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 June 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





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 definition 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 August 14, 2008, the issuer had
2,151,301 shares of Common Stock outstanding.








PART
I  -  FINANCIAL INFORMATION





Item
1.       Financial
Statements





BAY
NATIONAL CORPORATION





CONSOLIDATED BALANCE
SHEETS


As of
June 30, 2008 and December 31, 2007





June
      30,
              2008
            
            
            December
      31,
              2007ASSETS
            
            
            
            
            (Unaudited)Cash and due from
      banks
            
            
            
            $
            458,990
            
            $
            2,314,423Federal funds sold and other
      overnight investments
            
            
            
            
            12,183,948
            
            
            4,859,248Investment securities available
      for sale (AFS) - at fair value
            
            
            
            
            -
            
            
            399,529Other
      equity securities
            
            
            
            
            1,503,000
            
            
            1,715,000Loans
      held for sale
            
            
            
            
            4,216,362
            
            
            11,601,070Loans, net of unearned
      fees
            
            
            
            
            250,204,991
            
            
            229,355,171Total
      Loans
            
            
            
            
            254,421,353
            
            
            240,956,241Less: Allowance for credit
      losses
            
            
            
            
            (6,700,000
            )
            
            (5,000,000
            )Loans, net
            
            
            
            
            247,721,353
            
            
            235,956,241Other
      real estate owned, net
            
            
            
            
            2,067,955
            
            
            946,431Premises
      and equipment, net
            
            
            
            
            1,331,421
            
            
            1,210,787Investment
      in bank owned life insurance
            
            
            
            
            5,154,984
            
            
            5,041,662Accrued
      interest receivable and other assets
            
            
            
            
            5,404,730
            
            
            4,092,538Total Assets
            
            
            
            $
            275,826,381
            
            $
            256,535,859LIABILITIESNon-interest-bearing
      deposits
            
            
            
            $
            38,260,722
            
            $
            31,044,172Interest-bearing
      deposits
            
            
            
            
            188,890,888
            
            
            170,937,293Total deposits
            
            
            
            
            227,151,610
            
            
            201,981,465Short-term
      borrowings
            
            
            
            
            21,811,135
            
            
            25,371,508Subordinated
      debt
            
            
            
            
            8,000,000
            
            
            8,000,000Accrued
      expenses and other liabilities
            
            
            
            
            1,062,295
            
            
            1,262,334Total
    Liabilities
            
            
            
            
            258,025,040
            
            
            236,615,307STOCKHOLDERS'
      EQUITYCommon stock - $.01 par value,
      authorized:9,000,000 shares
      authorized, 2,147,551 and 2,137,633 issued and
              outstanding
      as of  June 30, 2008 and December 31, 2007,
              respectively
            
            
            
            
            21,476
            
            
            21,376Additional paid in
      capital
            
            
            
            
            17,931,954
            
            
            17,788,833Retained earnings (accumulated
      deficit)
            
            
            
            
            (152,089
            )
            
            2,110,343Total Stockholders'
      Equity
            
            
            
            
            17,801,341
            
            
            19,920,552Total Liabilities and
      Stockholders' Equity
            
            
            
            $
            275,826,381
            
            $
            256,535,859











See
accompanying notes to consolidated financial statements.





2




BAY
NATIONAL CORPORATION





CONSOLIDATED STATEMENTS OF
OPERATIONS


For the
three and six-month periods ended June 30, 2008 and 2007


(Unaudited)





Three
      Months Ended
              June
      30
            
            
            Six
      Months Ended
              June
      302008
            
            
            2007
            
            
            2008
            
            
            2007INTEREST
      INCOME:Interest and fees on
      loans
            $
            3,786,381
            
            $
            5,125,869
            
            $
            8,094,465
            
            $
            10,210,677Interest
      on federal funds sold and other overnight
              investments
            
            39,721
            
            
            184,928
            
            
            85,112
            
            
            427,214Taxable interest and dividends
      on investmentsecurities
            
            26,975
            
            
            33,526
            
            
            38,963
            
            
            49,646Total interest
    income
            
            3,853,077
            
            
            5,344,323
            
            
            8,218,540
            
            
            10,687,537INTEREST
      EXPENSE:Interest
      on deposits
            
            1,409,265
            
            
            2,101,080
            
            
            3,027,458
            
            
            4,130,527Interest
      on short-term borrowings
            
            37,729
            
            
            39,523
            
            
            152,094
            
            
            60,704Interest
      on subordinated debt
            
            150,131
            
            
            150,109
            
            
            300,122
            
            
            298,563Total
      interest expense
            
            1,597,125
            
            
            2,290,712
            
            
            3,479,674
            
            
            4,489,794Net
      interest income
            
            2,255,952
            
            
            3,053,611
            
            
            4,738,866
            
            
            6,197,743Provision
      for credit losses
            
            557,929
            
            
            -
            
            
            3,025,629
            
            
            -Net
      interest income after provision forcredit losses
            
            1,698,023
            
            
            3,053,611
            
            
            1,713,237
            
            
            6,197,743NON-INTEREST
      INCOME:Service charges on deposit
      accounts
            
            69,128
            
            
            35,470
            
            
            125,379
            
            
            72,411Gain
      on sale of mortgage loans
            
            60,993
            
            
            125,043
            
            
            140,637
            
            
            260,492Income
      from bank owned life insurance
            
            57,365
            
            
            -
            
            
            113,322
            
            
            -Other income
            
            14,403
            
            
            20,465
            
            
            30,904
            
            
            40,303Total non-interest
      income
            
            201,889
            
            
            180,978
            
            
            410,242
            
            
            373,206NON-INTEREST
      EXPENSES:Salaries and employee
      benefits
            
            1,625,370
            
            
            1,375,588
            
            
            3,184,327
            
            
            2,872,777Occupancy
    expenses
            
            187,707
            
            
            163,263
            
            
            374,418
            
            
            320,477Furniture and equipment
      expenses
            
            103,049
            
            
            84,674
            
            
            199,451
            
            
            169,911Legal and professional
      fees
            
            291,878
            
            
            76,044
            
            
            457,071
            
            
            139,905Data processing and other
      outside services
            
            276,855
            
            
            207,207
            
            
            530,455
            
            
            393,863Advertising
      and marketing related expenses
            
            152,214
            
            
            85,925
            
            
            301,090
            
            
            211,507Other expenses
            
            359,389
            
            
            224,262
            
            
            628,391
            
            
            403,414Total non-interest
      expenses
            
            2,996,462
            
            
            2,216,963
            
            
            5,675,203
            
            
            4,511,854(Loss)
      Income before income taxes
            
            (1,096,550
            )
            
            1,017,626
            
            
            (3,551,724
            )
            
            2,059,095Income
      tax (benefit) expense
            
            (320,292
            )
            
            396,000
            
            
            (1,289,292
            )
            
            818,000NET
      (LOSS) INCOME
            $
            (776,258
            )
            $
            621,626
            
            $
            (2,262,432
            )
            $
            1,241,095Per
      Share Data:Net (Loss) Income (basic) (1)
            $
            (.36
            )
            $
            .29
            
            $
            (1.06
            )
            $
            .58Net (Loss) Income (diluted)(1)
            $
            (.36
            )
            $
            .28
            
            $
            (1.06
            )
            $
            .56Weighted Average shares
      outstanding (basic) (1)
            
            2,141,806
            
            
            2,130,375
            
            
            2,140,825
            
            
            2,129,629Effect
      of Dilution – Stock options and Restricted
              shares(1)
            
            -
            
            
            79,866
            
            
            -
            
            
            80,388Weighted Average shares
      outstanding (diluted) (1)
            
            2,141,806
            
            
            2,210,241
            
            
            2,140,825
            
            
            2,210,017


(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
six months ended June 30, 2008 and 2007


(Unaudited)











Common
              Stock
            
            
            Additional
              Paid
      in
              Capital
            
            
            Retained
              Earnings
              (Accumulated
              Deficit)
            
            
            Total
              Stockholders’
              EquityBalances
      at January 1, 2008
            $
            21,376
            
            $
            17,788,833
            
            $
            2,110,343
            
            $
            19,920,552Stock-based
      compensation expense
            
            -
            
            
            52,646
            
            
            -
            
            
            52,646Issuance
      of Common Stock
            
            100
            
            
            90,475
            
            
            -
            
            
            90,575Net
      Loss
            
            -
            
            
            -
            
            
            (2,262,432
            )
            
            (2,262,432
            )Balances
      at June 30, 2008
            $
            21,476
            
            $
            17,931,954
            
            $
            (152,089
            )
            $
            17,801,341Common
              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
            
            -
            
            
            31,694
            
            
            -
            
            
            31,694Issuance
      of Common Stock
            
            22
            
            
            15,138
            
            
            -
            
            
            15,1601.1
      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
            
            -
            
            
            -
            
            
            1,241,095
            
            
            1,241,095Balances
      at June 30, 2007
            $
            21,311
            
            $
            17,694,575
            
            $
            2,414,069
            
            $
            20,129,955








See
accompanying notes to consolidated financial statements.


4


BAY
NATIONAL CORPORATION





CONSOLIDATED STATEMENTS OF
CASH FLOWS


For the
six months ended June 30, 2008 and 2007


(Unaudited)





2008
            
            
            2007Cash
      Flows From Operating Activities:Net (Loss)
Income
            
            
            $
            (2,262,432
            )
            $
            1,241,095Adjustments to reconcile net
      (loss) income to net cash provided
              (used)
      by operating activities:Depreciation
            
            
            
            156,229
            
            
            135,884Accretion
      of investment discounts
            
            
            
            (471
            )
            
            (15,567
            )Provisions
      for credit losses
            
            
            
            3,025,629
            
            
            -Provision for losses on other real estate owned
            
            
            
            46,663
            
            
            -Stock-based
      compensation expense
            
            
            
            52,646
            
            
            31,694Increase
      in cash surrender of bank owned life insurance
            
            
            
            (113,322
            )
            
            -Deferred
      income taxes
            
            
            
            (1,160,000
            )
            
            -Gain
      on sale of mortgage loans
            
            
            
            (140,637
            )
            
            (260,492
            )Origination
      of loans held for sale
            
            
            
            (59,494,188
            )
            
            (77,689,381
            )Proceeds
      from sale of loans
            
            
            
            67,019,533
            
            
            64,174,522Net
      (increase) decrease  in accrued interest receivable and
              other
      assets
            
            
            
            (152,192
            )
            
            93,721Net decrease in accrued
      expenses and other liabilities
            
            
            
            (132,204
            )
            
            (799,960
            )Net
      cash provided by (used in) operating activities
            
            
            
            6,845,254
            
            
            (13,088,484
            )Cash
      Flows From Investing Activities:Purchases of investment
      securities available for sale
            
            
            
            -
            
            
            (1,086,260
            )Maturities of investment
      securities available for sale
            
            
            
            400,000
            
            
            1,400,000Purchase
      of Federal Reserve Bank stock
            
            
            
            (66,900
            )
            
            -Redemption
      (purchase) of Federal Home Loan Bank of AtlantaStock
            
            
            
            278,900
            
            
            (668,700
            )Loan
      disbursements in excess of principal payments
            
            
            
            (24,168,659
            )
            
            1,145,141Proceeds
      from the sale of other real estate owned
            
            
            
            862,840
            
            
            -Expenditures
      for other real estate owned
            
            
            
            (37,817
            )
            
            -Expenditures
      for premises and equipment
            
            
            
            (276,863
            )
            
            (141,733)Net cash (used in) provided by
      investing activities
            
            
            
            (23,008,499
            )
            
            648,448Cash
      Flows From Financing Activities:Net increase (decrease) in
      deposits
            
            
            
            25,170,145
            
            
            (15,640,582
            )Net
      (decrease) increase in short-term borrowings
            
            
            
            (3,560,373
            )
            
            18,682,025Net proceeds from issuance of
      common stock
            
            
            
            22,740
            
            
            15,160Cash
      dividends paid in lieu of fractional shares
            
            
            
            -
            
            
            (487
            )Net cash provided by financing
      activities
            
            
            
            21,632,512
            
            
            3,056,116Net
      increase (decrease) in cash and cash equivalents
            
            
            
            5,469,267
            
            
            (9,383,920
            )Cash
      and cash equivalents at beginning of year
            
            
            
            7,173,671
            
            
            33,898,204Cash
      and cash equivalents at end of year
            
            
            $
            12,642,938
            
            $
            24,514,284Supplemental
      information:Interest
      paid
            
            
            $
            3,497,814
            
            $
            4,520,506Income
      taxes paid
            
            
            $
            353,894
            
            $
            1,005,000Accrued
      director fees paid in common stock
            
            
            $
            67,835
            
            $
            -Amount
      transferred from loans to other real estate owned
            
            
            $
            1,993,210
            
            $
            -










See
accompanying notes to consolidated financial statements.




5




BAY
NATIONAL CORPORATION





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS


For the
Three and Six Months Ended June 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 June 30,
2008, that the Bank meets all capital adequacy requirements to which it is
subject.





As of
June 30, 2008, the Bank has been categorized as “Well Capitalized” by the OCC
under the regulatory framework for prompt corrective action. To be categorized
as well 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
June 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.





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 June 30, 2008 (in thousands):





Carrying
              Value
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Loans
            $
            13,716
            
            $
            -
            
            $
            13,716
            
            $
            -Other
      real estate owned
            
            2,068
            
            
            -
            
            
            2,068
            
            
            -Total
      assets at fair value
            $
            15,784
            
            $
            -
            
            $
            15,784
            
            $
            -








7




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
June 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 were not considered in the
computation of diluted earnings per share for the three-month and six-month
periods ended June 30, 2008 because the result would have been
anti-dilutive.  There were no shares or options as of June 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 six-month periods ended June 30, 2008 and 2007. Amounts recognized in
the financial statements with respect to stock-based compensation are as
follows:





Three
      Months Ended
              June
      30
            
            
            Six
      Months Ended
              June
      302008
            
            
            2007
            
            
            2008
            
            
            2007Amounts
      charged against income, before tax
              benefit
            
            $
            29,126
            
            
            $
            15,194
            
            
            $
            52,646
            
            
            $
            31,694Amount
      of related income tax benefit
              recognized
      in income
            
            $
            9,075
            
            
            $
            3,221
            
            
            $
            17,198
            
            
            $
            8,831





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 June 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 six-month period ending June 30, 2008.  The
unrecognized compensation cost related to unvested stock option awards was
$7,044 at June 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 six-month
periods ended June 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
            
            (2,200
            )
            $        6.89Balance,
      June 30, 2007
            
            139,246
            
            $        6.98Balance,
      January 1, 2008
            
            138,741
            
            $        6.99Granted
            
            -
            
            -Cancelled
            
            -
            
            -Exercised
            
            (3,300
            )
            $        6.89Balance,
      June 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 June 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





The
aggregate intrinsic value of options outstanding and exercisable as of June 30,
2008 was $109,807 and $109,322, respectively, based upon a closing price of
$7.80 per share.





10


Restricted Stock
Units





The
following table summarizes the changes in outstanding shares under restricted
stock grants for the six-month periods ended June 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
            
            -
            
            -Cancelled
            
            -
            
            -Unvested
      grants at June 30, 2008
            
            34,500
            
            14.18Unvested
      grants at January 1, 2007
            
            13,200
            $
            17.23Granted
            
            -
            
            -Vested
            
            (3,300
            )
            17.23Cancelled
            
            -
            
            ­-Unvested
      grants at June 30, 2007
            
            9,900
            $
            17.23








During the six-month period ending
June 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.





The
Company incurred compensation expense of $50,582 associated with restricted
stock for the six-month period ending June 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 June 30, 2008 and December 31, 2007 and for the three-month
and six-month periods ended June 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 June 30, 2008 resulting from difficulties in its portfolio of
investor-owned residential real estate loans. Asset and loan growth were strong,
led by growth in the commercial loan portfolio. Key measurements for the
three-month and six-month periods ended June 30, 2008 include the
following:





·
            Total
      assets at June 30, 2008 increased to $275.8 million from $256.5 million as
      of December 31, 2007.





·
            Net
      loans outstanding increased from $236.0 million as of December 31, 2007 to
      $247.7 million as of June 30, 2008.





·
            There
      was approximately $13.7 million in non-accrual loans as of June 30,
      2008.  In addition, the Company held seven pieces of property
      related to investor-owned residential real estate in other real estate
      owned as of June 30, 2008. These properties are carried at estimated net
      realizable value of approximately $2.1 million. There were no other
      non-performing assets as of June 30, 2008. There was approximately $1.9
      million in non-accrual loans as of June 30, 2007.  The Company
      continues to maintain appropriate reserves for credit
    losses.





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





·
            Deposits
      at June 30, 2008 increased to $227.2 million from $202.0 million as of
      December 31, 2007.




12




·
            The
      Company incurred net losses of $776,258 and $2.3 million for the
      three-month and six-month periods ended June 30, 2008, respectively,
      compared to net income of $621,626 and $1.2 million for the same periods
      in 2007.





·
            Net
      interest income, the Company’s main source of income, was $2.3 million and
      $4.7 million during the three-month and six-month periods ended June 30,
      2008, respectively, compared to $3.1 million and $6.2 million for the
      three-month and six-month periods ended June 30, 2007,
      respectively.





·
            The
      Company added $3.0 million to the allowance for credit losses in order to
      replenish the allowance for 2008 net charge-offs which totaled $1.3
      million and to provide $1.7 million of additional reserves against the
      portfolio of residential real estate construction and reconstruction
      loans. 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 no charge-offs for the three-month and six-month
      periods ended June 30, 2007.





·
            Non-interest
      income increased by $20,911 and $37,036, or 11.6% and 9.9%, for the
      three-month and six-month periods ended June 30, 2008, respectively, as
      compared to the same periods ended June 30,
  2007.





·
            Non-interest
      expenses increased by $779,499 and $1.2 million, or 35.2% and 25.8%, for
      the three-month and six-month periods ended June 30, 2008, respectively,
      as compared to the same periods in
2007.





·
            The
      Company’s common stock closed at $7.80 on June 30, 2008, which represented
      a 52.8% decline from its closing price of $16.53 on June 30,
      2007.





·
            During
      the quarter, the Company eliminated eight (8) 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 $776,258 and $2.3 million for the three-month and
six-month periods ended June 30, 2008. This compares to net income of $621,626
and $1.2 million for the same periods in 2007. This is a decrease of $1.4
million and $3.5 million, or 224.9% and 282.3% for the three-month and six-month
periods, respectively. The decrease in year-over-year results is due primarily
to a $3.0 million provision for credit losses recorded against the Bank’s
portfolio of residential construction and reconstruction loans during the
six-months ended June 30, 2008 as well as a decrease in net interest
income.  The provision was due to charge-offs of approximately $1.3
million and management’s decision to record an additional $1.7 million
provision. In addition, there was an increase in non-interest expenses related
to the expansion of the Bank’s commercial business development staff in the
Baltimore-Washington




13




Corridor,
which commenced in the third quarter of 2007, and a declining rate environment
and increased non-accrual loans 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 six-month periods ended June 30, 2008 and 2007, net gains on the sale of
mortgage loans totaled $140,637 and $260,492, respectively.  Gains on
the sale of mortgage loans decreased for the six-month period ended June 30,
2008 as compared to the same period in 2007 due to a slowdown in the real estate
market in the Company’s markets.





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
June 30, 2008, the Company held $1.4 million of these loans which were
classified as held for sale. The Company earned $89,824 of interest on this
program for the six-month period ended June 30, 2008. This compares to $203,300
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 June 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 loan growth, the volatility of volume in the mortgage participations
purchasing program, 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 $2.3 million and $4.7 million for the
three-month and six-month periods ended June 30, 2008 as compared to $3.1
million and $6.2 million for the three-month and six-month periods in 2007. This
represents a decrease of 26.1% and 23.5% for the three-month and six-month
periods ended June 30, 2008, as compared to the same periods in
2007.





Total
interest income for the three-month and six-month periods ended June 30, 2008
was $3.9 million and $8.2 million, compared to $5.3 million and $10.7 million
for the same periods ended June 30, 2007.  The 27.9% and
23.1%  decrease for the three-month and six-month periods over the
same periods in 2007 was primarily attributed to lost interest from an average
of




14






approximately
$11.4 million of non-accrual loans 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% effective April 30, 2008.  The
yields on interest-earning assets decreased from 8.70% for the six-months ended
June 30, 2007 to 6.45% for the six-months ended June 30, 2008.





The
percentage of average interest-earning assets represented by loans was 94.5% and
90.8% for the six-month periods ended June 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
six-month period ended June 30, 2008, the average yield on the loan portfolio
decreased to 6.72% from 9.16% for the six-month period ended June 30,
2007.





The
average yield on the investment portfolio and other earning assets, such as
federal funds sold, was 1.76% for the six-month period ended June 30, 2008 as
compared to 4.22% 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 5.52% and 9.20% for the
six-month period ended June 30, 2008 and 2007, respectively.





Interest
expense from deposits and borrowings for the three-month and six-month periods
ended June 30, 2008 was $1.6 million and $3.5 million, respectively, compared to
$2.3 million and $4.5 million, respectively, for the same periods in 2007. The
22.5% decrease for the six-month period is the result of the previously
discussed reduction in the target federal funds rate as well as a reduction in
the mix of deposits held in the form of Certificates of Deposit (“CDs”). CDs are
the Bank’s most expensive form of deposits. As of June 30, 2008, these deposits
comprised 52.6% of average interest-bearing liabilities compared to 55.3% of
average interest-bearing liabilities as of June 30, 2007. Average rates paid on
all interest-bearing liabilities decreased from 4.57% for the six-month period
ended June 30, 2007 to 3.36% for the six-month period ended June 30,
2008.





As a
result of the factors discussed above, net interest margins decreased to 3.72%
for the six-month period ended June 30, 2008 from 5.05% 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. 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.





Six Months Ended June
      30, 2008Average
              Balance
            
            
            Interest
              and fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            242,229,366
            
            $
            8,094,465
            
            
            6.72
            %Investment
      securities
            
            
            1,321,227
            
            
            38,963
            
            
            5.93Federal
      funds sold and other overnight investments
            
            
            12,830,829
            
            
            85,112
            
            
            1.33Total
      earning assets
            
            
            256,381,422
            
            
            8,218,540
            
            
            6.45
            %Less:
      Allowance for credit losses
            
            
            (5,857,635
            )Cash
      and due from banks
            
            
            624,658Other
      real estate owned
            
            
            1,399,087Premises
      and equipment, net
            
            
            1,281,492Investment
      in bank owned life insurance
            
            
            5,089,206Accrued
      interest receivable and other assets
            
            
            4,351,950Total
      assets
            
            $
            263,270,180LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            75,104,609
            
            
            751,666
            
            
            2.01
            %Regular
      savings deposits
            
            
            1,792,941
            
            
            3,032
            
            
            .34Time
      deposits
            
            
            109,624,186
            
            
            2,272,760
            
            
            4.17Short-term
      borrowings
            
            
            13,713,145
            
            
            152,094
            
            
            2.23Subordinated
      debt
            
            
            8,000,000
            
            
            300,122
            
            
            7.54Total
      interest-bearing liabilities
            
            
            208,234,881
            
            
            3,479,674
            
            
            3.36
            %Net
      interest income and spread
            
            
            
            
            $
            4,738,866
            
            
            3.09
            %Non-interest-bearing
      demand deposits
            
            
            34,837,406Accrued
      expenses and other liabilities
            
            
            1,073,862Stockholders’
      equity
            
            
            19,124,037Total
      liabilities and stockholders’ equity
            
            $
            263,270,180Interest
      and fee income/earning assets
            
            
            6.45
            %Interest
      expense/earning assets
            
            
            2.73Net
      interest margin
            
            
            3.72
            %Return
      on Average Assets (Annualized)
            
            
            (1.73)
            %Return
      on Average Equity (Annualized)
            
            
            (23.79)
            %Average
      Equity to Average Assets
            
            
            7.26
            %





16





Six Months Ended June
      30, 2007Average
              Balance
            
            
            Interest
              and fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            224,881,716
            
            $
            10,210,677
            
            
            9.16
            %Investment
      securities
            
            
            1,764,766
            
            
            49,646
            
            
            5.67Federal
      funds sold and other overnight investments
            
            
            21,032,686
            
            
            427,214
            
            
            4.10Total
      earning assets
            
            
            247,679,168
            
            
            10,687,537
            
            
            8.70
            %Less:
      Allowance for credit losses
            
            
            (3,193,672
            )Cash
      and due from banks
            
            
            2,163,443Premises
      and equipment, net
            
            
            1,107,634Accrued
      interest receivable and other assets
            
            
            2,786,320Total
      assets
            
            $
            250,542,893LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            72,847,677
            
            
            1,350,634
            
            
            3.74
            %Regular
      savings deposits
            
            
            4,736,391
            
            
            43,238
            
            
            1.84Time
      deposits
            
            
            109,461,652
            
            
            2,736,655
            
            
            5.04Short-term
      borrowings
            
            
            2,859,097
            
            
            60,704
            
            
            4.28Subordinated
      debt
            
            
            8,000,000
            
            
            298,563
            
            
            7.53Total
      interest-bearing liabilities
            
            
            197,904,817
            
            
            4,489,794
            
            
            4.57
            %Net
      interest income and spread
            
            
            
            
            $
            6,197,743
            
            
            4.13
            %Non-interest-bearing
      demand deposits
            
            
            31,402,065Accrued
      expenses and other liabilities
            
            
            1,661,841Stockholders’
      equity
            
            
            19,574,170Total
      liabilities and stockholders’ equity
            
            $
            250,542,893Interest
      and fee income/earning assets
            
            
            8.70
            %Interest
      expense/earning assets
            
            
            3.65Net
      interest margin
            
            
            5.05
            %Return
      on Average Assets (Annualized)
            
            
            1.00
            %Return
      on Average Equity (Annualized)
            
            
            12.79
            %Average
      Equity to Average Assets
            
            
            7.81
            %





Provision
for Credit Losses





There was
a $557,929 and a $3.0 million provisionfor
credit losses for the three-month and six-month periods ended June 30, 2008,
respectively. There was no provision required for the same period 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 six-month periods ended June 30, 2008, the Company
realized non-interest income of $201,889 and $410,242, respectively, as compared
to $180,978 and $373,206 for the same periods ended June 30, 2007. Gains on the
sale of mortgage loans of $60,993 and $140,637




17




comprised
30.2% and 34.3% of the total for the three-month and six-month periods ended
June 30, 2008, respectively. This compares to gains on the sale of mortgage
loans of $125,043 and $260,492, or 69.1% and 69.8%, of total non-interest income
for the three-month and six-month periods ended June 30, 2007.





The level
of gains on the sale of mortgage loans decreased for the three-month and
six-month periods ended June 30, 2008 due to a general decrease in home purchase
and refinance activity in the Company’s markets.





Service
charges on deposit accounts totaled $69,128 and $125,379 for the three-month and
six-month periods ended June 30, 2008 as compared to $35,470 and $72,411 for the
same periods in 2007. The increases of 94.9% and 73.1% for the three and
six-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 $51,303 and $103,923, or 250.7% and 257.9%, in all other
non-interest income items for the three-month and six-month periods
ended  June 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 $57,365 and $113,322 related to increases
in this investment during the three-months and six-months ended June 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 six-month periods ended June 30, 2008 totaled
$3.0 million and $5.7 million, respectively. This compares to non-interest
expense for the comparable periods in 2007 of $2.2 million and $4.5 million,
respectively. The increases of approximately $779,000 and $1.2 million, or 35.2%
and 25.8%, 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 $250,000 and $312,000 for
the three-month and six-month periods related to staffing growth, including the
expansion into the Baltimore-Washington Corridor with the January 2008 opening
of an office in Columbia staffed with seven 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 and additional account managers were hired 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. The impact of the previously mentioned
reduction in staff had no impact on the periods, but should result in some
benefit realized starting in the quarter ending September 30, 2008.




18




Occupancy
expenses increased by $24,444 and $53,941 for the three-months and six-months
ended June 30, 2008 as compared to the same periods in 2007. The 15.0% and 16.8%
increase for the periods was 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 is currently
exploring an opportunity to sublet approximately 650 square feet of space
currently occupied by the Towson residential lending group.





Legal and
professional fees increased $215,834 and $317,166, or 283.8% and 226.7%, for the
three-month and six-month periods ended June 30, 2008 as compared to the same
periods in 2007. The increase was 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 increased $69,648 and $136,592, or
33.6% and 34.7%, for the three-month and six-month periods ended June 30, 2008
as compared to the three-month and six-month periods in 2007, respectively. The
increase for the 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.





Advertising
and marketing-related expenses increased $66,289 and $89,583, or 77.1% and
42.4%, for the three-month and six-month periods ended June 30, 2008 as compared
to the three-month and six-month periods in 2007, respectively. The increase is
a result of the expansion of the business development staff and the opening of
the office in the Baltimore-Washington Corridor.





The
$153,502 and $254,517, or 49.7% and 44.4%, increase in all other non-interest
expense items for the three-month and six-month periods ended June 30, 2008 were
primarily due to a $67,181 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 $129,206 and $125,824 for
the three-month and six-month periods ended June 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 loan loss
provision, and non-interest income. The Company’s efficiency ratio was 121.9%
and 110.2% for the three-month and six-month periods ended June 30, 2008,
respectively. This compares to 68.5% and 68.7% for the three-month and six-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.





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.





19


Income
Taxes





For the
three-month and six-month periods ended June 30, 2008, the Company recorded an
income tax benefit of $320,292 and $1.3 million, respectively. This compares to
income tax expense of $396,000 and $818,000 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 $3.1 million as of June 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 June 30,
2008.





Financial
Condition





Composition
of the Balance Sheet





As of
June 30, 2008, total assets were $275.8 million. This represents an increase of
$19.3 million, or 7.5%, since December 31, 2007. The change in total assets
includes increases of $7.3 million in Federal funds sold and other overnight
investments, $11.8 million in loans net of the allowance for credit losses, $1.1
million in other real estate owned, $113,322 in bank owned life insurance and
approximately $1.4 million in other non-earning assets. These increases were
offset by decreases of $7.4 million in loans held for sale, $1.9 million in cash
and due from banks, $399,529 in investment securities available for sale and
$212,000 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
June 30, 2008, the Company held $1.4 million of these 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 and the mortgage company’s ability to
use other funding sources as its volume fluctuates. As of August 12, 2008, the
Company sold $3.2 million of loans classified as held for sale that were
outstanding as of June 30, 2008.  One loan of approximately $972,000
could not be sold and is likely to be transferred to the Company’s
portfolio.  This loan is past due as of August 13, 2008 and the Bank
is pursuing restructure or foreclosure. Management believes that it has
established an adequate allowance for credit loss against this
loan.





As of
June 30, 2008, loans, excluding loans held for sale, totaled $250.2 million.
This represents an increase of $20.8 million, or 9.1%, from 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.




20




The
composition of the loan portfolio as of June 30, 2008 was approximately $117.6
million of commercial loans, $6.4 million of consumer loans, and $126.2 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 $4.2 million and $11.6 million as of June 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 June 30, 2008
was approximately $51.5 million of which $11.9 million was classified as
non-accrual and an additional $7.4 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
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 six-month period ending June 30, 2008, the Company foreclosed on eight
pieces of residential real estate related to investor-owned residential real
estate. These properties were placed into other real estate owned at estimated
net realizable value of approximately $2.0 million. The difference between the
related loan balances totaling approximately $3.3 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 four 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 $2.1 million as of
June 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 $19.3
million as of June 30, 2008 compared to approximately $14.3 million as of
December 31, 2007.





At June
30, 2008, the Company had cash and due from banks of $458,990 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 June 30, 2008, the
Company had federal funds sold and other overnight investments totaling $12.2
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
six months ending June 30, 2008 in the national market for CDs in order to fund
current and anticipated loan growth. The Company held $674,200 and $607,300 of
Federal Reserve Bank stock as of June 30, 2008 and December 31, 2007,
respectively. The Company also held Federal Home Loan Bank of Atlanta (“FHLB”)
stock of $828,800 and $1,107,700 as of June 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 was held as of June 30,
2008.





Deposits
at June 30, 2008 were $227.2 million of which approximately $7.8 million, or
3.4%, 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.




21




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 certificates of deposit 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. The Company also has the ability to raise deposits directly
through the network.  These deposits are also considered “Brokered
Deposits” for bank regulatory purposes. As of June 30, 2008, the Company had
approximately $4.0 million of CDARS deposits outstanding of which approximately
$228,000 was placed on behalf of customers and $3.8 million was raised by the
Company. 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 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
June 30, 2008, the Company had outstanding certificates of deposit of
approximately $44.2 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 3.7% and an average term of 21 months. Included in the $44.2
million are national market certificates of deposit totaling approximately $28.7
million that have been classified as “Brokered Deposits” for bank regulatory
purposes. These “Brokered Deposits” were issued with an average yield of 3.44%
and an average term of 13 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 $4.6 million.
Included in the $4.6 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 $3.0 million of the $7.8 million of deposits from the large customer
described above, stood at $191.6 million as of June 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 $18.2
million, or 10.5%, increase from the total as of December 31, 2007 of $173.4
million represented a return to more normal levels after unusual liquidity draw
downs by customers during the fourth quarter of 2007. The Company successfully
competed for new deposits during the period ended June 30, 2008 and restored
liquidity in order to pay down short-term borrowings and fund loan growth. 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 June 30, 2008 and
December 31, 2007, respectively:





June
      30,
              2008
            
            
            December
      31,
              2007Total
      deposits
            
            
            $
            227,151,610
            
            $
            201,981,465Commercial
      paper sweep balances
            
            
            
            13,661,135
            
            
            7,309,508National
      market certificates of deposit (includes CDARS
              deposits)
            
            
            
            (44,395,155
            )
            
            (32,661,081
            )Variable
      balance accounts (1 customer at June 30, 2008 and
              December
      31, 2007)
            
            
            
            (7,804,037
            )
            
            (6,230,689
            )Portion
      of variable balance accounts considered to be core
            
            
            
            3,000,000
            
            
            3,000,000Core
      deposits
            
            
            $
            191,613,553
            
            $
            173,399,203





As of
June 30, 2008, short-term borrowings consisted of $13.7 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 $8.1
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 theallowance
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 June 30, 2008 and December 31, 2007 was $6.7
million and $5.0 million, respectively. These amounts equated to 2.63% and 2.08%
of outstanding loans, including loans held for sale, as of June 30, 2008 and
December 31, 2007, respectively. Excluding loans held for sale, the allowance
for credit losses equated to 2.68% and 2.18% of outstanding loans as of June 30,
2008 and December 31, 2007, respectively. The increased percentage was due to an
additional provision of $1.7 million recorded in the first quarter of 2008 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
June 30, 2008, the Company had non-accrual loans totaling $13.7 million,
most of which were in the residential real estate construction and
reconstruction loan portfolio. 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 5.4%
of total outstanding loans, including loans held for sale, as of June 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 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.




24




The
Company recorded $557,929 and $1.3 million, of net charge-offs during the
three-month and six-month periods ended June 30, 2008, respectively. The Company
recovered $27,930 of 2006 charge-offs during the six-month period ended June 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 June
30, 2008, the Company had $458,990 in cash and due from banks, $12.2 million in
federal funds sold and other overnight investments and $3.2 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
relative stability in the overall level of liquid assets was the result of a
deliberate effort by management to tightly manage liquidity by maintaining a
high loan-to-deposit ratio and the use of short-term borrowings to meet unusual
draws on liquidity if the cost of using short-term borrowings is more
advantageous than issuing certificates of deposit. The goal of this strategy is
to maximize the net interest margin. 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 unsecured Federal funds lines of credit with three separate financial
institutions. The Company also has approximately $18.5 million of borrowing
capacity with the Federal Home Loan Bank of Atlanta as of June 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.





The
Company 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.





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.





25


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.





The
following table sets forth the amount of the Company's interest-earning assets
and interest-bearing liabilities as of June 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
            
            $
            12,183,948
            
            
            
            4.55
            %
            
            $
            12,183,948
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Loans
      held for sale
            
            
            4,216,362
            
            
            
            1.57
            
            
            
            4,216,362
            
            
            
            -
            
            
            
            -
            
            
            
            -Loans
      – Variable rate
            
            
            124,085,895
            
            
            
            46.28
            
            
            
            124,085,895
            
            
            
            -
            
            
            
            -
            
            
            
            -Loans
      – Fixed rate
            
            
            126,119,096
            
            
            
            47.04
            
            
            
            35,634,867
            
            
            
            19,382,356
            
            
            
            60,000,165
            
            
            
            11,101,708Other  earning
      assets
            
            
            1,503,000
            
            
            
            .56
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,503,000Total
      interest-earning assets
            
            $
            268,108,301
            
            
            
            100.00
            %
            
            $
            176,121,072
            
            
            $
            19,382,356
            
            
            $
            60,000,165
            
            
            $
            12,604,708Interest-bearing
      liabilitiesDeposits
      – Variable rate
            
            $
            80,782,319
            
            
            
            36.94
            %
            
            $
            80,782,319
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Deposits
      – Fixed rate
            
            
            108,108,569
            
            
            
            49.43
            
            
            
            34,772,156
            
            
            
            38,441,777
            
            
            
            34,894,636
            
            
            
            -Short-term
      borrowings – Variable
              rate
            
            
            21,811,135
            
            
            
            9.97
            
            
            
            21,811,135
            
            
            
            -
            
            
            
            -
            
            
            
            -Subordinated
      debt
            
            
            8,000,000
            
            
            
            3.66
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            8,000,000Total
      interest-bearing liabilities
            
            $
            218,702,023
            
            
            
            100.0
            %
            
            $
            137,365,610
            
            
            $
            38,441,777
            
            
            $
            34,894,636
            
            
            $
            8,000,000Periodic
      repricing differencesPeriodic
      gap
            
            
            
            
            
            
            
            
            
            $
            38,755,462
            
            
            $
            (19,059,421
            )
            
            $
            25,105,529
            
            
            $
            4,604,708Cumulative
      gap
            
            
            
            
            
            
            
            
            
            $
            38,755,462
            
            
            $
            19,696,041
            
            
            $
            44,801,570
            
            
            $
            49,406,278Ratio
      of rate sensitive assets to rate
              sensitive
      liabilities
            
            
            
            
            
            
            
            
            
            
            128.21
            %
            
            
            50.42
            %
            
            
            171.95
            %
            
            
            157.56
            %





The
Company has 52.4% of its interest-earning assets and 46.91% of its
interest-bearing liabilities in variable rate balances. Interest-earning assets
exceed interest-bearing liabilities by $49.4 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.




26









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.





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 June 30, 2008 and
December 31, 2007 are as follows:





June
      30,
              2008
            
            December
      31,
              2007Loan
      commitments
            $
            38,613,868
            $
            35,114,676Unused
      lines of credit
            
            88,031,375
            
            85,999,686Letters
      of credit
            
            7,630,283
            
            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.




27




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
moderate growth in the overall level of loan commitments as of June 30, 2008 as
compared to December 31, 2007 is reflective of the ongoing efforts to maintain a
steady flow of commercial and industrial loans in order to sustain loan growth
and increase revenue in order to leverage the investment made in additional
business development staff.





Capital
Resources





The
Company had stockholders’ equity at June 30, 2008 of $17.8 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 six-months ended June 30, 2008. The Company
has a commitment offer for up to a $6 million line of credit
that would be available to the holding company to fund the capital
needs of the Bank. 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 exceeded 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 have paid
dividends to the Company without approval from bank regulatory agencies at June
30, 2008; however, such payments are not 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.




28









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.





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.”





29


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 June 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 June 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.





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, asset and business growth, benefits resulting from previous
staff reductions, future sources of income, future realization of deferred tax
asset, commitment for a line of credit, operating results and profitability,
liquidity, allowance for credit losses, interest rate sensitivity, future market
conditions, market opportunities 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.assumptions, circumstances or events that
have changed after the forward-looking statements are made.


30




PART
II – OTHER INFORMATION





Item
1.        Legal
Proceedings.





None





Item
1A.  Risk Factors





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.





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.





At the Company’s Annual Meeting of
Stockholders held May 27, 2008, the following directors were elected to serve a
three-year term expiring upon the date of the Company’s 2011 Annual Meeting or
until their respective successors are duly elected and qualified:





Votes
      CastFor
            Withheld
            TotalJohn
      R. Lerch
            1,696,153
            1,711
            1,697,864James
      P. O’Conor
            1,691,264
            6,600
            1,697,864Carl
      A.J. Wright
            1,660,822
            37,042
            1,697,864





Names of
other directors continuing in office:





R.
      Michael GillDonald
      G. McClure, Jr.Hugh
      W. MohlerRobert
      L. MooreH.
      Victor Rieger, Jr.William
      B. RinnierEdwin
      A. Rommel, IIIHenry
      H. StansburyKenneth
      H. TroutEugene
      M. Waldron, Jr.





At the Company’s Annual Meeting of
Stockholders held May 27, 2008, the selection of Stegman & Company to serve
as independent registered public accountants to audit the Company’s financial
statements for the 2008 fiscal year was ratified by the following
vote:





Votes
      CastFor
            Against
            Abstain
            Total1,697,864
            0
            0
            1,697,864




31









There
      were no broker non-votes on these matters.Item
      5.
            Other
      Information.NoneItem
      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





32


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