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US Securities and Exchange Commission
 Washington, DC 20549
 Form 10-Q
 Quarterly Report Pursuant To Section 13 or 15(d)
Of the Securities Exchange Act of 1934
For the Quarterly Period Ended June 30, 2008
 Commission File Number 0001366367
 Yadkin Valley Financial Corporation
 (Exact name of registrant specified in its charter)
 North Carolina
(State of Incorporation)
    
    20-4495993
(I.R.S. Employer Identification No.)
 209 North Bridge Street, Elkin, North Carolina 28621
(address of principal executive offices)
 336-526-6300
(Registrants telephone number, including area code)
 þ o
  Large accelerated filer o
Accelerated filer þ
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company o o þ




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##### 



Part I. Financial InformationItem 1. Financial StatementsCondensed Consolidated Balance Sheets June 30, 2008 and December 31, 2007
    
    
    3Condensed Consolidated Statements of Income Three and Six Months Ended June 30, 2008 and 2007
    
    
    4Condensed Consolidated Statements of Comprehensive Income Three and Six Months Ended June 30, 2008 and 2007
    
    
    5Condensed Consolidated Statements of Stockholders Equity for the Six Months Ended June 30, 2008
    
    
    6Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007
    
    
    7Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    8-17Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17-28Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4. Controls and Procedures
    
    
    28-30Part II. Other InformationItem 4. Submission of Matters to Vote of Security Holders
    
    
    30-31Item 6. Exhibit Index
    
    
    31Signatures
    
    
    32Exhibits
    
    
    33-35Exhibit 10.3Exhibit 31.1Exhibit 32.1Exhibit 32.1
  2




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YADKIN VALLEY FINANCIAL CORPORATION  CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
 JUNE 30,
    
    
    DECEMBER 31,2008
    
    
    2007*ASSETSCASH AND CASH EQUIVALENTSCash and due from banks
    
    $
    28,403,211
    
    
    $
    24,267,806Federal funds sold
    
    
    
    
    
    
    Interest-bearing deposits
    
    
    14,244,754
    
    
    
    2,058,069TOTAL CASH AND CASH EQUIVALENTS
    
    
    42,647,965
    
    
    
    26,325,875SECURITIES AVAILABLE FOR SALE-At fair value
(Amortized cost $141,845,830 in 2008 and $141,439,626 in 2007)
    
    
    141,198,129
    
    
    
    142,483,720GROSS LOANS
    
    
    1,076,513,243
    
    
    
    898,753,056Less: Allowance for loan losses
    
    
    (15,248,992
    )
    
    
    (12,445,555
    )NET LOANS
    
    
    1,061,264,251
    
    
    
    886,307,501LOANS HELD FOR SALE
    
    
    47,142,870
    
    
    
    52,753,907ACCRUED INTEREST RECEIVABLE
    
    
    5,890,791
    
    
    
    6,054,982PREMISES AND EQUIPMENT, NET
    
    
    33,029,092
    
    
    
    26,779,889FEDERAL HOME LOAN BANK STOCK, AT COST
    
    
    6,767,100
    
    
    
    2,557,300INVESTMENT IN BANK-OWNED LIFE INSURANCE
    
    
    23,148,603
    
    
    
    22,682,702GOODWILL
    
    
    54,033,302
    
    
    
    32,696,900CORE DEPOSIT INTANGIBLE (net of accumulated amortization
of $4,641,258 at June 30, 2008 and $4,218,393 at December 31, 2007)
    
    
    5,114,229
    
    
    
    4,261,115OTHER ASSETS
    
    
    11,495,021
    
    
    
    8,173,350TOTAL ASSETS
    
    $
    1,431,731,353
    
    
    $
    1,211,077,241LIABILITIES AND STOCKHOLDERS EQUITYDEPOSITSNoninterest-bearing demand deposits
    
    $
    165,055,612
    
    
    $
    154,979,227Interest-bearing deposits:NOW, savings, and money market accounts
    
    
    283,403,636
    
    
    
    232,888,349Time certificates:Over $100,000
    
    
    276,956,845
    
    
    
    267,529,772Other
    
    
    371,302,935
    
    
    
    308,044,736TOTAL DEPOSITS
    
    
    1,096,719,028
    
    
    
    963,442,084SHORT-TERM BORROWINGS
    
    
    153,650,555
    
    
    
    66,425,129LONG-TERM BORROWINGS
    
    
    19,315,638
    
    
    
    37,774,000ACCRUED INTEREST PAYABLE
    
    
    3,381,573
    
    
    
    3,434,832OTHER LIABILITIES
    
    
    8,525,578
    
    
    
    6,732,202TOTAL LIABILITIES
    
    
    1,281,592,372
    
    
    
    1,077,808,247STOCKHOLDERS EQUITYCommon stock, $1.00 par value; authorized 20,000,000
shares; issued 11,515,807 shares in 2008 and 10,563,356
shares in 2007
    
    
    11,515,807
    
    
    
    10,563,356SURPLUS
    
    
    87,846,169
    
    
    
    70,986,684RETAINED EARNINGS
    
    
    51,185,189
    
    
    
    51,086,684ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
    
    
    (408,184
    )
    
    
    632,270TOTAL STOCKHOLDERS EQUITY
    
    
    150,138,981
    
    
    
    133,268,994TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    1,431,731,353
    
    
    $
    1,211,077,241
  
 *
    
    Derived from audited consolidated financial statements 3




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YADKIN VALLEY FINANCIAL CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)  THREE AND SIX MONTHS ENDED JUNE 30, 2008 AND 2007
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007INTEREST INCOMEInterest and fees on loans
    
    $
    17,223,085
    
    
    $
    16,915,817
    
    
    $
    33,436,771
    
    
    $
    33,324,966Interest on federal funds sold
    
    
    26,230
    
    
    
    128,245
    
    
    
    36,876
    
    
    
    168,188Interest on securities:Taxable
    
    
    1,344,168
    
    
    
    1,261,819
    
    
    
    2,649,631
    
    
    
    2,488,271Non-taxable
    
    
    373,136
    
    
    
    291,810
    
    
    
    741,732
    
    
    
    578,722Interest-bearing deposits
    
    
    134,371
    
    
    
    49,417
    
    
    
    139,112
    
    
    
    62,730Total interest income
    
    
    19,100,990
    
    
    
    18,647,108
    
    
    
    37,004,122
    
    
    
    36,622,877INTEREST EXPENSETime deposits of $100,000 or more
    
    
    2,726,486
    
    
    
    3,008,730
    
    
    
    5,682,475
    
    
    
    5,727,199Other deposits
    
    
    4,984,912
    
    
    
    4,757,494
    
    
    
    9,510,414
    
    
    
    9,249,568Borrowed funds
    
    
    1,016,501
    
    
    
    471,799
    
    
    
    2,081,145
    
    
    
    1,020,229Total interest expense
    
    
    8,727,899
    
    
    
    8,238,023
    
    
    
    17,274,034
    
    
    
    15,996,996NET INTEREST INCOME
    
    
    10,373,091
    
    
    
    10,409,085
    
    
    
    19,730,088
    
    
    
    20,625,881PROVISION FOR LOAN LOSSES
    
    
    1,078,000
    
    
    
    200,000
    
    
    
    1,528,000
    
    
    
    500,000NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
    
    
    9,295,091
    
    
    
    10,209,085
    
    
    
    18,202,088
    
    
    
    20,125,881NONINTEREST INCOMEService charges on deposit accounts
    
    
    1,065,379
    
    
    
    954,231
    
    
    
    2,074,546
    
    
    
    1,934,646Other service fees
    
    
    876,949
    
    
    
    1,013,679
    
    
    
    1,740,816
    
    
    
    1,855,800Net gain on sales of mortgage loans
    
    
    1,784,383
    
    
    
    1,645,664
    
    
    
    3,556,678
    
    
    
    3,056,366Net loss on sales of investment securities
    
    
    (6,575
    )
    
    
    
    
    
    
    (6,575
    )
    
    
    Income on investment in bank owned life insurance
    
    
    235,462
    
    
    
    313,574
    
    
    
    468,462
    
    
    
    530,343Mortgage banking income
    
    
    68,350
    
    
    
    132,981
    
    
    
    78,107
    
    
    
    212,267Bank owned life insurance death benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    481,940Other income
    
    
    23,135
    
    
    
    52,385
    
    
    
    64,491
    
    
    
    119,780Total noninterest income
    
    
    4,047,083
    
    
    
    4,112,514
    
    
    
    7,976,525
    
    
    
    8,191,142NONINTEREST EXPENSESalaries and employee benefits
    
    
    5,047,528
    
    
    
    4,989,416
    
    
    
    9,915,504
    
    
    
    9,828,017Occupancy and equipment expenses
    
    
    1,294,144
    
    
    
    987,709
    
    
    
    2,270,593
    
    
    
    2,002,617Printing and supplies
    
    
    195,555
    
    
    
    139,165
    
    
    
    380,532
    
    
    
    282,670Data processing
    
    
    270,990
    
    
    
    109,712
    
    
    
    383,410
    
    
    
    210,639Communication expense
    
    
    277,847
    
    
    
    347,765
    
    
    
    486,318
    
    
    
    597,074Amortization of core deposit intangible
    
    
    235,357
    
    
    
    197,469
    
    
    
    422,865
    
    
    
    394,937Other
    
    
    2,831,263
    
    
    
    1,911,837
    
    
    
    4,936,143
    
    
    
    3,631,526Total noninterest expense
    
    
    10,152,684
    
    
    
    8,683,073
    
    
    
    18,795,365
    
    
    
    16,947,480INCOME BEFORE INCOME TAXES
    
    
    3,189,490
    
    
    
    5,638,526
    
    
    
    7,383,248
    
    
    
    11,369,543INCOME TAXES
    
    
    1,053,066
    
    
    
    1,852,128
    
    
    
    2,332,511
    
    
    
    3,670,738NET INCOME
    
    $
    2,136,424
    
    
    $
    3,786,398
    
    
    $
    5,050,737
    
    
    $
    7,698,805NET INCOME PER COMMON SHARE:Basic
    
    $
    0.19
    
    
    $
    0.36
    
    
    $
    0.46
    
    
    $
    0.73Diluted
    
    $
    0.19
    
    
    $
    0.35
    
    
    $
    0.46
    
    
    $
    0.71CASH DIVIDENDS PER COMMON SHARE
    
    $
    0.13
    
    
    $
    0.13
    
    
    $
    0.26
    
    
    $
    0.25
  4




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YADKIN VALLEY FINANCIAL CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)  THREE AND SIX MONTHS ENDED JUNE 30, 2008 AND 2007
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007NET INCOME
    
    $
    2,136,424
    
    
    $
    3,786,399
    
    
    $
    5,050,737
    
    
    $
    7,698,805OTHER COMPREHENSIVE INCOME, BEFORE TAX:Unrealized holding losses on securities available for sale
    
    
    (3,353,233
    )
    
    
    (1,966,042
    )
    
    
    (1,685,220
    )
    
    
    (1,429,393
    )Tax effect
    
    
    1,290,994
    
    
    
    762,538
    
    
    
    648,810
    
    
    
    555,927Unrealized holding losses on securities available for
sale, net of tax
    
    
    (2,062,239
    )
    
    
    (1,203,504
    )
    
    
    (1,036,410
    )
    
    
    (873,466
    )Reclassification adjustment for realized losses
    
    
    (6,575
    )
    
    
    
    
    
    
    (6,575
    )
    
    
    Tax effect
    
    
    2,531
    
    
    
    
    
    
    
    2,531
    
    
    
    Reclassification adjustment for realized losses, net of tax
    
    
    (4,044
    )
    
    
    
    
    
    
    (4,044
    )
    
    
    OTHER COMPREHENSIVE INCOME, NET OF TAX
    
    
    (2,066,283
    )
    
    
    (1,203,504
    )
    
    
    (1,040,454
    )
    
    
    (873,466
    )TOTAL COMPREHENSIVE INCOME
    
    $
    70,141
    
    
    $
    2,582,895
    
    
    $
    4,010,283
    
    
    $
    5,951,873
  5




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YADKIN VALLEY FINANCIAL CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (UNAUDITED)  FOR THE SIX MONTHS ENDED JUNE 30, 2007 and 2008
 AccumulatedOther
    
    
    TotalCommon
    
    
    
    
    
    
    Retained
    
    
    Comprehensive
    
    
    StockholdersStock
    
    
    Surplus
    
    
    Earnings
    
    
    Income
    
    
    EquityBalance, December 31, 2006
    
    $
    10,611,052
    
    
    $
    71,151,626
    
    
    $
    43,107,431
    
    
    $
    (470,968
    )
    
    $
    124,399,141Net income
    
    
    
    
    
    
    
    
    
    
    7,698,805
    
    
    
    
    
    
    
    7,698,805Shares issued under stock option plan
    
    
    45,843
    
    
    
    304,276
    
    
    
    
    
    
    
    
    
    
    
    350,119Cash dividends declared
    
    
    
    
    
    
    
    
    
    
    (2,653,630
    )
    
    
    
    
    
    
    (2,653,630
    )Stock repurchased
    
    
    (48,608
    )
    
    
    (251,266
    )
    
    
    (639,901
    )
    
    
    
    
    
    
    (939,775
    )Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (873,466
    )
    
    
    (873,466
    )Balance, June 30, 2007
    
    $
    10,608,287
    
    
    $
    71,204,636
    
    
    $
    47,512,705
    
    
    $
    (1,344,434
    )
    
    $
    127,981,194Balance, December 31, 2007
    
    $
    10,563,356
    
    
    $
    70,986,684
    
    
    $
    51,086,684
    
    
    $
    632,270
    
    
    $
    133,268,994Net income
    
    
    
    
    
    
    
    
    
    
    5,050,737
    
    
    
    
    
    
    
    5,050,737Shares issued under stock option plan
    
    
    68,700
    
    
    
    385,252
    
    
    
    
    
    
    
    
    
    
    
    453,952Stock option compensation
    
    
    
    
    
    
    29,401
    
    
    
    
    
    
    
    
    
    
    
    29,401Tax benefit from exercise of stock options
    
    
    
    
    
    
    252,250
    
    
    
    
    
    
    
    
    
    
    
    252,250Cumulative effect of adoption of new accounting
standard (Note 9)
    
    
    
    
    
    
    
    
    
    
    (1,966,465
    )
    
    
    
    
    
    
    (1,966,465
    )Cash dividends declared
    
    
    
    
    
    
    
    
    
    
    (2,985,767
    )
    
    
    
    
    
    
    (2,985,767
    )Fractional shares purchased
    
    
    (59
    )
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    (57
    )Shares issued in
acquisition of Cardinal State Bank
    
    
    883,810
    
    
    
    16,192,580
    
    
    
    
    
    
    
    
    
    
    
    17,076,390Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,040,454
    )
    
    
    (1,040,454
    )Balance, June 30, 2008
    
    $
    11,515,807
    
    
    $
    87,846,169
    
    
    $
    51,185,189
    
    
    $
    (408,184
    )
    
    $
    150,138,981
  6




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YADKIN VALLEY FINANCIAL CORPORATION  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)  SIX MONTHS ENDED JUNE 30, 2008 AND 2007
 2008
    
    
    2007CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    5,050,737
    
    
    $
    7,698,805Adjustments to reconcile net income to net cash provided
by operating activities:Net amortization of premiums on investment securities
    
    
    (19,112
    )
    
    
    42,931Provision for loan losses
    
    
    1,528,000
    
    
    
    500,000Net gain on sales of mortgage loans held for sale
    
    
    (3,556,678
    )
    
    
    (3,056,366
    )Net loss on sales of available for sale securities
    
    
    6,575
    
    
    
    (Increase) decrease in investment in Bank owned life insurance
    
    
    (465,901
    )
    
    
    (530,343
    )Depreciation and amortization
    
    
    975,591
    
    
    
    1,000,210Net gain on sale of premises and equipment
    
    
    50,376
    
    
    
    (7,030
    )Gain on bank owned life insurance
    
    
    
    
    
    
    (481,940
    )Amortization of core deposit intangible
    
    
    422,865
    
    
    
    394,937Deferred tax benefit
    
    
    (996,511
    )
    
    
    Stock based compensation expense
    
    
    29,401
    
    
    
    Originations of mortgage loans held-for-sale
    
    
    (258,770,800
    )
    
    
    (495,955,031
    )Proceeds from sales of mortgage loans
    
    
    267,938,515
    
    
    
    500,473,694(Increase) decrease in accrued interest receivable
    
    
    798,810
    
    
    
    (32,151
    )(Increase) decrease in other assets
    
    
    514,930
    
    
    
    (1,676,582
    )Increase (decrease) in accrued interest payable
    
    
    (654,678
    )
    
    
    403,754Increase (decrease) in other liabilities
    
    
    (488,887
    )
    
    
    594,417Net cash provided by operating activities
    
    
    12,363,233
    
    
    
    9,369,305CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of available for sale securities
    
    
    (22,160,971
    )
    
    
    (21,325,213
    )Proceeds from sales of available for sale securities
    
    
    7,160,178
    
    
    
    7,998,622Proceeds from maturities of available for sale securities
    
    
    15,114,000
    
    
    
    2,935,000Net change in loans
    
    
    (26,564,874
    )
    
    
    (1,609,979
    )Acquisition of Cardinal State Bank, net of cash received
    
    
    11,985,011
    
    
    
    Purchases of premises and equipment
    
    
    (1,219,720
    )
    
    
    (1,732,340
    )Proceeds from redemption of Federal Home Loan Bank stock
    
    
    283,500
    
    
    
    850,300Purchases of Federal Home Loan Bank stock
    
    
    (3,942,100
    )
    
    
    Proceeds from sale of premises and equipment
    
    
    257,391
    
    
    
    30,925Proceeds from death benefit from bank owned life insurance
    
    
    
    
    
    
    1,277,376Net cash used in investing activities
    
    
    (19,087,585
    )
    
    
    (11,575,309
    )CASH FLOWS FROM FINANCING ACTIVITIES:Net increase (decrease) in checking, NOW, money market
and savings accounts
    
    
    (5,404,718
    )
    
    
    1,298,462Net increase (decrease) in time certificates
    
    
    (32,898,769
    )
    
    
    33,369,222Net increase (decrease) in borrowed funds
    
    
    63,629,553
    
    
    
    (29,151,263
    )Fractional shares retired
    
    
    (59
    )
    
    
    Purchases of common stock
    
    
    
    
    
    
    (939,774
    )Dividends paid
    
    
    (2,985,767
    )
    
    
    (2,653,633
    )Tax benefit from exercise of stock options
    
    
    252,250
    
    
    
    Proceeds from exercise of stock options
    
    
    453,952
    
    
    
    350,119Net cash provided by (used in) financing activities
    
    
    23,046,442
    
    
    
    2,273,133NET INCREASE IN CASH AND CASH
EQUIVALENTS
    
    
    16,322,090
    
    
    
    67,129CASH AND CASH EQUIVALENTS:Beginning of period
    
    
    26,325,875
    
    
    
    44,056,134End of period
    
    $
    42,647,965
    
    
    $
    44,123,263
  7




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##### Table of Contents



Notes to Unaudited Condensed Consolidated Financial Statements
 1. Significant Accounting Policies
 Basis of Presentation
   2. Stock-based Compensation
      8




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##### Table of Contents



3. Business Combination
   Fair ValueAssets:Cash and cash equivalents
    
    $
    18,028,591Federal funds sold
    
    
    18,047,000Loans, net
    
    
    149,947,952Premises and equipment, net
    
    
    6,312,841Other tangible assets acquired
    
    
    4,955,926Goodwill
    
    
    21,336,402Core deposit intangible
    
    
    1,275,979Liabilities:Deposits
    
    
    (170,689,695
    )Other liabilities
    
    
    (6,945,466
    )Total net assets acquired/consideration given
    
    $
    42,269,530
   Three Months EndedJune 30, 2007
    
    June 30, 2008Net interest income
    
    $
    12,038,938
    
    
    $
    10,243,599Noninterest income
    
    
    4,278,282
    
    
    
    4,047,083Total revenue
    
    
    16,317,220
    
    
    
    14,290,682
 9




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##### Table of Contents



Three Months EndedJune 30, 2007
    
    June 30, 2008Provision for loan losses
    
    
    188,900
    
    
    
    1,078,000Other noninterest expense
    
    
    10,274,876
    
    
    
    10,152,684Income before taxes
    
    
    5,853,444
    
    
    
    3,059,998Income tax expense
    
    
    1,925,200
    
    
    
    1,009,039Net income
    
    
    4,001,316
    
    
    
    2,050,959Basic earnings per share
    
    $
    0.35
    
    
    $
    0.18Diluted earnings per share
    
    
    0.35
    
    
    
    0.18
 Six Months EndedJune 30, 2007
    
    June 30, 2008Net interest income
    
    $
    23,872,919
    
    
    $
    21,093,400Noninterest income
    
    
    8,481,370
    
    
    
    8,102,159Total revenue
    
    
    32,354,289
    
    
    
    29,195,559Provision for loan losses
    
    
    246,800
    
    
    
    1,493,000Other noninterest expense
    
    
    20,214,418
    
    
    
    20,290,622Income before taxes
    
    
    11,893,071
    
    
    
    7,411,937Income tax expense
    
    
    3,670,738
    
    
    
    2,342,265Net income
    
    
    8,222,333
    
    
    
    5,069,672Basic earnings per share
    
    $
    0.72
    
    
    $
    0.46Diluted earnings per share
    
    
    0.70
    
    
    
    0.46
  4. Commitments and Contingencies
    10




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##### Table of Contents



5. Earnings per share
  Three Months Ended June 30,
    
    
    Six Months Ended June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007Basic EPS denominator:Weighted average
number of common
shares outstanding
    
    
    11,492,811
    
    
    
    10,613,687
    
    
    
    11,033,325
    
    
    
    10,613,902Dilutive effect
arising from assumed
exercise of stock
options
    
    
    32,929
    
    
    
    178,741
    
    
    
    59,656
    
    
    
    184,037Diluted EPS denominator
    
    
    11,525,740
    
    
    
    10,792,428
    
    
    
    11,092,981
    
    
    
    10,797,939
  6. Stockholders Equity
   11




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##### Table of Contents



7. Business Segment Information
  June 30, 2008
    
    Bank
    
    
    Sidus
    
    
    Other
    
    
    TotalInterest income
    
    $
    35,688,136
    
    
    $
    1,315,986
    
    
    $
    
    
    
    $
    37,004,122Interest expense
    
    
    16,060,134
    
    
    
    557,058
    
    
    
    656,842
    
    
    
    17,274,034Net interest income
    
    
    19,628,002
    
    
    
    758,928
    
    
    
    (656,842
    )
    
    
    19,730,088Provision for loan losses
    
    
    1,528,000
    
    
    
    
    
    
    
    
    
    
    
    1,528,000Net interest income after
provision for loan losses
    
    
    18,100,002
    
    
    
    758,928
    
    
    
    (656,842
    )
    
    
    18,202,088Net gain (loss) on sale
of investment securities
    
    
    (6,525
    )
    
    
    
    
    
    
    
    
    
    
    (6,525
    )Other income
    
    
    3,980,238
    
    
    
    3,556,678
    
    
    
    446,134
    
    
    
    7,983,050Other expense
    
    
    15,616,841
    
    
    
    3,070,565
    
    
    
    107,959
    
    
    
    18,795,365Income before income taxes
    
    
    6,456,874
    
    
    
    1,245,041
    
    
    
    (318,667
    )
    
    
    7,383,248Income taxes (2)
    
    
    1,846,945
    
    
    
    485,566
    
    
    
    
    
    
    
    2,332,511Net income
    
    $
    4,609,929
    
    
    $
    759,475
    
    
    $
    (318,667
    )
    
    $
    5,050,737Total assets (3)
    
    $
    1,464,170,796
    
    
    $
    53,996,839
    
    
    $
    (86,436,282
    )
    
    $
    1,431,731,353Net loans
    
    
    1,061,264,251
    
    
    
    
    
    
    
    
    
    
    
    1,061,264,251Loans held for sale
    
    
    421,750
    
    
    
    46,721,120
    
    
    
    
    
    
    
    47,142,870Goodwill
    
    
    49,089,430
    
    
    
    4,943,872
    
    
    
    
    
    
    
    54,033,302
 12




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##### Table of Contents



June 30, 2008
    
    Bank
    
    
    Sidus
    
    
    Other
    
    
    TotalInterest income (1)
    
    $
    35,320,232
    
    
    $
    1,379,645
    
    
    $
    (77,000
    )
    
    $
    36,622,877Interest expense
    
    
    14,979,819
    
    
    
    1,096,223
    
    
    
    (79,046
    )
    
    
    15,996,996Net interest income
    
    
    20,340,413
    
    
    
    283,422
    
    
    
    2,046
    
    
    
    20,625,881Provision for loan losses
    
    
    500,000
    
    
    
    
    
    
    
    
    
    
    
    500,000Net interest income after
provision for loan
losses
    
    
    19,840,413
    
    
    
    102,622
    
    
    
    2,046
    
    
    
    20,125,881Net gain (loss) on sale
of investment securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other income
    
    
    5,134,776
    
    
    
    3,056,366
    
    
    
    
    
    
    
    8,191,142Other expense
    
    
    14,330,830
    
    
    
    2,530,164
    
    
    
    86,486
    
    
    
    16,947,480Income before income taxes
    
    
    10,644,359
    
    
    
    809,624
    
    
    
    (84,440
    )
    
    
    11,369,543Income taxes (2)
    
    
    3,354,985
    
    
    
    315,753
    
    
    
    
    
    
    
    3,670,738Net income
    
    $
    7,289,374
    
    
    $
    493,871
    
    
    $
    (84,440
    )
    
    $
    7,698,805Total assets
    
    
    $1,139,699,602
    
    
    $
    47,638,748
    
    
    $
    (57,882,310
    )
    
    $
    1,129,456,040Net loans
    
    
    805,190,950
    
    
    
    
    
    
    
    
    
    
    
    805,190,950Loans held for sale
    
    
    97,000
    
    
    
    40,791,618
    
    
    
    
    
    
    
    40,888,618Goodwill
    
    
    27,753,028
    
    
    
    4,943,872
    
    
    
    
    
    
    
    32,696,900
 
 (1)
    
    Note: In 2007, the Bank allocated interest expense to Sidus based on the Banks cost of
funds plus an additional charge of 87.5 basis points. The additional basis points charge,
reflected in interest income to the Bank and interest expense to Sidus, is eliminated in the
Other column. In 2008, the Bank allocated interest expense based on its cost of funds as a
change in approach to report segment results.(2)
    
    Note: Income tax expense has been allocated to the Sidus business segment for comparative
purposes. As an LLC, Sidus passes its pre-tax income through to its single member, the Bank, which
is taxed on that income.(3)
    
    Note: The Other column includes asset eliminations representing the Banks Due from Sidus
account ($85,000,000 in 2008 and $55,000,000 in 2007), the Banks Investment in Sidus ($3,000,000
in 2008 and 2007), and the Banks A/R from Sidus ($93,390 in 2008 and $191,797 in 2007). Also
included in this column are Holding Company assets ($1,657,108 in 2008 and $309,487 in 2007) and
Holding Company income and expenses. 8. Reclassifications
  9. New Accounting Standards
  13




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.
 14




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10. Fair Value
  Fair Value Hierarchy
  Level 1
    
    Valuation is based upon quoted prices for identical instruments traded in active markets.Level 2
    
    Valuation is based upon quoted prices for similar instruments in active markets, quoted
prices for identical or similar instruments in markets that are not active, and
model-based valuation techniques for which all significant assumptions are observable in
the market.Level 3
    
    Valuation is generated from model-based techniques that use at least one significant
assumption not observable in the market. These unobservable assumptions reflect
estimates of assumptions that market participants would use in pricing the asset or
liability. Valuation techniques include use of option pricing models, discounted cash
flow models and similar techniques.
  Available-for-Sale Investment Securities
  15




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Interest Rate Locks and Forward Sale Loan Commitments
  Mortgage Servicing Rights
   Fair Value
    
    Level 1
    
    Level 2
    
    Level 3Available for sale securities
    
    $
    141,198,129
    
    
    $
    38,559
    
    
    $
    141,159,570
    
    
    
    Mortgage servicing rights
    
    
    1,836,634
    
    
    
    
    
    
    
    
    
    
    $
    1,836,634
  Fair Value
    
    Level 3Balance, beginning of period
    
    $
    2,000,770
    
    
    $
    2,000,770Losses included in earnings
    
    
    (196,798
    )
    
    
    (196,798
    )Net transfers
    
    
    (32,662
    )
    
    
    (32,662
    )Balance, end of period
    
    $
    1,836,634
    
    
    $
    1,836,634
 Mortgage Loans Held for Sale
  Loans Held for Investment
  16




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Fair Value
    
    Level 1
    
    Level 2
    
    Level 3Mortgage loans held for sale
    
    $
    47,142,870
    
    
    
    
    
    
    $
    47,142,870
    
    
    
    Impaired loans
    
    $
    9,337,842
    
    
    
    
    
    
    
    
    
    
    $
    9,337,842
 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS
   
    
    significant increases in competitive pressure in the banking and financial services
industries;
    
    changes in the interest rate environment which could reduce anticipated or actual
margins;
    
    changes in political conditions or the legislative or regulatory environment;
    
    general economic conditions, either nationally or regionally and especially in primary
service area, becoming less favorable than expected resulting in, among other things, a
deterioration in credit quality;
    
    changes occurring in business conditions and inflation;
    
    changes in technology;
    
    changes in deposit flows;
    
    the level of allowance for loan loss;
 
    
    the rate of delinquencies and amounts of charge-offs;
    
    the rates of loan growth;
    
    adverse changes in asset quality and resulting credit risk-related losses and expenses;
    
    changes in monetary and tax policies;
    
    loss of consumer confidence and economic disruptions resulting from terrorist
activities;
    
    changes in the securities markets; and
    
    other risks and uncertainties detailed from time to time in our filings with the
Securities and Exchange Commission.
 17




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Overview
      Changes in Financial Position
   18




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19




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Liquidity, Interest Rate Sensitivity and Market Risk
     Results of Operations
  20




---



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Net Interest Income
      21




---



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Average Balance Sheets and Net Interest Income Analysis
(Dollars in Thousands)
 June 30, 2008
    
    
    June 30, 2007(Unaudited)
    
    Average
    
    
    
    
    
    
    Yield/
    
    
    Average
    
    
    
    
    
    
    Yield/Six Months Ended:
    
    Balance
    
    
    Interest
    
    
    Rate
    
    
    Balance
    
    
    Interest
    
    
    RateINTEREST EARNING ASSETSFederal funds sold
    
    $
    3,394
    
    
    $
    37
    
    
    
    2.19
    %
    
    $
    6,137
    
    
    $
    168
    
    
    
    5.52
    %Interest bearing deposits
    
    
    9,800
    
    
    
    139
    
    
    
    2.84
    %
    
    
    2,728
    
    
    
    63
    
    
    
    4.66
    %Investment securities (1)
    
    
    144,036
    
    
    
    3,736
    
    
    
    5.15
    %
    
    
    132,036
    
    
    
    3,322
    
    
    
    5.07
    %Total loans (1,2)
    
    
    1,017,687
    
    
    
    33,515
    
    
    
    6.60
    %
    
    
    849,781
    
    
    
    33,399
    
    
    
    7.93
    %Total average earning assets (1)
    
    
    1,174,917
    
    
    
    37,427
    
    
    
    6.38
    %
    
    
    990,682
    
    
    
    36,952
    
    
    
    7.52
    %Noninterest earning assets
    
    
    126,125
    
    
    
    
    
    
    
    
    
    
    
    112,928Total average assets
    
    $
    1,301,042
    
    
    
    
    
    
    
    
    
    
    $
    1,103,610INTEREST BEARING LIABILITIESNOW and money market
    
    $
    223,633
    
    
    $
    2,013
    
    
    
    1.81
    %
    
    $
    187,481
    
    
    $
    2,059
    
    
    
    2.21
    %Savings
    
    
    36,597
    
    
    
    109
    
    
    
    0.60
    %
    
    
    36,160
    
    
    
    182
    
    
    
    1.01
    %Time certificates
    
    
    603,561
    
    
    
    13,071
    
    
    
    4.34
    %
    
    
    537,494
    
    
    
    12,735
    
    
    
    4.78
    %Total interest bearing deposits
    
    
    863,791
    
    
    
    15,193
    
    
    
    3.53
    %
    
    
    761,135
    
    
    
    14,976
    
    
    
    3.97
    %Repurchase agreements sold
    
    
    47,681
    
    
    
    628
    
    
    
    2.64
    %
    
    
    34,879
    
    
    
    570
    
    
    
    3.30
    %Borrowed funds
    
    
    78,556
    
    
    
    1,453
    
    
    
    3.71
    %
    
    
    19,607
    
    
    
    451
    
    
    
    4.64
    %Total interest bearing liabilities
    
    
    990,028
    
    
    
    17,274
    
    
    
    3.50
    %
    
    
    815,621
    
    
    
    15,997
    
    
    
    3.96
    %Noninterest bearing deposits
    
    
    152,462
    
    
    
    
    
    
    
    
    
    
    
    152,553Stockholders equity
    
    
    144,234
    
    
    
    
    
    
    
    
    
    
    
    127,719Other liabilities
    
    
    14,318
    
    
    
    
    
    
    
    
    
    
    
    7,717Total average liabilities and
stockholders equity
    
    $
    1,301,042
    
    
    
    
    
    
    
    
    
    
    $
    1,103,610NET INTEREST INCOME/
YIELD (3,4)
    
    
    
    
    
    $
    20,153
    
    
    
    3.44
    %
    
    
    
    
    
    $
    20,955
    
    
    
    4.27
    %INTEREST SPREAD (5)
    
    
    
    
    
    
    
    
    
    
    2.89
    %
    
    
    
    
    
    
    
    
    
    
    3.57
    %
 
 1.
    
    Interest income and yields related to securities and loans exempt from Federal income taxes are stated on a fully tax equivalent
basis, assuming a Federal income tax rate of 34%, reduced by the nondeductible portion of interest expense2.
    
    The loan average includes loans on which accrual of interest has been discontinued.3.
    
    Net interest income is the difference between income from earning assets and interest expense.4.
    
    Net interest yield is net interest income divided by total average earning assets.5.
    
    Interest spread is the difference between the average interest rate received on earning assets and the average
rate paid on interest bearing liabilities. Provisions and Allowance for Loan Losses
  22




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23




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Three Months
    
    
    Six MonthsBalance,
beginning of period
    
    $
    14,568
    
    
    $
    12,445Charge offs
    
    
    (484
    )
    
    
    (723
    )Recoveries
    
    
    87
    
    
    
    354Provision for loan loss
    
    
    1,078
    
    
    
    1,528Acquisition of Cardinal
    
    
    
    
    
    
    1,645Allowance
for Loan Loss, end of period
    
    $
    15,249
    
    
    $
    15,249
 24




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##### Table of Contents



Three Months
    
    
    Six MonthsBalance,
beginning of period
    
    $
    11,092
    
    
    $
    10,829Charge offs
    
    
    (112
    )
    
    
    (219
    )Recoveries
    
    
    96
    
    
    
    166Provision for loan loss
    
    
    200
    
    
    
    500Allowance
for Loan Loss, end of period
    
    $
    11,276
    
    
    $
    11,276
  June 30,
    
    
    December 31,2008
    
    
    2007Impaired loans without a related allowance for loan loss
    
    $
    3,455,453
    
    
    $
    1,610,836Impaired loans with a related allowance for loan loss
    
    
    8,163,507
    
    
    
    6,191,025Total impaired loans
    
    $
    11,618,960
    
    
    $
    7,801,861
 
 Noninterest Income
  
    
    Service charges on deposit accounts -
 
    
    Quarter to date service charges on deposit accounts increased
$111,000 due mainly to income from Cardinal of $99,000. NSF fees income,
excluding Cardinal, increased $76,000. A decrease in Automated Teller Machine
(ATM) fee income of $53,000 offset the increases.
    
    Year to date increases of $140,000 included income from Cardinal
of $99,000 and an increase in NSF fees excluding Cardinal, of $83,000. Partially
offsetting the increases, overdraft protection chargeoffs, net of recoveries,
increased which can be attributed to the weakening economy. Although gross
chargeoffs declined by $7,000, recoveries decreased by $25,000, resulting in an
$18,000 net decrease in income.
 
    
    Other service fee income
 
    
    Quarter to date other service fee income decreased by
approximately $137,000 due to decreases in the commission income earned from the
origination of mortgages of $148,000. Offsetting the decrease was income from
Cardinal of $8,000 and an increase in merchant fee income and credit card user
fees.
    
    Year to date other service fee income decreased approximately
$115,000. Mortgage origination fees were down by $190,000. Investment fee
income, earned by the brokerage division, Main Street Investment Services, Inc.,
increased by approximately $82,000.
 
    
    Gain on sale of mortgages
 
    
    Quarter to date results show a net gain in the sale of mortgages
increasing by approximately $139,000 or an 8.4% increase as total loans
originated and sold increased. The adjustment
 25




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##### Table of Contents



resulting from earlier
implementation of SAB 109 accounted for a $62,000 decrease as mortgage interest
rate lock commitments declined from $131.9 million at March 31, 2008 to $80.1
million at June 30, 2008. As discussed in note 4 to the financial statements,
mortgage interest rate lock commitments are under best efforts contracts to sell
mortgages to agencies and other investors.
    
    Year to date, gain on sale of mortgage loans increased $500,000
or 16.4%. The year-to-date SAB 109 adjustment resulted in an approximate
increase of $162,000. SAB 109 was implemented in the first quarter of 2008.
 
    
    Income on investment in bank-owned life insurance (BOLI) decreased by 11.67% for
the year to date and 25.73% for the quarter to date.
    
    Mortgage banking income decreased approximately $65,000, or 48.6%, for the quarter
and $134,000 or 63.2% for the year to date due in part to the valuation adjustment to
mortgage servicing rights (MSR) to reflect a steady decline in the average serviced
mortgage balances and a drop in the servicing fees received.
    
    Other income decreased by approximately $29,000 or 55.8% for the quarter and $55,000
or 46.2% for the year mainly due to losses on the sale of other real estate owned and
the reduction of the check cashing fees.
 Noninterest Expense
   
    
    Salaries and benefits 
 
    
    Quarter-to-date salaries and employee benefit expenses slightly
increased by $58,000 or 1.2%. Addition of the Cardinal employees increased
expense by $694,000. Accruals for the bonus incentive plan decreased $428,000
based on performance measures. Salaries and benefits associated with loan
originations caused a reduction of expenses by $574,000 due to increased
deferrals which were a product of increases in (1) loan volume and (2) cost per
loan that was deferred. Normal recurring salaries and wages increased by
168,000, or 4.9%. Other personnel expense increased by $153,000, primarily for
(1) post-retirement benefit accruals from split-dollar policies and for (2)
expenses associated with operating the Cardinal division after its
acquisition. Employee group insurance expense increased by $61,000, payroll
taxes by $35,000, 401(k) matching contributions by $22,000, and workmens comp
insurance by $14,000. Most of the increases in these categories were associated
with the addition of previous Cardinal employees. Commissions expenses
decreased by $88,000 as mortgage origination production at the Bank, excluding
Sidus declined by $169,000.
    
    Year-to-date increases in salaries and employee benefits were
up by $87,000 or 0.9% for same reasons as discussed above.
 
    
    Occupancy expenses 
 
    
    Quarter-to-date occupancy and equipment expenses increased by
$306,000 or 31.0%. The increase attributable to the addition of the Cardinal
branches was $267,000, with the remaining 1.4% increase attributable to normal
recurring increases in costs.
 26




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##### Table of Contents




    
    Year-to-date increases in occupancy and equipment expenses
increased by $268,000 for the same reasons as discussed above.
 
    
    Printing and supplies 
 
    
    Printing and supplies increased by $56,000, or 40.5%, comparing
second quarter 2008 with second quarter 2007. Supplies for the new offices
opened or acquired after the first quarter of 2008 created additional expenses
along with the normal increase in the price of supplies. Certain training and
merger supplies required for the June 2008 conversion of Cardinal files
increased the printing and supplies cost also.
    
    Year-to-date increases in printing and supplies increased
$98,000 for reasons discussed above and the additional expenses related to the
new offices opened after first quarter 2007.
 
    
    Data processing 
 
    
    Quarter-to-date data processing expense increased $161,000 or
147.0%, with $135,000 attributable to Cardinal processing expenses.
    
    Yearto-date data processing expense increased $173,000 or
82.0% for same reasons as discussed above.
 
    
    Communications expense 
 
    
    Quarter-to-date communications expense decreased by $70,000 or
20.1% compared with the second quarter of 2007 as the Company entered into a
new contract for data and voice services during the last half of 2007.
    
    Year-to-date communications expense decreased by $111,000 or
18.5% compared with the same period of 2007 for the same reason discussed
above.
 
    
    Amortization of the core deposit intangible -
 
    
    Amortization of the core deposit intangible, recognized with
the purchases of Main Street BankShares, Inc. in 2002, High Country Financial
Corporation in 2004, and Cardinal State Bank in 2008 increased $38,000, or
19.2%, for the quarter due to the intangible acquired in the purchase of
Cardinal on March 31, 2008. The CDI amortization is intended to match the
expected life of the related deposits. The amortization related to the
acquisition of Cardinal is $191,000 for the first twelve months and declines to
$128,000 per year in the fourth year, remaining constant thereafter until
amortization is completed in the second month of the tenth year.
    
    For the year, the amortization increased $28,000, or 7.1%, for
the same reason discussed above.
 
    
    Other operating expenses 
 
    
    Quarter to date, other operating expenses increased
approximately $919,000 or 48.1% with Cardinal contributing $262,000 of the
increase. The largest increases were in the following categories: accounting
fees due to additional services provided regarding loan and credit review (up
$98,000); other outside services (up $26,000) due to expanded loan review;
taxes and licenses (up $41,000) due to accrual of franchise tax for holding
company in addition to franchise tax for bank; advertising (up $97,000) for
special promotions and projects; ATM service fees (up $40,000) as a larger
number of debit cards were issued along with increased usage. Also, an
additional accrual was recorded in conjunction with potential expenditures
related to lawsuits discussed in note 4 to the financial statements.
    
    Year to date, other operating expenses increased $1.3 million
or 35.9% with Cardinal contributing $262,000. The largest increases were in the
following categories: accounting fees (up $250,000); ATM fees (down $40,000);
advertising (up $200,000); FDIC assessments (up $154,000); taxes and licenses
(up $94,000); outside service fees (up $141,000); courier expense (down
$34,000); and for various other expenses including accrual for lawsuits.
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##### Table of Contents



Income Tax Expense
   
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
   
 Item 4. Controls and Procedures
  28




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##### Table of Contents



Remediation Plan
   
    
    We have enhanced and re-emphasized the importance of procedures for underwriting, lien
perfection, and documentation for both residential and commercial loan renewals.
    
    We have emphasized the importance of risk grade completeness and accuracy at loan
origination and throughout the life of the loans. Lenders and loan operations personnel
have been informed of the requirement to assign risk grades to loans upon origination. The
importance of periodic review of risk grades has been emphasized to ensure that changes are
made as warranted due to the changes in the condition of the borrower, the collateral, or
general economic conditions. The controls over pre-and post-origination review of loans in
loan operations have been strengthened to ensure the accuracy and completeness of loan
data, including assignment of risk grades. The Chief Credit Officers complete authority
to assign risk grades was reiterated to management and loan officers. During second
quarter 2008, the Chief Credit Officer resigned and the Chief Lending Officer (CLO) who was
hired during the first quarter 2008 assumed responsibility for the credit function. The
CLOs responsibilities include assessing and managing risk in the loan portfolio. Further
plans for performing the credit function effectively were developed as discussed below in
second quarter 2008.
    
    We have modified the allowance for loan loss model to add support for assumptions and to
correct impaired loan data and charged-off loan balances.
    
    We will continue to assess current lending and credit administration policies and
procedures, and are revising them as necessary to develop and implement policies and
procedures that will promote a culture that expects reliability and integrity of data.
  
    
    Policies over loan approval and authority levels have been strengthened to ensure that
the proper level of management and committee oversight is in place based on the amount of
principal at risk.
    
    Information provided on payment delinquency reports has been added to provide more
complete data to management responsible for loan performance.
    
    The procedures over the communication process between line and staff in regard to
charging off loans has been enhanced to ensure that complete and accurate information is
available to decide whether to charge off loans on a timely basis.
    
    Executive management held a planning meeting to evaluate all policies and procedures
related to lending approval, loan documentation and servicing, develop recommendations and
execute changes.
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##### Table of Contents




    
    Loan authorities and reporting structure were clarified.
    
    New positions were implemented for the credit review function and a portion of the staff
in the credit review function was appointed.
    
    Credit risk review function was clarified with independent monitoring of loan quality
and compliance. Reporting structure for the credit review function was clarified to
provide for effective and efficient communication through the various levels of
responsibility up to the board level.
  Changes in Internal Control over Financial Reporting
  
 Part II. Other Information
 
 Item 4. Submission of Matters to Vote of Security Holders
  Proposal 1:
 Name
    
    For
    
    WithheldJ. T. Alexander, Jr.
    
    
    7,256,993
    
    
    
    165,165Ralph L Bentley
    
    
    7,253,732
    
    
    
    168,427Nolan G. Brown
    
    
    7,267,465
    
    
    
    154,694Faye E. Cooper
    
    
    7,230,244
    
    
    
    191,915Harry M. Davis
    
    
    7,312,307
    
    
    
    109,851James A. Harrell, Jr.
    
    
    7,296,758
    
    
    
    125,401Dan W. Hill III
    
    
    7,248,775
    
    
    
    173,384William A. Long
    
    
    7,315,096
    
    
    
    107,063Daniel J. Park
    
    
    6,921,233
    
    
    
    500,925James L. Poindexter
    
    
    6,976,977
    
    
    
    445,182Morris L. Shambley
    
    
    7,256,108
    
    
    
    166,051James N. Smoak
    
    
    7,315,791
    
    
    
    106,367Harry C. Spell
    
    
    7,310,064
    
    
    
    112,095C. Kenneth Wilcox
    
    
    7,190,652
    
    
    
    231,507
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##### Table of Contents



Proposal 2:
 For
    
    Against
    
    Withheld3,993,416
    
    
    666,940
    
    
    
    315,337
 
 Item 6. Exhibits
 Exhibit #
    
    Description10.1
    
    Cardinal State Bank 2000 Incentive Stock Option Plan (incorporated by reference to
Exhibit 4.5 to the Registration Statement on Form S-8 filed April 11, 2008)10.2
    
    Cardinal State Bank 2000 Nonstatutory Stock Option Plan (incorporated by reference to
Exhibit 4.6 to the Registration Statement on Form S-8 filed April 11, 2008)10.3
    
    2008 OMNIBUS STOCK OWNERSHIP AND LONG TERM INCENTIVE PLAN31.1
    
    Rule 13a-14(a)/15d-14(a) Certification31.2
    
    Rule 13a-14(a)/15d-14(a) Certification32.1
    
    Section 1350 Certification
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Yadkin Valley Financial CorporationBY:
    /s/ William A. LongWilliam A. Long, President and Chief Executive OfficerBY:
    /s/ Edwin E. LawsEdwin E. Laws, Executive Vice President and Chief Financial Officer  32