myrtle  Beach, S.C. 29582 |   |   |   | Conway, SC  29526 |
| 843-839-6864                 |   |   |   | 843-488-5510      |

 

## **ResidentialMortgage Lending**

 

| 1701 N. Oak  Street     |   | 1300 2nd  Avenue  |   | 273 Carolina  Forest Blvd. |   | 596 Highway  17 North         |
|-------------------------|--------|-------------------|--------|----------------------------|--------|-------------------------------|
| Myrtle  Beach, SC 29577 |   | Conway, SC  29526 |   | Myrtle  Beach, SC 29579    |   | North Myrtle  Beach, SC 29582 |
| 843-839-6255            |   | 843-488-5510      |   | 843-903-3223               |   | 843-663-1396                  |

 

----

*****   Denotes ATM Location

 

57

----