10-K 1 v146732_10k.htm Unassociated Document
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
(Mark One)
x
Annual Report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the fiscal year ended December 31, 2008
 
or
 
¨
Transition Report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from                  to                 
 
Commission file no. 000-30523
 
First National Bancshares, Inc.
(Exact name of registrant as specified in its charter)
 
South Carolina
 
58-2466370
(State or other jurisdiction
of incorporation or organization)
 
(I.R.S. Employer
Identification No.)
     
215 N. Pine St.
Spartanburg, S.C.
 
29302
(Address of principal executive offices)
 
(Zip Code)
 
864-948-9001
Registrant’s telephone number, including area code
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of class
 
Name of each exchange on which registered
Common Stock $0.01 par value
 
The NASDAQ Global Market
 
Securities registered pursuant to Section 12(g) of the Act: None.
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
 
Indicate by check mark 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or 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
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
 
The aggregate market value of the common stock held by non-affiliates (shareholders holding less than 5% of an outstanding class of stock, excluding directors and executive officers), computed by reference to the price at which the common stock was last sold was $8,784,232, as of the last business day of the registrant’s most recent completed second fiscal quarter.
 
6,296,698 shares of the registrant’s common stock were outstanding as of March 31, 2009 (the latest practicable date).
 
DOCUMENTS INCORPORATED BY REFERENCE
 
None.
 


 
 

 
 
IMPORTANT INFORMATION ABOUT THIS REPORT

In this report, the words “First National,” “Company,” “we,” “us” and “our” mean First National Bancshares, Inc., including First National Bank of the South, our wholly-owned national bank subsidiary.

SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS

This report, including information included or incorporated by reference in this document, contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements relate to the financial condition, results of operations, plans, objectives, future performance, and business of First National. Forward-looking statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “continue,” “assume,” “believe,” “intend,” “plan,” “forecast,” “goal,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements.  Potential risks and uncertainties that could cause our actual results to differ materially from those anticipated in our forward-looking statements include, but are not limited to the following:

 
·
our efforts to raise capital or otherwise increase our regulatory capital ratios;

 
·
the effects of our efforts to raise capital on our balance sheet, liquidity, capital and profitability;

 
·
whether our lender will exercise the remedies available to it in the event of default on the line of credit to our holding company;

 
·
our ability to retain our existing customers, including our deposit relationships;

 
·
our ability to comply with the terms of the consent order between the bank and its primary federal regulator within the timeframes specified;

 
·
adequacy of the level of our allowance for loan losses;

 
·
reduced earnings due to higher credit losses generally and specifically potentially because losses in our residential real estate loan portfolio are greater than expected due to economic factors, including declining real estate values, increasing interest rates, increasing unemployment, or changes in payment behavior or other factors;

 
·
reduced earnings due to higher credit losses because our loans are concentrated by loan type, industry segment, borrower type, or location of the borrower or collateral;

 
·
the rate of delinquencies and amounts of chargeoffs;

 
·
the rates of historical loan growth and the lack of seasoning of our loan portfolio;

 
·
the amount of our real estate-based loans, and the weakness in the commercial real estate market;

 
·
increased funding costs due to market illiquidity, increased competition for funding or regulatory requirements;

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

 
·
changes in the interest rate environment which could reduce anticipated or actual margins;
 
 
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·
construction delays and cost overruns related to the expansion of our branch network;

 
·
changes in political conditions or the legislative or regulatory environment;

 
·
general economic conditions, either nationally or regionally and especially in our primary service areas, becoming less favorable than expected, resulting in, among other things, a deterioration in credit quality;

 
·
changes occurring in business conditions and inflation;

 
·
changes in technology;

 
·
changes in deposit flows;

 
·
changes in monetary and tax policies;

 
·
changes in accounting principles, policies or guidelines;

 
·
our ability to maintain effective internal control over financial reporting;

 
·
our reliance on secondary funding sources such as Federal Home Loan Bank advances, Federal Reserve Bank discount window borrowings, sales of securities and loans, federal funds lines of credit from correspondent banks and out-of-market time deposits including brokered deposits, to meet our liquidity needs;

 
·
adverse changes in asset quality and resulting credit risk-related losses and expenses;

 
·
loss of consumer confidence and economic disruptions resulting from terrorist activities or other military actions;

 
·
changes in the securities markets;

 
·
reduced earnings from not realizing the expected benefits of the acquisition of Carolina National (as defined below) or from unexpected difficulties integrating the acquisition; and

 
·
other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

We have based our forward-looking statements on our current expectations about future events. Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee you that these expectations will be achieved. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

These risks are exacerbated by the recent developments in national and international financial markets, and we are unable to predict what effect these uncertain market conditions will have on us.  During 2008, the capital and credit markets have experienced extended volatility and disruption.  In recent months, the volatility and disruption have reached unprecedented levels.  There can be no assurance that these unprecedented recent developments will not continue to materially and adversely affect our business, financial condition and results of operations, as well as our ability to raise capital or other funding for liquidity and business purposes.

 
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PART I

Item 1.         Business.

First National Bancshares, Inc.

We are a South Carolina corporation organized in 1999 to serve as the holding company for First National Bank of the South, a national banking association, which is referred to herein as the "bank." The bank currently maintains its corporate headquarters and three full-service branches in Spartanburg, South Carolina, and nine additional full-service branches in select markets across the state.

Our assets consist primarily of our investment in the bank and our primary activities are conducted through the bank. As of December 31, 2008, our consolidated total assets were $812.7 million, our consolidated total loans were $709.3 million (including mortgage loans held for sale), our consolidated total deposits were $646.9 million, and our total shareholders’ equity was approximately $40.6 million.  In January 2008, we acquired Carolina National Corporation (“Carolina National”) and its wholly-owned bank subsidiary, Carolina National Bank and Trust Company.  As of January 31, 2008, Carolina National’s consolidated total assets were $220.9 million, its consolidated total loans were $203.3 million, its consolidated total deposits were $187.3 million, and its total shareholders’ equity was approximately $29.2 million.

Our net income is dependent primarily on our net interest income, which is the difference between the interest income earned on loans, investments, and other interest-earning assets and the interest paid on deposits and other interest-bearing liabilities.  In addition, our net income also is supported by our noninterest income, derived principally from service charges and fees on deposit accounts and on the origination, sale and/or servicing of financial assets such as loans and investments, as well as the level of noninterest expenses such as salaries, employee benefits, and occupancy costs.
 
Our operations are significantly affected by prevailing economic conditions, competition, and the monetary, fiscal, and regulatory policies of governmental agencies. Lending activities are influenced by a number of factors, including the general credit needs of individuals and small and medium-sized businesses in our market areas, competition among lenders, the level of interest rates, and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market interest rates (primarily the rates paid on competing investments), account maturities, and the levels of personal income and savings in our market areas.
 
As part of our previous strategic plan for growth and expansion, we executed the acquisition (the “Merger”) of Carolina National, effective January 31, 2008.  Through the Merger, Carolina National’s wholly owned bank subsidiary bank, Carolina National Bank and Trust Company, a national banking association, became a subsidiary of First National and, as of the close of business on February 18, 2008, was merged with and into our bank subsidiary.  On May 30, 2008, the core bank data processing system was successfully converted, bringing closure to the substantial undertaking of blending the two banks into one cohesive statewide branch network.

First National Bank of the South

First National Bank of the South is a national banking association with its principal executive offices in Spartanburg, South Carolina. The bank is primarily engaged in the business of accepting deposits insured by the Federal Deposit Insurance Corporation (“FDIC”) and providing commercial, consumer, and mortgage loans to the general public. We operate under a traditional community banking model and offer a variety of services and products to consumers and small businesses.  We commenced banking operations in March 2000 in Spartanburg, South Carolina, where we operate our corporate headquarters and three full-service branches.  In April 2007, we opened our new operations center adjacent to our corporate headquarters, which resulted in a total of 29,500 square feet of office space, including our existing corporate headquarters facility which continues to house a full-service branch.

 
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We rely on our branch network as a vehicle to deliver products and services to the customers in our markets throughout South Carolina.  While we offer traditional banking products and services to cater to our customers and generate noninterest income, we also provide a variety of unique options to complement our core business features.  Combining uncommon options with standard features allows us to maximize our appeal to a broad customer base while capitalizing on noninterest income potential.  We have offered trust and investment management services since August 2002, through a strategic alliance with Colonial Trust Company, a South Carolina private trust company established in 1913 (“Colonial Trust”).    Through a recent alliance with WorkLife Financial, we are able to offer business expertise in a variety of areas, such as human resource management, payroll administration, risk management, and other financial services, to our customers.  In addition, we earn income through the origination and sale of residential mortgages.  Each of these distinctive services represents not only an exceptional opportunity to build and strengthen customer loyalty but also to enhance our financial position with noninterest income, as we believe they are less directly impacted by current economic challenges.

Since 2003, we have expanded into three additional markets in the Carolinas, with twelve full-service branches operating under the name First National Bank of the South.  In 2004, we opened our first full-service branch in the coastal region in Mount Pleasant, SC and opened our market headquarters in 2007 in downtown Charleston.  On February 19, 2008, the four Columbia full-service branches of Carolina National Bank and Trust Company began to operate as First National Bank of the South.  In July 2008, we opened our fifth full-service branch in the Columbia market in Lexington, South Carolina.  We have also expanded our banking operations into York and Lancaster counties, beginning with a loan production office in Rock Hill that opened in February 2007.  In December 2007, the Office of the Comptroller of the Currency (“OCC”) approved the opening of a full-service branch in the Fort Mill/Tega Cay community in York County.  This new facility is currently under construction and is projected to open in the second quarter of 2009.

Our Business Strategy

We strive to be a community bank that matters.  We believe that we play a vital role in providing capital, in the form of loans, to households and small to medium-sized businesses throughout the state of South Carolina.  We seek to be a financial resource to our customers by offering them solid financial products and services, assisting with networking, and making business referrals.  We believe that being a community bank means that we and our employees are involved in our communities.  Our decentralized business strategy focuses on providing superior service through our experienced bankers who are relationship oriented and committed to their respective communities.  We are focused on maximizing revenue while tightly managing risks and controlling costs.  We believe that this strategy will allow us to experience renewed loan and deposit growth and improved financial performance as the economy ultimately recovers, positioning us as a leader in the community banking industry in our state.

Following the first quarter of 2008, we observed the deterioration in national and regional economic indicators and declining real estate values as well as slowing real estate sales activity in our markets.  As a result, we have experienced a significant rise in loan delinquencies and the level of our problem assets has increased.  Consequently, our loan loss provision for the year ended December 31, 2008 increased from $1.4 million for the year ended December 31, 2007 to $20.5 million for the year ended December 31, 2008.  In response to the changing business climate, we have reduced our asset growth plan from historic levels and modified our business strategy based on the following principles:

Improve asset quality by reducing the amount of our nonperforming assets.

To improve our results of operations, our primary focus over the next six to twelve months is to significantly reduce the amount of our nonperforming assets. Nonperforming assets hurt our profitability because they reduce the balance of earning assets, may require additional loan loss provisions or write-downs, and require significant devotion of staff time and financial resources to resolve.  Our level of nonperforming assets (loans not accruing interest, restructured loans, loans past due 90 days or more and still accruing interest, and other real estate owned) had increased to $75.5 million as of December 31, 2008 as compared to $14.3 million as of December 31, 2007.   We believe that the increase in the level of our nonperforming assets has occurred largely as a result of the severe housing downturn and deterioration in the residential real estate market.

We have moved aggressively to address this issue by increasing our reserves for losses and directing the efforts of an entire team of bankers solely to managing the liquidation of nonperforming assets.  This team is actively pursuing remedies with borrowers, including foreclosure, and working to hold the borrowers accountable for the principal and interest owed.  Additionally, we are vigorously marketing our inventory of foreclosed real estate.

 
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It is our goal to remove the majority of the nonperforming assets from our balance sheet as quickly as possible.  Accomplishing this goal will be a tremendous undertaking requiring both time and the considerable effort of our staff, given the current conditions in the real estate market, but we are committed to devoting significant resources to these efforts.  We will initiate workout plans for problem loans that are designed to promptly collect on or rehabilitate those problem loans in an effort to convert them to earning assets.  We also intend to sell foreclosed real estate and packages of nonperforming loans to investors at acceptable levels.  Additional provisions for loan losses may be required during 2009 to implement these plans since we will likely be required to accept discounted sales prices below appraised value to quickly dispose of these assets.

Strengthen our capital base.

Capital adequacy is an important indicator of financial stability and performance.  Our goal has been to maintain  a “well-capitalized” status for the bank  since failure to meet or exceed this classification affects how regulatory applications for certain activities, including acquisitions, continuation and expansion of existing activities, are evaluated and could make our customers and potential investors less confident in our bank.

The bank’s primary federal regulator, the OCC, recently completed a safety and soundness examination of the bank, which included a review of our asset quality.  We have received the final report from this examination.  On April 27, 2009, the bank entered into a consent order with the OCC, which contains a requirement that our bank maintain minimum capital requirements that exceed the minimum regulatory capital ratios for “well-capitalized” banks.  As a result of the consent order, the bank is no longer deemed “well-capitalized” regardless of its capital levels.  Therefore, we will need to raise additional capital, limit our growth, and/or sell assets to increase our capital ratios within 120 days of the execution of the consent order to meet these standards set forth by the OCC.

               In addition, the exam report includes a requirement that the bank’s board of directors develop a written strategic and capital plan covering at least a three-year period.  The plan must establish objectives for the bank’s overall risk profile, earnings performance, asset growth, balance sheet composition, off-balance sheet activities, funding sources, capital adequacy, reduction in nonperforming assets, product line development and market segments planned for development and growth.

We anticipate that we will also need additional capital in order to take the significant write-downs needed to remove the majority of nonperforming assets from our balance sheet in a relatively short time frame, given the particularly challenging real estate market.  In addition, we have recently performed a thorough review of our loan portfolio including both nonperforming loans and performing loans.  We have stress tested our borrowers’ ability to repay their loans and believe that we have identified substantially all of the loans that could become problem assets in the near future.  We have projected our estimate of the future possible losses associated with these potential problem assets which will also require additional capital if these potential losses are realized.   As a result of the recent downturn in the financial markets, the availability of many sources of capital (principally to financial services companies like ours) has become significantly restricted or has become increasingly costly as compared to the prevailing market rates prior to the volatility.  We cannot predict when or if the capital markets will return to more favorable conditions.  We are actively evaluating a number of capital sources and balance sheet management strategies to ensure that our projected level of regulatory capital can support our balance sheet and meet or exceed the minimum requirements set forth in the consent order.

Increase operating earnings.

Management is focused on increasing our operating earnings by implementing strategies to improve the core profitability of our franchise.  These strategies change the mix of our earning assets without growing our balance sheet.  Specifically, we are reducing the level of nonperforming assets, controlling our operating expenses, improving our net interest margin and increasing fee income. We do not expect our balance sheet to grow materially over the next twelve months as we reduce the amount of our nonperforming assets, which may require us to record additional provisions for loan losses to accomplish within this timeframe.  In fact, our balance sheet may shrink as we use cash from the disposal of nonperforming assets and loan repayments to reduce our wholesale funding.  We are also reducing the concentration of commercial real estate loans and construction loans within our loan portfolio and have generally ceased making new loans to homebuilders.  We are carefully evaluating all renewing loans in our portfolio to ensure that we are focusing our capital and resources on our best relationship customers.

 
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The benefits of slower balance sheet growth include more disciplined loan and deposit pricing going forward which should result in subsequent net interest margin expansion.  Additionally, we will seek to expand our net interest margin as our current loans and deposits reprice and renew.  Between January 1, 2009 and June 30, 2009, we have $276.9 million of time deposits that will reprice at current market rates, which represents approximately 65% of our total time deposits at December 31, 2008.  These time deposits had a weighted average interest rate of 3.57% at December 31, 2008. Additionally, we have $167.3 million of variable rate loans that are renewing between January 1, 2009 and June 30, 2009 which were initially made at a rate variable with the Wall Street Journal prime rate.  We will seek to put floors, or minimum interest rates, in our variable rate loans at renewal.  Generally, our new and renewing variable rate loans will be based on the First National prime rate instead of the Wall Street Journal prime rate.  We believe that indexing our loans on an internal benchmark will allow us to respond better to the prevailing interest rate environment.  Furthermore, we will look to cheaper sources of funding as they become available to us.

Aggressively manage operating costs and increase fee revenue.

We have always focused on controlling our operating expenses and managing our overhead to an efficient level. Given the recent downturn in the economy, we have embarked on an even more aggressive expense reduction campaign that we believe will save us over $5 million in annual expenditures compared to our level of operating expenses in 2007.  We believe that we can reach this level of efficiency by the end of 2009.  To achieve this goal, management has already reduced salary and benefits expense by eliminating several positions as a result of a review of employee efficiency, renegotiated vendor contracts, and implemented several other cost-saving measures to reduce noninterest expenses.  Reducing our level of nonperforming assets will also lower our operating costs.

We are streamlining our cost structure to reflect our projected base of earning assets and eliminate associated unnecessary infrastructure.  It is our goal to continually identify other ways to reduce costs through outsourcing and ensuring our operation is functioning as efficiently as possible. We are committed to maintaining these cost control measures and believe that this effort will play a major role in improving our performance. We also believe that our technology allows us to be efficient in our back-office operations.

To date, our noninterest income sources have primarily consisted of service charge income, mortgage banking related fees and commissions and fees from joint ventures to provide financial services to our customers. We seek to provide a broad range of products and services to better serve our customers while simultaneously attempting to increase our fee-based income as a percentage of our gross income (net interest income plus noninterest income).  Additionally, we will evaluate future opportunities to increase fee-based income as they arise. We expect that these efforts will help bolster our noninterest income sources.

Continue to increase local funding and core deposits.

We have grown rapidly since our inception, and we have historically funded our asset growth with a combination of local deposits and wholesale funding, including brokered time deposits and borrowings from the Federal Home Loan Bank of Atlanta.  We are focused on increasing the percentage of our balance sheet funded by local depositors and expanding our collection of core deposits while we reduce the level of wholesale funding on our balance sheet. Absent a waiver from the FDIC, we are now restricted on our ability to accept, renew and roll over brokered time deposits since we executed the consent order with our bank’s regulator on April 27, 2009.  We intend to apply for a waiver in future months to allow us to accept, renew or roll over brokered deposits.  However, we cannot be assured that our request for a waiver will be approved.  In addition, our ability to borrow funds from the Federal Home Loan Bank of Atlanta (“FHLB”) has been restricted following the FHLB’s quarterly review of our assigned credit risk rating for the fourth quarter of 2008.

Core deposit balances, generated from customers throughout our branch network, are generally a stable source of funds similar to long-term funding, but core deposits such as checking and savings accounts, are typically much less costly than alternative fixed rate funding. We believe that this cost advantage makes core deposits a superior funding source, in addition to providing cross-selling opportunities and fee income possibilities.  We work to increase our level of core deposits by actively cross-selling core deposits to our local depositors and borrowers.  As we grow our core deposits, we believe that our cost of funds should decrease, thereby increasing our net interest margin in the future.

Our team of experienced retail bankers is focused on strengthening our relationships with our retail customers to grow core deposits.  We hold our retail bankers accountable for sales production through our targeted officer calling program which includes weekly sales calls.  Additionally, our customer-focused sales training emphasizes product knowledge and enhanced customer service techniques.

We generate local deposits through a combination of competitive pricing and extensive personal and commercial relationships in the local market.  Five of our twelve branches are less than two years old, and we expect those branches to significantly increase their levels of deposits in the near future, as well as our thirteenth full-service branch which we expect to open during the second quarter of 2009.  Our strategy is to maintain a healthy mix of deposits that favors a larger concentration of non-time deposits, such as noninterest-bearing checking accounts, interest-bearing checking accounts and money market accounts.

 
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Our primary competition in our markets is larger regional and super-regional banks. We believe that our community banking philosophy and emphasis on customer service give us an excellent opportunity to take market share from our competitors. As a result, we intend to decrease our reliance on non-core funding as our full-service branches grow and mature. While building a core deposit base takes time, our strategy has experienced considerable success.  Since opening in 2000, the bank has climbed to the number three ranking for deposit market share in Spartanburg County, South Carolina with 12.1% of the deposit market.    As of the June 30, 2008 FDIC summary of deposits report, we have the eighth-highest deposit market share of the South Carolina-based banks.  Our long-term goal is to be in the top five institutions in deposit market share in each of our markets.

Deliver superior community banking to our customers.

We effectively compete with our super-regional competitors by providing superior customer service with localized decision-making capabilities. We believe that we can continue to deliver our level of superior customer service while managing through this challenging period of time.  We emphasize to our employees the importance of delivering superior customer service and seeking opportunities to strengthen relationships both with customers and in the communities we serve.

Our organizational structure, with its designation of regional executives, allows us to provide local decision-making consistent with our community banking philosophy. Our regional boards in Charleston, Columbia, and Greenville are comprised of local business and community leaders who act as ambassadors for us in their markets and help generate referrals for new business for the bank.  These board members also provide us with valuable insight on the financial needs of their communities, which allows us to deliver targeted financial products to each market.

Merger with Carolina National

On January 31, 2008, Carolina National, the holding company for Carolina National Bank and Trust Company, merged with and into First National.  Through the Merger, Carolina National’s wholly owned bank subsidiary, Carolina National Bank and Trust Company, a national banking association, became a subsidiary of First National and, as of the close of business on February 18, 2008, was merged with and into our bank subsidiary.  As a result of this acquisition, we added four full-service branches in the Columbia market to our operations.  On May 30, 2008, the core bank data processing system was successfully converted, bringing closure to the substantial undertaking of blending the two banks into one cohesive branch network.

Columbia’s central location in the state and convenient access to I-20, I-26, and I-77 make this area one of the fastest growing areas in South Carolina according to U.S. Census data. Home to the state capital, the University of South Carolina, and a variety of service-based and light manufacturing companies, this area provides a growing and diverse economy. According to SNL Financial (“SNL”), Columbia had an estimated population of 356,842 residents as of July 1, 2007, and is projected to grow 7.6% from 2007 to 2012. The South Carolina Department of Commerce reports that Richland County attracted over $442.0 million in announced capital investment since 2000. As of June 30, 2008, FDIC-insured institutions in Richland County and the Columbia metropolitan area had approximately $9.55 billion and $9.40 billion in deposits, respectively.

In connection with the Merger, our balance sheet reflects intangible assets consisting of core deposit intangibles and purchase accounting adjustments to reflect the fair valuation of loans, deposits and leases. The core deposit intangible represents the excess intangible value of acquired deposit customer relationships as determined by valuation specialists. The core deposit intangible is being amortized over a ten-year period using the declining balance line method. Adjustments recorded to the fair market values of loans and certificates of deposit are being recognized beginning with the effective date of the Merger, January 31, 2008, over 34 months and 5 months, respectively. Adjustments to leases are being amortized over the terms of the respective leases. See further discussion in Note 1- Summary of Significant Accounting Policies & Activities for additional information on purchase accounting adjustments and intangible assets associated with the Merger.

We recorded an after-tax noncash accounting charge of $28.7 million during the fourth quarter of 2008 as a result of our annual testing of the goodwill initially recorded in the Merger for impairment, as required by accounting standards.  The impairment analysis was negatively impacted by the unprecedented weakness in the financial markets. The first step of the goodwill impairment analysis involves estimating a hypothetical fair value and comparing that with the carrying amount or book value of the entity; our initial comparison suggested that the carrying amount of goodwill exceeded its implied fair value due to our low stock price, consistent with that of most publicly-traded financial institutions.  Therefore, we were required to perform the second step of the analysis to determine the amount of the impairment.  We prepared a discounted cash flow analysis which established the estimated fair value of the entity and conducted a full valuation of the net assets of the entity.  Following these procedures, we determined that no amount of the net asset value could be allocated to goodwill and recorded the impairment to the goodwill balance as a noncash accounting charge to our earnings in 2008.   Our regulatory capital ratios are not affected by this noncash impairment charge.

 
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Our Market Areas

To execute our strategic plan, we have organized our banking operations into four regions:

 
Upstate Region;

 
Coastal Region;

 
Northern Region; and

 
Midlands Region.

The Upstate Region serves as the backbone and support center for First National's expanding branch network. First National's corporate headquarters and home office are located in Spartanburg, along with three full-service branches. Within each other region, First National conducts its banking operations in selected market areas which meet the criteria for its business plan. First National has appointed an officer to each region to oversee the banking and business development activities and assist the executive management team in evaluating market areas within their respective regions for growth and development opportunities. These regional officers also serve as the liaison to their region's business community and function as the primary point of contact for the local regional board members.

Upstate Region

Our primary market area includes Spartanburg and Greenville Counties, which are located in the upstate region of South Carolina between Atlanta and Charlotte on the I-85 business corridor stretching to the Georgia border.  According to SNL, as of July 1, 2008, Spartanburg County's population totaled 277,796 residents. Population growth from 2008 to 2013 for Spartanburg County is projected to be 5.52%.  As of 2008, estimated median family income for the Spartanburg metropolitan statistical area was $54,000 versus $52,900 for the state of South Carolina, according to the U.S. Department of Housing and Urban Development. Greenville County is South Carolina’s most populous county with 428,744 residents as of July 1, 2008, according to SNL.  Greenville County’s projected population growth from 2008 to 2013 is 8.40%.  Greenville is also one of the state’s wealthiest counties, with an estimated median income of $55,100 in 2008 versus $52,900 for the state of South Carolina according to U.S. Department of Housing and Urban Development.

According to the Upstate Alliance, the Upstate has had over $712 million in capital investment in the past three years. In addition, the Upstate region announced more than $2 billion in capital investment and more than 6,000 new jobs for 2008, according to the Upstate Alliance. In 2007, the Greenville-Spartanburg area of South Carolina was noted as one of Expansion Management’s “Top Metros for Recruitment and Attraction,” according to Upstate Alliance. We believe that the Upstate region has a strong economic environment that will continue to encourage business growth and development and support our business in the future.

Spartanburg

Spartanburg serves as the support center for our statewide branch network. We maintain our corporate headquarters in Spartanburg.  We opened our operations center adjacent to our corporate headquarters in April 2007.  The completion of this addition created a total of 29,500 square feet of office space while continuing to house a full-service branch.

According to the Economic Futures Group, formerly known as Spartanburg Economic Development Corporation, more than 80 international firms, representing 18 nations, conduct business in Spartanburg County, including BMW, Milliken, Michelin, Cryovac and Invista. Spartanburg is also home to many domestic corporations, including Denny’s, QS/1, Extended Stay America and Advance America. Spartanburg is currently experiencing numerous business expansions as well as an influx of new business facilities. BMW's North American assembly plant in Greer announced a three-year construction project to expand its operations. This expansion represents $750 million in capital investment and will create 500 new jobs, according to a press release issued by BMW in early 2008. Other notable companies, including Adidas, Lear Corporation and Coca-Cola, have announced new or expanded facilities that will create many new jobs in the Spartanburg area. We believe that Spartanburg has a strong economic environment that will continue to support the community and provide a sound base for our business in the future.

 
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We advertise heavily in the Spartanburg market and, through our three full-service branches in Spartanburg, have positioned ourselves as the leading local community bank in this market. As of June 30, 2008, we were the third largest bank in Spartanburg County, with $448.0 million in total deposits, or 12.07% of the approximately $3.7 billion of deposits in the market.  The following table includes information from the FDIC website regarding our deposit market share in Spartanburg County relative to top competitor banks as of June 30, 2008:
 
Rank
 
Bank
 
Branches
 
Total Deposits
 
Market Share
 
1
 
Bank of America
   
8
 
$
632.2 million
    17.03 %
2
 
Wachovia
   
7
 
539.1 million
    14.52 %
3
 
First National Bank
   
3
 
448.0 million
    12.07 %
4
 
BB & T
   
9
 
404.6 million
    10.90 %
5
 
First Citizens
   
11
 
348.8  million
    9.39 %
6
 
Suntrust Bank
   
11
 
290.8 million
    7.83 %
7
 
First South Bank
   
2
 
233.4 million
    6.29 %
8
 
Arthur State Bank
   
7
 
182.6 million
    4.92 %
   
All others (10 institutions)
   
21
 
633.3 million
    17.05 %
                       
   
Total
   
79
  $
3.7 billion
    100.00 %
 
Greenville

In 2008, Greenville County announced more than $181 million in new capital investment and more than 1,500 new jobs, according to the Greenville Area Development Corporation. Greenville is also home for over 70 international firms, which have provided over 14,000 jobs, and has been rated first in the nation by Site Selection magazine for both new and expanding international firms. Greenville was named a top five finalist for “Most Business Friendly and Best Human Resources in Small Cities for 2007-2008,” according to Foreign Direct Investment magazine. In 2007, Greenville was listed as one of “America’s 50 Hottest Cities” by Expansion Management magazine.

As of June 30, 2008, with two full-service branches in the Greenville market, we were the 21st largest bank in Greenville County, with $37.8 million in total deposits, or 0.37% of the approximately $10.12 billion of deposits in the market.  The following table includes information from the FDIC website regarding deposit market share in Greenville County as of June 30, 2008:

Rank
 
Bank
 
Branches
 
Total Deposits
 
Market Share
 
1
 
Carolina First Bank
   
13
  $
2.86 billion
    28.29 %
2
 
Wachovia
   
18
 
1.48 billion
    14.58 %
3
 
BB&T
   
19
 
1.16 billion
    11.50 %
4
 
Bank of America
   
16
 
973.5 million
    9.62 %
5
 
Southern First Bank
   
3
 
467.9 million
    4.62 %
6
 
Suntrust
   
17
 
432.0 million
    4.27 %
7
 
Bank of Travelers Rest
   
9
 
392.7 million
    3.88 %
8
 
Palmetto Bank
   
11
 
349.7 million
    3.46 %
9
 
First Citizens
   
11
 
276.4 million
    2.73 %
10
 
Greer State Bank
   
4
 
275.5 million
    2.72 %
             
 
       
   
All others (24 institutions)
   
48
 
1.45 billion
    14.33 %
             
 
       
   
Total
   
169
 
10.12 billion
    100.00 %
             
 
       
21
 
First National Bank
   
2
  $
37.8 million
    0.37 %

Coastal Region

The Coastal Region consists of historic Charleston and its surrounding counties.  Our full-service branches in Mount Pleasant and on East Bay Street in downtown Charleston serve the fast-growing Charleston market.   The downtown location serves as First National's headquarters for the Charleston market area. According to the FDIC, total deposits in Charleston were $7.31 billion as of June 30, 2008.

 
10

 

As of July 1, 2008, Charleston County’s estimated population totaled 347,490 residents, and population growth for Charleston County is projected to be 6.39% from 2008 to 2013, according to SNL. For 2007, the Charleston-North Charleston Metropolitan Statistical Area (“MSA”) estimated population totaled 630,100 residents and is projected to total 652,380 residents by 2015, according to the Charleston Regional Development Alliance with data provided by the U.S. Census Bureau. The Charleston area achieved an employment growth rate of 16.5% from 2000 through 2007, outpacing national employment growth of 6.7% during that same period, according to the Charleston Regional Development Alliance.

Charleston is the beneficiary of significant investment and development. According to the Charleston Regional Development Alliance, Charleston County has attracted over $5.21 billion in announced capital investment and more than 19,600 new jobs since its inception in 1995. In 2008, Charleston County announced new capital investment projects totaling more than $70 million and introducing more than 350 new jobs to the area. In its August 2008 issue, Inc. magazine ranked Charleston as one of "The Top U.S. Cities for Doing Business," and in April 2007 Charleston was placed in the top 25 for job growth. The Charleston regional economy has attracted over 70 firms with internationally owned operations, according to the Center for Business Research. These firms include Bosch, Berchtold, Maersk Sealand, Rhodia, and Holset Engineering. Domestic firms also maintain significant operations in the Charleston area, including MeadWestvaco, Nucor Steel, Alcoa, Arborgen, Blackbaud, and Piggly Wiggly. In addition, as of July 2008, the U.S. Navy and the Charleston Air Force Base collectively employed over 20,000 full-time employees, according to the Charleston Metro Chamber of Commerce.

Charleston is also a popular travel destination, which helps fuel the local economy. Condé Nast Traveller magazine has ranked Charleston as one of the country's top 10 domestic travel destinations for the past 16 years. According to the Charleston Metro Chamber of Commerce, in 2007 there were over 4.3 million visitors to the Charleston region with an aggregate regional economic impact of $3.09 billion.

As of June 30, 2008, with two full-service branches in the Charleston market, we were the 20th largest bank in Charleston County, with $36.6 million in total deposits, or 0.50% of the approximately $7.31 billion of deposits in the market.  The following table includes information from the FDIC website regarding deposit market share in Charleston County as of June 30, 2008:
 
Rank
 
Bank
 
Branches
 
Total Deposits
 
Market Share
 
1
 
Wachovia
   
21
  $
2.01 billion
    27.45 %
2
 
Bank of America
   
16
 
1.06 billion
    14.46 %
3
 
First FS&LA of Charleston
   
19
 
991.7 million
    13.56 %
4
 
National Bank of South Carolina
   
6
 
441.0 million
    6.03 %
5
 
Tidelands
   
3
 
383.5 million
    5.24 %
6
 
Community First Bank
   
4
 
352.9 million
    4.83 %
7
 
BB & T
   
7
 
336.6 million
    4.60 %
8
 
First Citizens
   
15
 
311.6 million
    4.26 %
9
 
Southcoast Community Bank
   
7
 
306.7 million
    4.19 %
10
 
Carolina First Bank
   
4
 
186.9 million
    2.56 %
             
 
       
   
All others (15 institutions)
   
34
 
936.8 million
    12.82 %
                       
   
Total
   
136
 
7.31 billion
    100.00 %
                       
20
 
First National Bank
   
2
  $
36.6 million
    0.50 %
 
Northern Region

The opening of our loan production office in February 2007 in Rock Hill marked our entry into the Northern Region of our franchise.  This region includes growing York and Lancaster counties and the suburbs south of Charlotte, North Carolina. In 2001, York County had an estimated population of 199,957 residents and is projected to total 221,763 residents by 2012, according to the York County Economic Development Board. York County attracted over $46.3 million in announced capital investment in 2008, according to the South Carolina Department of Commerce. According to Rock Hill Economic Development, Rock Hill had an estimated population of 59,620 residents in 2007 and is projected to total 66,683 residents by 2012.

 
11

 

According to the U.S. Department of Housing and Urban Development, York County had one of, if not, the highest median household incomes in the state at $64,300 estimated for 2008.  The three largest employers in York County are Wells Fargo Home Mortgage, Bowater and Duke Power.  York County had $2.02 billion in deposits as of June 30, 2008, according to the FDIC.  With its opening already approved by the OCC, construction should be completed to open our full-service branch in the Tega Cay community of Fort Mill during the second quarter of 2009, which will also serve as our Northern region headquarters.

Midlands Region

As discussed previously, Columbia’s central location in the state and convenient access to I-20, I-26, and I-77 makes this area one of the fastest growing areas in South Carolina according to U.S. Census data.  Home to the state capital, the University of South Carolina, and a variety of service based and light manufacturing companies, this area provides a growing and diverse economy.

As of June 30, 2008, with four full-service branches in the Midlands market, we were the 8th largest bank in Richland County, with $147.4 million in total deposits, or 1.54% of the approximately $9.6 billion of deposits in the market.  The following table includes information from the FDIC website regarding deposit market share in Richland County as of June 30, 2008:

Rank
 
Bank
 
Branches
 
Total Deposits
 
Market Share
 
1
 
Wachovia
   
19
  $
2.41 billion
    25.27 %
2
 
Bank of America
   
15
 
2.08 billion
    21.78 %
3
 
National Bank of South Carolina
   
9
 
2.0 billion
    20.60 %
4
 
BB & T
   
9
 
820.8 million
    8.59 %
5
 
First Citizens
   
16
 
793.8 million
    8.31 %
6
 
Carolina First Bank
   
7
 
434.2 million
    4.54 %
7
 
South Carolina B&T
   
4
 
171.3 million
    1.79 %
8
 
First National Bank
   
4
 
147.4 million
    1.54 %
9
 
Bankmeridian
   
1
 
144.6 million
    1.51 %
10
 
First Community Bank
   
4
 
111.5 million
    1.17 %
             
 
       
   
All others (13 institutions)
   
25
 
467.2 million
    4.90 %
                       
   
Total
   
113
  $
9.55 billion
    100.00 %

Lending Activities

General.  We offer a variety of lending services, including real estate, commercial, and consumer loans, including home equity lines of credit, primarily to individuals and small- to mid-size businesses that are located, or conduct a substantial portion of their business in the Spartanburg, Greenville, Charleston, Columbia or Rock Hill markets.  As of December 31, 2008, we had total loans, including mortgage loans held for sale, of $709.3 million, representing 87.3% of our total assets.  We emphasize a strong credit culture based on traditional credit measures and our knowledge of our markets through experienced relationship managers.

Our credit risk management function is comprised of our senior credit officer and his credit department who execute our loan review process.  Through our credit risk management function, we continuously review our loan portfolio for credit risk.  This function is independent of the credit approval process and reports directly to our CEO. It provides regular reports to the board of directors and its committees on its activities.  Adherence to underwriting standards is managed through a documented credit approval process and post-funding review by the credit department.  Based on the volume and complexity of the problem loans in our portfolio, we adjust the resources allocated to the process of monitoring and resolution of these assets.  Compliance with these standards is closely supervised by a number of procedures, including reviews of exception reports.

Once problem loans are identified, policies require written plans for resolution and periodic reporting to credit risk management to review and document progress.  The Asset Classification Committee meets quarterly to review items such as credit quality trends, problem credits and updates on specific credits reviewed.  This committee is composed of executive management and credit risk management personnel, as well as several representatives from our board of directors.

 
12

 

As a result of the identification of adverse developments with respect to certain loans in our loan portfolio, we increased the amount of impaired loans during the fourth quarter of 2008 to $39.5 million.  As of March 31, 2009, this amount had increased to $69.1 million. The provision for loan losses generally, and the loans impaired under the criteria defined in FAS 114, specifically, reflect the negative impact of the continued deterioration in the residential real estate market, specifically in the counties in and around Charleston along the South Carolina coast, and the economy in general.  Recent reviews by the credit department have specifically focused on our residential real estate development and construction borrowers.

Our analysis of impaired loans and their underlying collateral values has revealed the continued deterioration in the level of property values as well as reduced borrower ability to make regularly scheduled payments.  Loans in our residential land development and construction portfolios are secured by unimproved and improved land, residential lots, and single-family and multi-family homes.  Generally, current lot sales by the developers and/or borrowers are taking place at a greatly reduced pace and at reduced prices.  As home sales volumes have declined, income of residential developers, contractors and other real estate-dependent borrowers has also been reduced.  This difficult operating environment, along with the additional loan carrying time, has caused some borrowers to exhaust payment sources.  Within the last several months, several of our clients have reached the point where payment sources have been exhausted which has increased our level of nonaccrual loans and foreclosed properties.

On December 31, 2008 and December 31, 2007, $69.1 million and $12.0 million in loans were on nonaccrual status, respectively.  Foregone interest income on these nonaccrual loans and other nonaccrual loans charged off during the twelve-month periods ended December 31, 2008 and 2007, was approximately $1,139,000 and $139,000, respectively.  There were no loans contractually past due in excess of 90 days and still accruing interest at December 31, 2008 and 2007.  There were impaired loans, under the criteria defined in FAS 114, of $69.1 million and $12.0 million with related valuation allowances of approximately $8.3 million, net of chargeoffs during 2008 of $4.5 million, and $655,000 at December 31, 2008 and 2007, respectively.  The amounts presented as of December 31, 2008 reflect our analysis of the effect of events subsequent to the balance sheet date to the date of this report.

Our underwriting standards vary for each type of loan.  While we generally underwrite the loans in our portfolio in accordance with our internal underwriting guidelines and regulatory supervisory guidelines, in certain circumstances we have made loans that exceed either our internal underwriting guidelines, supervisory guidelines, or both.  We are generally permitted to hold loans that exceed supervisory guidelines up to 100% of our capital.  We have made loans that exceed our internal guidelines to a limited number of our customers who have significant liquid assets, net worth, and amounts on deposit with the bank.  As of December 31, 2008, $96.6 million, or approximately 13.6% of our loans and 237.8% of our capital, had loan-to-value ratios that exceeded regulatory supervisory guidelines.

We have focused our lending activities primarily on small- and medium-sized business owners, commercial real estate developers, and professionals.  We also strive to maintain a diversified loan portfolio and limit the amount of our loans to any single customer.  As of December 31, 2008, our 10 largest individual customer loan balances represented approximately $38.4 million, or 5.5% of the loan portfolio, excluding mortgage loans held for sale.

Real Estate Mortgage Loans.  Loans secured by real estate mortgages are the principal component of our loan portfolio.  To increase the likelihood of the ultimate repayment of the loan, we obtain a security interest in real estate whenever possible, in addition to other available collateral.  As of December 31, 2008, loans secured by first or second mortgages on real estate made up approximately $636.8 million, or 89.8% of our loan portfolio, excluding mortgage loans held for sale.

Within the broader category of real estate mortgage loans, the following table describes the loan categories of one-to-four family residential real estate loans, multi-family residential real estate loans, home equity loans, commercial real estate loans, and land loans as of December 31, 2008 (dollars in thousands):

Type of Real Estate Loan
 
Amount
 
One-to-four residential
  $ 103,081  
Multi-family residential
    9,242  
HELOC
    66,842  
Commercial real estate
    345,114 (1)
Land
    112,499  
         
Total
  $ 636,778 (2)
 

(1)
Includes Small Business Administration (“SBA”) loans.
(2)
Total real estate loans do not include mortgage loans held for sale.

 
13

 

Most of our real estate loans are secured by residential or commercial property.  Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate.  Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, creditworthiness, and ability to repay the loan.

Commercial Real Estate Loans. As of December 31, 2008, our individual commercial real estate loans ranged in size from $15,200 to $4.5 million.  The average commercial real estate loan size was approximately $549,000. These loans generally have terms of five years or less, although payments may be structured on a longer amortization basis.  We evaluate each borrower on an individual basis and attempt to determine the business risks and credit profile of each borrower.  We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied properties where the loan-to-value ratio, established by independent appraisals, does not exceed 80%.  We prepare a credit analysis in addition to a cash flow analysis to support the loan.  In order to ensure secondary sources of payment and to support a loan request, we typically review all of the personal financial statements of the principal owners and require their personal guarantees.  These commercial real estate loans include various types of business purpose loans secured by commercial real estate.

Residential Real Estate Loans.  As of December 31, 2008, our individual residential real estate loans ranged in size from less than $1,000 to $1.8 million, with an average loan size of approximately $146,000.  Generally, we limit the loan-to-value ratio on our residential real estate loans to 80%.  We offer fixed and adjustable rate residential real estate loans with amortizations up to 20 years.  To limit our risk, we offer fixed rate and variable rate loans for terms greater than 20 years through a third party, rather than originating and retaining these loans ourselves.  Generally, we do not originate traditional long term residential mortgages for our portfolio, but we do issue traditional first and second mortgage residential real estate loans and home equity lines of credit.  As of December 31, 2008, included in the residential real estate loans was $27.8 million, or 34.7% of our residential loan portfolio, in first and second mortgages on individuals’ homes.

Home Equity Lines of Credit.  As of December 31, 2008, our individual home equity lines of credit ranged in size from less than $3,000 to $1.5 million, with an average balance of approximately $50,000.  Our underwriting criteria for and the risks associated with home equity loans and lines of credit are generally the same as those for first mortgage loans.  Home equity lines of credit typically have terms of 15 years or less.  We generally limit the extension of credit to 90% of the available equity of each property, although we may extend up to 100% of the available equity.  Approximately $66.8 million, or 10.5% of First National’s real estate loans, are home equity lines of credit.

Wholesale Mortgage Loans Held for Sale.  Our wholesale mortgage division began operations in January 2007.  This division offers a wide variety of conforming and non-conforming loans with fixed and variable rate options, although the trend is to move towards all loans being conforming or traditional mortgage loans.  Conforming loans are those that are fully documented and are in amounts less than $417,000.  The division offers FHA/VA and construction/permanent products to its customers.  The division’s customers are located primarily in South Carolina and are primarily other community banks.

Real Estate Construction and Land Development Loans. We offer adjustable and fixed rate residential and commercial construction loans to builders and developers.  As of December 31, 2008, our commercial construction and development real estate loans ranged in size from approximately $2,000 to $5.0 million, with an average loan size of approximately $355,000. As of December 31, 2008, our individual residential construction and development real estate loans ranged in size from less than $2,000 to $1.8 million, with an average loan size of approximately $280,000.  The duration of our construction and development loans generally is limited to 12 months, although payments may be structured on a longer amortization basis.  We attempt to reduce the risk associated with construction and development loans by obtaining personal guarantees and by keeping the loan-to-value ratio of the completed project at or below 80%.  Construction and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project or home and usually on the sale of the property or permanent financing.  Specific risks include:

 
cost overruns;

 
mismanaged construction;

 
inferior or improper construction techniques;

 
economic changes or downturns during construction;

 
rising interest rates that may prevent sale of the property; and

 
failure to sell completed projects in a timely manner.

 
14

 

As of December 31, 2008, total construction and development loans amounted to $223.6 million, or 31.5% of our total loan portfolio.  Included in the $223.6 million were $56.0 million in residential construction loans, or 25.0% of our construction and development loan portfolio, that were made to residential construction developers. We are reducing the concentration of real estate construction and land development loans in our portfolio and have generally ceased making new loans to homebuilders.

Commercial Business Loans.  Most of our commercial business loans are secured by first or second mortgages on real estate, as described above.  We also make some commercial business loans that are not secured by real estate.  We make loans for commercial purposes in various lines of business, including retail, service industry, and professional services.  As of December 31, 2008, our individual commercial business loans ranged in size from less than $1,000 to $1.3 million, with an average loan size of approximately $84,000.  As with other categories of loans, the principal economic risk associated with commercial loans is the creditworthiness of the borrower.  The risks associated with commercial loans vary with many economic factors, including the economy in our market areas.  Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because commercial loans may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate.  As of December 31, 2008, commercial business loans amounted to $48.4 million, or 6.8%, of our total loan portfolio.

Consumer Loans.  We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment loans and revolving lines of credit.  Consumer loans are underwritten based on the borrower’s income, current debt level, past credit history, and the availability and value of collateral.  Consumer rates are both fixed and variable, with negotiable terms.  Our installment loans typically amortize over periods up to 60 months.  However, we will offer consumer loans with a single maturity date when a specific source of repayment is available.  We typically require monthly payments of interest and a portion of the principal on our revolving loan products.  Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because consumer loans may be unsecured, or if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate.  As of December 31, 2008, consumer loans amounted to $8.4 million, or 1.2% of our loan portfolio.

Loan Approval.  Certain credit risks are inherent in making loans.  These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers.  We attempt to mitigate repayment risks by adhering to internal credit policies and procedures.  These policies and procedures include officer and customer lending limits, a multi-layered approval process for larger loans, documentation examination, and follow-up procedures for any exceptions to credit policies.  Our loan approval policies provide for various levels of officer lending authority and have recently been reduced by our Board Loan Committee.  All loans/cumulative debt exceeding $250,000 must be approved by the President, Senior Lending Officer and Senior Credit Officer.  Loans/cumulative debt exceeding $500,000 must be approved by our Board Loan Committee, the Board of Directors, with nine concurring members, can approve loans up to our legal lending limit.  As a result of the consent order the bank entered into with the OCC on April 27, 2009, additional procedures will be required before loans can be approved.  The bank may not, without approval of the Board Loan Committee, grant, extend, renew, alter or restructure any loan or other extension of credit until any outstanding credit or collateral exceptions are resolved.

Credit Administration and Loan Review.  We seek to emphasize a strong credit culture based on traditional credit measures and our knowledge of our markets through experienced relationship managers.  We rely heavily on the experience and knowledge of these individuals as well as our senior credit officer and his credit department to implement and maintain our credit culture.  However, despite their efforts, we have experienced a decline in credit quality over the last eighteen months as economic conditions in our markets have worsened.  We maintain a continuous internal loan review system and engage an independent consultant on an annual basis to review loan files on a test basis to confirm our loan grading.  Each loan officer is responsible for every loan he or she makes, regardless of whether other individuals or committees joined in the approval.  This responsibility continues until the loan is repaid or until the loan is officially assigned to another officer.  In the past, the compensation of our lending officers has been dependent in part on the asset quality of their loan portfolios.  We have adopted an incentive plan under which our loan officers are eligible to receive cash bonuses for achieving monthly and annual goals relating to, among other things, loan production and maintenance of minimum quality levels for the officer’s loan portfolio.  However, payment of incentives under this plan has been suspended during the current period of reduced profitability for the bank.

 Our dedication to strong credit quality is reinforced by our internal credit review process and performance benchmarks in the areas of nonperforming assets, chargeoffs, past dues, and loan documentation.  We intend to add additional employees to assist with credit administration and loan review as the complexity of this area grows.  In addition to our own in-house credit review function, we currently engage an outside firm to evaluate our loan portfolio on a quarterly basis for credit quality, a second outside firm for compliance issues on an annual basis, and a third outside firm to provide advice and recommendations and respond to specific loan-related inquiries at any time.  Pursuant to the executed consent order with the OCC, our bank’s loan review function will be enhanced by quarterly written reporting to the board of directors on the content of the results of the loan reviews performed.

 
15

 

Special Assets Management Group.  In order to concentrate our efforts on the timely resolution and disposition of nonperforming and foreclosed assets, we have formed a special assets management group.  This group’s objective is the expedient workout/resolution of assigned loans and assets at the highest present value recovery.  This separate operating unit reports directly to the senior credit officer with personnel dedicated solely to the assigned special assets.  When loans are scheduled to be moved to the group, they are assessed and assigned to the special assets officer best suited to manage that loan/asset.  The assigned special assets officer then begins the takeover and review process to determine the recommended action plan.  These plans are reviewed and approved by the senior credit officer and submitted for final approval.  In cases where the plan involves a loan restructure or modification, appropriate risk controls such as improved requirements for borrower/guarantor financial information, principal reductions or additional collateral or loan covenants specific to the project or borrower, may be utilized to preserve or strengthen our position.  The group also manages the disposition of foreclosed properties from the pre-foreclosure deed steps to the management, maintenance and marketing efforts with the objective of disposing of these assets in an expeditious manner at the highest present value to the bank, pursuant to asset-specific strategies which give consideration to holding costs.

Lending Limits.   Our lending activities are subject to a variety of lending limits imposed by federal law.  In general, our bank is subject to a legal limit on loans to a single borrower equal to 15% of the bank’s capital and unimpaired surplus.  This limit will increase or decrease as the bank’s capital increases or decreases.  Based upon the capitalization of the bank as of December 31, 2008, our legal lending limit was approximately $10.3 million.  We sell participations in our larger loans to other financial institutions, which allow us to manage the risk involved in these loans and to meet the lending needs of our customers requiring extensions of credit in excess of this limit.

Deposit Services

One of our principal sources of funds is core deposits (deposits other than time deposits of $100,000 or more).  As of December 31, 2008, approximately 76.8% of our total deposits were obtained from within our branch network.  We also rely on time deposits of $100,000 or more to support our growth, which are generally obtained through brokers with whom we maintain ongoing relationships.  Due to the April 27, 2009 execution of the consent order with the OCC, we are no longer able to accept, renew or roll over the time deposits obtained through brokers without a waiver from the FDIC.  There is no assurance that the FDIC will grant us a waiver.    We do not obtain time deposits of $100,000 or more through the internet.  As of December 31, 2008, 42.2% of our total time deposits were deposits of $100,000 or more.
 
We offer a full range of deposit services, including checking accounts, commercial accounts, savings accounts, and other time deposits of various types, ranging from daily money market accounts to certificates of deposit.  We regularly review our deposit rates to ensure that we remain competitive in our markets.

Trust and Investment Management Services

Since August 15, 2002, we have offered trust and investment management services through an alliance with Colonial Trust.  This arrangement allows our consumer and commercial customers access to a wide variety of services provided by Colonial Trust, including trust services, professional portfolio management, estate administration, individual financial and retirement planning, and corporate retirement planning services.  We receive a residual fee from Colonial Trust based on a percentage of the aggregate assets under management generated by referrals from the bank.

Other Banking Services

We rely on our branch network as a vehicle to deliver products and services to the customers in our markets throughout South Carolina.  While we offer traditional banking products and services to our customers which generate noninterest income for us, we also provide a variety of unique options to complement our core business features.  Combining these options with standard products and services allows us to maximize our appeal to a broad customer base while capitalizing on noninterest income potential.  Through our alliance with WorkLife Financial, we are able to offer business expertise to our customers in a variety of areas, such as human resource management, payroll administration, risk management, and other financial services through a fee based arrangement which provides residual income to us.

 In addition, we earn income through the origination and sale of residential mortgages.  Each of these distinctive services represents not only an exceptional opportunity to build and strengthen customer loyalty but also to enhance our financial position with noninterest income, as we believe they are less directly impacted by current economic challenges.

 
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We offer other banking services including safe deposit boxes, traveler’s checks, direct deposit, United States savings bonds, and banking by mail.  We earn fees for most of these services, including debit and credit card transactions, sales of checks, and wire transfers.  We provide ATM transactions to our customers at no charge; however, we receive ATM transaction fees from transactions performed at our branches by persons who are not customers of the bank.  We are associated with the Cirrus and Pulse ATM networks, which are available to our customers free of charge throughout the country.  Since we outsource our ATM services, we are charged related transaction fees from our ATM service provider.  We have contracted with an outside vendor to provide our core data processing services and our ATM processing.  Given our current size, we believe that outsourcing these services reduces our overhead by matching the expense in each period to the transaction volume that occurs during the period, as a significant portion of the fee charged is directly related to the number of loan and deposit accounts and the related number of transactions we have during the period.

First National Online, our internet website www.fnbwecandothat.com, provides our personal and business customers access to internet banking services, including electronic bill payment services and cash management services including account-to-account transfers.  The internet banking services are provided through a contractual arrangement with an outside vendor.

We offer our customers insurance services, including life, long term care, and annuities through vendors associated with the South Carolina Bankers Association.  Additionally, we provide equipment leasing arrangements through an outside vendor.
 
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SUPERVISION AND REGULATION

Both the company and the bank are subject to extensive state and federal banking laws and regulations that impose specific requirements or restrictions on and provide for general regulatory oversight of virtually all aspects of our operations.  These laws and regulations are generally intended to protect depositors, not shareholders.  The following summary is qualified by reference to the statutory and regulatory provisions discussed.  Changes in applicable laws or regulations may have a material effect on our business and prospects.  Our operations may be affected by legislative changes and the policies of various regulatory authorities.  We cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.

The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on our operations.  It is intended only to briefly summarize some material provisions.

First National Bancshares, Inc.

We own 100% of the outstanding capital stock of the bank, and therefore we are considered to be a bank holding company under the federal Bank Holding Company Act of 1956 (the “Bank Holding Company Act”).  As a result, we are primarily subject to the supervision, examination and reporting requirements of the Board of Governors of the Federal Reserve (the “Federal Reserve”) under the Bank Holding Company Act and its regulations promulgated there under.  Moreover, as a bank holding company of a bank located in South Carolina, we also are subject to the South Carolina Banking and Branching Efficiency Act.

Permitted Activities. Under the Bank Holding Company Act, a bank holding company is generally permitted to engage in, or acquire direct or indirect control of more than 5% of the voting shares of any company engaged in, the following activities:

 
banking or managing or controlling banks;

 
furnishing services to or performing services for our subsidiaries; and

 
any activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

 
factoring accounts receivable;

 
making, acquiring, brokering or servicing loans and usual related activities;

 
leasing personal or real property;

 
operating a non-bank depository institution, such as a savings association;

 
trust company functions;

 
financial and investment advisory activities;

 
conducting discount securities brokerage activities;

 
underwriting and dealing in government obligations and money market instruments;

 
providing specified management consulting and counseling activities;

 
performing selected data processing services and support services;

 
acting as agent or broker in selling credit life insurance and other types of insurance in connection with credit transactions; and

 
performing selected insurance underwriting activities.

 
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As a bank holding company, we had elected to be treated as a “financial holding company,” which allows us to engage in a broader array of activities.  In sum, a financial holding company can engage in activities that are financial in nature or incidental or complementary to financial activities, including insurance underwriting, sales and brokerage activities, providing financial and investment advisory services, underwriting services and limited merchant banking activities.  In order to maintain our  financial holding company status, each insured depository institution we control would have to be well-capitalized, well managed and have at least a satisfactory rating under the CRA (discussed below).  Our bank’s regulatory classification no longer qualifies as well-capitalized after our execution of the consent order with the OCC on April 27, 2009. Therefore, by notice of a letter dated April 30, 2009, to the Federal Reserve, we are decertified as a financial holding company.  The Federal Reserve has the authority to order a bank holding company or its subsidiaries to terminate any of these activities or to terminate its ownership or control of any subsidiary when it has reasonable cause to believe that the bank holding company’s continued ownership, activity or control constitutes a serious risk to the financial safety, soundness or stability of it or any of its bank subsidiaries.  However, none of the activities of our holding company will be affected by our decertifying.

Change in Control.  In addition, and subject to certain exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with regulations promulgated there under, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company.  Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company.  Following the relaxing of these restrictions by the Federal Reserve in September 2008, control will be rebuttably presumed to exist if a person acquires more than 33% of the total equity of a bank or bank holding company, of which it may own, control or have the power to vote not more than 15% of any class of voting securities.

Source of Strength.  In accordance with Federal Reserve Board policy, we are expected to act as a source of financial strength to the bank and to commit resources to support the bank in circumstances in which we might not otherwise do so.  If the bank were to become “undercapitalized” (see below “First National Bank of the South—Prompt Corrective Action”), we would be required to provide a guarantee of the bank’s plan to return to capital adequacy.  Additionally, under the Bank Holding Company Act, the Federal Reserve Board may require a bank holding company to terminate any activity or relinquish control of a non-bank subsidiary, other than a non-bank subsidiary of a bank, upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of a bank holding company.  Federal bank regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or non-bank subsidiaries if the agency determines that divestiture may aid the depository institution’s financial condition.  Further, any loans by a bank holding company to a subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank.  In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level would be assumed by the bankruptcy trustee and entitled to priority payment.

Capital Requirements.  The Federal Reserve Board imposes certain capital requirements on the bank holding company under the Bank Holding Company Act, including a minimum leverage ratio and minimum ratios of “certain” capital to risk-weighted assets.  These requirements are essentially the same as those that apply to the bank and are described below under “First National Bank of the South—Capital Regulations.”  Subject to our capital requirements and certain other restrictions, we are able to borrow money to make a capital contribution to the bank, and these loans may be repaid from dividends paid from the bank to the company.  Our ability to pay dividends depends on the bank’s ability to pay dividends to us, which is subject to regulatory restrictions as described below in “First National Bank of the South—Dividends.”  We are also able to raise capital for contribution to the bank by issuing securities without having to receive regulatory approval, subject to compliance with federal and state securities laws.

South Carolina State Regulation.  As a South Carolina bank holding company under the South Carolina Banking and Branching Efficiency Act, we are subject to limitations on sale or merger and to regulation by the South Carolina Board of Financial Institutions (the “S.C. Board”).  We are not required to obtain the approval of the S.C. Board prior to acquiring the capital stock of a national bank, but we must notify them at least 15 days prior to doing so.  We must receive the S.C. Board’s approval prior to engaging in the acquisition of a South Carolina state chartered bank or another South Carolina bank holding company.
 
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First National Bank of the South

The bank operates as a national banking association incorporated under the laws of the United States and subject to examination by the OCC.  Deposits in the bank are insured by the FDIC up to a maximum amount, which is currently $100,000 for each non-retirement depositor and $250,000 for certain retirement-account depositors.  However, the FDIC has temporarily increased the coverage up to $250,000 for each non-retirement depositor through December 31, 2009, and the bank is participating in the FDIC’s Transaction Account Guarantee Program (discussed below in greater detail) which fully insures certain noninterest bearing transaction accounts. The OCC and the FDIC regulate or monitor virtually all areas of the bank’s operations, including:

 
security devices and procedures;

 
adequacy of capitalization and loss reserves;
 
 
 
loans;

 
investments;

 
borrowings;

 
deposits;

 
mergers;

 
issuances of securities;

 
payment of dividends;

 
interest rates payable on deposits;

 
interest rates or fees chargeable on loans;

 
establishment of branches;

 
corporate reorganizations;

 
maintenance of books and records; and

 
adequacy of staff training to carry on safe lending and deposit gathering practices.

The OCC requires that the bank maintain specified capital ratios of capital to assets and imposes limitations on the bank’s aggregate investment in real estate, bank premises, and furniture and fixtures.  Two categories of regulatory capital are used in calculating these ratios—Tier 1 capital and total capital.  Tier 1 capital generally includes common equity, retained earnings, a limited amount of qualifying preferred stock, and qualifying minority interests in consolidated subsidiaries, reduced by goodwill and certain other intangible assets, such as core deposit intangibles, and certain other assets.  Total capital generally consists of Tier 1 capital plus Tier 2 capital, which includes the allowance for loan losses, preferred stock that did not qualify as Tier 1 capital, certain types of subordinated debt and a limited amount of other items.

The bank is required to calculate three ratios: the ratio of Tier 1 capital to risk-weighted assets, the ratio of total capital to risk-weighted assets, and the “leverage ratio,” which is the ratio of Tier 1 capital to assets on a non-risk-adjusted basis. For the two ratios of capital to risk-weighted assets, certain assets, such as cash and U.S. Treasury securities, have a zero risk weighting. Others, such as commercial and consumer loans, have a 100% risk weighting. Some assets, notably purchase-money loans secured by first-liens on residential real property, are risk-weighted at 50%. Risk-weighted assets also include amounts that represent the potential funding of off-balance sheet obligations such as loan commitments and letters of credit. These potential assets are assigned to risk categories in the same manner as funded assets. The total assets in each category are multiplied by the appropriate risk weighting to determine risk-adjusted assets for the capital calculations.

 
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The minimum capital ratios for both bank holding companies and banks are generally 8% for total capital, 4% for Tier 1 capital and 4% for leverage. To be eligible to be classified as “well-capitalized,” a bank must generally maintain a total capital ratio of 10% or more, a Tier 1 capital ratio of 6% or more, and a leverage ratio of 5% or more unless the bank is subject to an enforcement action or specific directive to maintain higher capital ratios.  Certain implications of the regulatory capital classification system and our bank’s current capital condition are discussed in greater detail below.

Prompt Corrective Action.  The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established “prompt corrective action” regulations in which every FDIC insured institution is placed in one of five regulatory categories, depending primarily on its regulatory capital levels. The OCC and the other federal banking regulators are permitted to take increasingly severe action as a bank’s capital position or financial condition declines  as described below. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s leverage ratio reaches two percent. Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital.  The prompt corrective action regulations set forth five capital categories, each with specific regulatory consequences. The categories are:

 
Well-Capitalized—The institution exceeds the required minimum level for each relevant capital measure.  A well- capitalized institution is one (i) having a total capital ratio of 10% or greater, (ii) having a tier 1 capital ratio of 6% or greater, (iii) having a leverage capital ratio of 5% or greater and (iv) that is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure.
 
 
 
Adequately Capitalized—The institution meets the required minimum level for each relevant capital measure.  No capital distribution may be made that would result in the institution becoming undercapitalized. An adequately capitalized institution is one (i) having a total capital ratio of 8% or greater, (ii) having a tier 1 capital ratio of 4% or greater and (iii) having a leverage capital ratio of 4% or greater or a leverage capital ratio of 3% or greater if the institution is rated composite 1 under the CAMELS (Capital, Assets, Management, Earnings, Liquidity and Sensitivity to Market Risk) rating system.

 
Undercapitalized—The institution fails to meet the required minimum level for any relevant capital measure.  An undercapitalized institution is one (i) having a total capital ratio of less than 8% or (ii) having a tier 1 capital ratio of less than 4% or (iii) having a leverage capital ratio of less than 4%, or if the institution is rated a composite 1 under the CAMEL rating system, a leverage capital ratio of less than 3%.

 
Significantly Undercapitalized—The institution is significantly below the required minimum level for any relevant capital measure.  A significantly undercapitalized institution is one (i) having a total capital ratio of less than 6% or (ii) having a tier 1 capital ratio of less than 3% or (iii) having a leverage capital ratio of less than 3%.

 
Critically Undercapitalized—The institution fails to meet a critical capital level set by the appropriate federal banking agency.  A critically undercapitalized institution is one having a ratio of tangible equity to total assets that is equal to or less than 2%.

If the OCC determines, after notice and an opportunity for hearing, that the bank is in an unsafe or unsound condition, the regulator is authorized to reclassify the bank to the next lower capital category (other than critically undercapitalized) and require the submission of a plan to correct the unsafe or unsound condition.

Our bank is required to maintain higher capital levels due to minimum requirements included in the formal enforcement action it executed with the OCC on April 27, 2009.  As a result, the bank is currently deemed to be adequately capitalized.  See Capital Resources for more details on the bank’s current capital condition and Consent Order for more details on the minimum capital requirements set forth in the consent order.

Because the bank is not considered well-capitalized, it cannot accept brokered deposits without prior FDIC approval and, if approval is granted, cannot offer an effective yield in excess of 75 basis points on interests paid on deposits of comparable size and maturity in such institution’s normal market area for deposits accepted from within its normal market area, or national rate paid on deposits of comparable size and maturity for deposits accepted outside the bank’s normal market area.  There is no assurance that the FDIC will grant us the approval when requested.

 
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 Moreover, if the bank becomes less than adequately capitalized, it must adopt a capital restoration plan acceptable to the OCC that is subject to a limited performance guarantee by the corporation.  The bank also would become subject to increased regulatory oversight, and is increasingly restricted in the scope of its permissible activities.  Each company having control over an undercapitalized institution also must provide a limited guarantee that the institution will comply with its capital restoration plan.  Except under limited circumstances consistent with an accepted capital restoration plan, an undercapitalized institution may not grow.  An undercapitalized institution may not acquire another institution, establish additional branch offices or engage in any new line of business unless determined by the appropriate Federal banking agency to be consistent with an accepted capital restoration plan, or unless it is determined that the proposed action will further the purpose of prompt corrective action.  The appropriate federal banking agency may take any action authorized for a significantly undercapitalized institution if an undercapitalized institution fails to submit an acceptable capital restoration plan or fails in any material respect to implement a plan accepted by the agency.  A critically undercapitalized institution is subject to having a receiver or conservator appointed to manage its affairs and for loss of its charter to conduct banking activities.

An insured depository institution may not pay a management fee to a bank holding company controlling that institution or any other person having control of the institution if, after making the payment, the institution, would be undercapitalized.  In addition, an institution cannot make a capital distribution, such as a dividend or other distribution that is in substance a distribution of capital to the owners of the institution if following such a distribution the institution would be undercapitalized.  Thus, if payment of such a management fee or the making of such would cause the bank to become undercapitalized, it could not pay a management fee or dividend to our holding company.

Standards for Safety and Soundness.     The FDIA also requires the federal banking regulatory agencies to prescribe, by regulation or guideline, operational and managerial standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; and (v) asset growth. The agencies also must prescribe standards for asset quality, earnings, and stock valuation, as well as standards for compensation, fees and benefits. The federal banking agencies have adopted regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness to implement these required standards. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. Under the regulations, if the OCC determines that the bank fails to meet any standards prescribed by the guidelines, the agency may require the bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the OCC. The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

Regulatory Examination.     The OCC also requires the bank to prepare annual reports on the bank’s financial condition and to conduct an annual audit of its financial affairs in compliance with its minimum standards and procedures.
 
All insured institutions must undergo regular on-site examinations by their appropriate banking agency. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. Insured institutions are required to submit annual reports to the FDIC, their federal regulatory agency, and state supervisor when applicable. The FDIC has developed a method for insured depository institutions to provide supplemental disclosure of the estimated fair market value of assets and liabilities, to the extent feasible and practicable, in any balance sheet, financial statement, report of condition or any other report of any insured depository institution. The federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating, among other things, to the following:
 
                 internal controls;
 
                 information systems and audit systems;
 
                 loan documentation;
 
                 credit underwriting;
 
                 interest rate risk exposure; and
 
         •        asset quality.

Recent Legislative and Regulatory Initiatives to Address Financial and Economic Crises.  The Congress, Treasury Department and the federal banking regulators, including the FDIC, have taken broad action since early September 2008 to address volatility in the U.S. banking system.

 
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In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorizes the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”).  The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other.  The Treasury Department has allocated $250 billion towards the TARP Capital Purchase Program (“CPP”).  Under the CPP, Treasury will purchase debt or equity securities from participating institutions.  The TARP also will include direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. EESA also temporarily increased FDIC deposit insurance on most accounts from $100,000 to $250,000.  This increase is in place until the end of 2009 and is not covered by deposit insurance premiums paid by the banking industry.

                 Following a systemic risk determination, the FDIC established the Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008.  The TLGP includes the Transaction Account Guarantee Program (“TAGP”), which provides unlimited deposit insurance coverage through December 31, 2009 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts.  Institutions participating in the TAGP pay a 10 basis point fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place.  The TLGP also includes the Debt Guarantee Program (“DGP”), under which the FDIC guarantees certain senior unsecured debt of FDIC-insured institutions and their holding companies.  The unsecured debt must be issued on or after October 14, 2008 and not later than June 30, 2009, and the guarantee is effective through the earlier of the maturity date or June 30, 2012.  On March 17, 2009, the FDIC adopted an interim rule that extends the DGP and imposes surcharges on existing rates for certain debt issuances.  This extension allows institutions that have issued guaranteed debt before April 1, 2009 to issue guaranteed debt during the extended issuance period that ends on October 31, 2009. For such institutions, the guarantee on debt issued on or after April 1, 2009, will expire no later than December 31, 2012. The DGP coverage limit is generally 125% of the eligible entity’s eligible debt outstanding on September 30, 2008 and scheduled to mature on or before June 30, 2009 or, for certain insured institutions, 2% of their liabilities as of September 30, 2008.  Depending on the term of the debt maturity, the nonrefundable DGP fee ranges from 60 to 110 basis points (annualized) for covered debt outstanding until the earlier of maturity or June 30, 2012 and 75 to 125 basis points (annualized) for covered debt outstanding until after June 30, 2012.  The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008.  We have elected to participate in the TAGP.

                 In addition, on March 23, 2009, the U.S. Treasury, in conjunction with the FDIC and the Federal Reserve, announced the Public-Private Partnership Investment Program for Legacy Assets which consists of two separate plans, addressing two distinct asset groups:

 
·
The Legacy Loan Program, which the primary purpose will be to facilitate the sale of troubled mortgage loans by eligible institutions, which include FDIC-insured federal or state banks and savings associations. Eligible assets may not be strictly limited to loans; however, what constitutes an eligible asset will be determined by participating Banks, their primary regulators, the FDIC and the U.S. Treasury. Additionally, the Loan Program’s requirements and structure will be subject to notice and comment rulemaking, which may take some time to complete.
 
·
The Securities Program, which will be administered by the U.S. Treasury, involves the creation of public-private investment funds to target investments in eligible residential mortgage-backed securities and commercial mortgage-backed securities issued before 2009 that originally were rated AAA or the equivalent by two or more nationally recognized statistical rating organizations, without regard to rating enhancements (collectively, “Legacy Securities”). Legacy Securities must be directly secured by actual mortgage loans, leases or other assets, and may be purchased only from financial institutions that meet TARP eligibility requirements

Insurance of Deposit Accounts and Regulation by the FDIC.   First National Bank of the South deposits are insured up to applicable limits by the Deposit Insurance Fund of the FDIC.  The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged effective March 31, 2006.  As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC- insured institutions.  It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund.  The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the Office of Thrift Supervision an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 
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Under regulations effective January 1, 2007, the FDIC adopted a new risk-based premium system that provides for quarterly assessments based on an insured institution’s ranking in one of four risk categories based upon supervisory and capital evaluations.   For deposits held as of March 31, 2009, institutions are assessed at annual rates ranging from 12 to 50 basis points, depending on each institution’s risk of default as measured by regulatory capital ratios and other supervisory measures.   Effective April 1, 2009, assessments will take into account each institution's reliance on secured liabilities and brokered deposits.   This will result in assessments ranging from 7 to 77.5 basis points.  We anticipate our future insurance costs to be substantially higher than in previous periods due to the change in our regulatory capital classification resulting from the consent order we executed with our bank’s regulators on April 27, 2009.
 
FDIC-insured institutions are required to pay a Financing Corporation assessment, in order to fund the interest on bonds issued to resolve thrift failures in the 1980’s.  For the first quarter of 2009, the Financing Corporation assessment equaled 1.14 basis points for domestic deposits.  These assessments, which may be revised based upon the level of deposits, will continue until the bonds mature in the years 2017 through 2019.
 
The FDIC may terminate the deposit insurance of any insured depository institution, including the bank, if it determines after a hearing that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OCC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital.  If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC.  Management of the bank is not aware of any practice, condition or violation that might lead to termination of the bank’s deposit insurance.

Transactions with Affiliates and Insiders. The company is a legal entity separate and distinct from the bank and its other subsidiaries.  Various legal limitations restrict the bank from lending or otherwise supplying funds to the company or its non-bank subsidiaries. The company and the bank are subject to Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W.   Section 23A of the Federal Reserve Act places limits on the amount of loans or extensions of credit to, or investments in, or certain other transactions with, affiliates and on the amount of advances to third parties collateralized by the securities or obligations of affiliates.  The aggregate of all covered transactions is limited in amount, as to any one affiliate, to 10% of the bank’s capital and surplus and, as to all affiliates combined, to 20% of the bank’s capital and surplus.  Furthermore, within the foregoing limitations as to amount, each covered transaction must meet specified collateral requirements.  The bank is forbidden to purchase low quality assets from an affiliate.

Section 23B of the Federal Reserve Act, among other things, prohibits an institution from engaging in certain transactions with certain affiliates unless the transactions are on terms substantially the same, or at least as favorable to such institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates. The regulation also limits the amount of loans that can be purchased by a bank from an affiliate to not more than 100% of the bank’s capital and surplus.

The bank is also subject to certain restrictions on extensions of credit to executive officers, directors, certain principal shareholders, and their related interests.  Such extensions of credit (i) must be made on substantially the same terms, including interest rates, and collateral, as those prevailing at the time for comparable transactions with third parties and (ii) must not involve more than the normal risk of repayment or present other unfavorable features.

Dividends.  The company’s principal source of cash flow, including cash flow to pay dividends to its shareholders, is dividends it receives from the bank. Statutory and regulatory limitations apply to the bank’s payment of dividends to the company. As a general rule, the amount of a dividend may not exceed, without prior regulatory approval, the sum of net income in the calendar year to date and the retained net earnings of the immediately preceding two calendar years. A depository institution may not pay any dividend if payment would cause the institution to become undercapitalized or if it already is undercapitalized. The OCC may prevent the payment of a dividend if it determines that the payment would be an unsafe and unsound banking practice. The OCC also has advised that a national bank should generally pay dividends only out of current operating earnings.  As a result of the executed enforcement action with the OCC, our bank may only pay dividends when it is in compliance with its approved capital plan required to be completed under the terms of the consent order and with the approval of the OCC.  There can be no assurance that the OCC would grant such approval.

 
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Branching.  National banks are required by the National Bank Act to adhere to branch office banking laws applicable to state banks in the states in which they are located. Under current South Carolina law, the bank may open branch offices throughout South Carolina with the prior approval of the OCC.  In addition, with prior regulatory approval, the bank is able to acquire existing banking operations in South Carolina.  Furthermore, federal legislation permits interstate branching, including out-of-state acquisitions by bank holding companies, interstate branching by banks if allowed by state law, and interstate merging by banks.  South Carolina law, with limited exceptions, currently permits branching across state lines only through interstate mergers.

Anti-Tying Restrictions.  Under amendments to the BHCA and Federal Reserve regulations, a bank is prohibited from engaging in certain tying or reciprocity arrangements with its customers. In general, a bank may not extend credit, lease, sell property, or furnish any services, or fix or vary the consideration for these on the condition that (i) the customer obtain or provide some additional credit, property, or services from or to the bank, the bank holding company or subsidiaries thereof or (ii) the customer may not obtain some other credit, property, or services from a competitor, except to the extent reasonable conditions are imposed to assure the soundness of the credit extended. Certain arrangements are permissible: a bank may offer combined-balance products and may otherwise offer more favorable terms if a customer obtains two or more traditional bank products; and certain foreign transactions are exempt from the general rule. A bank holding company or any bank affiliate also is subject to anti-tying requirements in connection with electronic benefit transfer services.

Community Reinvestment Act.  The Community Reinvestment Act requires that the OCC evaluate the record of the bank in meeting the credit needs of its local community, including low and moderate income neighborhoods.  These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility.  Failure to adequately meet these criteria could impose additional requirements and limitations on the bank.

Finance Subsidiaries. Under the Gramm-Leach-Bliley Act (the “GLBA”), subject to certain conditions imposed by their respective banking regulators, national and state-chartered banks are permitted to form “financial subsidiaries” that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible.  The GLBA imposes several safeguards and restrictions on financial subsidiaries, including that the parent bank’s equity investment in the financial subsidiary be deducted from the bank’s assets and tangible equity for purposes of calculating the bank’s capital adequacy.  In addition, the GLBA imposes new restrictions on transactions between a bank and its financial subsidiaries similar to restrictions applicable to transactions between banks and non-bank affiliates.

Consumer Protection Regulations. Activities of the bank are subject to a variety of statutes and regulations designed to protect consumers.  Interest and other charges collected or contracted for by the bank are subject to state usury laws and federal laws concerning interest rates.  The bank’s loan operations are also subject to federal laws applicable to credit transactions, such as:

 
the federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 
the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 
the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 
the Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;

 
the Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and

 
the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.

The deposit operations of the bank also are subject to a number of federal laws, such as:

 
the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

 
the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that Act, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.

 
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Enforcement Powers.  The bank and its “institution-affiliated parties,” including its management, employees, agents independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs, are subject to potential civil and criminal penalties for violations of law, regulations or written orders of a government agency.  These practices can include the failure of an institution to timely file required reports or the filing of false or misleading information or the submission of inaccurate reports.  Civil penalties may be as high as $1,000,000 a day for such violations.  Criminal penalties for some financial institution crimes have been increased to twenty years.  In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties.  Possible enforcement actions include the termination of deposit insurance.  Furthermore, banking agencies’ power to issue cease-and-desist orders were expanded.  Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnifications or guarantees against loss.  A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate.

Anti-Money Laundering.  Financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls; a designated compliance officer; an ongoing employee training program; and testing of the program by an independent audit function. The company and the bank are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and “knowing your customer” in their dealings with foreign financial institutions and foreign customers. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions, and recent laws provide law enforcement authorities with increased access to financial information maintained by banks. Anti-money laundering obligations have been substantially strengthened as a result of the USA Patriot Act, enacted in 2001 and renewed in 2006. Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications. The regulatory authorities have been active in imposing “cease and desist” orders and money penalty sanctions against institutions found to be violating these obligations.

USA PATRIOT Act/Bank Secrecy Act.  Financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls; a designated compliance officer; an ongoing employee training program; and testing of the program by an independent audit function. The USA PATRIOT Act, amended, in part, the Bank Secrecy Act and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering by enhancing anti-money laundering and financial transparency laws, as well as enhanced information collection tools and enforcement mechanics for the U.S. government, including: (i) requiring standards for verifying customer identification at account opening; (ii) rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering; (iii) reports by nonfinancial trades and businesses filed with the Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000; and (iv) filing suspicious activities reports if a bank believes a customer may be violating U.S. laws and regulations and requires enhanced due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons.  Bank regulators routinely examine institutions for compliance with these obligations and are required to consider compliance in connection with the regulatory review of applications.

Under the USA PATRIOT Act, the FBI can send to the banking regulatory agencies lists of the names of persons suspected of involvement in terrorist activities.  The bank can be requested, to search its records for any relationships or transactions with persons on those lists.  If the bank finds any relationships or transactions, it must file a suspicious activity report and contact the FBI.

The Office of Foreign Assets Control (“OFAC”), which is a division of the U.S. Department of the Treasury, is responsible for helping to insure that United States entities do not engage in transactions with “enemies” of the United States, as defined by various Executive Orders and Acts of Congress.  OFAC has sent, and will send, our banking regulatory agencies lists of names of persons and organizations suspected of aiding, harboring or engaging in terrorist acts.  If the bank finds a name on any transaction, account or wire transfer that is on an OFAC list, it must freeze such account, file a suspicious activity report and notify the FBI.  The bank has appointed an OFAC compliance officer to oversee the inspection of its accounts and the filing of any notifications.  The bank actively checks high-risk OFAC areas such as new accounts, wire transfers and customer files.  The bank performs these checks utilizing software, which is updated each time a modification is made to the lists provided by OFAC and other agencies of Specially Designated Nationals and Blocked Persons.
 
 
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Privacy and Credit Reporting.  Financial institutions are required to disclose their policies for collecting and protecting confidential information.  Customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under narrow circumstances, such as the processing of transactions requested by the consumer.  Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers.  It is our policy not to disclose any personal information unless required by law.  The OCC and the federal banking agencies have prescribed standards for maintaining the security and confidentiality of consumer information. We are subject to these standards, as well as standards for notifying consumers in the event of a security breach.

Like other lending institutions, our bank utilizes credit bureau data in its underwriting activities.  Use of such data is regulated under the Federal Credit Reporting Act on a uniform, nationwide basis, including credit reporting, prescreening, sharing of information between affiliates, and the use of credit data.  The Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”) permits states to enact identity theft laws that are not inconsistent with the conduct required by the provisions of the FACT Act.

Check 21. The Check Clearing for the 21st Century Act gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check.  Some of the major provisions include:

 
allowing check truncation without making it mandatory;

 
demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

 
legalizing substitutions for and replacements of paper checks without agreement from consumers;

 
retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

 
requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

 
requiring the re-crediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.

Effect of Governmental Monetary Policies.  Our earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies.  The Federal Reserve Bank’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession.  The monetary policies of the Federal Reserve Board have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits.  It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.

Proposed Legislation and Regulatory Action.  New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nation’s financial institutions.  We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

Competition

The banking business is highly competitive, and we experience competition in our markets from many other financial institutions.  Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services rendered, the convenience of banking facilities, and, in the case of loans to commercial borrowers, relative lending limits.  We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in the Spartanburg, Charleston, Greenville, Columbia and Rock Hill markets and elsewhere.
 
 
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As of June 30, 2008, there were 17 other financial institutions in Spartanburg County, 24 other financial institutions in Charleston County, 33 other financial institutions in Greenville County, 22 other financial institutions in Richland County, and 14 other financial institutions in York County.  We compete with institutions in these markets both in attracting deposits and in making loans.  In addition, we have to attract our customer base from other existing financial institutions and from new residents.  Many of our competitors are well established, larger financial institutions with substantially greater resources and lending limits, such as BB&T, Bank of America, and Wachovia.  These institutions offer some services, such as extensive and established branch networks, that we do not provide.  Other local or regional financial institutions have considerable business relationships and ties in their respective communities that assist them in competing for attracting customers.

We also compete with credit unions, in particular, in attracting deposits from retail customers.  Additionally, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally-insured banks.

We believe our emphasis on decision-making by our market executives and our management’s and directors’ ties to the communities in which we operate provide us with a competitive advantage.

Employees

As of March 31, 2009, we had 156 employees, of which 17 were part-time.  These employees provide the majority of their services to our bank.

 
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Item 1A.         Risk Factors.

Our business, financial condition, and results of operations could be harmed by any of the following risks, or other risks that have not been identified or which we believe are immaterial or unlikely.  Shareholders should carefully consider the risks described below in conjunction with the other information in this Form 10-K and the information incorporated by reference in this Form 10-K.
 
There is substantial doubt about our ability to continue as a going concern.
 
In its report dated April 29, 2009, our independent registered public accounting firm stated that the uncertainty created by our inability to repay or replace our holding company's line of credit or to obtain a waiver of covenant defaults on that line of credit through December 31, 2009 raises substantial doubt about our ability to continue as a going concern.  The lender has agreed in writing not to pursue the collateral underlying the line of credit through June 30, 2009.  All other terms and conditions of the loan documents will continue to exist and may be exercised at any time.  Our board of directors is actively considering strategic alternatives to secure additional capital for a variety of corporate purposes, including providing the funds needed to repay the outstanding balance on our line of credit in accordance with the terms of the related loan agreement.  We can give no assurance that a capital transaction or other strategic alternative, once identified, evaluated and consummated, will provide greater value to our shareholders than that reflected in the current stock price.  In addition, a transaction, which would likely involve equity financing, would result in substantial dilution to our current shareholders and could adversely affect the price of our common stock.  If we are unable to identify and execute a viable strategic alternative, we may be unable to continue as a going concern. Therefore, there is a risk the lender may declare an event of default under the line of credit, revoke the line of credit and attempt to exercise available remedies under the loan agreement including foreclosing on our bank stock collateral if the current agreement preventing this action until June 30, 2009 is not renewed.
 
We have sustained losses from a decline in credit quality and may see further losses.
 
                   Our ability to generate earnings is significantly affected by our ability to properly originate, underwrite and service loans. We have sustained losses primarily because borrowers, guarantors, or related parties have failed to perform in accordance with the terms of their loans and we failed to detect or respond to deterioration in asset quality in a timely manner. We could sustain additional losses for these reasons. Problems with credit quality or asset quality could cause our interest income and net interest margin to decrease, which could adversely affect our business, financial condition, and results of operations. We have recently identified credit deficiencies with respect to certain loans in our loan portfolio which are primarily related to the downturn in the residential housing industry. The residential housing market has been substantially affected by the current economic environment, increased levels of inventories of unsold homes, and higher foreclosure rates.  As a result, property values for this type of collateral have declined substantially.  In response to this determination, we increased our loan loss reserve during 2008 to $18.0 million to address the risks inherent within our loan portfolio. Recent developments, including further deterioration in the South Carolina real estate market as a whole, may cause management to adjust its opinion of the level of credit quality in our loan portfolio. Such a determination may lead to an additional increase in our provisions for loan losses, which could also adversely affect our business, financial condition, and results of operations.
 
We may have higher loan losses than we have allowed for in our allowance for loan losses.
 
                   Our loan losses could exceed our allowance for loan losses. Our average loan size has increased in recent years over historic levels, and reliance on our historic allowance for loan losses may not be adequate. As of December 31, 2008, we had $114.1 million in loans on our classified list, including loans classified since December 31, 2008. Classified loans are loans graded as substandard, doubtful or loss. Industry experience shows that a portion of loans will become delinquent and a portion of loans will require partial or entire chargeoff. Regardless of the underwriting criteria utilized, losses may be experienced as a result of various factors beyond our control, including:
 
 cost overruns;

declining property values;

 mismanaged construction;

 inferior or improper construction techniques;

 
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 economic changes or downturns during construction;

 rising interest rates that may prevent sale of the property; and

failure to sell completed projects or units in a timely manner.
 
                   The occurrence of any of the preceding risks could result in the deterioration of one or more of these loans which could significantly increase our percentage of nonperforming assets.  An increase in nonperforming loans may result in a loss of earnings from these loans, an increase in the related provision for loan losses and an increase in chargeoffs, all of which could have a material adverse effect on our financial condition and results of operations.
 
As a result of our bank’s recent examination by the OCC, we have become subject to a consent order pursuant to which the OCC will require us to take certain actions.
 
The bank’s primary federal regulator, the OCC, recently completed a safety and soundness examination of the bank, which included a review of our asset quality.  We have received the final report from this examination.  In addition, the bank entered into a consent order with the OCC on April 27, 2009, which contains a requirement that our bank achieve and maintain minimum capital requirements that exceed the minimum regulatory capital ratios for “well-capitalized” banks by August 25, 2009.   As a result of the terms of the executed consent order, the bank is no longer  deemed “well-capitalized,” regardless of its capital levels.  Under this enforcement action, we no longer meet the regulatory requirements to be eligible for expedited processing of branch applications and certain other regulatory approvals, and we are required to obtain OCC or FDIC approval before making certain payments to departing executives and before adding new directors or senior executives. Our regulators have considerable discretion in whether to grant required approvals, and no assurance can be given that such approvals would be forthcoming.  In addition, we will be required to take certain other actions in the areas of capital, liquidity, asset quality and interest rate risk management, as well as to file periodic reports with the OCC regarding our progress in complying with the order. We expect that the matters covered by our commitments, and the requirements of the executed formal enforcement action, are and would be appropriate and prudent responses to the issues facing us.   Any material failure to comply with the terms of the consent offer could result in further enforcement action by the OCC.  While we intend to take such actions as may be necessary to comply with the requirements of the consent order, we may be unable to comply fully with the deadlines or other terms of the consent order.

Our bank may become subject to a federal conservatorship or receivership if it cannot comply with the consent order, or if its condition continues to deteriorate.

As noted above, the executed consent order requires us to create and implement a capital plan, including provisions for contingency funding arrangements.  In addition, the condition of our loan portfolio may continue to deteriorate in the current economic environment and thus continue to deplete our capital and other financial resources.  Should we fail to comply with the capital and liquidity funding requirements in the consent order, or suffer a continued deterioration in our financial condition, we may be subject to being placed into a federal conservatorship or receivership by the OCC, with the FDIC appointed as conservator or receiver.  If these events occur, we probably would suffer a complete loss of the value of our ownership interest in the bank and we subsequently may be exposed to significant claims by the FDIC and the OCC.
 
If we do not perform well, we may be required to increase the valuation allowance against the deferred income tax asset, which could have a material adverse effect on our results of operations and financial condition.
 
Deferred income tax represents the tax effect of the differences between the book and tax basis of assets and liabilities. Deferred tax assets are assessed periodically by management to determine if they are realizable. Factors in management’s determination include the performance of the business including the ability to generate taxable income from a variety of sources and tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, then a valuation allowance against the deferred tax asset must be established with a corresponding charge to net income. Charges to increase the valuation allowance against the deferred tax asset could have a material adverse effect on our results of operations and financial condition.

 
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A significant portion of our loan portfolio is secured by real estate, and the recent weakening of the local real estate market could continue to hurt our business.
 
A significant portion of our loan portfolio is secured by real estate.  As of December 31, 2008, approximately 89.8% of our loans had real estate as the primary component of collateral.  The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended.  As of December 31, 2008, total residential construction and development loans totaled $56.1 million, or 8.1% of the loan portfolio. These loans carry a higher degree of risk than long-term financing of existing real estate since repayment is dependent on the ultimate completion of the project or home and usually on the sale of the property or permanent financing. Slow housing conditions have affected some of these borrowers’ ability to sell the completed projects in a timely manner. Although we believe that the combination of specific reserves in the allowance for loan losses and established impairments of these loans will be adequate to account for the current risk associated with the residential construction loan portfolio as of December 31, 2008, there can be no assurances in this regard. Recently, there has been a weakening of the residential real estate market and property values have been impacted negatively in our primary market areas. This weakened market has resulted and may continue to result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality.  If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.  Acts of nature, including hurricanes, tornados, earthquakes, fires and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.
 
The lack of seasoning of our loan portfolio makes it difficult to assess the adequacy of our loan loss reserves accurately.
 
We attempt to maintain an appropriate allowance for loan losses to provide for losses inherent in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:
 
 an ongoing review of the quality, mix, and size of our overall loan portfolio;

 our historical loan loss experience;

 evaluation of economic conditions;

 regular reviews of loan delinquencies and loan portfolio quality; and

the amount and quality of collateral, including guarantees, securing the loans.
 
However, there is no precise method of estimating credit losses, since any estimate of loan losses is necessarily subjective and the accuracy depends on the outcome of future events. In addition, due to our rapid growth over the past several years and our limited operating history, a large portion of the loans in our loan portfolio were originated in recent years. In general, loans do not begin to show signs of credit deterioration or default until they have been outstanding for some period of time, a process referred to as seasoning. As a result, a portfolio of more mature loans will usually behave more predictably than a newer portfolio. Because our loan portfolio is relatively new, the current level of delinquencies and defaults may not be representative of the level that will prevail when the portfolio becomes more seasoned, which may be higher than current levels. If chargeoffs in future periods increase, we may be required to increase our provision for loan losses, which would decrease our net income and possibly our capital.
 
 Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Consistent with our loan loss reserve methodology, we expect to make additions to our loan loss reserve levels to reflect the changing risk inherent in our portfolio of existing loans and any additions to our loan portfolio,, which may affect our short-term earnings.
 
  Federal regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan chargeoffs, based on judgments different than those of our management. Any increase in the amount of our provision of loans charged off as required by these regulatory agencies could have a negative effect on our operating results.
 
Our decisions regarding credit risk may materially and adversely affect our business.
 
   Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent in lending by adhering to specific underwriting practices, we may incur losses on loans that meet our underwriting criteria, and these losses may exceed our loan loss reserves. The risk of nonpayment is affected by a number of factors, including:

 
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 the duration of the credit;

 credit risks of a particular customer;

 changes in economic and industry conditions; and

in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.
 
                  While we generally underwrite the loans in our portfolio in accordance with our own internal underwriting guidelines and regulatory supervisory limits, in certain circumstances we have made loans that exceed either our internal underwriting guidelines, supervisory limits, or both. Pending final review by CLO and Credit Administration, as of December 31, 2008, approximately $96.6 million, or approximately 13.6% of our loans, net of unearned income, had loan-to-value ratios that exceeded regulatory supervisory limits. We generally consider making such loans only after taking into account the financial strength of the borrower. The number of loans in our portfolio with loan-to-value ratios in excess of supervisory limits, our internal guidelines, or both could increase the risk of delinquencies or defaults in our portfolio. Any such delinquencies or defaults could have an adverse effect on our results of operations and financial condition.
 
Liquidity needs could adversely affect our financial condition and results of operation.
 
        We have historically relied on dividends from our bank as a viable source of funds to service our holding company’s operating expenses, which are typically dividends and interest payments on preferred stock and other borrowings; however, given our bank's recent losses, this source of liquidity is no longer viable.  Therefore, we have a greater dependence on other funding sources to cover these expenses, such as drawing on our holding company’s line of credit with a correspondent bank.  As outlined in the terms of our current waiver, we will not be permitted to make additional draws on our line of credit other than to pay interest on the line of credit while we are not in compliance with all covenants associated with the line of credit.  Due to the increase in our nonperforming assets and the negative impact on our profitability, we are not in compliance with three of these covenants and are operating under a temporary waiver of these covenant defaults that is in effect until the lender completes its quarterly review of our December 31, 2008 financial statements relating to noncompliance with these covenants.    In addition, the lender has agreed to not pursue the collateral underlying the line of credit through June 30, 2009.  All other terms and conditions of the loan documents will continue to exist and may be exercised at any time by the lender.  Future waivers are discretionary and will be granted based on our correspondent bank’s review of our quarterly financial information.  There is no assurance that our lender will grant any future waivers.
 
 Traditionally, the primary sources of funds of our bank subsidiary are customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters and international instability.   Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, regulatory capital requirements, returns available to customers on alternative investments and general economic conditions. Accordingly, we may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include proceeds from FHLB advances, sales of investment securities and loans, and federal funds lines of credit from correspondent banks, as well as out-of-market time deposits.  There can be no assurance these sources will be sufficient to meet our future liquidity demands.  In addition, several of these sources have become restricted as a result of the issuance of our final regulatory examination report and the terms of the executed consent order with the OCC on April 27, 2009.
 
Our decision not to declare a dividend on our noncumulative preferred stock for the first quarter of 2009 and our intention to defer interest on our trust preferred securities will likely restrict our access to the debt capital markets until such time as we are current on our interest payments, which will further limit our sources of liquidity.
 
In light of the current period of volatility in the financial markets and our net loss for 2008, our board of directors did not declare a dividend for the first quarter of 2009 to our preferred shareholders.  The board expects to evaluate the decision to declare future dividends to preferred shareholders on a quarterly basis and may resume payment of these dividends in future quarters.  We also intend to defer future quarterly interest payments on our trust preferred securities as allowed by the terms of the underlying documents for similar reasons.

 
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 Because we have ceased to be deemed "well-capitalized" under applicable regulatory standards, we will no longer be able to accept, renew or roll over  brokered deposits and will be forced to find other sources of liquidity, limit our growth and/or sell assets, which could materially and adversely affect our financial condition and results of operation.
 
The bank’s total risk-based capital ratio, Tier 1 risk-based capital ratio, and leverage capital ratio were 9.75%, 8.48%, and 7.23%, respectively, as of December 31, 2008.  Generally, the regulatory guidelines for these measures for a bank to be considered "well-capitalized" are 10.00%, 6.00%, and 5.00%, respectively. However, the bank entered into a consent order with the OCC on April 27, 2009, which contains a requirement that our bank achieve and maintain minimum capital requirements by August 25, 2009 that exceed the minimum regulatory capital ratios for “well-capitalized” banks.    As a result of the  terms of the executed consent order, the bank is no longer deemed “well-capitalized” regardless of its capital levels.   As a result, we are not able to accept, renew or roll over brokered deposits without a waiver from the FDIC.  Under FDIC regulations, "well-capitalized" insured depository institutions may accept brokered deposits without restriction.   “Adequately capitalized” insured depository institutions may accept, renew, or roll over brokered deposits with a waiver from the FDIC (subject to certain restrictions on payments of interest rates), while “undercapitalized” insured depository institutions may not accept or renew brokered deposits.  There is no assurance that the FDIC will grant us a waiver.
 
As of December 31, 2008, we had brokered deposits of $150.2 million, of which $131.6 million are scheduled to mature prior to December 31, 2009.  Because of the consent order we will seek to find other sources of liquidity to replace these deposits as they mature while we pursue a waiver from the FDIC to regain our ability to accept, renew or roll over brokered deposits, which is not assured.  As a result, we must limit our growth, raise additional capital, and/or sell assets, which could materially and adversely affect our financial condition and results of operations.
 
We may face damage to our reputation and business as a result of negative publicity, including increase in deposit outflows.

Recent negative publicity that has been experienced due to our weak earnings performance, coupled with the substantial drop in our stock price over the last few quarters, has resulted in a minor level of deposit outflows. We believe that approximately 16.7% of our deposits are above FDIC insurance limits, and these deposits are particularly susceptible to withdrawal based on negative publicity about our current financial condition.  In addition, the increase in FDIC insurance limits to $250,000 per depositor from $100,000 per depositor is only in place through December 31, 2009.  We cannot predict whether the limit will be maintained or reduced when it expires. Future negative news, such as information about the OCC consent order executed on April 27, 2009, or a default notice on our line of credit with our correspondent bank, could raise withdrawal levels beyond the capacity of our currently available liquidity, which would result in a takeover of the bank by the FDIC.  Negative public opinion can adversely affect our ability to keep and attract customers and can expose us to litigation.  We cannot guarantee that we will be successful in avoiding damage to our business from a decline in our reputation.

Recent negative developments in the financial services industry and U.S. and global credit markets may adversely impact our operations and results.
 
              Negative developments in the capital markets in the latter half of 2007 and in 2008 and the expectation of the general economic downturn continuing in 2009 have resulted in uncertainty in the financial markets in general. Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. The competition for our deposits has increased significantly due to liquidity concerns at many of these same institutions. Stock prices of bank holding companies, like ours, have been negatively affected by the current condition of the financial markets, as has our ability, if needed, to raise capital or borrow in the debt markets. As a result, there is a potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and financial institution regulatory agencies are expected to be very aggressive in responding to concerns and trends identified in examinations. Negative developments in the financial services industry and the impact of new legislation in response to those developments could adversely impact our operations, including our ability to originate or sell loans, and adversely impact our financial performance.

 
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Continuation of the economic downturn could reduce our customer base, our level of deposits, and demand for financial products such as loans.

Our success significantly depends upon the growth in population, income levels, deposits, and housing starts in our markets.  The current economic downturn has negatively affected the markets in which we operate and, in turn, the quality of our loan portfolio.  If the communities in which we operate do not grow or if prevailing economic conditions locally or nationally remain unfavorable, our business may not succeed.  So far in 2009, there has been a continuation of the economic downturn or prolonged recession, an extension of which would likely result in the continued deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would hurt our business.  Interest received on loans represented approximately 91.7% of our interest income for the year ended December 31, 2008.  If the economic downturn continues or a prolonged economic recession occurs in the economy as a whole, borrowers will be less likely to repay their loans as scheduled.  Moreover, in many cases, the value of real estate or other collateral that secures our loans has been adversely affected by the economic conditions and could continue to be negatively affected.  Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic conditions across a large number of diversified economies.  A continued economic downturn could, therefore, result in losses that materially and adversely affect our business.
 
We face strong competition for customers in our market areas, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract deposits.
 
The banking business is highly competitive and the level of competition facing us may increase further. We experience competition in our markets from commercial banks, savings and loan associations, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national, and international financial institutions that operate offices in our primary market areas and elsewhere. Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us.
 
We compete with these types of institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. Many competitors are well established, larger financial institutions, such as BB&T, Bank of America, and Wachovia with substantially greater access to capital and other resources. These institutions offer larger lending limits and some services, such as extensive and established branch networks, that we do not provide. In new markets, we will also compete against well-established community banks that have developed relationships within the community.
 
Our relatively smaller size can be a competitive disadvantage due to the lack of multi-state geographic diversification and the inability to spread our marketing costs across a broader market. We may not be able to compete successfully with other financial institutions in our markets and may have to pay higher interest rates, as we have done in some marketing promotions in the past to attract deposits, resulting in reduced profitability. In addition to paying higher interest rates to attract deposits, we may need to find alternative funding sources to fund the growth in our loan portfolio. In 2008, deposit growth was not sufficient to fund our loan growth and we have used proceeds from Federal Home Loan Bank advances, out-of-market time deposits and principal and interest payments on available-for-sale securities to make up the difference. However, our borrowing ability is limited and has become more limited since our bank entered into the consent order with the OCC on April 27, 2009.  Thus, we may face contraction in our net interest margin if we must pay higher rates for deposits and borrowings to sustain our liquidity.
 
Changes in interest rates and our ability to successfully manage interest rates may reduce our profitability.
 
Our profitability depends in large part on the net interest income, which is the difference between interest income from interest-earning assets, such as loans and investment securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. We believe that we are liability sensitive over a one-year time frame, which means that our net interest income will generally rise in falling interest rate environments and decline in rising interest rate environments. Our net interest income will be adversely affected if the market interest rate changes such that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. Right now, short-term interest rates are at an all-time low, while time deposit rates remain stubbornly high.  This has severely squeezed our net interest margin.  If this situation persists, it could have a significant adverse affect on our profitability.
 
We need to raise additional capital that may not be available.
 
Regulatory authorities require us to maintain adequate levels of capital to support our operations. As described above, we have an immediate need to increase our capital ratios which requires us to raise additional capital and/or reduce the size of our balance sheet.  In addition, even if we succeed in raising this capital, we may need to raise additional capital in the future to support continued growth. The ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, additional capital may not be raised, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to increase our capital ratios could be materially impaired. In addition, if we issue additional equity capital, our existing shareholders' interest would be diluted.

 
34

 

The FDIC Deposit Insurance assessments that we are required to pay may materially increase in the future, which would have an adverse effect on our earnings and our ability to pay our liabilities as they come due.
 
As an FDIC-insured institution, we are required to pay quarterly deposit insurance premium assessments to the FDIC.  During the year ended December 31, 2008, we paid $529,000 in deposit insurance assessments.  Due to the recent failure of several unaffiliated FDIC-insured depository institutions, and the FDIC’s new liquidity guarantee program, the deposit insurance premium assessments paid by all banks will increase.  In addition to the increases to deposit insurance assessments approved by the FDIC, the bank’s risk category has also changed as a result of the recent regulatory examination which will also increase the bank’s premium assessments in 2009.  The FDIC has also proposed imposing a 20-basis point special emergency assessment payable September 30, 2009, with authorization of the FDIC board to implement an additional 10 basis-point premium in any quarter.  In addition, the FDIC has indicated that it intends to propose changes to the deposit insurance premium assessment system that will shift a greater share of any increase in such assessments onto institutions with higher risk profiles, including banks with heavy reliance on brokered deposits, such as our bank.  As a result, we anticipate our future insurance costs to be substantially higher than in previous periods.
 
We may not be able to reduce the balance on our holding company’s outstanding line of credit with a correspondent bank.
 
We have drawn approximately $9.5 million upon a revolving line of credit with a correspondent bank in the amount of $15 million.  We pledged all of the stock of our bank subsidiary as collateral for the line of credit, which contains various debt covenants.  As of December 31, 2008, we were not in compliance with certain covenants related to net income and asset quality contained in our related loan agreement.   As outlined in the terms of our current waiver, we will not be permitted to make additional draws on our line of credit other than to pay interest on the line of credit while we are not in compliance with the covenants.  We are currently operating under a waiver of covenant defaults as of September 30, 2008 that is in effect until the lender completes its quarterly review of our December 31, 2008 financial statements relating to noncompliance with these covenants.  We believe that the lender will continue to grant us such future waivers quarterly, but we do not have any assurances in this regard.  The lender has agreed not to pursue the collateral underlying the line of credit through June 30, 2009.  All other terms and conditions of the loan documents will continue to exist and may be exercised at any time by the lender.  Therefore, there is a risk that the lender may declare an event of default under the line of credit when our current waiver expires, revoke the line of credit and attempt to foreclose on our bank stock collateral if we are unable to pay off the outstanding balance on the line of credit or obtain future waivers.
 
Our core customer base of small- to medium-sized businesses may have fewer financial resources to weather the recent downturn in the economy.
 
We target the banking and financial services needs of small- and medium-sized businesses.  These businesses generally have fewer financial resources in terms of capital borrowing capacity than larger entities.  If the recent harsh economic conditions continue to negatively impact these businesses in the markets in which we operate, our business, financial condition, and results of operation may be adversely affected.
 
There can be no assurance that recently enacted legislation will help stabilize the U.S. financial system.  

The Emergency Economic Stabilization Act of 2008, or EESA, was signed into law on October 3, 2008 in response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. Pursuant to EESA, the Treasury has the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. The Treasury announced the Capital Purchase Program under EESA pursuant to which it has purchased and may continue to purchase senior preferred stock in participating financial institutions.
 
In addition, the FDIC created the Temporary Liquidity Guarantee Program (“TLGP”) as part of a larger government effort to strengthen confidence and encourage liquidity in the nation’s banking system.  The TLGP has two components. First, the FDIC will provide a complete guarantee of certain unsecured debt of participating organizations issued before June 30, 2009. Second, the FDIC will provide full insurance coverage for noninterest bearing transaction accounts, regardless of dollar amount, until December 31, 2009.  The Company did not opt out of the TLGP so its noninterest-bearing transaction accounts are fully FDIC-insured.

 
35

 
 
There can be no assurance that these government actions will achieve their purpose. The failure of the financial markets to stabilize, or a continuation or worsening of the current financial market conditions, could have a material adverse affect on our business, our financial condition, the financial condition of our customers, our common stock trading price, as well as our ability to access credit.  It could also result in declines in our investment portfolio which could be “other-than-temporary impairments.”
 
We have only recently adopted our new business plan and may not be able to implement it effectively.
 
Our future performance will depend on our ability to implement our new business plan successfully.  This implementation will involve a variety of complex tasks, including reducing our level of NPAs by continuing to aggressively work problem credits, exploring a bulk sale of loans or OREO, and possibly requiring significant write-downs to facilitate disposition.  We will also continue to increase core deposits, reduce dependency on wholesale funding (brokered CD’s and FHLB borrowings) and increase low cost accounts (DDA’s, NOW, etc.).  This should help expand our net interest margin and earnings without requiring additional capital.   Any failure or delay in executing these initiatives, whether due to regulatory delays or for other reasons, which may be beyond our control, is likely to impede, and could ultimately preclude, our successful implementation of our business plan and could materially adversely affect our business, financial condition, and results of operations.
 
Our recent operating results may not be indicative of our future operating results.
 
 We have historically grown at a rapid rate, but in the current economic climate we will likely not be able to grow our business as we have in the past and we may decide to contract our business through the sale of some of our assets.  Consequently, our historical results of operations will not necessarily be indicative of our future operations. Various factors, such as economic conditions, regulatory and legislative considerations, and competition, may also impede our ability to expand our market presence. If we experience a significant decrease in our historical rate of growth, our business, financial condition, and results of operation may be adversely affected because a high percentage of our operating costs are fixed expenses and would not experience a proportionate decrease.
 
Significant risks accompany our recent expansion.
 
We have recently experienced significant growth by opening new branches or loan production offices and through acquisitions. Such expansion could place a strain on our resources, systems, operations, and cash flow. Our ability to manage this expansion will depend on our ability to monitor operations and control costs, maintain effective quality controls, expand our internal management and technical and accounting systems and otherwise successfully integrate new branches and acquired businesses. If we fail to do so, our business, financial condition, and operating results will be negatively impacted. Risks associated with our recent acquisition activity include the following:
 
 inaccuracies in estimates and judgments to evaluate credit, operations, management, and market risks with respect to our recently acquired institution or its assets;

 our lack of experience in markets into which we have entered;

 difficulties and expense in integrating the operations and personnel of the combined businesses;

 loss of key employees and customers as a result of an acquisition that is poorly received;

 the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations; and
 
impairment of total loss of goodwill associated with our acquisition.
 
We may not be able to integrate any banks we have acquired successfully. Our inability to overcome these risks could have a material adverse effect on our ability to achieve our business strategy and on our financial condition and results of operations.

 
36

 
 
We depend on key individuals, and the unexpected loss of one or more of these key individuals could curtail our growth and adversely affect our prospects.
 
 Jerry L. Calvert, our president and chief executive officer, has substantial experience with our operations and has contributed significantly to our growth since our founding. If we lose Mr. Calvert's services, he would be difficult to replace and our business and development could be materially and adversely affected. Our success is dependent on the personal contacts and local experience of Mr. Calvert and other key management personnel in each of our market areas. Our success also depends in part on our continued ability to attract and retain experienced loan originators, as well as our ability to retain current key executive management personnel, including our chief financial officer, Kitty B. Payne, and our chief lending officer, David H. Zabriskie. We have entered into employment agreements with each of these executive officers. The existence of such agreements, however, does not necessarily assure that we will be able to continue to retain their services. The unexpected loss of the services of several of these key personnel could adversely affect our growth strategy and prospects to the extent we are unable to replace such personnel.
 
We are subject to extensive regulation that could limit or restrict our activities.
 
                   We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by the OCC, the FDIC, and the Federal Reserve Board. Compliance with these regulations is costly and restricts certain activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of branches. We must also meet regulatory capital requirements. If we fail to meet these capital and other regulatory requirements, our financial condition, liquidity, and results of operations would be materially and adversely affected. Our failure to remain "well-capitalized" and "well managed" for regulatory purposes could affect customer confidence, our ability to grow, our cost of funds and FDIC insurance, our ability to pay dividends on our capital stock, and our ability to make acquisitions.
 
                   The laws and regulations applicable to the banking industry could change at any time, and the effects of these changes on our business and profitability cannot be predicted. For example, new legislation or regulation could limit the manner in which we may conduct business, including our ability to obtain financing, attract deposits, make loans and expand our business through opening new branch offices. Many of these regulations are intended to protect depositors, the public, and the FDIC, not shareholders. In addition, the burden imposed by these regulations may place us at a competitive disadvantage compared to competitors who are less regulated. The laws, regulations, interpretations, and enforcement policies that apply to us have been subject to significant change in recent years, sometimes retroactively applied, and may change significantly in the future. The cost of compliance with these laws and regulations could adversely affect our ability to operate profitably. Moreover, as a regulated entity, we can be requested by regulators to implement changes to our operations. In the past we have addressed areas of regulatory concern through the adoption of board resolutions and improved policies and procedures.
 
Changes in federal laws could adversely affect our wholesale mortgage division.
 
        Changes in federal laws regarding the oversight of mortgage brokers and lenders could adversely affect our ability to originate, finance, and sell residential mortgage loans. The enactment of federal laws, such as licensing requirements for mortgage brokers, applicable to the types of mortgage loans originated could increase costs of operations and adversely affect origination volume, which would negatively impact our business, financial condition, and results of operations.

Item 1B.
Unresolved Staff Comments.

We have no unresolved staff comments with the SEC regarding our periodic or current reports under the Exchange Act.

Item 2.
Properties.

Properties

The following table provides information about our properties.
 
37

 
Location
 
Owned/Leased
 
Expiration
 
Square Footage and Description
 
Upstate Region
             
               
Corporate Headquarters and Main Office
215 North Pine Street
Spartanburg, South Carolina
 
Leased(1)
 
02/15/2032
 
Approximately 3.0 acre site which includes a 15,000 square foot building with office space and a full-service branch opened in February 2001 as well as an additional 14,500 square feet of finished space housing our operations center completed in April 2007
 
2680 Reidville Road
Spartanburg, South Carolina
 
Owned/Leased(2)
 
05/30/2020
 
3,500 square foot branch office opened in 2000
 
3090 Boiling Springs Road
Boiling Springs, South Carolina
 
Leased(1)
 
02/15/2032
 
3,000 square foot branch office opened in 2002
 
Market Headquarters
3401 Pelham Road
Greenville, South Carolina
 
Leased(3)
 
10/9/2032
 
6,000 square foot full-service branch office and market headquarters opened in June 2007
 
713 Wade Hampton Blvd.
Greer, South Carolina
 
Leased(3)
 
10/9/2032
 
3,000 square foot full-service branch office opened in August 2007
 
 
200 North Main Street
Suite 200
Greenville, South Carolina
 
Leased
 
10/31/2008
 
1,700 square foot office housing our wholesale mortgage division opened in January 2007
 
               
Coastal Region
             
               
Market Headquarters
140 East Bay Street
Charleston, South Carolina
 
Leased
 
08/31/2016
 
5,379 square foot market headquarters and full-service branch office in historic downtown Charleston opened in April 2007
 
651 Johnnie Dodds Blvd.
Mount Pleasant, South Carolina
 
Leased(3)
 
10/09/2032
 
1,700 square foot branch office opened in 2005
 
260 Seven Farms Dr., Suite B
Daniel Island, South Carolina
 
Leased
 
01/31/2009
 
853 square foot loan production office opened in February 2006
 
               
Midlands Region (4)
             
               
Market Headquarters
1350 Main Street
Columbia, South Carolina
 
Leased
 
1/31/2012
 
9,718 square foot full-service branch office acquired in Carolina National acquisition in January 2008
 
4840 Forest Drive
Columbia, South Carolina
 
Leased
 
1/31/2012
 
2,000 square foot full-service branch office acquired in Carolina National acquisition in January 2008
 
5075 Sunset Boulevard
Lexington, South Carolina
 
Owned/Leased(2)
 
1/31/2023
 
Opened in July 2008
3,000 square foot full-service branch
 
Corner of Two Notch Road and Sparkleberry Lane
Columbia, South Carolina
 
Leased
 
8/31/2015
 
2,000 square foot full-service branch office acquired in Carolina National acquisition in January 2008
 
6041 Garner’s Ferry Road
Columbia, South Carolina
 
Leased
 
4/30/2021
 
3,309 square foot full-service branch office acquired in Carolina National acquisition in January 2008
 
               
Northern Region
             
               
724 Arden Way, Suite 230
Rock Hill, South Carolina
 
Leased
 
03/01/2008
 
1,188 square foot loan production office opened in February 2007
 
 
38

 

(1) These properties were part of the sale/leaseback transaction we entered into in February 2007 with First National Holdings, LLC, a limited liability company owned by nine non-management directors. See "First National Relationships and Related Transactions" for a more detailed description of this transaction.

(2) We have a ground lease for the land and own the building and land improvements.

(3) These properties were part of a sale/leaseback transaction we entered into in October 2007 with First National Holdings II, LLC, a limited liability company owned by eight non-management directors. See "First National Relationships and Related Transactions" for a more detailed description of this transaction.

(4)  We also lease a parcel of land one block from the Columbia market headquarters office on which we operate a drive-through facility under a long-term lease.

               We intend to open a full-service branch in York County, South Carolina in 2009 on a parcel of land that we purchased in January of 2008 for approximately $1.4 million.

As part of our strategy to minimize nonearning assets, we may exercise future sale/leaseback transactions for the remaining properties we own. We analyze each transaction to determine whether owning or leasing the real property is the most efficient method of ownership of these properties and may contract to sell and lease back future acquired sites.

Item 3.
Legal Proceedings.

There are no material legal proceedings.

39

 
PART II

Item 5.
Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is listed on The NASDAQ Global Market under the symbol “FNSC.”  As of March 31, 2009, there were 1,135 shareholders of record. On April 16, 2009, we received a letter from NASDAQ indicating that we no longer complied with the continued listing requirements set forth in NASDAQ Listing Rule 5250(c)(1). The letter was issued as a result of our failure to timely file our Annual Report on Form 10-K for the fiscal year ended December 31, 2008, on or before April 15, 2009, the grace period provided for by our Notification of Late Filing on Form 12b-25. With this submission of our Annual Report on Form 10-K, we anticipate that NASDAQ will find us to be in compliance once again.

The following table shows the high and low sales prices published by NASDAQ for each quarter for the three year period ended December 31, 2008.  The prices shown reflect historical activity and have been adjusted for the 3 for 2 stock splits distributed on March 1, 2004 and January 18, 2006, the 6% stock dividend distributed on May 16, 2006, and the 7% stock dividend distributed on March 30, 2007.
 
   
2008
   
2007
   
2006
 
   
High
   
Low
   
High
   
Low
   
High
   
Low
 
First Quarter
  $ 13.15     $ 9.61     $ 19.39     $ 14.87     $ 20.32     $ 15.94  
Second Quarter
    10.45       6.50       18.73       14.40       19.63       14.32  
Third Quarter
    7.15       4.80       15.50       12.95       18.00       14.72  
Fourth Quarter
  $ 5.77     $ 1.44     $ 15.47     $ 11.60     $ 15.61     $ 14.52  
 
Our ability to pay cash dividends is dependent upon receiving cash in the form of dividends from our bank.  However, certain restrictions exist regarding the ability of the bank to transfer funds to the company in the form of cash dividends.  All dividends must be paid out of undivided profits then on hand, after deducting expenses, including reserves for losses and bad debts.  In addition, a national bank is prohibited from declaring a dividend on its shares of common stock until its surplus equals its stated capital, unless there has been transferred to surplus no less than one-tenth of the bank’s net profits of the preceding two consecutive half-year periods (in the case of an annual dividend).  The approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus.  In addition, the terms of the consent order executed by our bank with the OCC on April 27, 2009 places further restrictions on the bank’s ability to pay dividends to the holding company.  Further, we cannot pay cash dividends on our common stock during any calendar quarter unless full dividends on the Series A Preferred Stock for the dividend period ending during the calendar quarter have been declared and we have not failed to pay a dividend in the full amount of the Series A Preferred Stock with respect to the period in which such dividend payment in respect of our common stock would occur.

All of our outstanding shares of common stock are entitled to share equally in dividends from funds legally available therefore, when, as and if declared by the board of directors.  To date, we have not paid cash dividends on our common stock.  We currently intend to retain earnings to support operations and finance expansion and, therefore, we do not anticipate paying cash dividends on our common stock in the foreseeable future.
 
The following table sets forth equity compensation plan information as of December 31, 2008.
 
Equity Compensation Plan Information
 
Plan Category
 
Number of securities to be
issued upon exercise
of outstanding options
warrants and rights
   
Weighted-average
exercise price of
outstanding options,
warrants and rights
   
Number of securities
remaining available for
future issuance under
equity compensation
plans excluding
securities reflected in
column
 
                   
Equity compensation plans approved by security holders(1)
    428,238     $ 6.98       308,207  
Equity compensation plans not approved by security holders (2)
    663,507     $ 3.92       -  
                         
Total
    1,091,745     $ 5.12       308,207  

40

 

(1)
Pursuant to the Merger Agreement approved at special meetings of the First National and Carolina National shareholders held in December of 2007, an additional 141,346 shares of common stock are reserved for issuance upon the exercise of options outstanding as of the effective date of the Merger that were converted into options to purchase shares of First National common stock.

(2)
Each of our organizers received, for no additional consideration, a warrant to purchase two shares of common stock for $3.92 per share (adjusted for 3 for 2 stock splits distributed on and March 1, 2004 January 18, 2006, and 6% stock dividend distributed May 16, 2006 and the 7% stock dividend distributed on March 30, 2007) for every three shares purchased during our initial public offering completed in February 2000.  The warrants are represented by separate warrant agreements.  One-fifth of the warrants vested on each of the first five anniversaries of the completion of the offering and they are exercisable in whole or in part during the ten-year period following that date.  The warrants may not be assigned, transferred, pledged or hypothecated in any way.  The shares issued pursuant to the exercise of such warrants are transferable, subject to compliance with applicable securities laws.  If the OCC or the FDIC issues a capital directive or other order requiring the bank to obtain additional capital, the warrants will be forfeited if not immediately exercised.
 
41

 
Item 6.
Selected Financial Data.
 
Selected Consolidated Financial and Other Information
(dollars in thousands, except per share data)
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
Summary of Operations
                             
Net interest income
  $ 20,008     $ 17,503     $ 14,161     $ 9,511     $ 6,512  
Provision for loan losses
    20,460       1,396       1,192       594       679  
Noninterest income
    5,020       4,151       2,079       1,855       1,771  
Noninterest expense
    51,649       14,159       8,901       6,476       4,966  
Income taxes
    (2,234 )     2,039       2,095       1,461       823  
Net income/(loss)
  $ (44,847 )   $ 4,060     $ 4,052     $ 2,835     $ 1,815  
Per common share - basic
  $ (7.56 )   $ 0.93     $ 1.12     $ 0.90     $ 0.59  
Per common share - diluted
  $ (7.56 )   $ 0.84     $ 0.94     $ 0.73     $ 0.49  
                                         
Year End Balance Sheets
                                       
Investment securities
  $ 81,662     $ 70,530     $ 63,374     $ 45,151     $ 36,165  
Loans, net of unearned income
    692,876       474,685       379,490       251,405       188,508  
Allowance for loan losses
    23,033       4,951       3,795       2,719       2,259  
Mortgage loans held for sale
    16,411       19,408       -       -       -  
Total assets
    812,742       586,513       465,382       328,769       236,344  
Noninterest-bearing deposits
    39,088       44,466       31,321       18,379       15,695  
Interest-bearing deposits
    607,761       427,362       345,380       253,316       176,116  
FHLB advances and other borrowed funds
    107,736       51,051       45,446       26,612       23,079  
Junior subordinated debentures
    13,403       13,403       13,403       6,186       6,186  
Shareholders' equity
    40,624       47,556       26,990       22,029       13,911  
Tangible book value per share
    3.78       8.02       7.38       7.13       5.22  
Tangible book value per share (diluted)
    5.36       8.49       7.29       6.21       6.21  
Book value per share (diluted)
  $ 5.49     $ 8.49     $ 7.29     $ 6.21     $ 6.21  
                                         
Average Balance Sheets
                                       
Investment securities
  $ 73,371       69,785       52,423       39,683     $ 35,352  
Loans, net of unearned income
    682,437       430,683       314,610       222,026       160,914  
Total interest-earning assets
    779,940       516,757       373,253       269,745       199,653  
Noninterest-bearing demand deposits
    41,920       32,588       23,056       18,009       15,641  
Interest-bearing deposits
    600,870       394,223       285,522       208,854       159,386  
FHLB advances
  $ 60,538       41,014       33,421       27,966     $ 13,657  
                                         
Ratios and Other Data
                                       
Return on average assets
    (5.43 )%     0.76 %     1.05 %     1.01 %     0.87 %
Return on average equity
    (54.01 )%     10.89 %     16.82 %     17.72 %     13.87 %
Net interest margin
    2.57 %     3.39 %     3.79 %     3.53 %     3.26 %
Efficiency ratio
    206.37 %     65.39 %     54.81 %     56.98 %     59.94 %
Total risk-based capital ratio (holding company)
    8.33 %     13.48 %     11.13 %     13.16 %     12.21 %
Total risk-based capital ratio (bank)
    9.75 %     10.72 %     10.01 %     11.35 %     11.83 %
Net chargeoffs to average loans
    0.78 %     0.06 %     0.04 %     0.06 %     0.03 %
Nonperforming assets to loans and OREO, year end
    10.89 %     3.02 %     0.15 %     0.16 %     0.03 %
Allowance for loan losses to loans, year end
    3.32 %     1.04 %     1.00 %     1.08 %     1.20 %
Closing market price per share
  $ 2.06     $ 13.14     $ 14.95     $ 17.60     $ 15.58  
Price to earnings, year end
    (1.26 )     15.64       15.90       24.11       31.80  
 
All share and per share data reflects the 3 for 2 stock splits distributed on March 1, 2004, and January 18, 2006, the 6% stock dividend distributed on May 16, 2006, and the 7% stock dividend distributed on March 30, 2007.
 
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Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation.

FIRST NATIONAL BANCSHARES, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with the financial statements and the related notes and the other statistical information also included in this report.

Overview

The impact of the current economic challenges facing the banking industry negatively impacted our results of operations during 2008 which included our first net loss for a reporting period since we recorded our first quarterly profit in the fourth quarter of 2001.  We reported the following results of operations for the year ended December 31, 2008:

Provisions for loan losses increased as a result of the increase in our nonperforming assets.

Our nonperforming assets increased dramatically during 2008 due to the severe housing downturn and real estate market deterioration in each of our market areas.  As a result, we recorded a provision for loan losses during 2008 of $20.5 million, as compared to $1.4 million during 2007.  Included in the provision for loan losses of $20.5 million recorded during 2008 is $19.0 million which was recorded to reflect specific impairment charges related to the increase in our nonperforming assets during the year, in excess of the general provision for the loan losses recorded for 2008 of $1.5 million.  The Coastal Region of our franchise, primarily in and around Charleston, South Carolina, has been particularly affected by the volatility and weakness in the residential housing market.  These conditions have negatively affected the economy in this region of our state, making it especially difficult for a higher percentage of borrowers in this region to repay their loans to us than in other regions.   As of December 31, 2008, our nonperforming assets were $75.5 million, as compared to $38.0 million as of September 30, 2008.   As of December 31, 2007, our nonperforming assets were $14.3 million.

The net interest margin declined from 2007 to 2008 as a result of the rapidly declining interest rate environment and continued liquidity pressure.

During 2008, in an effort to alleviate liquidity, capital and other balance sheet pressures on financial institutions, the Federal Reserve lowered the federal funds rate from 4.25% in January of 2008 to near zero percent by the end of 2008.  The benchmark two-year Treasury yield began 2008 at a high of 3.05% but had decreased to 0.77% as of December 31, 2008 and the ten-year Treasury yield, which began 2008 at 4.03%, closed 2008 at 2.21%.   These dramatic changes in market interest rates have resulted in a lower net interest margin for us in 2008 as compared to previous years, which also caused our 2008 earnings to suffer.  The unprecedented interest rate reductions by the Federal Reserve described above had a negative impact on our net interest margin since interest rate cuts reduced the yield on our adjustable rate loans immediately, but our deposit costs did not fall as quickly or as far in response to these interest rate reductions since liquidity pressure in the retail deposit markets has kept these costs high.

Although the net interest margin fell by 82 basis points from 3.39% in 2007 to 2.57% in 2008, the increase in earning assets resulted in an increase of 14.3% in net interest income, which was relatively lower than the 62% increase in noninterest expense from 2007 to 2008.  The net interest income in 2008 increased to $20.0 million from $17.5 million in 2007, while noninterest expenses were $51.6 million for 2008, as compared to $14.2 million in 2007.  The relatively higher increase in noninterest expenses occurred primarily as a result of added operating costs related to the $220.9 million in assets added from the acquisition of Carolina National Corporation (Nasdaq:  CNCP) that closed on January 31, 2008.  In addition, higher noninterest expenses were incurred in 2008 to reflect the costs associated with the higher level of nonperforming assets from 2007 to 2008.  These expenses include impairment charges on the value of other real estate owned, salaries of personnel performing the duties of managing nonperforming assets and various carrying costs related to the foreclosed properties owned by our bank.
 
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A noncash accounting charge was recorded in 2008 to reflect the impairment of goodwill required to be evaluated as a result of declining stock prices for financial institutions.

We recorded an after-tax noncash accounting charge of $28.7 million during the fourth quarter of 2008 as a result of our annual testing of goodwill for impairment as required by accounting standards.  The impairment analysis was negatively impacted by the unprecedented weakness in the financial markets. The first step of the goodwill impairment analysis involves estimating a hypothetical fair value and comparing that with the carrying amount or book value of the entity; our initial comparison suggested that the carrying amount of goodwill exceeded its implied fair value due to our low stock price, consistent with that of most publicly-traded financial institutions.  Therefore, we were required to perform the second step of the analysis to determine the amount of the impairment.  We prepared a discounted cash flow analysis which established the estimated fair value of the entity and conducted a full valuation of the net assets of the entity.  Following these procedures, we determined that no amount of the net asset value could be allocated to goodwill and we recorded the impairment to the goodwill balance as a noncash accounting charge to our earnings in 2008. Our regulatory capital ratios are not affected by this noncash impairment charge.

Highlights of Results of Operations

The following table sets forth selected measures of our financial performance for the periods indicated (dollars in thousands).
 
As of or for the Years Ended December 31,
 
   
2008
   
2007
   
2006
 
Total revenue(1)
  $ 25,028     $ 21,654     $ 16,240  
Net income/(loss)
    (44,847 )     4,060       4,052  
Total assets
    812,742       586,513       465,382  
Total loans(2)
    692,876       474,685       379,490  
Total deposits
    646,849       471,828       376,701  


(1)
Total revenue equals net interest income plus total noninterest income.
(2)
Includes nonperforming loans, net of unearned income; does not include mortgage loans held for sale.
 
Like most financial institutions, we derive the majority of our income from interest we receive on our interest-earning assets, such as loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread.

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We maintain this allowance by charging a provision for loan losses against our operating earnings.  We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through other sources, such as fees and surcharges to our customers and income from the sale and/or servicing of financial assets such as loans and investments. We describe the various components of this noninterest income, as well as our noninterest expense, in the following discussion.

In reponse to financial conditions affecting the banking system and financial markets and the potential threats to the solvency of investment banks and other financial institutions, the United States government has taken unprecedented actions.  On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”).  Pursuant to the EESA, the  U.S. Department of Treasury will have the authority to, among other things, purchase mortgages, mortgage-backed securities, and other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.  On October 14, 2008, the U.S. Department of Treasury announced the Capital Purchase Program under the EESA.  Regardless of our participation, governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America and that are consistent with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in footnote 1 to our audited consolidated financial statements as of December 31, 2008.
 
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Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these policies to be critical accounting policies.  The judgments and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.  Management relies heavily on the use of judgments, assumptions and estimates to make a number of core decisions, including accounting for the allowance for loan losses, income taxes and intangible assets.  A brief discussion of each of these areas follows:

Allowance for Loan Losses

Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the creditworthiness of borrowers, the estimated value of the underlying collateral, cash flow assumptions, the determination of loss factors for estimating credit losses, the impact of current events, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Please see "Allowance for Loan Losses" for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Income Taxes

Deferred income tax assets are recorded to reflect the tax effect of the difference between the book and tax basis of assets and liabilities.  These differences result in future deductible amounts that are dependent on the generation of future taxable income through operations or the execution of tax planning strategies.   Due to the doubt of the ability of the company to continue as a going concern, management has established a valuation allowance for the deferred tax asset.  Based on the assumptions used by management regarding the ability of the bank to generate future earnings and the execution of tax planning strategies to generate income, the actual amount of the future tax benefit received may be different than the amount of the deferred tax asset net of the associated valuation allowance.

Intangible Assets

We recorded intangible assets in connection with the Merger, including goodwill, core deposit intangible, and purchase accounting adjustments to loans, deposits and leases to reflect the difference between the fair value and the book value of these assets and liabilities.  The methodology used to arrive at these fair values involves a significant degree of judgment.  To determine the value of assets and liabilities, as well as the extent to which related assets may be impaired, management makes assumptions and estimates related to discount rates, asset returns, prepayment rates and other factors.  The use of different discount rates or other valuation assumptions could produce significantly different results.  The outcome of valuations performed by management have a direct  bearing on the carrying amounts of assets and liabilities, including goodwill and the assets and liabilities acquired in the Merger.  The valuation and testing methodology used in our analysis of goodwill impairment are summarized in Note 1 – Summary of Significant Accounting Policies and Activities to the consolidated financial statements.

Results of Operations

Income Statement Review

Summary

Our net loss was $44.8 million, or $7.56 per diluted share, for the year ended December 31, 2008, as compared with net income of $4.1 million, or $0.84 per diluted share, for the year ended December 31, 2007.  Our net loss for the year ended December 31, 2008 included an impairment provision for goodwill of $28.7 million and an increase in provision for loan losses due to the severe housing downturn and real estate market deterioration in each of our market areas as well as a valuation allowance on our deferred tax asset. Diluted common shares outstanding for the year ended December 31, 2008, increased by 25.9% over the same period in 2007, due to the effect of a prorated amount to reflect the 2.7 million common shares issued to the former Carolina National shareholders as of the merger date of January 31, 2008.  The dilutive effects of the $18 million in noncumulative convertible perpetual preferred stock issued in July 2007 are not included in diluted weighted average shares outstanding for the year ended December 31, 2008 because we recognized a net loss for the year ended December 31, 2008.  Net interest income for the year ended December 31, 2008, increased by 14.3% or $2.5 million to $20.0 million, as compared to $17.5 million recorded during the same period in 2007, primarily due to the growth in average earning assets since December 31, 2007, of $263.2 million, or 50.9%. The increase in average earning assets during this period includes $191.3 million from the Carolina National acquisition.
 
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Our net income was $4.1 million, or $0.84 per diluted share, for the year ended December 31, 2007, as compared with $4.0 million, or $0.94 per diluted share, for the year ended December 31, 2006.  The relatively flat net income included a $3.3 million, or 23.6%, increase in net interest income.  The increase in net interest income was due primarily to the growth of our loan portfolio, which is largely made up of variable-rate loans.  The favorable blend of variable-rate to fixed-rate loans more than offset the increase in deposits.  In our deposit portfolio, the cost of funds was driven by increased rates, which outweighed the increase in volume for 2007.

Our return on average assets decreased from 0.76% for the year ended December 31, 2007, to (5.43%) in 2008.  This decreased return is due to the current year’s net loss, compared to prior year’s net income, despite an increased average asset base.  The diminished return on assets reflects the impact of the decreased net interest margin and an increased provision for loan losses.  Loans continued to contribute to net interest income as our most lucrative earning asset, but their positive contribution was proportionally matched by the growth in deposits, whose volume contributed approximately $11.8 million in costs, while loan growth generated almost double that expense at $21.5 million in income.  In contrast, lower loan rates reduced the positive contribution from loan volume by $16.2 million, or approximately threefourths of the positive contribution from greater loan volume. This ratio was matched on the deposit side, for which lower rates reduced those costs by approximately $8.9 million.

Our return on average assets decreased from 1.05% in 2006 to 0.76% in 2007 due to the flat net income compared to an increased average asset base.  The diminished return on assets reflects the impact of the decreased net interest margin.  Loans continued to grow consistently and to contribute to net interest income as our most lucrative earning asset, but their positive contribution was outweighed by the increased cost of funds, whereas deposit rates contributed approximately $7.0 million in costs, while deposit growth generated substantially less expense at $3.5 million.  In contrast, loan growth, at $8.1 million, contributed almost the same level of expense as loan rates, at $9.2 million.

Our return on average equity decreased from 10.89% for the year ended December 31, 2007 to (54.01%) for the year ended December 31, 2008.  This decrease was driven by our net loss recognized in 2008 versus net income for 2007 and the large increase in our average equity due to the acquisition of Carolina National during the first quarter of 2008.  Average equity had increased in 2007 due to $16.5 million in net proceeds received from the completion of the preferred stock offering in July 2007.

Our return on average equity decreased 16.82% in 2006 to 10.89% in 2007.  This decrease was driven by the large increase in our average equity due to the $16.5 million in net proceeds received from the completion of the preferred stock offering in July 2007, while our net income remained about the same from 2006 to 2007.  In addition, noninterest expense increased during 2007 due to the expansion of our branch network and the continued development of our infrastructure.

Net Interest Income

Our primary source of revenue is net interest income.  The level of net interest income is determined by the balances of interest-earning assets and interest-bearing liabilities and successful management of the net interest margin.  In addition to the growth in both interest-earning assets and interest-bearing liabilities, and the timing of repricing of these assets and liabilities, net interest income is also affected by the ratio of interest-earning assets to interest-bearing liabilities and the changes in interest rates earned on our assets and interest rates paid on our liabilities.

Our net interest income increased $2.5 million, or 14.3%, to $20.0 million in 2008, from $17.5 million in 2007.  Our net interest income increased $3.3 million, or 23.6%, to $17.5 million in 2007, from $14.2 million in 2006.  The increase in net interest income from 2007 to 2008 was due primarily to the growth in our average earning assets of $263.2 million, or 50.9%, which was partially offset by a decrease in our net interest margin for the years ended December 31, 2007 and 2008.  The increase in average earning assets during this period includes $215.4 million from the Carolina National acquisition.  The increase in net interest income from 2006 to 2007 was due primarily to the growth of our loan portfolio, as reflected in an increase in our average earning assets of 38.4% in 2007, which was partially offset by a decrease in our net interest margin of 40 basis points from 3.79% to 3.39% for the years ended December 31, 2006 and 2007, respectively.  The decrease in the net interest margin was primarily attributable to the high cost of deposits due to the increases in the prime rate that occurred throughout 2006.
 
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The following table sets forth, for the years ended December 31, 2008, 2007 and 2006, information related to our average balances, yields on average assets, and costs of average liabilities.  We derived average balances from the daily balances throughout the periods indicated.  We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. Average loans are stated net of unearned income and include nonaccrual loans. Interest income recognized on nonaccrual loans has been included in interest income (dollars in thousands).
 
                                                                  Average Balances, Income and Expenses, and Rates
                                                              For the Years Ended December 31,
 
   
2008
   
2007
   
2006
 
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
   
Average
   
Income/
   
Yield/
 
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
   
Balance
   
Expense
   
Rate
 
Loans, excluding held for sale
  $ 682,438     $ 40,901       5.98 %   $ 430,683     $ 35,661       8.28 %   $ 314,610     $ 26,237       8.34 %
Mortgage loans held for sale
    11,834       703       5.92 %     10,384       668       6.43 %     -       -       -  
Investment securities
    73,371       3,477       4.73 %     69,785       3,293       4.72 %     52,423       2,329       4.44 %
Federal funds sold and other
    12,297       306       2.48 %     5,905       346       5.86 %     6,220       320       5.14 %
Total interest-earning assets
  $ 779,940     $ 45,387       5.80 %   $ 516,757     $ 39,968       7.73 %   $ 373,253     $ 28,886       7.74 %
                                                                         
Time deposits
  $ 435,285     $ 18,038       4.13 %   $ 272,730     $ 13,940       5.11 %   $ 201,957     $ 9,129       4.52 %
Savings & money market
    121,919       3,199       2.62 %     76,184       3,445       4.52 %     57,962       2,331       4.02 %
NOW accounts
    43,666       802       1.83 %     45,285       1,487       3.28 %     25,603       674       2.63 %
FHLB advances
    60,538       2,060       3.39 %     41,014       1,957       4.77 %     33,421       1,570       4.70 %
Junior subordinated debentures
    13,403       740       5.51 %     13,403       1,025       7.65 %     11,663       877       7.52 %
Federal funds purchased and