**EXHIBIT 13**

 

***HCSB FINANCIAL CORPORATION***

* *

****

 

**HORRY COUNTY STATE BANK**

 

 

Loris, South Carolina

 

Annual Report

 

2008

 

 

www.hcsbaccess.com

 

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**HCSB FINANCIAL 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 | 8-28     |
| Report of  Independent Registered Public Accounting Firm                                    | 29       |
| Consolidated  Balance Sheets                                                                | 30       |
| Consolidated  Statements of Income                                                          | 31       |
| Consolidated  Statements of Changes in Shareholders’ Equity and Comprehensive Income   | 32       |
| Consolidated  Statements of Cash Flows                                                      | 33       |
| Notes to  Consolidated Financial Statements                                                 | 34-61    |
| Board of  Directors                                                                         | 62       |
| Corporate  Officers                                                                         | 63       |
| Branch  Locations                                                                           | 63       |

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

 

Certain statements in this annual report contain “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, such as statements relating to the future plans and expectations, andare thus prospective. Such forward-looking statements are subject to risks,uncertainties and other factors that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  Please see our annual reportfiled on Form 10-KSB for further discussion of these risks.

 

**HCSB Financial Corporation will furnish, free of charge, copies of theAnnual Report and the Company’s Report to the Securities and ExchangeCommission (Form 10-KSB) upon written request to James R. Clarkson,President and C.E.O., HCSB Financial Corporation, Post Office Box 218, Loris,South Carolina 29569.**

 

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**MESSAGE TO SHAREHOLDERS**

 

As I suggested one year ago that it would, the year 2008 did presentsignificant challenges to the banking industry as well as to Horry County StateBank.  I am very proud to announce,however, that HCSB met these challenges with much better results than manyother banks, not only in our marketplace, but nationwide as well.  In fact, in light of deteriorating economicconditions last year, in many ways HCSB experienced a remarkable year.

 

During 2008 total assets grew by 47% to a level of $644.3 million atthe end of the year.  Included in thisgrowth was an increase of $76.8 million in our loan portfolio, or 22%, as weconcluded the year with net loans of $424.6 million.  In addition, deposits grew by $143.9 million,or 42%, and were $484.8 million at year end.

 

With the deterioration in the real estate market and the potential forincreased loan losses that could result from the declining local economy, weincreased our Reserve for Loan Losses by $881,000, during 2008.  Despite doing this, however, net income forthe year was $2.2 million, which represented a 10% increase over 2007 earnings.

 

Other significant events for our bank during 2008 were the beginning ofconstruction of our new Operations Center in the Loris Commerce Center and theacquisition of a lot on Hwy. 17 in North Myrtle Beach on which we expect tobuild our permanent Ocean Drive Beach branch in 2009.  And, too,****we introduced our newcellular telephone banking service and remote deposit capture service whichenables certain business customers to make their deposits electronically attheir place of business rather than have to come to the bank to do so.

 

Thus, while the national media would have us all to believe that thebanking industry is in serious trouble and that banks have virtually ceasedmaking loans, such is certainly not the case at HCSB.  We have no investment in Fannie Mae or FreddieMac which were ruled insolvent, nor do we hold or invest in portfolios ofsub-prime residential mortgage loans.  Inaddition, we continue to maintain our status as a “well capitalized” bank inaccordance with regulatory guidelines.

 

Admittedly, the banking industry faces numerous additional challengesin 2009.  Despite the efforts of Congressto stimulate an economic turn-around quickly, an improvement of anysignificance is not likely to occur before late this year.  Many people nearing retirement age havesuffered substantial losses in their retirement funds with the stock marketdecline, and a great many good, honest people are suffering from the loss ofjobs or business volume.

 

We at HCSB are certainly not immune to these same problems, and weshall have to deal with the negative impact of low net interest margins as wellin 2009.  I do sincerely

 

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**MESSAGE TO SHAREHOLDERS — continued**

 

believe, however, that challenges do create opportunities, and we arepositioning ourselves to make the most of our opportunities.  Unlike a great many banks nationwide, HCSBhas maintained a strong safety and soundness rating by our regulatory agencies,and this has enabled our bank to gain approval to participate in the U.S.Treasury’s Capital Purchase Program. This additional capital will not only enable us to actively fund soundloans to provide needed financial support to solid, credit-worthy families,farmers and businesses within our trade area, but it will also better allow usto work with our present good customers who are experiencing short termdifficulties in their personal or business lives.  It is indeed a time for a strong communitybank like HCSB to stand by the many good customers around whom we have builtour bank.  We can work through thesedifficult times together if we are all willing to make necessary sacrifices,keep open lines of communication and utilize patience and common sense.

 

In summary, 2009 may truly be a year our adherence to our slogan “It’sthe little things that make a little bank...BIG!” really demonstrates thedifference between HCSB and our competitors. We have worked diligently for twenty-one years now to develop many loyalcustomer relationships as well as to increase the confidence of ourshareholders.  It is our full intentionto continue to make the types of prudent decisions that have enabled us to growthe bank’s assets and earnings steadily since our origin in 1988.

 

We have a tremendous group of employees here at HCSB, and we are mostappreciative and respectful of the trust that our shareholders have placed inus.  We continue to pledge in return ourdaily efforts to build on the values of our shareholders’ investments.

 

 

Most respectfully,

 

 

James R. Clarkson

President and CEO

 

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Ten Year History**

*(Omit 000’s)*

 
| **Year** | ** ** | **Assets** | ** ** | **Deposits** | ** ** | **Loans (net)** | ** ** | **Capital** | ** ** | **Earnings** | ** ** |
|----------|------------|------------|------------|--------------|------------|----------------------|------------|-------------|------------|--------------|------------|
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 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        |       |
|     |       |       |       |         |       |                 |       |        |       |         |       |
| 2008     |       | 644,347    |       | 484,751      |       | 424,622              |       | 34,450      |       | 2,244        |       |

 

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**Selected Financial Data**

 

The following table sets forth certain selected financial dataconcerning the Company.  The selectedfinancial data has been derived from the financial statements.  This information should be read inconjunction with the financial statements of the Company, including theaccompanying notes, included elsewhere herein.

 
| **Year Ended December 31,  (Dollars in thousands, except per share)** | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Financial Condition:**                                                                                      |       |       |       |       |       |       |       |       |       |       |       |
| Investment securities, available for sale                                                                     |       | $          | 166,992    |       | $          | 49,609     |       | $          | 50,830     |       | $          | 38,233 |   | $ | 42,597 |   |
| Allowance for loan losses                                                                                     |       | 4,416      |       | 3,535      |       | 2,718      |       | 2,569      |       | 2,155      |       |
| Net loans                                                                                                     |       | 424,622    |       | 348,671    |       | 251,849    |       | 232,509    |       | 210,649    |       |
| Premises and equipment, net                                                                                   |       | 19,056     |       | 16,051     |       | 16,139     |       | 11,681     |       | 11,803     |       |
| Total assets                                                                                                  |       | 644,347    |       | 438,353    |       | 359,537    |       | 331,662    |       | 296,807    |       |
| Noninterest-bearing deposits                                                                                  |       | 31,285     |       | 32,407     |       | 26,428     |       | 25,418     |       | 27,973     |       |
| Interest-bearing deposits                                                                                     |       | 453,466    |       | 308,444    |       | 248,723    |       | 228,719    |       | 194,416    |       |
| Total deposits                                                                                                |       | 484,751    |       | 340,851    |       | 275,151    |       | 254,137    |       | 222,389    |       |
| Advances from the Federal Home Loan Bank                                                                      |       | 92,000     |       | 52,300     |       | 43,390     |       | 43,390     |       | 43,390     |       |
| Total liabilities                                                                                             |       | 609,897    |       | 407,370    |       | 331,187    |       | 306,359    |       | 273,353    |       |
| Total shareholders’ equity                                                                               |       | 34,450     |       | 30,983     |       | 28,350     |       | 25,303     |       | 23,454     |       |
|                                                                                                          |       |       |       |       |       |       |       |       |       |       |       |
| **Results of Operations:**                                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Interest income                                                                                               |       | $          | 31,139     |       | $          | 28,536     |       | $          | 23,680     |       | $          | 19,164 |   | $ | 15,172 |   |
| Interest expense                                                                                              |       | 14,537     |       | 14,252     |       | 11,114     |       | 7,456      |       | 4,936      |       |
|                                                                                                          |       |       |       |       |       |       |       |       |       |       |       |
| Net interest income                                                                                           |       | 16,602     |       | 14,284     |       | 12,566     |       | 11,708     |       | 10,236     |       |
| Provision for loan losses                                                                                     |       | 1,754      |       | 985        |       | 770        |       | 1,070      |       | 1,285      |       |
| Net interest income after provision for  loan losses                                                          |       | 14,848     |       | 13,299     |       | 11,796     |       | 10,638     |       | 8,951      |       |
| Other income                                                                                                  |       | 3,586      |       | 2,696      |       | 2,604      |       | 1,931      |       | 2,156      |       |
| Other expense                                                                                                 |       | 15,086     |       | 12,903     |       | 10,308     |       | 8,903      |       | 7,961      |       |
|                                                                                                          |       |       |       |       |       |       |       |       |       |       |       |
| Income before income taxes                                                                                    |       | 3,348      |       | 3,092      |       | 4,092      |       | 3,666      |       | 3,146      |       |
| Income tax expense                                                                                            |       | 1,104      |       | 1,052      |       | 1,287      |       | 1,258      |       | 1,091      |       |
|                                                                                                          |       |       |       |       |       |       |       |       |       |       |       |
| Net income                                                                                                    | ** ** | **$**      | **2,244**  | ** ** | **$**      | **2,040**  | ** ** | **$**      | **2,805**  | ** ** | **$**      | **2,408** | ** ** | **$** | **2,055** | ** ** |
|                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per Share Data (1):**                                                                                       |       |       |       |       |       |       |       |       |       |       |       |
| Net income - basic                                                                                            |       | $          | 0.59       |       | $          | 0.53       |       | $          | 0.75       |       | $          | 0.64 |   | $ | 0.55 |   |
|                                                                                                          |       |       |       |       |       |       |       |       |       |       |       |
| Period end book value                                                                                         |       | $          | 9.09       |       | $          | 8.17       |       | $          | 7.47       |       | $          | 6.66 |   | $ | 6.21 |   |

 

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| (1) |   | Adjusted for 5% stock dividends declared in 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, February 2008  and January 2009, as well as the two-for-one stock split in the form of  a 100% stock dividend declared in January 2007. |
|-----|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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**Description of Company’s Business**

 

HCSB Financial Corporation (the Company) was incorporated on June 10,1999 to become a holding company for Horry County State Bank. The Company’sonly significant asset is its wholly owned subsidiary, Horry County State Bank(the Bank). The Bank is a state-chartered bank incorporated on December 18,1987 and located at 5201 Broad Street, Loris, South Carolina. The Company’sprimary market includes Horry County in South Carolina and Columbus andBrunswick Counties in North Carolina. From its 14 branch locations, the Companyoffers a full range of deposit services, including checking accounts, savingsaccounts, certificates of deposit, money market accounts, and IRAs, as well asa broad range of non-deposit investment services.

 

The Company is primarily engaged in thebusiness of attracting deposits from the general public and using thesedeposits together with other funds to make agricultural, commercial, consumer,and real estate loans. The Company’s operating results depend to a substantialextent on the difference between interest and fees earned on loans andinvestments and the Company’s interest expense, consisting principally ofinterest paid on deposits and borrowings. Unlike most industrial companies,virtually all of the assets and liabilities of financial institutions aremonetary. As a result, interest rates have a greater effect on the financialinstitution’s performance. In addition to competing with other traditionalfinancial institutions, the Company also competes for savings dollars withnontraditional financial intermediaries, such as mutual funds. This hasresulted in a highly competitive market area. The Company attempts to competein this highly competitive market by focusing on providing personal service andattention to its customers.

 

In 1995 the Company opened its first branchoffice in the Mt. Olive community of Horry County and has since expanded itsbranch network to 14 banking offices located throughout Horry County, as wellas an Operations Center in Loris, South Carolina which houses the Company’ssupport services. This expansion of its branch system has enabled the Companyto more effectively compete for deposits and loans. By expanding into differentcommunities, the Company has been able to substantially diversify its marketplace from one of a predominantly agricultural flavor to one which blends residentialdevelopments of retirees and others, tourism, major employment areas, centralcounty government and the market’s most active overall growth areas. In sodoing, the Company has reduced considerably the seasonality in its loanportfolio as well as the risks that are at times inherent with concentration ofloans in one particular segment of the economy.

 

In order to support this growth in its branchnetwork, the Company has undertaken several secondary 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 the reorganization was consummated in 1999, the Companycommitted to another secondary offering in 2002 whereby the Company issued anadditional 365,712 shares 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 participatedin the issuance of $6,000,000 of trust preferred securities through itsnon-consolidated subsidiary HCSB Financial Trust I (the Trust) to enable thecompany to pursue its growth goals and yet maintain a “well-capitalized” statusas defined by banking regulatory agencies.

 

On March 6, 2009, the Company issued12,985 shares of preferred stock, having $0.01 par value per share and aliquidation preference of $1,000 per share in connection with the United StatesTreasury’s Capital Purchase Program. The dividend rate of 5% per annum will bepayable for the first five years increasing to 9% per annum after five years. TheCompany also issued 91,714 warrants to purchase common stock at a strike priceof $21.09 per share. The warrants expire 10 years from the issue date. TheCompany plans to redeem all shares of this series of preferred stock withinfive years.

 

During the year 2006, the Company relocatedsome of its executive offices temporarily to the second floor of its branchbank at 1701 N. Oak Street, Myrtle Beach, S.C. due to the need for additionalspace in its Operations Center. The Company purchased a 5-acre tract of land inthe Loris Commerce Center in 2006 and began construction of a newCorporate/Operations Center on this site in November 2008 in order toaccommodate its executive offices and

 

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**DESCRIPTION OF BUSINESS****— *continued*

 

all support services in this new facility. TheCompany intends to offer its present Operations Center for sale upon completionof the new facility, which is anticipated to be in October, 2009.

 

Also in 2006 the Company acquired a lot and 25,710 square foot buildingthereon at 1300 Second Avenue, Conway, South Carolina as well as the adjacentlots which front on Third Avenue in 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 TLFcompleted construction of the interior of the Second Avenue and the parking loton Third Avenue, and the Company completed construction of its drive-up bankingfacility on Third Avenue as well. Thompson & Henry, P.A. moved intotheir offices on the third floor in October 2007 and the Company openedits branch and drive-up facility in November 2007. TLF and the Companyhave secured two tenants who are presently leasing the entire second floor.

 

Also in June 2007 the Company opened a new branch in The Plaza atGator Hole on Highway 17 in Ocean Drive Beach, South Carolina. The Companyentered into a two-year lease on this facility with an option for a one-yearrenewal, if necessary. In September 2008 the Company bought a lot at 617 Highway17 South, North Myrtle Beach, South Carolina and expects to begin constructionof it’s new permanent Ocean Drive branch on this site during the first quarterof 2009.

 

**Market for Common Share and Dividends**

** **

As of December 31,2008, there were 3,788,293 shares of our common stock outstanding held byapproximately 2,400 shareholders of record. There is currently no establishedpublic trading market in our common stock and trading and quotations of ourcommon stock have been limited and sporadic. Most of the trades of which theCompany is aware have been privately negotiated by local buyers and sellers. Inaddition to these trades, the Company is aware of a small number of tradesreported on Yahoo! that occurred on the OTC Bulletin Board between December 31,2007 and December 31, 2008. These trades ranged from $16.02 to $25.97. Wehave included these trades in the following table. Because there has not beenan established market for our common stock, we may not be aware of all pricesat which our common stock has been traded. We have not determined whether thetrades of which we are aware were the result of arm’s-length negotiationsbetween the parties. Based on information available to us, we believetransactions in our common stock can be fairly summarized as follows for theperiods indicated:

 
| ** **     | ** ** | **Low**    | ** ** | **High**   | ** ** |
|----------------|------------|------------|------------|------------|------------|
| **2008**       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Fourth Quarter |       | $          | 23.50      |       | $          | 27.00 |   |
| Third Quarter  |       | $          | 19.00      |       | $          | 27.00 |   |
| Second Quarter |       | $          | 19.90      |       | $          | 30.00 |   |
| First Quarter  |       | $          | 16.50      |       | $          | 28.00 |   |
| ** **     |       |       |       |       | ** ** |
| **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 | ** ** |

 

All share and per share data in this report has been adjusted toreflect all stock dividends and splits declared by the Company.

 

No cash dividends have ever been declared orpaid by the Company. However, the Board of Directors approved a 10% stockdividend for each of the five years ending December 31, 1996. The Companyalso paid a two-for-one stock split in the form of a 100% stock dividend in2000, a 5% stock dividend in each of the years 2001, 2002, and 2003, a 7.5%stock dividend in 2004, a 3% stock dividend in 2005, 2006 and 2008, and atwo-for-one stock split in the form of a 100% stock dividend in January 2007.The Company also paid a 3% stock dividend on February 20, 2009 toshareholders of record as of close of business February 6, 2009.

 

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**MARKET FOR COMMON SHARES AND DIVIDENDS****— *continued*

 

Management does not expect the Company to paycash dividends in the foreseeable future. The Company’s ability to paydividends depends on the ability of its subsidiary, Horry County State Bank, topay dividends to the Company. As a South Carolina state bank, the Bank may onlypay dividends out of its net profits, after deducting expenses, includinglosses and bad debts. In addition, the Bank is prohibited from declaring adividend on its shares of common stock until its surplus equals its statedcapital.

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATION**

** **

**INTRODUCTION**

 

The following discussion describes our results of operations for 2008as compared to 2007 and also analyzes our financial condition as of December 31,2008 as compared to December 31, 2007. Like most community banks, wederive most of our income from interest we receive on our loans andinvestments. Our primary source of funds for making these loans and investmentsis our deposits, both interest-bearing and 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 to maximize our net interest income, wemust not only manage the volume of these balance sheet items, but also theyields that we earn on our interest-earning assets and the rates that we pay oninterest-bearing liabilities.

 

We have included a number of tables to assist in our description ofthese measures. For example, the “Average Balances” table shows the averagebalance during 2008, 2007, and 2006 of each category of our assets andliabilities, as well as the yield we earned or the rate we paid with respect toeach category. A review of this table shows that our loans typically providehigher interest yields than do other types of interest earning assets, which iswhy we direct a substantial percentage of our earning assets into our loan portfolio.Similarly, the “Rate/Volume Analysis” table helps demonstrate the impact ofchanging interest rates and changing volume of assets and liabilities duringthe years shown. We also track the sensitivity of our various categories ofassets and liabilities to changes in interest rates, and we have included an“Interest Rate Sensitivity Analysis” table to help explain this. Finally, wehave included a number of tables that provide details about our investmentsecurities, our loans, and our deposits and other borrowings.

 

Of course, there are risks inherent in all loans, so we maintain anallowance for loan losses to absorb probable losses on existing loans that maybecome uncollectible. We establish and maintain this allowance by charging aprovision for loan losses against our operating earnings. In the Loan Portfoliosection we have included a detailed discussion of this process, as well asseveral tables describing our allowance for loan losses and the allocation ofthis allowance among our various categories of loans.

 

In addition to earning interest on our loansand investments, we earn income through fees that we charge to our customers.Likewise, we incur other operating expenses as well. We describe the variouscomponents of this noninterest income, as well as our noninterest expense, inthe Other Income and Other Expense section.

 

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**GENERAL**

 

Markets in the United States and elsewherehave experienced extreme volatility and disruption for more than 12 months. Thesecircumstances have exerted significant downward pressure on prices of equitysecurities and virtually all other asset classes, and have resulted insubstantially increased market volatility, severely constrained credit andcapital markets, particularly for financial institutions, and an overall lossof investor confidence. Loan portfolio performances have deteriorated at manyinstitutions resulting from, among other factors, a weak economy and a declinein the value of the collateral supporting their loans. Dramatic slowdowns inthe housing industry with falling home prices and increasing foreclosures andunemployment have created strains on financial institutions. Across the countrymany borrowers are now unable to repay their loans, and the collateral securingthese loans has, in some cases, declined below the loan balance. The followingdiscussion and analysis describes our performance in this challenging economicenvironment.

 

The Company continued to grow throughout2008. Total assets increased by $205,994,000, or 46.99%, and net loansincreased by $75,951,000, or 21.78%. Much of this growth is attributable to thesuccess of our branch network, especially the office in Myrtle Beach and NorthMyrtle Beach, and the employment of additional lenders and other personnel whohave helped grow our market share and customer base.

 

Profitability increased in 2008 by 10.00%,from $2,040,000 in 2007 to $2,244,000 in 2008, primarily as a result of anincrease in interest income on our taxable securities. The growth of the loanportfolio resulted in a loan to deposit ratio of 88.51%. The Company will needto attract additional deposits, borrow more money, or a combination of the twoto continue expansion of the loan portfolio. A more detailed discussion of thefactors contributing to growth and challenges is presented below.

 

**RESULTS OF OPERATIONS**

 

The Company experienced an increase of$325,000, or 1.29%, in interest income on loans and related fees for the yearended December 31, 2008. The Company also experienced an increase in theinterest income on taxable securities, which increased $2,743,000 or 124.01%. Thiscontributed to an increase in total interest income of $2,603,000 or 9.12%,over the course of 2008. Because of the increase in growth in interest-bearingdeposits, total interest expense increased $285,000, or 2.00%, to $14,537,000. Thisresulted in a $2,318,000, or 16.23%, increase in net interest income in 2008. TheCompany also experienced increases in non-interest income and expenses. Non-interestincome increased $905,000, or 33.57%, due to the bank’s investment inbank-owned life insurance, which increased $7,503,000, or 779.94%, during 2008.Non-interest expenses increased $2,136,000, or 16.55%, during 2008 due to theacquisition of additional personnel in our finance, credit review and trainingareas as a result of the growth of the bank. Overall, the Company had netincome for the year ended December 31, 2008 of $2,244,000, compared to$2,040,000 for the year ended December 31, 2007. This represents anincrease in net income of $204,000, or 10.00%.

 

**ASSETS, LIABILITIES, AND SHAREHOLDERS’ EQUITY**

** **

During thetwelve months ended December 31, 2008, total assets increased$205,994,000, or 46.99%, when compared to December 31, 2007. The primary reasonfor the increase in total assets was an increase in securitiesavailable-for-sale of $117,383,000, or 236.62%, during 2008 from $49,609,000 atDecember 31, 2007. Total deposits increased $143,900,000, or 42.22%, fromthe December 31, 2007 amount of $340,851,000. Interest-bearing depositsincreased $145,022,000, or 47.02%, and noninterest-bearing deposits decreased$1,122,000, or 3.46%, during 2008. The increase in deposits was primarily dueto the increase in our time deposits which increased $156,567,000, or 103%,from $152,002,000 at December 31, 2007 to $308,569,000 at December 31,2008.

 

9

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

** **

The Company has sought to maintain a conservative approach indetermining the distribution of its assets and liabilities. The following tablepresents the percentage relationships of significant components of theCompany’s average balance sheets for the last three fiscal years.

 

**Balance Sheet Categories as a Percent of Average Total Assets**

 
| ** **                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **Assets:**                                     |       |       |       |       |       |       |       |
| Interest earning assets:                        |       |       |       |       |       |       |       |
| Federal funds sold                              |       | .88        | %          | 2.83       | %          | 5.86       | %          |
| Investment securities                           |       | 19.79      |       | 13.48      |       | 14.36      |       |
| Loans                                           |       | 72.52      |       | 76.86      |       | 71.72      |       |
|                                            |       |       |       |       |       |       |       |
| Total interest earning assets                   |       | 93.19      |       | 93.17      |       | 91.94      |       |
|                                            |       |       |       |       |       |       |       |
| Cash and due from banks                         |       | 1.74       |       | 2.00       |       | 3.06       |       |
| Allowance for loan losses                       |       | (.72       | )          | (0.78      | )          | (0.77      | )          |
| Premises and equipment                          |       | 3.18       |       | 3.84       |       | 3.75       |       |
| Other assets                                    |       | 2.61       |       | 1.77       |       | 2.02       |       |
|                                            |       |       |       |       |       |       |       |
| Total assets                                    | ** ** | **100.00** | **%**      | **100.00** | **%**      | **100.00** | **%**      |
|                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities and shareholders’ equity:**  |       |       |       |       |       |       |       |
| Interest-bearing liabilities:                   |       |       |       |       |       |       |       |
| Interest-bearing deposits                       |       | 71.17      | %          | 70.08      | %          | 68.82      | %          |
| Federal funds purchased                         |       | .34        |       | 0.09       |       | —     |       |
| Advances from the Federal Home Loan Bank        |       | 12.27      |       | 11.59      |       | 12.57      |       |
| Repurchase Agreement                            |       | 1.84       |       | .43        |       | —     |       |
| Debt due to trust                               |       | 1.17       |       | 1.57       |       | 1.79       |       |
| Notes Payable                                   |       | .14        |       | —     |       | 0.25       |       |
|                                            |       |       |       |       |       |       |       |
| Total interest-bearing liabilities              |       | 86.93      |       | 83.76      |       | 83.43      |       |
|                                            |       |       |       |       |       |       |       |
| Noninterest-bearing deposits                    |       | 6.26       |       | 8.00       |       | 7.94       |       |
| Accrued interest and other liabilities          |       | .74        |       | 0.78       |       | 0.87       |       |
|                                            |       |       |       |       |       |       |       |
| Total liabilities                               |       | 93.93      |       | 92.54      |       | 92.24      |       |
|                                            |       |       |       |       |       |       |       |
| Shareholders’ equity                       |       | 6.07       |       | 7.46       |       | 7.76       |       |
|                                            |       |       |       |       |       |       |       |
| Total liabilities and shareholders’ equity | ** ** | **100.00** | **%**      | **100.00** | **%**      | **100.00** | **%**      |

 

**NET INTEREST INCOME**

 

Earnings are dependent to a large degree on net interest income. Netinterest income represents the difference between gross interest earned onearning assets, primarily loans and investment securities, and interest paid ondeposits and borrowed funds. Net interest income is affected by the interestrates earned or paid and by volume changes in loans, investment securities,deposits, and borrowed funds. The interest rate spread and the net yield onearning assets are two significant elements in analyzing the Company’s netinterest income. The interest rate spread is the difference between the yieldon average earning assets and the rate on average interest-bearing liabilities.The net yield on earning assets is computed by dividing net interest income bythe average earning assets.

 

For the year ended December 31, 2008, net interest income was$16,602,000, an increase of $2,318,000, or 16.23%, over net interest income of$14,284,000 in 2007. Interest income from loans, including fees, was$25,600,000, an increase of $325,000, or 1.29%, from 2007 to 2008 as employmentof additional lenders resulted in an increase in loans. Interest expense forthe year ended December 31, 2008 was $14,537,000, compared to $14,252,000for 2007.

 

10

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**NET INTEREST INCOME****— *continued*

 

This represents an increase of $285,000, or 2.00%, compared to theprior year. The interest rate spread and net yield on earning assets reflectedthe pressure created by the lower interest rate environment when compared tothe previous year as our customers began to move more of their money out oflower cost funding into time deposit accounts, which increased $156,567,000, or103.00%, throughout 2008. Our time deposit accounts have become very attractiveto our customers in the current interest rate environment. The net yieldrealized on earning assets was 3.35% for 2008, compared to 3.89% in 2007. Theinterest rate spread was 3.14% and 3.45% in 2008 and 2007, respectively.

 

The following table sets forth, for the periods indicated, theweighted-average yields earned, the weighted-average yields paid, the interestrate spread, and the net yield on earning assets. The table also indicates theaverage daily balance and the interest income or expense by specificcategories.

 

**Average Balances, Income and Expenses, andRates**

 
| ** **                                       | ** ** | **2008**    | ** **  | **2007**    | ** ** | **2006**   | ** ** |
|--------------------------------------------------|------------|-------------|-------------|-------------|------------|------------|------------|
| **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                             |       | 93,538      |        | 4,955       |       | 5.30       | %          | $ | 42,538 |   | 2,212 |   | 5.20 | % | $ | 39,395 |   | $ | 1,869 |   | 4.74 | % |
| Securities,  nontaxable                          |       | 7,570       |        | 295         |       | 3.90       |       | 7,571 |   | 290 |   | 3.83 |   | 7,273 |   | 274 |   | 3.77 |   |
| Loans (1)                                        |       | 385,277     |        | 25,600      |       | 6.64       |       | 302,965 |   | 25,275 |   | 8.34 |   | 247,614 |   | 20,417 |   | 8.25 |   |
| Federal funds  sold                              |       | 4,681       |        | 112         |       | 2.39       |       | 11,161 |   | 586 |   | 5.25 |   | 20,230 |   | 964 |   | 4.77 |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Nonmarketable  equity securities                 |       | 4,029       |        | 177         |       | 4.39       |       | 3,035 |   | 173 |   | 5.70 |   | 2,933 |   | 156 |   | 5.32 |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total earning  assets                            |       | 495,095     | ** **  | **$**       | **31,139** |       | 6.29       | % | 367,270 | ** ** | **$** | **28,536** |   | 7.77 | % | 317,445 | ** ** | **$** | **23,680** |   | 7.46 | % |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                         |       | 9,252       |        |        |       |       |       | 7,869 |   |   |   |   |   | 10,572 |   |   |   |   |   |
| Allowance for  loan losses                       |       | (3,810      | )           |        |       |       |       | (3,069 | ) |   |   |   |   | (2,673 | ) |   |   |   |   |
| Premises and  equipment                          |       | 16,870      |        |        |       |       |       | 15,157 |   |   |   |   |   | 12,966 |   |   |   |   |   |
| Other assets                                     |       | 13,867      |        |        |       |       |       | 6,962 |   |   |   |   |   | 6,961 |   |   |   |   |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     | ** ** | **$**       | **531,274** | ** **  | ** ** | ** ** | ** ** |   | **$** | **394,189** | ** ** |   |   |   |   | **$** | **345,271** |   |   |   |   |   |
|                                             | ** ** | ** **  | ** **  | ** **  | ** ** | ** ** |       | ** ** | ** ** |   |   |   |   | ** ** |   |   |   |   |   |
| **Liabilities:**                                 |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-Bearing  Liabilities:                   |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                       |       | 378,116     |        | 11,215      |       | 2.97       | %          | $ | 276,269 |   | 11,298 |   | 4.09 | % | $ | 237,599 |   | $ | 8,391 |   | 3.53 | % |
| Other borrowings                                 |       | 83,695      |        | 3,332       |       | 3.97       | %          | 53,925 |   | 2,954 |   | 5.48 |   | 50,446 |   | 2,723 |   | 5.40 |   |
| Total  interest-bearing liabilities              |       | 461,811     |        | 14,537      |       | 3.15       | %          | 330,194 |   | 14,222 |   | 4.31 | % | 288,045 |   | 11,114 |   | 3.86 | % |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  deposits                    |       | 33,282      |        |        |       |       |       | 31,545 |   |   |   |   |   | 27,415 |   |   |   |   |   |
| Accrued interest  and other liabilities          |       | 3,919       |        |        |       |       |       | 3,060 |   |   |   |   |   | 3,006 |   |   |   |   |   |
| Shareholders’  equity                       |       | 32,262      |        |        |       |       |       | 29,390 |   |   |   |   |   | 26,805 |   |   |   |   |   |
|                                             |       |        |        |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | **$**       | **531,274** |        |       |       |       |   | **$** | **394,189** |   |   |   |   |   | **$** | **345,271** |   |   |   |   |   |
|                                             |       | ** **  |        |        |       |       |       | ** ** |   |   |   |   |   | ** ** |   |   |   |   |   |
| Net interest  income/spread                      | ** ** | ** **  |        | **$**       | **16,602** |       | 3.14       | % |   | ** ** | **$** | **14,284** |   | 3.45 | % |   |   | **$** | **12,566** |   | 3.60 | % |
|                                             | ** ** | ** **  |        | ** **  |       |       |       |   | ** ** | ** ** |   |   |   |   |   | ** ** |   |   |   |
| Net interest  margin                             |       |        |        |        |       | 3.35       | %          |   |   |   |   | 3.89 | % |   |   |   |   | 3.96 | % |

 

----

(1)   The effects of loans innonaccrual status and fees collected are not significant to the computations.

 

11

----

 

**RATE/VOLUME ANALYSIS**

 

Net interest income can alsobe analyzed in terms of the impact of changing rates and changing volume.  The following table describes the extent towhich changes in interest rates and changes in the volume of earning assets andinterest-bearing liabilities have affected the Company’s interest income andinterest expense during the periods indicated. Information on changes in eachcategory attributable to (i) changes due to volume (change in volumemultiplied by prior period rate), (ii) changes due to rates (changes inrates multiplied by prior period volume), and (iii) changes in rate andvolume (change in rate multiplied by the change in volume) is provided asfollows:

 
| ** **                           | ** ** | **2008 compared to 2007**              | ** ** |
|--------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                           | ** ** | **Due to increase (decrease) in** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume(1)**                                         | ** ** | **Rate (1)** | ** ** | **Volume/Rate** | ** ** | **Total** | ** ** |
| Interest income:                     |       |                                                  |       |   |   |   |   |   |   |
| Taxable securities                   |       | $                                                     | 2,652      |   | $ | 41 |   | $ | 50 |   | $ | 2,743 |   |
| Nontaxable securities                |       | —                                                |       | 5 |   | — |   | 5 |   |
| Loans                                |       | 6,867                                                 |       | (5,144 | ) | (1,398 | ) | 325 |   |
| Federal funds sold                   |       | (340                                                  | )          | (319 | ) | 185 |   | (474 | ) |
| Nonmarketable equity securities      |       | 57                                                    |       | (40 | ) | (13 | ) | 4 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest income                |       | 9,236                                                 |       | (5,457 | ) | (1,176 | ) | 2,603 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Interest expense:                    |       |                                                  |       |   |   |   |   |   |   |
| Interest-bearing deposits            |       | 4,165                                                 |       | (3,104 | ) | (1,144 | ) | (83 | ) |
| Other borrowings                     |       | 1,631                                                 |       | (814 | ) | (449 | ) | 368 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest expense               |       | 5,796                                                 |       | (3,918 | ) | (1,593 | ) | 285 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Net interest income                  |       | **$**                                                 | **3,440**  | ** ** | **$** | **(1,539** | **)** | **$** | **417** | ** ** | **$** | **2,318** | ** ** |

 
| ** **                           | ** ** | **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 | ) |
| Nonmarketable equity securities      |       | 6                                                     |       | 11 |   | — |   | 17 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest income                |       | 4,298                                                 |       | 534 |   | 24 |   | 4,856 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Interest expense:                    |       |                                                  |       |   |   |   |   |   |   |
| Interest-bearing deposits            |       | 1,366                                                 |       | 1,326 |   | 215 |   | 2,907 |   |
| Other borrowings                     |       | 188                                                   |       | 40 |   | 3 |   | 231 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Total interest expense               |       | 1,554                                                 |       | 1,366 |   | 218 |   | 3,138 |   |
|                                 |       |                                                  |       |   |   |   |   |   |   |
| Net interest income                  |       | **$**                                                 | **2,744**  | ** ** | **$** | **(832** | **)** | **$** | **(194** | **)** | **$** | **1,718** | ** ** |

 

----

(1)  Volume-rate changes have been allocated to eachcategory based on a consistent basis between rate and volume.

 

12

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**RATE SENSITIVITY**

 

Interest rates paid on deposits and borrowed funds andinterest rates earned on loans and investments have generally followed thefluctuations in market rates in 2008 and 2007. However, fluctuations in market interest rates do not necessarily have asignificant impact on net interest income, depending on the Company’s interestrate sensitivity position. A rate-sensitive asset or liability is one that can berepriced either up or down in interest rate within a certain time interval.When a proper balance exists between rate-sensitive assets and rate-sensitiveliabilities, market interest rate fluctuations should not have a significantimpact on liquidity and earnings.  Thelarger the imbalance, the greater the interest rate risk assumed and thegreater the positive or negative impact of interest fluctuations on liquidityand earnings.

 

Interest rate sensitivity management is concerned with themanagement of both the timing and the magnitude of repricing characteristics ofinterest-earning assets and interest-bearing liabilities and is an importantpart of asset/liability management.  Theobjectives of interest rate sensitivity management are to ensure the adequacyof net interest income and to control the risks to net interest incomeassociated with movements in interest rates. The following table, “Interest Rate Sensitivity Analysis,” indicatesthat, on a cumulative basis, after three through twelve months, rate-sensitiveliabilities exceeded rate-sensitive assets, resulting in a twelve-monthliability sensitive position.  For a bankwith a liability-sensitive position, or negative gap, falling interest rateswould generally be expected to have a positive effect on net interest income,and rising interest rates would generally be expected to have the oppositeeffect.  The following table presents theCompany’s rate sensitivity at each of the time intervals indicated as of December 31,2008 and may not be indicative of the Company’s rate-sensitivity position atother points in time:

 

**Interest Rate Sensitivity Analysis**

 
| ** **                                      | ** ** | ** **          | ** ** | **After One** | ** ** | **After Three** | ** ** | ** **          | ** **   | **Greater**       | ** ** | ** **   | ** ** |
|-------------------------------------------------|------------|---------------------|------------|--------------------|------------|----------------------|------------|---------------------|--------------|-------------------|------------|--------------|------------|
| ** **                                      | ** ** | ** **          | ** ** | **Through**        | ** ** | **Through**          | ** ** | ** **          | ** **   | **Than One** | ** ** | ** **   | ** ** |
| **December 31, 2008**                 | ** ** | **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                               |       | $                   | —     |               | $          | —               |       | $                   | —       |              | $          | —       |       | $ | — |   | $ | — |   |
| Loans                                           |       | 265,256             |       | 10,117             |       | 32,102               |       | 307,475             |         | 121,633           |       | 429,108      |       |
| Securities                                      |       | —              |       | —             |       | 158                  |       | 158                 |         | 172,095           |       | 172,253      |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total earning assets                            |       | 265,256             |       | 10,117             |       | 32,260               |       | 307,633             |         | 293,728           |       | 601,361      |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| **Liabilities**                                 |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Interest-bearing liabilities:                   |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Interest-bearing deposits:                      |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Demand deposits                                 |       | 76,513              |       | —             |       | —               |       | 76,513              |         | —            |       | 76,513       |       |
| Savings deposits                                |       | 99,669              |       | —             |       | —               |       | 99,669              |         | —            |       | 99,669       |       |
| Time deposits                                   |       | 22,954              |       | 100,418            |       | 148,395              |       | 271,767             |         | 36,802            |       | 308,569      |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total interest-bearing deposits                 |       | 199,136             |       | 100,418            |       | 148,395              |       | 447,949             |         | 36,802            |       | 484,751      |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Other borrowings                                |       | 35,225              |       | 11,000             |       | 14,500               |       | 60,725              |         | 52,600            |       | 113,325      |       |
| Junior subordinated debentures                  |       | —              |       | 6,186              |       | —               |       | 6,186               |         | —            |       | 6,186        |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Total interest-bearing liabilities              |       | 234,361             |       | 117,604            |       | 162,895              |       | 514,860             |         | 89,402            |       | 604.262      |       |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Period gap                                      |       | **$**               | **30,895** | ** **         | **$**      | **(107,487**         | **)**      | **$**               | **(130,635** | **)**             | **$**      | **(207,227** | **)**      | **$** | **204,326** | ** ** |   |   |
|                                            |       | ** **          | ** ** | ** **         | ** ** | ** **           | ** ** | ** **          | ** **   | ** **        | ** ** |         |       |
| Cumulative gap                                  |       | **$**               | **30,895** | ** **         | **$**      | **(76,592**          | **)**      | **$**               | **(207,227** | **)**             | **$**      | **(207,227** | **)**      | **$** | **(2,901** | **)** |   |   |
|                                            |       |                |       |               |       |                 |       |                |         |              |       |         |       |
| Ratio of cumulative gap to total earning assets |       | 5.14                | %          | (12.74             | )%         | (34.46               | )%         | (34.46              | )%           | (0.48             | )%         |         |       |
|                                                 |            |                     |            |                    |            |                      |            |                     |              |                   |            |              |            |  |  |  |  |  |  |

 

13

----

 

**PROVISION FOR LOAN LOSSES**

 

The provision for loan losses is charged to earnings basedupon management’s evaluation of specific loans in its portfolio and generaleconomic conditions and trends in the marketplace.  The 2008 and 2007 provisions for loan lossesand their related effect of increasing the allowance for loan losses arerelated to growth in the loan portfolio. Please refer to the section “Loan Portfolio” for a discussion ofmanagement’s evaluation of the adequacy of the allowances for loan losses. In2008 and 2007, the provisions for loan losses were $1,754,000 and $985,000,respectively.

 

**NONINTEREST INCOME**

** **

Noninterest income was $3,601,000 for the year ended December 31,2008, an increase of $905,000, or 33.57%, when compared with the year ended December 31,2007.  The increase is primarily a resultof net gains on sale of securities of $439,000 for the year ended December 31,2008 as compared to a loss of $92,000 for the same period in 2007, an increaseof $531,000, or 577.17%.  The Bank had anopportunity to restructure the portfolio away from long-term investments and totake advantage of a low interest rate environment by selling securities thatproduced gains in non-interest income during the fourth quarter of 2008.  The Bank was able to reinvest this money atcomparable rates, therefore not losing interest income.  This increase in noninterest income is also aresult of an increase of $270,000, or 627.91%, in income from cash value oflife insurance from $43,000 for the year ended December 31, 2007 to$313,000 for the year ended December 31, 2008.  This is due to the Bank’s investment inbank-owned life insurance policies of $7,503,000 during 2008.  In addition, service charges on depositaccounts increased $253,000, or 17.48%, from $1,447,000 for the year ended December 31,2007 to $1,700,000 for the year ended December 31, 2008.  Also, other fees increased $102,000, or291.43%, from $35,000 for the year ended December 31, 2007 to $137,000 forthe year ended December 31, 2008. This increase is due to gains in the sale of fixed assets of $18,000 forthe year ended 2008 and growth in rental income received on our foreclosed property of $71,000, which was an increase of411.84% over the amount of such rental income we generated in 2007.  We incurred a decrease in brokeragecommissions of $170,000, or 53.97%, from $315,000 for the year ended 2007compared to $145,000 for the year ended 2008, due to the decline in the generalhealth of the economy.  Also, gains onthe sale of residential mortgage loans sold in the secondary market declined$94,000, or 14.97%, from $628,000 for the year ended 2007 compared to $534,000for the year ended 2008.  The Bankexpects improvement in this area with the addition of a mortgage originatorduring the fourth quarter of 2008 and due to the low interest rate environmentgenerating more business.

 

**NONINTEREST EXPENSES**

** **

Most categories of noninterest expenses increased during2008 due to continued growth of the Company. Salaries and employee benefits increased $1,138,000, or 14.80%, due tothe employment of additional lenders and other personnel needed for thecontinued growth and success of the Bank. Also, net occupancy expenses increased $244,000, or 28.11%, from$868,000 for the year ended December 31, 2007 to $1,112,000 for the yearended December 31, 2008.  Inaddition, other operating expenses also increased $847,000, or 33.29%, duemainly to the increase in FDIC insurance premiums during 2008 and an increasein other expenses due to the growth of the bank.

 

## **INCOME TAXES**

## ** **

The Company’s income tax expense for 2008 was $1,104,000,an increase of $52,000 from the 2007 expense of $1,052,000. The increase in theexpense results from the increase in income before taxes in 2008 compared to2007.  The Company’s effective tax ratesfor the years ended December 31, 2008 and 2007 were 32.97% and 34.02%,respectively.

 

14

----

 

**LIQUIDITY**

** **

Liquidity is the ability to meet current and futureobligations through liquidation or maturity of existing assets or theacquisition of additional liabilities. The Company manages both assets and liabilities to achieve appropriatelevels of liquidity.  Cash and federalfunds sold are the Company’s primary sources of asset liquidity.  These funds provide a cushion againstshort-term fluctuations in cash flow from both deposits and loans.  The investment securities portfolio is theCompany’s principal source of secondary asset liquidity.  However, the availability of this source offunds is influenced by market conditions. Individual and commercial deposits are the Company’s primary source offunds for credit activities.  Althoughnot historically used as principal sources of liquidity, federal fundspurchased from correspondent banks and advances from the Federal Home Loan Bankare other options available to management.

 

As of December 31, 2008, the Company had unused linesof credit to purchase federal funds from unrelated banks totaling$28,300,000.  These lines of credit areavailable on a one to fourteen day basis for general corporate purposes.  The lenders have reserved the right not torenew their respective lines.  Unpledgedsecurities available-for-sale, which totaled $52,101,000 at December 31,2008, 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 71.00% and 87.11% at December 31,2008 and 2007, respectively.

 

**IMPACT OF OFF-BALANCE-SHEET INSTRUMENTS**

** **

The Company is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments consist ofcommitments to extend credit and standby letters of credit.  Commitments to extend credit are legallybinding agreements to lend to a customer at predetermined interest rates 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.  A commitment involves, to varyingdegrees, elements of credit and interest rate risk in excess of the amountrecognized in the balance sheets.  TheCompany’s exposure to credit loss in the event of nonperformance by the otherparty to the instrument is represented by the contractual notional amount ofthe instrument.  Since certaincommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements.  Letters of credit are conditional commitmentsissued to guarantee a customer’s performance to a third party and haveessentially the same credit risk as other lending facilities.  Standby letters of credit often expirewithout being used.  Management believesthat through various sources of liquidity, the Company has the necessaryresources to meet obligations arising from these financial instruments.

 

The Company uses the samecredit underwriting procedures for commitments to extend credit and standbyletters 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 not involvedin off-balance-sheet contractual relationships, other than those disclosed inthis report, which it believes could result in liquidity needs or othercommitments or that could significantly impact earnings.

 

As of December 31,2008, commitments to extend credit totaled $61,918,000 and standby letters ofcredit totaled $1,478,000.

 

15

----

 

**IMPACT OF OFF-BALANCE-SHEET INSTRUMENTS** – *continued*

 

The following table setsforth the length of time until maturity for unused commitments to extend creditand standby letters of credit at December 31, 2008.

 
| ** **                           | ** ** | ** ** | ** ** | **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  |       | $          | 1,974      |               | $          | 7,327                |       | $          | 25,179     |              | $          | 34,480     |       | $ | 27,438 |   | $ | 61,918 |   |
|                                 |       |       |       |               |       |                 |       |       |       |              |       |       |       |
| Standby letters of credit            |       | —     |       | 5                  |       | 1,381                |       | 1,386      |       | 92                |       | 1,478      |       |
|                                 |       |       |       |               |       |                 |       |       |       |              |       |       |       |
| Totals                               |       | **$**      | **1,974**  | ** **         | **$**      | **7,332**            | ** ** | **$**      | **26,560** | ** **        | **$**      | **35,866** | ** ** | **$** | **27,530** | ** ** | **$** | **63,396** | ** ** |

 

The Company entered intointerest rate swap agreements associated with Federal Home Loan Bank advancesduring the third quarter of 2003.  Theinterest rate swaps effectively converted the fixed interest rates on theadvances to a variable rate. The notional amount of advances involved in thistransaction totaled $14,600,000.  Theunrealized gain related to the interest rate swaps was $83,000 at December 31,2008 and a cumulative negative effect of $145,000 to earnings.  The Company believes that the hedging of suchdebt was very effective as management protected against further declines ininterest rates as well as a continuation of interest rates at or near their lowlevels at the time the transaction was consummated.

 

**IMPACT OF INFLATION AND CHANGING PRICES**

** **

The financial statements and related financial datapresented herein have been prepared in accordance with generally acceptedaccounting principles which require the measurement of financial position andoperating results in terms of historical dollars without considering changes inrelative purchasing power over time due to inflation.  Unlike most industrial companies, virtuallyall of the assets and liabilities of a financial institution are monetary innature.  As a result, interest ratesgenerally have a more significant impact on a financial institution’sperformance than does the effect of inflation.

 

While the effect of inflation on a bank is normally not assignificant as its influence on those businesses that have large investments inplant and inventories, it does have an effect. Interest rates generally increase as the rate of inflation increases,but the magnitude of the change in rates may not be the same.  While interest rates have traditionally movedwith inflation, the effect on income is diminished because both interest earnedon assets and interest paid on liabilities vary directly with each other unlessthe Company is in a high liability sensitive position.  Also, general increases in the price of goodsand services will result in increased operating expenses.

 

16

----

 

**CAPITAL RESOURCES**

** **

The Company uses severalindicators of capital strength.  The mostcommonly used measure is average common equity to average assets, which was6.07% in 2008 compared to 7.46% in 2007. The change in this ratio reflects an increase in the Company’s assets ata higher rate than in earnings in 2008 as compared to 2007.

 

The Company and the Bank aresubject to various regulatory capital requirements administered by the federalbanking agencies.  Failure to meetminimum 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.

 

Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial 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.

 

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 Bank arealso required to maintain capital at a minimum level based on quarterly averageassets, which is known as the leverage ratio. Only the strongest banks are allowed to maintain capital at the minimumrequirement of 3%.  All others aresubject to maintaining ratios 1% to 2% above the minimum.

 

As of December 31,2008, 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.

 

17

----

 

**CAPITAL RESOURCES*— continued***

** **

The Company and the Bank arerequired to maintain certain risk-based and leverage ratios.  The Company and the Bank exceeded theseregulatory capital ratios at December 31, 2008, 2007, and 2006 as setforth in the following tables.

 
| **December 31,**                                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
|---------------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| **(Dollars in thousands)**                                | ** ** | **2008**   | ** **  | **2007**   | ** ** | **2006**    | ** ** |
| **The Company**                                                     |       |       |        |       |       |        |       |
| Tier 1 capital                                                      |       | $          | 39,352      |       | $          | 36,989      |       | $ | 34,773 |   |
| Tier 2 capital                                                      |       | 4,416      |        | 3,534      |       | 2,718       |       |
|                                                                |       |       |        |       |       |        |       |
| Total qualifying capital                                            |       | **$**      | **43,768**  | ** ** | **$**      | **40,524**  | ** ** | **$** | **37,491** | ** ** |
|                                                                |       | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
| Risk-adjusted total assets (including off-balance-sheet  exposures) |       | **$**      | **458,154** | ** ** | **$**      | **361,051** | ** ** | **$** | **270,498** | ** ** |
|                                                                |       |       |        |       |       |        |       |
| Tier 1 risk-based capital ratio                                     |       | 8.59       | %           | 10.24      | %          | 12.86       | %          |
| Total risk-based capital ratio                                      |       | 9.55       | %           | 11.22      | %          | 13.86       | %          |
| Tier 1 leverage ratio                                               |       | 7.41       | %           | 9.38       | %          | 10.07       | %          |
|                                                                |       |       |        |       |       |        |       |
| **The Bank**                                                        |       |       |        |       |       |        |       |
| Tier 1 capital                                                      |       | $          | 42,714      |       | $          | 36,100      |       | $ | 33,885 |   |
| Tier 2 capital                                                      |       | 4,416      |        | 3,534      |       | 2,718       |       |
|                                                                |       |       |        |       |       |        |       |
| Total qualifying capital                                            |       | **$**      | **47,130**  | ** ** | **$**      | **39,634**  | ** ** | **$** | **36,603** | ** ** |
|                                                                |       | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** |
| Risk-adjusted total assets (including off-balance-sheet  exposures) |       | **$**      | **457,174** | ** ** | **$**      | **360,346** | ** ** | **$** | **266,373** | ** ** |
|                                                                |       |       |        |       |       |        |       |
| Tier 1 risk-based capital ratio                                     |       | 9.35       | %           | 10.02      | %          | 12.72       | %          |
| Total risk-based capital ratio                                      |       | 10.31      | %           | 11.00      | %          | 13.74       | %          |
| Tier 1 leverage ratio                                               |       | 6.86       | %           | 8.55       | %          | 9.71        | %          |

 

The Company does not expect to pay cash dividends toshareholders during 2008.

 

**INVESTMENT PORTFOLIO**

** **

Management classifies investment securities as eitherheld-to-maturity or available-for-sale based on their intentions and theCompany’s ability to hold them until maturity. In determining such classifications, securities that management has thepositive intent and the Company has the ability to hold until maturity areclassified as held-to-maturity and carried at amortized cost.  All other securities are designated asavailable-for-sale and carried at estimated fair value with unrealized gainsand losses included in shareholders’ equity on an after-tax basis.  As of December 31, 2008 and 2007, allsecurities were classified as available-for-sale.

 

During 2009 growth in thesecurities portfolio resulted primarily from purchases of fixed rate AgencyMortgage securities. Purchases of Mortgage securities are part of a strategy todiversify the Company’s earning assets and to reduce the negative impact offalling rates on our net interest income. Beginning in December 2008, management began to restructure theinvestment portfolio by selling 30 year fixed rate securities and purchasingshorter duration fixed rate and adjustable rate securities.

 

18

----

 

**INVESTMENT PORTFOLIO *- continued***

** **

The following tablessummarize the carrying value of investment securities as of the indicated datesand the weighted-average yields of those securities at December 31, 2008.

 

**Investment Securities Portfolio Composition**

 
| **December 31,**                      | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|
| **(Dollars in thousands)**       | ** ** | **2008**   | ** **  | **2007**   | ** ** | **2006**   | ** ** |
| Government-Sponsored Enterprises           |       | $          | 19,316      |       | $          | 20,447     |       | $ | 19,092 |   |
| Obligations of state and local governments |       | 7,668      |        | 7,730      |       | 7,435      |       |
| Mortgage-backed securities                 |       | 140,008    |        | 21,432     |       | 23,449     |       |
| Equity securities available-for-sale       |       | —     |        | —     |       | 854        |       |
| Nonmarketable equity securities            |       | 5,261      |        | 3,327      |       | 2,948      |       |
|                                       |       |       |        |       |       |       |       |
| Total securities                           |       | **$**      | **172,253** | ** ** | **$**      | **52,936** | ** ** | **$** | **53,778** | ** ** |

 

**Investment Securities Portfolio Maturity Schedule**

 
| ** **                                       | ** ** | **Available-for-Sale** | ** **  |
|--------------------------------------------------|------------|------------------------|-------------|
| **December 31, 2008**                  | ** ** | **Carrying**           | ** **  | ** ** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Amount**             | ** **  | **Yield** | ** ** |
| Government-Sponsored Enterprises due:            |       |                   |        |   |   |
| After five years but within ten years            |       | 8,382                  |        | 5.58 | % |
| After ten years                                  |       | 10,934                 |        | 5.76 | % |
|                                             |       |                   |        |   |   |
| Obligations of states and local governments due: |       |                   |        |   |   |
| After one year but within five years             |       | 2,145                  |        | 3.81 | % |
| After five years but within ten years            |       | 4,750                  |        | 3.95 | % |
| After ten years                                  |       | 773                    |        | 4.39 | % |
|                                             |       |                   |        |   |   |
|                                             |       | 7,668                  |        | 3.95 | % |
| Mortgage-backed securities                       |       | 102,346                |        | 5.58 | % |
|                                             |       |                   |        |   |   |
| Collateralized Mortgage Obligation (CMOs)        |       | 37,662                 |        | 5.37 | % |
|                                             |       |                   |        |   |   |
|                                             |       | **$**                  | **166,992** | ** ** | **5.33** | **%** |
|                                                  |            |                        |             |  |  |  |

 

**LOAN PORTFOLIO**

** **

Management believes the loan portfolio is adequatelydiversified.  There are no foreign loans,and agricultural loans as of December 31, 2008 are limited.  There are no significant concentrations ofloans in any particular individuals or industry or group of related individualsor industries.

 

The Company has experiencedcontinued growth of its loan portfolio throughout 2008 and 2007, resulting inincreases of $76,832,000 and $97,639,000, respectively.  Management has concentrated on seeking tomaintain quality in the loan portfolio. The loan-to-deposit ratio is used tomonitor a financial institution’s potential profitability and efficiency ofasset distribution and utilization. Generally, a higher loan-to-deposit ratio is indicative of higherinterest income since loans typically yield a higher return than otherinterest-earning assets.  Theloan-to-deposit ratios were 88.51% and 103.33% at December 31, 2008 and2007, respectively.  The Company wantedto improve its liquidity position by investing more in its securitiesportfolio, which not only provides cash flow but also improves our net interestmargin.  The loans-to-total borrowedfunds ratio was 71.00% and 87.11% at December 31, 2008 and 2007,respectively.  Management intends todeploy available funds to loans to the extent it deems prudent to achieve itstargeted ratio of loans to deposits; however, there can be no assurance thatmanagement will be able to execute its strategy or that loan demand willcontinue to support growth.

 

19

----

** **

**LOAN PORTFOLIO***- continued*

** **

**Loan Portfolio Composition**

 
| **December 31,**                            | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
|--------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|------------|-------------|------------|------------|
| **(Dollars in thousands)**             | ** ** | **2008**   | ** **  | **2007**   | ** ** | **2006**    | ** ** | **2005**   | ** **  | **2004**   | ** ** |
| Real estate -  construction and land development |       | $          | 60,643      |       | $          | 59,084      |       | $          | 28,124      |       | $          | 18,686 |   | $ | 8,026 |   |
| Real estate - mortgage  and commercial           |       | 253,450    |        | 201,448    |       | 147,156     |       | 133,527    |        | 110,584    |       |
| Agricultural                                     |       | 7,613      |        | 7,221      |       | 6,099       |       | 5,141      |        | 6,136      |       |
| Commercial and  industrial                       |       | 84,568     |        | 64,019     |       | 54,313      |       | 55,909     |        | 62,991     |       |
| Consumer                                         |       | 19,655     |        | 18,535     |       | 18,267      |       | 21,168     |        | 22,881     |       |
| All other loans  (including overdrafts)          |       | 3,109      |        | 1,899      |       | 608         |       | 647        |        | 2,186      |       |
|                                             |       |       |        |       |       |        |       |       |        |       |       |
| Total gross  loans                               |       | **$**      | **429,038** | ** ** | **$**      | **352,206** | ** ** | **$**      | **254,567** | ** ** | **$**      | **235,078** | ** ** | **$** | **212,804** | ** ** |

 

**Credit Risk Management**

** **

Credit risk entails both general risk, which is inherent in the processof lending, and risk that is specific to individual borrowers.  The management of credit risk involves theprocesses of loan underwriting and loan administration.  The Company seeks to manage credit riskthrough a strategy of making loans within the Company’s primary marketplace andwithin the Company’s limits of expertise. Although management seeks to avoid concentrations of credit by loan typeor industry through diversification, a substantial portion of the borrowers’ability to honor the terms of their loans is dependent on the business andeconomic conditions in Horry and Marion Counties in South Carolina and Columbusand Brunswick Counties in North Carolina. A continuation of the economic downturn or prolonged recession couldresult in the deterioration of the quality of our loan portfolio and reduce ourlevel of deposits, which in turn would have a negative impact on ourbusiness.  Additionally, since realestate is considered by the Company as the most desirable nonmonetary collateral,a significant portion of the Company’s loans are collateralized by real estate;however, the cash flow of the borrower or the business enterprise is generallyconsidered as the primary source of repayment. Generally, the value of real estate is not considered by the Company asthe primary source of repayment for performing loans.  The Company also seeks to limit totalexposure 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 loan officers and loan administration staff are chargedwith monitoring the Company’s loan portfolio and identifying changes in theeconomy or in a borrower’s circumstances which may affect the ability to repaythe debt or the value of the pledged collateral.  In order to assess and monitor the degree ofrisk in the Company’s loan portfolio, several credit risk identification andmonitoring processes are utilized.  TheCompany assesses credit risk initially through the assignment of a risk gradeto each loan based upon an assessment of the borrower’s financial capacity toservice the debt and the presence and value of any collateral.

 

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 andinherent losses in the loan portfolio and for determining the adequacy of theallowance for loan losses.

 

20

----

 

**LOAN PORTFOLIO***- continued*

** **

**Maturities and Sensitivity of Loans to Changes inInterest Rates:**

 

The following table summarizes the loan maturity distribution, by type,at December 31, 2008 and related interest rate characteristics:

 
| ** **                                       | ** ** | ** **        | ** **  | **Over**            | ** ** | ** **         | ** ** | ** ** | ** **  |
|--------------------------------------------------|------------|-------------------|-------------|---------------------|------------|--------------------|------------|------------|-------------|
| ** **                                       | ** ** | ** **        | ** **  | **One Year**   | ** ** | ** **         | ** ** | ** ** | ** **  |
| **December 31, 2008**                  | ** ** | **One Year** | ** **  | **Through**         | ** ** | **Over Five** | ** ** | ** ** | ** **  |
| **(Dollars in thousands)**             | ** ** | **or Less**  | ** **  | **Five Years** | ** ** | **Years**          | ** ** | **Total**  | ** **  |
| Real estate -  construction and land development |       | $                 | 48,694      |                | $          | 11,483             |       | $          | 466         |   | $ | 60,643 |   |
| Real estate -  other                             |       | 108,989           |        | 103,415             |       | 41,046             |       | 253,450    |        |
| Agricultural                                     |       | 2,956             |        | 3,262               |       | 1,395              |       | 7,613      |        |
| Commercial and  industrial                       |       | 48,474            |        | 31,966              |       | 4,128              |       | 84,568     |        |
| Consumer                                         |       | 6,707             |        | 12,159              |       | 789                |       | 19,655     |        |
| All other loans  (including overdrafts)          |       | 2,434             |        | 517                 |       | 158                |       | 3,109      |        |
|                                             |       |              |        |                |       |               |       |       |        |
| ** **                                       | ** ** | **$**             | **218,254** | ** **          | **$**      | **162,802**        | ** ** | **$**      | **47,982**  | ** ** | **$** | **429,038** |   |
| Loans maturing  after one year with:             |       |              |        |                |       |               |       |       |        |
| Fixed interest  rates                            |       |              |        |                |       |               |       | $          | 45,581      |   |
| Floating  interest rates                         |       |              |        |                |       |               |       | 169,181    |        |
|                                             |       |              |        |                |       |               |       |       |        |
| ** **                                       |       |              |        |                |       |               |       | **$**      | **214,762** |   |

 

**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 the loanis 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)**                        | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Nonaccrual loans  (includes impaired loans)                 |       | $          | 9,040      |       | $          | 2,696      |       | $          | 760        |       | $          | 2,044 |   | $ | 4,295 |   |
| Total  nonperforming loans                                  |       | 9,040      |       | 2,696      |       | 760        |       | 2,044      |       | 4,295      |       |
|                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Other real  estate owned                                    |       | 2,965      |       | 338        |       | 95         |       | 485        |       | 964        |       |
|                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Total  nonperforming assets                                 |       | **$**      | **12,005** | ** ** | **$**      | **3,034**  | ** ** | **$**      | **855**    | ** ** | **$**      | **2,529** | ** ** | **$** | **5,259** | ** ** |
|                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Loans 90 days or  more past due and still accruing interest |       | $          | —     |       | $          | —     |       | $          | 1,714      |       | $          | 843 |   | $ | 378 |   |
| Nonperforming  assets to period end loans                   |       | 2.80       | %          | 0.86       | %          | 0.33       | %          | 1.08       | %          | 2.47       | %          |

 

21

----

 

**LOAN PORTFOLIO***- continued*

** **

For loans to be in excess of 90 days delinquent and still accruinginterest, the borrowers must be either remitting payments although not able toget current, liquidation on loans deemed to be well secured must be nearcompletion, or the Company must have a reason to believe that correction of thedelinquency status by the borrower is near. The amount of both nonaccrual loans and loans past due 90 days or morewere considered in computing the allowance for loan losses as of December 31,2008.  Generally, the Company placesloans which are in excess of 90 days delinquent on nonaccrual status.  If the borrower is able to bring the accountcurrent, the loan is then placed back on regular accrual status.

 

**Summary of Loan Loss Experience**

 
| **(Dollars in thousands)**                         | ** ** | **2008**   | ** **  | **2007**   | ** ** | **2006**    | ** ** | **2005**   | ** **  | **2004**   | ** ** |
|--------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|------------|-------------|------------|------------|
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Total loans  outstanding at end of period                    |       | **$**      | **429,108** | ** ** | **$**      | **354,214** | ** ** | **$**      | **256,800** | ** ** | **$**      | **235,669** | ** ** | **$** | **212,808** | ** ** |
|                                                         |       | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** | ** **  | ** ** | ** ** |
| Average loans  outstanding                                   |       | **$**      | **385,277** | ** ** | **$**      | **302,965** | ** ** | **$**      | **247,614** | ** ** | **$**      | **226,528** | ** ** | **$** | **211,028** | ** ** |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Balance of allowance  for loan losses at beginning of period |       | $          | 3,535       |       | $          | 2,718       |       | $          | 2,569       |       | $          | 2,155 |   | $ | 1,774 |   |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Charge-offs:                                                 |       |       |        |       |       |        |       |       |        |       |       |
| Real estate                                                  |       | 385        |        | —     |       | 4           |       | 122        |        | 354        |       |
| Commercial                                                   |       | 550        |        | 54         |       | 418         |       | 382        |        | 286        |       |
| Consumer and  credit card                                    |       | 294        |        | 165        |       | 289         |       | 287        |        | 328        |       |
| Other                                                        |       | 23         |        |       |       |        |       |       |        |       |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Total  charge-offs                                           |       | 1,252      |        | 219        |       | 711         |       | 791        |        | 968        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Recoveries of  loans previous charged-off                    |       | 379        |        | 51         |       | 90          |       | 135        |        | 64         |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Net charge-offs                                              |       | 873        |        | 168        |       | 621         |       | 656        |        | 904        |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Provision  charged to operations                             |       | 1,754      |        | 985        |       | 770         |       | 1,070      |        | 1,285      |       |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Balance of  allowance for loan losses at end of period       |       | **$**      | **4,416**   | ** ** | **$**      | **3,535**   | ** ** | **$**      | **2,718**   | ** ** | **$**      | **2,569** | ** ** | **$** | **2,155** | ** ** |
|                                                         |       |       |        |       |       |        |       |       |        |       |       |
| Ratios:                                                      |       |       |        |       |       |        |       |       |        |       |       |
| Net charge-offs  to average loans outstanding                |       | 0.23       | %           | 0.06       | %          | 0.25        | %          | 0.29       | %           | 0.43       | %          |
| Net charge-offs  to loans at end of year                     |       | 0.20       | %           | 0.05       | %          | 0.24        | %          | 0.28       | %           | 0.42       | %          |
| Allowance for  loan losses to average loans                  |       | 1.15       | %           | 1.17       | %          | 1.10        | %          | 1.13       | %           | 1.02       | %          |
| Allowance for  loan losses to loans at end of year           |       | 1.03       | %           | 1.00       | %          | 1.06        | %          | 1.09       | %           | 1.01       | %          |
| Net charge-offs  to allowance for loan losses                |       | 19.77      | %           | 4.75       | %          | 22.85       | %          | 25.54      | %           | 41.95      | %          |
| Net charge-offs  to provisions for loan losses               |       | 49.77      | %           | 17.06      | %          | 80.65       | %          | 61.31      | %           | 70.35      | %          |

 

22

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**LOAN PORTFOLIO***- continued*

** **

Management has established an allowance for loan losses through aprovision for loan losses charged to expense onour statements of income.  Theallowance represents an amount which management believes will be adequate toabsorb probable losses on existing loans that may become uncollectible.  Management does not allocate specificpercentages of our allowance for loan losses to the various categories of loansbut evaluates the adequacy on an overall portfolio basis utilizing severalfactors.  The primary factor consideredis the credit risk grading system, which is applied to each loan.  The amount of both nonaccrual loans and loanspast due 90 days or more is also considered. The historical loan loss experience, the size of our lending portfolio,changes in the lending policies and procedures, changes in volume or type of credits, changes in volume/severity of problemloans, quality of loan review and board of director oversight, concentrationsof credit, and peer group comparisons, and current and anticipatedeconomic conditions are also considered in determining the provision for loanlosses. The amount of the allowance is adjusted periodically based on changingcircumstances.  Recognized losses are charged to the allowance for loan losses, whilesubsequent recoveries are added to the allowance.

 

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, 2008 and2007, management considered the allowances for loan losses adequate based onits judgments, 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.

 

At December 31, 2008, the allowance for loan losses represented0.9 times the amount of non-performing loans, compared to 1.3 times and 3.3times at December 31, 2007 and 2006, respectively.  The coverage level of the allowance at December 31,2008 decreased from the coverage level at December 31, 2007 due to anincrease in non-performing loans.  As of December 31,2008 and 2007, the Company had nonaccrual loans of approximately $9,040,000 and$2,696,000, respectively.  These loanscomprise a substantial majority of loans classified as impaired.  A significant portion, or 88.6%, of nonperformingloans at December 31, 2008 are secured by real estate.  We have evaluated the underlying collateralon these loans and believe that the collateral on these loans is sufficient tominimize future losses.  However, the recent downturn in the real estate market hasresulted in increased loan delinquencies, defaults and foreclosures, and webelieve that these trends are likely to continue.  In some cases, this downturn has resulted ina significant impairment to the value of the collateral used to secure theseloans and the ability to sell the collateral upon foreclosure.  These conditions have adversely affected ourloan portfolio.  The real estatecollateral in each case provides an alternate source of repayment in the eventof default by the borrower and may deteriorate in value during the time thecredit is extended.  If real estatevalues continue to decline, it is also more likely that we would be required toincrease our allowance for loan losses. If during a period of reduced real estate values we are required toliquidate the property collateralizing a loan to satisfy the debt or toincrease the allowance for loan losses, this could materially reduce ourprofitability and adversely affect our financial condition.

 

23

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**AVERAGE DAILY DEPOSITS**

** **

The following table summarizes the Company’s average daily depositsduring the years ended December 31, 2008, 2007, and 2006.  These totals include time deposits $100,000and over, which at December 31, 2008 totaled $81,082,000.  Of this total, scheduled maturities withinthree months were $24,439,000; over three through twelve months were$50,261,000; and over twelve months were $6,382,000.

 
| ** **                             | ** ** | **2008**    | ** **  | **2007**    | ** ** | **2006**    | ** ** |
|----------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|
| ** **                             | ** ** | ** **  | ** **  | **Average** | ** ** | ** **  | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                             | ** ** | **Average** | ** **  | **Rate**    | ** ** | **Average** | ** ** | **Rate** | ** ** | **Average** | ** ** | **Rate** | ** ** |
| ** **                             | ** ** | **Amount**  | ** **  | **Paid**    | ** ** | **Amount**  | ** ** | **Paid** | ** ** | **Amount** | ** ** | **Paid** | ** ** |
| ** **                             | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Noninterest-bearing  demand            |       | 33,282      |        | 0.00        | %          | $           | 31,545     |   | 0.00 | % | $ | 27,415 |   | 0.00 | % |
| Interest-bearing  transaction accounts |       | 46,376      |        | 0.56        | %          | 47,171      |       | 1.19 |   | 65,145 |   | 1.73 |   |
| Money market  savings account          |       | 93,125      |        | 2.19        | %          | 102,532     |       | 4.54 |   | 67,634 |   | 4.51 |   |
| Other savings  accounts                |       | 5,602       |        | 1.34        | %          | 5,402       |       | 1.22 |   | 5,846 |   | 1.27 |   |
| Time deposits                          |       | 233,013     |        | 3.79        | %          | 121,164     |       | 4.94 |   | 98,974 |   | 4.19 |   |
|                                   |       |        |        |        |       |        |       |   |   |   |   |   |   |
| Total deposits                         |       | **$**       | **411,398** | ** **  | ** ** | ** **  | **$**      | **307,814** |   |   |   | **$** | 265,014 |   |   |   |
|                                        |            |             |             |             |            |             |            |  |  |  |  |  |  |  |  |  |

 

**ADVANCES FROM THE FEDERAL HOMELOAN BANK**

 

The following table summarizes the Company’s short-term borrowings forthe years ended December 31, 2008, 2007 and 2006.

 
| ** **                            | ** ** | **Maximum**        | ** ** | ** **  | ** ** | **Weighted** | ** ** | ** **           | ** ** |
|---------------------------------------|------------|--------------------|------------|-------------|------------|--------------|------------|----------------------|------------|
| ** **                            | ** ** | **Outstanding**    | ** ** | ** **  | ** ** | **Average**  | ** ** | ** **           | ** ** |
| ** **                            | ** ** | **at any**    | ** ** | **Average** | ** ** | **Interest** | ** ** | **Balance**          | ** ** |
| **(Dollars in thousands)**  | ** ** | **Month End** | ** ** | **Balance** | ** ** | **Rate**     | ** ** | **December 31** | ** ** |
| ** **                            |       |               |       |        |       |         |       |                 |       |
| **2008**                              |       |               |       |        |       |         |       |                 |       |
| Advances from  Federal Home Loan Bank |       | $                  | 92,500     |        | 65,195     |         | 3.37       | %                    | 92,000     |   |
|                                  |       |               |       |        |       |         |       |                 |       |
| **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 |   |

 

Advances from the Federal Home Loan Bank are collateralized by one-to-fourfamily residential mortgage loans, certain commercial real estate loans,certain securities in the Bank’s investment portfolio and the Company’sinvestment in Federal Home Loan Bank stock. Although we expect to continue using Federal Home Loan Bank advances asa secondary funding source, core deposits will continue to be our primaryfunding source.  Of the $92,000,000advances from Federal Home Loan Bank outstanding at December 31, 2008,$8,400,000 have scheduled principal reductions in 2009, $14,600,000 in 2010,$5,000,000 in 2011 and the remainder after five years.

 

As discussed in the notes to the financial statements, the Company hasentered into interest rate swap agreements associated with Federal Home LoanBank advances 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 3.20% at December 31,2008****and is based on the three month LIBORindex.

 

24

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**JUNIOR SUBORDINATED DEBENTURES**

 

On December 21, 2004, HCSB Financial Trust I (the “Trust”), anon-consolidated subsidiary of the Company, issued and sold a total of 6,000trust preferred securities, with $1,000 liquidation amount per capital security(the “Capital Securities”), to institutional buyers in a pooled trust preferredissue.  The Capital Securities, which arereported on the consolidated balance sheet as junior subordinated debentures,generated proceeds of $6 million.  TheTrust loaned these proceeds to the Company to use for general corporatepurposes.  The junior subordinateddebentures qualify as Tier 1 capital under Federal Reserve Board guidelines,subject to limitations.  See Note 11 tothe consolidated financial statements for more information about the terms ofthe junior subordinated debentures.

 

Debt issuance costs, net of accumulated amortization, from juniorsubordinated debentures totaled $95,000 and $98,694 at December 31, 2008and 2007, respectively, and are included in other assets on the consolidatedbalance sheet.  Amortization of debtissuance costs from junior subordinated debentures totaled $3,667 for the yearsended December 31, 2008, and December 31, 2007, and are reported inother expenses on the consolidated income statement for the years ended December 31,2008, and December 31, 2007.

 

**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.

 
| ** **                | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
|                      |       |     |       |     |       |     |       |
| Return on  average assets |       | 0.42     | %          | 0.52     | %          | 0.81     | %          |
| Return on  average equity |       | 6.96     | %          | 6.94     | %          | 10.46    | %          |
| Equity to assets  ratio   |       | 6.07     | %          | 7.46     | %          | 7.77     | %          |

 

**ACCOUNTING AND FINANCIALREPORTING ISSUES**

** **

We have adoptedvarious accounting policies which govern the application of accountingprinciples generally accepted in the United States in the preparation of ourfinancial statements.  Our significantaccounting policies are described in the footnotes to the consolidatedfinancial statements at December 31, 2008, as filed on our annual reporton Form 10-K. Certain accounting policies involve significant judgmentsand assumptions by us which have a material impact on the carrying value ofcertain assets and liabilities.  Weconsider these accounting policies to be critical accounting policies. Thejudgments and assumptions we use are based on historical experience and otherfactors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgments andassumptions we make, actual results could differ from these judgments andestimates which could have a material impact on our carrying values of assetsand 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-Oxley Act of 2002**

 

The Congress of the United States of America passed the Sarbanes-OxleyAct in 2002 in the aftermath of corporate scandals among several major publiclytraded corporations.  The intent of theAct was to legislate corporate governance and better ascertain the accuracy offinancial reporting by companies regulated by the Securities and ExchangeCommission.

 

Section 404 of the Sarbanes-Oxley Act, which becomes effective forthe Company in 2008, requires that the Company adopt and maintain effectiveinternal controls that will, among other things, permit the preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America.

 

25

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**INDUSTRY DEVELOPMENTS - *continued***

** **

Management of the Company has the responsibility to adopt soundaccounting policies, maintain an adequate and efficient accounting system,safeguard assets and devise policies to ensure that the Company complies withapplicable laws and regulations.

 

To assist in this process the company has purchased software from thenational accounting firm of Crowe Chizek and retained the services of ElliottDavis, LLC and Co Source, LLC to work with management and participate in the Section 404process.  Elliott Davis, LLC will performonly those services in this regard that are acceptable by the Public CompanyAccounting Oversight Board (PCAOB). Compliance with Section 404 of the Sarbanes-Oxley Act willcertainly add to the Company’s operating expenses due to requirements foradditional technology, record keeping, and professional assistance that isnecessary.

 

From time to time, various bills are introduced in the United StatesCongress with respect to the regulation of financial institutions.  Certain of these proposals, if adopted, couldsignificantly change the regulation of banks and the financial servicesindustry.  The Company cannot predictwhether any of these proposals will be adopted or, if adopted, how theseproposals would affect the Company.

 

**Recent Legislative and Regulatory Initiatives toAddress Financial and Economic Crises**

 

The Congress, Treasury Department and the federal banking regulators,including the FDIC, have taken broad action since early September 2008 toaddress volatility in the U.S. banking system.

 

In October 2008, the Emergency Economic Stabilization Act of 2008(“EESA”) was enacted. The EESA authorizes the Treasury Department topurchase from financial institutions and their holding companies up to $700billion in mortgage loans, mortgage-related securities and certain otherfinancial instruments, including debt and equity securities issued by financialinstitutions and their holding companies in a troubled asset relief program (“TARP”).  Thepurpose of TARP is to restore confidence and stability to the U.S. bankingsystem and to encourage financial institutions to increase their lending tocustomers and to each other.  The Treasury Department has allocated$250 billion towards the TARP Capital Purchase Program (“CPP”).  Underthe CPP, Treasury will purchase debt or equity securities from participatinginstitutions.  The TARP also will include direct purchases orguarantees of troubled assets of financial institutions. Participants inthe CPP are subject to executive compensation limits and are encouraged toexpand their lending and mortgage loan modifications.

 

On March 6, 2009, as part of the TARP CPP, the Company enteredinto a Letter Agreement and Securities Purchase Agreement (collectively, the “CPPPurchase Agreement”) with the Treasury Department, pursuant to which theCompany sold (i) 12,895 shares of the Company’s Fixed Rate CumulativePerpetual Preferred Stock, Series T (the “Series T Preferred Stock”)and (ii) a warrant (the “CPP Warrant”) to purchase 91,714 shares of theCompany’s common stock for an aggregate purchase price of $12,895,000 in cash.

 

The Series T Preferred Stock will qualify as Tier 1 capital andwill be entitled to cumulative dividends at a rate of 5% per annum for thefirst five years, and 9% per annum thereafter. The Company must consult with the FDIC before it may redeem the Series TPreferred Stock but, contrary to the original restrictions in the EESA, willnot necessarily be required to raise additional equity capital in order toredeem this stock.  The Warrant has a10-year term and is immediately exercisable upon its issuance, with an exerciseprice, subject to anti-dilution adjustments, equal to $21.09 per share of thecommon stock. Please see the Form 8-K we filed with the SEC on March 6,2009, for additional information about the Series T Preferred Stock andthe Warrant.

 

EESA also increased FDIC deposit insurance on most accounts from$100,000 to $250,000.  This increase is in place until the end of2009 and is not covered by deposit insurance premiums paid by the bankingindustry.

 

Following a systemic risk determination, the FDIC established theTemporary Liquidity Guarantee Program (“TLGP”) on October 14,2008.  The TLGP includes the Transaction Account Guarantee Program (“TAGP”),which provides unlimited deposit insurance coverage through December 31,2009 for noninterest-bearing transaction

 

26

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**INDUSTRY DEVELOPMENTS - *continued***

** **

accounts (typically business checking accounts) and certain funds sweptinto noninterest-bearing savings accounts.  Institutionsparticipating in the TLGP pay a 10 basis points fee (annualized) on the balanceof each covered account in excess of $250,000, while the extra depositinsurance is in place.  The TLGP also includes the Debt GuaranteeProgram (“DGP”), under which the FDIC guarantees certain senior unsecured debtof FDIC-insured institutions and their holding companies.  Theunsecured debt must be issued on or after October 14, 2008 and not laterthan June 30, 2009, and the guarantee is effective through the earlier ofthe maturity date or June 30, 2012.  The DGP coverage limit isgenerally 125% of the eligible entity’s eligible debt outstanding on September 30,2008 and scheduled to mature on or before June 30, 2009 or, for certaininsured institutions, 2% of their liabilities as of September 30,2008.  Depending on the term of the debt maturity, the nonrefundableDGP fee ranges from 50 to 100 basis points (annualized) for covered debtoutstanding until the earlier of maturity or June 30, 2012.  TheTAGP and DGP are in effect for all eligible entities, unless the entity optedout on or before December 5, 2008.  We will participate in theTAGP and have opted out of the DGP.

 

**Insurance of Accountsand Regulation by the FDIC**

 

Our deposits are insured up to applicable limits by the DepositInsurance Fund of the FDIC.  The Deposit Insurance Fund is thesuccessor to the Bank Insurance Fund and the Savings Association InsuranceFund, which were merged effective March 31, 2006.  As insurer,the FDIC imposes deposit insurance premiums and is authorized to conductexaminations of and to require reporting by FDIC insuredinstitutions.  It also may prohibit any FDIC insured institution fromengaging in any activity the FDIC determines by regulation or order to pose aserious risk to the insurance fund.  The FDIC also has the authorityto initiate enforcement actions against savings institutions, after giving theOffice of Thrift Supervision an opportunity to take such action, and mayterminate the deposit insurance if it determines that the institution hasengaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

Under regulations effective January 1, 2007, the FDIC adopted anew risk-based premium system that provides for quarterly assessments based onan insured institution’s ranking in one of four risk categories based uponsupervisory and capital evaluations.  Institutions are assessed at annualrates ranging from 5 to 43 basis points, respectively, depending on eachinstitution’s risk of default as measured by regulatory capital ratios andother supervisory measures.  Under a proposal announced by the FDICon October 7, 2008, the assessment rate schedule would be raised uniformlyby seven basis points (annualized) beginning on January 1, 2009. Beginningwith the second quarter of 2009, base assessment rates before adjustments wouldrange from 10 to 45 basis points, and further changes would be made to thedeposit insurance assessment system, including requiring riskier institutionsto pay a larger share.  The proposal would impose higher assessmentrates on institutions with a significant reliance on secured liabilities and oninstitutions which rely significantly on brokered deposits (but, forwell-managed and well-capitalized institutions, only when accompanied by rapidasset growth).  The proposal would reduce assessment rates forinstitutions that hold long-term unsecured debt and, for smaller institutions,high levels of Tier 1 (defined below) capital. In addition, on February 27, 2009, the FDIC approved an interim rule toraise 2009 second quarter deposit insurance premiums for Risk Category I banksfrom 10 to 14 basis points to 12 to 16 basis points.  The FDIC will also impose a 10-basis pointspecial emergency assessment payable September 30, 2009, and the FDICboard authorized the FDIC to implement an additional 10 basis-point premium inany quarter.  We anticipate our future insurancecosts to be higher than in previous periods. However, we are not currently able to accurately determine the amount ofadditional cost.

 

FDIC insured institutions are required to pay a Financing Corporationassessment, in order to fund the interest on bonds issued to resolve thriftfailures in the 1980s.  For the quarterly period ended December 31,2008, the Financing Corporation assessment equaled 1.61 basis points for each$100 in domestic deposits.    These assessments, which maybe revised based upon the level of deposits, will continue until the bondsmature in the years 2017 through 2019.

 

The FDIC may terminate the deposit insurance of any insured depositoryinstitution, including the bank, if it determines after a hearing that theinstitution has engaged in unsafe or unsound practices, is in an unsafe orunsound condition to continue operations or has violated any applicable law,regulation, rule, order or condition imposed by

 

27

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**INDUSTRY DEVELOPMENTS - *continued***

** **

the FDIC or the OCC.  It also may suspend depositinsurance temporarily during the hearing process for the permanent terminationof insurance, if the institution has no tangible capital.  If insurance ofaccounts is terminated, the accounts at the institution at the time of thetermination, less subsequent withdrawals, shall continue to be insured for aperiod of six months to two years, as determined by theFDIC.  Management of the bank is not aware of any practice, conditionor violation that might lead to termination of the bank’s deposit insurance.

 

**MANAGEMENT’S ANNUAL REPORT ONINTERNAL 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 published financialstatements.

 

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, 2008. Basedon this assessment management believes that as of December 31, 2008, theCompany’s internal control over financial reporting was effective.  Management based this assessment on criteriafor effective internal control over financial reporting described in *“Internal Control — Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission.”*  Management’s assessment included anevaluation of the design of our internal control over financial reporting and testingof the operational effectiveness of its internal control over financialreporting.  Management reviewed theresults of its assessment with the Audit Committee of the Board of Directors.  Based on this assessment, management believesthat HCSB Financial Corporation maintained effective internal control overfinancial reporting as of December 31, 2008.

 

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 theCompany’s registered public accounting firm pursuant to temporary rules ofthe Securities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report.

 

28

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**REPORT OF INDEPENDENT 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, 2008 and 2007,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 financialstatements.  An audit also includesassessing the accounting principles used and the significant estimates made bymanagement as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of HCSBFinancial Corporation and its subsidiary as of December 31, 2008 and 2007,and the results of their operations and their cash flows for the years thenended, in conformity with U. S. generally accepted accounting principles.

 

We were not engaged to examine management’s assertion of theeffectiveness of HCSB Financial Corporation’s internal control over financialreporting as of December 31, 2008, 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 9, 2009       |   |

 

29

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                                            | ** ** | **December 31,** | ** **  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|
| **(Dollars in thousands)**                                                                                                                                  | ** ** | **2008**              | ** **  | **2007** | ** ** |
| **Assets:**                                                                                                                                                           |       |                  |        |   |   |
| Cash and cash equivalents:                                                                                                                                            |       |                  |        |   |   |
| Cash and due from banks                                                                                                                                               |       | $                     | 10,423      |   | $ | 7,958 |   |
| Federal funds sold                                                                                                                                                    |       | —                |        | 3,655 |   |
| Total cash and cash equivalents                                                                                                                                       |       | 10,423                |        | 11,613 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Investment securities:                                                                                                                                                |       |                  |        |   |   |
| Securities available-for-sale                                                                                                                                         |       | 166,992               |        | 49,609 |   |
| Nonmarketable equity securities                                                                                                                                       |       | 5,261                 |        | 3,327 |   |
| Total investment securities                                                                                                                                           |       | 172,253               |        | 52,936 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Loans held for sale                                                                                                                                                   |       | 70                    |        | 2,008 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Loans receivable                                                                                                                                                      |       | 429,038               |        | 352,206 |   |
| Less allowance for loan losses                                                                                                                                        |       | (4,416                | )           | (3,535 | ) |
|                                                                                                                                                                  |       |                  |        |   |   |
| Loans, net                                                                                                                                                            |       | 424,622               |        | 348,671 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Premises, furniture and equipment, net                                                                                                                                |       | 19,056                |        | 16,051 |   |
| Accrued interest receivable                                                                                                                                           |       | 3,625                 |        | 3,473 |   |
| Cash Value of life insurance                                                                                                                                          |       | 8,465                 |        | 962 |   |
| Other assets                                                                                                                                                          |       | 5,833                 |        | 2,639 |   |
| Total assets                                                                                                                                                          | ** ** | **$**                 | **644,347** | ** ** | **$** | **438,353** | ** ** |
|                                                                                                                                                                  | ** ** | ** **            | ** **  | ** ** | ** ** |
| **Liabilities:**                                                                                                                                                      |       |                  |        |   |   |
| Deposits:                                                                                                                                                             |       |                  |        |   |   |
| Noninterest-bearing transaction accounts                                                                                                                              |       | $                     | 31,285      |   | $ | 32,407 |   |
| Interest-bearing transaction accounts                                                                                                                                 |       | 45,228                |        | 43,299 |   |
| Money market savings accounts                                                                                                                                         |       | 94,008                |        | 104,310 |   |
| Other savings accounts                                                                                                                                                |       | 5,661                 |        | 8,833 |   |
| Time deposits $100 and over                                                                                                                                           |       | 81,082                |        | 64,044 |   |
| Other time deposits                                                                                                                                                   |       | 227,487               |        | 87,958 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Total deposits                                                                                                                                                        |       | 484,751               |        | 340,851 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Federal Funds Purchased                                                                                                                                               |       | 7,653                 |        |   |   |
| Repurchase Agreements                                                                                                                                                 |       | 9,172                 |        | 5,000 |   |
| Advances from the Federal Home Loan Bank                                                                                                                              |       | 92,000                |        | 52,300 |   |
| Notes Payable                                                                                                                                                         |       | 4,500                 |        | — |   |
| Junior subordinated debentures                                                                                                                                        |       | 6,186                 |        | 6,186 |   |
| Accrued interest payable                                                                                                                                              |       | 2,105                 |        | 982 |   |
| Other liabilities                                                                                                                                                     |       | 3,530                 |        | 2,051 |   |
| Total liabilities                                                                                                                                                     |       | 609,897               |        | 407,370 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| **Commitments and Contingencies (Notes 4, 12  and 13)**                                                                                                               |       |                  |        |   |   |
| ** **                                                                                                                                                            |       |                  |        |   |   |
| **Shareholders’ Equity:**                                                                                                                                        |       |                  |        |   |   |
| Common stock, $0.01 par value, 10,000,000  shares authorized; 3,788,293 and 3,677,974 shares issued and outstanding at  December 31, 2008 and 2007, respectively |       | 38                    |        | 37 |   |
| Capital surplus                                                                                                                                                       |       | 30,728                |        | 28,689 |   |
| Nonvested restricted stock                                                                                                                                            |       | (645                  | )           | (645 | ) |
| Retained earnings                                                                                                                                                     |       | 3,231                 |        | 2,908 |   |
| Accumulated other comprehensive loss                                                                                                                                  |       | 1,098                 |        | (6 | ) |
| Total shareholders’ equity                                                                                                                                       |       | 34,450                |        | 30,983 |   |
|                                                                                                                                                                  |       |                  |        |   |   |
| Total liabilities and shareholders’ equity                                                                                                                       | ** ** | **$**                 | **644,347** | ** ** | **$** | **438,353** | ** ** |

 

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

 

30

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Consolidated Statements of Income**

 
| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands except share amounts)** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| **Interest income:**                                                     |       |                                        |       |   |   |
| Loans, including fees                                                    |       | $                                           | 25,600     |   | $ | 25,275 |   |
| Investment securities:                                                   |       |                                        |       |   |   |
| Taxable                                                                  |       | 4,955                                       |       | 2,212 |   |
| Tax-exempt                                                               |       | 295                                         |       | 290 |   |
| Nonmarketable equity securities                                          |       | 177                                         |       | 173 |   |
| Federal funds sold and other                                             |       | 112                                         |       | 586 |   |
|                                                                     |       |                                        |       |   |   |
| Total                                                                    |       | 31,139                                      |       | 28,536 |   |
|                                                                     |       |                                        |       |   |   |
| **Interest expense:**                                                    |       |                                        |       |   |   |
| Deposits                                                                 |       | 11,215                                      |       | 11,298 |   |
| Borrowings                                                               |       | 3,322                                       |       | 2,954 |   |
|                                                                     |       |                                        |       |   |   |
| Total                                                                    |       | 14,537                                      |       | 14,252 |   |
|                                                                     |       |                                        |       |   |   |
| **Net interest income**                                                  | ** ** | **16,602**                                  |       | 14,314 |   |
| ** **                                                               | ** ** | ** **                                  |       |   |   |
| Provision for loan losses                                                |       | 1,754                                       |       | 985 |   |
|                                                                     |       |                                        |       |   |   |
| **Net interest income after provision for  loan losses**                 | ** ** | **14,848**                                  |       | 13,329 |   |
| ** **                                                               | ** ** | ** **                                  |       |   |   |
| **Noninterest income:**                                                  |       |                                        |       |   |   |
| Service charges on deposit accounts                                      |       | 1,700                                       |       | 1,447 |   |
| Credit life insurance commissions                                        |       | 52                                          |       | 57 |   |
| Gain on sale of residential mortgage loans                               |       | 534                                         |       | 628 |   |
| Brokerage commissions                                                    |       | 145                                         |       | 315 |   |
| Other fees and commissions                                               |       | 281                                         |       | 263 |   |
| Gain (Losses) on sales of securities                                     |       | 439                                         |       | (92 | ) |
| Income from cash value life insurance                                    |       | 313                                         |       | 43 |   |
| Other                                                                    |       | 122                                         |       | 35 |   |
|                                                                     |       |                                        |       |   |   |
| Total                                                                    |       | 3,586                                       |       | 2,696 |   |
|                                                                     |       |                                        |       |   |   |
| **Noninterest expenses:**                                                |       |                                        |       |   |   |
| Salaries and employee benefits                                           |       | 8,889                                       |       | 7,689 |   |
| Net occupancy                                                            |       | 1,112                                       |       | 868 |   |
| Marketing and advertising                                                |       | 450                                         |       | 491 |   |
| (Gain) Loss on sale of assets                                            |       | (15                                         | )          | 11 |   |
| Loss on sale of OREO                                                     |       | 259                                         |       | 0 |   |
| Furniture and equipment                                                  |       | 1,259                                       |       | 1,300 |   |
| Other operating                                                          |       | 3,132                                       |       | 2,544 |   |
|                                                                     |       |                                        |       |   |   |
| Total                                                                    |       | 15,086                                      |       | 12,903 |   |
|                                                                     |       |                                        |       |   |   |
| **Income before income taxes**                                           | ** ** | **3,348**                                   |       | 3,092 |   |
| ** **                                                               | ** ** | ** **                                  |       |   |   |
| Income tax provision                                                     |       | 1,104                                       |       | 1,052 |   |
|                                                                     |       |                                        |       |   |   |
| **Net income**                                                           | ** ** | **$**                                       | **2,244**  | ** ** | **$** | **2,040** | ** ** |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Net income per common share**                                          |       |                                        |       |   |   |
| Basic                                                                    | ** ** | **$**                                       | **0.59**   | ** ** | **$** | **0.53** | ** ** |
|                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Diluted                                                                  | ** ** | **$**                                       | **0.59**   | ** ** | **$** | **0.53** | ** ** |
|                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Average common shares outstanding**                                    |       |                                        |       |   |   |
| Basic                                                                    | ** ** | **3,788,296**                               | ** ** | **3,787,791** | ** ** |
|                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Diluted                                                                  | ** ** | **3,829,061**                               | ** ** | **3,816,082** | ** ** |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

31

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

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

**Years ended December 31, 2008 and 2007**

 
| **(Dollars in thousands,**                       | ** ** | **Common Stock** | ** ** | **Nonvested  restricted** | ** ** | **Capital** | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | ** **             | ** ** |
|------------------------------------------------------------|------------|-----------------------|------------|---------------------------|------------|-------------|------------|--------------|------------|---------------------------------------|------------|------------------------|------------|
| **except share amounts)**                                  | ** ** | **Shares**            | ** ** | **Amount**                | ** ** | **stock**   | ** ** | **surplus**  | ** ** | **earnings**                          | ** ** | **income (loss)** | ** ** | **Total** | ** ** |
| ** **                                                 |       |                  |       |                      |       |        |       |         |       |                                  |       |                   |       |   |   |
| **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, 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 |   |
| ** **                                                 |       |                  |       |                      |       |        |       |         |       |                                  |       |                   |       |   |   |
| Net income                                                 |       |                  |       |                      |       |        |       |         |       | 2,244                                 |       |                   |       | 2,244 |   |
| Other comprehensive income, net of tax  expense of $648    |       |                  |       |                      |       |        |       |         |       |                                  |       | 1,104                  |       | 1,104 |   |
| Comprehensive income                                       |       |                  |       |                      |       |        |       |         |       |                                  |       |                   |       | 3,348 |   |
| Payment of fractional shares                               |       | (19                   | )          |                      |       |        |       |         |       | (28                                   | )          |                   |       | (28 | ) |
| Stock option expense                                       |       |                  |       |                      |       |        |       | 147          |       |                                  |       |                   |       | 147 |   |
| Declaration of 3% stock dividend on January 22,  2009 |       | 110,338               |       | 1                         |       |        |       | 1,892        |       | (1,893                                | )          |                   |       | — |   |
|                                                       |       |                  |       |                      |       |        |       |         |       |                                  |       |                   |       |   |   |
| **Balance, December 31, 2008**                        | ** ** | **3,788,293**         | ** ** | **$**                     | **38**     | ** **  | **$**      | **(645**     | **)**      | **$**                                 | **30,728** | ** **             | **$**      | **3,231** | ** ** | **$** | **1,098** | ** ** | **$** | **34,450** | ** ** |
|                                                            |            |                       |            |                           |            |             |            |              |            |                                       |            |                        |            |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

32

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Consolidated Statements of Cash Flows**

 
| ** **                                                                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                                                    | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Cash flows from operating activities:**                                                               |       |                                        |       |   |   |
| Net income                                                                                              |       | $                                           | 2,244      |   | $ | 2,040 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:                      |       |                                        |       |   |   |
| Provision for loan losses                                                                               |       | 1,754                                       |       | 985 |   |
| Deferred income tax benefit                                                                             |       | (207                                        | )          | (252 | ) |
| Depreciation expense                                                                                    |       | 874                                         |       | 728 |   |
| Premium amortization less discount  accretion                                                           |       | 105                                         |       | 33 |   |
| Amortization of net deferred loan costs                                                                 |       | 14                                          |       | 14 |   |
| (Gain) Loss on sale of securities  available-for-sale                                                   |       | (439                                        | )          | 92 |   |
| Loss on sale of other real estate owned                                                                 |       | 271                                         |       | 10 |   |
| Gain on disposal of premises and equipment                                                              |       | (18                                         | )          | — |   |
| Increase (decrease) in loans held for sale                                                              |       | (1,938                                      | )          | 225 |   |
| Increase in interest receivable                                                                         |       | (152                                        | )          | (593 | ) |
| Increase in interest payable                                                                            |       | 1,123                                       |       | 210 |   |
| (Increase) decrease in other assets                                                                     |       | (363                                        | )          | 605 |   |
| Stock compensation expense                                                                              |       | 147                                         |       | 147 |   |
| Increase (decrease) in other liabilities                                                                |       | 834                                         |       | (159 | ) |
|                                                                                                    |       |                                        |       |   |   |
| Net cash provided by operating activities                                                               |       | 4,249                                       |       | 4,085 |   |
|                                                                                                    |       |                                        |       |   |   |
| **Cash flows from investing activities:**                                                               |       |                                        |       |   |   |
| Purchases of securities available-for-sale                                                              |       | (145,348                                    | )          | (21,265 | ) |
| Maturities of securities available-for-sale                                                             |       | 15,370                                      |       | 12,077 |   |
| Proceeds from sales of securities  available-for-sale                                                   |       | 14,681                                      |       | 10,947 |   |
| Net increase in loans to customers                                                                      |       | (77,982                                     | )          | (97,934 | ) |
| Purchase of premises, furniture and  equipment                                                          |       | (3,880                                      | )          | (2,347 | ) |
| Proceeds from sale of premises, furniture  and equipment                                                |       | 19                                          |       | 1,707 |   |
| Proceeds from sale of other real estate  owned                                                          |       | 1,241                                       |       | 85 |   |
| Purchase of life insurance contracts                                                                    |       | (7,503                                      | )          | — |   |
| Purchase of nonmarketable equity securities                                                             |       | (1,934                                      | )          | (379 | ) |
|                                                                                                    |       |                                        |       |   |   |
| Net cash used by investing activities                                                                   |       | (205,336                                    | )          | (97,334 | ) |
|                                                                                                    |       |                                        |       |   |   |
| **Cash flows from financing activities:**                                                               |       |                                        |       |   |   |
| Net increase (decrease) in demand deposits,  interest-bearing transaction accounts and savings accounts |       | (12,667                                     | )          | 19,639 |   |
| Net increase in time deposits                                                                           |       | 156,567                                     |       | 46,061 |   |
| Net increase (decrease) in notes payable                                                                |       | 4,500                                       |       | (3,478 | ) |
| Net increase in FHLB borrowings                                                                         |       | 39,700                                      |       | 8,910 |   |
| Net increase in repurchase agreements                                                                   |       | 4,172                                       |       | 5,000 |   |
| Increase in federal funds purchased                                                                     |       | 7,653                                       |       | — |   |
| Exercise of stock options                                                                               |       | —                                      |       | 29 |   |
| Cash paid for fractional shares                                                                         |       | (28                                         | )          | — |   |
|                                                                                                    |       |                                        |       |   |   |
| Net cash provided by financing activities                                                               |       | 199,897                                     |       | 76,161 |   |
|                                                                                                    |       |                                        |       |   |   |
| **Net decrease in cash and cash equivalents**                                                           |       | (1,190                                      | )          | (17,088 | ) |
| ** **                                                                                              |       |                                        |       |   |   |
| **Cash and cash equivalents, beginning of  year**                                                       |       | 11,613                                      |       | 28,701 |   |
| ** **                                                                                              |       |                                        |       |   |   |
| **Cash and cash equivalents, end of year**                                                              | ** ** | **$**                                       | **10,423** | ** ** | **$** | **11,613** | ** ** |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

33

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -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 in determiningthe estimated useful lives and methods for depreciating premises and 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 aboutinformation available 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** - Investmentsecurities available-for-sale by the Company are carried at amortized cost andadjusted to their estimated fair value. The unrealized gain or loss is recorded in shareholders’ equity net ofthe deferred tax effects.  Managementdoes not actively trade securities classified as available-for-sale, butintends to hold these securities for an indefinite period of time and may sellthem prior to maturity to achieve certain objectives.  Reductions in fair value considered bymanagement to be other than temporary are reported as a realized loss and areduction in the cost basis in the security. The adjusted cost basis of securities available-for-sale is determinedby specific identification and is used in computing the realized gain or lossfrom 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 Silverton Bankstock are included as a separate component in interest income.

 

At December 31, 2008 and 2007, the investment in Federal Home LoanBank stock was $4,928,000 and $2,994,000, respectively.  The investment in Silverton Bank stock was$122,000 at December 31, 2008 and 2007. The Company also had a $25,000 investment in the holding company of acommunity bank at December 31, 2008 and 2007.  Also included in nonmarketable equities isinvestment in the Trust, which totaled $186,000 at December 31, 2008 and2007.

 

34

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -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 of Financial AccountingStandards (SFAS) No. 114, *Accounting by Creditorsfor 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 loansmeasured at 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 loanscomprise a substantial majority of loans classified as impaired at December 31,2008 and 2007.

 

**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 $314,093,000 and $84,568,000, respectively, at December 31,2008, representing 911.73% and 245.48%, respectively, of total equity and73.97% and 19.92%, respectively, of net loans receivable.

 

35

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

**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 real estateowned 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.

 

36

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -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 of fairvalue 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, 2008, 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$449,000 and $491,000, were included in the Company’s results of operations for2008 and 2007, 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.

 

37

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -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)**                                   | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| Unrealized gains on securities available-for-sale                      |       | $                                           | 2,191      |   | $ | 570 |   |
| Reclassification adjustment for (gains) losses  realized in net income |       | (439                                        | )          | 92 |   |
|                                                                   |       |                                        |       |   |   |
| Net unrealized losses on securities                                    |       | 1,752                                       |       | 662 |   |
|                                                                   |       |                                        |       |   |   |
| Tax effect                                                             |       | (648                                        | )          | (245 | ) |
|                                                                   |       |                                        |       |   |   |
| Net-of-tax amount                                                      | ** ** | **$**                                       | **1,104**  | ** ** | **$** | **417** | ** ** |

 

**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)**                      | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cash paid for interest                                    |       | $                                           | 13,414     |   | $ | 14,012 |   |
|                                                      |       |                                        |       |   |   |
| Cash paid for income taxes                                |       | 1,344                                       |       | 1,232 |   |
|                                                      |       |                                        |       |   |   |
| Supplemental noncash investing and  financing activities: |       |                                        |       |   |   |
| Foreclosures on loans                                     |       | 2,639                                       |       | 338 |   |
|                                                           |            |                                             |            |  |  |  |  |

 

**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.

 

**RecentlyIssued Accounting Pronouncements** – The followingis a summary of recent authoritative pronouncements that affect accounting,reporting, and disclosure of financial information by the Company.

 

InDecember 2007, the Financial Accounting Standards Board*(“*FASB*”)* issuedStatement of Financial Accounting Standard*(“*SFAS*”)* No. 141(R), “Business Combinations,” (“SFAS 141(R)”)which replaces SFAS 141. SFAS 141(R) establishes principles andrequirements for how an acquirer in a business combination recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any controlling interest; recognizes and measuresgoodwill 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. SFAS 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.

 

38

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES***- continued*

 

Also, 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 net incomeattributable 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 was effective for the Company on January 1,2009.  The Company has determined thatSFAS 160 will have no impact on the Company’s financial position, results ofoperations or cash flows.

 

In February 2008, the FASB issued FASBStaff Position No. 140-3, “Accounting for Transfers of Financial Assetsand Repurchase Financing Transactions,” (“FSP 140-3”).  This FSP providesguidance on accounting for a transfer of a financial asset and the transferor’srepurchase financing of the asset.  This FSP presumes that an initialtransfer of a financial asset and a repurchase financing are considered part ofthe same arrangement (linked transaction) under SFAS 140. However, if certaincriteria are met, the initial transfer and repurchase financing are notevaluated as a linked transaction and are evaluated separately under SFAS 140. FSP 140-3 was effective for the Company on January 1, 2009. The adoption of FSP 140-3 will have no impact on the Company’s financialposition, results of operations or cash flows.

 

InMarch 2008, the FASB issued SFAS No. 161, “Disclosures aboutDerivative Instruments and Hedging Activities,” (“SFAS 161”).  SFAS 161 requires enhanced disclosures aboutan entity’s derivative and hedging activities, thereby improving thetransparency of financial reporting.  Itis intended to enhance the current disclosure framework in SFAS 133 byrequiring that objectives for using derivative instruments be disclosed interms of underlying risk and accounting designation. This disclosure isintended to convey the purpose of derivative use in terms of the risks that theentity is intending to manage. SFAS 161 was effective for the Company on January 1,2009 and will result in additional disclosures.

 

In April 2008, the FASB issued FASB StaffPosition No. 142-3, “Determination of the Useful Life of Intangible Assets,”(“FSP 142-3”).  This FSP amends thefactors that should be considered in developing renewal or extensionassumptions used to determine the useful life of a recognized intangible assetunder SFAS No. 142, “Goodwill andOther Intangible Assets,” (“SFAS 142”). The intent of this FSP is to improve the consistency between the usefullife of a recognized intangible asset under SFAS 142 and the period of expectedcash flows used to measure the fair value of the asset under SFAS 141(R) andother U.S. generally accepted accounting principles.  This FSP was effective for the Company on January 1,2009 and is not expected to have a material impact on the Company’s financialposition, results of operations or cash flows*.*

 

In May, 2008, the FASBissued SFAS No. 162, “The Hierarchy of Generally Accepted AccountingPrinciples,” (“SFAS 162”).  SFAS 162identifies the sources of accounting principles and the framework for selectingthe principles used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (GAAP) in the United States (the GAAPhierarchy).  SFAS 162 is effective November 15,2008.  The FASB has stated that it doesnot expect SFAS 162 will result in a change in current practice. Theapplication of SFAS 162 had no effect on the Company’s financial position,results of operations or cash flows.

 

In June, 2008, the FASB issued FASB StaffPosition No. EITF 03-6-1, “Determining Whether Instruments Granted inShare-Based Payment Transactions are Participating Securities,” (“FSP EITF03-6-1”).  The Staff Position providesthat unvested share-based paymentawards that contain nonforfeitable rights to dividends or dividend

 

39

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES** –*continued*

 

equivalents areparticipating securities and must be included in the earnings per sharecomputation.  FSPEITF 03-6-1 was effective January 1, 2009 and is not expected to have amaterial impact on the Company’s financial position, results of operations orcash flows.

 

TheSEC’s Office of the Chief Accountant and the staff of the FASB issued press release2008-234 on September 30, 2008 (“Press Release”) to provide clarificationson fair value accounting.  The PressRelease includes guidance on the use of management’s internal assumptions andthe use of “market” quotes.  It alsoreiterates the factors in SEC Staff Accounting Bulletin (“SAB”) Topic 5M whichshould be considered when determining other-than-temporary impairment: thelength of time and extent to which the market value has been less than cost;financial condition and near-term prospects of the issuer; and the intent andability of the holder to retain its investment for a period of time sufficientto allow for any anticipated recovery in market value.

 

OnOctober 10, 2008, the FASB issued FSP SFAS 157-3, “Determining the FairValue of a Financial Asset When the Market for That Asset Is Not Active” (“FSPSFAS 157-3”). This FSP clarifies the application of SFAS No. 157, “FairValue Measurements” (see Note 22) in a market that is not active and providesan example to illustrate key considerations in determining the fair value of afinancial asset when the market for that asset is not active.  The FSP is effective upon issuance, includingprior periods for which financial statements have not been issued. For theCompany, this FSP was effective for the quarter ended September 30, 2008.

 

FSPSFAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) aboutTransfers of Financial Assets and Interests in Variable Interest Entities,”(“FSP SFAS 140-4 and FIN 46(R)-8”) was issued in December 2008 to requirepublic entities to disclose additional information about transfers of financialassets and to require public enterprises to provide additional disclosuresabout their involvement with variable interest entities.  The FSP also requires certain disclosures forpublic enterprises that are sponsors and servicers of qualifying specialpurpose entities.  The FSP is effectivefor the first reporting period ending after December 15, 2008.  The Company does not sponsor special purposeentities to transfer financial assets and, therefore, this FSP will have noimpact on the financial position of the Company.

 

FSPEITF 99-20-1, “Amendments to the Impairment Guidance of EIFT Issue No. 99-20,”(“FSP EITF 99-20-1”) was issued in January 2009.  Prior to the Staff Position,other-than-temporary impairment was determined by using either EITF Issue No. 99-20,“Recognition of Interest Income and Impairment on Purchased BeneficialInterests and Beneficial Interests that Continue to be Held by a Transferor inSecuritized Financial Assets,” (“EITF 99-20”) or SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” (“SFAS 115”) dependingon the type of security.  EITF 99-20required the use of market participant assumptions regarding future cash flowsregarding the probability of collecting all cash flows previouslyprojected.  SFAS 115 determinedimpairment to be other than temporary if it was probable that the holder wouldbe unable to collect all amounts due according to the contractual terms. Toachieve a more consistent determination of other-than-temporary impairment, theStaff Position amends EITF 99-20 to determine any other-than-temporaryimpairment based on the guidance in SFAS 115, allowing management to use morejudgment in determining any other-than-temporary impairment.  The Staff Position is effective for interimand annual reporting periods ending after December 15, 2008 and shall beapplied prospectively.

 

TheCompany considered the guidance in the Press Release, FSP SFAS 157-3 and FSPEITF 99-20-1when conducting its review for other-than-temporary impairment asof December 31, 2008 as discussed in Note 3.

 

Otheraccounting standards that have been issued or proposed by the FASB or otherstandards-setting bodies are not expected to have a material impact on theCompany’s financial position, results of operations or cash flows.

 

**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

 

40

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 1 -ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES** –*continued*

 

payments.  Market risk reflectschanges in the value of collateral underlying loans receivable and thevaluation of real estate held by the 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.

 

Additionally, the Company is subject to certain regulations due to ourparticipation in the Capital Purchase Program. Pursuant to the terms of the CPP Purchase Agreement between us and theTreasury, we adopted certain standards for executive compensation and corporategovernance for the period during which the Treasury holds the equity issuedpursuant to the CPP Purchase Agreement, including the common stock which may beissued pursuant to the CPP Warrant. These standards generally apply to our Chief Executive Officer, ChiefFinancial Officer and the three next most highly compensated senior executiveofficers. The standards include (1) ensuring that incentive compensationfor senior executives does not encourage unnecessary and excessive risks thatthreaten the value of the financial institution; (2) required clawback ofany bonus or incentive compensation paid to a senior executive based onstatements of earnings, gains or other criteria that are later proven to bematerially inaccurate; (3) prohibition on making golden parachute paymentsto senior executives; and (4) agreement not to deduct for tax purposesexecutive compensation in excess of $500,000 for each senior executive.  In particular, the change to thedeductibility limit on executive compensation will likely increase the overallcost of our compensation programs in future periods and may make it moredifficult to attract suitable candidates to serve as executive officers.

 

Legislation that has been adopted after we closed on our sale of Series TPreferred Stock and warrants to the Treasury for $12.9 million pursuant to theCapital Purchase Program on March 6, 2009, or any legislation orregulations that may be implemented in the future, may have amaterial impact on the terms of our Capital Purchase Program transactionwith the Treasury.   If we determine thatany such legislation or any regulations, in whole or in part, alter the termsof our Capital Purchase Program transaction with the Treasury in ways that webelieve are adverse to our ability to effectively manage our business, then itis possible that we may seek to unwind, in whole or in part, the CapitalPurchase Program transaction by repurchasing some or all of the preferred stockand warrants that we sold to the Treasury pursuant to the Capital PurchaseProgram.  If we were to repurchase all ora portion of such preferred stock or warrants, then our capital levels could bematerially reduced.

 

**Reclassifications** - Certain captions andamounts in the 2007 financial statements were reclassified to conform with the2008 presentation.

 

**NOTE 2 -CASH AND DUE FROM BANKS**

 

The Bank is required by regulation to maintain an average cash reservebalance based on a percentage of deposits. At December 31, 2008 and 2007, the requirements were satisfied byamounts on deposit with the Federal Reserve Bank and cash on hand.

 

41

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**HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 3 -INVESTMENT SECURITIES**

 

Securities available-for-sale consisted of the following:

 
| ** **                                 | ** ** | **Amortized** | ** **  | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|--------------------------------------------|------------|---------------|-------------|---------------------------|------------|---------------|------------|
| **(Dollars in thousands)**       | ** ** | **Cost**      | ** **  | **Gains**                 | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| **December 31, 2008**                 |       |          |        |                      |       |          |       |   |   |
| Government-sponsored enterprises           |       | $             | 18,953      |                      | $          | 363           |       | $ | — |   | $ | 19,316 |   |
| Mortgage-backed securities                 |       | 138,682       |        | 2,374                     |       | 1,048         |       | 140,008 |   |
| Obligations of state and local governments |       | 7,613         |        | 157                       |       | 102           |       | 7,668 |   |
|                                       |       |          |        |                      |       |          |       |   |   |
| Total                                      | ** ** | **$**         | **165,248** | ** **                | **$**      | **2,894**     | ** ** | **$** | **1,150** | ** ** | **$** | **166,992** | ** ** |
|                                       | ** ** | ** **    | ** **  | ** **                | ** ** | ** **    | ** ** | ** ** | ** ** |
| **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** | ** ** |

 

The following is a summary of maturities of securitiesavailable-for-sale as of December 31, 2008.  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                 |       | $                      | 157         |   | $ | 158 |   |
| Due after one year but within five years  |       | 4,337                  |        | 4,395 |   |
| Due after five years but within ten years |       | 22,862                 |        | 22,817 |   |
| Due after ten years                       |       | 137,892                |        | 139,622 |   |
|                                      |       |                   |        |   |   |
| Total                                     | ** ** | **$**                  | **165,248** | ** ** | **$** | **166,992** | ** ** |

 

42

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes toConsolidated Financial Statements**

 

**NOTE 3 - INVESTMENT SECURITIES****- *continued***

 

The following table showsgross unrealized losses and fair value, aggregated by investment category, andlength of time that individual securities have been in a continuous unrealizedloss position, at:

 

**SecuritiesAvailable for Sale**

 
| ** **                                  | ** ** | **Less than  twelve months** | ** ** | **December 31, 2008  Twelve months  or more** | ** ** | **Total**           | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                  | ** ** | ** **                             | ** ** | **Unrealized**                                                    | ** ** | ** **          | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| **(Dollars in thousands)**        | ** ** | **Fair value**                    | ** ** | **losses**                                                        | ** ** | **Fair value** | ** ** | **losses** | ** ** | **Fair value** | ** ** | **losses** | ** ** |
|                                        |       |                                   |       |                                                              |       |                |       |   |   |   |   |   |   |
| Government-sponsored  enterprises           |       | $                                      | —     |                                                              | $          | —              |       | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Mortgage-backed securities                  |       | 25,080                                 |       | 1,036                                                             |       | 1,741               |       | 12 |   | 26,821 |   | 1,048 |   |
| Obligations of state and  local governments |       | 403                                    |       | 3                                                                 |       | 1,401               |       | 99 |   | 1,804 |   | 102 |   |
|                                        |       |                                   |       |                                                              |       |                |       |   |   |   |   |   |   |
| Total                                       | ** ** | **$**                                  | **25,483** | ** **                                                        | **$**      | **1,039**           | ** ** | **$** | **3,142** | ** ** | **$** | **111** | ** ** | **$** | **28,625** | ** ** | **$** | **1,150** | ** ** |

 
| ** **                                  | ** ** | **Less than  twelve months** | ** ** | **December 31, 2007  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** | ** ** |

 

Management evaluates itsinvestment portfolio periodically to identify any impairment that is other thantemporary.  At December 31, 2008,the Company had seventeen individual securities, or 17.15% 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, 2008and 2007, investment securities with a book value of $112,682,000 and$46,951,000, respectively, and a market value of $114,891,000 and $46,966,000,respectively, were pledged to secure deposits.

 

Gross realized losses andgains on sales of available-for-sale securities in 2008 were $2,000 and$441,000, respectively.

 

**NOTE 4 - LOANS RECEIVABLE**

 

Loans consisted of thefollowing:

 
| ** **                                       | ** ** | **December 31,** | ** **  |
|--------------------------------------------------|------------|-----------------------|-------------|
| **(Dollars in thousands)**             | ** ** | **2008**              | ** **  | **2007** | ** ** |
|                                             |       |                  |        |   |   |
| Real estate - construction  and land development |       | $                     | 60,643      |   | $ | 59,084 |   |
| Real estate - mortgage and  commercial           |       | 253,450               |        | 201,448 |   |
| Agricultural                                     |       | 7,613                 |        | 7,221 |   |
| Commercial and industrial                        |       | 84,568                |        | 64,019 |   |
| Consumer                                         |       | 19,655                |        | 18,535 |   |
| All other loans (including  overdrafts)          |       | 3,109                 |        | 1,899 |   |
|                                             |       |                  |        |   |   |
| Total gross loans                                | ** ** | **$**                 | **429,038** | ** ** | **$** | **352,206** | ** ** |

 

43

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** **

**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes toConsolidated Financial Statements**

 

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

 

Certain parties (principallycertain directors and officers of the Company, their immediate families, andbusiness interests) were loan customers and had other transactions in thenormal course of business with the Company. Related party loans are made on substantially the same terms, includinginterest rates and collateral, as those prevailing at the time for comparabletransactions with unrelated persons and do not involve more than normal risk ofcollectibility.  The aggregate dollaramounts of loans to related parties were $16,957,000 and $13,790,000 atDecember 31, 2008 and 2007, respectively. During 2008, advances on related party loans totaled $6,309,000, andrepayments were $3,142,000.

 

Transactions in theallowance for loan losses are summarized below:

 
| ** **                                  | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                                        |       |                                        |       |   |   |
| Balance, beginning of year                  |       | $                                           | 3,535      |   | $ | 2,718 |   |
| Provision charged to  operations            |       | 1,754                                       |       | 985 |   |
| Recoveries on loans previously  charged off |       | 379                                         |       | 51 |   |
| Loans charged off                           |       | (1,252                                      | )          | (219 | ) |
|                                        |       |                                        |       |   |   |
| Balance, end of year                        | ** ** | **$**                                       | **4,416**  | ** ** | **$** | **3,535** | ** ** |

 

Loans on the Company’sproblem loan watch list are considered potentially impaired loans.  These loans are evaluated in determining whetherall outstanding principal and interest are expected to be collected.  Loans are not considered impaired if aminimal delay occurs and all amounts due, including accrued interest at thecontractual interest rate for the period of the delay, are expected to becollected.

 

As of December 31, 2008and 2007, the Company had nonaccrual loans of approximately $9,040,000 and$2,696,000, 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, 2008,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 $391,000 and $267,000 during 2008 and 2007,respectively.  Average impaired loans asof December 31, 2008 and 2007 were $5,131,000 and $1,195,000, respectively.

 

The Company is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments includecommitments 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 tocredit loss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit and standby letters of credit isrepresented by the contractual or notional amount of those instruments.  The Company uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance-sheetinstruments.

 

Standby letters of creditare conditional commitments issued by the Company to guarantee the performanceof a customer to a third party.  Thecredit risk involved in issuing letters of credit is essentially the same asthat involved in extending loans to customers. The fair value of standby letters of credit is insignificant.

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the contract. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawnupon, the total commitment amounts do not necessarily represent future cashrequirements.  The Company evaluates eachcustomer’s creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemednecessary by the Company upon extension of credit, is based on management’scredit evaluation of the counter-party.

 

44

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

** **

**Notes toConsolidated Financial Statements**

 

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

 

Collateral held forcommitments 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)** | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                 |       |                  |       |   |   |
| Commitments to extend  credit        |       | $                     | 61,918     |   | $ | 66,575 |   |
| Standby letters of credit            |       | 1,478                 |       | 761 |   |
|                                      |            |                       |            |  |  |  |  |

 

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

 

Premises, furniture andequipment consisted of the following:

 
| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**    | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                    |       |                  |       |   |   |
| Land                                    |       | $                     | 7,099      |   | $ | 4,219 |   |
| Buildings and land  improvements        |       | 10,567                |       | 7,931 |   |
| Furniture and equipment                 |       | 5,966                 |       | 5,579 |   |
| Leasehold improvements                  |       | 65                    |       | 58 |   |
| Construction in progress                |       | 972                   |       | 3,073 |   |
|                                    |       |                  |       |   |   |
|                                    |       | 24,669                |       | 20,860 |   |
| Less accumulated  depreciation          |       | (5,613                | )          | (4,809 | ) |
|                                    |       |                  |       |   |   |
| Premises, furniture and  equipment, net | ** ** | **$**                 | **19,056** | ** ** | **$** | **16,051** | ** ** |

 

Depreciation expense for theyears ended December 31, 2008 and 2007 was $874,000 and $728,000,respectively.

 

The Company had $100 and$91,000 in capitalized interest during construction in 2008 and 2007,respectively.

 

In 2006 the Companypurchased a 5-acre lot of land in the Loris Commerce Center in Loris, S.C. tobegin construction of a new Operations Center on this site in 2009 in order toaccommodate its executive offices and all support services in this newfacility.  The amounts shown asconstruction in progress for the years ended December 31, 2008 reflect theCompany’s investment in this property. The Company expects to complete all phases of the construction processduring the fourth quarter of 2009 and at that time allocate the balance inconstruction in progress among land, buildings and land improvements, furnitureand fixtures and equipment.  Theestimated cost to complete the construction of the Operations Center isexpected to be $4,000,000.

 

**NOTE 6 - OTHER ASSETS**

 

Other assets consisted ofthe following:

 
| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                 |       |                  |       |   |   |
| Other real estate owned              |       | 2,965                 |       | 338 |   |
| Prepaid expenses and  insurance      |       | 426                   |       | 491 |   |
| Unamortized software                 |       | 221                   |       | 143 |   |
| Net deferred tax asset               |       | 975                   |       | 768 |   |
| Other                                |       | 1,246                 |       | 899 |   |
|                                 |       |                  |       |   |   |
| Total                                | ** ** | **$**                 | **5,833**  | ** ** | **$** | **2,639** | ** ** |
|                                      |            |                       |            |  |  |  |  |

 

45

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

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

 

The Company maintains anoverall interest-rate risk-management strategy that incorporates the use of derivativesto minimize significant unplanned fluctuations in earnings that are caused byinterest-rate volatility.  As part ofthis strategy, the Company entered certain interest rate swap agreements, whichremain in place.  Such interest rateswaps are derivative financial instruments (“derivatives”).  Interest rate swaps generally involve theexchange of fixed and variable rate interest payments between two parties,based on a common notional amount and maturity date.  The Company’s goal is to manage interest-ratesensitivity by modifying the repricing or maturity characteristics of specificbalance-sheet assets and liabilities so that the net-interest margin is not, ona material basis, adversely affected by movements in interest rates. Theinterest-rate swaps entered by the Company converted certain nonprepayablefixed rate long term debt to floating rates. As a result of interest-ratefluctuations, hedged assets and liabilities will appreciate or depreciate inmarket value.  The effect of thisunrealized appreciation or depreciation will generally be offset by income orloss on the derivatives that are linked to the hedged assets andliabilities.  The Company views thisstrategy as a prudent management of interest-rate sensitivity, such thatearnings are not exposed to undue risk presented by changes in interest rates.

 

Byusing derivative instruments, the Company is exposed to credit and marketrisk.  If the counterparty fails toperform, credit risk is equal to the extent of the fair-value gain in a derivative.  When the fair value of a derivative contractis positive, this generally indicates that the counterparty owes the Company,and, therefore, creates a repayment risk for the Company.  When the fair value of a derivative contractis negative, the Company owes the counterparty and, therefore, it has norepayment risk.  The Company minimizesthe credit (or repayment) risk in derivative instruments by entering intotransactions with high-quality counterparties that are reviewed by theCompany’s credit committee.

 

Marketrisk is the adverse effect that a change in interest rates, currency, orimplied volatility rates has on the value of a financial instrument.  The Company manages the market riskassociated with interest rate swap contracts by establishing and monitoringlimits as to the types and degree of risk that may be undertaken.  The Company periodically measures this riskby using a value-at-risk methodology.

 

TheCompany’s derivatives activities are monitored by its risk-management committeeas part of that committee’s oversight of the Company’s asset/liability andtreasury functions.  The Company’sasset/liability committee is responsible for implementing various hedgingstrategies that are developed through its analysis of data from financialsimulation models and other internal and industry sources.  The resulting hedging strategies are thenincorporated into the Company’s overall interest-rate risk-management andtrading strategies.

 

Theinterest rate swap agreements provide for the Company to make payments at avariable rate determined by a specified index (three month LIBOR) in exchangefor receiving payments at a fixed rate of 3.4%. During 2008 and 2007, the Company recognized $56,000 and $273,000,respectively, as an increase in interest expense on Federal Home Loan BankAdvances as a result of its interest rate swaps.

 

At December 31, 2008and 2007, the information pertaining to outstanding interest rate swapagreements used to hedge fixed rate debt is as follows:

 
| **(Dollars in thousands)**                   | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                   |       |     |       |     |       |
| Notional amount                                        |       | $        | 14,600     |     | $          | 14,600 |   |
| Weighted average fixed  (receive) rate                 |       | 3.43     | %          | 3.43     | %          |
| Weighted average variable  (pay) rate                  |       | 3.28     | %          | 5.40     | %          |
| Weighted average maturity  in years                    |       | 1.6      |       | 2.6      |       |
|                                                   |       |     |       |     |       |
| Unrealized gain(loss)  relating to interest rate swaps |       | $        | 83         |     | $          | (339 | ) |

 

AtDecember 31, 2008 and 2007, the unrealized gain(loss) of $83,000 and($339,000), respectively, related to interest rate swaps were recorded inderivative assets and other liabilities at the same amount.

 

46

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

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

 

Riskmanagement results for the year ended December 31, 2008 and 2007 relatedto the balance sheet hedging of long-term debt indicate that the hedges were100% effective and that there was no component of the derivative instruments’gain or loss which was excluded from the assessment of hedge effectiveness.

 

**NOTE 8 - NOTE PAYABLE**

 

On September 25, 2008the Company entered into a line of credit agreement with South CarolinaBank & Trust to borrow up to $5,000,000.  At December 31, 2008 the balanceextended under the agreement was $4,500,000. On March 6, 2009 all principal and interest was repaid.  The line of credit agreement expires onSeptember 25, 2009.

 

**NOTE 9 - DEPOSITS**

 

AtDecember 31, 2008, the scheduled maturities of time deposits were asfollows:

 
| **(Dollars in thousands)  Maturing In** | ** ** | **Amount** | ** **  |
|--------------------------------------------------------|------------|------------|-------------|
|                                                   |       |       |        |
| 2009                                                   |       | $          | 271,767     |   |
| 2010                                                   |       | 31,859     |        |
| 2011                                                   |       | 2,115      |        |
| 2012                                                   |       | 690        |        |
| 2013 and thereafter                                    |       | 2,138      |        |
|                                                   |       |       |        |
| Total                                                  | ** ** | **$**      | **308,569** | ** ** |

 

Overdrawn transactionaccounts in the amount of $161,000 and $157,000 were classified as loans as ofDecember 31, 2008 and 2007, respectively.

 

Deposits by directorsincluding their affiliates and executive officers totaled approximately$4,568,000 and $2,766,000 at December 31, 2008 and 2007, respectively.

 

47

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

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

 

Advances from the FederalHome Loan Bank consisted of the following:

 
| **(Dollars in thousands)**             | ** ** | **Interest** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------|------------|-----------------------|------------|
| **Advances maturing on:**              | ** ** | **Rate**     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | ** **   | ** ** | ** **            | ** ** | ** ** | ** ** |
| March 11, 2008  (converted to fixed rate)   |       | 3.09         | %          | $                     | —     |   | $ | 5,000 |   |
| December 8, 2008  (converted to fixed rate) |       | 3.87         | %          | —                |       | 1,700 |   |
| April 2, 2009                               |       | 0.46         | %          | 8,400                 |       | — |   |
| 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                 |       | 5,000 |   |
| March 22, 2011                              |       | 1.53         | %          | 5,000                 |       | 5,000 |   |
| January, 17, 2012                                |       | 4.55         | %          | 5,000                 |       | 5,000 |   |
| July 23, 2012                               |       | 3.81         | %          | 5,000                 |       | 5,000 |   |
| September 4, 2012                           |       | 4.42         | %          | 5,000                 |       | 5,000 |   |
| September 7, 2012                           |       | 4.05         | %          | 1,000                 |       | 1,000 |   |
| January 30, 2013                            |       | 3.36         | %          | —                |       | 5,000 |   |
| October 18, 2013                            |       | 2.63         | %          | 5,000                 |       | — |   |
| December 8, 2014                            |       | 3.24         | %          | 5,000                 |       | 5,000 |   |
| January 26, 2015                            |       | 2.73         | %          | 2,000                 |       | — |   |
| March 19, 2015                              |       | 2.66         | %          | 4,000                 |       | — |   |
| August 20, 2018                             |       | 3.44         | %          | 5,000                 |       | — |   |
| September 4, 2018                           |       | 3.60         | %          | 2,000                 |       | — |   |
| September 4, 2018                           |       | 3.32         | %          | 5,000                 |       | — |   |
| September 10, 2018                          |       | 3.25         | %          | 5,000                 |       | — |   |
| September 10, 2018                          |       | 3.45         | %          | 5,000                 |       | — |   |
| September 18, 2018                          |       | 2.95         | %          | 5,000                 |       | — |   |
| October 10, 2018                            |       | 2.63         | %          | 5,000                 |       | — |   |
|                                             |       |         |       |                  |       |   |   |
| Total                                            | ** ** | ** **   | ** ** | **$**                 | **92,000** |   | **$** | **52,300** |   |

 

Interest is payablequarterly, except for advance dated October 18, 2013, which is payablemonthly.  Initially all advances bearinterest at a fixed rate; except for advance dated April 2, 2009 for$8,400,000, which is a variable rate advance; however, at a certain date foreach of the advances, at the Federal Home Loan Bank’s option, the rates can beconverted to floating, except for advance dated October 18, 2013 for$5,000,000, which is a fixed rate advance. Also on these dates the Federal Home Loan Bank has the option to callthe advances.  As of December 31,2008, $14,600,000 were fixed rate credits; $59,000,000 were convertibleadvances;  $10,000,000 were adjustablerate credits; and $8,400,000 were daily credits.

 

As of December 31,2008, scheduled principal reductions include $8,400,000 in 2009, $14,600,000 in2010, $5,000,000 in 2011, $16,000,000 in 2012, and $48,000,000 in the yearsthereafter.

 

As collateral, the Companyhas pledged its portfolio of first mortgage one-to-four family residentialloans aggregating $28,568,000 at December 31, 2008, as well as half of itscommercial real estate loan portfolio, totaling $2,579,000 at December 31,2008.  Also, the Company has pledged halfof its portfolio of HELOCS and second mortgage loans totaling $7,824,000, andits investment in Federal Home Loan Bank stock with a carrying value of$4,928,000.  The Company also has pledgedsecurities with a market value of $57,111,000 against its FHLB borrowings.  The Company has $4,905,000 in excess with theFederal Home Loan Bank that is available if liquidity needs should arise.

 

As discussed in Note 7, theCompany has entered into interest rate swap agreements associated with FederalHome Loan Bank advances maturing on March 1, 2010, May 24, 2010 andMarch 22, 2011.  The interest rateswaps effectively converted the fixed interest rates on the advances to avariable rate.  The variable rate of theswap payable was 3.20% at December 31, 2008 and is based on the threemonth LIBOR index.

 

48

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes to Consolidated Financial Statements**

 

**NOTE 11 -JUNIOR SUBORDINATED DEBENTURES**

 

On December 21, 2004,HCSB Financial Trust I, (a non-consolidated subsidiary) issued $6.0 millionfloating rate trust preferred securities with a maturity of December 31,2034.  The rate is adjusted quarterly andwas 5.17% at December 31, 2008.  Inaccordance with the revised FIN 46, the trust has not been consolidated inthese financial statements.  The Company receivedfrom the Trust the $6.0 million proceeds from the issuance of the securitiesand the $186,000 initial proceeds from the capital investment in the Trust, andaccordingly has shown the funds due to the trust as a $6,186,000 juniorsubordinated debenture.  The currentregulatory rules allow certain amounts of junior subordinated debenturesto be included in the calculation of regulatory capital.  The debenture issuance costs, net ofaccumulated amortization, totaled $95,000 at December 31, 2008 and isincluded in other assets on the consolidated balance sheet.  Amortization of debt issuance costs totaled$3,667 for each of the years ended December 31, 2008 and 2007.

 

The Company invested$5,880,000 in the Company’s wholly-owned subsidiary, Horry County StateBank.  The remaining balance is beingmaintained by the Company to fund operations.

 

**NOTE 12 - LEASE COMMITMENTS**

 

On January 1, 2008, theCompany renewed a lease agreement for land on which to operate its Tabor Citybranch.  The lease has a five-year termthat expires December 31, 2012.  TheCompany has an option for nine additional five-year renewal periodsthereafter.  The lease has a rentalamount of $1,000 per month through December 31, 2012.  The lease gives the Company the first rightof refusal to purchase the property at an unimproved value if the owners decideto sell.  The Company also paysapplicable property taxes on the property.

 

On April 23, 2007, theCompany entered into an annual lease agreement for office space located at ThePlaza at Gator Hole in North Myrtle Beach, South Carolina.  The term of this lease is two years with anoption to renew the lease for an additional one-year term.  The monthly rental amount is $4,666.67.  The leased premises are being used to operatea bank branch location.

 

Expected future minimumlease payments as of December 31, 2008 are as follows:

 
| **(Dollars in thousands)** | ** ** | **Amount** | ** ** |
|--------------------------------------|------------|------------|------------|
|                                 |       |       |       |
| 2009                                 |       | $          | 31,229     |   |
| 2010                                 |       | 12,563     |       |
| 2011                                 |       | 12,563     |       |
| 2012                                 |       | 12,563     |       |
|                                 |       |       |       |
| Total                                | ** ** | **$**      | **68,918** | ** ** |

 

**NOTE 13 - COMMITMENTS AND CONTINGENCIES**

 

In the ordinary course ofbusiness, the Company may, from time to time, become a party to legal claimsand disputes.  At December 31, 2008management was not aware of any pending or threatened litigation or unassertedclaims that could result in losses, if any, that would be material to thefinancial statements.  On January 1,2008 the Company entered into two new lease agreements.  The details for these leases are disclosed inNote 12 — Lease Commitments.

 

**NOTE 14 - SHAREHOLDERS’ EQUITY**

 

**Stock Dividends** - In January 2008, the Board ofDirectors declared 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.  In January 2009, theBoard of Directors declared a 3% stock dividend payable on February 20,2009, to shareholders of record on February 6, 2009.  As a result of the dividend, 110,338 shareswere issued.  All share and per shareamounts have been adjusted to reflect these dividends.

 

49

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes toConsolidated Financial Statements**

 

**NOTE 14 - SHAREHOLDERS’ EQUITY*****-continued***

 

**Restrictionson Dividends** -South Carolina banking regulations restrict the amount of dividends that can bepaid to shareholders.  All of the Bank’sdividends to HCSB Financial Corporation and Subsidiary are payable only fromthe undivided profits of the Bank.  AtDecember 31, 2008 the Bank’s undivided profits were $18,151,640.  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 regulatory examination.  Under Federal Reserve Board regulations, theamounts of loans or advances from the Bank to the parent company are alsorestricted.

 

**NOTE 15 - CAPITAL REQUIREMENTS**

 

The Company and the Bank aresubject to various regulatory capital requirements administered by the federalbanking agencies.  Failure to meetminimum 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 adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Company’s and the Bank’sassets, liabilities, and certain off-balance-sheet items as calculated underregulatory accounting practices.  TheCompany’s and the Bank’s capital amounts and classifications are also subjectto qualitative judgments by the regulators about components, risk-weightings,and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Company andthe Bank to maintain minimum ratios (set forth in the table below) of Tier 1and total capital as a percentage of assets and off-balance-sheet exposures, adjustedfor risk-weights ranging from 0% to 100%. Tier 1 capital of the Bank consists of common shareholders’ equity,excluding the unrealized gain or loss on securities available for sale, minuscertain intangible assets.  Tier 2capital consists of the allowance for loan losses subject to certainlimitations.  Total capital for purposesof computing the capital ratios consists of the sum of Tier 1 and Tier 2capital.

 

The Company and the Bank arealso required to maintain capital at a minimum level based on quarterly averageassets (as defined), which is known as the leverage ratio.  Only the strongest institutions are allowedto maintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios1% to 2% above the minimum.

 

As of the most recentregulatory examination, the Bank was deemed well capitalized under theregulatory 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.

 

50

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**HCSBFINANCIAL CORPORATION AND SUBSIDIARY**

 

**Notes toConsolidated Financial Statements**

 

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

 

The following tablesummarizes the capital ratios and the regulatory minimum requirements for theCompany and the Bank.

 
| ** **                                | ** ** | **Actual** | ** ** | **Minimum Requirement  For Capital  Adequacy Purposes** | ** ** | **To Be Well-  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **Amount** | ** ** | **Ratio**                                                              | ** ** | **Amount**                                                                                        | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **December 31,  2008**               |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| **The  Company**                          |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| Total capital (to  risk-weighted assets)  |       | $          | 43,768     |                                                                   | 9.55       | %                                                                                                 | 36,652     |   | 8.00 | % | N/A |   | N/A |   |
| Tier 1 capital (to  risk-weighted assets) |       | 39,352     |       | 8.59                                                                   | %          | 18,326                                                                                            |       | 4.00 | % | N/A |   | N/A |   |
| Tier 1 capital (to average  assets)       |       | 39,352     |       | 7.41                                                                   | %          | 21,251                                                                                            |       | 4.00 | % | N/A |   | N/A |   |
|                                      |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| **The Bank**                              |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| Total capital (to  risk-weighted assets)  |       | $          | 47,130     |                                                                   | 10.31      | %                                                                                                 | 36,553     |   | 8.00 | % | 45,692 |   | 10.00 | % |
| Tier 1 capital (to  risk-weighted assets) |       | 42,714     |       | 9.35                                                                   | %          | 18,277                                                                                            |       | 4.00 | % | 27,415 |   | 6.00 | % |
| Tier 1 capital (to average  assets)       |       | 42,714     |       | 6.86                                                                   | %          | 24,898                                                                                            |       | 4.00 | % | 31,122 |   | 5.00 | % |
|                                      |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| **December 31,  2007**               |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| **The  Company**                          |       |       |       |                                                                   |       |                                                                                              |       |   |   |   |   |   |   |
| Total capital (to  risk-weighted assets)  |       | $          | 40,524     |                                                                   | 11.22      | %                                                                                                 | $          | 28,884 |   | 8.00 | % | N/A |   | N/A |   |
| Tier 1 capital (to  risk-weighted assets) |       | 36,989     |       | 10.24                                                                  | %          | 14,442                                                                                            |       | 4.00 | % | N/A |   | N/A |   |
| Tier 1 capital (to average  assets)       |       | 36,989     |       | 9.38                                                                   | %          | 15,768                                                                                            |       | 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 | % |
|                                           |            |            |            |                                                                        |            |                                                                                                   |            |  |  |  |  |  |  |  |  |  |

 

**NOTE 16 - RETIREMENT AND BENEFITS**

 

**Trusteed Retirement Savings Plan** - The Bank has a trustee retirement savingsplan which provides retirement benefits to substantially all officers andemployees who meet certain age and service requirements.  The plan includes a “salary reduction”feature pursuant to Section 401(k) of the Internal Revenue Code.  Under the plan and present policies,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$233,000 and $183,000 to earnings for the retirement savings plan in 2008 and2007, respectively.

 

**DirectorsDeferred Compensation Plan** - The Company has a deferred compensation plan whereby directors mayelect to defer the payment of their fees. Under the terms of the plan, the Company accrues an expense equal to theamount deferred plus an interest component based on the prime rate of interestat the beginning of each year.  TheCompany has also purchased life insurance contracts on each of the participatingdirectors.  At December 31, 2008 and2007, $912,000 and $787,000, respectively, of directors’ fees were deferred andare included in other liabilities.

 

51

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

** **

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

 

**Performance Compensation forIncentive Plan** - The Company implemented an employeebonus program in 2003 which it refers to as its Performance CompensationPlan.  The plan pays employees based on aschedule of key performance indicators they are required to meet in order to berewarded.  The plan accrues for itsemployee bonuses based 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 $40,000 and $167,000 toearnings for the stakeholder plan in 2008 and 2007, respectively.

 

**NOTE 17 -EARNINGS PER SHARE**

 

Earnings per share- basic is computed by dividing net income by the weighted average number ofcommon shares outstanding.  Earnings pershare - diluted is computed by dividing net income by the weighted averagenumber of common shares outstanding and dilutive common share equivalents usingthe treasury stock method.  Dilutivecommon share equivalents include common shares issuable upon exercise ofoutstanding stock options.  All shareamounts have been adjusted for stock splits and dividends.

 
| **(Dollars in thousands, except**                                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **per share amounts)**                                                         | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| **Basic  earnings per share:**                                                           |       |                                        |       |   |   |
|                                                                                     |       |                                        |       |   |   |
| Net income  available to common shareholders                                             | ** ** | **$**                                       | **2,244**  | ** ** | **$** | **2,040** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Average common  shares outstanding - basic                                               | ** ** | **3,788,296**                               | ** ** | **3,787,791** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Basic earnings  per share                                                                | ** ** | **$**                                       | **0.59**   | ** ** | **$** | **0.53** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| **Diluted  earnings per share:**                                                         |       |                                        |       |   |   |
|                                                                                     |       |                                        |       |   |   |
| Net income  available to common shareholders                                             |       | $                                           | 2,244      |   | $ | 2,040 |   |
|                                                                                     |       |                                        |       |   |   |
| Average common  shares outstanding - basic                                               |       | 3,788,296                                   |       | 3,787,791 |   |
|                                                                                     |       |                                        |       |   |   |
| Incremental  shares from assumed conversion of stock options and restricted stock awards |       | 40,765                                      |       | 28,291 |   |
|                                                                                     |       |                                        |       |   |   |
| Average common  shares outstanding - diluted                                             | ** ** | **3,829,061**                               | ** ** | **3,816,082** | ** ** |
|                                                                                     |       |                                        |       |   |   |
| Diluted earnings  per share                                                              | ** ** | **$**                                       | **0.59**   | ** ** | **$** | **0.53** | ** ** |

 

**NOTE 18 - STOCK COMPENSATION PLAN**

 

#### **In 2004, upon shareholder approval, the Company adopted an Omnibus StockOwnership and Long Term Incentive Plan (the “Stock Plan”).  The Stock Plan authorizes the grant ofoptions and awards of restricted stock to certain of our employees for up to400,000 shares of the Company’s common stock from time to time during the termof the Stock Plan, subject to adjustments upon change in capitalization.  The Stock Plan is administered by theCompensation Committee of the Board of Directors of the Company.**

 

52

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

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

 

#### **Options granted under the Stock Plan are incentive stock options, andthey are vested over a five year period with none vesting at the time of thegrant.  All unexercised incentive stockoptions expire ten years after the date of the grant.  A summary of the Company’s incentive stockoptions as of December 31, 2008 and 2007 is as follows *(with adjustments for the 3% stock dividend and the 2-for1stock splitfor each period):***

 
| ** **                        | ** ** | **2008**   | ** ** | **2007**     | ** ** |
|-----------------------------------|------------|------------|------------|--------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding at  beginning of year |       | 71,676     |       | $            | 13.97      |   | 72,984 |   | $ | 14.06 |   |
| Granted                           |       | —     |       | —       |       | — |   |   |   |
| Exercised                         |       | —     |       | —       |       | (1,308 | ) | 13.44 |   |
| Forfeited                         |       | —     |       | —       |       | — |   |   |   |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding at  end of year       | ** ** | **71,676** |       | $            | 13.97      | ** ** | **71,676** |   | $ | 13.97 |   |

#### ** **

#### **The Company had no options exercised during 2008.**

#### ** **

#### **Restricted stock awards included in the Stock Plan vest after the firstthree consecutive periods during which the Bank’s return on average assets(ROAA) averages 1.15%.  At December 31,2008 and 2007, none of the restricted stock had vested; therefore, nocompensation expense related to the vesting was recognized.  All ungranted restricted stock awardsexpire.  A summary of the Company’srestricted stock awards as of December 31, 2008 and 2007 is as follows *(with adjustments for3% stock dividends and the 2-for-1 stock split foreach period):***

#### ** **

| ** **                        | ** ** | **2008**   | ** ** | **2007**     | ** ** |
|-----------------------------------|------------|------------|------------|--------------|------------|
| ** **                        | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                        | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                        | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding at  beginning of year |       | 48,867     |       | $            | 14.40      |   | 49,012 |   | $ | 14.40 |   |
| Granted                           |       | —     |       | —       |       | — |   | — |   |
| Exercised                         |       | —     |       | —       |       | — |   | — |   |
| Forfeited                         |       | —     |       | —       |       | — |   |   |   |
|                              |       |       |       |         |       |   |   |   |   |
| Outstanding at  end of year       | ** ** | **48,867** |       | $            | 14.40      | ** ** | **49,012** |   | $ | 14.40 |   |

 

The following tablesummarizes information about stock options outstanding under the Company’splans at December 31, 2008 *(withadjustments for the 2-for-1 stock split for the two periods):*

 
| ** **                      | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|---------------------------------|------------|-----------------|------------|-----------------|------------|
|                            |       |            |       |            |       |
| Number of  options              |       | 120,543         |       | 50,260          |       |
| Weighted average remaining life |       | 4  years        |       | 1  years        |       |
| Weighted average exercise price |       | $               | 14.14      |            | $          | 14.14 |   |
|                                 |            |                 |            |                 |            |  |  |

 

The aggregateintrinsic value of shares outstanding at December 31, 2008 was $892,000.

 

The Companymeasures the fair value of each option award on the date of grant using theBlack-Scholes option-pricing model.  TheCompany determines the assumptions used in the Black-Scholes option pricingmodel as follows:  the risk-free interestrate is based on the U.S. Treasury yield curve in effect at the time of thegrant; the dividend yield is based on the Company’s dividend yield at the timeof the grant (subject to adjustment if the dividend yield on the grant date isnot expected to approximate the dividend yield over the expected life of theoptions); the volatility factor is based on the historical volatility of theCompany’s stock (subject to adjustment if historical volatility is reasonablyexpected to differ from the past); the weighted-average expected life is basedon the historical behavior of employees related to exercises, forfeitures andcancellations.

 

53

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

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

 

There were nostock options granted in 2008 or 2007. The Company received $29,000 as a result of stock option exercisesduring the year ended December 31, 2007. In accordance with Statement 123(R), this benefit is included as afinancing activity in the accompanying Statements of Cash Flows.

 

A summary of thestatus of the nonvested shares as of December 31, 2008, and changes duringthe year ended December 31, 2008, is presented below:

 
| ** **                           | ** ** | ** ** | ** ** | **Weighted-**       | ** ** |
|--------------------------------------|------------|------------|------------|---------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | **Average**         | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Grant-Date**      | ** ** |
| **Nonvested Shares**            | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                                 |       |       |       |                |       |
| Nonvested at January 1,  2008   |       | 36,101     |       | 19.18               |       |
| Granted                              |       | —     |       | —              |       |
| Vested                               |       | (14,683    | )          | —              |       |
| Forfeited                            |       | —     |       | —              |       |
|                                 |       |       |       |                |       |
| Nonvested at  December 31, 2008 | ** ** | **21,418** | ** ** | **$**               | **19.18**  | ** ** |
|                                      |            |            |            |                     |            |  |

 

As of December 31,2008, there was $114,000 of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements granted under the plans.  That cost is expected to be recognized over aweighted-average period of 1.5 years. The total fair value of shares vested during the years ended December 31,2008 and 2007 was $390,568 and $417,018, respectively.

 

#### **NOTE19 - OTHER EXPENSES**

#### ** **

Other expenses aresummarized as follows:

 
| ** **                           | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                                 |       |                                        |       |   |   |
| Stationery,  printing, and postage   |       | $                                           | 439        |   | $ | 477 |   |
| Telephone                            |       | 259                                         |       | 232 |   |
| Director and  advisory fees          |       | 134                                         |       | 141 |   |
| Insurance                            |       | 450                                         |       | 67 |   |
| ATM services                         |       | 167                                         |       | 115 |   |
| Courier services                     |       | 138                                         |       | 194 |   |
| Other                                |       | 1,545                                       |       | 1,318 |   |
|                                 |       |                                        |       |   |   |
| Total                                | ** ** | **$**                                       | **3,132**  | ** ** | **$** | **2,544** | ** ** |

 

54

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

#### **NOTE20 - INCOME TAXES**

#### ** **

Income tax expense issummarized as follows:
| ** **                                   | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                                         |       |                                        |       |   |   |
| Currently  payable:                          |       |                                        |       |   |   |
| Federal                                      |       | $                                           | 1,465      |   | $ | 1,021 |   |
| State                                        |       | 58                                          |       | 83 |   |
|                                         |       |                                        |       |   |   |
| Total current                                |       | 1,523                                       |       | 1,104 |   |
|                                         |       |                                        |       |   |   |
| Deferred income  taxes                       |       | 229                                         |       | 194 |   |
|                                         |       |                                        |       |   |   |
| Income tax  expense                          | ** ** | **$**                                       | **1,752**  | ** ** | **$** | **1,298** | ** ** |
|                                         | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Income tax  expense is allocated as follows: |       |                                        |       |   |   |
| To continuing  operations                    |       | $                                           | 1,104      |   | $ | 1,052 |   |
| To shareholders’  equity                |       | 648                                         |       | 246 |   |
|                                         |       |                                        |       |   |   |
| Total                                        | ** ** | **$**                                       | **1,752**  | ** ** | **$** | **1,298** | ** ** |

 
| The components  of the net deferred tax asset are as follows: |   |   |   |   |   |
|---------------------------------------------------------------|--------|--------|--------|--------|--------|

 
| ** **                                             |       | **December 31,** |       |
|--------------------------------------------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                            | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                                   |       |                  |       |   |   |
| Deferred tax  assets:                                  |       |                  |       |   |   |
| Allowance for  loan losses                             |       | $                     | 1,265      |   | $ | 939 |   |
| Net capitalized  loan costs                            |       | 163                   |       | 168 |   |
| State net  operating loss                              |       | 72                    |       | 59 |   |
| Deferred  directors’ fees                         |       | 367                   |       | 267 |   |
| Nonaccruing  interest                                  |       | 133                   |       | 95 |   |
| Net unrealized  loss on securities available-for-sale  |       | —                |       | 3 |   |
| Other real  estate owned                               |       | 88                    |       | — |   |
| Other                                                  |       | 14                    |       | 24 |   |
|                                                   |       |                  |       |   |   |
| Total deferred  tax assets                             |       | 2,102                 |       | 1,555 |   |
|                                                   |       |                  |       |   |   |
| Valuation  Allowance                                   |       | 72                    |       | 59 |   |
|                                                   |       |                  |       |   |   |
| Total net  deferred tax assets                         |       | 2,030                 |       | 1,496 |   |
|                                                   |       |                  |       |   |   |
| Deferred tax  liabilities:                             |       |                  |       |   |   |
| Accumulated  depreciation                              |       | 854                   |       | 698 |   |
| Gain on sale of  real estate                           |       | 73                    |       | 73 |   |
| Net unrealized  gains on securities available-for-sale |       | 645                   |       | — |   |
| Prepaid expenses                                       |       | 62                    |       | 100 |   |
|                                                   |       |                  |       |   |   |
| Total deferred  tax liabilities                        |       | 1,634                 |       | 871 |   |
|                                                   |       |                  |       |   |   |
| Net deferred tax  asset                                | ** ** | **$**                 | **396**    | ** ** | **$** | **625** | ** ** |

 

55

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

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

 

Deferred taxassets represent the future tax benefit of future deductible differences and,if it is more likely than not that a tax asset will not be realized, avaluation allowance is required to reduce the recorded deferred tax assets tonet realizable value.  Management hasdetermined that a valuation allowance is needed for the deferred tax asset associatedwith South Carolina net operating losses. Deferred tax assets are included in other assets.

 

The Company hasSouth Carolina net operating losses of $2,186,628 for income tax purposes as ofDecember 31, 2008.  These netoperating losses will begin to expire in 2019.

 

A reconciliationbetween the 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)**                 | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Tax expense at  statutory rate                       |       | $                                           | 1,138      |   | $ | 1,051 |   |
| State income  tax, net of federal income tax benefit |       | 38                                          |       | 55 |   |
| Tax-exempt  interest income                          |       | (93                                         | )          | (105 | ) |
| Stock  compensation expense                          |       | 50                                          |       | 50 |   |
| Other                                                |       | (29                                         | )          | 1 |   |
|                                                 |       |                                        |       |   |   |
| Income tax  provision                                | ** ** | **$**                                       | **1,104**  | ** ** | **$** | **1,052** | ** ** |

 

#### **NOTE21 - UNUSED LINES OF CREDIT**

#### ** **

As of December 31,2008, the Company had unused lines of credit to purchase federal funds fromunrelated banks totaling $28,300,000. These lines of credit are available on aone to fourteen 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 $52,101,000 atDecember 31, 2008, if liquidity needs should arise.

 

#### **NOTE22 - FAIR VALUE OF FINANCIAL INSTRUMENTS**

#### ** **

The fair value ofa financial instrument is the price that would be received to sell an asset orpaid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. Fair value estimates are made at a specific point in time based onrelevant market information and information about the financialinstruments.  Because no market valueexists for a significant portion of the financial instruments, fair value estimatesare based on judgments regarding future expected loss, current economicconditions, risk characteristics of various financial instruments, and otherfactors.

 

The followingmethods and assumptions were used to estimate the fair value of significantfinancial instruments:

 

***Cashand Due from Banks***- The carrying amount is a reasonableestimate of fair value.

 

***FederalFunds Sold**and Purchased***-Federal funds sold and purchased are for a term of one day and the carryingamount approximates the fair value.

 

***TimeDeposits with Other Banks*** - Time deposits with otherbanks have a term less than 90 days and the carrying amount approximates thefair value.

 

***InvestmentSecurities Available-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.

 

56

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#### ** **

**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

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

 

***NonmarketableEquity Securities***- The carrying amount is a reasonableestimate of fair value since no ready market 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.

 

***LoansReceivable***- For certain categories of loans, such asvariable rate loans which are repriced frequently and have no significantchange in credit risk and credit card receivables, fair values are based on thecarrying amounts.  The fair value ofother types of loans is estimated by discounting the future cash flows usingthe current rates at which similar loans would be made to the borrowers withsimilar credit ratings and for 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.

 

***Advancesfrom the Federal Home Loan Bank***- For the portion ofborrowings immediately callable, fair value is based on the carryingamount.  The fair value of the portionmaturing at a later date is estimated using a discounted cash flow calculationthat applies the interest rate of the immediately callable portion to theportion maturing at the future date.

 

***JuniorSubordinated Debentures*** - The carrying value of juniorsubordinated debentures is a reasonable estimate of fair value since thedebentures were issued at a floating rate.

 

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

*** ***

***AccruedInterest Receivable and Payable***- The carrying value ofthese instruments is a reasonable estimate of fair value.

 

***Commitmentsto Extend Credit and Standby Letters of Credit***- Thecontractual amount is a reasonable estimate of fair value for the instrumentsbecause commitments to extend credit and standby letters of credit are issuedon a short-term or floating rate basis and include no unusual credit risks.

 

***InterestRate Swaps*** - Fair values are based on the present valueof future cash flows based on the interest rate spread between the fixed rateand the floating rate.

 

57

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

** **

**Notes to Consolidated FinancialStatements**

 

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

 

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

 
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **2008**              | ** ** | **2007** | ** ** |
| ** **                                                          | ** ** | **Carrying**          | ** ** | **Estimated** | ** ** | **Carrying** | ** ** | **Estimated** | ** ** |
| **(Dollars in thousands)**                                | ** ** | **Amount**            | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                          |       |                  |       |   |   |   |   |   |   |
| **Financial  Assets:**                                              |       |                  |       |   |   |   |   |   |   |
| Cash and due  from banks                                            |       | $                     | 10,423     |   | $ | 10,423 |   | $ | 7,958 |   | $ | 7,958 |   |
| Federal funds  sold                                                 |       | —                |       | — |   | 3,655 |   | 3,655 |   |
| Investment  securities available-for-sale                           |       | 166,992               |       | 166,992 |   | 49,609 |   | 49,609 |   |
| Nonmarketable equity  securities                                    |       | 5,261                 |       | 5,261 |   | 3,327 |   | 3,327 |   |
| Loans and loans  held-for-sale                                      |       | 429,108               |       | 433,665 |   | 354,214 |   | 353,194 |   |
| Accrued interest  receivable                                        |       | 3,625                 |       | 3,625 |   | 3,473 |   | 3,473 |   |
| Other assets -  interest rate swaps                                 |       | 83                    |       | 83 |   | 339 |   | 339 |   |
|                                                                |       |                  |       |   |   |   |   |   |   |
| **Financial  Liabilities:**                                         |       |                  |       |   |   |   |   |   |   |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $                     | 176,182    |   | $ | 176,182 |   | $ | 188,849 |   | $ | 188,849 |   |
| Certificates of  deposit                                            |       | 308,569               |       | 310,175 |   | 152,002 |   | 151,278 |   |
| Repurchase  agreements                                              |       | 9,172                 |       | 9,172 |   | 5,000 |   | 5,000 |   |
| Advances from  the Federal Home Loan Bank                           |       | 92,000                |       | 94,743 |   | 52,300 |   | 52,395 |   |
| Notes Payable                                                       |       | 4,500                 |       | 4,500 |   | — |   | — |   |
| Junior  subordinated debentures                                     |       | 6,186                 |       | 6,186 |   | 6,186 |   | 6,186 |   |
| Accrued interest  payable                                           |       | 2,105                 |       | 2,105 |   | 982 |   | 982 |   |
| Other  liabilities - interest rate swaps                            |       | 83                    |       | 83 |   | 339 |   | 339 |   |
| ** **                                                          | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                          | ** ** | **Notional**          | ** ** | **Estimated** | ** ** | **Notional** | ** ** | **Estimated** | ** ** |
| ** **                                                          | ** ** | **Amount**            | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Fair Value** | ** ** |
| **Off-Balance  Sheet Financial Instruments:**                       |       |                  |       |   |   |   |   |   |   |
| Commitments to  extend credit                                       |       | $                     | 61,918     |   | $ | N/A |   | $ | 66,575 |   | N/A |   |
| Standby letters  of credit                                          |       | 1,478                 |       | N/A |   | 761 |   | N/A |   |

 

Effective January 1,2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS157”) which provides a framework for measuring and disclosing fair value undergenerally accepted accounting principles. SFAS 157 requires disclosures aboutthe fair value of assets and liabilities recognized in the balance sheet inperiods subsequent to initial recognition, whether the measurements are made ona recurring basis (for example, available-for-sale investment securities) or ona nonrecurring basis (for example, impaired loans).

 

58

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

 

**Notes to Consolidated FinancialStatements**

 

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

 

SFAS 157 defines fairvalue as the exchange price that would be received for an asset or paid totransfer a liability (an exit price) in the principal or most advantageousmarket for the asset or liability in an orderly transaction between marketparticipants on the measurement date. SFAS 157 also establishes a fair valuehierarchy which requires an entity to maximize the use of observable inputs andminimize the use of unobservable inputs when measuring fair value. The standarddescribes three levels of inputs that may be used to measure fair value:

 
| **Level 1** |   | Quoted prices in active  markets for identical assets or liabilities. Level 1 assets and liabilities  include debt and equity securities and derivative contracts that are traded  in an active exchange market, as well as U.S. Treasuries and money market  funds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **  |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **Level 2** |   | Observable inputs other  than Level 1 prices such as quoted prices for similar assets or liabilities;  quoted prices in markets that are not active; or other inputs that are  observable or can be corroborated by observable market data for substantially  the full term of the assets or liabilities. Level 2 assets and liabilities  include debt securities with quoted prices that are traded less frequently  than exchange-traded instruments, mortgage-backed securities, municipal  bonds, corporate debt securities, and derivative contracts whose value is determined  using a pricing model with inputs that are observable in the market or can be  derived principally from or corroborated by observable market data. This  category generally includes certain derivative contracts and impaired loans. |
| ** **  |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **Level 3** |   | Unobservable inputs  that are supported by little or no market activity and that are significant  to the fair value of the assets or liabilities. Level 3 assets and  liabilities include financial instruments whose value is determined using  pricing models, discounted cash flow methodologies, or similar techniques, as  well as instruments for which the determination of fair value requires  significant management judgment or estimation. For example, this category  generally includes certain private equity investments, retained residual  interests in securitizations, residential mortgage servicing rights, and  highly-structured or long-term derivative contracts.                                                                                                                                |

 
| **(Dollars in thousands)**      | ** ** | **Quoted market price in  active markets  (Level 1)** | ** ** | **Significant other  oberservable inputs  (Level 2)** | ** ** | **Significant unobservable  inputs  (Level 3)** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                | ** ** | ** **                                                                     | ** ** | ** **                                                           | ** ** | ** **                                                | ** ** |
| Available-for-sale  investment securities |       | $                                                                              | —     |                                                                 | $          | 166,992                                                   |       | — |   |
|                                      |       |                                                                           |       |                                                                 |       |                                                      |       |   |   |
| Mortgage loans  held for sale             |       | —                                                                         |       | $                                                                    | 70         |                                                      | —     |   |
|                                      |       |                                                                           |       |                                                                 |       |                                                      |       |   |
| Fair Value Hedge                          |       | —                                                                         |       | $                                                                    | 82,789     |                                                      | —     |   |
|                                      |       |                                                                           |       |                                                                 |       |                                                      |       |   |
| Total                                     |       | $                                                                              | —     |                                                                 | 249,851    |                                                      | —     |   |
|                                           |            |                                                                                |            |                                                                      |            |                                                           |            |  |  |  |  |

 

The Company has noliabilities carried at fair value or measured at fair value on a nonrecurringbasis.

 

The Company ispredominantly an asset based lender with real estate serving as collateral on asubstantial majority of loans. Loans which are deemed to be impaired areprimarily valued nonrecurring basis at the fair values of the underlying realestate collateral. Such fair values are obtained using independent appraisals,which the Company considers to be level 2 inputs. The aggregate carrying amountof impaired loans at December 31, 2008 was $9,040,000.

 

59

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

 

**Notes to Consolidated FinancialStatements**

 

**NOTE 23 - HCSB FINANCIALCORPORATION (*PARENT COMPANY ONLY*)**

 

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

 

**CondensedBalance Sheets**

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**             | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **Assets**                                       |       |                  |       |   |   |
| Cash                                             |       | $                     | 52         |   | $ | 16 |   |
| Investment in  banking subsidiary                |       | 43,811                |       | 36,095 |   |
| Investment in  trust                             |       | 186                   |       | 186 |   |
| Nonmarketable  equity securities                 |       | 25                    |       | 25 |   |
| Other assets                                     |       | 1,080                 |       | 867 |   |
|                                             |       |                  |       |   |   |
| Total assets                                     | ** ** | **$**                 | **45,154** | ** ** | **$** | **37,189** | ** ** |
|                                             | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Liabilities  and shareholders’ equity**   |       |                  |       |   |   |
| Interest  payable-notes payable                  |       | $                     | 6          |   | $ | — |   |
| Interest  payable-junior subordinated debentures |       | 12                    |       | 20 |   |
| Notes payable                                    |       | 4,500                 |       | — |   |
| Junior  subordinated debentures                  |       | 6,186                 |       | 6,186 |   |
|                                             |       |                  |       |   |   |
| Total  liabilities                               |       | 10,704                |       | 6,206 |   |
|                                             |       |                  |       |   |   |
| Shareholders’  equity                       |       | 34,450                |       | 30,983 |   |
|                                             |       |                  |       |   |   |
| Total  liabilities and shareholder’s equity | ** ** | **$**                 | **45,154** | ** ** | **$** | **37,189** | ** ** |

 
| **Condensed Statements of Income**                                                                 |
|----------------------------------------------------------------------------------------------------|
| ** **                                                                                         |   |   |   |   |   |
| ** **                                                                                         | ** ** | **Years ended December 31,** | ** ** |
| **(Dollars in thousands)**                                                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Income**                                                                                         |   |   |   |   |   |
| Dividends from  banking subsidiary                                                                 |   | $ | 372 |   | $ | 239 |   |
| Dividend from  trust preferred securities                                                          |   | 11 |   | 15 |   |
| Other Income                                                                                       | ** ** | **—** | ** ** | **—** | ** ** |
|                                                                                               |   | 383 |   | 254 |   |
| **Expenses**                                                                                       |   |   |   |   |   |
| Interest expense  on notes payable                                                                 |   | 53 |   | 8 |   |
| Interest expense  on junior subordinated debentures                                                |   | 348 |   | 490 |   |
| Other expenses                                                                                     |   | 158 |   | 183 |   |
|                                                                                               |   |   |   |   |   |
| **Income  (loss) before income taxes and equity in undistributed earnings of banking  subsidiary** |   | (176 | ) | (427 | ) |
| ** **                                                                                         |   |   |   |   |   |
| Income tax  benefit                                                                                |   | (207 | ) | (252 | ) |
|                                                                                               |   |   |   |   |   |
| Equity in  undistributed earnings of banking subsidiary                                            |   | 2,213 |   | 2,215 |   |
|                                                                                               |   |   |   |   |   |
| **Net  income**                                                                                    | ** ** | **$** | **2,244** | ** ** | **$** | **2,040** | ** ** |

 

60

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**HCSB FINANCIAL CORPORATION ANDSUBSIDIARY**

 

**Notes to Consolidated FinancialStatements**

 

**NOTE 23 - HCSB FINANCIALCORPORATION (*PARENT COMPANY ONLY*)***- continued*

 

**Condensed Statements of CashFlows**

 
| ** **                                                                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
| **Cash  flows from operating activities:**                                         |       |                                        |       |   |   |
| Net income                                                                         |       | $                                           | 2,244      |   | $ | 2,040 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                        |       |   |   |
| Equity in  undistributed earnings of banking subsidiary                            |       | (2,213                                      | )          | (2,215 | ) |
| Increase in  other assets                                                          |       | (213                                        | )          | (206 | ) |
| Decrease in  other liabilities                                                     |       | (2                                          | )          | (12 | ) |
| Stock  compensation expense                                                        |       | 147                                         |       | 147 |   |
|                                                                               |       |                                        |       |   |   |
| Net cash used by  operating activities                                             |       | (37                                         | )          | (246 | ) |
|                                                                               |       |                                        |       |   |   |
| **Cash  flows from investing activities:**                                         |       |                                        |       |   |   |
| Proceeds from  sale of land and building                                           |       | —                                      |       | 3,529 |   |
|                                                                               |       |                                        |       |   |   |
| Net cash  provided (used) from investing activities                                |       | —                                      |       | 3,529 |   |
|                                                                               |       |                                        |       |   |   |
| **Cash  flows from financing activities:**                                         |       |                                        |       |   |   |
| Proceeds from  stock issuance                                                      |       | —                                      |       | 28 |   |
| Proceeds from  notes payable                                                       |       | 4,500                                       |       | (3,478 | ) |
| Capital  contribution to the Bank                                                  |       | (4,400                                      | )          |   |   |
| Cash paid for  fractional shares                                                   |       | (27                                         | )          | — |   |
|                                                                               |       |                                        |       |   |   |
| Net cash  provided (used) by financing activities                                  |       | 73                                          |       | (3,450 | ) |
|                                                                               |       |                                        |       |   |   |
| **Increase  (decrease) in cash**                                                   |       | 36                                          |       | (167 | ) |
| ** **                                                                         |       |                                        |       |   |   |
| **Cash  and cash equivalents, beginning of year**                                  |       | 16                                          |       | 183 |   |
| ** **                                                                         |       |                                        |       |   |   |
| **Cash  and cash equivalents, end of year**                                        |       | **$**                                       | **52**     | ** ** | **$** | **16** | ** ** |

 

61

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# **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 Service, 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  President and CEO |   | D. Singleton  Bailey  Secretary |

 

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# **HCSB FINANCIAL CORPORATION AND SUBSIDIARY**

 

**HORRYCOUNTY STATE BANK CORPORATE OFFICERS**

 

James R. Clarkson,President/CEO

Glenn R. Bullard,Senior Executive Vice President

Jerry J. Cox, Jr.,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., Senior Vice President/CFO

Ron L. Paige, Executive Vice President/Myrtle Beach Region

Douglas E. Shaffer, Executive Vice President/North Strand Region

 

**HORRYCOUNTY STATE BANK BRANCHES AND ATM LOCATIONS**

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

###### ** **

----

*****Denotes ATM Location

 

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