UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 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, 2008





Commission
file number: 000-51765











Bay
National Corporation


(Exact
name of registrant as specified in its charter)





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





2328 West Joppa Road,
Lutherville, MD 21093


(Address
of principal executive offices)





(410)
494-2580


(Registrant’s
telephone number, including area code)





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





Yes
            X
            
            No




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





Large
      accelerated filer o
            Accelerated
      filer o





Non-accelerated
filer o (Do
not check if a smaller reporting
company)                                                                                        Smaller
reporting company þ





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





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date:





At November 14, 2008, the issuer had
2,153,101 shares of Common Stock outstanding.








PART
I  -   FINANCIAL INFORMATION





Item
1.       Financial
Statements





BAY
NATIONAL CORPORATION





CONSOLIDATED BALANCE
SHEETS


As of
September 30, 2008 and December 31, 2007





September
      30,
              2008
            
            
            December
      31,
              2007ASSETS
            
            (Unaudited)Cash and due from
      banks
            
            $
            554,626
            
            
            $
            2,314,423Federal funds sold and other
      overnight investments
            
            
            16,602,735
            
            
            
            4,859,248Investment securities available
      for sale (AFS) - at fair value
            
            
            -
            
            
            
            399,529Other
      equity securities
            
            
            1,239,600
            
            
            
            1,715,000Loans
      held for sale
            
            
            1,452,260
            
            
            
            11,601,070Loans,
      net of unearned fees
            
            
            243,179,878
            
            
            
            229,355,171Total
      Loans
            
            
            244,632,138
            
            
            
            240,956,241Less: Allowance for credit
      losses
            
            
            (6,675,000
            )
            
            
            (5,000,000
            )Loans, net
            
            
            237,957,138
            
            
            
            235,956,241Other
      real estate owned, net
            
            
            4,985,097
            
            
            
            946,431Premises
      and equipment, net
            
            
            1,265,015
            
            
            
            1,210,787Investment
      in bank owned life insurance
            
            
            5,213,457
            
            
            
            5,041,662Deferred
      tax asset
            
            
            3,832,000
            
            
            
            1,942,000Accrued
      interest receivable and other assets
            
            
            2,473,310
            
            
            
            2,150,538Total Assets
            
            $
            274,122,978
            
            
            $
            256,535,859LIABILITIESNon-interest-bearing
      deposits
            
            $
            39,853,731
            
            
            $
            31,044,172Interest-bearing
      deposits
            
            
            193,490,223
            
            
            
            170,937,293Total deposits
            
            
            233,343,954
            
            
            
            201,981,465Short-term
      borrowings
            
            
            15,717,344
            
            
            
            25,371,508Subordinated
      debt
            
            
            8,000,000
            
            
            
            8,000,000Accrued
      expenses and other liabilities
            
            
            1,028,945
            
            
            
            1,262,334Total
    Liabilities
            
            
            258,090,243
            
            
            
            236,615,307STOCKHOLDERS'
      EQUITYCommon stock - $.01 par value,
      authorized:9,000,000 shares
      authorized, 2,153,101 and 2,137,633 issued and
              outstanding
      as of  September 30, 2008 and December 31, 2007,
              respectively
            
            
            21,531
            
            
            
            21,376Additional paid in
      capital
            
            
            17,942,053
            
            
            
            17,788,833(Accumulated deficit) retained
      earnings
            
            
            (1,930,849
            )
            
            
            2,110,343Total Stockholders'
      Equity
            
            
            16,032,735
            
            
            
            19,920,552Total Liabilities and
      Stockholders' Equity
            
            $
            274,122,978
            
            
            $
            256,535,859











See
accompanying notes to consolidated financial statements.





2




BAY
NATIONAL CORPORATION





CONSOLIDATED STATEMENTS OF
OPERATIONS


For the
three and nine-month periods ended September 30, 2008 and 2007


(Unaudited)





Three
      Months Ended
              September
      30
            
            
            Nine
      Months Ended
              September
      302008
            
            
            2007
            
            
            2008
            
            
            2007INTEREST
      INCOME:Interest and fees on
      loans
            
            $
            3,556,294
            
            
            $
            4,941,695
            
            
            $
            11,650,759
            
            
            $
            15,152,372Interest
      on federal funds sold and other overnight
              investments
            
            
            25,179
            
            
            
            184,057
            
            
            
            110,291
            
            
            
            611,271Taxable interest and dividends
      on investmentsecurities
            
            
            4,649
            
            
            
            12,894
            
            
            
            43,612
            
            
            
            62,540Total interest
    income
            
            
            3,586,122
            
            
            
            5,138,646
            
            
            
            11,804,662
            
            
            
            15,826,183INTEREST
      EXPENSE:Interest
      on deposits
            
            
            1,358,319
            
            
            
            1,978,220
            
            
            
            4,385,777
            
            
            
            6,108,747Interest
      on short-term borrowings
            
            
            68,539
            
            
            
            88,671
            
            
            
            220,633
            
            
            
            149,375Interest
      on subordinated debt
            
            
            151,523
            
            
            
            151,764
            
            
            
            451,645
            
            
            
            450,327Total
      interest expense
            
            
            1,578,381
            
            
            
            2,218,655
            
            
            
            5,058,055
            
            
            
            6,708,449Net
      interest income
            
            
            2,007,741
            
            
            
            2,919,991
            
            
            
            6,746,607
            
            
            
            9,117,734Provision
      for credit losses
            
            
            2,491,623
            
            
            
            350,000
            
            
            
            5,517,252
            
            
            
            350,000Net
      interest income after provision forcredit losses
            
            
            (483,882
            )
            
            
            2,569,991
            
            
            
            1,229,355
            
            
            
            8,767,734NON-INTEREST
      INCOME:Service charges on deposit
      accounts
            
            
            58,711
            
            
            
            38,885
            
            
            
            184,090
            
            
            
            111,296Gain
      on sale of mortgage loans
            
            
            73,387
            
            
            
            91,442
            
            
            
            214,024
            
            
            
            351,934Income
      from bank owned life insurance
            
            
            58,473
            
            
            
            -
            
            
            
            171,795
            
            
            
            -Other income
            
            
            12,647
            
            
            
            17,759
            
            
            
            43,551
            
            
            
            58,062Total non-interest
      income
            
            
            203,218
            
            
            
            148,086
            
            
            
            613,460
            
            
            
            521,292NON-INTEREST
      EXPENSES:Salaries and employee
      benefits
            
            
            1,545,944
            
            
            
            1,397,783
            
            
            
            4,730,271
            
            
            
            4,270,560Occupancy
    expenses
            
            
            193,306
            
            
            
            163,850
            
            
            
            567,724
            
            
            
            484,327Furniture and equipment
      expenses
            
            
            105,349
            
            
            
            86,905
            
            
            
            304,800
            
            
            
            256,816Legal and professional
      fees
            
            
            194,543
            
            
            
            99,058
            
            
            
            651,614
            
            
            
            238,963Data processing and other
      outside services
            
            
            212,790
            
            
            
            225,875
            
            
            
            743,245
            
            
            
            619,738Advertising
      and marketing related expenses
            
            
            110,067
            
            
            
            111,155
            
            
            
            411,157
            
            
            
            322,662Other expenses
            
            
            228,996
            
            
            
            190,305
            
            
            
            857,387
            
            
            
            593,719Total non-interest
      expenses
            
            
            2,590,995
            
            
            
            2,274,931
            
            
            
            8,266,198
            
            
            
            6,786,785(Loss)
      Income before income taxes
            
            
            (2,871,659
            )
            
            
            443,145
            
            
            
            (6,423,383
            )
            
            
            2,502,241Income
      tax (benefit) expense
            
            
            (1,092,899
            )
            
            
            182,000
            
            
            
            (2,382,191
            )
            
            
            1,000,000NET
      (LOSS) INCOME
            
            $
            (1,778,760
            )
            
            $
            261,145
            
            
            $
            (4,041,192
            )
            
            $
            1,502,241Per
      Share Data:Net (Loss) Income (basic) (1)
            
            $
            (.83
            )
            
            $
            .12
            
            
            $
            (1.88
            )
            
            $
            .70Net (Loss) Income (diluted)(1)
            
            $
            (.83
            )
            
            $
            .12
            
            
            $
            (1.88
            )
            
            $
            .68Weighted Average shares
      outstanding (basic) (1)
            
            
            2,151,825
            
            
            
            2,135,688
            
            
            
            2,144,519
            
            
            
            2,131,671Effect
      of Dilution – Stock options and Restricted
              shares(1)
            
            
            -
            
            
            
            77,052
            
            
            
            -
            
            
            
            79,433Weighted Average shares
      outstanding (diluted) (1)
            
            
            2,151,825
            
            
            
            2,212,740
            
            
            
            2,144,519
            
            
            
            2,211,104


(1)
            Adjusted
      to reflect 1.1 stock split in the form of a dividend recorded on June 29,
      2007





See
accompanying notes to consolidated financial statements.


3


BAY
NATIONAL CORPORATION





CONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS’ EQUITY


For the
nine months ended September 30, 2008 and 2007


(Unaudited)











Common
              Stock
            
            
            Additional
              Paid
      in
              Capital
            
            
            (Accumulated
              Deficit)
              Retained
              Earnings
            
            
            Total
              Stockholders’
              EquityBalances
      at January 1, 2008
            
            $
            21,376
            
            
            $
            17,788,833
            
            
            $
            2,110,343
            
            
            $
            19,920,552Stock-based
      compensation expense
            
            
            -
            
            
            
            62,800
            
            
            
            -
            
            
            
            62,800Issuance
      of Common Stock
            
            
            155
            
            
            
            90,420
            
            
            
            -
            
            
            
            90,575Net
      Loss
            
            
            -
            
            
            
            -
            
            
            
            (4,041,192
            )
            
            
            (4,041,192
            )Balances
      at September 30, 2008
            
            $
            21,531
            
            
            $
            17,942,053
            
            
            $
            (1,930,849
            )
            
            $
            16,032,735Common
              Stock
            
            
            Additional
              Paid
      in
              Capital
            
            
            Retained
              Earnings
            
            
            Total
              Stockholders’
              EquityBalances
      at January 1, 2007
            
            $
            19,354
            
            
            $
            17,649,678
            
            
            $
            1,173,461
            
            
            $
            18,842,493Stock-based
      compensation expense
            
            
            -
            
            
            
            48,504
            
            
            
            -
            
            
            
            48,504Issuance
      of Common Stock
            
            
            87
            
            
            
            58,826
            
            
            
            -
            
            
            
            58,9131.1
      to one stock split in the form of a
              stock
      dividend
            
            
            1,935
            
            
            
            (1,935
            )
            
            
            -
            
            
            
            -Cash
      paid in lieu of fractional shares
              on
      stock dividend
            
            
            -
            
            
            
            -
            
            
            
            (487
            )
            
            
            (487
            )Net
      Income
            
            
            -
            
            
            
            -
            
            
            
            1,502,241
            
            
            
            1,502,241Balances
      at September 30, 2007
            
            $
            21,376
            
            
            $
            17,755,073
            
            
            $
            2,675,215
            
            
            $
            20,451,664







See
accompanying notes to consolidated financial statements.


4


BAY
NATIONAL CORPORATION





CONSOLIDATED STATEMENTS OF
CASH FLOWS


For the
nine months ended September 30, 2008 and 2007


(Unaudited)





2008
            
            
            2007Cash
      Flows From Operating Activities:Net (Loss)
Income
            
            $
            (4,041,192
            )
            
            $
            1,502,241Adjustments to reconcile net
      (loss) income to net cash provided
              (used)
      by operating activities:Depreciation
            
            
            244,911
            
            
            
            210,655Accretion
      of investment discounts
            
            
            (471
            )
            
            
            (20,282
            )Provisions
      for credit losses
            
            
            5,517,252
            
            
            
            350,000Provision
      for losses on other real estate owned
            
            
            117,323
            
            
            
            -Gain
      on sale of other real estate owned
            
            
            (1,111
            )
            
            
            -Stock-based
      compensation expense
            
            
            62,800
            
            
            
            48,504Increase
      in cash surrender of bank owned life insurance
            
            
            (171,795
            )
            
            
            -Deferred
      income taxes
            
            
            (1,890,000
            )
            
            
            (70,891
            )Gain
      on sale of mortgage loans
            
            
            (214,024
            )
            
            
            (351,934
            )Origination
      of loans held for sale
            
            
            (70,412,407
            )
            
            
            (111,589,665
            )Proceeds
      from sale of loans
            
            
            79,803,097
            
            
            
            108,204,154Net
      increase in accrued interest receivable and other assets
            
            
            (322,772
            )
            
            
            (68,850
            )Net decrease in accrued
      expenses and other liabilities
            
            
            (233,389
            )
            
            
            (917,155
            )Net
      cash provided by (used in) operating activities
            
            
            8,458,222
            
            
            
            (2,703,223
            )Cash
      Flows From Investing Activities:Purchases of investment
      securities available for sale
            
            
            -
            
            
            
            (1,481,607
            )Maturities of investment
      securities available for sale
            
            
            400,000
            
            
            
            1,800,000Purchase
      of Federal Reserve Bank stock
            
            
            (96,900
            )
            
            
            -Redemption
      of Federal Home Loan Bank of Atlanta Stock
            
            
            572,300
            
            
            
            51,300Loan
      disbursements in excess of principal payments
            
            
            (21,957,327
            )
            
            
            (5,553,226
            )Proceeds
      from the sale of other real estate owned
            
            
            1,141,721
            
            
            
            -Expenditures
      for other real estate owned
            
            
            (34,087
            )
            
            
            -Expenditures
      for premises and equipment
            
            
            (299,139
            )
            
            
            (239,068
            )Net cash used in investing
      activities
            
            
            (20,273,432
            )
            
            
            (5,422,601
            )Cash
      Flows From Financing Activities:Net increase in
      deposits
            
            
            31,362,489
            
            
            
            919,912Net
      (decrease) increase in short-term borrowings
            
            
            (9,654,164
            )
            
            
            4,457,903Net proceeds from issuance of
      common stock
            
            
            90,575
            
            
            
            58,913Cash
      dividends paid in lieu of fractional shares
            
            
            -
            
            
            
            (487
            )Net cash provided by financing
      activities
            
            
            21,798,900
            
            
            
            5,436,241Net
      increase (decrease) in cash and cash equivalents
            
            
            9,983,690
            
            
            
            (2,689,583
            )Cash
      and cash equivalents at beginning of year
            
            
            7,173,671
            
            
            
            33,898,204Cash
      and cash equivalents at end of year
            
            $
            17,157,361
            
            
            $
            31,208,621





Supplemental
      information:Interest
      paid
            
            $
            5,072,088
            
            
            $
            6,886,338Income
      taxes paid
            
            $
            353,894
            
            
            $
            1,430,168Accrued
      director fees paid in common stock
            
            $
            67,835
            
            
            $
            -Amount
      transferred from loans to other real estate owned
            
            $
            5,262,512
            
            
            $
            1,048,012Amount
      transferred from loans held for sale to loans
            
            $
            972,144
            
            
            $
            -





See
accompanying notes to consolidated financial statements.




5






BAY
NATIONAL CORPORATION





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS


For the
Three and Nine Months Ended September 30, 2008 and 2007


(Unaudited)





1.
            GENERAL





Organization





Bay
National Corporation (the “Company”) was incorporated on June 3, 1999 under the
laws of the State of Maryland to operate as a bank holding company of a national
bank with the name Bay National Bank (the “Bank”). On May 12, 2000, the Company
purchased all the shares of common stock issued by the Bank. The Bank commenced
operations on May 12, 2000 after successfully meeting the conditions of the
Office of the Comptroller of the Currency (the “OCC”) to receive its charter
authorizing it to commence operations as a national bank, obtaining the approval
of the Federal Deposit Insurance Corporation to insure its deposit accounts, and
meeting certain other regulatory requirements.





Basis
of Presentation





The
accompanying consolidated financial statements include the activity of Bay
National Corporation and its wholly owned subsidiary, Bay National Bank. All
significant intercompany transactions and balances have been eliminated in
consolidation.





The
foregoing consolidated financial statements are unaudited; however, in the
opinion of management, all adjustments (comprising only normal recurring
accruals) necessary for a fair presentation of the results of the interim
periods have been included. The balances as of December 31, 2007 have been
derived from audited financial statements. These consolidated financial
statements should be read in conjunction with the consolidated financial
statements and accompanying notes included in Bay National Corporation’s 2007
Annual Report on Form 10-K. There have been no significant changes to the
Company’s accounting policies as disclosed in the 2007 Annual Report. The
results shown in this interim report are not necessarily indicative of results
to be expected for the full year 2008 or any other interim period.





The
accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States of America and to general
practices in the banking industry.





Reclassifications





Certain reclassifications have been
made to amounts previously reported to conform to the current presentation.
These reclassifications had no effect on previously reported results of
operations or retained earnings.





2.
            REGULATORY
      MATTERS





The Bank
is subject to various regulatory capital requirements administered by the
federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory - and possibly additional discretionary - actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital action, the Bank must meet
specific capital guidelines that involve quantitative measures of the Bank’s
assets, liabilities and certain off-balance sheet items as calculated under
regulatory accounting practices. The Bank's capital amounts and classification
are also subject to qualitative judgments by the regulators about components,
risk weighting and other factors.





6




Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain minimum amounts and ratios. Management believes, as of September 30,
2008, that the Bank meets all capital adequacy requirements to which it is
subject.





As of
September 30, 2008, the Bank has been categorized as “Adequately Capitalized” by
the OCC under the regulatory framework for prompt corrective action. To be
categorized as adequately capitalized, the Bank must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios.





3.    FAIR
VALUE MEASUREMENTS





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





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





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





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





As of
September 30, 2008, the Company had no balance sheet categories that are
required by generally accepted accounting principles to be recorded at fair
value.





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





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





7


On a
nonrecurring basis, the Company may be required to measure certain assets at
fair value in accordance with generally accepted accounting
principles.  These adjustments usually result from application of
lower-of-cost-or-market accounting or write-downs of specific
assets.  The following table includes the assets measured at fair
value on a nonrecurring basis as of September 30, 2008 (in
thousands):





Carrying
              Value
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Impaired
      Loans
            
            $
            18,711
            
            
            $
            -
            
            
            $
            18,711
            
            
            $
            -Other
      real estate owned
            
            
            4,985
            
            
            
            -
            
            
            
            4,985
            
            
            
            -Total
      assets at fair value
            
            $
            23,696
            
            
            $
            -
            
            
            $
            23,696
            
            
            $
            -








In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities – Including an Amendment of FASB Statement No.
115.” This Statement permits entities to choose to measure many financial
instruments and certain other items at fair value. Unrealized gains and losses
on items for which the fair value option has been elected will be reported in
earnings. The objective is to improve financial reporting by providing entities
with the opportunity to mitigate volatility in reported earnings caused by
measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. This Statement is expected to expand the
use of fair value measurement, which is consistent with the FASB’s long-term
measurement objectives for accounting for financial instruments.  SFAS No.
159 is effective for fiscal years beginning after November 15, 2007. The Company
has not elected the fair value option for any financial assets or liabilities at
September 30, 2008.





4.      INCOME
TAXES





The
Company employs the liability method of accounting for income taxes as required
by Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for
Income Taxes.” Under the liability method, deferred-tax assets and liabilities
are determined based on differences between the financial statement carrying
amounts and the tax basis of existing assets and liabilities (i.e., temporary
differences) and are measured at the enacted rates that will be in effect when
these differences reverse.  The Company adopted the provisions of FASB
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” in the
first quarter of 2008.  The Company utilizes statutory requirements
for its income tax accounting and avoids risks associated with potentially
problematic tax positions that may incur challenge upon audit, where an adverse
outcome is more likely than not.  Therefore, no provisions are made
for either uncertain tax positions nor accompanying potential tax penalties and
interest for underpayments of income taxes in the Company’s tax
reserves.





5.      EARNINGS
PER SHARE





Earnings per common share are
computed by dividing net income by the weighted average number of common shares
outstanding during the period. Diluted earnings per common share is computed by
dividing net income by the weighted average number of common shares outstanding
during the period, including any potential dilutive common shares outstanding,
such as options. The Company’s common stock options, of which 135,441 shares
were outstanding as of September 30, 2008, were not considered in the
computation of diluted earnings per share for the three-month and nine-month
periods ended September 30, 2008 because the result would have been
anti-dilutive.  There were no shares or options as of September 30,
2007 excluded from the diluted net income per share computation.  All
shares and per share data have been adjusted to reflect the 1.1 stock split in
the form of a dividend recorded on June 29, 2007.


8


6.    STOCK-BASED
COMPENSATION





Effective
January 1, 2006, the Company adopted SFAS No. 123(R), Share-based Payment,and has
included the stock-based employee compensation cost in its income statements for
the three and nine-month periods ended September 30, 2008 and 2007. Amounts recognized in
the financial statements with respect to stock-based compensation are as
follows:





Three
      Months Ended
              September
      30
            
            
            Nine
      Months Ended
              September
      302008
            
            
            2007
            
            
            2008
            
            
            2007Amounts
      charged against income, before tax
              benefit
            
            $
            10,155
            
            
            $
            16,810
            
            
            $
            62,800
            
            
            $
            48,504Amount
      of related income tax benefit
              recognized
      in income
            
            $
            3,453
            
            
            $
            5,715
            
            
            $
            20,650
            
            
            $
            14,546





The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used for grants during the year ended December 31,
2002:





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





No stock
options have been issued since 2002.





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




The
Incentive Plan authorizes the issuance of up to 200,000 shares of common stock
plus any shares that were available under the Company’s 2001 Stock Option Plan
(“Option Plan”) that terminated as of May 22, 2007 and shares subject to options
granted under the Option Plan that expire or terminate without having been fully
exercised.  The Incentive Plan has a term of ten years and is
administered by the Compensation Committee of the Board of Directors. The
Compensation Committee consists of at least three non-employee directors
appointed by the Board of Directors. In general, the options have an exercise
price equal to 100% of the fair market value of the common stock on the date of
the grant.  As of September 30, 2008, thirteen Awards had been granted
under the Incentive Plan.  Five of these Awards included an
unrestricted stock grant of 550 shares to five employees in August 2007 based on
their 2006 performance.  The Awards vested immediately upon issuance
and the closing stock price on the grant date was $15.46.  The
remaining eight Awards represent restricted stock awards and are discussed in
more detail below in the section entitled “Restricted Stock Units.”





The
Company incurred compensation expense of $2,064 associated with vested stock
options for the nine-month period ending September 30, 2008.  The
unrecognized compensation cost related to unvested stock option awards was
$7,044 at September 30, 2008 based upon a weighted average fair value of
$2.75.





9




The
following is a summary of changes in outstanding options for the nine-month
periods ended September
30, 2008 and 2007 (amounts previously reported have been adjusted to reflect a
1.1 to 1 stock split in the form of a dividend recorded on June 29,
2007):





Number
      of
              Shares
            
            
            Weighted
              Average
              Exercise
              PriceBalance,
      January 1, 2007
            
            
            141,446
            
            
            $
            6.98Granted
            
            
            -
            
            
            
            -Cancelled
            
            
            -
            
            
            
            -Exercised
            
            
            (2,705
            )
            
            $
            6.89Balance,
      September 30, 2007
            
            
            138,741
            
            
            $
            6.99Balance,
      January 1, 2008
            
            
            138,741
            
            
            $
            6.99Granted
            
            
            -
            
            
            
            -Cancelled
            
            
            -
            
            
            
            -Exercised
            
            
            3,300
            
            
            $
            6.89Balance,
      September 30, 2008
            
            
            135,441
            
            
            $
            6.99Weighted
      average fair value of options
              granted
      during 2002
            
            $
            2.75





The
following table summarizes information about options outstanding at September
30, 2008:





Options
      Outstanding
            
            
            Options
      ExercisableExercise
      Price
            
            
            Number
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
              (in
      years)
            
            
            Weighted
              Average
              Exercise
              Price
            
            
            Number
            
            
            Weighted
              Average
              Exercise
              Price$
            6.89
            
            
            
            116,945
            
            
            
            1
            
            
            $
            6.89
            
            
            
            116,945
            
            
            $
            6.89$
            7.61
            
            
            
            18,496
            
            
            
            2
            
            
            $
            7.61
            
            
            
            15,935
            
            
            $
            7.61135,441
            
            
            
            
            
            
            $
            6.99
            
            
            
            132,880
            
            
            $
            6.98





Based
upon a closing stock price of $5.70 per share as of September 30, 2008, there
was no aggregate intrinsic value in options outstanding and
exercisable.





10


Restricted Stock
Units





The
following table summarizes the changes in outstanding shares under restricted
stock grants for the nine-month periods ended September 30, 2008 and
2007.  Amounts have been adjusted to reflect a 1.1 to one stock split
in the form of a dividend recorded on June 29, 2007.





Number
      of Shares
            
            
            
            
            
            Weighted
              Value
      at
              Issuance
      DateUnvested
      grants at January 1, 2008
            
            
            24,000
            
            
            
            
            
            $
            15.91Granted
            
            
            10,500
            
            
            
            
            
            
            10.23Vested
            
            
            (5,550
            )
            
            
            
            
            
            
            15.92Cancelled
            
            
            (15,750
            )
            
            
            
            
            
            
            -Unvested
      grants at September 30, 2008
            
            
            13,200
            
            
            
            
            
            
            
            13.24Unvested
      grants at January 1, 2007
            
            
            13,200
            
            
            
            
            
            
            $
            17.23Granted
            
            
            24,000
            
            
            
            
            
            
            
            15.91Vested
            
            
            (3,300
            )
            
            
            
            
            
            
            17.23Cancelled
            
            
            (9,900
            )
            
            
            
            
            
            ­-Unvested
      grants at September 30, 2007
            
            
            24,000
            
            
            
            
            
            
            $
            15.91








Based on 2007 grants, 5,550 shares had
vested during the three month period ending September 30,
2008.  During the nine-month period ending September 30, 2008, a total
of 10,500 shares of the Company’s common stock had been awarded to four
employees.  These Awards vest 20% on each anniversary of the
employee’s hiring date over 5 years.  Two recipients of these Awards
granted during 2008 and one recipient under the 2007 grant are no longer
employed with the Company.  As such, their unvested grants, totaling
15,750 shares, were forfeited during the quarter ended September 30,
2008.





The
Company incurred compensation expense of $60,736 associated with restricted
stock for the nine-month period ending September 30, 2008.








11


Item
2.    Management's Discussion and
Analysis of Financial Condition and Results of Operations





This
discussion and analysis provides an overview of the financial condition and
results of operations of Bay National Corporation (the “Parent”) and its
national bank subsidiary, Bay National Bank (the “Bank”), collectively (the
“Company”), as of September 30, 2008 and December 31, 2007 and for the
three-month and nine-month periods ended September 30, 2008 and
2007.





Overview





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





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





The
Company continued to experience unsatisfactory operating results during the
quarter ended September 30, 2008 resulting from difficulties in its portfolio of
investor-owned residential real estate loans. The Company experienced moderate
asset and loan growth, excluding loans held for sale, which was led by growth in
the commercial loan portfolio. Key measurements for the three-month and
nine-month periods ended September 30, 2008 include the following:





·
            Total
      assets at September 30, 2008 increased to $274.1 million from $256.5
      million as of December 31, 2007.





·
            Net
      loans outstanding increased from $236.0 million as of December 31, 2007 to
      $238.0 million as of September 30,
2008.





·
            There
      was approximately $18.7 million in non-accrual loans as of September 30,
      2008.  In addition, the Company held sixteen pieces of property
      related to investor-owned residential real estate in other real estate
      owned as of September 30, 2008. These properties are carried at estimated
      net realizable value of approximately $5.0 million. There were no other
      non-performing assets as of September 30, 2008. There was approximately
      $3.6 million in non-accrual loans as of September 30, 2007.  The
      Company continues to maintain appropriate reserves for credit
      losses.





·
            Six
      properties, previously held in other real estate owned, were sold in the
      nine-months ended September 30, 2008. The amounts realized upon the sale
      of these properties closely approximated the value at which they were
      carried.




12





·
            Deposits
      at September 30, 2008 increased to $233.3 million from $202.0 million as
      of December 31, 2007.





·
            The
      Company incurred net losses of $1.8 million and $4.0 million for the
      three-month and nine-month periods ended September 30, 2008, respectively,
      compared to net income of $261,145 and $1.5 million for the same periods
      in 2007.





·
            Net
      interest income, the Company’s main source of income, was $2.0 million and
      $6.7 million during the three-month and nine-month periods ended September
      30, 2008, respectively, compared to $2.9 million and $9.1 million for the
      three-month and nine-month periods ended September 30, 2007,
      respectively.





·
            The
      Company had a provision for credit losses of $5.5 million in order to
      replenish the allowance for 2008 net charge-offs, which totaled $3.8
      million and to provide approximately $1.7 million of additional reserves
      against its loan portfolio. The charge-offs were primarily a result of
      weaknesses in the Company’s portfolio of residential construction and
      reconstruction loans arising from problems in the housing market in the
      Company’s target markets. There were $315,989 of net charge-offs for the
      three-month and nine-month periods ended September 30,
    2007.





·
            Non-interest
      income increased by $55,132 and $92,168, or 37.2% and 17.7%, for the
      three-month and nine-month periods ended September 30, 2008, respectively,
      as compared to the same periods ended September 30,
  2007.





·
            Non-interest
      expenses increased by $316,024 and $1.5 million, or 13.9% and 21.8%,
      for the three-month and nine-month periods ended September 30, 2008,
      respectively, as compared to the same periods in
  2007.





·
            The
      Company’s common stock closed at $5.70 on September 30, 2008, which
      represented a 62.9% decline from its closing price of $15.35 on September
      28, 2007.





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





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





Results
of Operations





General





The
Company recorded net losses of $1.8 million and $4.0 million for the three-month
and nine-month periods ended September 30, 2008. This compares to net income of
$261,145 and $1.5 million for the same periods in 2007. This is a decrease of
$2.0 million and $5.5 million for the three-month and nine-month periods,
respectively. The decrease in year-over-year results is due primarily to a $5.5
million provision for credit losses, the majority of which was related to




13




the
Bank’s portfolio of residential construction and reconstruction loans, recorded
during the nine-months ended September 30, 2008 as well as a decrease in net
interest income.  The provision was due to net charge-offs of
approximately $3.8 million and management’s decision to record an additional
$1.7 million provision to reflect continued weaknesses in its portfolio of loans
secured by real estate. In addition, there was an increase in non-interest
expenses related to the management of non-performing assets, the expansion of
the Bank’s commercial business development staff in the Baltimore-Washington
Corridor, which commenced in the third quarter of 2007, and a declining interest
rate environment and increased non-accrual loans that have combined to create
pressure on the Bank’s interest margins.





The
Bank’s mortgage origination operations, located in Towson and Salisbury,
Maryland, originate conventional first and second lien residential mortgage
loans. The Bank sells most of its first and second lien residential mortgage
loans in the secondary market and typically recognizes a gain on the sale of
these loans after the payment of commissions to the loan origination officer.
For the nine-month periods ended September 30, 2008 and 2007, net gains on the
sale of mortgage loans totaled $214,024 and $351,934,
respectively.  Gains on the sale of mortgage loans decreased for the
nine-month period ended September 30, 2008 as compared to the same period in
2007 due to a slowdown in the real estate market in the Company’s lending
territories.





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





As of
September 30, 2008, the Company held no such loans under the participation which
were classified as held for sale. The Company earned $97,264 of interest on this
program for the nine-month period ended September 30, 2008. This compares to
$306,871 for the same period in 2007. The decrease in interest from this program
is due to a decrease in the average balances outstanding under the program as
well as a decrease in the prime rate of interest in effect for the period ended
September 30, 2008.





Management
expects the remainder of 2008 to continue to be challenging for earnings as a
result of the slowing economy, the weakness in the residential real estate
market and the cost structure associated with the Company’s decision to invest
in personnel to support its long-term growth.  Actual results will be
subject to the volatility of the provision for credit losses, which is related
to asset quality and loan growth and the volatility of mortgage loan production,
all of which are sensitive to economic and interest rate fluctuations, and other
competitive pressures that arise in a slowing economy.





Net
Interest Income





Net
interest income is the difference between income on earning assets and the cost
of funds supporting those assets. Earning assets are composed primarily of
loans, investments, and federal funds sold. Interest-bearing deposits, other
short-term borrowings and subordinated debt make up the cost of funds.
Non-interest bearing deposits and capital are also funding sources. Changes in
the volume and mix of earning assets and funding sources along with changes in
associated interest rates determine changes in net interest income.





As
previously stated, net interest income was $2.0 million and $6.7 million for the
three-month and nine-month periods ended September 30, 2008 as compared to $2.9
million and $9.1 million for the three-month and nine-month periods in 2007.
This represents a decrease of 31.2% and 26.0%
for the three-month and nine-month periods ended September 30, 2008, as compared
to the same periods in 2007.




14




Total
interest income for the three-month and nine-month periods ended September 30,
2008 was $3.6 million and $11.8 million, compared to $5.1 million and $15.8
million for the same periods ended September 30, 2007.  The 30.2% and
25.4% decreases for the three-month and nine-month periods over the same periods
in 2007 were primarily attributed to lost interest from an average of
approximately $12.9 million of non-accrual loans, an increase from an average of
$1.3 million in the prior year, and the decline in residential construction loan
originations. In addition, the target federal funds rate decreased from 5.25% as
of March 31, 2007 to 2.0%, which was effective beginning April 30,
2008.    As a result, the yields on interest-earning assets
decreased from 8.59% for the nine-months ended September 30, 2007 to 6.09% for
the nine-months ended September 30, 2008.  The target federal funds
rate was further reduced two times in October 2008, each a decrease of 0.50%, to
1.0% effective October 29, 2008.  This will further decrease our
yields on interest-earning assets and have a negative impact on our interest
income for the fourth quarter of 2008.





The
percentage of average interest-earning assets represented by loans was 94.8%
and   91.0% for the nine-month periods ended September 30, 2008
and 2007, respectively. The high percentage of loans to earning assets is
consistent with management’s strategy to maximize net interest income by
maintaining a higher concentration of loans, which typically earn higher yields
than investment securities. For the nine-month period ended September 30, 2008,
the average yield on the loan portfolio decreased to 6.34% from 9.03% for the
nine-month period ended September 30, 2007.





The
average yield on the investment portfolio and other earning assets, such as
federal funds sold, was 1.52% for the nine-month period ended September 30, 2008
as compared to 4.07% for the same period in 2007. This decline in the average
yield was a direct result of a decrease in the rates paid on these investments
for the majority of the 2008 period.  The percentage of average
interest-earning assets represented by investments was 5.2% and 9.0% for the
nine-month period ended September 30, 2008 and 2007, respectively.





Interest
expense from deposits and borrowings for the three-month and nine-month periods
ended September 30, 2008 was $1.6 million and $5.1 million, respectively,
compared to $2.2 million and $6.7 million, respectively, for the same periods in
2007. The 28.9% and 24.6% decreases for the three-month and nine-month periods,
respectively, are primarily the result of the previously discussed reduction in
the target federal funds rate.  Average rates paid on all
interest-bearing liabilities decreased from 4.55% for the nine-month period
ended September 30, 2007 to 3.20% for the nine-month period ended September 30,
2008.





As a
result of the factors discussed above, net interest margins decreased to 3.48%
for the nine-month period ended September 30, 2008 from 4.95% for the same
period in 2007. Although management has been able to implement deposit rate
decreases, the yield on loans and investments decreased at a faster rate than
the cost of funds. The increase in non-accrual loans has also contributed to
this decline.  Management has observed ongoing pressure to offer lower
rates on loans as the market for loans has become more
competitive.  In addition, the market is very competitive for
deposits, which, as is typical, has limited management’s ability to maintain
margins through reductions in the interest rates on deposit
accounts.


15


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





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





Nine Months Ended
      September 30, 2008Average
              Balance
            
            
            Interestand fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            245,469,775
            
            
            $
            11,650,759
            
            
            
            6.34
            %Investment
      securities
            
            
            1,335,063
            
            
            
            43,612
            
            
            
            4.36Federal
      funds sold and other overnight investments
            
            
            12,197,159
            
            
            
            110,291
            
            
            
            1.21Total
      earning assets
            
            
            259,001,997
            
            
            
            11,804,662
            
            
            
            6.09
            %Less:
      Allowance for credit losses
            
            
            (6,292,206
            )Cash
      and due from banks
            
            
            616,815Other
      real estate owned
            
            
            1,926,912Premises
      and equipment, net
            
            
            1,290,746Investment
      in bank owned life insurance
            
            
            5,118,128Accrued
      interest receivable and other assets
            
            
            4,842,661Total
      assets
            
            $
            266,505,053LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            75,649,935
            
            
            
            1,041,630
            
            
            
            1.84
            %Regular
      savings deposits
            
            
            1,586,431
            
            
            
            3,632
            
            
            
            0.31Time
      deposits
            
            
            110,540,597
            
            
            
            3,340,515
            
            
            
            4.04Short-term
      borrowings
            
            
            15,580,423
            
            
            
            220,633
            
            
            
            1.89Subordinated
      debt
            
            
            8,000,000
            
            
            
            451,645
            
            
            
            7.54Total
      interest-bearing liabilities
            
            
            211,357,386
            
            
            
            5,058,055
            
            
            
            3.20
            %Net
      interest income and spread
            
            
            
            
            
            $
            6,746,607
            
            
            
            2.89
            %Non-interest-bearing
      demand deposits
            
            
            35,765,362Accrued
      expenses and other liabilities
            
            
            1,098,372Stockholders’
      equity
            
            
            18,283,933Total
      liabilities and stockholders’ equity
            
            $
            266,505,053Interest
      and fee income/earning assets
            
            
            6.09
            %Interest
      expense/earning assets
            
            
            2.61Net
      interest margin
            
            
            3.48
            %Return
      on Average Assets (Annualized)
            
            
            (2.03
            )%Return
      on Average Equity (Annualized)
            
            
            (29.52
            )%Average
      Equity to Average Assets
            
            
            6.86
            %








16




Nine Months Ended
      September 30, 2007Average
              Balance
            
            
            Interestand fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            224,214,486
            
            
            $
            15,152,372
            
            
            
            9.03
            %Investment
      securities
            
            
            1,684,930
            
            
            
            62,540
            
            
            
            4.96Federal
      funds sold and other overnight investments
            
            
            20,447,334
            
            
            
            611,271
            
            
            
            4.00Total
      earning assets
            
            
            246,346,750
            
            
            
            15,826,183
            
            
            
            8.59
            %Less:
      Allowance for credit losses
            
            
            (3,196,732
            )Cash
      and due from banks
            
            
            2,510,890Other
      real estate owned
            
            
            11,517Premises
      and equipment, net
            
            
            1,108,267Accrued
      interest receivable and other assets
            
            
            2,824,694Total
      assets
            
            $
            249,605,386LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            74,909,337
            
            
            
            2,058,879
            
            
            
            3.67
            %Regular
      savings deposits
            
            
            4,462,053
            
            
            
            69,596
            
            
            
            2.08Time
      deposits
            
            
            105,606,487
            
            
            
            3,980,272
            
            
            
            5.04Short-term
      borrowings
            
            
            4,304,175
            
            
            
            149,375
            
            
            
            4.64Subordinated
      debt
            
            
            8,000,000
            
            
            
            450,327
            
            
            
            7.53Total
      interest-bearing liabilities
            
            
            197,282,052
            
            
            
            6,708,449
            
            
            
            4.55
            %Net
      interest income and spread
            
            
            
            
            
            $
            9,117,734
            
            
            
            4.04
            %Non-interest-bearing
      demand deposits
            
            
            30,804,512Accrued
      expenses and other liabilities
            
            
            1,613,505Stockholders’
      equity
            
            
            19,905,317Total
      liabilities and stockholders’ equity
            
            $
            249,605,386Interest
      and fee income/earning assets
            
            
            8.59
            %Interest
      expense/earning assets
            
            
            3.64Net
      interest margin
            
            
            4.95
            %Return
      on Average Assets (Annualized)
            
            
            0.80
            %Return
      on Average Equity (Annualized)
            
            
            10.09
            %Average
      Equity to Average Assets
            
            
            7.98
            %





Provision
for Credit Losses





There was
a $2.5 million and a $5.5 million provisionfor
credit losses for the three-month and nine-month periods ended September 30,
2008, respectively. There was a $350,000 provision required for the same periods
in 2007. The provision for credit losses is reflective of the ongoing decline in
the residential real estate market resulting in difficulty on the part of
borrowers to refinance or sell residential real estate. For additional
information regarding the methodology used to determine the provision for credit
losses, see the Management Discussion and Analysis section entitled “Allowance
for Credit Losses and Credit Risk Management.”





Non-Interest
Income





Non-interest
income consists primarily of gains on the sale of mortgage loans, deposit
account service charges, income on bank owned life insurance and cash management
fees. For the three-month and nine-month periods ended September 30, 2008, the
Company realized non-interest income of $203,218 and $613,460, respectively, as
compared to $148,086 and $521,292 for the same periods ended September 30, 2007.
Gains on the sale of mortgage loans of $73,387 and $214,024 comprised 36.1% and
34.9% of the total for the three-month and nine-month periods ended September
30, 2008, respectively. This compares to gains on the sale of mortgage loans of
$91,442 and $351,934, or 61.7% and 67.5%, of total non-interest income for the
three-month and nine-month periods ended September 30, 2007.




17




The level
of gains on the sale of mortgage loans decreased for the three-month and
nine-month periods ended September 30, 2008 due to a general decrease in home
purchase and refinance activity in the Company’s markets.  The change
in gains as a percentage of non-interest income is a result of the addition of
income from bank owned life insurance in the fourth quarter of
2007.





Service
charges on deposit accounts totaled $58,711 and $184,090 for the three-month and
nine-month periods ended September 30, 2008 as compared to $38,885 and $111,296
for the same periods in 2007. The increases of 51.0% and 65.4% for the three and
nine-month periods are attributable to an increase in overdraft fees charged on
transaction accounts as well as an increase in analysis fees charged on business
checking accounts. Although overdraft fees increased, the Company continues to
maintain a very low level of average overdrafts. Analysis fees have increased as
a result of the previously discussed Federal Reserve actions, which reduced the
rates used to calculate credits available to customers to offset any analysis
fees they incurred.





The
increase of $53,361 and $157,284, or 300.5% and 270.9%, in all other
non-interest income items for the three-month and nine-month periods ended
September 30, 2008 was primarily attributable to the Company’s investment in
bank owned life insurance (“BOLI”), which was purchased during the fourth
quarter of 2007.  The initial investment totaled $5.0 million and the
Company recognized income of $58,473 and $171,795 related to increases in this
investment during the three-months and nine-months ended September 30,
2008.





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





Non-Interest
Expense





Non-interest
expense for the three-month and nine-month periods ended September 30, 2008
totaled $2.6 million and $8.3 million, respectively. This compares to
non-interest expense for the comparable periods in 2007 of $2.3 million and $6.8
million, respectively. The increases of approximately $316,000 and $1.5 million,
or 13.9% and 21.8%, are spread across almost all expense categories and were
primarily due to the growth of the business development staff resulting from
geographic expansion into the Baltimore-Washington Corridor as well as the costs
associated with managing the portfolio of investor-owned residential real estate
loans.





The
increases in salaries and benefits of approximately $148,000 and $460,000 for
the three-month and nine-month periods related to staffing growth, including the
expansion into the Baltimore-Washington Corridor with the January 2008 opening
of an office in Columbia currently staffed with four experienced commercial
relationship managers, a cash management specialist and a commercial account
manager. In addition, an experienced commercial relationship manager was added
in the Lutherville office in January 2008 and additional account managers were
hired in the fourth quarter of 2007 and in January of 2008 to manage the
anticipated growth in business from these offices. These additions were made to
continue to expand the Bank’s market presence, as well as to manage the growth
of the loan and deposit portfolios and support increased operational volume. The
cost of this additional staffing was somewhat offset by a reduction in
commissions paid due to a significant decline in the origination of residential
construction and reconstruction loans. In addition, the Company began to realize
some benefit from the previously mentioned reduction in staff.




18




Occupancy
expenses increased by $29,456 and $83,397 for the three-months and nine-months
ended September 30, 2008 as compared to the same periods in 2007. The 18.0%
and 17.2% increases for the three and nine-month periods, respectively,
were due to scheduled rent increases and the acquisition of new space obtained
in December 2007 for the Company’s Baltimore-Washington Corridor office located
in Columbia, Maryland. The Company currently sublets approximately 650 square
feet of space currently occupied by the Towson residential lending
group.





Legal and
professional fees increased $95,485 and $412,651, or 96.4% and 172.7%, for the
three-month and nine-month periods ended September 30, 2008 as compared to the
same periods in 2007. The increase was primarily related to legal fees and other
costs incurred to manage the collection and foreclosure process on loans in the
Company’s residential real estate portfolio.





Data
processing and other outside services expense decreased by $13,085 and increased
by $123,507, or 5.8% and 19.9%, for the three-month and nine-month periods ended
September 30, 2008 as compared to the three-month and nine-month periods in
2007, respectively. The increase for the nine-month period is due to the cost of
implementing and supporting a computer infrastructure at an additional location,
the costs associated with implementation and expansion of the Company’s remote
deposit capture product, an increase in outsourced data and item processing
costs that are a function of the growth of the Bank, recruiting expenses
associated with hiring new staff and an increased use of outsourced
administrative services to accommodate the growth of the Company in lieu of
adding additional administrative staff.  The decrease in expenses for
the three-month period was primarily related to a reduction in human resource
and other consulting fees due to expense management.





Advertising
and marketing-related expenses decreased by $1,088 and increased by $88,495, or
1.0% and 27.4%, for the three-month and nine-month periods ended September 30,
2008 as compared to the three-month and nine-month periods in 2007,
respectively. The increase for the nine-month period is a result of the
expansion of the business development staff and the opening of the office in the
Baltimore-Washington Corridor.  The slight decrease for the
three-month period was driven by reduced public relation expenses due to the
previously mentioned staff reduction and a continued focus on expense
management.





The
$57,135 and $311,652, or 20.6% and 36.6%, increases in all other
non-interest expense items for the three-month and nine-month periods ended
September 30, 2008 were primarily due to an approximate $57,000 reduction in the
value of two properties in other real estate owned as well as loan collection
costs incurred to manage the weaknesses in the Company’s residential real estate
loan portfolio.  Loan collection costs totaled $16,468 and $142,292
for the three-month and nine-month periods ended September 30, 2008,
respectively.  Increases in other various costs were associated with
the increased size and complexity of the Company.





The
banking industry utilizes an “efficiency ratio” as a key measure of expense
management and overall operating efficiency. This ratio is computed by dividing
non-interest expense by the sum of net interest income, before the provision for
credit losses, and non-interest income. The Company’s efficiency ratio was
117.2% and 112.3% for the three-month and nine-month periods ended September 30,
2008, respectively. This compares to 74.1% and 70.4% for the three-month and
nine-month periods in 2007, respectively. The increase in the efficiency ratio
from the prior year is a result of the previously discussed decline in revenue
as well as management’s decision to continue to invest in personnel to
support the long-term growth of the Company.




19




Management
will continue to focus on the preservation of capital and liquidity while
managing asset/portfolio risk seeking to improve our operating efficiencies. The
Company will also continue to commit the necessary resources to work through the
asset quality issues in the residential real estate portfolio.





Income
Taxes





For the
three-month and nine-month periods ended September 30, 2008, the Company
recorded an income tax benefit of $1.1 million and $2.4 million, respectively.
This compares to income tax expense of $182,000 and $1.0 million recorded for
the same periods in 2007, respectively.  The change is a direct result
of the significant decline in taxable income between the periods.





The
Company recognized a deferred tax asset of $3.8 million as of September 30, 2008
determined based on the difference between the financial statement and tax bases
of its assets and liabilities. Management believes that the future realization
of this deferred tax asset is more likely than not as of September 30,
2008.





Financial
Condition





Composition
of the Balance Sheet





As of
September 30, 2008, total assets were $274.1 million. This represents an
increase of $17.6 million, or 6.9%, since December 31, 2007. The change in total
assets includes increases of $11.7 million in Federal funds sold and other
overnight investments, $2.0 million in loans net of the allowance for credit
losses, $4.0 million in other real estate owned, $171,795 in bank owned life
insurance and approximately $2.3 million in other non-earning assets. These
increases were offset by decreases of $1.8 million in cash and due from banks,
$399,529 in investment securities available for sale and $475,400 in other
equity securities.





Under a
program introduced during the second quarter of 2004, the Company purchases a
100% participation in mortgage loans originated by a mortgage company in the
Baltimore metropolitan area. These participations are for loans that a secondary
market investor has committed to purchase. The participations are typically held
for a period of three to four weeks before being sold to the secondary market
investor, during which time the secondary market investor reviews the files for
completeness and accuracy. The Company earns interest on these loans at a rate
indexed to the prime rate. The primary risk of this program is that the
secondary market investor may decline to purchase the loans due to documentary
deficiencies or errors. The Company attempts to manage this risk by conducting a
thorough review of the documentation prior to purchasing the participation. If
the secondary market investor declines to purchase the loan, the Company could
attempt to sell the loan to other investors or hold the loan in its loan
portfolio.





As of
September 30, 2008, the Company held no such loans which were classified as held
for sale. There were $8.2 million of loans outstanding under this program as of
December 31, 2007. This fluctuation in balances is indicative of the cyclical
nature of mortgage lending, the mortgage company’s ability to use other funding
sources as its volume fluctuates and the downturn in the residential real estate
market.







20




As of
September 30, 2008, loans, excluding loans held for sale, totaled $243.2
million. This represents an increase of $13.8 million, or 6.0%, as compared
to a balance of $229.4 million as of December 31, 2007. Loan growth was
particularly strong in the Company’s Lutherville office and its newly opened
Baltimore-Washington Corridor office. This growth resulted from the addition of
experienced Commercial Relationship Managers that were well positioned to take
advantage of market disruptions caused by turnover in the lending staffs of two
institutions in the Company’s markets.





The
composition of the loan portfolio as of September 30, 2008 was approximately
$118.5 million of commercial loans, $3.7 million of consumer loans, and $121.0
million of real estate loans (excluding mortgage loans held for sale). The
composition of the loan portfolio as of December 31, 2007 was approximately
$102.7 million of commercial loans, $4.1 million of consumer loans, and $122.6
million of real estate loans (excluding mortgage loans held for sale). Mortgage
loans held for sale were $1.5 million and $11.6 million as of September 30, 2008
and December 31, 2007, respectively.





The
Company has experienced ongoing weakness in its portfolio of residential
construction and reconstruction loans. The total portfolio as of September 30,
2008 was approximately $37.3 million of which $11.2 million was classified as
non-accrual and an additional $7.1 million was 30 days or more past due.
Management is proactively and aggressively addressing the problems in this
portfolio by reviewing the specific credits more frequently, consulting with
legal counsel when necessary, working with borrowers for potential restructure
or working with potential investors to facilitate the sale of the property. In
addition, the Company has significantly tightened underwriting standards for
these types of loans and is currently originating very little of this type of
business.  Resolving these issues will take time as the residential
real estate market works through its downturn and housing inventories return to
normal levels; therefore, there can be no assurance that management’s actions
will result in immediate decreases in the rate of non-accrual and past due
loans.





During
the nine-month period ending September 30, 2008, the Company foreclosed on
eleven pieces of residential real estate related to investor-owned properties.
These properties were placed into other real estate owned at estimated net
realizable value of approximately $5.3 million. The difference between the
related loan balances totaling approximately $8.5 million and the net realizable
value was charged off to the allowance for credit losses during the period.
These foreclosures combined with the sale of six properties and additional
write-downs and reserves on properties already held in other real estate owned
brought the total other real estate owned to approximately $5.0 million as of
September 30, 2008.





Funds not
extended in loans are invested in cash and due from banks and various
investments including federal funds sold and other overnight investments, U.S.
Treasury securities, Federal Reserve Bank stock, Federal Home Loan Bank stock
and bank owned life insurance. These investments totaled approximately $23.6
million as of September 30, 2008 compared to approximately $14.3 million as of
December 31, 2007.





At
September 30, 2008, the Company had cash and due from banks of $554,626 as
compared to $2.3 million as of December 31, 2007. Management attempts to limit
the amount of these funds since they are non-interest bearing. As of September
30, 2008, the Company had federal funds sold and other overnight investments
totaling $16.6 million as compared to $4.9 million as of December 31, 2007. The
increase is a result of management’s decision to gather relatively low cost
funds during the nine months ending September 30, 2008 in the national market
for CDs in order to fund current and anticipated loan growth. The Company
held $704,200 and $607,300 of Federal Reserve Bank stock as of
September 30, 2008 and December 31, 2007, respectively. The Company also held
Federal Home Loan Bank of Atlanta (“FHLB”) stock of $535,400
and $1,107,700 as of September 30, 2008 and December 31, 2007,
respectively. The decrease in FHLB stock is a result of reduced borrowings under
FHLB lines of credit which require the purchase of stock equivalent to 4.5% of
outstanding borrowings. As of December 31, 2007, the Company held U.S. Treasury
bills with a maturity value of $400,000, none of which were held as of September
30, 2008.




21




Deposits
at September 30, 2008 were $233.3 million of which approximately $8.4 million,
or 3.6%, was related to one customer. Deposits at December 31, 2007 were $202.0
million of which deposits for the same customer stood at approximately $6.2
million, or 3.1%, of total deposits. The deposits for this customer tend to
fluctuate significantly; as a result, management monitors these deposits on a
daily basis to ensure that liquidity levels are adequate to compensate for these
fluctuations.  The increase in total deposits from December 31, 2007
was related to replenishment of core deposits that were drawn down in the fourth
quarter of 2007 as well as the previously discussed effort to gather reasonably
priced national market CDs to fund current and anticipated loan growth as well
as pay down short-term borrowings. National market CDs are discussed in more
detail below.





In the
first quarter of 2006, the Company began using brokered certificates of deposit
through the Promontory Financial Network. Through this deposit matching network
and its certificate of deposit account registry service (CDARS), the Company has
the ability to offer its customers access to FDIC-insured deposit products in
aggregate amounts exceeding current insurance limits. When the Company places
funds through CDARS on behalf of a customer, it receives matching deposits
through the network. Due to its operating results, the Company is currently
unable to raise deposits directly through the network.  These deposits
are also considered “Brokered Deposits” for bank regulatory purposes. As of
September 30, 2008, the Company had approximately $5.0 million of CDARS deposits
outstanding of which all was placed on behalf of customers. As of December 31,
2007, the Company had approximately $27.0 million of CDARS deposits outstanding
of which $1.0 million were placed on behalf of customers and $26.0 million were
raised by the Company. The decrease in CDARS deposits from December 31, 2007
reflects management’s decision to payoff short-term funding sources and uses the
national market for CDs to extend the terms on time deposits at more favorable
rates.





The
market in which the Company operates is very competitive; therefore, the rates
of interest paid on deposits are affected by rates paid by other depository
institutions. Management closely monitors rates offered by other institutions
and seeks to be competitive within the market. The Company has chosen to
selectively compete for large certificates of deposit. The Company will choose
to pursue such deposits when expected loan growth provides for adequate spreads
to support the cost of those funds or when the cost of funds for these deposits
is determined to be low enough to lock in for longer term funding needs. As of
September 30, 2008, the Company had outstanding certificates of deposit of
approximately $70.2 million that were obtained through the listing of
certificate of deposit rates on two Internet-based listing services (such
deposits are sometimes referred to herein as national market certificates of
deposit). The national market certificates of deposit were issued with an
average yield of 3.8% and an average term of 9 months. Included in the
$70.2 million are national market certificates of deposit totaling approximately
$57.3 million that have been classified as “Brokered Deposits” for bank
regulatory purposes. These “Brokered Deposits” were issued with an average yield
of 3.8% and an average term of 9 months.  As of December 31, 2007, the
total certificates of deposit obtained through the listing of certificate of
deposit rates on the Internet-based listing services were approximately $31.6
million. Included in the $31.6 million were national market certificates of
deposit totaling $199,000 that had been classified as “Brokered Deposits” for
bank regulatory purposes.





Core
deposits, which management categorizes as commercial paper sweep balances and
all deposits other than national market certificates of deposit, CDARS deposits
and $5.4 million of the $8.4 million of deposits from the large customer
described above, stood at $170.0 million as of September 30, 2008. Although
commercial paper sweep balances are reflected as short-term borrowings on the
balance sheet, management considers them core deposits as they represent stable
customer relationships with commercial enterprises.  The $3.4 million,
or 2.0%, decrease from the total as of December 31, 2007 of $173.4 million was
primarily driven by an increase in national market CDs to manage liquidity needs
in the current interest rate environment.  Core deposits are closely
monitored by management because they consider such deposits not only a
relatively stable source of funding but also reflective of the growth of
commercial and consumer depository relationships.




22









Below is
a reconciliation of total deposits to core deposits as of September 30, 2008 and
December 31, 2007, respectively:





September
      30,
              2008
            
            
            December
      31,
              2007Total
      deposits
            
            $
            233,343,954
            
            
            $
            201,981,465Commercial
      paper sweep balances
            
            
            14,087,343
            
            
            
            7,309,508National
      market certificates of deposit (includes CDARS
              deposits)
            
            
            (72,092,429
            )
            
            
            (32,661,081
            )Variable
      balance accounts (1 customer at September 30, 2008
              and
      December 31, 2007)
            
            
            (8,373,154
            )
            
            
            (6,230,689
            )Portion
      of variable balance accounts considered to be core
            
            
            3,000,000
            
            
            
            3,000,000Core
      deposits
            
            $
            169,965,714
            
            
            $
            173,399,203





As of
September 30, 2008, short-term borrowings consisted of $14.1 million borrowed
under an Overnight Commercial Paper program. Borrowings under the Overnight
Commercial Paper are unsecured and are subordinated to all deposits. While these
amounts are not classified as deposits, they do represent customer relationships
with commercial enterprises.  In addition, the Company borrowed $1.6
million under its secured FHLB credit facility.





Included
in short-term borrowings as of December 31, 2007 is $7.3 million of borrowings
under the previously-mentioned Overnight Commercial Paper program and $3.6
million borrowed under Federal Funds lines of credit. These borrowings are
unsecured and are subordinated to all deposits. In addition, the Company
borrowed $14.4 million under its secured FHLB credit facility.





Subordinated
debt consists of $8 million of fixed interest rate trust preferred securities
issued through a Delaware trust subsidiary, Bay National Capital Trust I (the
“Trust”). The Company formed the Trust on December 12, 2005, and the Trust
issued $8 million of trust preferred securities to investors at a fixed interest
rate of 7.20%. The trust preferred securities bear a maturity date of February
23, 2036, but may be redeemed at the Company’s option on any February 23, May
23, August 23 or November 23 on or after February 23, 2011, and require
quarterly distributions by the trust to the holder of the trust preferred
securities. The securities are subordinated to the prior payment of any other
indebtedness of the Company that, by its terms, is not similarly subordinated
securities. The trust preferred securities qualify as Tier 1 capital, subject to
regulatory guidelines that limit the amount included to an aggregate of 25% of
Tier 1 capital.





Allowance
for Credit Losses and Credit Risk Management





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




23




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





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





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





The
allowance for credit losses as of September 30, 2008 and December 31, 2007 was
$6.7 million and $5.0 million, respectively. These amounts equated to 2.73% and
2.08% of outstanding loans, including loans held for sale, as of September 30,
2008 and December 31, 2007, respectively. Excluding loans held for sale, the
allowance for credit losses equated to 2.74% and 2.18% of outstanding loans as
of September 30, 2008 and December 31, 2007, respectively. The increased
percentage was primarily due to an additional provision of $1.7 million recorded
during the period due to ongoing weaknesses in the Company’s portfolio of
residential construction and reconstruction loans.  This is a direct
result of weaknesses in the housing markets in its target
markets.  Bay National Corporation has no exposure to foreign
countries or foreign borrowers. Management believes that the allowance for
credit losses is adequate for each period presented.





As of
September 30, 2008, the Company had non-accrual loans totaling $18.7
million, most of which, approximately $11.2 million, were in the residential
real estate construction and reconstruction loan portfolio.  The
remainder, approximately $7.5 million, represents commercial and consumer loans
secured by real estate.  This is a direct result of the slowdown in
the real estate market, which has resulted in an increase in loan extensions and
delinquencies due to the inability of borrowers to refinance or sell properties
as quickly as anticipated.  These nonperforming loans represented 7.6%
of total outstanding loans, including loans held for sale, as of September 30,
2008.  All of these loans are at least partially collateralized by
real estate. As of December 31, 2007, the Company had $9.4 million of
non-accrual loans representing 3.9% of total outstanding
loans.  Management will continue to closely monitor these loans and
the overall




24




level of
delinquencies; however, management believes that the allowance for credit losses
is adequate for these loans.  Any losses on these loans will be
charged off as soon as the amount of loss is determinable.





The
Company recorded $2.5 million and $3.8 million of net charge-offs during the
three-month and nine-month periods ended September 30, 2008, respectively. The
Company recorded $315,989 of net charge-offs during the three-month and
nine-month periods ended September 30, 2007.





Management
believes that the overall allowance for credit losses is adequate for each
period presented.





Liquidity





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





The
Company’s primary sources of funds are deposits, short-term borrowings in the
form of borrowings under the Overnight Commercial Paper program, Federal funds
and FHLB credit facilities, scheduled amortization and prepayment of loans,
funds provided by operations and capital. While scheduled principal repayments
on loans are a relatively predictable source of funds, deposit flows and loan
prepayments are greatly influenced by economic conditions and rates offered by
our competition.





The
Company's most liquid assets are cash and assets that can be readily converted
into cash, including investment securities maturing within one year. As of
September 30, 2008, the Company had $554,626 in cash and due from banks, $16.6
million in federal funds sold and other overnight investments and $1.5 million
in loans expected to be sold within 60 days. As of December 31, 2007, the
Company had $2.3 million in cash and due from banks, $4.9 million in federal
funds sold and other overnight investments, $399,529 in three-month U.S.
Treasury Securities and $11.6 million in loans expected to be sold within 60
days.





The
increase in the overall level of liquid assets was the result of a deliberate
effort by management to strengthen the Company’s liquidity position in an
extremely volatile market. Growth in the Company’s loan portfolio, without
corresponding growth in deposits, would reduce liquidity as would reductions in
the level of customer deposits.





The
Company has commitments for a total of $9 million of borrowing availability
under secured and unsecured Federal funds lines of credit with three separate
financial institutions. The Company also has approximately $22.5 million of
borrowing capacity with the Federal Home Loan Bank of Atlanta as of September
30, 2008. These credit facilities can be used in conjunction with the normal
deposit strategies, which include pricing changes to increase deposits as
necessary. From time-to-time, the Company may sell or participate out loans to
create additional liquidity as required.





As of
September 30, 2008, the Company is unable to accept additional brokered deposits
without prior approval of the FDIC.  This is a standard requirement
for banks that are deemed to be “Adequately Capitalized.”  As of
September 30, 2008, $2.7 million of the $57.3 million of brokered CDs will
mature by December 31, 2008 and $27.7 million will mature during the first
quarter of 2009.  As such, management does not expect that this
requirement will have a material impact on liquidity during the remainder of
2008.





25




The
Company currently has sufficient liquidity to meet its loan commitments as well
as fluctuations in deposits. The Company will choose to retain maturing
certificates of deposit, when necessary, by offering competitive
rates.





In
response to the credit crisis, the federal government has recently taken several
steps to free up bank liquidity.  One of these measures is the U.S.
Department of Treasury’s Capital Purchase Program under the Emergency Economic
Stabilization Act of 2008 (the “EESA”).  Under this program, the
Treasury intends to make senior preferred stock investments in participating
financial institutions that will qualify as Tier 1
Capital.  Management is currently evaluating the Company’s
participation in this program.  Regardless of the Company’s
participation, governmental intervention and new regulations under this program
could materially and adversely affect its business, financial condition and
results of operation.





Management
is not aware of any known trends, events or uncertainties, not otherwise
discussed above, that will have or are reasonably likely to have a material
effect on liquidity, capital or operations, nor is management aware of any
current recommendation by regulatory authorities, which if implemented, would
have a material effect on liquidity, capital or operations.





Interest
Rate Sensitivity





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





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


26


The
following table sets forth the amount of the Company's interest-earning assets
and interest-bearing liabilities as of September 30, 2008, which are expected to
mature or reprice in each of the time periods shown:









Maturity
      or repricing withinAmount
            
            
            Percent
      of
              Total
            
            
            0
      to 3
              Months
            
            
            
            4
      to 12
              Months
            
            
            1
      to 5
              Years
            
            
            
            Over
      5
              YearsInterest-earning
      assetsFederal
      funds sold and other
              overnight
      investments
            
            $
            16,602,735
            
            
            
            6.33
            %
            
            $
            16,602,735
            
            
            
            $
            -
            
            
            $
            -
            
            
            
            $
            -Loans
      held for sale
            
            
            1,452,260
            
            
            
            .55
            
            
            
            1,452,260
            
            
            
            
            -
            
            
            
            -
            
            
            
            
            -Loans
      – Variable rate
            
            
            118,257,273
            
            
            
            45.06
            
            
            
            118,257,273
            
            
            
            
            -
            
            
            
            -
            
            
            
            
            -Loans
      – Fixed rate
            
            
            124,922,606
            
            
            
            47.59
            
            
            
            35,267,322
            
            
            
            
            15,670,827
            
            
            
            64,694,895
            
            
            
            
            9,289,562Other  earning
      assets
            
            
            1,239,600
            
            
            
            .47
            
            
            
            -
            
            
            
            
            -
            
            
            
            -
            
            
            
            
            1,239,600Total
      interest-earning assets
            
            $
            262,474,474
            
            
            
            100.00
            %
            
            $
            171,579,590
            
            
            
            $
            15,670,827
            
            
            $
            64,694,895
            
            
            
            $
            10,529,162Interest-bearing
      liabilitiesDeposits
      – Variable rate
            
            $
            65,631,317
            
            
            
            30.22
            %
            
            $
            65,631,317
            
            
            
            $
            -
            
            
            $
            -
            
            
            
            $
            -Deposits
      – Fixed rate
            
            
            127,812,793
            
            
            
            58.86
            
            
            
            25,994,123
            
            
            
            
            76,056,313
            
            
            
            25,762,357
            
            
            
            
            -Short-term
      borrowings – Variable
              rate
            
            
            15,717,344
            
            
            
            7.24
            
            
            
            15,717,344
            
            
            
            
            -
            
            
            
            -
            
            
            
            
            -Subordinated
      debt
            
            
            8,000,000
            
            
            
            3.68
            
            
            
            -
            
            
            
            
            -
            
            
            
            -
            
            
            
            
            8,000,000Total interest-bearing liabilities
            
            $
            217,161,454
            
            
            
            100.00
            %
            
            $
            107,342,784
            
            
            
            $
            76,056,313
            
            
            $
            25,762,357
            
            
            
            $
            8,000,000Periodic
      repricing differencesPeriodic
      gap
            
            
            
            
            
            
            
            
            
            $
            64,236,806
            
            
            
            $
            (60,385,486
            )
            
            $
            38,932,538
            
            
            
            $
            2,529,162Cumulative
      gap
            
            
            
            
            
            
            
            
            
            $
            64,236,806
            
            
            
            $
            3,851,320
            
            
            $
            42,783,858
            
            
            
            $
            45,313,020Ratio
      of rate sensitive assets to rate
              sensitive
      liabilities
            
            
            
            
            
            
            
            
            
            
            159.84
            %
            
            
            
            20.60
            %
            
            
            251.12
            %
            
            
            
            131.61
            %





The
Company has 51.9% of its interest-earning assets and 37.5% of its
interest-bearing liabilities in variable rate balances. Interest-earning assets
exceed interest-bearing liabilities by $45.3 million. The majority of this gap
is concentrated in items maturing or repricing within five years. This gap is
generally reflective of the Company’s effort, over the past nine months, to
maintain flexibility in the balance sheet in a declining interest rate
environment. As rates have dropped over the past nine months, the Company has
begun to extend the term on time deposits in order to lock in lower deposit
rates for a longer period of time. This analysis indicates that the Company will
benefit from increasing market rates of interest. However, since all interest
rates and yields do not adjust at the same pace, the gap is only a general
indicator of interest rate sensitivity. The analysis of the Company's
interest-earning assets and interest-bearing liabilities presents only a static
view of the timing of maturities and repricing opportunities, without taking
into consideration the fact that changes in interest rates do not affect all
assets and liabilities equally. Net interest income may be affected by other
significant factors in a given interest rate environment, including changes in
the volume and mix of interest-earning assets and interest-bearing
liabilities.





Management
constantly monitors and manages the structure of the Company's balance sheet,
seeks to control interest rate exposure, and evaluates pricing strategies.
Strategies to better match maturities of interest-earning assets and
interest-bearing liabilities include structuring loans with rate floors and
ceilings on variable-rate notes and providing for repricing opportunities on
fixed-rate notes. Management believes that a lending strategy focusing on
variable-rate loans and short-term fixed-rate loans will best facilitate the
goal of minimizing interest rate risk. However, management will
opportunistically enter into longer term fixed-rate loans and/or investments
when, in management’s judgment, rates adequately compensate the Company for the
interest rate risk. The Company's current investment concentration in Federal
funds sold and other overnight investments provides the most flexibility and
control over rate sensitivity, since it generally can be restructured more
quickly than the loan portfolio. On the liability side, deposit products can be
restructured so as to offer incentives to attain the maturity distribution
desired; although, competitive factors sometimes make control over deposit
maturity difficult.




27




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





Off-Balance
Sheet Arrangements





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





Outstanding
loan commitments and lines and letters of credit as of September 30, 2008 and
December 31, 2007 are as follows:





September
      30,
              2008
            
            
            December
      31,
              2007Loan
      commitments
            
            $
            22,627,482
            
            
            $
            35,114,676Unused
      lines of credit
            
            
            89,101,487
            
            
            
            85,999,686Letters
      of credit
            
            
            3,449,816
            
            
            
            3,564,927





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Commitments
generally have interest rates fixed at current market amounts, fixed expiration
dates or other termination clauses and may require payment of a fee. Unused
lines of credit represent the unused portion of lines of credit previously
extended and available to the customer as long as there is no violation of any
contractual condition. These lines generally have variable interest rates. Since
many of the commitments are expected to expire without being drawn upon, and
since it is unlikely that customers will draw upon their line of credit in full
at any time, the total commitment amount or line of credit amount does not
necessarily represent future cash requirements. The Company is not aware of any
loss it would incur by fully funding its commitments or lines of
credit.





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





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





The
decline in the overall level of loan commitments as of September 30, 2008 as
compared to December 31, 2007 is reflective of management’s decision to become
more selective in order to manage capital.




28




Capital
Resources





The
Company had stockholders’ equity at September 30, 2008 of $16.0 million as
compared to $19.9 million at December 31, 2007. The decrease in capital is a
result of the operating loss incurred for the nine-months ended September 30,
2008. Management is extremely focused on ensuring that the Company has adequate
capital to support projected asset growth over the next 12 months.





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





Banking
regulations also limit the amount of dividends that may be paid without prior
approval of the Bank's regulatory agencies. Regulatory approval is required to
pay dividends that exceed the Bank’s net profits for the current year plus its
retained net profits for the preceding two years. The Bank could not have paid
dividends to the Company without approval from bank regulatory agencies at
September 30, 2008, and no such payments are currently planned.





Application
of Critical Accounting Policies





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





Based on
the valuation techniques used and the sensitivity of financial statement amounts
to the methods, assumptions and estimates underlying those amounts, management
has identified the determination of the allowance for credit losses as the
accounting area that requires the most subjective or complex judgments, and as
such could be most subject to revision as new information becomes
available.









29




Management
has significant discretion in making the judgments inherent in the determination
of the provision and allowance for credit losses. The establishment of allowance
factors is a continuing exercise and allowance factors may change over time,
resulting in an increase or decrease in the amount of the provision or allowance
based upon the same volume and classification of loans. Changes in allowance
factors or in management’s interpretation of those factors will have a direct
impact on the amount of the provision and a corresponding effect on income and
assets. Also, errors in management’s perception and assessment of the allowance
factors could result in the allowance not being adequate to cover losses in the
portfolio, and may result in additional provisions or charge-offs, which would
adversely affect income and capital.





For
additional information regarding the allowance for credit losses, see “Allowance
for Credit Losses and Credit Risk Management.”





30


Item
3.  Quantitative and Qualitative
Disclosures About Market Risk





Not applicable.





Item
4.   Controls and
Procedures





As of the
end of the period covered by this quarterly report on Form 10-Q, Bay National
Corporation’s Chief Executive Officer and Chief Financial Officer evaluated the
effectiveness of Bay National Corporation’s disclosure controls and
procedures.  Based upon that evaluation, Bay National Corporation’s
Chief Executive Officer and Chief Financial Officer concluded that Bay National
Corporation’s disclosure controls and procedures are effective as of September
30, 2008.  Disclosure controls and procedures are controls and other
procedures that are designed to ensure that information required to be disclosed
by Bay National Corporation in the reports that it files or submits under the
Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission’s rules and forms.





In addition, there were no changes in
Bay National Corporation’s internal control over financial reporting (as defined
in Rule 13a-15 under the Exchange Act) during the quarter ended September 30,
2008, that have materially affected, or are reasonably likely to materially
affect, Bay National Corporation’s internal control over financial
reporting.





Information
Regarding Forward-Looking Statements





This
report contains certain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended and Section 21E
of the Exchange Act.  Forward-looking statements also may be included
in other statements that we make.  All statements that are not
descriptions of historical facts are forward-looking statements. Forward-looking
statements often use words such as “believe,” “expect,” “plan,” “may,” “will,”
“should,” “project,” “contemplate,” “anticipate,” “forecast,” “intend” or other
words of similar meaning. You can also identify them by the fact that they do
not relate strictly to historical or current facts.









31




The
statements presented herein with respect to, among other things, the Company’s
plans, objectives, expectations and intentions, including statements regarding
long-term growth, market expansion, earnings during the remainder of 2008 or
beyond such time, loan, asset and business growth, benefits resulting from
previous staff reductions, future sources of income, the impact or worsening
economic conditions on the Company, future realization of deferred tax asset,
operating results and profitability, liquidity, allowance for credit losses,
interest rate sensitivity, retention of deposits, and financial and other goals,
as well as statements with respect to the future status of our loan portfolio
are forward-looking. These statements are based on the Company’s beliefs and
assumptions, and on information available to it as of the date of this filing,
and involve risks and uncertainties. These risks and uncertainties include,
among others, those discussed in this report on Form 10-Q; the Company’s
dependence on key personnel; risks related to the Bank’s choice of loan
portfolio; continuing declines in the real estate market in the Company’s
markets and in the economy generally; risks related to the Bank’s lending limit;
risks of a competitive market; the impact of any new or amended government
regulations on operating results; and the effects of developments in technology.
For a more complete discussion of these risks and uncertainties, see the
discussion under the caption “Risk Factors” in Bay National Corporation’s Form
10-K for the year ended December 31, 2007. The Company’s actual results and the
actual outcome of our expectations and strategies could differ materially from
those anticipated or estimated because of these risks and uncertainties and you
should not put undue reliance on any forward-looking statements. All
forward-looking statements speak only as of the date of this filing, and the
Company undertakes no obligation to update the forward-looking statements to
reflect factual assumptions, circumstances or events that have changed after the
forward-looking statements are made.




32


PART
II – OTHER INFORMATION





Item
1.        Legal
Proceedings.





None





Item
1A.  Risk Factors





Except as discussed below, there have
been no material changes in the risk factors from those disclosed in our Annual
Report on Form 10-K for the year ended December 31, 2007.





If economic conditions
deteriorate our results of operations and financial condition could be adversely
affected as borrowers’ ability to repay loans declines and the value of the
collateral securing our loans decreases.  The capital and
credit markets have been extremely volatile for over twelve months and there
have been significant declines in the residential real estate market during the
same period.  As such, the Company continues to experience weaknesses
in its residential construction and reconstruction loan portfolio as loan
delinquencies increase, collateral values decline, and foreclosures
increase.  Although the Company’s commercial loan portfolio continues
to perform well given the current instability in the economy, a worsening of
these conditions may adversely impact this portfolio.  The Company
does not expect improvement in these current market conditions in the near
future, which will continue to negatively affect its business, financial
condition and results of operation.





Liquidity could be impaired
by an inability to access the capital markets or an unforeseen cash
outflow.  The Company’s liquidity could be impaired due to
circumstances that it may be unable to control such as a general capital market
disruption.  Given that the Bank is unable to issue brokered CDs
without prior approval from the FDIC, the Bank’s inability to replace maturing
brokered deposits with core deposits or cash flows from loan repayments may
require the Bank to generate liquidity through other means.





A capital raise may be
required in the future, but that capital may not be available or may not be on
acceptable terms when it is needed.  The Company and the Bank
are required by federal regulatory authorities to maintain adequate capital
levels to support operations.  The Company’s ability to raise
additional capital is dependent on capital market conditions at that time and on
its financial performance.  If the Company cannot raise additional
capital when needed, its ability to further expand operations through internal
growth and deposit gathering could be materially impaired.





Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds.None





Item
      3.
            Defaults
      Upon Senior Securities.Not
      applicable.





Item
      4.
            Submission
      of Matters to a Vote of Securities Holders.None





Item
      5.
            Other
      Information.None




33





Item
      6.
            Exhibits.(a)
            Exhibits.31.1
            Rule 13a-14(a)Certification of
      Chief Executive Officer31.2
            Rule 13a-14(a)Certification of
      Chief Financial Officer32
            Rule 13a-14(b)Certification of
      Chief Executive Officer and Chief Financial Officer





34


SIGNATURES





Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned thereunto duly
authorized.








Bay
      National CorporationDate:
      November 14,  2008
            
            By:
            /s/
      Hugh W. MohlerHugh
      W. Mohler, President(Principal
      Executive Officer)Date:
      November 14, 2008
            
            By:
            /s/
      Mark A. SemanieMark
      A. Semanie, Treasurer(Principal
      Accounting and Financial Officer)










35