** **

**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  September 30, 2009**                                        |

** **

**CommissionFile Number 000-52099**

 

**Yadkin Valley Financial Corporation**

**(Exact name of registrant specified inits charter)**

** **

| **North  Carolina**       | ** ** | **20-4495993**                        |
|---------------------------|------------|---------------------------------------|
| (State of  Incorporation) | ** ** | (I.R.S. Employer  Identification No.) |

** **

**209 NorthBridge Street, Elkin, North Carolina 28621**

(address ofprincipal executive offices)

 

**336-526-6300**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether theregistrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes xNo o

 

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

 

| Large accelerated filer  o |   | Accelerated filer x          |
|----------------------------|--------|-----------------------------------|
|                       |   |                              |
| Non-accelerated filer o    |   | Smaller reporting  company o |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  Yes oNo x

 

Indicate by check mark whether the registrant has submitted electronicallyand posted on its corporate Web site, if any, every Interactive Data Filerequired to be submitted and posted pursuant to Rule 405 of Regulation S-T(§232.405 of this chapter) during the preceding 12 months (or for such shorterperiod that the registrant was required to submit and post such files).  x Yes  o No

 

Common shares outstanding as of November 4, 2009, par value $1.00per share, were 16,129,640.

 

 

 

----

 
| **Part I. Financial  Information**                                                                                   |   |
|--------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                           |   |
| Item 1.  Financial Statements                                                                                                  |   |
|                                                                                                                           |   |
| Condensed Consolidated Balance Sheets September 30,  2009 and December 31, 2008                                      | 3      |
|                                                                                                                           |   |
| Condensed Consolidated Statements of Income (Loss) Three  and Nine Months Ended September 30, 2009 and 2008               | 4      |
|                                                                                                                           |   |
| Condensed Consolidated Statements of Comprehensive  Income (Loss) Three and Nine Months Ended September 30, 2009 and 2008 | 5      |
|                                                                                                                           |   |
| Condensed Consolidated Statement of Shareholders’  Equity Nine Months Ended September 30, 2009 and 2008              | 6      |
|                                                                                                                           |   |
| Condensed Consolidated Statements of Cash Flows Nine  Months Ended September 30, 2009 and 2008                            | 7      |
|                                                                                                                           |   |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                                | 8-33   |
|                                                                                                                           |   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                           | 33-48  |
|                                                                                                                           |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                                            | 48-49  |
|                                                                                                                           |   |
| Item 4. Controls  and Procedures                                                                                               | 49-51  |
|                                                                                                                           |   |
| **Part II.  Other Information**                                                                                           |   |
|                                                                                                                           |   |
| Item 1. Legal  Proceedings                                                                                                     | 51     |
|                                                                                                                           |   |
| Item 2.  Unregistered Sale of Equity Securities and Use of Proceeds                                                            | 51     |
|                                                                                                                           |   |
| Item 6.  Exhibit Index                                                                                                    | 52     |
|                                                                                                                           |   |
| Signatures                                                                                                                     | 53     |
|                                                                                                                           |   |
| Exhibits                                                                                                                       |   |

 

2

----

 

**YADKIN VALLEY FINANCIAL CORPORATION**

**CONDENSEDCONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 
| ** **                                                                                                   | ** ** | **September 30,** | ** **    | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------------------|---------------|-----------------------|------------|
| ** **                                                                                                   | ** ** | **2009**               | ** **    | **2008***             | ** ** |
|                                                                                                         |       |                   |          |                  |       |
| **ASSETS**                                                                                                   |       |                   |          |                  |       |
| ** **                                                                                                   |       |                   |          |                  |       |
| CASH AND CASH EQUIVALENTS                                                                                    |       |                   |          |                  |       |
| Cash and due from banks                                                                                      |       | $                      | 70,702,266    |                  | $          | 22,553,561 |   |
| Federal funds sold                                                                                           |       | 723                    |          | 58,000                |       |
| Interest-bearing deposits                                                                                    |       | 2,984,412              |          | 3,410,977             |       |
| TOTAL CASH AND CASH EQUIVALENTS                                                                              |       | 73,687,401             |          | 26,022,538            |       |
|                                                                                                         |       |                   |          |                  |       |
| SECURITIES AVAILABLE FOR SALE-At fair value   (Amortized cost $186,467,810 in 2009 and $134,533,342 in 2008) |       | 191,422,660            |          | 137,813,529           |       |
|                                                                                                         |       |                   |          |                  |       |
| GROSS LOANS                                                                                                  |       | 1,646,326,304          |          | 1,187,568,945         |       |
| Less: Allowance for loan losses                                                                              |       | (54,269,997            | )             | (22,355,231           | )          |
| NET LOANS                                                                                                    |       | 1,592,056,307          |          | 1,165,213,714         |       |
|                                                                                                         |       |                   |          |                  |       |
| LOANS HELD FOR SALE                                                                                          |       | 46,910,701             |          | 49,929,375            |       |
|                                                                                                         |       |                   |          |                  |       |
| ACCRUED INTEREST RECEIVABLE                                                                                  |       | 7,648,538              |          | 5,441,754             |       |
|                                                                                                         |       |                   |          |                  |       |
| PREMISES AND EQUIPMENT, NET                                                                                  |       | 44,272,020             |          | 33,899,915            |       |
|                                                                                                         |       |                   |          |                  |       |
| FORECLOSED REAL ESTATE                                                                                       |       | 9,366,226              |          | 4,017,880             |       |
|                                                                                                         |       |                   |          |                  |       |
| FEDERAL HOME LOAN BANK STOCK, AT COST                                                                        |       | 10,539,400             |          | 7,876,800             |       |
|                                                                                                         |       |                   |          |                  |       |
| INVESTMENT IN BANK-OWNED LIFE INSURANCE                                                                      |       | 24,308,463             |          | 23,607,675            |       |
|                                                                                                         |       |                   |          |                  |       |
| GOODWILL                                                                                                     |       | 4,943,872              |          | 53,502,887            |       |
|                                                                                                         |       |                   |          |                  |       |
| CORE DEPOSIT INTANGIBLE (net of accumulated  amortization of $5,997,292 in 2009 and $4,869,974 in 2008)      |       | 6,524,569              |          | 4,660,116             |       |
|                                                                                                         |       |                   |          |                  |       |
| OTHER ASSETS                                                                                                 |       | 39,992,168             |          | 12,301,838            |       |
|                                                                                                         |       |                   |          |                  |       |
| TOTAL ASSETS                                                                                                 |       | $                      | 2,051,672,325 |                  | $          | 1,524,288,021 |   |
|                                                                                                         |       |                   |          |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                               |       |                   |          |                  |       |
|                                                                                                         |       |                   |          |                  |       |
| DEPOSITS                                                                                                     |       |                   |          |                  |       |
| Noninterest-bearing demand deposits                                                                          |       | $                      | 205,674,124   |                  | $          | 153,573,487 |   |
| Interest-bearing deposits:                                                                                   |       |                   |          |                  |       |
| NOW, savings, and money market accounts                                                                      |       | 413,694,450            |          | 283,890,757           |       |
| Time certificates:                                                                                           |       |                   |          |                  |       |
| Over $100,000                                                                                                |       | 549,492,607            |          | 333,375,040           |       |
| Other                                                                                                        |       | 577,883,703            |          | 384,202,791           |       |
| TOTAL DEPOSITS                                                                                               |       | 1,746,744,884          |          | 1,155,042,075         |       |
|                                                                                                         |       |                   |          |                  |       |
| SHORT-TERM BORROWINGS                                                                                        |       | 57,263,715             |          | 169,111,959           |       |
|                                                                                                         |       |                   |          |                  |       |
| LONG-TERM BORROWINGS                                                                                         |       | 79,002,082             |          | 38,849,795            |       |
|                                                                                                         |       |                   |          |                  |       |
| ACCRUED INTEREST PAYABLE                                                                                     |       | 3,389,367              |          | 3,554,522             |       |
|                                                                                                         |       |                   |          |                  |       |
| OTHER LIABILITIES                                                                                            |       | 16,163,082             |          | 8,085,348             |       |
|                                                                                                         |       |                   |          |                  |       |
| TOTAL LIABILITIES                                                                                            |       | 1,902,563,130          |          | 1,374,643,699         |       |
|                                                                                                         |       |                   |          |                  |       |
| SHAREHOLDERS’ EQUITY                                                                                    |       |                   |          |                  |       |
| Common stock *(a)*                                                                                           |       | 16,129,640             |          | 11,536,500            |       |
| Preferred stock *(b)*                                                                                        |       | 46,018,226             |          | —                |       |
| Surplus *(c)*                                                                                                |       | 118,135,566            |          | 88,030,481            |       |
|                                                                                                         |       |                   |          |                  |       |
| Retained earnings (deficit)                                                                                  |       | (34,241,635            | )             | 48,070,348            |       |
| Accumulated other comprehensive income                                                                       |       | 3,067,398              |          | 2,006,993             |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                              |       | 149,109,195            |          | 149,644,322           |       |
|                                                                                                         |       |                   |          |                  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                              |       | $                      | 2,051,672,325 |                  | $          | 1,524,288,021 |   |

 

----

*(a)**       **$1.00 par value, authorized20,000,000 shares; issued 16,129,640 in 2009 and 11,536,500 in December 2008.*

*(b)**       **1,000,000 shares of authorized,no par value preferred stock of which 49,312 shares are issued and outstandingin 2009 and none in 2008.*

*(c)**        **Includes ten-year warrantswith an allocated fair value of $1.7 million and $1.8 million at issuance topurchase up to 385,990 shares and 273,534 shares of common stock, $1.00 parvalue, at an initial price of $13.99 per share and $7.30 per share,respectively.*

Seenotes to condensed consolidated financial statements

*Derived from audited consolidated financial statements

 

3

----

 

**YADKINVALLEY FINANCIAL CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTSOF INCOME (LOSS) *(UNAUDITED)***

**THREE ANDNINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 
| ** **                                                             | ** ** | **Three Months Ended** | ** **  | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|
| ** **                                                             | ** ** | **September 30,** | ** **  | **September 30,** | ** ** |
| ** **                                                             | ** ** | **2009**               | ** **  | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| INTEREST  INCOME                                                       |       |                   |        |                   |       |   |   |   |   |
| Interest  and fees on loans                                            |       | $                      | 24,730,726  |                   | $          | 17,552,428 |   | $ | 64,694,447 |   | $ | 50,989,199 |   |
| Interest  on federal funds sold                                        |       | 19,305                 |        | 8,195                  |       | 21,554 |   | 45,071 |   |
| Interest  on securities:                                               |       |                   |        |                   |       |   |   |   |   |
| Taxable                                                                |       | 1,310,988              |        | 1,334,959              |       | 3,848,993 |   | 3,984,590 |   |
| Non-taxable                                                            |       | 565,829                |        | 381,658                |       | 1,463,437 |   | 1,123,390 |   |
| Interest-bearing  deposits                                             |       | 9,928                  |        | 161,331                |       | 31,226 |   | 300,443 |   |
| Total  interest income                                                 |       | 26,636,776             |        | 19,438,571             |       | 70,059,657 |   | 56,442,693 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| INTEREST  EXPENSE                                                      |       |                   |        |                   |       |   |   |   |   |
| Time  deposits of $100,000 or more                                     |       | 4,516,603              |        | 2,950,752              |       | 11,351,454 |   | 8,633,227 |   |
| Other  deposits                                                        |       | 3,004,546              |        | 4,594,436              |       | 10,717,517 |   | 14,104,850 |   |
| Borrowed  funds                                                        |       | 734,374                |        | 1,268,265              |       | 2,141,324 |   | 3,349,410 |   |
| Total  interest expense                                                |       | 8,255,523              |        | 8,813,453              |       | 24,210,295 |   | 26,087,487 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NET  INTEREST INCOME                                                   |       | 18,381,253             |        | 10,625,118             |       | 45,849,362 |   | 30,355,206 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| PROVISION  FOR LOAN LOSSES                                             |       | 18,285,660             |        | 1,334,000              |       | 45,292,967 |   | 3,492,000 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES                   |       | 95,593                 |        | 9,291,118              |       | 556,395 |   | 26,863,206 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NONINTEREST  INCOME                                                    |       |                   |        |                   |       |   |   |   |   |
| Service  charges on deposit accounts                                   |       | 1,576,817              |        | 1,171,772              |       | 4,159,462 |   | 3,246,318 |   |
| Other  service fees                                                    |       | 1,189,285              |        | 858,162                |       | 3,619,091 |   | 2,598,978 |   |
| Net  gain on sales of mortgage loans                                   |       | 2,750,707              |        | 1,872,365              |       | 10,751,489 |   | 5,429,043 |   |
| Net  loss on investment securities                                     |       | —                 |        | 6,549                  |       | — |   | (26 | ) |
| Income  on investment in bank owned life insurance                     |       | 235,238                |        | 237,759                |       | 700,788 |   | 706,221 |   |
| Mortgage  banking income (loss)                                        |       | 6,971                  |        | (10,878                | )          | (507,204 | ) | 67,229 |   |
| Other  income                                                          |       | 94,111                 |        | 61,111                 |       | 162,902 |   | 208,642 |   |
| Total  noninterest income                                              |       | 5,853,129              |        | 4,196,840              |       | 18,886,528 |   | 12,256,405 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NONINTEREST  EXPENSE                                                   |       |                   |        |                   |       |   |   |   |   |
| Salaries  and employee benefits                                        |       | 7,761,861              |        | 5,136,319              |       | 21,688,130 |   | 15,051,823 |   |
| Occupancy  and equipment expenses                                      |       | 1,858,092              |        | 1,307,042              |       | 5,027,659 |   | 3,577,635 |   |
| Printing  and supplies                                                 |       | 345,300                |        | 176,085                |       | 849,479 |   | 556,617 |   |
| Data  processing                                                       |       | 348,996                |        | 217,010                |       | 908,956 |   | 600,420 |   |
| Communication  expense                                                 |       | 371,936                |        | 271,657                |       | 1,023,982 |   | 757,975 |   |
| Advertising  and marketing expense                                     |       | 357,385                |        | 445,138                |       | 946,415 |   | 780,945 |   |
| Amortization  of core deposit intangible                               |       | 326,954                |        | 228,717                |       | 901,921 |   | 651,582 |   |
| FDIC  assessment expense                                               |       | 973,461                |        | 199,489                |       | 3,432,549 |   | 442,665 |   |
| Acquisition  related costs                                             |       | 291,601                |        | —                 |       | 2,593,655 |   | — |   |
| Attorney  fees                                                         |       | 468,548                |        | 110,971                |       | 991,747 |   | 239,977 |   |
| Accounting  fees                                                       |       | 438,687                |        | 81,970                 |       | 947,627 |   | 533,777 |   |
| Other  than temporary impairment of securities                         |       | 175,405                |        | 972,800                |       | 354,898 |   | 972,800 |   |
| Goodwill  impairment                                                   |       | 61,565,768             |        | —                 |       | 61,565,768 |   | — |   |
| Net  loss on other real estate owned                                   |       | 1,217,922              |        | 166,349                |       | 1,368,983 |   | 249,389 |   |
| Other                                                                  |       | 2,421,242              |        | 1,586,385              |       | 7,319,035 |   | 5,362,732 |   |
| Total  noninterest expense                                             |       | 78,923,158             |        | 10,899,932             |       | 109,920,804 |   | 29,778,337 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| INCOME  (LOSS) BEFORE INCOME TAXES                                     |       | (72,974,436            | )           | 2,588,026              |       | (90,477,881 | ) | 9,341,274 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| INCOME  TAX EXPENSE (BENEFIT)                                          |       | (4,715,553             | )           | 795,271                |       | (11,505,081 | ) | 2,907,282 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NET  INCOME (LOSS)                                                     |       | (68,258,883            | )           | 1,792,755              |       | (78,972,800 | ) | 6,433,992 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| Preferred  stock dividend and amortization of preferred stock discount |       | 708,079                |        | —                 |       | 1,681,079 |   | — |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NET  INCOME (LOSS) TO COMMON SHAREHOLDERS                              |       | $                      | (68,966,962 | )                      | $          | 1,792,755 |   | $ | (80,653,879 | ) | $ | 6,433,992 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| NET  INCOME (LOSS) TO COMMON SHAREHOLDERS PER COMMON SHARE:            |       |                   |        |                   |       |   |   |   |   |
| Basic                                                                  |       | $                      | (4.28       | )                      | $          | 0.16 |   | $ | (5.62 | ) | $ | 0.57 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| Diluted                                                                |       | $                      | (4.28       | )                      | $          | 0.15 |   | $ | (5.62 | ) | $ | 0.57 |   |
|                                                                   |       |                   |        |                   |       |   |   |   |   |
| CASH  DIVIDENDS PER COMMON SHARE                                       |       | $                      | —      |                   | $          | 0.13 |   | $ | 0.12 |   | $ | 0.39 |   |

 

See notes to condensed consolidated financialstatements

 

4

----

 

**YADKIN VALLEY FINANCIAL CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(LOSS) (UNAUDITED)**

**THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008**

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** **  | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------|-------------|------------------------|------------|
| ** **                                                                      | ** ** | **September 30,** | ** **  | **September 30,** | ** ** |
| ** **                                                                      | ** ** | **2009**               | ** **  | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                      | ** ** | ** **             | ** **  | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| NET INCOME (LOSS)                                                               |       | $                      | (68,258,883 | )                      | $          | 1,792,755 |   | $ | (78,972,800 | ) | $ | 6,433,992 |   |
|                                                                            |       |                   |        |                   |       |   |   |   |   |
| OTHER COMPREHENSIVE INCOME (LOSS), BEFORE TAX:                                  |       |                   |        |                   |       |   |   |   |   |
|                                                                            |       |                   |        |                   |       |   |   |   |   |
| Unrealized holding gains (losses) on securities  available for sale             |       | 1,859,785              |        | 1,315,130              |       | 1,674,667 |   | (383,240 | ) |
| Tax effect                                                                      |       | (716,577               | )           | (506,324               | )          | (614,262 | ) | 147,548 |   |
| Unrealized holding gains (losses) on securities  available for sale, net of tax |       | 1,143,208              |        | 808,806                |       | 1,060,405 |   | (235,692 | ) |
|                                                                            |       |                   |        |                   |       |   |   |   |   |
| Reclassification adjustment for realized losses                                 |       | —                 |        | 966,251                |       | — |   | 972,826 |   |
| Tax effect                                                                      |       | —                 |        | (372,007               | )          | — |   | (374,538 | ) |
| Reclassification adjustment for realized losses,  net of tax                    |       | —                 |        | 594,244                |       | — |   | 598,288 |   |
|                                                                            |       |                   |        |                   |       |   |   |   |   |
| OTHER COMPREHENSIVE INCOME, NET OF TAX                                          |       | 1,143,208              |        | 1,403,050              |       | 1,060,405 |   | 362,596 |   |
|                                                                            |       |                   |        |                   |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS)                                                     |       | $                      | (67,115,675 | )                      | $          | 3,195,805 |   | $ | (77,912,395 | ) | $ | 6,796,588 |   |

 

Seenotes to condensed consolidated financial statements

 

5

----

 

**YADKIN VALLEY FINANCIAL CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY(UNAUDITED)**

**NINE MONTHSENDED SEPTEMBER 30, 2009 AND 2008**

 
| ** **                                                                       | ** ** | **Common Stock** | ** ** | **Preferred Stock** | ** ** | **Surplus** | ** ** | **Retained Earnings** | ** **  | **Accumulated Other  Comprehensive  Income** | ** ** | **Total Shareholders’  Equity** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|-------------|------------|----------------------------|-------------|---------------------------------------------------|------------|-------------------------------------------|------------|
| Balance,  December 31, 2007*                                                |       | $                     | 10,563,356 |                | $          | —      |       | $                          | 70,986,684  |                                              | $          | 51,086,684                                |       | $ | 632,270 |   | $ | 133,268,994 |   |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Net  income                                                                      |       | —                |       | —              |       | —      |       | 6,433,992                  |        | —                                            |       | 6,433,992                                 |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Shares  issued under stock option plan                                           |       | 86,254                |       | —              |       | 510,854     |       | —                     |        | —                                            |       | 597,108                                   |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Stock  option compensation                                                       |       | —                |       | —              |       | 47,669      |       | —                     |        | —                                            |       | 47,669                                    |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Tax  benefit from exercise of stock options                                      |       | —                |       | —              |       | 252,250     |       | —                     |        | —                                            |       | 252,250                                   |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Cumulative  effect of adoption of EITF 06-04                                     |       | —                |       | —              |       | —      |       | (897,253                   | )           | —                                            |       | (897,253                                  | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Common  cash dividends declared                                                  |       | —                |       | —              |       | —      |       | (4,484,118                 | )           | —                                            |       | (4,484,118                                | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Fractional  shares purchased                                                     |       | (58                   | )          |                |       | 2           |       |                       |        |                                              |       | (56                                       | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Shares  issued in acquisition of Cardinal State Bank                             |       | 883,747               |       | —              |       | 16,191,450  |       | —                     |        | —                                            |       | 17,075,197                                |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Other  comprehensive income                                                      |       | —                |       | —              |       | —      |       | —                     |        | 362,596                                           |       | 362,596                                   |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Balance,  September 30, 2008                                                |       | $                     | 11,533,299 |                | $          | —      |       | $                          | 87,988,909  |                                              | $          | 52,139,305                                |       | $ | 994,866 |   | $ | 152,656,379 |   |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Balance,  December 31, 2008*                                                |       | 11,536,500            |       | —              |       | 88,030,481  |       | 48,070,348                 |        | 2,006,993                                         |       | 149,644,322                               |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Net  loss                                                                        |       | —                |       | —              |       | —      |       | (78,972,800                | )           | —                                            |       | (78,972,800                               | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Shares  issued under stock option plan                                           |       | 8                     |       |                |       | 111         |       |                       |        |                                              |       | 119                                       |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Preferred  stock issued                                                          |       | —                |       | 49,312,000          |       | —      |       | —                     |        | —                                            |       | 49,312,000                                |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Preferred  stock discount                                                        |       | —                |       | (3,581,000          | )          | —      |       | —                     |        | —                                            |       | (3,581,000                                | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Warrants  issued                                                                 |       | —                |       | —              |       | 3,581,000   |       | —                     |        | —                                            |       | 3,581,000                                 |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Discount  accretion of preferred stock warrants                                  |       | —                |       | 287,226             |       | —      |       | (287,226                   | )           | —                                            |       | —                                    |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Stock  option compensation                                                       |       | —                |       | —              |       | 54,929      |       | —                     |        | —                                            |       | 54,929                                    |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Preferred  stock dividends accrued                                               |       | —                |       | —              |       | —      |       | (1,393,853                 | )           | —                                            |       | (1,393,853                                | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Common  cash dividends declared                                                  |       | —                |       | —              |       | —      |       | (1,658,104                 | )           | —                                            |       | (1,658,104                                | )          |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Common  shares issued in acquisition of American Community Bancshares, Inc. |       | 4,593,132             |       |                |       | 26,469,045  |       |                       |        |                                              |       | 31,062,177                                |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Other  comprehensive income                                                      |       | —                |       | —              |       | —      |       | —                     |        | 1,060,405                                         |       | 1,060,405                                 |       |
|                                                                             |       |                  |       |                |       |        |       |                       |        |                                              |       |                                      |       |
| Balance,  September 30, 2009                                                |       | $                     | 16,129,640 |                | $          | 46,018,226  |       | $                          | 118,135,566 |                                              | $          | (34,241,635                               | )          | $ | 3,067,398 |   | $ | 149,109,195 |   |

 

See notes to condensedconsolidated financial statements

 

----

* Derived from auditedconsolidated financial statements

 

6

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**YADKINVALLEY FINANCIAL CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**NINE MONTHS ENDED SEPTEMBER 30,2009 AND 2008**

 
| ** **                                                                               | ** ** | **2009**       | ** **  | **2008**     | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------|-------------|--------------|------------|
| ** **                                                                               | ** ** | ** **     | ** **  | ** **   | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                    |       |           |        |         |       |
| Net income (loss)                                                                        |       | $              | (78,972,800 | )            | $          | 6,433,992 |   |
| Adjustments to reconcile net income(loss) to net  cash provided by operating activities: |       |           |        |         |       |
| Net amortization (accretion) of premiums  (discounts) on investment securities           |       | 475,675        |        | (30,840      | )          |
| Provision for loan losses                                                                |       | 45,292,967     |        | 3,492,000    |       |
| Net gain on sales of mortgage loans held for sale                                        |       | (10,751,489    | )           | (5,429,043   | )          |
| Increase in investment in Bank owned life  insurance                                     |       | (700,788       | )           | (706,221     | )          |
| Depreciation and amortization                                                            |       | 2,024,299      |        | 1,511,501    |       |
| Net loss on sale of premises and equipment                                               |       | 126,716        |        | 50,029       |       |
| Net loss on sale of other real estate owned                                              |       | 1,368,983      |        | —       |       |
| Net loss on sale of available for sale securities                                        |       | —         |        | 26           |       |
| Impairment of goodwill                                                                   |       | 61,565,768     |        | —       |       |
| Other than temporary impairment of cost method  investments                              |       | 354,898        |        | 972,800      |       |
| Amortization of core deposit intangible                                                  |       | 901,921        |        | 651,582      |       |
| Deferred tax benefit                                                                     |       | (9,313,763     | )           | (1,419,553   | )          |
| Stock based compensation expense                                                         |       | 54,929         |        | 47,669       |       |
| Originations of mortgage loans held-for-sale                                             |       | (1,392,024,046 | )           | (772,639,226 | )          |
| Proceeds from sales of mortgage loans                                                    |       | 1,405,794,209  |        | 785,981,484  |       |
| (Increase) decrease in accrued interest receivable                                       |       | (212,951       | )           | 405,972      |       |
| Increase in other assets                                                                 |       | (9,774,273     | )           | (1,831,365   | )          |
| Decrease in accrued interest payable                                                     |       | (753,487       | )           | (666,193     | )          |
| Increase (decrease) in other liabilities                                                 |       | 5,749,422      |        | (696,712     | )          |
|                                                                                     |       |           |        |         |       |
| Net cash provided by operating activities                                                |       | 21,206,190     |        | 16,127,902   |       |
|                                                                                     |       |           |        |         |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                    |       |           |        |         |       |
| Purchases of available for sale securities                                               |       | (31,228,898    | )           | (30,762,451  | )          |
| Proceeds from sales of available for sale  securities                                    |       | 41,889,460     |        | 13,067,292   |       |
| Proceeds from maturities of available for sale  securities                               |       | 8,000,000      |        | 19,624,095   |       |
| Net change in loans                                                                      |       | (65,295,035    | )           | (69,357,144  | )          |
| Acquisition of Cardinal State Bank, net of cash  acquired                                |       | —         |        | 11,979,969   |       |
| Acquisition of American Community Bancshares, net  of cash acquired                      |       | 2,040,754      |        | —       |       |
| Purchases of premises and equipment                                                      |       | (4,020,925     | )           | (1,703,824   | )          |
| Proceeds from redemption of Federal Home Loan Bank  stock                                |       | 1,851,100      |        | 1,161,100    |       |
| Purchases of Federal Home Loan Bank stock                                                |       | (2,385,300     | )           | (5,742,000   | )          |
| Proceeds from sale of premises and equipment                                             |       | 895,492        |        | 287,136      |       |
| Proceeds from sale of other real estate owned                                            |       | 3,213,500      |        | —       |       |
| Proceeds from death benefit from bank owned life  insurance                              |       | —         |        | 2,561        |       |
|                                                                                     |       |           |        |         |       |
| Net cash used in investing activities                                                    |       | (45,039,854    | )           | (61,443,266  | )          |
|                                                                                     |       |           |        |         |       |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                    |       |           |        |         |       |
| Net increase (decrease) in checking, NOW, money  market and savings accounts             |       | 49,140,991     |        | (17,487,340  | )          |
| Net increase (decrease) in time certificates                                             |       | 102,612,761    |        | (9,639,973   | )          |
| Net increase (decrease) in borrowed funds                                                |       | (125,363,022   | )           | 88,872,850   |       |
| Fractional shares retired                                                                |       | —         |        | (56          | )          |
| Proceeds from issuance of preferred stock and  warrants                                  |       | 49,312,000     |        | —       |       |
| Dividends paid                                                                           |       | (4,204,324     | )           | (4,484,118   | )          |
| Tax benefit from exercise of stock options                                               |       | —         |        | 252,250      |       |
| Proceeds from exercise of stock options                                                  |       | 119            |        | 597,108      |       |
|                                                                                     |       |           |        |         |       |
| Net cash provided by financing activities                                                |       | 71,498,525     |        | 58,110,721   |       |
|                                                                                     |       |           |        |         |       |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                                |       | 47,664,863     |        | 12,795,357   |       |
|                                                                                     |       |           |        |         |       |
| CASH AND CASH EQUIVALENTS:                                                               |       |           |        |         |       |
| Beginning of period                                                                      |       | 26,022,538     |        | 26,325,875   |       |
| End of period                                                                            |       | $              | 73,687,401  |         | $          | 39,121,232 |   |
|                                                                                     |       |           |        |         |       |
| SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCIAL  ACTIVITIES:                  |       |           |        |         |       |
|                                                                                     |       |           |        |         |       |
| Cash paid for interest                                                                   |       | $              | 27,907,907  |         | $          | 26,152,261 |   |
| Cash paid for income taxes                                                               |       | 2,897,414      |        | 4,092,214    |       |
| Transfer from loans to foreclosed real estate                                            |       | 9,498,079      |        | 3,192,880    |       |

 

See notes to condensedconsolidated financial statements

 

7

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**Notes toUnaudited Condensed Consolidated Financial Statements**

 

***1.  SignificantAccounting Policies***

 

**Basisof Presentation**

 

The accompanyingunaudited condensed consolidated financial statements include the accounts ofYadkin Valley Financial Corporation and its subsidiary, Yadkin Valley Bank andTrust Company.  On July 1, 2006,Yadkin Valley Bank and Trust Company (the “Bank”) became a subsidiary of YadkinValley Financial Corporation (the “Company”) through a one for one shareexchange of the then outstanding 10,648,300 shares.  Sidus Financial, LLC (“Sidus”) is a singlemember LLC with the Bank as its single member. Sidus offers mortgage bankingservices and is headquartered in Greenville, NC. The Company acquired AmericanCommunity Bancshares Inc., on April 17, 2009 (See note 5). The interimfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America for interimfinancial statements and with instructions to Form 10-Q and Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by Generally Accepted Accounting Principles(“GAAP”) for complete financial statements. Because the accompanying condensed consolidated financial statements donot include all of the information and footnotes required by GAAP, they shouldbe read in conjunction with the audited consolidated financial statements andaccompanying footnotes included with the Company’s 2008 Annual Report on Form 10-Kfiled with the Securities and Exchange Commission (“SEC”) on March 31,2009.  Operating results, for the threeand nine months ended September 30, 2009, do not necessarily indicate theresults that may be expected for the year or other interim periods.

 

In the opinion ofmanagement, the accompanying condensed consolidated financial statementscontain all the adjustments, all of which are normal recurring adjustments,necessary to present fairly the financial position of the Company as of September 30,2009 and December 31, 2008, and the results of its operations and cashflows for the three and nine months ended September 30, 2009 and2008.  The accounting policies followedare set forth in Note 1 to the Consolidated Financial Statements in the Company’s2008 Annual Report on Form 10-K.

 

***2. New Accounting Standards***

 

**Recently Adopted Accounting Standards**

 

In June 2009, the FASB developed andimplemented *The FASB Accounting Standards Codification*and the Hierarchy of Generally Accepted Accounting Principles— (“Codification”)as the source of authoritative generally accepted accounting principles (“GAAP”)for nongovernmental entities. The Codification does not change GAAP.Instead, it takes the thousands of individual pronouncements that currentlycomprise GAAP and reorganizes them into approximately 90 accounting Topics, anddisplays all Topics using a consistent structure. Contents in each Topic arefurther organized first by Subtopic, then Section and finallyParagraph.  The Paragraph level is theonly level that contains substantive content. Citing particular content in theCodification involves specifying the unique numeric path to the content throughthe Topic, Subtopic, Section and Paragraph structure.  FASB suggests that all citations begin with “FASBASC,” where ASC stands for Accounting Standards Codification. SFAS 168, (FASBASC 105-10-05, 10, 15, 65, 70) is effective for interim and annual periodsending after September 15, 2009 and will not have an impact on the Company’sfinancial position but will change the referencing system for accountingstandards.

 

Effective January 1, 2009, the Company adopted new accounting fordisclosures about derivative instruments and hedging activities.  Under the Derivative and Hedging topic of theFASB Accounting Standards Codification, companies are required to enhancedisclosures about how and why derivative instruments are used, how derivativeinstruments and related hedged items are accounted for and how derivativeinstruments and related hedged items affect the balance sheet, income statementand statement of cash flows. Adoption of this standard did not result in achange to 

 

8

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the accounting for the Company’s derivative financial instruments butinstead resulted in enhanced disclosures which are in Note 10.

 

In the second quarter of 2009, additional guidance was issued under theFair Value Measurements and Disclosures topic of the FASB Accounting StandardsCodification for determining fairvalue when the volume and level of activity for the asset or liability havesignificantly decreased and for identifying transactions that are not orderly.  The new standard also includes guidance onidentifying circumstances that indicate a transaction is not orderly. Further,the new accounting emphasizes that even if there has been a significantdecrease in the volume and level of activity for the asset or liability andregardless of the valuation technique(s) used, the objective of a fairvalue measurement remains the same. Fair value is the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction (that is, not a forced liquidation or distressed sale) betweenmarket participants at the measurement date under current market conditions.Certain additional disclosures are now required in interim and annual periodsto discuss the inputs and valuation technique(s) used to measure fairvalue. The adoption of the new accounting disclosures did not have a materialeffect on the Company’s financial position or results of operations; however,it did result in additional disclosures.

 

In the second quarter of 2009, the Company adopted new accountingpractices for the interim disclosuresabout fair value of financial instruments.  The Company now provides disclosures about fairvalue of financial instruments for interim reporting periods as well as inannual financial statements.

 

On April 9, 2009, the FASB issued guidance on the recognition andpresentation of Other-Than-Temporary Impairments (“OTTI”).  The recognition practice categorizes losseson debt securities available-for-sale or held-to-maturity determined bymanagement to be other-than-temporarily impaired into losses due to creditissues and losses related to all other factors.  Other-than-temporaryimpairment exists when it is more likely than not that the security will matureor be sold before its amortized cost basis can be recovered.  An OTTIrelated to credit losses should be recognized through earnings.  AnOTTI related to other factors should be recognized in other comprehensiveincome.  Required annual disclosures are now also required forinterim periods (including the aging of securities with unrealized losses). Theadoption of the new practices did not have a material effect on the Company’sfinancial position or results of operations, however it did result inadditional disclosures.

 

In May 2009, theCompany adopted new accounting disclosure practices for subsequent events.  Under the Subsequent Events topic of the FASBAccounting Standards Codification, all subsequent events that provideadditional evidence about conditions that existed at the date of the balancesheet should be recognized at the balance sheet date. Subsequent events thatprovide evidence about conditions that arose after the balance sheet date butbefore financial statements are issued, or are available to be issued, are notrequired to be recognized. The date through which subsequent events have beenevaluated must be disclosed as well as whether it is the date the financialstatements were issued or the date the financial statements were available tobe issued.  For nonrecognized subsequentevents which should be disclosed to keep the financial statements from beingmisleading, the nature of the event and an estimate ofits financial effect, or astatement that such an estimate cannot be made, should be disclosed.  See Note 18 for management’s evaluation ofsubsequent events.

 

In December 2007, the FASB issuedguidance under the business combinations topic of the FASB Accounting StandardsCodification.  The new guidance requiresan acquirer to measure the identifiable assets acquired, the liabilitiesassumed and any noncontrolling interest in the acquiree at their fair value onthe acquisition date, with goodwill being the excess value of considerationpaid over the fair value of the net identifiable assets acquired and replacesthe cost allocation method used in mergers entered into prior to December 15,2008. Other key differences that resulted under the new guidance include theexpensing of acquisition-related costs as incurred as opposed to thecapitalization of those costs in previous mergers.  We followed the new guidance under thebusiness combinations topic, as originally issued, for our American CommunityBancshares, Inc. acquisition in April 2009. This new guidance doesnot require retroactive restatement of accounting for business combinationsprior to January 1, 2009 and therefore was not required for our CardinalState Bank acquisition in 2008.

 

9

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**Recently Issued but not yet Effective Accounting Pronouncements:**

 

In June 2009,the FASB issued an update to the accounting standards for transfers andservicing of financial assets which eliminates the concept of a qualifyingspecial purpose entity (QSPE), changes the requirements for derecognizingfinancial assets, and requires additional disclosures, including informationabout continuing exposure to risks related to transferred financial assets.This update is effective for financial asset transfers occurring after thebeginning of fiscal years beginning after November 15, 2009.  Thedisclosure requirements must be applied to transfers that occurred before andafter the effective date. The Company is currently evaluating the impact on itsfinancial statements of adopting this update.

 

In June 2009,the FASB issued an update to the accounting standards for consolidation whichcontains new criteria for determining the primary beneficiary, eliminates theexception to consolidating QSPE’s, requires continual reconsideration ofconclusions reached in determining the primary beneficiary, and requiresadditional disclosures. This update for consolidations is effective as of thebeginning of fiscal years beginning after November 15, 2009 and is appliedusing a cumulative effect adjustment to retained earnings for any carryingamount adjustments (e.g., for newly- consolidated Variable Interest Entities).The Company is currently evaluating the impact on its financial statements ofadopting this update.

 

***3.  Participation inU.S. Treasury Capital Purchase Program and Private Placement of Common Stock***

 

On January 16, 2009, Yadkin Valley Financial Corporation issued36,000 shares of senior preferred stock, each with a liquidation preference of$1,000 per share, to the U.S. Treasury for $36 million pursuant to the CapitalPurchase Program (“CPP”). Additionally, the Company issued a warrant topurchase up to 385,990 shares of common stock to the U.S. Treasury as acondition to its participation in the CPP. The warrant has an exercise price of$13.99 per share, is immediately exercisable and expires 10 years from thedate of issuance. Proceeds from this sale of the preferred stock are expectedto be used for general corporate purposes, including supporting the continuedgrowth and lending in the communities served by the Bank. The CPP preferredstock is non-voting, other than having class voting rights on certain matters,and pays cumulative dividends quarterly at a rate of 5% per annum for the firstfive years and 9% thereafter. The preferred shares are redeemable at the optionof the Company under certain circumstances during the first three years andonly thereafter without restriction.

 

In order todetermine the relative value of the preferred stock, the present value of thepreferred stock cash flows, using a discount rate of 14%, was calculated as$18.2 million.  The following table showsthe determination of the value attributed to the proceeds of $36 millionreceived for the preferred stock and warrant based on the relative values ofeach.

 

**RelativeValue Calculation**

 
| ** **                             | ** ** | **Fair Value  (in millions)** | ** ** | **Relative Value (%)** | ** ** | **Relative Value  (in millions)** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| NPV of Preferred (14% discount)        |       | $                                       | 18.2       |                             | 95.3       | %                                           | $          | 34.3 |   |
| Fair Value of warrants (Black Scholes) |       | 0.9                                     |       | 4.7                              | %          | 1.7                                         |       |
| Total                                  |       | $                                       | 19.1       |                             | 100.0      | %                                           | $          | 36.0 |   |

 

These common stockwarrants have been assigned a fair value of $2.38 per share, or $0.9 million inaggregate as of January 16, 2009. Using a relative fair value allocation approach, $1.7 million wasrecorded as a discount on the preferred stock and will be accreted as areduction in the net income available for common shareholders over the nextfive years at $300,000 to $400,000 per year.

 

10

----

 

Under the CPP, the Company issued an additional $13.3 million inCumulative Perpetual Preferred Stock, Series T-ACB, on July 24,2009.  In addition, the Company provided a warrant to the Treasury topurchase 273,534 shares of the Company’s common stock at an exercise price of$7.30 per share.  These warrants are immediately exercisable andexpire ten years from the date of issuance.  The preferred stock isnon-voting, other than having class voting rights on certain matters, and payscumulative dividends quarterly at a rate of 5% per annum for the first fiveyears and 9% per annum thereafter.  The preferred shares are redeemable at the option ofthe Company under certain circumstances during the first three years and onlythereafter without restriction.

 

**RelativeValue Calculation**

 
| ** **                             | ** ** | **Fair Value  (in millions)** | ** ** | **Relative Value (%)** | ** ** | **Relative Value  (in millions)** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| NPV of Preferred (14% discount)        |       | $                                       | 6.7        |                             | 86.1       | %                                           | $          | 11.5 |   |
| Fair Value of warrants (Black Scholes) |       | 1.1                                     |       | 13.9                             | %          | 1.8                                         |       |
| Total                                  |       | $                                       | 7.8        |                             | 100.0      | %                                           | $          | 13.3 |   |

 

These common stockwarrants have been assigned a fair value of $3.97 per share, or $1.1 million inaggregate as of July 24, 2009. Using a relative fair value allocation approach, $1.8 million wasrecorded as a discount on the preferred stock and will be accreted as areduction in the net income available for common shareholders over the nextfive years at $300,000 to $400,000 per year.

 

As a condition of the CPP, the Company must obtain consent from theUnited States Department of the Treasury to repurchase its common stock or toincrease its cash dividend on its common stock from the June 30, 2009quarterly amount.  Furthermore, the Company has agreed to certainrestrictions on executive compensation.  Under the American Recoveryand Reinvestment Act of 2009, the Company is limited to using restricted stockas the form of payment to the top five highest compensated executives under anyincentive compensation programs.

 

***4.  Stock-basedCompensation***

 

On May 22, 2008 the shareholders approved the2008 Omnibus Stock Ownership and Long Term Incentive Plan (the “Omnibus Plan”).An aggregate of 700,000 shares have been reserved for issuance by the Companyunder the terms of the Omnibus Plan pursuant to the grant of incentive stockoptions (not to exceed 200,000 shares), non-statutory stock options, restrictedstock and restricted stock units, long-term incentive compensation units andstock appreciation rights.

 

During the three and nine months ended September 30,2009, 100 and 26,700 options were vested, respectively.  During the three and nine months ended September 30,2008, 100 and 14,442 options were vested, respectively. At September 30,2009, there were 97,100 options unvested and no shares available for futuregrants of options other than shares available under the abovementioned OmnibusPlan.

 

On March 31, 2008, the number of outstandingoptions increased by 140,258 in conjunction with the acquisition of CardinalState Bank.  These options were fullyvested according to the merger agreement, and they have a weighted averageexercise price of $13.04 per option and a weighted average life of 6.25 years.

 

On April 16, 2009, the number of outstandingoptions increased by 149,358 in conjunction with the acquisition of AmericanCommunity Bank.  These options were fullyvested according to the merger agreement, and they have a weighted averageexercise price of $11.86 per option and a weighted average life of 5.85years.  The fair market value (“FMV”) ofthe replacement stock options resulted in additional consideration paid in theacquisition of American Community Bank of approximately $197,000.

 

During the third quarter of 2009, there were 5,000options granted at a weighted average fair value of $3.607 per option. The fairvalue of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model. During the third quarter of 2008, there were no options granted.

 

11

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The compensation expense related to options was$18,416 for the three-month period ending September 30, 2009 and $54,929for the nine-month period ending September 30, 2009. As of September 30,2009, there was $223,932 of total unrecognized compensation cost related tononvested share-based compensation arrangements granted under all of theCompany’s stock benefit plans.  This costis expected to be recognized over an average vesting period of 1.3 years.

 

Cash received fromthe options exercised during the nine months ended September 30, 2009 was$119.  There were no options exercisedduring the three months ended September 30, 2009.  Cash received from the options exercisedduring the three and nine months ended September 30, 2008 was $143,156 and$597,108, respectively.

 

***5. Business Combination***

 

Effective at the beginningof business on April 17, 2009, the Company acquired 100% of theoutstanding common stock of American Community Bancshares, Inc. (“AmericanCommunity”), and its subsidiary American Community Bank, headquartered inCharlotte, NC. American Community had $527.5 million in tangible assets,including $416.3 million in loans and $33.6 million in tangible equity at theclosing date. Pursuant to the agreement, for each share of American Communitycommon stock, American Community shareholders received either $12.35 in cash or0.8517 shares of the Company’s common stock, subject to an overall allocationof 19.5% cash and 80.5% stock.  Theoverall acquisition cost was approximately $47.2 million based on the issuanceof 4.6 million shares of the Company’s common stock at a stock price of $6.72at the date of the merger, and cash payment of $16.1 million to Americanshareholders.  Further details areavailable in the press release and Form 8-K filed April 23, 2009.

 

The American Communitymerger is being accounted for under the acquisition method of accounting.  The statement of net assets acquired as of April 17,2009 is presented in the following table. The purchased assets and assumed fair value of liabilities were recordedat their respective acquisition date fair values, and identifiable intangibleassets were recorded at fair value.  Fairvalues are preliminary and subject to refinement for up to one year after theclosing date of the merger as information relative to closing date fair valuebecomes available. Goodwill of $13.0 million is calculated as the purchasepremium after adjusting for the fair value of net assets acquired.  None of the goodwill is expected to bedeductible for income tax purposes. The newly acquired American Community Bankprovided revenue of $10.9 million and net loss of $3.4 million for the periodof April 17, 2009 to September 30, 2009, and is included in theconsolidated financial statements. American Community’s results of operations prior to the acquisition arenot included in the Company’s statement of income.

 

12

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| **Acquisition of American  Community Bancshares, Inc. (in thousands)** | ** ** | **April 17, 2009** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
|                                                                        |       |                    |       |
| Consideration:                                                              |       |                    |       |
| Cash                                                                        |       | $                       | 16,140     |   |
| Stock                                                                       |       | 31,063                  |       |
| Fair value of total  consideration paid                                     |       | $                       | 47,203     |   |
|                                                                        |       |                    |       |
| Cash and cash equivalents                                                   |       | 16,219                  |       |
| Investments                                                                 |       | 71,736                  |       |
| Loans, net                                                                  |       | 416,339                 |       |
| Premises and equipment,  net                                                |       | 8,623                   |       |
| Core deposit intangible                                                     |       | 2,766                   |       |
| Other assets                                                                |       | 16,372                  |       |
|                                                                        |       |                    |       |
| Deposits                                                                    |       | (439,949                | )          |
| Liabilities                                                                 |       | (57,909                 | )          |
| Total identifiable net  assets at fair value                                |       | 34,197                  |       |
|                                                                        |       |                    |       |
| Goodwill                                                                    |       | 13,006                  |       |
| Fair value of total  consideration paid                                     |       | $                       | 47,203     |   |

 

The Company performed aninterim goodwill impairment valuation given the substantial declines in itscommon stock price, operating results, asset quality trends, market comparablesand the economic outlook for our industry. As a result of this valuation, it was determined that impairment existedin the banking segment, including the newly acquired goodwill from AmericanCommunity, and a full impairment charge was taken for goodwill related to thebanking segment.

 

Purchased loans acquired ina business combination are recorded at estimated fair value on their purchasedate and prohibit the carryover of the related allowance for loan losses, whichinclude loans purchased in the American Community acquisition. Purchasedimpaired loans are accounted for under the Receivables Topic of the FASBAccounting Standards Codification when the loans have evidence of creditdeterioration since origination and it is probable at the date of acquisitionthat the Company will not collect all contractually required principal andinterest payments. Evidence of credit quality deterioration as of the purchasedate may include statistics such as past due and nonaccural status. Purchasedimpaired loans generally meet the Company’s definition for nonaccrual status.The difference between contractually required payments at acquisition and thecash flows expected to be collected at acquisition is referred to as thenonaccretable difference which is included in the carrying amount of the loans.Subsequent decreases to the expected cash flows will generally result in aprovision for loan losses. Subsequent increases in cash flows result in areversal of the provision for loan losses to the extent of prior charges, or areversal of the nonaccretable difference with a positive impact on interestincome. Further, any excess of cash flows expected at acquisition over theestimated fair value is referred to as the accretable yield and is recognizedinto interest income over the remaining life of the loan when there is areasonable expectation about the amount and timing of such cash flows.  Purchased performing loans are recorded atfair value, including a credit discount. The fair value discount is accreted as an adjustment to yield over theestimated lives of the loans.  There isno allowance for loan losses established at the acquisition date for purchasedperforming loans.  A provision for loanlosses is recorded for any further deterioration in these loans subsequent tothe merger.

 

The carrying amount ofacquired loans at April 17, 2009 consisted of purchased impaired loans andpurchased performing loans as detailed in the following table:

 

13

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| ** **                                            | ** ** | ** **          | ** ** | **Purchased**       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|---------------------|------------|---------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Purchased**       | ** ** | **Performing**      | ** ** | ** **       | ** ** |
| ** **                                            | ** ** | **Impaired  Loans** | ** ** | **Loans**           | ** ** | **Total  Loans** | ** ** |
| ** **                                            | ** ** | ** **          | ** ** | **(In  thousands)** | ** ** | ** **       | ** ** |
| Commercial, financial, and agricultural               |       | $                   | 265        |                | $          | 58,033           |       | $ | 58,298 |   |
| Construction, land development & other  land |       | 8,362               |       | 123,496             |       | 131,858          |       |
| Real estate- 1-4 Family mortgage loans                |       | 795                 |       | 41,530              |       | 42,325           |       |
| Real estate- Commercial and other                     |       | 837                 |       | 98,549              |       | 99,386           |       |
| Home equity lines of credit                           |       | 58                  |       | 47,760              |       | 47,818           |       |
| Installment loans to individuals                      |       | 63                  |       | 12,878              |       | 12,941           |       |
| Other loans                                           |       | 308                 |       | 23,405              |       | 23,713           |       |
| Total                                                 |       | $                   | 10,688     |                | $          | 405,651          |       | $ | 416,339 |   |

 

The following table presents thepurchased performing loans receivable at the acquisition date of April 17,2009.  The amounts include principal onlyand do not reflect accrued interest as of the date of the acquisition orbeyond:

 
| ** **                                                      | ** ** | **(In thousands)** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|
| Contractually required  principal payments receivable           |       | $                  | 416,833    |   |
| Fair value adjustment for  credit, interest rate, and liquidity |       | (11,182            | )          |
| Fair value of purchased  performing loans receivable            |       | $                  | 405,651    |   |

 

The following table presents thepurchased impaired loans receivable at the acquisition date of April 17,2009.  The Company has initially appliedthe cost recovery method to all purchased performing loans at the acquisitiondate due to uncertainty as to the timing of expected cash flows as reflected inthe following table:

 
| ** **                                            | ** ** | **(In thousands)** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|
| Contractually required  principal payments receivable |       | $                  | 14,513     |   |
| Nonaccretable difference                              |       | (3,825             | )          |
| Present value of cash  flows expected to be collected |       | 10,688             |       |
| Accretable difference                                 |       | —             |       |
| Fair value of purchased  impaired loans acquired      |       | $                  | 10,688     |   |

 

As previously disclosed, we identified several unreconciled items inthe American Community general ledger subsequent to the merger date with theCompany.  Our internal investigation isnow substantially complete and we are pursuing various claims to recover all orpart of the money lost due to these items. The pending claims are confidential and will not be disclosed.  The internal investigation indicated thatimproper activity by two individuals contributed to the unreconciled itemsprior to the acquisition of American Community. These two individuals are no longer with the Company.

 

The proforma consolidated condensed statements of income for YadkinValley and American Community for the nine months ended September 30, 2009and 2008 are presented below as if the combination had occurred on January 1.  The unaudited proforma information presenteddoes not necessarily reflect the results of operations that would have 

 

14

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resulted had the acquisition been completed at the beginning of theapplicable periods presented, nor does it indicate the results of operations infuture periods.

 

The proforma purchase accounting adjustments related to investments,loans and leases, deposits, and other borrowed funds are being accreted oramortized into income using methods that approximate a level yield over theirrespective estimated lives.  Purchaseaccounting adjustments related to identifiable intangibles are being amortizedand recorded as noninterest expense over their respective estimated lives usingaccelerated methods.

 
| **Nine Months Ended September 30, 2009****dollars in thousands except per share data** | ** ** | **Yadkin Valley** | ** ** | **American  Community** | ** ** | **Proforma  Adjustments** | ** ** | **Proforma  Combined** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                                                                                                                                    | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                | ** ** | ** **             | ** ** |
| Interest Income                                                                                                                               |       | $                      | 54,778     |                    | $          | 17,228                    |       | $                      | 6,735      |   | $ | 78,741 |   |
| Interest Expense                                                                                                                              |       | 22,092                 |       | 8,749                   |       | (3,486                    | )          | 27,355                 |       |
| Net Interest Income                                                                                                                           |       | 32,686                 |       | 8,479                   |       | 10,221                    |       | 51,386                 |       |
| Provision for Loan Losses                                                                                                                     |       | 31,114                 |       | 2,424                   |       | 14,575                    |       | 48,113                 |       |
| Net Interest Income (Loss) after Provision for  Loan Losses                                                                                   |       | 1,572                  |       | 6,055                   |       | (4,354                    | )          | 3,273                  |       |
| Noninterest Income                                                                                                                            |       | 16,362                 |       | 1,116                   |       | —                    |       | 17,478                 |       |
| Noninterest Expense                                                                                                                           |       | 103,688                |       | 13,632                  |       | 376                       |       | 117,696                |       |
| Income (Loss) Before Taxes                                                                                                                    |       | (85,754                | )          | (6,461                  | )          | (4,730                    | )          | (96,945                | )          |
| Income Tax Provision (Benefit)                                                                                                                |       | (35,997                | )          | (2,506                  | )          | (1,823                    | )          | (40,326                | )          |
| Net Income (Loss)                                                                                                                             |       | (49,757                | )          | (3,955                  | )          | (2,907                    | )          | (56,619                | )          |
| Preferred stock dividend and amortization of  preferred stock discount                                                                        |       | 1,681                  |       | —                  |       | —                    |       | 1,681                  |       |
|                                                                                                                                          |       | $                      | (51,438    | )                       | $          | (3,955                    | )          | $                      | (2,907     | ) | $ | (58,300 | ) |
|                                                                                                                                          |       |                   |       |                    |       |                      |       |                   |       |
| Earnings (loss) per common share                                                                                                              |       | $                      | (3.47      | )                       | $          | (0.59                     | )          |                   |       | $ | (2.99 | ) |
| Diluted earnings (loss) per common share                                                                                                      |       | $                      | (3.47      | )                       | $          | (0.59                     | )          |                   |       | $ | (2.99 | ) |
|                                                                                                                                          |       |                   |       |                    |       |                      |       |                   |       |
| Average common shares outstanding                                                                                                             |       | 14,356,544             |       | 6,680,663               |       | (2,087,531                | )          | 18,949,676             |       |
| Diluted average common shares outstanding                                                                                                     |       | 14,356,544             |       | 6,680,663               |       | (2,087,531                | )          | 18,949,676             |       |

 

**Assumptions:**

(a) Interestincome increased by $6.7 million due to accretion of the loans fair marketvalue adjustment.

(b) Interestexpense decreased by $3.4 million due to the amortization of the time depositfair market value adjustment and $81,000 from the amortization of theborrowings fair market value adjustment.

(c) Provisionfor loan losses increased by $14.6 million from the impact of the subsequentdeterioration of American Community loans.

(d) Noninterest expense increased by $376,000 from amortizing the core depositintangible.

(e) Provisionfor income taxes decreased by $1.8 million from the net tax impact ofadjustments to income before taxes.

 

15

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| **Nine Month Ended September 30, 2008****dollars in thousands except per share data** | ** ** | **Yadkin Valley** | ** ** | **American  Community** | ** ** | **Proforma  Adjustments** | ** ** | **Proforma  Combined** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **             | ** ** | ** **              | ** ** | ** **                | ** ** | ** **             | ** ** |
| Interest Income                                                                                                                              |       | $                      | 56,443     |                    | $          | 23,329                    |       | $                      | 6,735      |   | $ | 86,507 |   |
| Interest Expense                                                                                                                             |       | 26,088                 |       | 11,070                  |       | (3,486                    | )          | 33,672                 |       |
| Net Interest Income                                                                                                                          |       | 30,355                 |       | 12,259                  |       | 10,221                    |       | 52,835                 |       |
| Provision for Loan Losses                                                                                                                    |       | 3,492                  |       | 2,163                   |       | 14,575                    |       | 20,230                 |       |
| Net Interest Income after Provision  for Loans Losses                                                                                        |       | 26,863                 |       | 10,096                  |       | (4,354                    | )          | 32,605                 |       |
| Noninterest Income                                                                                                                           |       | 11,034                 |       | 1,846                   |       | —                    |       | 12,880                 |       |
| Noninterest Expense                                                                                                                          |       | 28,556                 |       | 13,515                  |       | 376                       |       | 42,447                 |       |
| Income (Loss) Before Taxes                                                                                                                   |       | 9,341                  |       | (1,573                  | )          | (4,730                    | )          | 3,038                  |       |
| Income Tax Provision                                                                                                                         |       | 2,907                  |       | 151                     |       | (1,823                    | )          | 1,235                  |       |
| Net Income (Loss)                                                                                                                            |       | 6,434                  |       | (1,724                  | )          | (2,907                    | )          | 1,803                  |       |
| Preferred stock dividend  and amortization of preferred stock discount                                                                       |       | —                 |       | —                  |       | —                    |       | —                 |       |
|                                                                                                                                         |       | $                      | 6,434      |                    | $          | (1,724                    | )          | $                      | (2,907     | ) | 1,803 |   |
|                                                                                                                                         |       |                   |       |                    |       |                      |       |                   |       |
| Earnings per common share                                                                                                                    |       | $                      | 0.57       |                    | $          | (0.26                     | )          |                   |       | $ | 0.11 |   |
| Diluted earnings per  common share                                                                                                           |       | $                      | 0.57       |                    | $          | (0.26                     | )          |                   |       | $ | 0.11 |   |
|                                                                                                                                         |       |                   |       |                    |       |                      |       |                   |       |
| Average common shares  outstanding                                                                                                           |       | 11,198,506             |       | 6,538,950               |       | (1,934,677                | )          | 15,802,779             |       |
| Diluted average common  shares outstanding                                                                                                   |       | 11,275,946             |       | 6,631,918               |       | (2,038,786                | )          | 15,869,078             |       |

 

**Assumptions:**

(a) Interestincome increased by $6.7 million due to accretion of the loans fair marketvalue adjustment.

(b) Interestexpense decreased by $3.4 million due to the amortization of the time depositfair market value adjustment and $81,000 from the amortization of theborrowings fair market value adjustment.

(c) Provisionfor loan losses increased by $14.6 million from the impact of the subsequentdeterioration of American Community loans.

(d) Noninterest expense increased by $376,000 from amortizing the core depositintangible.

(e) Provisionfor income taxes decreased by $1.8 million from the net tax impact ofadjustments to income before taxes.

 

The proformaresults are not necessarily indicative of what actually would have occurred ifthe acquisition had been completed as of the beginning of each fiscal periodpresented, nor are they necessarily indicative of future consolidated results.

 

16

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***6. Investment Securities***

 

Investment securities at September 30, 2009 and December 31,2008 are summarized as follows:

** **
| ** **                                         | ** ** | **September 30, 2009** | ** **  |
|----------------------------------------------------|------------|-----------------------------|-------------|
| ** **                                         | ** ** | **Amortized Cost**          | ** **  | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Available-for-sale  securities:                    |       |                        |        |   |   |   |   |   |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| Securities of U.S.  government agencies due:       |       |                        |        |   |   |   |   |   |   |
| Within 1 year                                      |       | $                           | 4,993,804   |   | $ | 183,706 |   | $ | — |   | $ | 5,177,510 |   |
| After 1 but within 5 years                         |       | 21,371,026                  |        | 620,039 |   | — |   | 21,991,065 |   |
| After 5 but within 10  years                       |       | 17,721,538                  |        | 466,752 |   | 34,329 |   | 18,153,961 |   |
|                                               |       | 44,086,368                  |        | 1,270,497 |   | 34,329 |   | 45,322,536 |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| Government sponsored  agencies:                    |       |                        |        |   |   |   |   |   |   |
| Mortgage-backed securities                         |       |                        |        |   |   |   |   |   |   |
| Within 1 year                                      |       | 939,342                     |        | 8,063 |   | — |   | 947,405 |   |
| After 1 but within 5 years                         |       | 4,205,197                   |        | 38,664 |   | 6,353 |   | 4,237,508 |   |
| After 5 but within 10  years                       |       | 6,350,861                   |        | 331,776 |   | — |   | 6,682,637 |   |
| After 10 years                                     |       | 41,649,713                  |        | 1,778,880 |   | 4,157 |   | 43,424,436 |   |
|                                               |       | 53,145,113                  |        | 2,157,383 |   | 10,510 |   | 55,291,986 |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| Collateralized mortgage  obligation                |       |                        |        |   |   |   |   |   |   |
| After 5 but within 10  years                       |       | 4,035,482                   |        | 23,026 |   | — |   | 4,058,508 |   |
| After 10 years                                     |       | 21,807,917                  |        | 348,687 |   | — |   | 22,156,604 |   |
|                                               |       | 25,843,399                  |        | 371,713 |   | — |   | 26,215,112 |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| Private label  collateralized mortgage obligations |       |                        |        |   |   |   |   |   |   |
| After 10 years                                     |       | 2,837,737                   |        | — |   | 417,755 |   | 2,419,982 |   |
|                                               |       | 2,837,737                   |        | — |   | 417,755 |   | 2,419,982 |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| State and municipal  securities due:               |       |                        |        |   |   |   |   |   |   |
| Within 1 year                                      |       | 5,374,383                   |        | 92,363 |   | — |   | 5,466,746 |   |
| After 1 but within 5 years                         |       | 14,729,376                  |        | 587,677 |   | — |   | 15,317,053 |   |
| After 5 but within 10  years                       |       | 15,283,896                  |        | 408,704 |   | 5,441 |   | 15,687,159 |   |
| After 10 years                                     |       | 25,042,081                  |        | 561,764 |   | 58,115 |   | 25,545,730 |   |
|                                               |       | 60,429,736                  |        | 1,650,508 |   | 63,556 |   | 62,016,688 |   |
| Common and preferred  stocks:                      |       |                        |        |   |   |   |   |   |   |
| After 10 years                                     |       | 125,457                     |        | 31,801 |   | 902 |   | 156,356 |   |
|                                               |       | 125,457                     |        | 31,801 |   | 902 |   | 156,356 |   |
|                                               |       |                        |        |   |   |   |   |   |   |
| Total available-for-sale  securities               |       | $                           | 186,467,810 |   | $ | 5,481,902 |   | $ | 527,052 |   | $ | 191,422,660 |   |

 

17

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| ** **                                          | ** ** | **December 31, 2008** | ** **  |
|-----------------------------------------------------|------------|----------------------------|-------------|
| ** **                                          | ** ** | **Amortized Cost**         | ** **  | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
| Available-for-sale securities:                      |       |                       |        |   |   |   |   |   |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Securities of U.S.  government agencies due:        |       |                       |        |   |   |   |   |   |   |
| Within 1 year                                       |       | $                          | 3,998,265   |   | $ | 59,235 |   | $ | — |   | $ | 4,057,500 |   |
| After 1 but within 5 years                          |       | 26,892,399                 |        | 865,391 |   | — |   | 27,757,790 |   |
| After 5 but within 10  years                        |       | 10,976,867                 |        | 858,320 |   | — |   | 11,835,187 |   |
|                                                |       | 41,867,531                 |        | 1,782,946 |   | — |   | 43,650,477 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Government sponsored  agencies:                     |       |                       |        |   |   |   |   |   |   |
| Mortgage-backed securities  due                     |       |                       |        |   |   |   |   |   |   |
| Within 1 year                                       |       | 1,011,391                  |        | 3,825 |   | 2 |   | 1,015,214 |   |
| After 1 but within 5 years                          |       | 2,169,311                  |        | 5,814 |   | 7,597 |   | 2,167,528 |   |
| After 5 but within 10  years                        |       | 2,994,894                  |        | 105,554 |   | — |   | 3,100,448 |   |
| After 10 years                                      |       | 35,332,745                 |        | 1,346,010 |   | 21,235 |   | 36,657,520 |   |
|                                                |       | 41,508,341                 |        | 1,461,203 |   | 28,834 |   | 42,940,710 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Collateralized mortgage  obligations                |       |                       |        |   |   |   |   |   |   |
| After 10 years                                      |       | 7,078,889                  |        | 103,621 |   | 2,105 |   | 7,180,405 |   |
|                                                |       | 7,078,889                  |        | 103,621 |   | 2,105 |   | 7,180,405 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Privatel label  collateralized mortgage obligations |       |                       |        |   |   |   |   |   |   |
| After 10 years                                      |       | 3,305,624                  |        | — |   | 363,635 |   | 2,941,989 |   |
|                                                |       | 3,305,624                  |        | — |   | 363,635 |   | 2,941,989 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| State and municipal  securities due:                |       |                       |        |   |   |   |   |   |   |
| Within 1 year                                       |       | 1,325,459                  |        | 7,922 |   | — |   | 1,333,381 |   |
| After 1 but within 5 years                          |       | 16,615,757                 |        | 450,157 |   | 3,427 |   | 17,062,487 |   |
| After 5 but within 10  years                        |       | 9,777,202                  |        | 201,711 |   | 42,335 |   | 9,936,578 |   |
| After 10 years                                      |       | 13,013,444                 |        | 53,169 |   | 321,722 |   | 12,744,891 |   |
|                                                |       | 40,731,862                 |        | 712,959 |   | 367,484 |   | 41,077,337 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Common and preferred  stocks:                       |       |                       |        |   |   |   |   |   |   |
| Within 1 year                                       |       | 1,171                      |        | — |   | — |   | 1,171 |   |
| After 10 years                                      |       | 39,924                     |        | 4 |   | 18,488 |   | 21,440 |   |
|                                                |       | 41,095                     |        | 4 |   | 18,488 |   | 22,611 |   |
|                                                |       |                       |        |   |   |   |   |   |   |
| Total available-for-sale  securities                |       | $                          | 134,533,342 |   | $ | 4,060,733 |   | $ | 780,546 |   | $ | 137,813,529 |   |

 

Mortgage-backed securities are included in maturity groups based uponstated maturity date. At September 30, 2009, $55.3 million of the Bank’s mortgage-backed securities were pass-throughsecurities and $28.6 million were collateralized mortgageobligations.  At December 31, 2008, $42.8million of the Bank’s mortgage-backed securities were pass-through securitiesand $10.2 million were collateralized mortgage obligations.  Actual maturity will vary based on******repayment of the underlyingmortgage loans.

 

18

----

 

Therewere no gross realized gains or losses on sale of securities for the three andnine months ended September 30, 2009. For the three and nine months ended September 30, 2008, grossrealized gains (losses) on sale of securities were $6,549 and $(26),respectively.

 

Investmentsecurities with carrying values of approximately $110,530,464 and $68,086,225at September 30, 2009 and December 31, 2008, respectively, werepledged as collateral for public deposits and for other purposes as required orpermitted by law.

 

The followingtable provides information on the gross unrealized losses and fair value of theCompany’s investments that are not deemed to be other-than-temporarily impaired(“OTTI”) and the length of time that the securities have been in a continuousunrealized loss position at September 30, 2009. Securities that have been ina loss position for twelve months or more at September 30, 2009 includeone mortgage-backed security, three municipal securities, and one preferredstock.  The unrealized losses relate tosecurities that have incurred fair value reductions due to increases ininvestment market interest rates since the securities were purchased, and areconsidered by management to be temporary. The marketable securities in an unrealized loss position as of September 30,2009 are all still performing and are expected to perform through maturity andthe issuers have not experienced significant adverse events that would callinto question their ability to repay these debt obligations according tocontractual terms. Further, because the Company does not intend to sell theseinvestments and it is not more likely than not that the Company will berequired to sell the investments before recovery of their amortized cost bases,which may be maturity, the Company does not consider any of its marketablesecurities to be other-than-temporarily impaired as of September 30, 2009.

 
| ** **                                        | ** ** | **Less Than 12 Months** | ** ** | **12 Months or More**  | ** ** | **Total**      | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|------------------------|------------|----------------|------------|
| **September 30,  2009**                      | ** ** | **Fair value**          | ** ** | **Unrealized  losses** | ** ** | **Fair value** | ** ** | **Unrealized  losses** | ** ** | **Fair value** | ** ** | **Unrealized  losses** | ** ** |
| Securities available for sale:                    |       |                    |       |                   |       |           |       |   |   |   |   |   |   |
| U.S. government agencies                          |       | $                       | 4,226,240  |                   | $          | 34,329         |       | $ | — |   | $ | — |   | $ | 4,226,240 |   | $ | 34,329 |   |
| Government sponsored agencies:                    |       |                    |       |                   |       |           |       |   |   |   |   |   |   |
| Mortgage backed securities                        |       | 34,279                  |       | 6,353                  |       | 143,727        |       | 4,157 |   | 178,006 |   | 10,510 |   |
| Private label collateralized mortgage obligations |       | 549,649                 |       | 28,230                 |       | 1,870,333      |       | 389,525 |   | 2,419,982 |   | 417,755 |   |
| State and municipal securities                    |       | 3,798,107               |       | 35,119                 |       | 1,065,884      |       | 28,437 |   | 4,863,991 |   | 63,556 |   |
| Common and preferred stocks                       |       | 47,850                  |       | 902                    |       | —         |       | — |   | 47,850 |   | 902 |   |
|                                              |       |                    |       |                   |       |           |       |   |   |   |   |   |   |
| Total temporarily impaired securities             |       | $                       | 8,656,125  |                   | $          | 104,933        |       | $ | 3,079,944 |   | $ | 422,119 |   | $ | 11,736,069 |   | $ | 527,052 |   |

 
| ** **                                         | ** ** | **Less  Than 12 Months** | ** ** | **12  Months or More** | ** ** | **Total**       | ** ** |
|----------------------------------------------------|------------|--------------------------|------------|------------------------|------------|-----------------|------------|
| **December 31, 2008**                         | ** ** | **Fair  value**          | ** ** | **Unrealized  losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** |
| Securities  available for sale:                    |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| Government  sponsored agencies:                    |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| Mortgage  backed securities                        |       | $                        | 1,007,562  |                   | $          | 15,861          |       | $ | 720,914 |   | $ | 12,973 |   | $ | 1,728,476 |   | $ | 28,834 |   |
| Collateralized  mortgage obligations               |       | 721,916                  |       | 2,105                  |       | —          |       | — |   | 721,916 |   | 2,105 |   |
| Private  label collateralized mortgage obligations |       | 2,941,988                |       | 363,635                |       | —          |       | — |   | 2,941,988 |   | 363,635 |   |
| State  and municipal securities                    |       | 12,113,871               |       | 367,484                |       | —          |       | — |   | 12,113,871 |   | 367,484 |   |
| Common  and preferred stocks                       |       | 21,440                   |       | 18,488                 |       | —          |       | — |   | 21,440 |   | 18,488 |   |
|                                               |       |                     |       |                   |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities             |       | $                        | 16,806,777 |                   | $          | 767,573         |       | $ | 720,914 |   | $ | 12,973 |   | $ | 17,527,691 |   | $ | 780,546 |   |

 

19

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If management determines that an investment has experienced an OTTI,the loss is recognized in the income statement.

 

The aggregate cost of the Company’s costmethod investments at September 30, 2009 totaled $14,162,122.   Cost method investments include $10,539,400in Federal Home Loan Bank of Atlanta (“FHLB”) stock and $3,622,722 ofinvestments in various trust and financial companies, which are included inother assets.  All equity investmentswere evaluated for impairment at September 30, 2009.  The following factors have been considered indetermining the carrying amount of FHLB stock; 1) the recoverability of the parvalue, 2) we have sufficient liquidity to meet all operational needs in theforeseeable future and would not need to dispose of the stock below recordedamounts, 3) redemptions and purchases of the stock are at the discretion of theFHLB, 4) we feel the FHLB has the ability to absorb economic losses given theexpectation that the various FHLBanks have a high degree of government support,5) the unrealized losses related to securities owned by the FHLB are manageablegiven the capital levels of the organization, and 6) even though the FHLB didnot make dividend payments over the past three quarters, this investment wasnot made for the receipt of dividends but rather for the purpose and right toreceive advances from the FHLB.  TheCompany estimated that the fair value equaled or exceeded the cost of each ofthese investments (that is, the investments were not impaired) on the basis ofthe redemption provisions of the issuing entities with two exceptions.  During the first quarter of 2009 the Company wroteoff its investment of $151,722 in Silverton Financial Services, Inc. (“SFS”)based on events occurring after the financial statement date but prior to theissuance of the statements. On May 1, 2009 the Office of the Comptroller of theCurrency (“OCC”) closed Silverton Bank, National Association, a wholly ownedsubsidiary of SFS.  The OCC appointed theFDIC as receiver, and the FDIC createda bridge bank, Silverton Bridge Bank, National Association, to take over theoperations until July 29, 2009 to allow customers to transfer theiraccount relationships in an orderly fashion. Additionally, the Company’sinvestment in a trust company was written down by $27,771 in the first quarterof 2009, and an additional $143,265 in the third quarter because it was consideredto be other than temporarily impaired. An investment in a privately held bank was also written down by $32,140in the third quarter of 2009 as the result of a recent merger announcement.

 

***7.  Commitments andContingencies***

 

Inthe normal course of business, there are various outstanding commitments andcontingent liabilities, such as commitments to extend credit, which are notreflected in the accompanying financial statements.  At September 30, 2009, the Company hadcommitments outstanding of $356.5 million for additional loan amounts.  Commitments of Sidus Financial, LLC (“Sidus”),the Bank’s mortgage lending subsidiary, are excluded from this amount anddiscussed in the paragraph below. Additional commitments totaling $10.1 million were outstanding understandby letters of credit.  Managementdoes not expect any significant losses to result from these commitments.

 

At September 30, 2009,Sidus had $145.0 million of commitments outstanding to originate mortgage loansheld for sale at fixed prices and $190.7 million of forward commitmentsoutstanding under best efforts contracts to sell mortgages to agencies andother investors.  See Note 10 foradditional disclosures on these derivative financial instruments.

 

***8.    Earnings per share***

 

Basic net income per share is computed by dividing net income by theweighted average number of shares of common stock outstanding for the reportingperiods.  Diluted net income per commonshare reflects additional common shares that would have been outstanding if dilutivepotential common shares had been issued, as well as any adjustment to incomethat would result from the assumed issuance.  The numerators of the basic net income per sharecomputations are the same as the numerators of the diluted net income per sharecomputations for all the periods presented. A reconciliation of the denominator of the basic net income per sharecomputations to the denominator of the diluted net income per sharecomputations is as follows:

 

20

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| ** **                                                    | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                    | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
| ** **                                                    | ** ** | **2009**                | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| Basic EPS denominator:                                        |       |                    |       |                   |       |   |   |   |   |
|                                                          |       |                    |       |                   |       |   |   |   |   |
| Weighted average number ofcommon shares outstanding           |       | 16,129,632              |       | 11,525,277             |       | 14,356,544 |   | 11,198,506 |   |
|                                                          |       |                    |       |                   |       |   |   |   |   |
| Dilutive effect arising from assumedexercise of stock options |       | —                  |       | 57,465                 |       | — |   | 77,440 |   |
|                                                          |       |                    |       |                   |       |   |   |   |   |
| Diluted EPS denominator                                       |       | 16,129,632              |       | 11,582,742             |       | 14,356,544 |   | 11,275,946 |   |

 

Forthe three months ended September 30, 2009 and 2008, net income (loss) fordetermining net income (loss) per common share was reported as net income(loss) less the dividend on preferred stock. During the quarter ended September 30, 2009, 614,516 warrants andstock options were not considered dilutive because the exercise prices exceededthe average market price of $6.20 per share. These non-dilutive shares hadexercise prices ranging from $6.36 to $19.07 per share and had a weightedaverage price of $12.94 per share. During the first nine months of 2009, 565,752 warrants and stock optionswere not considered dilutive because the exercise prices exceeded the averagemarket price of $7.01 per share. These non-dilutive shares had exercise pricesranging from $7.43 to $19.07 per share and had a weighted average price of $13.56per share. Unvested shares of restricted stock and all other common stockequivalents were excluded from the determination of diluted earnings per sharefor the three and nine months ended September 30, 2009 due to the Company’sloss position for those periods.

 

***9.   Shareholders’Equity***

 

On June 30, 2009,the Board of Directors of the Company declared a quarterly cash dividend of$0.06 per share to all common shareholders of record on July 13, 2009, andpayable July 31, 2009. The dividend reduced shareholders’ equity by$967,806.

 

On September 21, 2009, the Company announced that its Board ofDirectors voted to suspend payment of the Company’s quarterly cash dividend inorder to preserve capital.  The Boardwill continue to evaluate the payment of a quarterly cash dividend on aquarterly basis.

 

On May 24,2007, the Board approved a plan to repurchase up to 100,000 shares of theCompany’s outstanding common shares (“2007 plan”).  The Company did not repurchase any commonshares during the first three quarters of 2009. There was no 2008 common stock repurchase plan approved or repurchasesmade in 2008, and future plans to repurchase stock would be subject to the Troubled AssetRelief Program (“TARP”)limitations.  Under the 2007 plan, theCompany repurchased a total of 71,281 common shares at an average price of$17.10 per share during 2007.  There are28,719 common shares available to purchase under the 2007 plan at September 30,2009.

 

***10.  Derivatives***

 

The Company is exposed to certain risks relating to its ongoingmortgage origination business.  Sidus,the Company’s mortgage lending subsidiary, enters into interest rate lockcommitments and commitments to sell mortgages. The primary risks managed by derivative instruments are these interestrate lock commitments and forward loan sale commitments.  Interest rate lock commitments are enteredinto to manage interest rate risk associated with the Company’s fixed rate loancommitments.  The period of time betweenthe issuance of a loan commitment and the 

 

21

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closing and sale of the loan generally ranges from 10 to 60 days.Such interest rate lock commitments and forward loans sale commitmentsrepresent derivative instruments which are required to be carried at fairvalue. These derivative instruments do not qualify as hedges under theDerivatives and Hedging topic of the FASB Accounting Standards Codification.The fair value of the Company’s interest rate lock commitments and forward loansales commitments are based on current secondary market pricing and included onthe balance sheet in the loans held for sale and on the income statement ingain on sale of mortgages.  The gains andlosses from the future sales of the mortgages is recognized when the Company, theborrower and the investor enter into the loan contract and the resulting gainor loss is recorded on the income statement under gains on sales of mortgages.

 

At September 30,2009, Sidus had $145.0 million of commitments outstanding to originate mortgageloans held for sale at fixed prices and $190.7 million of forward commitmentsoutstanding under best efforts contracts to sell mortgages to agencies andother investors.  The fair valueof interest rate locks was $548,769 and was recorded in other assets.  The fair value of the forward salescommitments was $386,023 and was recorded in other liabilities. Recognition oflosses related to the change in fair value of the interest rate lockcommitments were $130,447 and $51,918 for the three and nine months ended September 30,2009, respectively, and are included in other income.

 

22

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***11.  Business SegmentInformation***

 

Sidus is a singlemember LLC with the Bank as the single member. Sidus is headquartered in Greenville, North Carolina and offers mortgagebanking services to its customers in Alabama, Arkansas, Connecticut, Delaware,Florida, Georgia, Kentucky, Louisiana, Maine, Maryland, Massachusetts,Mississippi, New Hampshire, North Carolina, Pennsylvania, Rhode Island, SouthCarolina, Tennessee, Vermont, Virginia and West Virginia.  The following table details the results ofoperations for the first nine months of 2009 and 2008 for the Company and forSidus.

 
| ** **                                                  | ** ** | **Bank**      | ** **    | **Sidus**  | ** ** | **Other**  | ** ** | **Total**     | ** **   |
|-------------------------------------------------------------|------------|---------------|---------------|------------|------------|------------|------------|---------------|--------------|
| **For Nine Months Ended September 30, 2009**           |       |          |          |       |       |       |       |          |         |
| Interest  income                                            |       | $             | 66,938,453    |       | $          | 3,121,204  |       | $             | —       |   | $ | 70,059,657 |   |
| Interest  expense                                           |       | 23,215,090    |          | 318,713    |       | 676,492    |       | 24,210,295    |         |
| Net  interest income                                        |       | 43,723,363    |          | 2,802,491  |       | (676,492   | )          | 45,849,362    |         |
|                                                        |       |          |          |       |       |       |       |          |         |
| Provision  for loan losses                                  |       | 45,238,856    |          | 54,111     |       | —     |       | 45,292,967    |         |
| Net  interest income (loss) after provision for loan losses |       | (1,515,493    | )             | 2,748,380  |       | (676,492   | )          | 556,395       |         |
| Other  income                                               |       | 6,151,083     |          | 10,763,697 |       | 602,766    |       | 17,517,546    |         |
| Other  expense                                              |       | 39,482,056    |          | 6,948,766  |       | 555,231    |       | 46,986,053    |         |
| Goodwill  impairment                                        |       | 61,565,768    |          | —     |       | —     |       | 61,565,768    |         |
| Income  (loss) before income taxes (benefit)                |       | (96,412,234   | )             | 6,563,311  |       | (628,957   | )          | (90,477,880   | )            |
| Income  taxes (benefit)                                     |       | (14,064,772   | )             | 2,559,691  |       | —     |       | (11,505,081   | )            |
| Net  income(loss)                                           |       | $             | (82,347,462   | )          | $          | 4,003,620  |       | $             | (628,957     | ) | $ | (78,972,799 | ) |
|                                                        |       |          |          |       |       |       |       |          |         |
| Total  assets                                               |       | $             | 2,169,540,992 |       | $          | 56,735,558 |       | $             | (174,604,225 | ) | $ | 2,051,672,325 |   |
| Net  loans                                                  |       | 1,590,496,972 |          | 1,559,335  |       | —     |       | 1,592,056,307 |         |
| Loans  held for sale                                        |       | 1,210,400     |          | 45,700,301 |       | —     |       | 46,910,701    |         |
| Goodwill                                                    |       | —        |          | 4,943,872  |       | —     |       | 4,943,872     |         |
|                                                        |       |          |          |       |       |       |       |          |         |
| **For Three Months Ended September 30, 2009**          |       |          |          |       |       |       |       |          |         |
| Interest  income                                            |       | $             | 25,967,941    |       | $          | 668,835    |       | $             | —       |   | $ | 26,636,776 |   |
| Interest  expense                                           |       | 7,977,888     |          | 46,324     |       | 231,311    |       | 8,255,523     |         |
| Net  interest income                                        |       | 17,990,053    |          | 622,511    |       | (231,311   | )          | 18,381,253    |         |
| Provision  for loan losses                                  |       | 18,293,206    |          | (7,546     | )          | —     |       | 18,285,660    |         |
| Net  interest income (loss) after provision for loan losses |       | (303,153      | )             | 630,057    |       | (231,311   | )          | 95,593        |         |
| Other  income                                               |       | 1,677,240     |          | 2,771,915  |       | 186,052    |       | 4,635,207     |         |
| Other  expense                                              |       | 13,810,453    |          | 2,135,132  |       | 193,883    |       | 16,139,468    |         |
| Goodwill  impairment                                        |       | 61,565,768    |          | —     |       | —     |       | 61,565,768    |         |
| Income  (loss) before income taxes (benefit)                |       | (74,002,134   | )             | 1,266,840  |       | (239,142   | )          | (72,974,436   | )            |
|                                                        |       |          |          |       |       |       |       |          |         |
| Income  taxes (benefit)                                     |       | (5,209,621    | )             | 494,068    |       | —     |       | (4,715,553    | )            |
| Net  income(loss)                                           |       | $             | (68,792,513   | )          | $          | 772,772    |       | $             | (239,142     | ) | $ | (68,258,883 | ) |

 

23

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| ** **                                               | ** ** | **Bank**      | ** **    | **Sidus**  | ** ** | **Other**  | ** ** | **Total**     | ** **  |
|----------------------------------------------------------|------------|---------------|---------------|------------|------------|------------|------------|---------------|-------------|
| **For the Nine Months Ended  September 30, 2008**   | ** ** | ** **    | ** **    | ** ** | ** ** | ** ** | ** ** | ** **    | ** **  |
| ** **                                               | ** ** | ** **    | ** **    | ** ** | ** ** | ** ** | ** ** | ** **    | ** **  |
| Interest income                                          |       | $             | 54,496,332    |       | $          | 1,946,361  |       | $             | —      |   | $ | 56,442,693 |   |
| Interest expense                                         |       | 24,381,777    |          | 772,921    |       | 932,789    |       | 26,087,487    |        |
| Net interest income                                      |       | 30,114,555    |          | 1,173,440  |       | (932,789   | )          | 30,355,206    |        |
| Provision for loan losses                                |       | 3,492,000     |          | —     |       | —     |       | 3,492,000     |        |
| Net interest income after provision for loan losses      |       | 26,622,555    |          | 1,173,440  |       | (932,789   | )          | 26,863,206    |        |
| Net gain (loss) on sale of investment securities         |       | (972,826      | )             | —     |       | —     |       | (972,826      | )           |
| Other income                                             |       | 6,064,168     |          | 5,429,043  |       | 513,831    |       | 12,007,042    |        |
| Other expense                                            |       | 23,675,432    |          | 4,725,828  |       | 154,888    |       | 28,556,148    |        |
| Income before income taxes                               |       | 8,038,465     |          | 1,876,655  |       | (573,846   | )          | 9,341,274     |        |
| Income taxes                                             |       | 2,175,387     |          | 731,895    |       | —     |       | 2,907,282     |        |
| Net income                                               |       | $             | 5,863,078     |       | $          | 1,144,760  |       | $             | (573,846    | ) | $ | 6,433,992 |   |
|                                                     |       |          |          |       |       |       |       |          |        |
| Total assets                                             |       | $             | 1,503,292,786 |       | $          | 44,840,692 |       | $             | (86,308,207 | ) | $ | 1,461,825,271 |   |
| Net loans                                                |       | 1,102,792,522 |          | —     |       | —     |       | 1,102,792,522 |        |
| Loans held for sale                                      |       | —        |          | 52,395,095 |       | —     |       | 52,395,095    |        |
| Goodwill                                                 |       | 49,204,856    |          | 4,943,872  |       | —     |       | 54,148,728    |        |
|                                                     |       |          |          |       |       |       |       |          |        |
| **For the Three Months ended  September 30, 2008:** |       |          |          |       |       |       |       |          |        |
| ** **                                               |       |          |          |       |       |       |       |          |        |
| Interest income                                          |       | $             | 18,808,196    |       | $          | 630,375    |       | $             | —      |   | $ | 19,438,571 |   |
| Interest expense                                         |       | 8,321,643     |          | 215,863    |       | 275,947    |       | 8,813,453     |        |
| Net interest income                                      |       | 10,486,553    |          | 414,512    |       | (275,947   | )          | 10,625,118    |        |
| Provision for loan losses                                |       | 1,334,000     |          | —     |       | —     |       | 1,334,000     |        |
| Net interest income after provision for loan losses      |       | 9,152,553     |          | 414,512    |       | (275,947   | )          | 9,291,118     |        |
| Net gain (loss) on sale of investment securities         |       | (966,301      | )             | —     |       | —     |       | (966,301      | )           |
| Other income                                             |       | 2,083,930     |          | 1,872,365  |       | 67,697     |       | 4,023,992     |        |
| Other expense                                            |       | 8,058,591     |          | 1,655,263  |       | 46,929     |       | 9,760,783     |        |
| Income before income taxes                               |       | 2,211,541     |          | 631,614    |       | (255,179   | )          | 2,588,026     |        |
| Income taxes                                             |       | 548,942       |          | 246,329    |       | —     |       | 795,271       |        |
| Net income                                               |       | $             | 1,662,599     |       | $          | 385,285    |       | $             | (255,179    | ) | $ | 1,792,755 |   |

 

----

(1) Note:  Income tax expense hasbeen allocated to the Sidus business segment for comparative purposes.  As an LLC, Sidus passes its pre-tax incomethrough to its single member, the Bank, which is taxed on that income.

 

(2) Note:  The “Other” column includes asseteliminations representing the Bank’s Due from Sidus account ($175,000,000 in2009 and $85,000,000 in 2008), the Bank’s Investment in Sidus ($3,000,000 in2009 and 2008), and the Bank’s A/R from Sidus ($66,579 in 2009 and $93,390 in2008).  Also included in this column areHolding Company assets ($3,470,915 in 2009 and $1,657,108 in 2008) and HoldingCompany income and expenses.

 

***12. Allowance for Loan Losses***

 

The Bank calculated an allowance for loan losses of $54.3 million at September 30,2009 as compared to $22.4 million at December 31, 2008 based on application ofits model for the allowance calculation applied to the loan portfolio at eachbalance sheet date.  This increase in netcharge-offs totaling $13.4 million and provision expense of $45.3 million forthe nine months ended September 30, 2009 as compared to $3.5 million for thesame period in the prior year, lead to the increase in the allowance of $31.9million. The allowance model is applied to determine the specific allowancebalance for impaired loans and the general allowance balance for unimpairedloans grouped by loan type.  Out of the$54.3 million in total allowance for loans losses at September 30, 2009,the specific allowance for impaired loans 

 

24

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accounted for $11.4 million, up from $3.7 million at year end.  The remaining general allowance, $42.9million, was attributed to performing loans and was up from $18.7 million atyear end.  This increase in the generalallowance was driven primarily by increased charge-offs for the nine monthsended September 30, 2009 as compared to the year ended December 31,2008.  Other model factors that added tothe increase in allowance included rising trends in the Bank’s past due andnonaccrual loans and rising unemployment rates. Usually, we expect the general allowance for performing loans to increasewhen periods of economic weakness are coupled with look-back periods ofincreasing charged-offs.  Conversely, weexpect the general allowance to decrease as a percentage of loans when astronger economy is combined with a decrease in the Bank’s charged off loans.

 

Changes in the allowance for loan losses for the nine months of 2009and 2008 are as follows:

 
| ** **                               | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
|------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| Balance, December 31, 2008 and 2007 |       | $                            | 22,355,231 |                         | $          | 12,445,555 |   |
| Charge-offs                              |       | (13,762,385                  | )          | (1,461,956                   | )          |
| Recoveries                               |       | 384,184                      |       | 392,575                      |       |
| Provision for loan losses                |       | 45,292,967                   |       | 3,492,000                    |       |
| Acquisition of Cardinal State Bank       |       | —                       |       | 1,658,265                    |       |
| Allowance for Loan Losses                |       | $                            | 54,269,997 |                         | $          | 16,526,439 |   |

 

The following table presents the Bank’sinvestment in loans considered to be impaired and related information on thoseimpaired loans:

 
| ** **                                                                                 | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Impaired loans under  $100,000 that are not individually reviewed                          |       | $                           | 5,467,333  |                       | $          | 6,942,036 |   |
| Impaired loans without a  related allowance for loan losses                                |       | 13,333,250                  |       | —                     |       |
| Impaired loans with a  related allowance for loan losses                                   |       | 24,482,695                  |       | 7,496,309                  |       |
| Impaired loans acquired  without a related allowance for loan losses                       |       | 5,876,330                   |       | —                     |       |
| Impaired loans acquired  with subsequent deterioration and related allowance for loan loss |       | 3,129,890                   |       | —                     |       |
| Total impaired loans                                                                       |       | $                           | 52,289,498 |                       | $          | 14,438,345 |   |
|                                                                                       |       |                        |       |                       |       |
| Allowance for loan losses  related to impaired loans                                       |       | $                           | 11,404,028 |                       | $          | 3,663,409 |   |

 

Impaired loans acquired with arelated allowance for loan losses includes loans for which no additionalreserves have been recorded in excess of credit discounts for purchasedimpaired loans.  Impaired loans acquiredwith subsequent deterioration and related allowance for loan loss are loans inwhich additional impairment has been identified in excess of credit discountsresulting in additional reserves.  Theseadditional reserves are included in the allowance for loan losses related toimpaired loans.

 

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Impaired loans are summarized asfollows:

 
| ** **                           | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Impaired loans:                      |       |                        |       |                       |       |
| Nonaccrual                           |       | $                           | 45,685,235 |                       | $          | 13,647,312 |   |
| Restructured                         |       | 5,178,330                   |       | —                     |       |
| Other impaired loans*                |       | 1,425,933                   |       | 791,033                    |       |
| Total impaired loans                 |       | $                           | 52,289,498 |                       | $          | 14,438,345 |   |
|                                 |       |                        |       |                       |       |
| Nonaccrual loans                     |       | $                           | 45,685,235 |                       | $          | 13,647,312 |   |
| Loans past due 90 days and  accruing |       | —                      |       | —                     |       |
| Foreclosed real estate               |       | 9,366,226                   |       | 4,017,880                  |       |
| Total Nonperforming Assets           |       | $                           | 55,051,461 |                       | $          | 17,665,192 |   |

 

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*Other impaired loans consists ofloans in which regular payments are still received however some uncertaintyexists as to whether or not the full contractual amounts will be collected inaccordance with the terms of the loan agreement.

 

The following table presentsinformation regarding all purchased impaired loans, which includes the Company’sacquisition of American Community on April 17, 2009:

 
| ** **                                 | ** ** | ** **      | ** ** | **Fair  Value**    | ** ** | ** **   | ** ** |
|--------------------------------------------|------------|-----------------|------------|--------------------|------------|--------------|------------|
| ** **                                 | ** ** | **Contractual** | ** ** | **Adjustment**     | ** ** | ** **   | ** ** |
| ** **                                 | ** ** | **Principal**   | ** ** | **(nonaccretable** | ** ** | **Carrying** | ** ** |
| ** **                                 | ** ** | **Receivable**  | ** ** | **difference)**    | ** ** | **Amount**   | ** ** |
| As of April 17, 2009 acquisition date |       | $               | 14,513,154 |               | $          | 3,824,951    |       | $ | 10,688,203 |   |
| Change due to payment received             |       | (380,281        | )          | (61,255            | )          | (319,026     | )          |
| Transfer to foreclosed real estate         |       | (2,416,856      | )          | (247,822           | )          | (2,169,034   | )          |
| Change due to charge-offs                  |       | (2,559,510      | )          | (2,262,409         | )          | (297,101     | )          |
| Balance at September 30, 2009         |       | $               | 9,156,507  |               | $          | 1,253,465    |       | $ | 7,903,042 |   |

 

At September 30,2009, the outstanding balance of purchased impaired loans from AmericanCommunity, which includes principal, interest and fees due, was $9,156,507 withallowances for loan losses of $1.1 million. Because of the uncertainty of the expected cash flows, the Company isaccounting for each purchased impaired loan under the cost recovery method, inwhich all cash payments are applied to principal.  Thus, there is no accretable yield associatedwith the above loans.  There was oneremaining purchased impaired loan from the Cardinal State Bank merger as of September 30,2009 in the amount of $23,503.  All otherpurchased impaired loans from Cardinal State Bank have been paid or charged-off.

 

***13. Fair Value***

 

The Company utilizes fair value measurements to record fair valueadjustments for certain assets and liabilities and to determine fair valuedisclosures. Available-for-sale securities, mortgage servicing rights, interestrate lock commitments and forward sale loan commitments are recorded at fairvalue on a monthly basis. Additionally, from

 

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time to time, the Company may be required to record other assets atfair value, such as loans held for investment and certain other assets. Thesenonrecurring fair value adjustments usually involve writing the asset down tofair value or the lower of cost or market value.

 

**Fair Value Hierarchy**

 

Under the Fair Market Value Measurements and Disclosures topic of theFASB Accounting Standards Codification, the Company groups assets andliabilities at fair value in three levels, based on the markets in which theassets and liabilities are traded and the reliability of the assumptions usedto determine fair value. These levels are:

 
| 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. |

 

Following is a description of valuation methodologies used for assetsand liabilities recorded at fair value.

 

**Available-for-Sale Investment Securities**

 

Available-for-sale investment securities are recorded at fair value ona recurring basis. Fair value measurement is based upon quoted prices, ifavailable. If quoted prices are not available, fair values are measured usingindependent pricing models or other model-based valuation techniques such asthe present value of future cash flows, adjusted for the security’s creditrating, prepayment assumptions and other factors such as credit lossassumptions. Level 1 securities include those traded on an active exchange,such as the New York Stock Exchange, U.S. Treasury securities that are tradedby dealers or brokers in active over-the-counter markets and money marketfunds. Level 2 securities include mortgage-backed securities issued bygovernment sponsored entities and private label entities, municipal bonds andcorporate debt securities.

 

**Interest Rate Locks and Forward Sale Loan Commitments**

 

Sidus, the Company’s mortgage lending subsidiary, enters into interestrate lock commitments and commitments to sell mortgages.  At December 31, 2008, the amount of fairvalue was considered immaterial for reporting purposes under the Fair MarketValue Measurements and Disclosures topic of the FASB Accounting StandardsCodification. At September 30, 2009, the amount of fair value associatedwith these interest rate lock commitments and sale commitments was $548,769 and$386,023, respectively.

 

**Mortgage Servicing Rights**

 

A valuation of mortgage servicing rights is performed using a poolingmethodology.  Similar loans are pooledtogether and evaluated on a discounted earnings basis to determine the presentvalue of future earnings.  The presentvalue of the future earnings is the estimated market value for the pool,calculated using consensus assumptions that a third party purchaser wouldutilize in evaluating a potential acquisition of the servicing.  As such, the Company classifies loan servicingrights as Level 3.

 

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Assets (liabilities)subjected to recurring fair value adjustments:

 
| **September 30,  2009 (in thousands)**        | ** ** | **Fair Value** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|----------------------------------------------------|------------|----------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Available for sale  securities:                    |       |           |       |        |       |        |       |        |       |
| U.S. government agencies                           |       | $              | 45,323     |        | $          | —      |       | $           | 45,323     |   | $ | — |   |
| Government sponsored  agencies:                    |       |           |       |        |       |        |       |        |       |
| Mortgage backed securities                         |       | 55,292         |       |        |       | 55,292      |       |        |       |
| Collateralized mortgage  obligations               |       | 26,215         |       |        |       | 26,215      |       |        |       |
| Private label  collateralizedmortgage  obligations |       | 2,420          |       |        |       | 2,420       |       |        |       |
| State and municipal  securities                    |       | 62,017         |       | —      |       | 62,017      |       | —      |       |
| Common and preferred  stocks                       |       | 157            |       | 157         |       | —      |       | —      |       |
| Interest rate lock  commitments                    |       | 549            |       | —      |       | 549         |       | —      |       |
| Forward loan sale  commitments                     |       | (386           | )          | —      |       | (386        | )          | —      |       |
| Mortgage servicing rights                          |       | 1,423          |       | —      |       | —      |       | 1,423       |       |
|                                                    |            |                |            |             |            |             |            |             |            |  |  |  |  |

 
| **December 31,  2008 (in thousands)**         | ** ** | **Fair Value** | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
|----------------------------------------------------|------------|----------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Available for sale  securities:                    |       |           |       |        |       |        |       |        |       |
| U.S. government agencies                           |       | $              | 43,650     |        | $          | —      |       | $           | 43,650     |   | $ | — |   |
| Government sponsored  agencies:                    |       |           |       |        |       |        |       |        |       |
| Mortgage backed securities                         |       | 42,941         |       |        |       | 42,941      |       |        |       |
| Collateralized mortgage  obligations               |       | 7,180          |       |        |       | 7,180       |       |        |       |
| Private label  collateralizedmortgage  obligations |       | 2,942          |       |        |       | 2,942       |       |        |       |
| State and municipal  securities                    |       | 41,077         |       | —      |       | 41,077      |       | —      |       |
| Common and preferred  stocks                       |       | 23             |       | 23          |       | —      |       | —      |       |
| Mortgage servicing rights                          |       | 1,745          |       | —      |       | —      |       | 1,745       |       |
|                                                    |            |                |            |             |            |             |            |             |            |  |  |  |  |

 

The followingtable presents a rollforward of mortgage servicing rights from December 31,2008 to September 30, 2009 and December 31, 2007 to September 30,2008 and shows that the mortgage servicing rights are classified as Level 3 asdiscussed above.

 

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| ** **                       | ** ** | **Fair  Value** | ** ** |
|----------------------------------|------------|-----------------|------------|
| Balance, December 31, 2008  |       | $               | 1,745,466  |   |
| Capitalized                      |       | 583,580         |       |
| Change in fair value             |       | (905,886        | )          |
| Balance, September 30, 2009 |       | $               | 1,423,160  |   |

 
| ** **                        | ** ** | **Fair Value** | ** ** |
|-----------------------------------|------------|----------------|------------|
| Balance, December 31,  2007  |       | $              | 2,000,770  |   |
| Capitalized                       |       | 57,860         |       |
| Change in fair value              |       | (325,250       | )          |
| Balance,  September 30, 2008 |       | $              | 1,733,380  |   |

 

**Mortgage Loans Held for Sale**

 

Loans held for sale are carried at lower of cost or market value. Thefair value of loans held for sale is based on what secondary markets arecurrently offering for portfolios with similar characteristics. As such, theCompany classifies loans subjected to nonrecurring fair value adjustments asLevel 2.  At September 30, 2009 thecost of the Company’s mortgage loans held for sale was less than the marketvalue.  Accordingly, at quarter end theCompany’s loans held for sale were carried at cost.

 

**Impaired Loans**

 

The Company does not record loans held forinvestment at fair value on a recurring basis. However, from time to time, aloan is considered impaired and an allowance for loan losses is established.Loans for which it is probable that payment of interest and principal will notbe made in accordance with the contractual terms of the loan agreement areconsidered impaired. Once a loan is identified as individually impaired,management measures impairment in accordance with the Receivables topic of theFASB Accounting Standards Codification. The fair value of impaired loans isestimated using one of several methods, including collateral value, marketvalue of similar debt, enterprise value, liquidation value and discounted cashflows. Those impaired loans not requiring an allowance represent loans forwhich the fair value of the expected repayments or collateral exceed therecorded investments in such loans. At September 30, 2009, substantially all ofthe total impaired loans were evaluated based on the fair value of thecollateral. When the fair value of the collateral is based on an observablemarket price or a current appraised value, the Company records the impaired loanas nonrecurring Level 2. When an appraised value is not available or managementdetermines the fair value of the collateral is further impaired below theappraised value and there is no observable market price, the Company recordsthe impaired loan as nonrecurring Level 3.

 

**Other RealEstate Owned**

 

Other real estate owned (“OREO”)is adjusted to fair value upon transfer of the loans to OREO. Subsequently,OREO is carried at the lower of carrying value or fair value. Fair value isbased upon independent market prices, appraised values of the collateral ormanagement’s estimation of the value of the collateral. When the fair value ofthe collateral is based on an observable market price or a current appraisedvalue, the Company records the foreclosed asset as nonrecurring Level 2. Whenan appraised value is not available or management determines the fair value ofthe collateral is further impaired below the appraised value and there is noobservable market price, the Company records the OREO as nonrecurring Level 3.The current carrying value of OREO at September 30, 2009 is$9,366,226.  At December 31, 2008 thecarrying value of OREO was $4,017,880.

 

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**Goodwill**

 

Weperform our annual goodwill impairment assessment for the banking segment on April 30th and October 1st for the Sidussegment, respectively.  We also makejudgments about goodwill whenever events or changes in circumstances indicatethat impairment in the value of goodwill recorded on our balance sheet mayexist.  In order to estimate the fairvalue of goodwill, we typically make various judgments and assumptions,including, among other things, the identification of the reporting units, theassignment of assets and liabilities to reporting units, the future prospectsfor the reporting unit that the asset relates to, the market factors specificto that reporting unit, the future cash flows to be generated by that reportingunit, and the weighted average cost of capital for purposes of establishing adiscount rate. Assumptions used in these assessments are consistent with ourinternal planning.  At September 30,2009, it was determined that impairment existed in the banking reporting unitand a goodwill impairment charge of $61.6 million was recorded.  See additional disclosures and discussionsregarding the goodwill impairment in Footnote 15 to the financial statements.

 

Assets subjected to nonrecurring fair value adjustments:

 
| ** **                                         | ** ** | **Fair  Value** | ** ** | **Level  1** | ** ** | **Level  2** | ** ** | **Level  3** | ** ** |
|----------------------------------------------------|------------|-----------------|------------|--------------|------------|--------------|------------|--------------|------------|
| Other real estate owned at September 30, 2009 |       | $               | 9,366,226  |         | $          | —       |       | $            | —     |   | $ | 9,366,226 |   |
| Other real estate owned at December 31, 2008  |       | 4,017,880       |       | —       |       | —       |       | 4,017,880    |       |
| Impaired loans at September 30, 2009          |       | 16,208,557      |       | —       |       | —       |       | 16,208,557   |       |
| Impaired loans at December 31, 2008           |       | 3,832,900       |       | —       |       | —       |       | 3,832,900    |       |
|                                                    |            |                 |            |              |            |              |            |              |            |  |  |  |  |

 

***14. Financial Instruments***

 

The following is a summaryof the carrying amounts and fair values of the Company’s financial assets andliabilities at September 30, 2009 and December 31, 2008:

 
| ** **                                               | ** ** | **September 30,  2009** | ** **   | **December 31,  2008** | ** ** |
|----------------------------------------------------------|------------|------------------------------|--------------|-----------------------------|------------|
| ** **                                               | ** ** | **Carrying  amount**         | ** **   | **Estimated  fair value**   | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** |
| ** **                                               | ** ** | **(in thousands)**           | *** *** |
| Financial assets:                                        |       |                         |         |                        |       |   |   |   |   |
| Cash and cash equivalents                                |       | $                            | 73,687       |                        | $          | 73,687 |   | $ | 26,023 |   | $ | 26,023 |   |
| Investment securities                                    |       | 191,423                      |         | 191,423                     |       | 137,814 |   | 137,814 |   |
| Loans and loans held for sale, net                       |       | 1,638,967                    |         | 1,576,321                   |       | 1,215,143 |   | 1,266,545 |   |
| Accrued interest receivable                              |       | 7,649                        |         | 7,649                       |       | 5,442 |   | 5,442 |   |
| Federal Home Loan Bank stock                             |       | 10,539                       |         | 10,539                      |       | 7,877 |   | 7,877 |   |
| Investment in Bank owned life insurance                  |       | 24,308                       |         | 24,308                      |       | 23,608 |   | 23,608 |   |
| Financial liabilities:                                   |       |                         |         |                        |       |   |   |   |   |
| Demand deposits, NOW, savings and money market  accounts |       | 619,369                      |         | 619,369                     |       | 437,464 |   | 437,464 |   |
| Time deposits                                            |       | 1,127,376                    |         | 1,130,131                   |       | 717,578 |   | 734,012 |   |
| Borrowed funds                                           |       | 136,266                      |         | 140,627                     |       | 207,962 |   | 207,344 |   |
| Accrued interest payable                                 |       | 3,389                        |         | 3,389                       |       | 3,554 |   | 3,554 |   |
|                                                          |            |                              |              |                             |            |  |  |  |  |  |  |  |  |

 

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The carrying amounts of cashand cash equivalents approximate their fair value.

 

The fair value of marketablesecurities is based on quoted market prices and prices obtained fromindependent pricing services.

 

For certain categories ofloans, such as installment and commercial loans, the fair value is estimated bydiscounting the future cash flows using the current rates at which similarloans would be made to borrowers with similar credit ratings and for the sameremaining maturities.The cost of fixed rate mortgage loans held-for-sale approximates thefair values as these loans are typically sold within 60 days of origination.Fair values for adjustable-rate mortgages are based on quoted market prices ofsimilar loans adjusted for differences in loan characteristics.

 

The carrying value ofFederal Home Loan Bank Stock approximates fair value based on the redemptionprovisions of the Federal Home Loan Bank Stock.

 

The investment in bank ownedlife insurance represents the cash value of the policies at September 30,2009 and December 31, 2008.  Therates are adjusted annually thereby minimizing market fluctuations.

 

The fair value of demanddeposits and savings accounts is the amount payable on demand at September 30,2009 and December 31, 2008, respectively. The fair value of fixed-maturitycertificates of deposit and individual retirement accounts is estimated usingthe present value of the projected cash flows using rates currently offered forsimilar deposits with similar maturities.

 

The fair value of borrowingsare based on discounting expected cash flows at the interest rate for debt withthe same or similar remaining maturities and collateral requirements.Short-term borrowings, including overnight, securities sold under agreements torepurchase, federal funds purchased and FHLB advances, are carried atapproximate fair value because of the short maturities of those instruments.

 

The fair value of accrued interest receivable and accrued interestpayable approximates their book values because of their short-term duration.

 

***15. Goodwill***

 

Goodwill represents the excess of the cost of an acquisition over thefair value of the net assets acquired.  Goodwill impairment testingis performed annually or more frequently if events or circumstances indicatepossible impairment.  An impairment loss is recorded to the extentthat the carrying value of goodwill exceeds its implied fair value.

 

In performing the first step (“Step 1”) of the goodwill impairmenttesting and measurement process to identify possible impairment, the estimatedfair value of the reporting units (Bank reporting unit and Sidus reportingunit) was developed using the income, tangible book value, and marketapproaches to value the Company.  The income approach consists ofdiscounting projected long-term future cash flows, which are derived frominternal forecasts and economic expectations for the Company.  Thesignificant inputs to the income approach include the multiple of earnings at19.835 derived from recent acquisitions, an annual discount rate of 16%representing investors’ estimated long-term required rate of return, andprojected long-term earnings for the reporting units.  This compares to multiple of earnings at22.85 and an annual discount rate of 14% as of April 2009.  Significant inputs to the tangible book valueapproach include a multiple of long-term book value of 1.146 derived fromrecent acquisitions, an annual discount rate of 16% consistent with investors’expectations, and long-term tangible book values for the reporting units ascompared to a multiple of long-term book value of 2.02 and an annual discountrate of 14% as of April 2009.   The market valuation approachutilizes the current stock price adjusted by an appropriate control premium asan indicator of fair market value.

 

The valuation has declined over the last six months as investors havedemanded a higher return for equity investments in the financial institutionsdue to sustained weakness in the industry. Earnings multiples have declined and discount rates have increased asdiscussed in the paragraph above.  Theseindustry trends coupled with lower cash flow

 

31

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projections by Bank have resulted in management reducing its internalvaluations.  The lower valuations haveresulted in goodwill impairment.

 

We updated our Step 1 goodwill impairment testing as of September 30,2009.  Given the substantial declines in our common stock price,declining operating results, asset quality trends, market comparables and theeconomic outlook for our industry, the results of this Step 1 process indicatedthat the Company’s estimated fair value was less than book value, thusrequiring a second step (“Step 2”) of the goodwill impairment test inaccordance with accounting for Intangibles- Goodwill and other.  TheStep 2 analysis included a determination of the fair value of net assets thatwas compared with the fair value of the reporting units as determined in Step1.  Assumptions included in the fairvalue of net assets included current market rates for loans, deposits, andother borrowings.   Based on the Step 2analysis, it was determined that the Bank’s fair value did not support thegoodwill recorded; therefore, the Company has recorded a $61.6 million goodwillimpairment charge to write-off a substantial portion of its goodwill at theBank reporting unit as of September 30, 2009.   This non-cashgoodwill impairment charge to earnings was recorded as a component ofnon-interest expense on the consolidated statement of income (loss).  Step 2 analysis performed on the Sidusreporting unit indicated that the fair value did support goodwill recordedtherefore no impairment charge was taken.

 

Ourannual goodwill assessment in April 2009, indicated that the goodwillcontinued to properly value the acquired company and had not been impaired atthat time given that fair value of the Company’s common stock of $14.50 pershare was greater than both stated and tangible common book value ($12.95 pershare and $7.93 per share, respectively). No impairment was recorded as a result of goodwill testing performedduring 2008.

 

***16.  Legal Proceedings***

 

The Company was a party to the following legal proceedings andpotential claims arising in the normal conduct of our business.  TheCompany was sued for damages in excess of $850,000 for 3.99 years of severance,continued benefits and fringe benefits by two former employees who allegedbreach of contract.  In addition, the plaintiffs sought liquidated damagesand costs (including reimbursement for reasonable attorney fees) under theirwage and hour claims.  They also asserted that non-compete provisions ofthe employment agreements did not apply to their separation.  Bothplaintiffs filed for judgment on the pleadings in state court and prevailed.  The Company appealed the orders to the NorthCarolina Court of Appeals before the trial court had determined damages. Plaintiffs prevailed before the Court of Appeals and the Company’s furtherappeal to the North Carolina Supreme Court was denied.   The Supreme Court remanded the case to thetrial court for a determination of damages.  On July 9, 2009, thecase was settled by confidential agreement of the parties.  The fullamount of the settlement had been reserved in prior periods and no additionalreserves are deemed necessary.

 

There are no othermaterial pending legal proceedings to which we are a party or of which any ofour properties are the subject.

 

***17.  Limited Liability Companies***

 

On September 29, 2009, the Company established Green Street I, LLC;Green Street II, LLC; Green Street III, LLC; Green Street IV, LLC and GreenStreet V, LLC for the purpose of maintaining real estate properties acquiredthrough foreclosure.  All LLCs are 100%owned by the Bank.  As of November 4,2009, no assets have been transferred from the Bank to the LLCs.

 

***18.  Subsequent Events***

 

In accordance with the Subsequent Eventstopic of the FASB Accounting Standards Codification, issued in May 2009and effective for periods ending after June 15, 2009, management performedan evaluation to determine whether there have been any subsequent events sincethe balance sheet date.  The evaluationwas performed through November 4,

 

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2009, the date on which the Company’s 10-Qwas issued as filed with the Securities and Exchange Commission and noadditional events or disclosures were identified.

 

**Item2.**  **Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**CAUTIONARY STATEMENT REGARDING FORWARD LOOKINGSTATEMENTS**

 

The following is our discussion and analysis of certain significantfactors that have affected our financial position and operating results duringthe periods included in the accompanying financial statements.  This commentary should be read in conjunctionwith the financial statements and the related notes and the other statisticalinformation included in this report.

 

This report containsstatements which constitute “forward-looking statements” within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934.  Forward-looking statementsrelate to the financial condition, results of operations, plans, objectives,future performance, and business of our Company.  Forward-looking statements are based on manyassumptions and estimates and are not guarantees of future performance. Ouractual results may differ materially from those anticipated in any forward-lookingstatements, as they will depend on many factors about which we are unsure,including many factors which are beyond our control. The words “may,” “would,” “could,”“should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “continue,”“assume,” “believe,” “intend,” “plan,” “forecast,” “goal,” and “estimate,” aswell as similar expressions, are meant to identify such forward-lookingstatements.  Potential risks anduncertainties that could cause our actual results to differ materially fromthose anticipated in our forward-looking statements include, withoutlimitation, those described under the heading “Risk Factors” in our AnnualReport on Form 10-K (as amended) for the year ended December 31, 2008as filed with the Securities and Exchange Commission (the “SEC”) and thefollowing:

 

·                  significant increases in competitive pressurein the banking and financial services industries;

·                  changes in the interest rate environmentwhich could reduce anticipated or actual margins;

·                  expected revenue synergies and cost savingsfrom the ACB combination may not be fully realized;

·                  changes in political conditions or thelegislative or regulatory environment;

·                  general economic conditions, eithernationally or regionally and especially in our primary service area, becomingless favorable than expected resulting in, among other things, a deteriorationin credit quality;

·                  changes occurring in business conditions andinflation;

·                  changes in technology;

·                  changes in monetary and tax policies;

·                  adequacy of the level of our allowance forloan losses;

·                  construction delays and cost overruns relatedto the expansion of our branch network;

·                  changes in deposit flows;

·                  changes in accounting principles, policies orguidelines;

·                  Yadkin Valley’s ability to maintain internalcontrol over financial reporting;

·                  Yadkin Valley’s reliance on secondary sourcessuch as Federal Home Loan Bank advances, sales of securities and loans, federalfunds lines of credit from correspondent banks and out-of-market time deposits,to meet its liquidity needs;

·                  the rate of delinquencies and amounts ofloans charged-off;

·                  the rates of loan growth and the lack ofseasoning of our loan portfolio;

·                  adverse changes in asset quality;

·                  reduced earnings due to higher credit lossesgenerally and specifically because losses in our residential real estate loanportfolio may be greater than expected due to economic factors, includingdeclining real estate values, increasing interest rates, increasingunemployment, or changes in payment behavior or other factors;

 

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·                  loss of consumer confidence and economicdisruptions resulting from terrorist activities or other military action;

·                  our ability toretain our existing customers, including our deposit relationships;

·                  changes in the securities markets; and

·                  other risks and uncertainties detailed fromtime to time in our filings with the SEC.

 

We have based our forward-looking statements on our currentexpectations about future events. Although we believe that the expectationsreflected in our forward-looking statements are reasonable, we cannot guaranteeyou that these expectations will be achieved. We undertake no obligation topublicly update or otherwise revise any forward-looking statements, whether asa result of new information, future events, or otherwise.

 

These risks are exacerbated by the recent developments in national andinternational financial markets, and we are unable to predict what effect theseuncertain market conditions will have on us. During 2008 and continuing through the third quarter of 2009, thecapital and credit markets have experienced extended volatility anddisruption.  In recent months, thevolatility and disruption have reached unprecedented levels.  There can be no assurance that theseunprecedented recent developments will not continue to materially and adverselyaffect our business, financial condition and results of operations.

 

**Recent Government Actions**

 

On October 14, 2008, under authority granted by the Emergency EconomicStabilization Act of 2008 (the “EESA”), the United States Department of theTreasury adopted the Troubled Asset Relief Program and the Capital PurchaseProgram (the “Capital Purchase Program”) pursuant to which the Treasury intendsto make senior preferred stock investments in participating financialinstitutions. The terms and conditions of the Capital Purchase Program aregenerally described in the Treasury’s term sheet available on the Treasury’swebsite at http://www.ustreas.gov. The Company applied for and receivedapproval to participate in the Treasury’s Capital Purchase Program and received$36 million in additional capital in January 2009 and $13 million in July 2009.

 

Another aspect of EESA (in addition to the Capital Purchase Plan) whichbecame effective on October 3, 2008 is a temporary increase of the basiclimit on federal deposit insurance coverage from $100,000 to $250,000 perdepositor.  The basic deposit insurancelimit will return to $100,000 after December 31, 2013.

 

All FDIC institutions are covered for the first 30 days at nocost.  After the initial 30 day periodexpires, the institution must opt out if it no longer wishes to participate inthe program; otherwise, it will be assessed for future participation. Therewill be a 75-basis point fee to protect new debt issues and an additional10-basis point fee to fully cover non-interest bearing deposit transactionaccounts.

 

Following a systemic risk determination, the FDIC established theTemporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008.  The TLGP includes the Transaction Account GuaranteeProgram (“TAGP”), which provides unlimited deposit insurance coverage through June 30,2010 for noninterest-bearing transaction accounts (typically business checkingaccounts) and certain funds swept into noninterest-bearing savingsaccounts.  Institutions participating inthe TLGP pay a 10 basis points fee (annualized) on the balance of each coveredaccount in excess of $250,000, while the extra deposit insurance is inplace.  The TLGP also includes the Debt GuaranteeProgram (“DGP”), under which the FDIC guarantees certain senior unsecured debtof FDIC-insured institutions and their holding companies.  The unsecured debt must be issued on or afterOctober 14, 2008 and not later than June 30, 2009, and the guaranteeis effective through the earlier of the maturity date or June 30, 2012. OnMarch 17, 2009, the FDIC adopted an interim rule that extends the DGP andimposes surcharges on existing rates for certain debt issuances.  Thisextension allows institutions that have issued guaranteed debt before April 1,2009 to issue guaranteed debt during the extended issuance period that ends on October 31,2009. For such institutions, the guarantee on debt issued on or after April 1,2009, will expire no later than December 31, 2012. The DGP coverage limitis generally 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

 

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certain insured institutions, 2% of their liabilities as of September 30,2008.  Depending on the term of the debtmaturity, the nonrefundable DGP fee ranges from 60 to 110 basis points(annualized) for covered debt outstanding until the earlier of maturity or June30, 2012 and 75 to 125 basis points (annualized) for covered debt outstandinguntil after June 30, 2012.  The TAGPand DGP are in effect for all eligible entities, unless the entity opted out onor before December 5, 2008.  At September 30,2009, the Bank is participating in the TLGP. The Company and the Bank are participating in the DGP as of September 30,2009 but have elected not to have the option of issuing certain non-guaranteedsenior unsecured debt before issuing the maximum amount of guaranteeddebt.  Had we selected thisnon-guaranteed debt option, the FDIC would have assessed the Bank 37.5 basispoints times its two percent of liabilities as of September 30, 2008.

 

**Overview**

 

The followingdiscussion describes our results of operations for the three-month andnine-month periods ended September 30, 2009 as compared to the three-monthand nine-month periods ended September 30, 2008, and also analyzes ourfinancial condition as of September 30, 2009 as compared to December 31,2008.  Like most community banks, wederive most of our income from interest we receive on our loans andinvestments.  Our primary source of fundsfor making these loans and investments is our deposits, on which we payinterest.  Consequently, one of the keymeasures of our success is our amount of net interest income, or the differencebetween the income on our interest-earning assets, such as loans andinvestments, and the expense on our interest-bearing liabilities, such asdeposits.  Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

Of course, thereare risks inherent in all loans, so we maintain an allowance for loan losses toabsorb probable losses on existing loans that may become uncollectible.  We establish and maintain this allowance bycharging a provision for loan losses against our operating earnings.  In the following section, we have included adetailed discussion of this process.

 

In addition toearning interest on our loans and investments, we earn income through fees andother expenses we charge to our customers. We describe the various components of this noninterest income, as wellas our noninterest expense, in the following discussion.

 

#### **The following discussion and analysis also identifiessignificant factors that have affected our financial position and operatingresults during the periods included in the accompanying financialstatements.  We encourage you to readthis discussion and analysis in conjunction with the financial statements andthe related notes and the other statistical information also included in thisreport.**

#### ** **

The Company doesnot undertake, and specifically disclaims any obligation, to publicly releasethe result of any revisions which may be made to any forward-looking statementsto reflect events or occurrences after the date of such statements or toreflect the occurrence of anticipated or unanticipated events.

 

**Changesin Financial Position**

 

Total assets at September 30, 2009 were $2,051.7million, an increase of $527.4 million, or 34.6%, compared to assets of$1,524.3 million at December 31, 2008. The increase included assets acquired from the American Community mergertotaling $545.1 million.  Without theadditional assets acquired in the merger, assets would have decreased $17.6million or 1.2%. Theloan portfolio, net of allowance for losses, was $1,592.1 million including netloans at fair value from the American Community acquisition of $416.3 millionat April 17, 2009, compared to $1,165.2 million at December 31,2008.  Gross loans held for investmentincreased by $458.8 million, or 38.6%, of which $416.3 million came from theAmerican Community acquisition. Excluding the impact of the American Communityacquisition, gross loans held for investment increased by $42.5 million, or 3.6%.  The allowance for loan losses increased $31.9million driven primarily by increased net charge-offs for the nine months endedSeptember 30, 2009, which totaled $13.4 million,

 

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and provision expense of $45.3 million due to rising trends in the Bank’spast due and nonaccrual loans, and the state’s rising unemployment rates.

 

Loan growthconcentration was divided within the following categories.  Commercial loans increased by $30.9 millionwith $58.3 million acquired at the American Community merger.  Commercial real estate loans increased by$151.2 million with $99.4 million acquired at the American Communitymerger.  Construction and landdevelopment loans increased by $142.3 million with $131.9 million acquired atthe American Community merger. Home equity lines of credit increased $64.5million with $47.8 million acquired at the American Community merger. Consumerloans increased by $12.5 million with $12.9 million acquired at the AmericanCommunity merger.  Loans were funded bycertificates of deposit (“CODs”), negotiable orders of withdrawal (“NOW”), andmoney market deposits.  The Bank promotedone or more special COD rates throughout the period.

 

Mortgage loansheld for sale decreased by $3.0 million, or 6.1%, from December 31, 2008to September 30, 2009 as the Bank continued its strategy of sellingmortgage loans mostly to various investors with servicing rights released andto a lesser extent to the Federal National Mortgage Association with servicingrights retained.  These loans arenormally held for a period of two to three weeks before being sold toinvestors.  The timing of the loansclosed within each month allowed the Bank to sell more of its outstanding loansat September 30, 2009 than at December 31, 2008.  Mortgage loans closed in the first ninemonths of 2009 ranged from a low of $72.5 million in September to a highof $225.4 million in March and totaled $1,392.0 million.  In the first nine months of 2008, total loansclosed were $772.6 million.  Mortgageloans sold during the nine months ended September 30, 2009 totaled$1,396.0 million compared to $780.5 million during the same period in the prioryear. During April, 2008, Sidus expanded its footprint along the East Coast byentering into nine new states in the New England area. This, along with thedrop in mortgage interest rates, contributed to the increase in gains on salesof mortgages and to the increased volume in mortgage loans originated and sold.

 

The securitiesportfolio increased from $137.8 million at December 31, 2008, to $191.4million at September 30, 2009, an increase of 38.9%, with $71.7 millionacquired in the American Community merger. The portfolio is comprised of securities of U.S. government agencies(23.7%), mortgage-backed securities (43.8%), state and municipal securities(32.4%), and publicly traded common and preferred stocks (0.1%).  Temporary investments, including deposits atthe Federal Home Loan Bank and federal funds sold, increased from approximately$469,000 at December 31, 2008 to $2.3 million at September 30, 2009.

 

Other assetsincreased $27.7 million due largely to the $13.3 million acquired in thepurchase of American Community, of which $7.0 million was related to deferredtax assets and income tax receivables. OREO increased $5.3 million with $433,000 attributable to the AmericanCommunity merger and foreclosures in the amount of $9.5 million lessdispositions of $3.2 million and losses of $1.4 million.

 

The Company evaluates the banking segment for impairment on an annualbasis at April 30 and the Sidus segment on October 1,respectively.  The Company performed aninterim goodwill impairment test because the market price of the Company’sstock was below book value at the balance sheet date.  Upon evaluation, management determined thatgiven the substantial declines in common stock price, declining operatingresults, asset quality trends, market comparables and the economic outlook forour industry, impairment existed in the banking segment, including the newlyacquired goodwill from American Community, and a full impairment charge of$61.6 million was taken for goodwill related to the banking segment.  See additional disclosures and discussionsregarding the goodwill impairment in Footnote 15 to the financial statements.

 

Deposits increased $591.7 million, or 51.2%, comparing September 30,2009 to December 31, 2008. Deposits totaling $439.9 million wereattributable to the American Community acquisition.  Overall, noninterest-bearing demand deposits increased $52.1million, or 33.9%, which includes $50.2 million from the American Communityacquisition. NOW, savings, and money market accounts increased $129.8 million,or 45.7%, with American Community contributing $82.6 million. Certificates ofdeposit (“CODs”) over $100,000 increased $216.1 million, or 64.8%, and otherCODs increased $193.7 million, or 50.4%. American Community contributed $183.5 million in CODs over

 

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$100,000 and$123.6 million in other CODs, with the remaining increase primarily due toincreases in brokered deposits. Excluding American Community, the largest increase in interest-bearingdeposits was in the money market accounts which increased $42.3 million. NOWaccounts and savings increased $4.4 million. The Bank promoted one ormore special money market account rates throughout the period.

 

Borrowed fundsdecreased $71.7 million or 34.5 % comparing September 30, 2009 to December 31,2008.  Advances from the FHLB decreased$89.4 million excluding the $26.0 million in FHLB advances acquired fromAmerican Community, for a net decrease in FHLB advances of $63.4 million.  Repurchase agreements increased $14.8million, with $16.9 million added in the American Community merger, andovernight borrowings decreased $23.2 million.  Long term borrowings included $34.9 million in trust preferredsecurities and advances from the FHLB of $39.1 million.  The American Community merger added $10.3million in trust preferred securities at a rate equal to the three-month LIBORrate plus 2.80% and will mature in 2033. Yadkin Valley Statutory Trust I (“the Trust”) issued $25.8 million intrust preferred securities at a rate equal to the three-month LIBOR rate plus1.32%.  The trust preferred securities mature in 30 years, and can becalled by the Trust without penalty after five years.

 

Other liabilitiesincreased by $8.1 million, or 99.9%, from December 31, 2008 to September 30,2009. Of that increase, $5.7 million was attributable to the other liabilities acquiredfrom the purchase of American Community. Increases in accounts payable of $2.6 million and additional accrualsfor FDIC expense of $900,000 also contributed to the increase.

 

At September 30,2009, total shareholders’ equity was $149.1 million or a book value of $6.39per common share compared to $149.6 million or a book value of $12.97 per shareat year-end December 31, 2008.  At September 30,2009, the Company was in compliance with all existing regulatory capitalrequirements. The Company’s equity to assets ratio was 7.27% and 9.8%,respectively, at September 30, 2009 and December 31, 2008.

 

The following table sets forth the Company’s and the Bank’s variouscapital ratios as of September 30, 2009, and December 31, 2008.  On an ongoing basis, we continue to evaluatevarious options, such as issuing common or preferred stock, to increase thebank’s capital and related capital ratios in order to maintain adequate capitallevels.  The Company and the Bankexceeded the minimum regulatory capital ratios as of September 30, 2009,as well as the ratios to be considered “well capitalized.”

 
| ** **                       | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Holding  Company**        | ** ** | **Bank**                   | ** ** | **Holding  Company** | ** ** | **Bank** | ** ** |
|                             |       |                        |       |                       |       |   |   |   |   |
| Total risk-based capital  ratio  |       | 10.5                        | %          | 10.2                       | %          | 10.2 | % | 10.1 | % |
| Tier 1 risk-based capital  ratio |       | 9.3                         | %          | 8.9                        | %          | 9.0 | % | 8.9 | % |
| Leverage ratio                   |       | 7.8                         | %          | 7.5                        | %          | 8.1 | % | 8.0 | % |

 

Capital adequacy is an important indicator of financial stability andperformance.  Our goal has been tomaintain  a “well-capitalized” status forthe Bank since failure to meet or exceed this classification affects howregulatory applications for certain activities, including acquisitions,continuation and expansion of existing activities, are evaluated and could makeour customers and potential investors less confident in our Bank.

 

**Liquidity,Interest Rate Sensitivity and Market Risk**

 

The Bank derivesthe majority of its liquidity from its core deposit base and to a lesser extentfrom wholesale borrowing.  The balancesheet liquidity ratio, measured by the sum of cash (less reserve requirements),investments, and loans held for sale reduced by pledged securities, as comparedto deposits and short-term borrowings, was 11.5%

 

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at September 30,2009 compared to 11.9% at December 31, 2008.  Additional liquidity is provided by $161.2million in unused credit including federal funds purchased lines provided bycorrespondent banks as well as credit availability from the FHLB. In addition,the Bank has unpledged marketable securities of $80.9 million available for useas a source of collateral.  At September 30,2009, brokered deposits totaled $112.2 million, or 6.4% of total deposits, andconsisted of certificates of deposit totaling $60.4 million, CDARS® products,and NOW public funds totaling $3.1 million. Brokered certificates of deposit are primarily short-term withmaturities of nine months or less.

 

The Bankcontracted with Promontory Interfinancial Network in 2008 for various servicesincluding wholesale CD funding. Promontory’s CDARS® product, One-Way BuySM, enables the Bank to bid on a weekly basis through aprivate auction for CD terms ranging from four weeks to 260 weeks(approximately five years) with settlement available each Thursday. At September 30,2009, the balance of funds acquired through the One-Way Buy product totaled$25.7 million.

 

Promontory alsoprovides a product, CDARS® Reciprocal, which allows the Bank’s customers toplace funds in excess of the FDIC insurance limit with Promontory’s network ofparticipating Banks so that the customer is fully insured for the amountdeposited. Promontory provides reciprocating funds to the Bank from fundsplaced at other banks by their customers. The Bank sets its customers’ interestrates when they place deposits through the network and pays/receives the ratedifference to/from the other banks whose reciprocal funds are held by the Bank.The overall impact of this process is that the Bank effectively pays the rateoffered to its relationship customer. Therefore, the Bank does not considerthese funds to be wholesale or brokered funds. In compliance with FDICreporting requirements, the Bank reports include reciprocal deposits asbrokered deposits in its quarterly Federal Financial Institutions ExaminationCouncil Call Report.  At September 30,2009, CDARS® reciprocal deposits totaled $23.0 million.

 

Management continues to assess interest rate risk internally and byutilizing outside sources.  The balancesheet is asset sensitive over a three-month period, meaning that there will bemore assets than liabilities immediately repricing as market rates change. Overa period of twelve months, the balance sheet remains slightly asset sensitive.We generally would benefit from increasing market interest rates when we havean asset-sensitive, or a positive interest rate gap, and we would generallybenefit from decreasing market interest rates when we have liability-sensitive,or a negative interest rate gap.

 

The mortgage loans held for sale by Sidus are funded by short-termborrowings and brokered deposits. Although the repricing dates of the mortgage assets and borrowings areapproximately the same, the interest rate spread fluctuates because the assetsand liabilities reprice at different points on the yield curve.  The fifteen to thirty year mortgage assets,usually held for two to three weeks prior to being sold, are priced based onthe fifteen to thirty year mortgage-backed security yield curve, whereas theborrowing rates to fund Sidus’ loans are based on the one month point on theLIBOR yield curve.  While the netinterest income between these points is positive unless the yield curve isinverted, a decrease in the slope of the yield curve will result in a decreasein the net interest margin for Sidus. Conversely, an increase in the slope will result in an increase in Sidus’net interest margin.  The yield curve forthe first nine months of 2009 was generally steeper than it was for the firstnine months of 2008, and as expected, Sidus’ net interest margin increased by37 basis points from the third quarter of 2008 to the third quarter of 2009 andby 135 basis pointsfrom the first nine months of 2008 to the first nine months of 2009.

 

The Company hasnot used derivative financial instruments such as futures, forwards, swaps andoptions historically, however, such instruments are available to management ifneeded.  The Company has no market risksensitive instruments held for trading purposes.  The Company’s exposure to market risk isreviewed regularly by management.

 

The management of equity is a critical aspect of capital management inany business. The determination of the appropriate amount of equity is affectedby a number of factors. The primary factor for a regulated financialinstitution is the amount of capital needed to meet regulatory requirements,although other factors, such as the “risk equity” the business requires andbalance sheet leverage, also affect the determination. To be categorized aswell capitalized, the

 

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Company and the Bank each must maintain minimum amounts andratios.  At September 30, 2009, theCompany was in compliance with all existing regulatory requirements and iswell-capitalized for regulatory purposes both at the bank and holding companylevel.  The Company suspended itsquarterly cash dividend in September 2009 and will continue to evaluate anumber of capital raising options.

 

**Resultsof Operations**

 

Net loss for thethree-month period ended September 30, 2009 was $68.3 million beforepreferred dividends, compared to net income of $1.8 million in the same periodof 2008.  The largest contributor to theincreased loss was a $61.6 million goodwill impairment writedown.  See additional disclosures and discussionsregarding the goodwill impairment in Footnote 15 to the financialstatements.  Net loss allocated to commonshareholders for the three-month period ended September 30, 2009 was $69.0million.  Basic and diluted losses percommon share were $4.28 for the three-month period ended September 30,2009.  Basic and diluted earnings percommon share were $0.16 and $0.15 for the three month period ended September 30,2008, respectively.  On an annualizedbasis, third quarter results represent a return on average assets of (12.70%)at September 30, 2009 compared to (0.69%) at December 31, 2008 and 0.49%at September 30, 2008, and a return on average equity of (125.9%) comparedto (6.64%) at December 31, 2008 and 4.66% at September 30, 2008.

 

Net loss for thenine-month period ended September 30, 2009 was $79.0 million beforepreferred dividends, compared to net income of $6.4 million in the same periodof 2008.  Net loss allocated to commonshareholders for the nine-month period ended September 30, 2009 was $80.7million.  Basic and diluted losses percommon share were $5.62 for the nine-month period ended September 30,2009.  Basic and diluted earnings percommon share were $0.57 for the nine-month period ended September 30,2008.  On an annualized basis,year-to-date results represent a return on average assets of (5.54%) at September 30,2009 compared to 0.64% at September 30, 2008, and a return on average equity of(51.0%) compared to 5.87% at September 30, 2008.

 

###### **Net Interest Income**

###### ** **

Net interestincome, the largest contributor to earnings, increased $7.8 million or 73.0% to$18.4 million in the third quarter of 2009, compared with $10.6 million in thesame period of 2008. Net interest income earned by the recently acquiredAmerican Community region was $2.5 million for the quarter.  The net interest margin increased slightly to3.82% in the third quarter of 2009 from 3.80% in the second quarter of 2009 andincreased from 3.33% in the third quarter of 2008.

 

Net interestincome for the nine-month period ended September 30, 2009 increased to $45.8million from $30.4 million when compared to the same period in 2008. Thedecrease in the prime interest rate was offset by the additional net interestincome earned by the recently acquired American Community region of $4.7million for the period and the accretion of fair market valuations of $8.3million. The net interest margin increased to 3.54% in the first nine months of2009 from 3.39% in the first nine months of 2008.  The increase in margin year over year wasdriven by the accretion of fair market valuations of loans and depositsacquired in the merger with American Community. Excluding the accretion, net interest margin for the first nine monthsof 2009 decreased to 2.89% as compared to 3.39% in the first nine months of 2008.   A comparison of the first nine months of2009 and 2008 shows that yield on earning assets decreased by 88 basis pointswhich was offset by a decrease of 123 basis points in the cost on interestbearing liabilities.  The significantchange in yields on interest earning assets and interest bearing liabilitiesare the result of the $8.3 million accretion of fair market valueadjustments.  Fair market valueadjustments are accreted on a double declining basis over 112 months.  Roughly half of the total fair market valueadjustments recorded at the merger have been accreted into income during thepast six months.  The decline in yield onearning assets was attributable to the yield on loans which declined by 89basis points in the first nine months of 2009 as compared to the first ninemonths of 2008.  Variable rate loans thatreprice within three months together with fixed rate loans that mature withinthree months comprised 32.7% of total loans held for investment at September 30,2009, down from 45.0% at September 30, 2008.  The Company maintains an asset-sensitiveposition with respect to the impact of changing rates on net interest income.

 

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After a period ofabout twelve months following a rate increase, the Company’s net interestmargin should begin to increase assuming a constant mix of asset and liabilitycategories. The Company’s internal management reports indicate that the monthlynet interest margin, excluding the impact of Sidus, reached its lowest pointfor the first nine months during May and began to rise in June.  Comparing the linked third and secondquarters of 2009, the net interest margin expanded by 6 basis points.

 

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**Average Balance Sheets and Net Interest Income Analysis**

**(Dollars inThousands)**

 
| ** **                                               | ** ** | **September 30, 2009** | ** ** | **September 30, 2008** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **(Unaudited)**                                          | ** ** | **Average**                      | ** ** | ** **                       | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| **Nine Months Ended:**                         | ** ** | **Balance**                      | ** ** | **Interest**                     | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| INTEREST EARNING ASSETS                                  |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                       |       | $                                | 15,946     |                             | $          | 22 |   | 0.18 | % | $ | 4,294 |   | $ | 45 |   | 1.40 | % |
| Interest bearing deposits                                |       | 10,190                           |       | 31                               |       | 0.41 | % | 11,095 |   | 300 |   | 3.60 | % |
| Investment securities (1)                                |       | 172,597                          |       | 5,957                            |       | 4.61 | % | 142,817 |   | 5,603 |   | 5.23 | % |
| Total loans (1)(2)                                       |       | 1,563,466                        |       | 64,813                           |       | 5.54 | % | 1,057,970 |   | 51,104 |   | 6.43 | % |
| Total average earning  assets (1)                        |       | 1,762,199                        |       | 70,823                           |       | 5.37 | % | 1,216,176 |   | 57,052 |   | 6.25 | % |
| Noninterest earning assets                               |       | 185,963                          |       |                             |       |   |   | 129,706 |   |   |   |   |   |
| Total average assets                                     |       | $                                | 1,948,162  |                             |       |   |   |   | $ | 1,345,882 |   |   |   |   |   |
|                                                     |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| INTEREST BEARING  LIABILITIES                            |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| NOW and money market                                     |       | $                                | 332,470    |                             | $          | 2,266 |   | 0.91 | % | $ | 232,443 |   | $ | 3,010 |   | 1.73 | % |
| Savings                                                  |       | 45,822                           |       | 92                               |       | 0.27 | % | 36,942 |   | 155 |   | 0.56 | % |
| Time certificates                                        |       | 999,200                          |       | 19,711                           |       | 2.64 | % | 619,681 |   | 19,572 |   | 4.21 | % |
| Total interest bearing  deposits                         |       | 1,377,492                        |       | 22,069                           |       | 2.14 | % | 889,066 |   | 22,737 |   | 3.41 | % |
| Repurchase agreements sold                               |       | 57,051                           |       | 506                              |       | 1.19 | % | 50,005 |   | 922 |   | 2.46 | % |
| Borrowed funds                                           |       | 82,594                           |       | 1,635                            |       | 2.65 | % | 94,158 |   | 2,428 |   | 3.44 | % |
| Total interest bearing  liabilities                      |       | 1,517,137                        |       | 24,210                           |       | 2.13 | % | 1,033,229 |   | 26,087 |   | 3.36 | % |
|                                                     |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| Noninterest bearing  deposits                            |       | 178,193                          |       |                             |       |   |   | 155,585 |   |   |   |   |   |
| Shareholders’ equity                                |       | 206,860                          |       |                             |       |   |   | 146,134 |   |   |   |   |   |
| Other liabilities                                        |       | 45,972                           |       |                             |       |   |   | 10,934 |   |   |   |   |   |
| Total average liabilities  and shareholders’ equity |       | $                                | 1,948,162  |                             |       |   |   |   | $ | 1,345,882 |   |   |   |   |   |
| NET INTEREST INCOME/YIELD  (3)(4)                        |       |                             |       | $                                | 46,613     |   | 3.54 | % |   |   | $ | 30,965 |   | 3.39 | % |
|                                                     |       |                             |       |                             |       |   |   |   |   |   |   |   |   |
| INTEREST SPREAD (5)                                      |       |                             |       |                             |       | 3.24 | % |   |   |   |   | 2.89 | % |

 

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| (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 expense |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | The loan average includes loans on which accrual of interest has been  discontinued.                                                                                                                                                           |
| (3) | Net interest income is the difference between interest income from  earning assets and interest expense.                                                                                                                                       |
| (4) | Net interest margin 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.                                                                                    |

 

**Provisionsand Allowance for Loan Losses**

 

Adequacy ofthe allowance or reserve for loan losses of the Bank is a significant estimatethat is based on management’s assumptions regarding, among other factors,general and local economicconditions, which aredifficult to predict and are beyond the Bank’s control.  In estimating these loss reserve levels,management also considers the financial conditions of specific borrowers andcredit concentrations with specific borrowers, groups of borrowers, and 

 

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industries.

 

The loan loss provision is determined by management’s assessment of theamount of allowance for loan losses to absorb losses inherent in the loanportfolio due to credit deterioration or changes in the risk profile.  The allowance for loan losses is created bydirect charges to provision expense. Losses on loans are charged against the allowance for loan losses in theaccounting period in which they are determined by management to beuncollectible.  Recoveries during theperiod are credited to the allowance for loan losses.

 

The Bank calculated an allowance for loan losses of $54.3 million at September 30,2009, or 3.30% of loans held for investment, as compared to $22.4 million, or1.88% of loans held for investment, at December 31, 2008 based on theapplication of its model for the allowance calculation applied to the loanportfolio at each balance sheet date. Increases in the allowance for loan losses were due to rising trends inthe Bank’s past due and non-performing loans (as discussed in the followingnonperforming assets section) and rising unemployment rates.  This increase in non-performing loans is adirect result of the weak economic environment, taking a toll on numerousborrowers’ ability to pay as scheduled. This has resulted in increased loan delinquencies, and in some casesimpairment of the value of the collateral used to secure real estate loans andthe ability to sell the collateral upon foreclosure.  Collateral value is assessed based oncollateral value trends, liquidation value trends, and other liquidationexpenses to determine logical and credible discounts that may be needed.  In response to this deterioration in realestate loan quality, management is aggressively monitoring its classified loansand is continuing to monitor credits with material weaknesses.

 

Ourreal estate portfolio has approximately $375.1 million of construction loans,$611.6 million of commercial real estate loans, $363.7 million in first lienmortgage loans, and $5.8 million in junior lien mortgage loans as of September 30,2009.  We consider our construction and junior lien mortgage loans ourriskiest loans within our real estate portfolio.  We do not have any option ARM products orsubprime loans in our portfolio. Construction loans are typically comprised of loans to borrowers forreal estate to be developed (into properties such as sub-divisions or spechouses).  Normally, these loans are repaid with the proceeds from the saleof the developed property.  The greater degree of strain on these realestate types of loans and the significance to our overall loan portfolio hascaused us to apply a greater degree of scrutiny in analyzing the ultimatecollectability of amounts due.  The majority of these borrowers are havingfinancial difficulties.  Our analysis has resulted in a significantprovision expense in order to increase our allowance to appropriate levelsbased on our estimates.   As of September 30,2009, $40.8 million of our real estate loans had interest reserves includingboth borrower and bank funded.  There isa risk that an interest reserve could mask problems with a borrower’swillingness and ability to repay the debt consistent with the terms andconditions of the loan obligation, therefore the Company has implemented reviewpolicies to identify and monitor all loans with interest reserves.

 

The allowance model is applied to the loan portfolio quarterly todetermine the specific allowance balance for impaired loans and the generalallowance balance for performing loans grouped by loan type.  Out of the $54.3 million in total allowancefor loan losses at September 30, 2009, the specific allowance for impairedloans accounted for $11.4 million, up from $3.7 million at year end.  The remaining general allowance, $42.9million, was attributed to performing loans and was up from $18.7 million atyear end.  Increased charge-offs for therolling eight quarters ended September 30, 2009 as compared to the eightquarter period ending December 31, 2008 accounted for approximately 88% ofthe increase in general allowance.  Othermodel factors that added to the allowance included rising trends in the Bank’spast due and nonaccrual loans and rising unemployment rates.  Usually, we expect the general allowance onperforming loans to increase when periods of economic weakness are coupled withlook-back periods of increasing charged-offs. Conversely, we expect the general allowance to decrease as a percentageof loans when a stronger economy is combined with a decrease in the rollingeight-quarter average of the Bank’s charged off loans.

 

Net loan charge offs (recoveries) were $13,378,202, or 1.14%(annualized), of average loans held for investment, for the nine months ending September 30,2009 compared to $1,069,381, or 0.14% (annualized), of average loans held forinvestment, for the nine months ending September 30, 2008.  The increase over last year was caused bysome weakening in the economy resulting in an uptick in charge-offs across allloan types.  The following is a summaryof charge-off by loan category (in thousands):

 

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| ** **                              | ** ** | **For the nine months ended** | ** ** | **For the nine months ended** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | **September 30, 2009**   | ** ** | **September 30, 2008**   | ** ** |
| ** **                              | ** ** | ** **                    | ** ** | **Net charge-offs**           | ** ** | ** ** | ** ** | **Net charge-offs** | ** ** |
| ** **                              | ** ** | ** **                    | ** ** | **to average**                | ** ** | ** ** | ** ** | **to average** | ** ** |
| **Loan Type**                           | ** ** | **Net Charge-offs**           | ** ** | **balances**                  | ** ** | **Net Charge-offs** | ** ** | **balances** | ** ** |
| Construction                            |       | $                             | 4,576      |                          | 1.50       | % | $ | 51 |   | 0.03 | % |
| Commercial, financial and  agricultural |       | 4,658                         |       | 2.36                          | %          | 239 |   | 0.17 | % |
| Mortgage                                |       | 270                           |       | 0.11                          | %          | 81 |   | 0.05 | % |
| Commercial real estate                  |       | 1,726                         |       | 0.34                          | %          | 63 |   | 0.02 | % |
| Installment loans                       |       | 737                           |       | 0.96                          | %          | 404 |   | 0.63 | % |
| Revolving 1-4 family loans              |       | 1,411                         |       | 0.85                          | %          | 231 |   | 0.21 | % |
| Total                                   |       | 13,378                        |       | 1.14                          | %          | 1,069 |   | 0.31 | % |
|                                         |            |                               |            |                               |            |  |  |  |  |  |  |

 

Generally, all loans with outstanding balances of $100,000 or greaterthat have been identified as impaired, are reviewed periodically in order todetermine if a specific allowance is required. Charge off history, credit administration’s determination of loanimpairment and risk grades, and other internal and external qualitative factorsare primary considerations in calculating the allowance for loan losses.  The risk grades are based on several factorsincluding historical data, current economic factors, and assessments ofindividual credits within specific loan types. Because these factors are dynamic, the provision for loan losses canfluctuate.  Periodic credit qualityreviews performed on a sample basis are based primarily on analysis ofborrowers’ cash flows, with asset values considered only as a second source ofpayment (except where the sale of the asset is considered to be the primarysource of repayment).

 

Management uses several measures toassess and monitor the credit risks in the loan portfolio, including a loangrading system that begins upon loan origination and continues for the entirelife of the loan.  Upon loan origination,the Bank’s originating loan officer evaluates the quality of the loan andassigns one of eight risk levels.  Theloan officer monitors the loan’s performance and credit quality and makeschanges to the risk grade as conditions warrant.  The Chief Credit Officer coordinates the loanapproval process for loans not involving the Board of Directors by delegatingauthority to certain lenders with Board approval. The Bank Loan Committee iscomprised of senior bank management and approves new loans and relationshipexposures over certain dollar amounts. Officer loan approval limits arereviewed and approved by the Board of Directors.  The Chief Credit Officer is responsible forthe credit policy which includes underwriting guidelines and procedures.  The Chief Credit Officer is a voting memberof the Bank Loan Committee.

 

Management uses the information developed from the procedures above inevaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality ofthe loan portfolio and to assist management in determining the appropriatelevels of the allowance for loan losses.

 

As a part of the continual grading process, loans over $20,000 areassigned a credit risk grade based on their credit quality, which is subject tochange as conditions warrant.  Anychanges in risk assessments as determined by loan officers, creditadministrators, regulatory examiners and management are also considered.  Management considers certain loans graded “doubtful”or “loss” to be individually impaired and may consider “substandard” loansindividually impaired depending on the borrower’s payment history.  The Bank measures impairment based uponprobable cash flows and the value of the collateral.  Collateral value is assessed based oncollateral value trends, liquidation value trends, and other liquidationexpenses to determine logical and credible discounts that may be needed.   Updated appraisals are required for allimpaired loans and typically at renewal or modification of material loans ifthe appraisal is greater than 12 months old. Impaired loans are identified and evaluated for specific reserves in 

 

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a periodic analysis of the adequacy of the reserve.  In estimating reserve levels, the Bankaggregates the remaining loans not deemed to be impaired and reviews thehistorical loss experience as well as environmental factors by type of loan asadditional criteria to allocate the allowance. The historical loss experience factors applied to “watch list” and “substandard”loans that are not individually impaired are adjusted for other factors thatare not necessarily captured in the historical loss ratios.  Internal environmental factors applied toperforming loan pools include past-due and nonaccrual trends, risk grademigration trends and the assessment of underwriting and servicing.  External environmental factors includeinterest rate trends, unemployment rate trends, and real estate loanconcentrations.  There were no changes inthe current quarter to the model other than changes in factors discussedabove.  We are currently re-evaluatingthe methodologies used in our allowance model for estimating reserves on ourperforming loans, including internal and external environmental factors,adjustments, and other factors utilized.

 

Management considers the allowance for loan losses adequate to coverthe estimated losses inherent in the Bank’s loan portfolio as of September 30,2009. No assurance can be given in this regard, however, especially consideringthe overall weakness in the commercial real estate market in the Bank’s marketareas. Management believes it has established the allowance in accordance withaccounting principles generally accepted in the United States of America andwill consider future changes to the allowance that may be necessary based onchanges in economic and other conditions. Additionally, various regulatory agencies, as an integral part of theirexamination process, periodically review the Bank’s allowance for loanlosses.  Such agencies may require therecognition of adjustments to the allowances based on their judgments ofinformation available to them at the time of their examinations.

 

Management realizes that general economic trends greatly affect loanlosses. The recent downturn in the real estate market has resulted in increasedloan delinquencies, defaults and foreclosures, and we believe that these trendsare likely to continue. In some cases, this downturn has resulted in asignificant impairment to the value of our collateral and our ability to sellthe collateral upon foreclosure. The real estate collateral in each caseprovides an alternate source of repayment in the event of default by theborrower and may deteriorate in value during the time the credit is extended.If real estate values continue to decline, it is also more likely that we wouldbe required to increase our allowance for loan losses and our net charge-offswhich could have a material adverse effect on our financial condition andresults of operations. Assurances cannot be made either (1) that further chargesto the allowance account will not be significant in relation to the normalactivity or (2) that further evaluation of the loan portfolio based onprevailing conditions may not require sizable additions to the allowance andcharges to provision expense.

 

As of September 30, 2009, the allowance for loan losses was $54.3million, or 3.30%, of gross loans held for investment.  This allowance level compares with $22.4million, or 1.88%, of loans held for investment at December 31, 2008, and$16.5 million, or 1.48%, at September 30, 2008.

 

**NonperformingAssets**

 

Totalnon-performing assets increased from $17.7 million to $55.1 million and from1.16% to 2.68% of total assets as of December 31, 2008 and September 30,2009, respectively.  Total OREO increasedfrom approximately $4.0 million at December 31, 2008 to $9.4 million at September 30,2009.  Total nonaccrual loans increasedfrom $13.6 million, or 1.10% of loans, at December 31, 2008 to $45.7million, or 2.70% of loans, at September 30, 2009, with $8.6 millionacquired in the merger with American Community.   The increases in nonaccrual loans, impairedloans, and OREO are the result of some economic softening in our markets duringthe past nine months.   We have analyzedour non-performing loans to determine what we believe is the amount needed toreserve in the allowance for loan losses based on an assessment of thecollateral value or discounted cash flows of the loan.  We have downgraded loans for which the probabilityof collection is more uncertain and written down OREO property values where netrealizable values have declined.  Specificallowance for nonperforming loans accounted for $11.4 million, up from $3.7million at year end.

 

The increase in non-performing loans from December 31, 2008 to September 30,2009 is related primarily to continued deterioration in the Bank’s overallconstruction loan portfolio. The total number of loans on nonaccrual hasincreased from 101 to 285 since December 31, 2008, of which 91 wereacquired from American Community. The average non-

 

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accrual loan balance is $129,293 and $159,402 as of December 31,2008 and September 30, 2009, respectively.  At September 30,2009, 89% of the non-accrual loans were secured by real estate.

 

The largest amountof nonaccrual loans for one customer totaled $2.4 million of construction loansfor which $1.3 million was specifically assigned to the allowance. Nonaccrualloans also included two other large relationships each totaling $1.9 million.  The first relationship is a commercial, nonreal estate loan, with specific allowances of $1.0 million, and the otherrelationship consists of construction loans with specific allowances of$110,000.  These loans were placed innonaccrual status because of the customers’ inability to pay, collateraldeterioration and dismal future industry outlook.  The following table is a breakdown of allnonaccrual loans by type:

 
| ** **                             | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | ** **                   | ** ** | **% of  Total**             | ** ** | ** ** | ** ** | **% of  Total** | ** ** |
| **Loan Type**                          | ** ** | **Balance**                  | ** ** | **Nonaccrual  Loans**       | ** ** | **Balance** | ** ** | **Nonaccrual  Loans** | ** ** |
| Construction                           |       | $                            | 23,164,052 |                        | 50.7       | % | $ | 5,036,053 |   | 32.4 | % |
| Commercial, financial and agricultural |       | 4,798,088                    |       | 10.5                        | %          | 4,657,327 |   | 30.6 | % |
| Mortgage                               |       | 8,208,460                    |       | 18.0                        | %          | 1,818,458 |   | 20.5 | % |
| Commercial real estate                 |       | 9,115,359                    |       | 20.0                        | %          | 1,593,673 |   | 15.2 | % |
| Installment loans                      |       | 13,523                       |       | 0.0                         | %          | 323,008 |   | 1.2 | % |
| Open end, unsecured                    |       | 385,753                      |       | 0.8                         | %          | 218,793 |   | 0.1 | % |
| Total                                  |       | $                            | 45,685,235 |                        | 100.0      | % | $ | 13,647,312 |   | 100.0 | % |

 

All loans more than 90 days past due are put on nonaccrual and stopaccruing interest.  In addition, loans are placed on nonaccrual status if,based on current information, circumstances, or events, we believe it isprobable that the Bank will not collect the scheduled payments of principal andinterest when due according to the contractual terms of the loan agreement.Nonaccrual loan relationships with balances of at least $100,000 will beconsidered impaired and evaluated for specific allowances as needed.   When a nonaccrual loan has paid according tothe schedule for at least six months, or waiver granted by the Chief CreditOfficer, and the customer demonstrates the intent and ability to continue topay in a timely manner, the Bank may begin accruing interest, and it will nolonger be considered impaired.

 

**NoninterestIncome**

 

Noninterest incomeconsists of all revenues that are not included in interest and fee incomerelated to earning assets.  Totalnoninterest income increased approximately $1.7 million, or 39.5%, comparingthe third quarters of 2009 and 2008. Total noninterest income increasedapproximately $6.6 million, or 54.1%, for the nine months ended September 30,2009 as compared to noninterest income for the nine months ended September 30,2008. The fluctuations in the income categories that make up noninterest incomeare as follows:

 

·  Quarter to date service charges on deposit accountsincreased $405,000 due mainly to income from American Community of $498,000.Excluding American Community, ATM charges decreased $53,000 and NSF fee incomedecreased $48,000.

 

Year to dateincreases in service charges on deposit accounts of $913,000 included incomefrom American Community of $959,000. Excluding American Community, ATM charges decreased $59,000 and NSF feesdecreased $10,000.  Offsetting thisdecrease was an increase in service charges of $29,000.

 

·  Quarter to date other service fee income increased byapproximately $331,000 due to income from American Community of $105,000 andincreases in the commission income for mortgage originations and 

 

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investment feeincome of $300,000.  Increases werepartially offset by decreases in merchant fee income and credit card user feesof $121,000.  

 

Year to date otherservice fee income increased approximately $1.0 million due to income fromAmerican Community of $142,000 and increases in commissions and fees of$788,000.

 

·  Quarter to date results show an increase in net gainin the sale of mortgages of approximately $878,000 or 46.9% as total loansoriginated and sold increased.  Thedecline in conventional mortgage rates since 2008 resulted in an increase inmortgage loans originated from $247 million in the third quarter of 2008 to$251 million in the third quarter of 2009.

 

Year to date, gainon sale of mortgage loans increased by approximately $5.3 million or 98.0% forthe same reasons as discussed above.

 

·  Income on investment in bank-owned life insurance (“BOLI”)decreased only slightly by 1.1% for the quarter to date and 0.77% for the yearto date.

 

·  Mortgage banking income increased approximately$18,000 to a gain for the quarter of $7,000 due to an increase in the averageservicing portfolio for the quarter in comparison to the prior year.  The increase in portfolio size was offsetpartially by decreases in the valuation adjustment to mortgage servicing rights(“MSR”) and a drop in the servicing fees received.

 

Year to date,mortgage banking income decreased approximately $574,000 due in part to thevaluation adjustment to mortgage servicing rights (“MSR”) to reflect a steadydecline in the average serviced mortgage balances and a drop in servicing feesreceived.  The decline in servicedmortgage balances was attributed to the market rate decreases that resulted inserviced mortgage customers refinancing.

 

·  Other income increased by approximately $33,000 or 54.0%for the quarter and decreased $46,000 for the year mainly due to the reductionin dividend income from the FHLB.

 

**NoninterestExpense**

 

Total noninterestexpenses were $78.9 million for the third quarter of 2009, compared to $10.9million in the same period of 2008, an increase of $68.0 million, or 624.1%. Totalnoninterest expenses were $109.9 million for the nine months ended September 30,2009, compared to $29.8 million for the same period of 2008, an increase of$80.1 million, or 269.1%.  The largestcontributor to the increase was a $61.6 million goodwill impairmentwritedown.  See additional disclosuresand discussions regarding the goodwill impairment in Footnote 15 to thefinancial statements.

 

The following is asummary of the fluctuations, other than goodwill impairment, for the quarterand nine months ended September 30, 2009 as compared to September 30,2008.

 

·            Quarter-to-date salaries and employeebenefit expenses increased by $2.6 million or 51.1%.  The major components of the $2.6 millionincrease are summarized as follows.  Salaries and wages increased by $2.1million, with $1.1 million related to the American Community acquisition. The increase in Sidus’ salaries of $429,000 was attributable to the additionalstaff necessary to process the increased mortgage loan volume.  Salaries and benefit costs directly relatedto loan originations, which are expensed over the life of the loan, increased$531,000, directly offsetting the increase in wages. These increased costdeferrals were a product of increases in (1) loan volume and (2) costper loan (held for investment) that

 

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was deferred.  Accruals for the mortgage lending subsidiary’sbonus incentive plan increased $115,000 based on performance measures. Other personnel expenses increased by $315,000, primarily for (1) post-retirementbenefit accruals from split-dollar policies and for (2) expensesassociated with operating the American Community division after itsacquisition.  In the aggregate, employee group insurance expense increasedby $180,000, payroll taxes by $133,000, and 401(k) matching contributionsby $68,000.  Most of the increases in these categories were associatedwith the addition of previous American Community employees.  Commissionexpenses increased by $186,000 as mortgage origination production at the Bankincreased.

 

Year-to-date increases in salaries and employee benefits were $6.6million or 44.1% for same reasons as discussed above.

 

·            Quarter-to-date occupancy and equipmentexpenses increased by $551,000 or 42.2%. The increase attributable tothe addition of the American Community branches was $570,000, offsetting theincrease was a decrease in maintenance expenses.

 

Year-to-date increases in occupancy andequipment expenses increased by $1.5 million, or 40.5%, for the same reasons asdiscussed above.

 

·            Printing and supplies increased by$169,000, or 96.1%, comparing third quarter 2009 with third quarter 2008. Theincrease attributable to the addition of the American Community branches was$62,000.  Certain training and mergersupplies required for the June 2009 conversion of American Community filesincreased the printing and supplies cost also.

 

Year-to-date increases in printing and supplies increased $293,000, or52.6%, for reasons discussed above.

 

·            Quarter-to-date data processing expenseincreased $132,000, or 60.8%, with $62,000 attributable to American Communityprocessing expenses.  Excluding AmericanCommunity, data processing expense increased by $70,000 due to the outsourcingof nightly processing to an outside company beginning in June 2009.

 

Year–to-date data processing expense increased$309,000, or 51.4%, for same reasons as discussed above.

 

·            Quarter-to-date communication expenseincreased $100,000, or 36.9%, with $129,000 attributable to American Communityexpenses.  Excluding American Community,communication expense decreased $29,000 due to the fact that in the quarterended September 30, 2008, additional expenses were incurred related to theCardinal State Bank acquisition.

 

Year–to-date communication expense increased $266,000,or 35.1%, with $185,000 attributable to American Community expenses.  Excluding American Community, communicationexpense increased $41,000, partially due to the installation of a newcommunication system and training provided.

 

·            Quarter-to-date advertising and marketingexpense increased $88,000, or 19.7%, with $12,000 attributable to AmericanCommunity expenses.  The increase is dueto additional advertising and marketing campaigns related to the merger with AmericanCommunity, and the introduction of new products.

 

Year-to-date advertising and marketing expenseincreased $165,000, or 21.2%, for the same reasons as discussed above.

 

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·            Amortization of the core depositintangible, recognized with the purchases of Main Street BankShares, Inc.in 2002, High Country Financial Corporation in 2004, Cardinal State Bank in2008, and American Community Bancshares, Inc in 2009, increased $98,000, or43.0%, for the quarter and $250,000, or 38.4%, for the year due to the purchaseof American Community on April 17, 2009.

 

·            Quarter-to-date and year-to-date FDICassessment expenses increased $774,000 and $3.0 million, respectively, due toadditional assessments imposed by the FDIC and an increase in deposits relatedto the American Community merger.

 

·            Quarter to date, other operating expenses(including attorney fees, accounting fees, and acquisition costs) increasedapproximately $2.1 million or 71.8% with American Community contributing$279,000 of the increase. The largest increases were in the followingcategories:  merger expenses incurred inthe acquisition of American Community of $292,000, attorney fees (up $351,000),accounting fees due to additional services (up $356,000); outside professionalservice fees, including transfer agent fees, (up $127,000); ATM and debit cardtransaction fees (up $117,000) and loan collection expense (up $361,000).

 

Year to date, other operating expenses increased $6.2 million or 84.5%with American Community contributing $511,000. The largest increases were inthe following categories:  mergerexpenses incurred in the acquisition of American Community of $2.6 million,attorney fees due to additional services (up $712,000), accounting fees (up$412,000); outside professional service fees, including transfer agent fees,(up $378,000); loan collection expense (up $521,000); check losses (up$168,000) and contributions (up $119,000).

 

**Income Tax Expense**

 

Income tax benefit for the third quarter of 2009 was $4.7 millioncompared to income tax expense of $795,000 in the third quarter of 2008, a decreaseof 693.0%.  The effective tax rate for the third quarter of 2009 was(6.5%) compared to 30.7% for the same period of 2008.   Decrease inthe effective tax rate was the result of the goodwill impairment charge whichhas no deferred or current tax implications. Excluding the impairment of goodwill, the effective tax rate for thethird quarter of 2009 was (41.3)%.  TheCompany will continue to monitor deferred tax assets for impairment.

 

Income tax benefit for the nine month period ended September 30,2009 was $11.5 million compared to income tax expense of $2.9 million for thesame period of 2008, a decrease of 495.7%.  The effective tax rate for thenine months ended September 30, 2009 was (12.7%) compared to 31.1% in thesame period of 2008.  The effective tax rate decrease was attributable tothe goodwill impairment.  Excluding theimpairment of goodwill, the effective tax rate for the nine months ended September 30,2009 was (39.8)%.

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

Market risk is therisk of loss from adverse changes in market prices and rates.  Our market risk arises principally frominterest rate risk inherent in our lending, deposit, and borrowing activities.  Management actively monitors and manages itsinterest rate risk exposure.  In additionto other risks that we manage in the normal course of business, such as creditquality and liquidity, management considers interest rate risk to be asignificant market risk that could potentially have a material effect on ourfinancial condition and results of operations. The information contained in Item 2 in the section captioned “Liquidity,Interest Rate Sensitivity and Market Risk” is incorporated herein byreference.  Other types of market risks,such as foreign currency risk and commodity price risk, do not arise in thenormal course of our business activities. The acquisition of American Community and expansion into new market areasin North and South Carolina have marketing risks that are mitigated by retainingthe American Community brand 

 

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name in thesemarkets.  Credit risk associated withloans acquired in the merger are part of the overall discussion of credit riskin the sections captioned “Provision and Allowance for Loan Losses” and“Non-Performing Assets.”

 

The primaryobjective of asset and liability management is to manage interest rate risk andachieve reasonable stability in net interest income throughout interest ratecycles.  This is achieved by maintainingthe proper balance of rate-sensitive earning assets and rate-sensitiveinterest-bearing liabilities.  Therelationship of rate-sensitive earning assets to rate-sensitiveinterest-bearing liabilities is the principal factor in projecting the effectthat fluctuating interest rates will have on future net interest income.  Rate-sensitive assets and liabilities arethose that can be repriced to current market rates within a relatively shorttime period. Management monitors the rate sensitivity of earning assets andinterest-bearing liabilities over the entire life of these instruments, butplaces particular emphasis on the next twelve months.  Following a period of rateincreases (or decreases) net interest income will increase (or decrease) overboth a three-month and a twelve-month period.

 

**Item4.  Controls and Procedures**

 

As of the end of the period covered by this report, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as defined in ExchangeAct Rule 13a-15(e). Our disclosure controls and procedures are designed toensure that information required to be disclosed by us in the reports that wefile or submit under the Exchange Act is (i) recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms, and (ii) accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate to allow timely decisions regarding requireddisclosures.

 

Basedupon that evaluation, the Chief Executive Officer and the Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures werenot effective as of September 30, 2009, because of the existence ofmaterial weaknesses in internal control over financial reporting. A materialweakness is a deficiency, or a combination of deficiencies, in internal controlover financial reporting, such that there is a reasonable possibility that amaterial misstatement of the company’s annual or interim financial statementswill not be prevented or detected on a timely basis. As disclosed in Item 9A ofour 2008 Annual Report on Form 10-K, we have identified the followingmaterial weaknesses as of December 31, 2008:

 

*Control Environment*

Acontrol environment sets the tone of an organization, influences the controlconsciousness of its people, and is the foundation of all other components ofinternal control over financial reporting. The Company’s control environmentdid not sufficiently promote effective internal control over financialreporting throughout the organization. Specifically, the following materialweaknesses were identified in the Company’s control environment at December 31,2008:

 

· Although management has taken steps to remediatedeficiencies identified in the Annual Report on Form 10-K for the yearended December 31, 2007, management still needs to place greater emphasison supporting effective application of policies, execution of procedures, andremediation of the deficiencies identified in previous periods.

 

· Management needs additional financial reportingresources to ensure appropriate accounting, presentation, and disclosure inCompany filings.

 

Thesedeficiencies in the control environment contributed to the material weaknessesdescribed below, and resulted in a reasonable possibility that a material errorin the Company’s interim or annual financial statements would not be preventedor detected.

 

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*Accounting for Significant Estimates*

TheCompany did not maintain sufficient internal controls over the preparation andreview of its allowance for loan losses model, including obtaining approval anddocumented support for changes in the underlying assumptions being used for theestimation. In addition, the Company did not maintain policies and proceduresto ensure that identification of impaired loans and estimates of valuationallowances required under the receivables topic of the FASB Accounting Standards Codification are madetimely and accurately, and are subject to a detailed supervisory review. Thesedeficiencies contributed to various mathematical errors and inappropriateassumptions being made in the estimation of the allowance for loan losses.Material adjustments were subsequently made to the Company’s preliminaryconsolidated financial statements.

 

*Credit Administration*

Whilemanagement has committed substantial additional resources to creditadministration in 2008 and 2009, the Company needs to make further improvementto its internal control over certain areas involving credit administration, inorder to reduce the possibility of material errors in the estimation of theallowance for loan losses. Specifically, the Company needs further internalcontrols over documentation of underwriting practices over renewals andextensions, collateral inspection on construction loans before approval ofadvances, monitoring of interest reserves on certain acquisition anddevelopment loans, and independent review of appraisals.

 

*Preparationof Financial Reports*

TheCompany did not maintain sufficient internal controls over the preparation andreview of its financial reports for use in Company filings. In addition, thelack of adequate financial reporting resources prevented the Company from beingable to properly prepare financial reports on a timely basis in accordance withgenerally accepted accounting principles. As a result, material errors andinadequate disclosures were made in the Company’s preliminary financialstatements that required adjustments prior to completion of the Form 10-K.

 

**Remediation Plan**

 

In response to the material weaknesses identified, we have developedthe following remediation plan to address the material weaknesses, and we areproceeding expeditiously with the following measures to enhance internalcontrols.

 

·                  We continue toemphasize the importance of following existing procedures for underwriting,lien perfection, and documentation for new and existing loans.

·                  We continue toemphasize the importance of accurate risk grades on loans and will continue todevelop our Credit Risk Review with our Regional Credit Officer staff to ensureproper grading of loans at origination, as well as throughout the life of theloan.  Lenders and loan operationspersonnel have been informed of the requirement to assign risk grades to loansupon origination.  The importance ofperiodic review of risk grades has been emphasized to ensure that changes aremade as warranted due to the changes in the condition of the borrower, thecollateral, or general economic conditions. The controls over pre-and post-origination review of loans in loanoperations have been strengthened to ensure the accuracy and completeness ofloan data, including assignment of risk grades. Our Credit Risk Review staffwill perform periodic reviews of risk grades on selected loans to ensure riskgrading accuracy.

·                  We developed aformal procedure for recommending and approving any changes to the allowancefor loan loss model to ensure that such changes are appropriate. Controls overcompleteness and accuracy of the model were strengthened during the quarter,especially with regard to calculation of specific allowances for impairedloans.  In addition review controls wereimproved for the calculation of historical loss factors, calculation ofperforming watch list loan amounts, and calculation of ratios used forestimating the impact of environmental factors for the general allowance forunimpaired loans.

·                  We continue toassess and strengthen current lending and credit administration policies andprocedures, and are revising them as necessary to develop and implementpolicies and procedures that will promote a culture that expects reliabilityand integrity of data.

·                  We enhancedfinancial reporting resources by adding personnel from the merger with AmericanCommunity Bancshares, Inc. In addition, a review of the staffing resourcesthat are needed to support accurate, complete, 

 

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and timely financial reporting according to generally acceptedaccounting principles was completed by management and approved by the auditcommittee. A proposal for remediation was submitted to the Audit Committee in June 2009.This proposal included documentation of the process enhancements and personnelresponsible for both preparation and review. Implementation began immediatelythereafter and additional staff was hired, including a Chief Financial Officerwith a significant amount of banking experience,during the third quarter of 2009.  Management continues to evaluate itsfinancial reporting process for possible improvements in efficiency whilemaintaining completeness and accuracy.

 

Our Board of Directors is actively monitoring these remediation effortsand may direct additional measures as deemed appropriate from time totime.  We cannot be certain how long itwill take to fully implement the remediation plan, whether the remediation planwill be effective to maintain adequate controls over our financial reportingprocess in the future, or whether the remediation plan will be sufficient toaddress and eliminate the material weaknesses.

 

**Changes in Internal Control over Financial Reporting**

 

The only changes in our internal control over financial reporting thatoccurred during the nine months ended September 30, 2009 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting, are summarized above in thedescription of our material weaknesses in internal control over financialreporting, as well as the ongoing remediation efforts described above.

 

**Part II. Other Information**

 

**Item 1.    Legal Proceedings.**

 

As previously disclosed in our SEC filings, the Company was aparty to the following legal proceedings and potential claims arising in thenormal conduct of business.  The Company was sued for damages in excess of$850,000 for 3.99 years of severance, continued benefits and fringe benefits bytwo former employees who alleged breach of contract.  In addition, theplaintiffs sought liquidated damages and costs (including reimbursement forreasonable attorney fees) under their wage and hour claims.  They alsoasserted that non-compete provisions of the employment agreements did not applyto their separation.  Both plaintiffs filed for judgment on the pleadingsin state court and prevailed.  The Company appealed the orders to theNorth Carolina Court of Appeals before the trial court had determineddamages.  Plaintiffs prevailed before the Court of Appeals, and theCompany’s further appeal to the North Carolina Supreme Court was denied.   The Supreme Court remanded the case to thetrial court for a determination of damages.  On July 9, 2009, thecase was settled by confidential agreement of the parties.  The fullamount of the settlement had been reserved in prior periods and no additionalreserves are deemed necessary.

 

Except as described above, we are not a party to, nor are any of ourproperties subject to, any material legal proceedings, other than legalproceedings that we believe are routine litigation incidental to our business.

 

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds.**

 

On July 24, 2009, the Company entered into a Letter Agreement(including the Securities Purchase Agreement—Standard Terms incorporated byreference therein, the “Purchase Agreement”) with the U.S. Department of theTreasury (“Treasury”) dated July 24, 2009 pursuant to which the Companyissued and sold to Treasury (i) 13,312 shares of the Company’s Fixed RateCumulative Perpetual Preferred Stock, Series T-ACB, having a liquidationpreference of $1,000 per share (the “Series T-ACB Preferred Stock”), and (ii) aten-year warrant to purchase up to 273,534 shares of the Company’s commonstock, par value $1.00 per share (“Common Stock”), at an initial exercise priceof $7.30 per share (the “Warrant”), for an aggregate purchase price of$13,312,000 in cash.  The terms of the Series T-ACB Preferred Stockare the same as the CPP preferred stock issued to Treasury on January 16,2009.  For a more detailed discussion ofthe transaction, see the Company’s Form 8-K filed with the SEC on July 27,2009.

 

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**Item 6.  Exhibits**

 
| **Exhibit #** | ** ** | **Description**                                                                                                                                                                                                                                                                                                      |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 3.1                |       | Amended and Restated Bylaws of Yadkin Valley Financial Corporation  dated July 16, 2009 (incorporated by reference to Exhibit 3.1 to  Form 8-K filed on July 21, 2009).                                                                                                                          |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 3.2                |       | Articles of Amendment to the Company’s Restated Articles of  Incorporation establishing the terms of the Series T-ACB Preferred Stock  (incorporated by reference to Exhibit 3.1 to Form 8-K filed on  July 27, 2009).                                                                      |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 4.1                |       | Warrant to Purchase up to 13,312 shares of Common Stock (incorporated  by reference to Exhibit 4.1 to Form 8-K filed on July 27,  2009).                                                                                                                                                              |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 4.2                |       | Form of Series T-ACB Preferred Stock Certificate  (incorporated by reference to Exhibit 4.2 to Form 8-K filed on  July 27, 2009).                                                                                                                                                           |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 10.1               |       | American Community 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               |       | American Community 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               |       | Letter Agreement, dated July 24, 2009, including Securities  Purchase Agreement — Standard Terms incorporated by reference therein,  between the Company and the United States Department of the Treasury  (incorporated by reference to Exhibit 10.1 to Form 8-K filed on  July 27, 2009). |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 10.4               |       | ARRA Side Letter Agreement, dated July 24, 2009, between the  Company and the United States Department of the Treasury (incorporated by  reference to Exhibit 10.2 to Form 8-K filed on July 27, 2009).                                                                                          |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 10.5               |       | Form of Waiver, executed by each of Messrs. John M. Brubaker,  Edwin E. Laws, William A. Long, John W. Mallard, and Steven S. Robinson (incorporated  by reference to Exhibit 10.3 to Form 8-K filed on July 27,  2009).                                                                    |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 10.6               |       | Form of Letter Amendment, executed by each of Messrs. John M.  Brubaker, Edwin E. Laws, William A. Long, John W. Mallard, Jr., and  Steven S. Robinson with the Company (incorporated by reference to  Exhibit 10.4 to Form 8-K filed on July 27, 2009).                               |
|               |       |                                                                                                                                                                                                                                                                                                                 |
| 31.1               |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                     |
| 31.2               |       | Rule 13a-14(a)/15d-14(a) Certification                                                                                                                                                                                                                                                                     |
| 32.1               |       | Section 1350  Certification                                                                                                                                                                                                                                                                                     |

 

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**Signatures**

 

Pursuant to therequirements of Securities Exchange Act of 1934, the registrant has duly causedthis report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 

Yadkin ValleyFinancial Corporation

 
| BY:                                                                    | /s/ William A.  Long |   |
|------------------------------------------------------------------------|----------------------|--------|
| *William  A. Long, President and Chief Executive Officer*              |                 |
|                                                                   |                 |   |
| BY:                                                                    | /s/ Jan H.  Hollar   |   |
| *Jan H. Hollar, Executive Vice President and Chief  Financial Officer* |                 |
|                                                                   |                 |   |
|                                                                   |                 |   |
| November 4,  2009                                                 |                 |

 

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