- Amended Quarterly Report (10-Q/A)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2009

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from ___________ to __________

Commission file number 000-30523

First National Bancshares, Inc.

(Exact name of registrant as specified in its charter)

South Carolina		58-2466370
(State of Incorporation)		(I.R.S. Employer Identification No.)

215 N. Pine St.
Spartanburg, South Carolina		29302
(Address of principal executive offices)		(Zip Code)

864-948-9001

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address

and former fiscal year,

if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the 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 o

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

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

Large accelerated filer o Accelerated filer o Non-accelerated filer o 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 o No x

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: On August 11, 2009, 6,305,840 shares of the issuer’s common stock, par value $0.01 per share, were issued and outstanding.

Index

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

Consolidated Balance Sheets – June 30, 2009, and December 31, 2008			4

Consolidated Statements of Operations – For the three months and six months ended June 30, 2009 and 2008			5

Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income/(Loss) For the six months ended June 30, 2009 and 2008			6

Consolidated Statements of Cash Flows – For the six months ended June 30, 2009 and 2008			7

Notes to Unaudited Consolidated Financial Statements			8-16

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16-37

Item 3. Quantitative and Qualitative Disclosures About Market Risk			55

Item 4. Controls and Procedures			55

PART II. OTHER INFORMATION

Item 1. Legal Proceedings			56

Item 1A. Risk Factors			56

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			56

Item 3. Defaults Upon Senior Securities			56

Item 4. Submission of Matters to a Vote of Security Holders			56

Item 5. Other Information			56

Item 6. Exhibits			57

FIRST NATIONAL BANCSHARES, INC. AND SUBSIDIARY

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

Consolidated Balance Sheets

(dollars in thousands)

	June 30, 2009				December 31, 2008
Assets		(Unaudited)
Cash and cash equivalents		$	88,562		$	7,700
Securities available for sale			103,376			81,662
Loans, net of allowance for loan losses of $23,534 and $23,033, respectively			595,875			669,843
Mortgage loans held for sale			6,714			16,411
Premises and equipment, net			8,477			7,620
Other real estate			9,666			6,510
Other			22,026			22,996
Total assets		$	834,696		$	812,742
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing		$	39,210		$	39,088
Interest-bearing			682,376			607,761
Total deposits			721,586			646,849
FHLB advances			67,064			86,363
Federal funds purchased and other short-term borrowings			-			11,873
Junior subordinated debentures			13,403			13,403
Long-term debt			9,641			9,500
Accrued expenses and other liabilities			4,136			4,130
Total liabilities		$	815,830		$	772,118
Commitments and contingencies
Shareholders' equity:
Preferred stock, par value $0.01 per share, 10,000,000 shares authorized; 717,500 and 720,000 shares issued and outstanding, respectively			7			7
Common stock, par value $0.01 per share, 100,000,000 shares authorized; 6,300,270 and 6,296,698 shares issued and outstanding for each period, respectively, net of treasury shares outstanding			64			64
Treasury stock, 106,981 shares for each period, at cost			(1,131	)		(1,131	)
Unearned ESOP shares			(478	)		(478	)
Additional paid-in capital			83,438			83,401
Retained deficit			(63,198	)		(41,807	)
Accumulated other comprehensive income			164			568
Total shareholders' equity		$	18,866		$	40,624
Total liabilities and shareholders' equity		$	834,696		$	812,742

See accompanying notes to unaudited consolidated financial statements.

FIRST NATIONAL BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Operations

(dollars in thousands, except share data) (unaudited)

	For the three months							For the six months
	ended June 30,							ended June 30,
		2009			2008			2009			2008
Interest income:
Loans		$	7,729		$	10,732		$	16,142		$	21,528
Taxable securities			588			652			1,385			1,275
Nontaxable securities			158			188			359			358
Federal funds sold and other			59			90			102			181
Total interest income			8,534			11,662			17,988			23,342
Interest expense:
Deposits			4,604			5,518			9,103			11,277
FHLB advances			524			465			1,040			903
Long-term debt			161			57			326			59
Junior subordinated debentures			114			167			245			396
Federal funds purchased and other short-term borrowings			-			95			1			189
Total interest expense			5,403			6,302			10,715			12,824
Net interest income			3,131			5,360			7,273			10,518
Provision for loan losses			18,045			943			20,197			1,409
Net interest income/(expense) after provision for loan losses			(14,914	)		4,417			(12,924	)		9,109
Noninterest income:
Mortgage banking income			497			603			1,208			1,334
Service charges and fees on deposit accounts			425			482			825			862
Gain on sale of securities available for sale			286			-			469			-
Service charges and fees on loans			114			88			265			203
Other			95			60			221			165
Total noninterest income			1,417			1,233			2,988			2,564
Noninterest expense:
Salaries and employee benefits			2,594			2,796			5,138			5,611
Occupancy and equipment expense			800			808			1,594			1,579
FDIC insurance			1,281			149			1,411			267
Professional fees			535			211			735			423
Data processing and ATM expense			296			392			594			650
Telephone and supplies			169			178			330			316
Other real estate owned expense			261			29			312			64
Public relations			129			175			249			246
Loan related expenses			108			166			239			300
Other			359			462			853			827
Total noninterest expense			6,532			5,366			11,455			10,283
Net income/(loss) before income taxes			(20,029	)		284			(21,391	)		1,390
Income tax expense			-			95			-			466
Net income/(loss)			(20,029	)		189			(21,391	)		924
Cash dividends declared on preferred stock			-			326			-			652
Net income/(loss) available to common shareholders		$	(20,029	)	$	(137	)	$	(21,391	)	$	272
Net income/(loss) per common share
Basic		$	(3.18	)	$	(0.02	)	$	(3.40	)	$	0.05
Diluted		$	(3.18	)	$	(0.02	)	$	(3.40	)	$	0.04
Weighted average common shares outstanding
Basic			6,299,681			6,333,833			6,298,197			5,901,557
Diluted			6,299,681			6,333,833			6,298,197			6,439,929

See accompanying notes to unaudited consolidated financial statements.

FIRST NATIONAL BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income/(Loss)

For the six months ended June 30, 2009 and 2008

(dollars in thousands except share amounts, unaudited)

See accompanying notes to unaudited consolidated financial statements.

	Preferred Stock					Common Stock				Treasury Stock
	Shares			Amount		Shares		Amount		Shares			Amount			Unearned ESOP Shares			Additional Paid-In Capital		Retained Earnings/ (Deficit)			Accumulated Other Comprehensive Income/(Loss)			Total Shareholders’ Equity
Balance, December 31, 2007		720,000		$	7		3,738,729	$	37		(13,781	)	$	(224	)	$	(518	)	$	43,809	$	4,408		$	37		$	47,556
Shares issued pursuant to acquisition		-			-		2,663,674		27		-			-			-			39,512		-			-			39,539
Grant of employee stock options		-			-		-		-		-			-			-			55		-			-			55
Cumulative adjustment for change in accounting for post retirement benefit obligation		-			-		-		-		-			-			-			-		(63	)		-			(63	)
Shares repurchased pursuant to share repurchase program		-			-		-		-		(79,200	)		(816	)		-			-		-			-			(816	)
Cash dividends declared on preferred stock		-			-		-		-		-			-			-			-		(653	)		-			(653	)
Comprehensive income:
Net income		-			-		-		-		-			-			-			-		924			-			924
Change in net unrealized gain/(loss) on securities available for sale, net of income tax of $431		-			-		-		-		-			-			-			-		-			(836	)		(836	)
Total comprehensive income		-			-		-		-		-			-			-			-		-			-			88
Balance, June 30, 2008		720,000		$	7		6,402,403	$	64		(92,981	)	$	(1,040	)	$	(518	)	$	83,376	$	4,616		$	(799	)	$	85,706

Balance, December 31, 2008		720,000		$	7		6,403,679	$	64		(106,981	)	$	(1,131	)	$	(478	)	$	83,401	$	(41,807	)	$	568		$	40,624
Conversion of preferred shares into common shares		(2,500	)				3,572
Grant of employee stock options		-			-		-		-		-			-			-			37		-			-			37
Comprehensive income/(loss):
Net loss		-			-		-		-		-			-			-			-		(21,391	)		-			(21,391	)
Change in net unrealized gain on securities available for sale, net of income tax of $49		-			-		-		-		-			-			-			-		-			(95	)		(95	)
Reclassification adjustment for gains included in net income, net of income tax of $159		-			-		-		-		-			-			-			-		-			(309	)		(309	)
Total comprehensive income/(loss)		-			-		-		-		-			-			-			-		-			-			(21,795	)
Balance, June 30, 2009		717,500		$	7		6,407,251	$	64		(106,981	)	$	(1,131	)	$	(478	)	$	83,438	$	(63,198	)	$	164		$	18,866

FIRST NATIONAL BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

(dollars in thousands, unaudited)

	For the six months
	ended June 30,
	2009			2008
Cash flows from operating activities:
Net income/(loss)	$	(21,391	)	$	924
Adjustments to reconcile net income/(loss) to net cash provided by operating activities:
Provision for loan losses		20,197			1,409
Provision for deferred income tax benefit		-			-
Depreciation		383			354
(Accretion) / amortization of purchase accounting adjustments, net		100			(590	)
Accretion of securities discounts and premiums, net		(79	)		(32	)
Gain on sale of securities available for sale		(469	)		-
Gain on sale of guaranteed portion of SBA loans		-			(28	)
Gain on sale of other real estate owned		(46	)		-
Loss on impairment of investment in equity securities		117			-
Origination of residential mortgage loans held for sale		(141,714	)		(190,926	)
Proceeds from sale of residential mortgage loans held for sale		151,412			195,028
Compensation expense for employee stock options granted		37			55
Changes in deferred and accrued amounts:
Prepaid expenses and other assets		(2,899	)		(4,070	)
Accrued expenses and other liabilities		5			(485	)
Net cash provided by/(used in) operating activities		5,653			1,639
Cash flows from investing activities:
Proceeds from maturities/prepayment of securities available for sale		576,839			14,880
Proceeds from sale of securities available for sale		25,461			-
Purchases of securities available for sale		(624,078	)		(20,501	)
Proceeds from sale of guaranteed portion of SBA loans		-			695
Loan repayments/(originations), net of disbursements/principal collections		53,771			(23,043	)
Net purchases of premises and equipment		(1,240	)		(2,965	)
Redemption/(purchase) of FHLB and other stock		750			(3,146	)
Acquisition, net of funds received		-			(6,733	)
Net cash provided by/(used in) investing activities		31,503			(40,813	)
Cash flows from financing activities:
Dividends paid on preferred stock		-			(653	)
Increase in FHLB advances		23,725			54,306
Repayment of FHLB advances		(43,024	)		(17,037	)
Net increase/(decrease) in federal funds purchased and other short-term borrowings		(11,873	)		(9,914	)
Proceeds from the issuance of long-term debt		141			6,500
Shares repurchased pursuant to share repurchase program		-			(816	)
Net increase in deposits		74,737			2,659
Net cash provided by financing activities		43,706			35,045
Net increase/(decrease) in cash and cash equivalents		80,862			(4,129	)
Cash and cash equivalents, beginning of year		7,700			8,426
Cash and cash equivalents, end of period	$	88,562		$	4,297

See accompanying notes to unaudited consolidated financial statements.

FIRST NATIONAL BANCSHARES, INC. AND SUBSIDIARY

Notes to Unaudited Consolidated Financial Statements

Note 1 – Nature of Business and Basis of Presentation

Business Activity

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 ten 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 June 30, 2009, our consolidated total assets were $834.7 million, our consolidated total loans were $626.1 million (including mortgage loans held for sale), our consolidated total deposits were $721.6 million, and our total shareholders’ equity was approximately $18.9 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 is also 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. In addition, we record a provision for loan losses to maintain an adequate allowance for loan losses.

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, Carolina National Bank and Trust Company, a national banking association, became a subsidiary of First National Bancshares, Inc. (“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.

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 more recent alliance with WorkLife Financial, we 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. We believe that 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 four additional markets in the Carolinas, with thirteen full-service branches operating under the name First National Bank of the South, including two full-service branches opened in the Greenville Market in the upstate of South Carolina during 2007. 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 18, 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. In May of 2009, we opened our thirteenth full-service branch and market headquarters in the Tega Cay community of Fort Mill, South Carolina.

Basis of Presentation

The accompanying unaudited consolidated financial statements include all of our accounts and the accounts of the bank. All significant inter-company accounts and transactions have been eliminated in consolidation. The accompanying unaudited consolidated financial statements, as of June 30, 2009 and for the three-month and six-month periods ended June 30, 2009 and 2008, are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all information and footnotes required by GAAP for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position as of June 30, 2009, and the results of operations and cash flows for the three-month and six month periods ended June 30, 2009 and 2008, have been included.

As a result of our assessment of our ability to continue as a going concern, we have prepared our consolidated financial statements on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets, and the amounts or classification of liabilities that may result should we be unable to continue as a going concern. Management continues to assess a number of factors including liquidity, capital, and profitability that affect our ability to continue in operation. In addition, the uncertainty surrounding our lender's intention to continue granting quarterly waivers of the covenant defaults on the line of credit through December 31, 2009 is a factor that has cast doubt about our ability to continue in operation. On August 26, 2009, we announced that we had reached an agreement in principle to modify our holding company's loan agreement with our lender. The modifications to the loan agreement would include revisions to the financial covenants which would cure existing covenant violations and eliminate the uncertainty surrounding our lender's intention to continue granting quarterly waivers of the covenant defaults. The terms of this agreement in principle are not binding and are subject to the execution of a definite agreement. Management believes that its current strategy to raise additional capital and dispose of assets to deleverage will allow us to raise our capital ratios to the minimums set forth in the consent order. In addition, management has taken a number of actions to increase its short-term liquidity position to meet our projected liquidity needs during this timeframe. Although management is committed to developing strategies to eliminate the uncertainty surrounding each of these areas, the outcome of these developments cannot be predicted at this time.

We operate in a highly-regulated industry and must plan for the liquidity needs of both our bank and our holding company separately. A variety of sources of liquidity are available to us to meet our short-term and long-term funding needs. Although a number of these sources have been limited following execution of the consent order with the OCC, management has prepared forecasts of these sources of funds and our projected uses of funds during 2009 and believes that the sources available are sufficient to meet our projected liquidity needs for this period. Since December 31, 2008, we have substantially increased our short-term liquidity position.

Operating results for the three-month and six-month periods ended June 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009, or for any other interim period. For further information, refer to the financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008, as filed with the Securities and Exchange Commission on May 1, 2009. The consolidated financial statements and notes thereto are presented in accordance with the instructions for Form 10-K.

The information included in our 2008 Annual Report on Form 10-K should be referred to in connection with these unaudited interim financial statements. We are not an accelerated filer as defined in Rule 12b-2 of the Exchange Act. As a result, we qualify for the extended compliance period with respect to the accountant’s report on management’s assessment of internal control over financial reporting and management’s annual report on internal control over financial reporting required by Public Company Accounting Oversight Board Auditing Standards No. 5. We have evaluated subsequent events through the date that the financial statements were issued, which was August 14, 2009, the date of the First National Bancshares, Inc.’s Quarterly Report on Form 10-Q for the period ended June 30, 2009.

Regulatory Matters

Due to our condition, the OCC has required that our Board of Directors sign a formal enforcement action with the OCC which conveys specific actions needed to address certain findings from the examination and to address our current financial condition. We entered into a consent order with the OCC on April 27, 2009, which contains a list of strict requirements ranging from a capital directive, which requires us to achieve and maintain minimum regulatory capital levels in excess of the statutory minimums to be well-capitalized, to developing a liquidity risk management and contingency funding plan, in connection with which we will be subject to limitations on the maximum interest rates we can pay on deposit accounts. The consent order also contains restrictions on future extensions of credit and requires the development of various programs and procedures to improve our asset quality as well as routine reporting on our progress toward compliance with the consent order to the Board of Directors and the OCC. As a result of the terms of the executed consent order, we are no longer deemed “well-capitalized,” regardless of our capital levels. The Federal Reserve Bank of Richmond (the “FRB”) has also required our bank holding company to enter into a written agreement which contains provisions similar to the articles in the bank’s consent order with the OCC.

The consent order with the OCC requires the establishment of certain plans and programs. We have established a compliance committee to monitor and coordinate compliance with the consent order. The committee consists of five members of our board of directors and meets at least monthly to receive written progress reports from management on the results and status of actions needed to achieve full compliance with each article of the consent order.

In order to comply with the consent order, the bank has:


·		developed by July 26, 2009, a three-year capital plan for the bank, which included, among other things, specific plans for maintaining adequate capital, a discussion of the sources and timing of additional capital, as well as contingency plans for alternative sources of capital;

·		developed, by July 26, 2009, a strategic plan covering at least a three-year period, which, among other things, included a specific description of the strategic goals and objectives to be achieved, the targeted markets, the specific bank personnel who are responsible and accountable for the plan, and a description of systems to monitor the bank’s progress;

·		revised, by June 26, 2009, a liquidity risk management program, which will assess, on an ongoing basis, the bank’s current and projected funding needs, and ensure that sufficient funds exist to meet those needs. The plan included specific plans for how the bank plans to comply with regulatory restrictions which limit the interest rates the bank can offer to depositors;

·		revised, by June 26, 2009, the bank’s loan policy, a commercial real estate concentration management program. The bank also established a new loan review program to ensure the timely and independent identification of problem loans and modify its existing program for the maintenance of an adequate allowance for loan and lease losses;

·		taken immediate and continuing action to protect the bank’s interest in certain assets identified by the OCC or any other bank examiner by developing a criticized assets report covering the entire credit relationship with respect to such assets;

·		developed, by July 26, 2009, an independent appraisal review and analysis process to ensure that appraisals conform to appraisal standards and regulations, and will order, within 30 days following any event that triggers an appraisal analysis, a current independent appraisal or updated appraisal on loans secured by certain properties;

·		developed, by May 27, 2009, a revised OREO program to ensure that the OREO properties are managed in accordance with certain applicable banking regulations; and

·		ensured the bank has competent management in place on a full-time basis to carry out the board’s policies and operate the bank in a safe and sound manner.

In addition, the order requires the bank


·		to achieve and maintain Tier 1 capital at least equal to 11% of risk-weighted assets and at least equal to 9% of adjusted total assets by August 25, 2009;

The bank has submitted all materials requested to the OCC in a timely fashion. On July 24, 2009, our board submitted a written strategic plan and capital plan to the OCC covering the three-year period. Once we receive the OCC’s written determination of no supervisory objection, our Board of Directors will adopt and implement the plans. We are also working on efforts to achieve the capital levels imposed under the consent order, but we do not anticipate achieving these levels by August 25, 2009, the deadline specified in the consent order.

Additionally, on June 15, 2009, our holding company entered into a written agreement with The Federal Reserve Bank of Richmond (the “FRB”), which contains provisions similar to the articles in the bank’s consent order with the OCC and is attached hereto as Exhibit 10.1. The holding company has taken action to comply with each article of the written agreement to date and has submitted all materials requested to the FRB in a timely fashion. On July 30, 2009, under the terms of the written agreement that we entered into with the FRB, we submitted a capital plan to the FRB. We will adopt the written plan within 10 days of its approval by the FRB.

Cash and Cash Equivalents

We consider all highly-liquid investments with a maturity of three months or less to be cash equivalents.

Supplemental Noncash Investing and Financing Data

Cash paid for interest during the six months ended June 30, 2009 and 2008, totaled $5.4 million and $11.3 million, respectively. Cash paid for income taxes during the six months ended June 30, 2008, totaled $530,000. There were no taxes paid during the six months ended June 30, 2009 due to the net operating loss carryforwards from 2008. Please see Note 6 – Income Taxes for further discussion.

Non-cash investing activities for the six months ended June 30, 2009 and 2008, included $95,000 in unrealized gains, net of realized gains of $309,000, and $836,000 of unrealized losses on available for sale securities, net of income tax, respectively. Non-cash investing activities also included loans transferred to other real estate owned during the six months ended June 30, 2008 of $5.0 million charged to our allowance for loan losses, net of write downs of $602,000. For the six months ended June 30, 2009, loans transferred to other real estate owned totaled $8,288,000 net of write downs of $865,000.

Note 2 – Net Income per Common Share

The following is a reconciliation of the numerator and denominator of the basic and diluted per share computations for net income per common share for the three-month periods ended June 30, 2009 and 2008 (dollars in thousands).

	Three Months Ended June 30,
	2009						2008
	BASIC			DILUTED (1),(2),(3)			BASIC			DILUTED (1),(2),(3)
Net income/(loss), as reported	$	(20,029	)	$	(20,029	)	$	189		$	189
Preferred stock dividends declared		-			-			(326	)		(326	)
Net loss available to common shareholders	$	(20,029	)	$	(20,029	)	$	(137	)	$	(137	)
Weighted average common shares outstanding		6,299,681			6,299,681			6,333,333			6,333,333
Effect of dilutive securities:
Stock options and warrants		-			-			-			-
Noncumulative convertible perpetual preferred stock		-			-			-			-
Weighted average common shares outstanding		6,299,681			6,299,681			6,333,333			6,333,333
Net loss per common share	$	(3.18	)	$	(3.18	)	$	(0.02	)	$	(0.02	)


(1)	For the three-month periods ended June 30, 2008 and 2009, we recognized a loss available to common shareholders rather than net income. In this scenario, diluted earnings per share equals basic earnings per share because additional shares would be anti-dilutive.

(2)	The conversion of noncumulative convertible perpetual preferred stock shares would have been anti-dilutive for the three-month periods ended June 30, 2008 and 2009, and therefore, common shares issuable upon conversion of such securities are ignored in the computation of diluted EPS.

(3)	For the three months ended June 30, 2008, and 2009 the conversion of stock options and warrants would have been anti-dilutive to net income per diluted share. In this scenario, diluted earnings per share equals basic earnings per share.


	Six Months Ended June 30,
	2009						2008
	BASIC			DILUTED (1),(2),(3)			BASIC			DILUTED (2)
Net income/(loss), as reported	$	(21,391	)	$	(21,391	)	$	924		$	924
Preferred stock dividends declared		-			-			(652	)		(652	)
Net income/(loss) available to common shareholders	$	(21,391	)	$	(21,391	)	$	272		$	272
Weighted average common shares outstanding		6,298,197			6,298,197			5,901,557			5,901,557
Effect of dilutive securities:
Stock options and warrants		-			-			-			538,372
Noncumulative convertible perpetual preferred stock		-			-			-			-
Weighted average common shares outstanding		6,298,197			6,298,197			5,901,557			6,439,929
Net income/(loss) per common share	$	(3.40	)	$	(3.40	)	$	0.05		$	0.04

(1)	For the six months ended June 30, 2009, we recognized a loss available to common shareholders rather than net income. In this scenario, diluted earnings per share equals basic earnings per share because additional shares would be anti-dilutive.

(2)	The conversion of noncumulative convertible perpetual preferred stock shares would have been anti-dilutive for the six months ended June 30, 2008 and 2009, and therefore, common shares issuable upon conversion of such securities are ignored in the computation of diluted EPS.

(3)	For the six months ended June 30, 2009, the conversion of stock options and warrants would have been anti-dilutive to net income per diluted share. In this scenario, diluted earnings per share equals basic earnings per share.

The assumed exercise of stock options and warrants and the conversion of preferred stock can create a difference between basic and diluted net income per common share. Dilutive common shares arise from the potentially dilutive effect of our outstanding stock options and warrants, as well as the potential conversion of our convertible perpetual preferred stock. In order to arrive at net income/(loss) available to common shareholders, net income/(loss) is reduced by the amount of preferred stock dividends declared for that period. This approach reflects the preferred stock dividend as if it were an expense so that its impact to the common shareholder is not obscured by its inclusion in retained earnings. However, when a net loss is recognized rather than net income, or when the preferred stock dividend during a period outweighs net income for that period, resulting in a loss available to common shareholders, diluted earnings per share for that period equals basic earnings per common share. The average diluted shares have been computed utilizing the “treasury stock” method. The weighted average shares outstanding exclude 106,981 and 92,981 common shares of treasury stock repurchased by us through our share repurchase program as of June 30, 2009, and 2008, respectively.

Note 3 - Stock Compensation Plans

We use the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) SFAS No. 123(R), Accounting for Stock-Based Compensation , to account for compensation costs under our stock option plans. Previously, we utilized the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issues to Employees (as amended) (“APB 25”). Under the intrinsic value method prescribed by APB 25, no compensation costs were recognized for our stock options granted in years prior to 2003. Adopting SFAS No. 123 (R) on January 1, 2006, allowed us to use the modified prospective method to account for the transition. Under the modified prospective method, compensation cost is recognized from the adoption date forward for all stock options granted after that date and for any outstanding unvested awards as if the fair value method had been applied to those awards as of the date of grant. Prior to January 1, 2006, we disclosed the pro forma effects on net income and earnings per share as if the fair value recognition provisions of SFAS 123(R) had been utilized.

The weighted average fair value per share of options granted in the six-month period ended June 30, 2008, amounted to $5.70. No options were granted in the six-month period ended June 30, 2009. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option pricing model, with the following assumptions used for grants: expected volatility of 41.68% for the six-month period ended June 30, 2008, interest rate of 2.25% for the six-month period ended June 30, 2008, and expected lives of the options of seven years in all periods presented. There were no cash dividends to shareholders of common stock in any periods presented.

Note 4 – 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. As of January 31, 2008, Carolina National’s consolidated total assets were $220.9 million, its consolidated total loans were $203.3 million, it consolidated total deposits were $187.3 million, and its total shareholders’ equity was approximately $29.2 million. On February 18, 2008, Carolina National Bank and Trust Company merged with and into the Company’s bank subsidiary, First National Bank of the South. As a result of this acquisition, four full-service branches in the Columbia market were added to First National’s operations that had been previously operated as Carolina National Bank and Trust Company.

Carolina National was a South Carolina corporation registered as a bank holding company with the Federal Reserve Board. Carolina National engaged in a general banking business through its subsidiary, Carolina National Bank and Trust Company, a national banking association, which commenced operations in July 2002. As a result of the Merger, First National moved its Columbia loan production office to Carolina National’s former main office and full-service branch and the former Carolina National loan production office in Rock Hill moved to the existing First National loan production office in Rock Hill.

Under the terms of the definitive agreement, Carolina National's shareholders were given the option to elect to receive either 1.4678 shares of First National common stock or $21.65 of cash for each share of Carolina National common stock held, or a combination of stock and cash, provided that the aggregate consideration consisted of 70% stock and 30% cash. Based on the “Final Buyer Stock Price,” as defined in Section 9.1(g) of the Agreement and Plan of Merger dated August 26, 2007, by and between First National and Carolina National (the “Merger Agreement”), of $12.85, and including the value of Carolina National's outstanding options and warrants, the transaction closed with an aggregate value of $54.1 million. After the allocation and proration processes set forth in the Merger Agreement were applied to the elections made by Carolina National shareholders, the total Merger consideration resulted in an additional 2,663,674 shares of First National common stock outstanding upon the completion of the exchange of Carolina National shares on March 31, 2008. In addition, cash consideration of $16,848,809 was paid in exchange for shares of Carolina National common stock.

In connection with the Merger, the 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 are being recognized over 34 months. Adjustments to leases are being amortized over the terms of the respective leases. Adjustments to certificates of deposit were fully amortized after 5 months.

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 recorded the impairment to the goodwill balance as a noncash accounting charge to our earnings in 2008.

Note 5 – Loans

A summary of loans by classification as of June 30, 2009, is as follows (dollars in thousands).

	June 30, 2009						December 31, 2008
	Amount			% of Total (1)			Amount			% of Total (1)
Commercial and industrial	$	39,158			6.25	%	$	48,432			6.83	%
Commercial secured by real estate		353,357			56.44	%		429,868			60.61	%
Real estate - residential mortgages		220,474			35.21	%		206,910			29.17	%
Installment and other consumer loans		7,022			1.12	%		8,439			1.19	%
Total loans		620,011						693,649
Mortgage loans held for sale		6,714			1.07	%		16,411			2.31	%
Unearned income		(602	)		(0.10	%)		(773	)		(0.11	%)
Total loans, net of unearned income		626,123			100.00	%		709,287			100.00	%
Less allowance for loan losses		(23,534	)		3.80%			(23,033	)		3.32	%
Total loans, net	$	602,589					$	686,254

(1)	As a % of total loans includes mortgage loans held for sale.

(2)	Loan loss allowance % to total loans excludes mortgage loans held for sale.

Approximately $401,936,000 of the loans were variable interest rate loans as of June 30, 2009. The remaining portfolio was comprised of fixed interest rate loans.

As of June 30, 2009 and 2008, nonperforming assets (nonperforming loans plus other real estate owned) were $116.6 million and $12.0 million, respectively. Foregone interest income on these nonaccrual loans and other nonaccrual loans charged off during the six-month periods ended June 30, 2009 and 2008, was approximately $1,279,000 and $360,000, respectively. There was one performing loan of $498,000 contractually past due in excess of 90 days and still accruing interest at June 30, 2009. There were no loans contractually past due in excess of 90 days and still accruing interest at June 30, 2008. There were impaired loans, under the criteria defined in FAS 114, of $101.6 million and $18.5 million, with related valuation allowances of $8.4 million (net of $19.7 million in chargeoffs during the six months ended June 30, 2009) and $2.0 million at June 30, 2009 and 2008, respectively. The large provision for loan loss this quarter is part of our proactive strategy to accelerate our efforts to resolve our non-performing assets with the goal of removing them from our balance sheet.

Also included in nonperforming assets as of June 30, 2009, is $9.7 million in other real estate owned, or 8.29% of total nonperforming assets as of this date. Other real estate owned consists of property acquired through foreclosure. During the six-month period ended June 30, 2009, other real estate owned increased by $3.2 million net, due to the foreclosure of several properties, partially offset by the disposition of several pieces of foreclosed property. The transfer of these properties represents the next logical step from their previous classification as nonperforming loans to other real estate owned to give First National the ability to control the properties. The repossessed collateral is made up of single-family residential properties in varying stages of completion and various commercial properties. These properties are being actively marketed and maintained with the primary objective of liquidating the collateral at a level which most accurately approximates fair market value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time. The cost of owning the properties was approximately $312,000, for the six months ended June 30, 2009, compared to $64,000 for the six months ended June 30, 2008. The carrying value of these assets is believed to be representative of their fair market value, although there can be no assurance that the ultimate net proceeds from the sale of these assets will be equal to or greater than the carrying values.

As of June 30, 2009, qualifying loans held by the bank and collateralized by 1-4 family residences, home equity lines of credit (“HELOC’s”) and commercial properties totaling $72,010,000 were pledged as collateral for FHLB advances outstanding of $67,064,000. We access and monitor current FHLB guidelines to determine the eligibility of loans to qualify as collateral for an FHLB advance. We are subject to the FHLB’s credit risk rating which was effective June 27, 2008. This revised policy incorporated enhancements to the FHLB’s credit risk rating system which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter. In addition, residential collateral discounts have been recently applied which may further reduce our borrowing capacity. While we are operating under our current regulatory enforcement action, we are not allowed to obtain future advances from FHLB.

Changes in the allowance for loan losses for the six-month periods ended June 30, 2009 and 2008 were as follows (dollars in thousands).

	June 30,				June 30,
		2009			2008
Balance, beginning of year		$	23,033		$	4,951
Allowance from acquisition			-			2,976
Provision charged to operations			20,197			1,409
Loans charged off			(19,699	)		(629	)
Recoveries on loans previously charged off			3			27
Balance, end of period		$	23,534		$	8,734

The provision for loan losses has been made primarily as a result of management’s assessment of general loan loss risk after considering historical operating results, as well as comparable peer data. Our evaluation is inherently subjective as it requires estimates that are susceptible to significant change. In addition, various regulatory agencies review our allowance for loan losses through their periodic examinations, and they may require us to record additions to the allowance for loan losses based on their judgment about information available to them in the time of their examinations. Our losses will undoubtedly vary from our estimates, and there is a possibility that chargeoffs in future periods will exceed the allowance for loan losses as estimated at any point in time.

Note 6 – Income Taxes

The following is a summary of the items which caused recorded income taxes to differ from taxes computed using the statutory tax rate for the six months ended June 30, 2009 and 2008 (dollars in thousands).

	June 30,				June 30,
		2009			2008
Income tax expense/(benefit) at federal statutory rate of 34%		$	(7,273	)	$	473
State income tax, net of federal effect			-			27
Increase in valuation allowance for deferred tax asset			7,333			-
Tax-exempt securities income			(104	)		(103	)
Capital loss on writedown of equity securities			40			-
Bank-owned life insurance earnings			(22	)		(23	)
Other, net			26			92
Income tax expense/(benefit)		$	-		$	466

The components of the deferred tax assets and liabilities at June 30, 2009 and December 31, 2008 are as follows (dollars in thousands):

	2009		2008
Deferred tax liability:
Core deposit intangible	$	401	$	438
Unrealized gain on securities available for sale		85		293
Tax depreciation in excess of book		185		219
Prepaid expenses deducted currently for tax		157		192
Deferred loss on sale/leaseback transaction		104		107
Loan servicing rights		72		82
Other		5		5
Total deferred tax liability		1,009		1,336
Deferred tax asset:
Allowance for loan losses	$	7,674	$	7,469
Net operating loss carryforward		9,813		2,649
Writedowns on other real estate owned		642		797
Other		33		33
Total deferred tax asset		18,162		10,948
Valuation allowance		11,533		4,200
Deferred tax asset after valuation allowance		6,629		6,748
Net deferred tax asset	$	5,620	$	5,412

The net deferred tax asset is included in "other" the accompanying consolidated balance sheets.

The Company has analyzed the tax positions taken or expected to be taken in its tax returns and concluded it has no liability related to uncertain tax positions in accordance with FIN 48. The change in the net deferred tax asset is due to the change of $208,000 in the tax effect of the decrease in the unrealized gain on securities available for sale.

Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value. As of June 30, 2009, we increased the valuation allowance to reflect the portion of the deferred income tax asset that is not able to be offset against net operating loss carrybacks and reversals of net future taxable temporary differences projected to occur in 2009. Management determined that this valuation allowance of $11,533,000 has been recorded due to the substantial doubt of the ability of the Company to be able to realize all of the net deferred tax assets.

Note 7 – Fair Value Disclosures

Effective January 1, 2008, the Company adopted SFAS 157 for its financial assets and liabilities. SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157 requires, among other things, the Company to maximize the use of observable inputs and minimize the use of unobservable inputs in its fair value measurement techniques. The adoption of SFAS 157 resulted in no change to January 1, 2008 retained earnings.

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 – Valuations are based on quoted prices in active markets for identical assets and liabilities. Level 1 assets include debt and equity securities that are traded in an active exchange market, as well as certain U.S. Treasury securities that are highly liquid and are actively traded in over-the-counter markets.

Level 2 – Valuations are based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. Valuations are obtained from third party pricing services for similar assets or liabilities. This category generally includes U.S. government agencies, agency mortgage-backed debt securities, private-label mortgage-backed debt securities, state and municipal bonds, corporate bonds, certain derivative contracts, and mortgage loans held for sale.

Level 3 – Valuations include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets. For example, certain available for sale securities included in this category are not readily marketable and may only be redeemed with the issuer at par. This category includes certain derivative contracts for which independent pricing information was not able to be obtained for a significant portion of the underlying assets.

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis (dollars in thousands).

	June 30, 2009
	Total		Level 1		Level 2		Level 3
Securities available for sale	$	103,376	$	-	$	103,376	$	-
Mortgage loans held for sale		6,714		-		6,714		-
Equity Investments		7,068		-		-		7,068
Total	$	117,158	$	-	$	110,090	$	7,068

The table below presents the balances of assets and liabilities measured at fair value on a nonrecurring basis (dollars in thousands).

	June 30, 2009
	Total		Level 1		Level 2		Level 3
Impaired loans	$	101,600	$	-	$	-	$	101,600
Other real estate owned		9,666		-		-		9,666
Total	$	111,266	$	-	$	-	$	111,266

Item 2. 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.

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 OCC FRB, or FDIC taking additional significant regulatory action against us due to our cumulative losses and capital position;

whether our lender will exercise the remedies available to it 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, and the consequences resulting from our inability to increase our capital ratios to the required amounts by the deadline imposed by the consent order;

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;

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 available 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 and 2009, the capital and credit markets have experienced extended volatility and disruption. 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.

Overview

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 more 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 thirteen full-service branches operating under the name First National Bank of the South including two branches which opened in the Greenville market of the upstate of South Carolina in 2007. In 2004, we opened our first full-service branch in the coastal region in Mount Pleasant, South Carolina 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. In May of 2009, we opened our thirteenth full-service branch and northern market headquarters in the Tega Cay community of Fort Mill, South Carolina.

We manage liquidity for our bank and our holding company separately. This approach considers the unique funding sources available to each entity, as well as each entity’s capacity to manage through adverse conditions. This approach also recognizes that adverse market conditions or other events could negatively affect the availability or cost of liquidity for either entity.

We typically would rely on dividends from our bank as our primary source of liquidity. The holding company is a legal entity separate and distinct from the bank. Various legal limitations, including in the consent order we signed with the OCC, prohibit the bank from lending or otherwise supplying funds to the holding company to meet its obligations, including paying dividends. The Federal Reserve Bank of Richmond (the “FRB”) has also required our bank holding company to enter into a written agreement which contains provisions similar to the articles in the bank’s consent order with the OCC. In addition, the terms of the consent order described above further limit the bank's ability to pay dividends to the holding company to satisfy its funding needs. As part of the acquisition of Carolina National Corporation, the holding company entered into a loan agreement in December 2007 with a correspondent bank for a line of credit to finance a portion of the cash paid in the transaction and to fund operating expenses of the holding company including interest and dividend payments on its noncumulative preferred stock and trust preferred securities. The holding company pledged all of the stock of the bank as collateral for the line of credit which had an outstanding balance of $9.64 million as of June 30, 2009. We were out of compliance with various covenants governing this line of credit requiring the maintenance of certain capital levels, profitability levels and asset quality. We are currently negotiating with our lender regarding certain modifications to this line of credit.

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 is elevated. Consequently, our loan loss provision for the six-month period ended June 30, 2009 increased from $1.4 million for the six-month period ended June 30, 2008 to $20.2 million for the six-month period ended June 30, 2009. 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.

We believe that the elevated level of our nonperforming assets has occurred largely as a result of the severe housing downturn and deterioration in the residential real estate market, as many of our commercial loans are for residential real estate projects. To improve our results of operations, our primary focus for 2009 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) has increased during 2009 to $116.6 million as of the date of this report as compared to $75.5 million as of December 31, 2008. However, we have closed on sales of over $15 million of nonperforming loans and other real estate owned during the second quarter of 2009.

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.

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 have devoted 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 continue to be required later 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, completed a safety and soundness examination of the bank, which included a review of our asset quality, during the fourth quarter of 2008. 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. The FRB has also required our bank holding company to enter into a written agreement which contains provisions similar to the articles in the banks consent order with the OCC. In addition, as of June 30, 2009, as a result of increased losses in the first half of 2009, our capital levels fell below the minimum regulatory capital ratios for “adequately-capitalized” banks. We are working on efforts to achieve the Tier 1 capital levels imposed under the consent order, including by raising additional capital, limiting our growth, and selling assets, but we do not anticipate achieving these levels by August 25, 2009, the deadline specified in the consent order.

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. The capital plan outlines the actions needed to improve our capital ratios to a level which complies with the minimum capital levels in the consent order. On July 24, 2009 our board submitted a written strategic plan and capital plan to the OCC to increase our capital ratios. Once we receive the OCC’s written determination of no supervisory objection, our Board of Directors will adopt and implement the plans. Additionally, on June 15, 2009, our holding company entered into a written agreement with the FRB, which agreement contains provisions similar to the articles in the bank’s consent order with the OCC. On June 15, 2009, under the terms of the written agreement that we entered into with the FRB , we submitted a capital plan to the FRB. We will adopt the written plan within 10 days of its approval by the FRB.

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 timeframe, 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.

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 April 1, 2009 and December 31, 2009, we have $355.4 million of time deposits that will reprice at current market rates, which represents approximately 75% of our total time deposits at June 30, 2009. These time deposits had a weighted average interest rate of 2.98% at June 30, 2009. Additionally, we have $211.0 million of variable rate loans that are renewing between April 1, 2009 and December 31, 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 2008. 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 (“FHLB”). 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 additional funds from the 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 within the limitations applicable to our bank due to its financial condition. Our retail bankers also use their network of extensive personal and commercial relationships in the local market to generate deposits. Five of our thirteen branches are less than two years old, and we expect those branches to significantly increase their levels of deposits in the near future. 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.

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 seek to 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.

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.

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 and income taxes. 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 our ability to utilize the deferred tax asset, management has established a valuation allowance for the net 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.

Results of Operations

Income Statement Review

Summary

Three months ended June 30, 2009 and 2008

Our net loss was $20.03 million, or $3.18 per diluted share, for the quarter ended June 30, 2009, as compared with net income of $189,000 for the quarter ended June 30, 2008. The preferred stock dividend for the three-month period ended June 30, 2008, exceeded net income recorded for this period, resulting in a loss available to common shareholders of $137,000, or $0.02 net loss per diluted share. Our board of directors did not declare a preferred stock dividend for the second quarter of 2009 due to our net loss for the period. Our net loss for the quarter ended June 30, 2009 included an increase of $18.8 million in the provision for loan losses. This increase was recorded to adjust the allowance for loan losses to reflect the risk inherent in the loan portfolio which continues to be negatively affected by the severe housing downturn and real estate market deterioration in each of our market areas during 2009 as compared to the quarter ended June 30, 2008. Diluted common shares outstanding for the period ended June 30, 2009 decreased slightly over the same period in 2008, due to the effect of treasury stock purchases throughout 2008, which have reduced common shares outstanding. Net interest income for the quarter ended June 30, 2009, decreased by 41.6%, or $2.3 million, to $3.1 million, as compared to $5.4 million recorded during the same period in 2008, primarily due to the negative impact of the proportionally increased level of nonperforming loans.

The net interest margin for the quarter ended June 30, 2009 was 1.45%, as compared to the 2.70% net interest margin recorded for the quarter ended June 30, 2008, or a reduction of 125 basis points. During 2008, the Federal Reserve lowered the federal funds rate from 4.25% in January of 2008 to near zero percent by the end of 2008, where it has stayed through June 30, 2009. 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 2009 as compared to previous years, which have also caused our 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. In addition, while nonperforming loans continue to be treated as interest-earning assets, the interest lost on these loans reduces net interest income, particularly in the quarter the loans first are considered nonperforming, as any interest accrued on the loans is reversed at that point. Therefore, these nonperforming loans reduce interest income while inflating the interest-earning asset base, causing the net interest margin to be further negatively impacted.

Our return on average assets decreased by 925 basis points from 0.09% for the quarter ended June 30, 2008, to (9.16%) for the same period in 2009 due to the net loss for the quarter as compared to net income recorded in the same quarter of the prior year. The diminished return on average assets reflects the impact of the decreased net interest income and an increased provision for loan losses as compared to 2008.

Our return on average equity decreased by 20,691 basis points, from 0.87% for the quarter ended June 30, 2008, to (206.04%) for the quarter ended June 30, 2009. This decrease is driven by our net loss recognized in the second quarter of 2009 versus net income for the second quarter of 2008.

Our efficiency ratio increased by 76.5% from 81.38% for the three months ended June 30, 2008, to 143.62% for the three months ended June 30, 2009, primarily due to the decrease in net interest income of $2.3 million, or 41.6%, and an increase in noninterest expense of $1.2 million, or 21.7%. The increased noninterest expense was primarily due to increased annual assessment fees by the FDIC and our accrual during the second quarter of 2009 for a special assessment to be paid during the third quarter as a result of the recessionary U.S. economy and increased numbers of bank failures. While noninterest income increased by 14.9%, the $184,000 increase only partially offset the decreased net interest income and increased noninterest expense.

Six months ended June 30, 2009 and 2008

Our net loss was $21.39 million, or $3.40 per diluted share, for the six months ended June 30, 2009, as compared with net income of $924,000, or $0.04 per diluted share, for the six months ended June 30, 2008. Our net loss for the six months ended June 30, 2009 included an increase of $18.8 million in the provision for loan losses. This increase was recorded to adjust the allowance for loan losses to reflect the risk inherent in the loan portfolio which continues to be negatively affected by the severe housing downturn and real estate market deterioration in each of our market areas during 2009 as compared to the six months ended June 30, 2008. Diluted common shares outstanding for the six-month period ended June 30, 2009 decreased slightly over the same period in 2008 due to the effect of treasury stock purchases throughout 2008, which have reduced common shares outstanding. Net interest income for the six months ended June 30, 2009, decreased by 30.9%, or $3.2 million, to $7.3 million, as compared to $10.5 million recorded during the same period in 2008, primarily due to the negative impact of the proportionally increased level of nonperforming loans.

The net interest margin for the six months ended June 30, 2009 was 1.76%, as compared to the 2.80% net interest margin recorded for the six months ended June 30, 2008, or a reduction of 104 basis points. During 2008, the Federal Reserve lowered the federal funds rate from 4.25% in January of 2008 to near zero percent by the end of 2008, where it has stayed through June 30, 2009. 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 2009 as compared to previous years, which have also caused our 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.

Our return on average assets decreased by 533 basis points from 0.23% for the six months ended June 30, 2008, to (5.10%) for the same period in 2009 due to the net loss for the period as compared to net income recorded in the same six-month period of the prior year. The diminished return on average assets reflects the impact of the decreased net interest income and an increased provision for loan losses as compared to 2008.

Our return on average equity decreased by 11,050 basis points, from 2.38% for the six months ended June 30, 2008, to (108.12%) for the six months ended June 30, 2009. This decrease is driven by our net loss recognized in the first six months of 2009 versus net income for the first six months of 2008.

Our efficiency ratio increased by 42.0% from 78.60% for the six months ended June 30, 2008, to 111.64% for the six months ended June 30, 2009, primarily due to the decrease in net interest income of $3.2 million, or 30.9%, and an increase in noninterest expense of $1.2 million, or 11.4%. The increased noninterest expense was primarily due to increased annual premiums by the FDIC due to our financial condition and our accrual during the second quarter of 2009 for a special assessment to be paid during the third quarter as a result of the recessionary U.S. economy and increased numbers of bank failures. While noninterest income increased by 16.5%, the $424,000 increase only partially offset the decreased net interest income and increased noninterest expense.

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.

Three months ended June 30, 2009 and 2008

Our net interest income decreased by $2.3 million, or 41.6%, to $3.1 million for the quarter ended June 30, 2009, from $5.4 million for the same period in 2008. The decrease in net interest income was due primarily to the decrease in our net interest margin of 125 basis points from 2.70% to 1.45% for the three-month periods ended June 30, 2008 and 2009, respectively. Decreased earning rates on the loan portfolio was the primary contributing factor, along with overall decreased loan volume. Combined, loan rates and volume contributed $2.9 million toward our decreased net interest income for the three-month period ended June 30, 2009. We are deliberately decreasing the size of our loan portfolio. The continued deterioration in the South Carolina real estate markets and the volatile economy in general support our current strategy of decreasing the size of our loan portfolio.

The following table sets forth, for the quarters ended June 30, 2009 and 2008, 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 Three Months Ended June 30,
	2009								2008
	Average			Income/		Yield/			Average		Income/		Yield/
	Balance			Expense		Rate *			Balance		Expense		Rate *
Loans, including nonaccrual loans		$	658,888	$	7,622		4.64	%	$	704,711	$	10,550		6.00	%
Mortgage loans held for sale			8,468		107		5.07	%		11,929		182		6.12	%
Investment securities			152,582		746		1.96	%		72,151		840		4.67	%
Federal funds sold and other			45,393		59		0.52	%		6,615		90		5.46	%
Total interest-earning assets		$	865,331	$	8,534		3.96	%	$	795,406	$	11,662		5.88	%
Time deposits		$	593,336	$	4,348		2.94	%	$	457,980	$	4,670		4.09	%
Savings and money market			73,424		218		1.19	%		115,985		708		2.45	%
NOW accounts			38,941		38		0.39	%		46,762		140		1.20	%
FHLB advances			67,638		524		3.11	%		55,311		465		3.38	%
Junior subordinated debentures			13,403		114		3.41	%		13,403		167		5.00	%
Federal funds purchased and other borrowings			9,639		161		6.70	%		21,438		152		2.83	%
Total interest-bearing liabilities		$	796,381	$	5,403		2.72	%	$	710,879	$	6,302		3.56	%
Net interest spread							1.24	%						2.32	%
Net interest income/margin				$	3,131		1.45	%			$	5,360		2.70	%

*Annualized for the three-month period

The net interest spread, which is the difference between the rate we earn on interest-earning assets and the rate we pay on interest-bearing liabilities, was 1.24% for the quarter ended June 30, 2009, compared to 2.32% for the quarter ended June 30, 2008. Our consolidated net interest margin, which is net interest income divided by average interest-earning assets for the period, was 1.45% for the quarter ended June 30, 2009, as compared to 2.70% for the quarter ended June 30, 2008.

Our net interest spread and our net interest margin decreased from 2008 to 2009. This decrease occurred principally due to the faster decrease in yields on average interest-earning assets relative to the slower repricing of our average interest-bearing liabilities following the 400 basis point decrease in the prime rate during 2008. We have incorporated interest rate floors as a standard on all new and renewing loans, and we are now using First National Prime, an internal standard interest rate set by us based on our cost of funds to price all new and renewing loans. These actions allow us to effectively control the pricing of loans.

Changes in interest rates paid on assets and liabilities, the rate of growth of the asset and liability base, the ratio of interest-earning assets to interest-bearing liabilities and management of the balance sheet’s interest rate sensitivity all factor into changes in net interest income. Therefore, improving our net interest income in the current challenging market will continue to require deliberate and attentive management.

Six months ended June 30, 2009 and 2008

Our net interest income decreased by $3.2 million, or 30.9%, to $7.3 million for the six months ended June 30, 2009, from $10.5 million for the same period in 2008. The decrease in net interest income was due primarily to the decrease in our net interest margin of 104 basis points from 2.80% to 1.76% for the six-month periods ended June 30, 2008 and 2009, respectively. While loan growth contributed positively for the six-month period ended June 30, 2009, loan rates contributed $5.6 million toward the decrease in net interest income. While deposit rates decreased as well, growth in deposits partially offset the positive impact of the reduced deposit rates. We are deliberately decreasing the size of our loan portfolio. The continued deterioration in the South Carolina real estate markets and the volatile economy in general support our current strategy of decreasing the size of our loan portfolio.

The following table sets forth, for the six months ended June 30, 2009 and 2008, 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 Six Months Ended June 30,
	2009								2008
	Average			Income/		Yield/			Average		Income/		Yield/
	Balance			Expense		Rate *			Balance		Expense		Rate *
Loans, excluding held for sale		$	672,766	$	15,825		4.74	%	$	661,766	$	21,140		6.41	%
Mortgage loans held for sale			12,495		317		5.12	%		13,461		388		5.78	%
Investment securities			117,671		1,744		2.99	%		70,187		1,633		4.67	%
Federal funds sold and other			31,948		102		0.64	%		7,047		181		5.15	%
Total interest-earning assets		$	834,880	$	17,988		4.34	%	$	752,461	$	23,342		6.22	%
Time deposits		$	533,764	$	8,404		3.18	%	$	428,622	$	9,282		4.34	%
Savings & money market			88,475		584		1.33	%		113,928		1,648		2.90	%
NOW accounts			41,351		115		0.56	%		44,998		347		1.55	%
FHLB advances			71,481		1,040		2.93	%		49,029		903		3.69	%
Junior subordinated debentures			13,403		245		3.69	%		13,403		396		5.93	%
Federal funds purchased and other borrowings			15,397		327		4.28	%		15,969		248		3.11	%
Total interest-bearing liabilities		$	763,871	$	10,715		2.83	%	$	665,949	$	12,824		3.86	%
Net interest spread							1.51	%						2.36	%
Net interest income/margin				$	7,273		1.76	%			$	10,518		2.80	%

*Annualized for the six-month period

The net interest spread, which is the difference between the rate we earn on interest-earning assets and the rate we pay on interest-bearing liabilities, was 1.51% for the six months ended June 30, 2009, compared to 2.36% for the six months ended June 30, 2008. Our consolidated net interest margin, which is net interest income divided by average interest-earning assets for the period, was 1.76% for the six months ended June 30, 2009, as compared to 2.80% for the six months ended June 30, 2008.

Analysis of Changes in Net Interest Income

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume. The following table sets forth the effect that the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented (dollars in thousands).

	Changes in Net Interest Income/(Expense)
	For the Quarters Ended June 30, 2009 vs. 2008 Increase (Decrease) Due to									For the Quarters Ended June 30, 2008 vs. 2007 Increase (Decrease) Due to
	Volume			Rate			Total			Volume		Rate			Total
Interest-Earning Assets
Federal funds sold and other	$	528		$	(559	)	$	(31	)	$	21	$	(9	)	$	12
Investment securities		936			(1,030	)		(94	)		50		(3	)		47
Mortgage loans held for sale		(53	)		(22	)		(75	)		8		1			9
Loans (1)		(686	)		(2,242	)		(2,928	)		6,076		(4,373	)		1,703
Total interest-earning assets	$	725		$	(3,853	)	$	(3,128	)	$	6,155	$	(4,384	)	$	1,771
Interest-Bearing Liabilities
Deposits	$	1,097		$	(2,011	)	$	(914	)	$	2,966	$	(2,066	)	$	900
FHLB advances		105			(46	)		59			182		(210	)		(28	)
Federal funds purchased and other		(84	)		93			9			61		(175	)		(114	)
Junior subordinated debentures		-			(53	)		(53	)		-		(87	)		(87	)
Total interest-bearing liabilities	$	1,118			(2,017	)		(899	)	$	3,209	$	(2,538	)	$	671
Net interest income/(expense)	$	(393	)	$	(1,836	)	$	(2,229	)	$	2,946	$	(1,846	)	$	1,100

(1) Loan fees, which are not material for any of the periods shown, have been included for rate calculation purposes.

Investment securities contributed to net interest income as our most lucrative earning asset, but their positive contribution was exceeded by the growth in deposits and other interest-bearing liabilities, whose volume contributed approximately $1.1 million in costs. The reduction in average loan growth and the decrease in loan rates since 2008 resulted in a net reduction to net interest income of $2.9 million. Rates on interest-bearing liabilities also decreased, reducing interest expense by approximately $2.0 million for the quarter ended June 30, 2009.

	Changes in Net Interest Income/(Expense)
	For the Six Months Ended June 30, 2009 vs. 2008 Increase (Decrease) Due to												For the Six Months Ended June 30, 2008 vs. 2007 Increase (Decrease) Due to
	Volume			Rate			One Day Difference (2)			Total			Volume		Rate			One Day Difference (2)		Total
Interest-Earning Assets
Federal funds sold and other	$	636		$	(714	)	$	(1	)	$	(79	)	$	76	$	(28	)	$	1	$	49
Investment securities		1,099			(978	)		(10	)		111			95		(7	)		8		96
Mortgage loans held for sale		(28	)		(41	)		(2	)		(71	)		185		(10	)		1		176
Loans (1)		350			(5,549	)		(116	)		(5,315	)		10,897		(6,755	)		93		4,235
Total interest-earning assets	$	2,057		$	(7,282	)	$	(129	)	$	(5,354	)	$	11,253	$	(6,800	)	$	103	$	4,556
Interest-Bearing Liabilities
Deposits	$	1,871		$	(3,982	)	$	(63	)	$	(2,174	)	$	5,451	$	(2,909	)	$	48	$	2,590
FHLB advances		411			(269	)		(5	)		137			234		(286	)		5		(47	)
Federal funds purchased and other		(9	)		89			(1	)		79			38		(219	)		2		(179	)
Junior subordinated debentures		-			(149	)		(2	)		(151	)		-		(113	)		3		(110	)
Total interest-bearing liabilities	$	2,273			(4,311	)		(71	)		(2,109	)	$	5,723		(3,527	)		58		2,254
Net interest income/(expense)	$	(216	)	$	(2,971	)	$	(58	)	$	(3,245	)	$	5,530	$	(3,273	)	$	45	$	2,302

(1) Loan fees, which are not material for any of the periods shown, have been included for rate calculation purposes.

(2)	Presented to reflect the impact of February having 29 days in 2008 vs. 28 days in 2007 and 2009.

Investment securities contributed to net interest income as our most lucrative earning asset, but their positive contribution was exceeded by the growth in deposits and other interest-bearing liabilities, whose volume contributed approximately $2.3 million in costs. Average loan growth contributed $350,000 in volume, whereas the decrease in loan rates since 2008 outweighed the positive contribution from the marginal loan growth with a decrease of $5.5 million. Rates on interest-bearing liabilities also decreased, reducing interest expense by approximately $4.3 million for the six months ended June 30, 2009.

Provision for Loan Losses

At the end of each quarter or more often, if necessary, we analyze the collectability of our loans and accordingly adjust the loan loss allowance to an appropriate level. Our loan loss allowance covers estimated credit losses on individually evaluated loans that are determined to be impaired, as well as estimated credit losses inherent in the remainder of the loan portfolio. We strive to follow a comprehensive, well-documented, and consistently applied analysis of our loan portfolio in determining an appropriate level for the loan loss allowance. We consider what we believe are all significant factors that affect the collectability of the portfolio and support the credit losses estimated by this process. Our loan review system and controls (including our loan grading system) are designed to identify, monitor, and address asset quality problems in an accurate and timely manner. We evaluate any loss estimation model before it is employed and document inherent assumptions and adjustments. We promptly charge off loans that we determine are uncollectible. It is essential that we maintain an effective loan review system that works to ensure the accuracy of our internal grading system and, thus, the quality of the information used to assess the appropriateness of the loan loss allowance. Our board of directors is responsible for overseeing management’s significant judgments and estimates pertaining to the determination of an appropriate loan loss allowance by reviewing and approving the institution’s written loan loss allowance policies, procedures and model quarterly.

In arriving at our loan loss allowance, we consider those qualitative or environmental factors that are likely to cause credit losses, as well as our historical loss experience. Because of our relatively short history, we also factor in a five-year trend of peer data on historical losses. In addition, as part of our model, we consider changes in lending policies and procedures, including changes in underwriting standards, and collection, chargeoff, and recovery practices not considered elsewhere in estimating credit losses, as well as changes in regional and local economic and business conditions. Further, we factor in changes in the nature and volume of the portfolio and in the terms of loans, changes in the experience, ability, and depth of lending management and other relevant staff, the volume of past due and nonaccrual loans, as well as adversely graded loans, changes in the value of underlying collateral for collateral-dependent loans, and the existence and effect of any concentrations of credit. Please see the discussion below under “Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Our provision for loan losses was $18.0 million and $943,000 for the three months ended June 30, 2009 and 2008, respectively, an increase of $17.1 million. Our provision for loan losses was $20.2 million and $1.4 million for the six months ended June 30, 2009 and 2008, respectively, an increase of $18.8 million. The percentage of allowance for loan losses was increased to 3.80% of gross loans outstanding as of June 30, 2009, from 1.25% as of June 30, 2008. The actual loss on disposition of the loan and/or the underlying collateral may be more or less than the amount charged off to date. Also included in the allowance for loan losses as of June 30, 2008, was $2.9 million added from the acquisition of Carolina National. The allowance has been recorded based on management’s ongoing evaluation of inherent risk and estimates of probable credit losses within the loan portfolio. Management believes that specific reserves have been allocated in its allowance for loan losses as of June 30, 2009 related to the nonperforming assets and other nonaccrual loans that it believes will offset losses it anticipates may arise from less than full recovery of the loans from the supporting collateral. No assurances can be given in this regard, however, especially considering the overall weakness in the real estate market.

The recent downturn in the real estate market has resulted in increased loan delinquencies, defaults and foreclosures, primarily in our residential real estate portfolio, and we believe that these trends are likely to continue. In some cases, this downturn has resulted in a significant impairment to the value of our collateral and our ability to sell the collateral upon foreclosure, and there is a risk that this trend will continue. 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. If real estate values continue to decline, it is also more likely that we would be required to increase our allowance for loan losses. If during a period of reduced real estate values we are required to liquidate the property collateralizing a loan to satisfy the debt or to increase the allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition. This downturn in the real estate market has resulted in an increase in our nonperforming loans, and there is a risk that this trend will continue, which could result in a net loss of earnings and an increase in our provision for loan losses and loan chargeoffs, all of which could have a material adverse effect on our financial condition and results of operations.

Noninterest Income

Three months ended June 30, 2009 and 2008

The following table sets forth information related to the various components of our noninterest income (dollars in thousands).

	For the Three Months Ended June 30,
	2009		2008
Mortgage banking income	$	497	$	603
Service charges and fees on deposit accounts		425		482
Gain on sale of securities available for sale		286		-
Service charges and fees on loans		114		88
Other		95		60
Total noninterest income	$	1,417	$	1,233

Noninterest income for the three months ended June 30, 2009, was $1.4 million, a net increase of 14.9% compared to noninterest income of $1.2 million during the same period in 2008. The increase is primarily due to the gain on securities available for sale recognized during the quarter ended June 30, 2009. Management decided to sell securities when the Federal Reserve took action to increase readily available market liquidity, causing rates in the bond market to decrease. This situation presented a unique opportunity to capitalize on an increased unrealized gain position on several securities in our investment portfolio. Please see Investments for more details. Service charges and fees on loans increased $26,000, or 29.5%, from $88,000 for the quarter ended June 30, 2008 to $114,000 for the quarter ended June 30, 2009, primarily due to late charges. Other noninterest income increased by $35,000, or 58.3%, from $60,000 for the quarter ended June 30, 2008 to $95,000 for the quarter ended June 30, 2009. This increase included approximately $46,000 recognized on the sale of one property we previously had foreclosed on. In addition, service charges and fees on deposit accounts decreased by $57,000, or 11.8% from 2008 to 2009.

The noninterest income generated by the wholesale mortgage division for the three months ended June 30, 2009, decreased by $106,000, or 17.6%, as compared to $603,000 earned for the three months ended June 30, 2008 due to the decrease in volume of loans originated. This division offers a wide variety of conforming and non-conforming mortgage loan products to other community banks and mortgage brokers which are held for sale in the secondary market. Sales of mortgage loans originated through the division occur pursuant to sales contracts entered into with the investors at the time of the loan commitment. As of June 30, 2009, $6.7 million in mortgage loans were held for sale to investors, a decrease of $8.6 million or 56.1%, from $15.3 million at June 30, 2008.

Six months ended June 30, 2009 and 2008

The following table sets forth information related to the various components of our noninterest income (dollars in thousands).

	For the Six Months Ended June 30,
	2009		2008
Mortgage banking income	$	1,208	$	1,334
Service charges and fees on deposit accounts		825		862
Gain on sale of securities available for sale		469		-
Service charges and fees on loans		265		203
Other		221		165
Total noninterest income	$	2,988	$	2,564

Noninterest income for the six months ended June 30, 2009 was $3.0 million, a net increase of 16.5% compared to noninterest income of $2.6 million during the same period in 2008. The increase is primarily due to the gain on securities available for sale recognized during the six months ended June 30, 2009. Management decided to sell securities when the Federal Reserve took action to increase readily available market liquidity, causing rates in the bond market to decrease. This situation presented a unique opportunity to capitalize on an increased unrealized gain position on several securities in our investment portfolio. Please see Investments for more details. Service charges and fees on loans increased $62,000, or 30.5%, from $203,000 for the six months ended June 30, 2008 to $265,000 for the six months ended June 30, 2009, primarily due to late charges. Other noninterest income increased by $56,000, or 33.9%, from $165,000 for the six months ended June 30, 2008 to $221,000 for the six months ended June 30, 2009. This increase included approximately $46,000 recognized on the sale of one property we previously had foreclosed on. In addition, service charges and fees on deposit accounts decreased by $37,000, or 4.3% from 2008 to 2009.

The noninterest income generated by the wholesale mortgage division for the six months ended June 30, 2009, decreased by $126,000, or 9.4%, as compared to $1.3 million earned for the six months ended June 30, 2008 due to the decrease in volume of loans originated. This division offers a wide variety of conforming and non-conforming mortgage loan products to other community banks and mortgage brokers which are held for sale in the secondary market. Sales of mortgage loans originated through the division occur pursuant to sales contracts entered into with the investors at the time of the loan commitment. As of June 30, 2009, $6.7 million in mortgage loans were held for sale to investors, a decrease of $8.6 million or 56.1%, from $15.3 million at June 30, 2008.

Noninterest Expenses

Three months ended June 30, 2009 and 2008

The following table sets forth information related to the various components of our noninterest expenses (dollars in thousands).

	For the Three Months Ended June 30,
	2009		2008
Salaries and employee benefits	$	2,594	$	2,796
FDIC insurance		1,281		149
Occupancy and equipment expense		800		808
Professional fees		535		211
Data processing and ATM expense		296		392
Other real estate owned expense		261		29
Telephone and supplies		169		178
Public relations		129		175
Loan related expenses		108		166
Other		359		462
Total noninterest expense	$	6,532	$	5,366

Noninterest expense increased by $1.1 million, or 21.7%, from $5.4 million for the quarter ended June 30, 2008 to $6.5 million for the quarter ended June 30, 2009. Noninterest expenses for the three months ended June 30, 2009 include the addition of our thirteenth full-service branch and market headquarters, which opened May 18, 2009 in the Tega Cay community of Fort Mill, South Carolina. Given the recent downturn in the economy, we have embarked on an aggressive expense reduction campaign that we believe will save us over $5 million in annual expenditures compared to our level of operating expenses in 2008. 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 other noninterest expenses.

Salaries and employee benefits decreased for the quarter ended June 30, 2009 compared to 2008 by $202,000, or 7.2%, from $2.8 million to $2.6 million, as we have eliminated and/or combined many positions since the quarter ended June 30, 2008. While the cost of personnel had increased in recent quarters to support our expansion into new markets, particularly our addition of four full-service branches in the Columbia market with the acquisition of Carolina National on January 31, 2008, and two full-service branches opening since the summer of 2008, our revised strategic plan does not provide for our expansion through branching in the near term. Therefore, our analysis of overall employee efficiency has resulted in the streamlining of our personnel needs through the reduction or combination of certain employee positions.

FDIC insurance expense increased $1.1 million, or 759.7%, from $149,000 for the three-month period ended June 30, 2008, to $1.3 million for the three-month period ended June 30, 2009. This increase includes increased annual premiums by the FDIC due to the increase in our deposit base and our current financial condition and the accrual during the second quarter of 2009 for a special assessment to be paid during the third quarter as a result of the recessionary U.S. economy and increased numbers of bank failures.

Occupancy and equipment expenses were relatively constant between the quarters ended June 30, 2008 and 2009. The positive effects of many of our recently renegotiated vendor contracts are reflected in the slight decrease in occupancy and equipment expenses from 2008 to 2009, as the three months ended June 30, 2009 include our thirteenth full-service branch and market headquarters in the Tega Cay community of Fort Mill, South Carolina, with a decrease of 1.0% reflected for the period ended June 30, 2009.

Data processing and ATM expenses were $296,000 and $392,000 for the quarters ended June 30, 2009 and 2008, respectively. The majority of the decrease of $96,000, or 24.5%, reflects the impact of efficiencies achieved through the Merger, as the three-month period ended June 30, 2008 included trailing expenses driven by Carolina National data processing costs.

Other real estate owned expense increased by $232,000, or 800.0%, from $29,000 for the quarter ended June 30, 2008 to $261,000 for the quarter ended June 30, 2009 as the level of foreclosed assets increased from 2008 to 2009. This expense includes costs incurred to maintain properties we have foreclosed on, including property taxes and insurance, utilities, property renovations and maintenance. These expenses also would include any writedowns to the carrying value of these foreclosed properties as market conditions change subsequent to the foreclosure action. The repossessed collateral is made up of single-family residential properties in varying stages of completion and various commercial properties. These properties are being actively marketed and maintained with the primary objective of liquidating the collateral at a level which most accurately approximates fair market value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time.

Professional fees increased by $324,000, or 153.6%, from 2008 to 2009 due to the costs of various outside consultants enlisted in our efforts to comply with the requirements of the consent order with the OCC.

Public relations expense decreased by $46,000, or 26.3%, to $129,000 for the quarter ended June 30, 2009, as compared to $175,000 for the same period in 2008. During 2008, we implemented a rebranding project and suspended our brand-related marketing activities while we were developing the new brand from the fourth quarter of 2007 to the third quarter of 2008 for its public debut. The rebranding will drive all of our future marketing endeavors.

Loan related expenses decreased by $58,000, or 34.9%, from $166,000 for the quarter ended June 30, 2008 to $108,000 for the quarter ended June 30, 2009 due to our deliberately decreased loan origination activities during 2009.

Included in the line item “Other,” which decreased $103,000, or 22.3%, between 2009 and 2008, are charges for fees paid to our board of directors and our regional boards in the Greenville, Columbia and Charleston markets; postage, printing and stationery expenses; and various customer-related expenses. As of February 28, 2009, board fees were suspended due to the bank’s reduced profitability.

Although we recognize the importance of controlling noninterest expenses to improve profitability, we remain committed to attracting and retaining a team of seasoned and well-trained officers and staff, maintaining highly technical operations support functions, and further developing a professional marketing program.

Six months ended June 30, 2009 and 2008

The following table sets forth information related to the various components of our noninterest expenses for the six months ended June 30, 2009 and 2008 (dollars in thousands).

	For the Six Months Ended June 30,
	2009		2008
Salaries and employee benefits	$	5,138	$	5,611
Occupancy and equipment		1,594		1,579
FDIC insurance		1,411		267
Professional fees		735		423
Data processing and ATM expense		594		650
Telephone and supplies		330		316
Other real estate owned expense		312		64
Public relations		249		246
Loan related expenses		239		300
Other		853		827
Total noninterest expense	$	11,455	$	10,283

Noninterest expense increased by $1.2 million, or 11.4%, from $10.3 million for the six months ended June 30, 2008 to $11.5 million for the six months ended June 30, 2009. Noninterest expenses for the six months ended June 30, 2009 include the addition of our thirteenth full-service branch and market headquarters, which opened May 18, 2009 in the Tega Cay community of Fort Mill, South Carolina. In addition, the six months ended June 30, 2008 reflected only five months of expenses from the four branches added from the Merger. Given the recent downturn in the economy, we have embarked on an aggressive expense reduction campaign that we believe will save us over $5 million in annual expenditures compared to our level of operating expenses in 2008. 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 other noninterest expenses.

Salaries and employee benefits decreased for the six months ended June 30, 2009 compared to 2008 by $473,000, or 8.4%, from $5.6 million to $5.1 million, as we have eliminated and/or combined many positions since the six months ended June 30, 2008. While the cost of personnel had increased in recent quarters to support our expansion into new markets, particularly our addition of four full-service branches in the Columbia market with the acquisition of Carolina National on January 31, 2008, and two full-service branches opened since the summer of 2008, our revised strategic plan does not provide for our expansion through branching in the near term. Therefore, our analysis of overall employee efficiency has resulted in the streamlining of our personnel needs through the reduction or combination of certain employee positions.

Occupancy and equipment expenses were relatively constant between the six months ended June 30, 2008 and 2009, with an increase of only 0.9% reflected for the period ended June 30, 2009. The costs of the four new Columbia area full-service branches which were added to our branch network on January 31, 2008, are reflected in the six months ended June 30, 2008 for only five months because the Merger occurred at the end of January of 2008. The positive effects of many of our recently renegotiated vendor contracts are reflected in the negligible increase in occupancy and equipment expenses from 2008 to 2009, despite including a full six months of expenses for the Columbia area branches.

FDIC insurance expense increased $1.1 million, or 428.5%, from $267,000 for the six-month period ended June 30, 2008, to $1.4 million for the six-month period ended June 30, 2009. This increase includes increased annual premiums by the FDIC due to the increase in our deposit base and our current financial condition and the accrual during the second quarter of 2009 for a special assessment to be paid during the third quarter as a result of the recessionary U.S. economy and increased numbers of bank failures.

Professional fees increased by $312,000, or 73.8%, from 2008 to 2009 due to the costs of various outside consultants enlisted in our efforts to comply with the requirements of the consent order with the OCC.

Data processing and ATM expenses were $594,000 and $650,000 for the six months ended June 30, 2009 and 2008, respectively. The majority of the decrease of $56,000, or 8.6%, reflects the impact of efficiencies achieved through the Merger, as the six-month period ended June 30, 2008 included trailing expenses driven by Carolina National data processing costs. We have contracted with an outside computer service company to provide our core data processing services. A significant portion of the fee charged by the third party processor is directly related to the number of loan and deposit accounts and the related number of transactions. The growth in deposit accounts is due to the increasing customer base resulting from the full-service branches added throughout 2007 and in 2008. As five of our twelve branches are less than two years old, we expect their customer base, and the related servicing costs, to grow in the coming years. However, we evaluate our operating costs on an ongoing basis, with the goal of reducing or managing expenses while maintaining the outstanding customer service that is integral to our bank.

Other real estate owned expense increased by $248,000, or 387.5%, from $64,000 for the six months ended June 30, 2008 to $312,000 for the six months ended June 30, 2009 as the level of foreclosed assets increased from 2008 to 2009. This expense includes costs incurred to maintain properties we have foreclosed on, including property taxes and insurance, utilities, property renovations and maintenance. These expenses also would include any writedowns to the carrying value of these foreclosed properties as market conditions change subsequent to the foreclosure action. The repossessed collateral is made up of single-family residential properties in varying stages of completion and various commercial properties. These properties are being actively marketed and maintained with the primary objective of liquidating the collateral at a level which most accurately approximates fair market value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time.

Loan related expenses decreased by $61,000, or 20.3%, from $300,000 for the six months ended June 30, 2008 to $239,000 for the six months ended June 30, 2009 due to our deliberately decreased loan origination activities during 2009.

Included in the line item “Other,” which increased $26,000, or 3.1%, between 2009 and 2008, are charges for fees paid to our board of directors and our regional boards in the Greenville, Columbia and Charleston markets; postage, printing and stationery expenses; and various customer-related expenses. As of February 28, 2009, board fees were suspended due to the bank’s reduced profitability. Also included in noninterest expense for the six months ended June 30, 2009 was the one-time writedown of our investment in nonmarketable equity securities of $117,000, which we determined to be impaired due to the closure of Silverton Bank on May 1, 2009 by its primary regulator.

Provision for Income Taxes

Income tax expense can be analyzed as a percentage of net income before income taxes. The following discussions set forth information related to our income tax expense for the three and six-month periods ended June 30, 2009 and 2008 (dollars in thousands).

	For the Three Months Ended June 30,
		2009			2008
Provision for income taxes		$	-		$	95
Net income before income taxes			(20,029	)		284
Effective income tax rate			0.0	%		33.5	%

	For the Six Months Ended June 30,
		2009			2008
Provision for income taxes		$	-		$	466
Net income before income taxes			(21,391	)		1,390
Effective income tax rate			0.0	%		33.5	%

Our effective tax rate for the three and six-month periods ended June 30, 2009 decreased from the three and six-month periods ended June 30, 2008. The deferred tax expense recognized to record the valuation allowance against the deferred tax asset as of December 31, 2008 completely offset the deferred tax benefit recognized to reflect the impact of nontaxable income recorded in 2009 in addition to the tax benefit of the increase in the net operating loss reflected for the three and six months ended June 30, 2009.

Balance Sheet Review

General

As of June 30, 2009, we had total assets of $834.7 million, an increase of $22.0 million, or 2.7%, over total assets of $812.7 million as of December 31, 2008. Total assets on June 30, 2009, and December 31, 2008, consisted of loans, net of unearned income, of $602.6 million and $686.3 million, respectively; securities available for sale of $103.4 million and $81.7 million, respectively; other assets of $22.0 million and $23.0 million, respectively; premises and equipment, net of accumulated depreciation and amortization of $8.5 million and $7.6 million, respectively; and cash and cash equivalents of $88.6 million and $7.7 million, respectively.

Our interest-earning assets, consisting of loans, net of unearned income, securities available for sale and interest-earning bank balances, grew to $823.0 million as of June 30, 2009, or an increase of 6.1% over the balance of $775.6 million as of December 31, 2008. We recently have launched several very successful deposit specials to lessen our current and future dependence on overnight borrowings. These specials have lasted only a short number of days, have offered attractive terms for new money to the bank, and have produced positive results by increasing market exposure and boosting liquidity. As a result, our cash and due from banks, interest bearing bank balances and federal funds sold had increased to $88.6 million, or 10.5% of total assets as of June 30, 2009 from $7.7 million or 0.91% of total assets as of December 31, 2008.

As of June 30, 2009, our interest-earning assets also included mortgage loans held for sale, an asset resulting from the addition of the wholesale mortgage division effective January 29, 2007. During the six months ended June 30, 2009, our wholesale mortgage division, combined with our previously existing retail mortgage staff, originated a total of approximately $141.7 million in loans to be sold to secondary market investors. Of these loans held for sale, approximately $151.4 million had been sold as of June 30, 2009, with approximately $6.7 million remaining on the balance sheet as mortgage loans held for sale, compared to $16.4 million at December 31, 2008. Due to the nature of this division, the loans held for sale typically are held for a seven- to ten-day period. Therefore, the liquidity needs of this activity have leveled off since its initial reporting period in 2007, as the ongoing activity of the wholesale mortgage division generally funds future loans with the proceeds from the sale of loans in the existing portfolio.

Premises and equipment increased by $857,000, net of purchases and depreciation expense, during the six months ended June 30, 2009, primarily due to the construction of the bank’s thirteenth full-service branch in the Tega Cay/Fort Mill community of York County. This branch and the market headquarters for our northern region opened May 18, 2009.

Our liabilities on June 30, 2009, were $815.8 million, an increase of 5.7% over liabilities as of December 31, 2008, of $772.1 million, and consisted primarily of deposits of $721.6 million, $67.1 million in Federal Home Loan Bank advances, $13.4 million in junior subordinated debentures, and $9.6 million in long-term debt.

As of June 30, 2009, our interest-bearing deposits included wholesale funding in the form of brokered certificates of deposit (“CDs”) of approximately $243.5 million, an increase of 62.1% over brokered CDs as of December 31, 2008, of $150.2 million. We generally obtain out-of-market time deposits of $100,000 or more through brokers with whom we maintain ongoing relationships. The guidelines governing our participation in brokered CD programs are part of our Asset Liability Management Program Policy, which is reviewed, revised and approved annually by our Asset Liability Committee. In addition, we also generally accept brokered CDs only from approved correspondents. These guidelines allow us to take advantage of the attractive terms that wholesale funding can offer while mitigating the inherent related risk.

Our ability to access brokered deposits through the wholesale funding market is now restricted as a result of the consent order that our bank entered into with the OCC on April 27, 2009. Our bank is not able to accept, renew or rollover brokered deposits without being granted a waiver of this prohibition by the FDIC. There is no assurance that the FDIC will grant us a waiver. Please see Regulatory Matters under Note 1 – Nature of Business and Basis for Presentation for more details on restrictions on our use of brokered CDs as a funding source. We are using cash and unpledged liquid investment securities as well as retail deposits gathered from our state-wide branch network to fund the maturity of our brokered deposits.

Investments

On June 30, 2009, and December 31, 2008, our investment securities portfolio of $103.4 and $81.7 million, respectively, represented approximately 12.4% and 10.2%, respectively, of our interest-earning assets. As of June 30, 2009, and December 31, 2008, we were invested in U.S. Treasury securities, U.S. Government agency securities, mortgage-backed securities, and municipal securities with an amortized cost of $103.1 million and $80.8 million, respectively, for unrealized gains of approximately $249,000 and $861,000, respectively.

The increase in our securities portfolio since December 31, 2008 primarily resulted from the investment of approximately $50 million in U.S. Treasury securities. Partially offsetting this increase was the sale of several mortgage-backed and municipal securities totaling $25.5 million, which were sold for a gain of approximately $469,000. The decision to sell the mortgage-backed securities was made based on the Federal Reserve’s announcement on March 18, 2009, that they would be purchasing additional mortgage and agency debt to further increase the size of the Federal Reserve’s balance sheet. The impact of this decision during this time of low interest rates presented an opportunity for us to recognize unrealized gains on the sale of the securities. The municipal security sales have been strategically planned to minimize our risk while maximizing the tax benefit gleaned from the municipal securities within our portfolio. The sales of securities during the six months ended June 30, 2009 was partially offset by purchases made during the same period to reinvest funds received from the sales to provide collateral for our municipal deposits.

Fair values and yields on our investments (all available for sale) as of June 30, 2009, and December 31, 2008, are shown in the following tables based on contractual maturity dates. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Yields on municipal securities are presented on a tax equivalent basis (dollars in thousands).

	As of June 30, 2009
	Within one year			After one but within five years			After five but within ten years			Over ten years			Total
	Amount		Yield	Amount		Yield	Amount		Yield	Amount		Yield	Amount		Yield
U.S. Government/government sponsored agencies	$	-	-	$	-	-	$	1,896	4.25%	$	-	-	$	1,896	4.25%
U.S. Treasury Securities		49,990	0.00%		-	-		-	-		-	-		49,990	0.00%
Mortgage-backed securities		749	4.66%		1,599	4.22%		1,105	4.00%		36,724	5.19%		40,177	5.11%
Municipal securities		-	-		-	-		3,189	3.89%		8,124	4.11%		11,313	4.05%
Total	$	50,739	4.66%	$	1,599	4.22%	$	6,190	4.02%	$	44,848	5.00%	$	103,376	4.76%

	As of December 31, 2008
	Within one year			After one but within five years			After five but within ten years			Over ten years			Total
	Amount		Yield	Amount		Yield	Amount		Yield	Amount		Yield	Amount		Yield
U.S. Government/government sponsored agencies	$	-	-	$	-	-	$	-	-	$	4,013	5.00%	$	4,013	5.10%
Mortgage-backed securities		106	5.00%		4,117	4.24%		1,284	4.20%		52,663	5.18%		58,170	5.09%
Municipal securities		-	-		1,359	2.92%		5,695	3.84%		12,425	3.52%		19,479	3.57%
Total	$	106	5.00%	$	5,476	3.91%	$	6,979	3.70%	$	69,101	4.88%	$	81,662	4.73%

The amortized cost and fair value of our investments (all available for sale) as of June 30, 2009, and December 31, 2008, are shown in the following table (dollars in thousands).

	June 30, 2009						December 31, 2008
	Amortized			Fair			Amortized			Fair
	Cost			Value			Cost			Value
U.S. Government/government sponsored agencies		$	2,000		$	1,896		$	3,950		$	4,013
U.S. Treasury Securities			49,993			49,990			-			-
Mortgage-backed securities			39,343			40,177			56,971			58,170
Municipal securities			11,783			11,313			19,880			19,479
Total		$	103,119		$	103,376		$	80,801		$	81,662

We also maintain certain equity investments required by law that are included in the consolidated balance sheets as “other assets.” The carrying amounts of these investments as of June 30, 2009, and December 31, 2008, consisted of the following:

	As of June 30,			As of December 31,
		2009		2008
Federal Reserve Bank stock		$	1,821	$	1,821
Federal Home Loan Bank stock			4,594		5,344

The level of FHLB stock varies with the level of FHLB advances and decreased during the three months ended June 30, 2009 to reflect the net decrease in FHLB advances during the quarter. The level of Federal Reserve Bank (“FRB”) stock is tied to our equity. We are subject to the FHLB’s credit risk rating which was effective June 27, 2008. This revised policy incorporated enhancements to the FHLB’s credit risk rating system which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter. In addition, residential collateral discounts have been recently applied which may further reduce our borrowing capacity. We have been notified by FHLB that it will not allow future advances to us while we are operating under our current regulatory enforcement action.

No ready market exists for these stocks and they have no quoted market value. However, redemption of these stocks has historically been at par value. Accordingly, we believe the carrying amounts are a reasonable estimate of fair value.

Other Real Estate

Other real estate owned of $11.6 million was recorded at $9.7 million, net of reserves of $1.9 million, including estimated costs to sell of $0.7 million as of June 30, 2009. The balance in other real estate owned consists of property acquired through foreclosure which has been recorded at its net realizable value. During the six months ended June 30, 2009, the gross balance in other real estate owned increased by approximately $2.7 million with the sale of $3.2 million in foreclosed properties during the six months ended June 30, 2009. The sale of these properties was partially offset by the transfer of property acquired through foreclosure during the six months ended June 30, 2009. The transfer of these properties represents the next logical step from their previous classification as nonperforming loans to other real estate owned to give us the ability to control the properties. The repossessed collateral is primarily made up of single-family residential properties in varying stages of completion. These properties are being actively marketed and maintained with the primary objective of liquidating the collateral at a level which most accurately approximates fair market value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time. The carrying value of these assets is believed to be representative of their fair market value, although there can be no assurance that the ultimate proceeds from the sale of these assets will be equal to or greater than the carrying values.

Other Assets

As of June 30, 2009, other assets decreased slightly to $22.0 million from $23.0 million as of December 31, 2008. Included in other assets are bank owned life insurance (“BOLI”), interest receivable on loans and investment securities and investments in nonmarketable equity securities, as discussed in “Investments” above. While BOLI growth has been marginal, interest receivable decreased approximately $454,000, or 14.9%, and investments in nonmarketable equity securities decreased $867,000, or 11.3%, each compared to December 31, 2008. Interest receivable and investments in bank stock each increase and decrease in tandem with their related assets, the loan and investment portfolios, and FHLB advances and our bank’s capital, respectively.

Loans

Since loans typically provide higher interest yields than do other types of interest-earning assets, we invested a substantial percentage of our earning assets in our loan portfolio. Average loans for the six months ended June 30, 2009 and 2008, were $672.8 million and $633.8 million, respectively. Total loans outstanding as of June 30, 2009, and December 31, 2008, were $626.1 million and $709.3 million, respectively, before applying the allowance for loan losses. Included in the $709.3 million and $626.1 million in total loans at December 31, 2008 and June 30, 2009, were $16.4 million and $6.7 million in wholesale mortgages held for sale, respectively.

The following table summarizes the composition of our loan portfolio as of June 30, 2009 and December 31, 2008 (dollars in thousands).

	June 30, 2009						December 31, 2008
	Amount			% of Total (1)			Amount			% of Total (1)
Commercial and industrial	$	39,158			6.25	%	$	48,432			6.83	%
Commercial secured by real estate		353,357			56.44	%		429,868			60.61	%
Real estate - residential mortgages		220,474			35.21	%		206,910			29.17	%
Installment and other consumer loans		7,022			1.12	%		8,439			1.19	%
Total loans		620,011						693,649
Mortgage loans held for sale		6,714			1.07	%		16,411			2.31	%
Unearned income		(602	)		(0.10	%)		(773	)		(0.11	%)
Total loans, net of unearned income		626,123			100.00	%		709,287			100.00	%
Less allowance for loan losses		(23,534	)		3.80	%		(23,033	)		3.32	%
Total loans, net	$	602,589					$	686,254

The principal component of our loan portfolio for all periods presented was commercial loans secured by real estate mortgages. As the loan portfolio grows, the current mix of loans may change over time. We do not generally originate traditional long-term residential mortgages, but we do issue traditional second mortgage residential real estate loans and home equity lines of credit. We obtain a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan. Generally, we limit the loan-to-value ratio on loans we make to 80%. Due to the short time our portfolio has existed, the current mix may not be indicative of the ongoing portfolio mix. We attempt to maintain a relatively diversified loan portfolio to help reduce the risk inherent in concentration in certain types of collateral.

The decrease in our commercial loans secured by real estate from December 31, 2008, to June 30, 2009, is primarily due to the recent downturn in the residential real estate market. The commercial real estate loans we originate are primarily secured by shopping centers, office buildings, warehouse facilities, retail outlets, hotels, motels and multi-family apartment buildings.

Commercial real estate lending entails unique risks compared to residential lending. Commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience of such loans is typically dependent upon the successful operation of the real estate project. These risks can be significantly affected by supply and demand conditions in the market for office and retail space and for apartments and, as such, may be subject, to a greater extent, to adverse conditions in the economy. In dealing with these risk factors, we generally limit ourselves to a real estate market or to borrowers with which we have experience. We generally concentrate on originating commercial real estate loans secured by properties located within our market areas. In addition, many of our commercial real estate loans are secured by owner-occupied property with personal guarantees for the debt.

The recent downturn in the real estate market could continue to increase loan delinquencies, defaults and foreclosures, and could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides alternate sources of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. As real estate values have declined, we have been required to increase our allowance for loan losses. If during a period of reduced real estate values we are required to liquidate the property collateralizing a loan to satisfy the debt or to increase the allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition. Our other real estate owned net of reserves has grown to $9.7 million as of June 30, 2009, and these repossessed properties are being actively marketed and maintained with the primary objective of liquidating the collateral at a level which most accurately approximates fair market value and allows recovery of as much of the unpaid principal balance as possible upon the sale of the property in a reasonable period of time. Although we closely monitor and manage risk concentrations and utilize various portfolio management practices, the increase in overall nonperforming loans could result in a continued decrease in earnings and future increases in the provision for loan losses and loan chargeoffs, all of which could have a material adverse effect on our financial condition and results of operations.

Commercial real estate loans make up the majority of our nonaccrual loans due to the downturn in the residential housing industry. The following table shows the spread of the nonaccrual loans geographically and by product type (dollars in thousands).

	June 30, 2009 CRE Nonaccrual Loans by Geography
CRE Nonaccrual Loans by Product Type	Upstate			Midlands			Coastal			Northern			Other			Total
Residential Construction		3,629			1,874			8,841			1,219			-			15,563		14.6	%
Residential Other		8,780			2,908			10,399			1,677			720			24,484		22.9	%
Residential Land		6,938			3,801			16,887			6,773			-			34,399		32.2	%
Commercial Owner Occupied		5,187			469			865			3,375			-			9,896		9.3	%
Commercial Other		5,713			679			7,064			117			3,798			17,371		16.2	%
Total		30,247			9,731			44,056			13,161			4,518			101,713		95.2	%

		28.3	%		9.1	%		41.2	%		12.3	%		4.2	%		95.2	%
Total Nonperforming Assets		106,900

	December 31, 2008 CRE Nonaccrual Loans by Geography
	Upstate			Midlands			Coastal			Northern & Other			Total			% of Total
CRE Nonaccrual Loans by Product Type
Residential construction	$	1,754		$	1,726		$	11,653		$	2,814		$	17,947			26.0	%
Residential other		5,321			1,207			6,497			414			13,440			19.5	%
Residential land		3,658			253			7,281			4,189			15,382			22.3	%
Commercial owner occupied		1,635			269			3,612			105			5,622			8.1	%
Commercial other		1,861			488			4,234			-			10,242			14.8	%
Commercial land		0			250			0			3,658			250			0.4	%
Total	$	14,230		$	4,194		$	33,277		$	11,180		$	62,883			91.1	%
CRE Nonaccrual Loans as % of Total Nonaccrual		20.6	%		6.1	%		48.2	%		16.2	%		91.1	%
Total Nonaccrual Loans December 31, 2008	$	69,052

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following tables is based on the contractual maturities of individual loans, including loans that may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon their maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

The following table summarizes the loan maturity distribution by type and related interest rate characteristics as of June 30, 2009, and December 31, 2008 (dollars in thousands).

	As of June 30, 2009
	One year or less		After one year but less than five		After five years years		Total
Commercial	$	9,046	$	11,405	$	439	$	20,890
Real estate - construction		110,779		41,170		424		152,373
Real estate - mortgage		122,530		263,128		54,223		439,881
Consumer and other		4,089		2,402		376		6,867
Total	$	246,444	$	318,105	$	55,462	$	620,011
Mortgage loans held for sale								6,714
Unearned income								(602	)
Total loans, net of unearned income							$	626,123
Loans maturing after one year with:
Fixed interest rates							$	163,320
Floating interest rates							$	210,247

	As of December 31, 2008
	One year or less		After one year but less than five		After five years years		Total
Commercial	$	12,221	$	12,397	$	441	$	25,059
Real estate - construction		171,062		51,718		226		223,006
Real estate - mortgage		78,801		294,753		63,747		437,301
Consumer and other		4,485		3,114		684		8,283
Total	$	266,569	$	361,982	$	65,098	$	693,649
Mortgage loans held for sale								16,411
Unearned income								(773	)
Total loans, net of unearned income							$	709,287
Loans maturing after one year with:
Fixed interest rates							$	191,132
Floating interest rates							$	235,948

Allowance for Loan Losses

The allowance for loan losses represents an amount that we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Assessing the adequacy of the allowance for loan losses is a process that requires considerable judgment. Our judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans, including consideration of factors such as the balance of impaired loans; the quality, mix and size of our overall loan portfolio; economic conditions that may affect the borrower’s ability to repay; the amount and quality of collateral securing the loans; our historical loan loss experience; and a review of specific problem loans. We adjust the amount of the allowance periodically based on changing circumstances as a component of the provision for loan losses. We charge recognized losses against the allowance and add subsequent recoveries back to the allowance.

We calculate the allowance for loan losses for specific types of loans (excluding mortgage loans held for sale) and evaluate the adequacy on an overall portfolio basis utilizing our credit grading system which we apply to each loan. We combine our estimates of the reserves needed for each component of the portfolio, including loans analyzed on a pool basis and loans analyzed individually. The allowance is divided into two portions: (1) an amount for specific allocations on significant individual credits and (2) a general reserve amount.

Specific Reserve

We analyze individual loans within the portfolio and make allocations to the allowance based on each individual loan’s specific factors and other circumstances that affect the collectability of the credit in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” Significant individual credits classified as doubtful or substandard/special mention within our credit grading system require both individual analysis and specific allocation.

Loans in the substandard category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action such as declining or negative earnings trends and declining or inadequate liquidity. Loans in the doubtful category exhibit the same weaknesses found in the substandard loan; however, the weaknesses are more pronounced. These loans, however, are not yet rated as loss because certain events may occur which could salvage the debt such as injection of capital, alternative financing, or liquidation of assets.

In these situations where a loan is determined to be impaired (primarily because it is probable that all principal and interest due according to the terms of the loan agreement will not be collected as scheduled), the loan is excluded from the general reserve calculations described below and is assigned a specific reserve. We calculate specific reserves on those impaired loans exceeding $250,000. These reserves are based on a thorough analysis of the most probable source of repayment which is usually the liquidation of the underlying collateral, but may also include discounted future cash flows or, in rare cases, the market value of the loan itself.

Generally, for larger collateral dependent loans, current market appraisals are ordered to estimate the current fair value of the collateral. However, in situations where a current market appraisal is not available, management uses the best available information (including recent appraisals for similar properties, communications with qualified real estate professionals, information contained in reputable trade publications and other observable market data) to estimate the current fair value. The estimated costs to sell the subject property are then deducted from the estimated fair value to arrive at the “net realizable value” of the loan and to determine the specific reserve on each impaired loan reviewed. The credit risk management group periodically reviews the fair value assigned to each impaired loan and adjusts the specific reserve accordingly.

General Reserve

We calculate our general reserve based on a percentage allocation for each of the categories of the following unclassified loan types: real estate, commercial, SBA, consumer, A&D/construction and mortgage. We apply our historical trend loss factors to each category and adjust these percentages for qualitative or environmental factors, as discussed below. The general estimate is then added to the specific allocations made to determine the amount of the total allowance for loan losses.

We also maintain a general reserve in accordance with December 2006 regulatory interagency guidance in our assessment of the loan loss allowance. This general reserve considers qualitative or environmental factors that are likely to cause estimated credit losses including, but not limited to: changes in delinquent loan trends, trends in risk grades and net chargeoffs, concentrations of credit, trends in the nature and volume of the loan portfolio, general and local economic trends, collateral valuations, the experience and depth of lending management and staff, lending policies and procedures, the quality of loan review systems, and other external factors.

Credit Risk Management

Our credit risk management function is comprised of our senior credit officer and the 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 the board of directors.

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.

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 quarter ended June 30, 2009 to $101.6 million, with related valuation allowances of $8.4 million, to address the risks within our loan portfolio. 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 along the South Carolina coast, and the economy in general. Recent reviews by the credit department have specifically included several of 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 have 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.

The actual loss on disposition of the loan and/or the underlying collateral may be more or less than the amount charged off to date. The large provision for loan loss this quarter is part of our proactive strategy to accelerate our efforts to resolve our non-performing assets with the goal of removing them from our balance sheet.

As of June 30, 2009 and 2008, nonperforming assets (nonperforming loans plus other real estate owned) were $116.6 million and $12.0 million, respectively. Foregone interest income on these nonaccrual loans and other nonaccrual loans charged off during the periods ended June 30, 2009 and 2008, was approximately $1,279,000 and $360,000, respectively. There was one performing loan of $498,000 contractually past due in excess of 90 days and still accruing interest at June 30, 2009. There were no loans contractually past due in excess of 90 days and still accruing interest at June 30, 2008. There were impaired loans, under the criteria defined in FAS 114, of $101.6 million and $18.5 million, with related valuation allowances of $8.4 million (net of $19.7 million in chargeoffs during the six months ended June 30, 2009) and $2.0 million at June 30, 2009 and 2008, respectively.

The following table sets forth the breakdown of the allowance for loan losses by loan category and the percentage of loans in each category to gross loans for each of the periods represented (dollars in thousands).

	As of					As of				As of
	June 30, 2009					December 31, 2008				June 30, 2008
Commercial	$	6,552	$	3.4	%	$	1,787	3.6	%	$	576		6.3	%
Real estate - construction	10,243			24.6	%		12,648	32.1	%		4,110		34.9	%
Real estate - mortgage	6,675			70.9	%		8,509	63.1	%		4,051		57.6	%
Consumer	64			1.1	%		89	1.2	%		90		1.2	%
Unallocated		N/A		N/A			N/A	N/A			(93	)	N/A
Total allowance for loan losses	$	23,534		100.0	%	$	23,033	100.0	%	$	8,734		100.0	%

We believe that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of further losses and does not restrict the use of the allowance to absorb losses in any other category.

The provision for loan losses has been made primarily as a result of management’s assessment of general loan loss risk after considering historical operating results, as well as comparable peer data. Our evaluation is inherently subjective as it requires estimates that are susceptible to significant change. In addition, various regulatory agencies review our allowance for loan losses through their periodic examinations, and they may require us to record additions to the allowance for loan losses based on their judgment about information available to them at the time of their examinations. Our losses will undoubtedly vary from our estimates, and there is a possibility that chargeoffs in future periods will exceed the allowance for loan losses as estimated at any point in time. Please see Note 5 - Loans in the Notes to unaudited Consolidated Financial Statements included in this report for additional information.

The following table sets forth the changes in the allowance for loan losses for the twelve-month period ended December 31, 2008 and the six months ended June 30, 2009 and 2008 (dollars in thousands).

	As of or For the Six Months Ended June 30, 2009			As of or For the Year Ended December 31, 2008			As of or For the Six Months Ended June 30, 2008
Balance, beginning of period	$	23,033		$	4,951		$	4,951
Allowance from acquisition		-			2,976			2,976
Provision charged to operations		20,197			20,460			1,409
Loans charged off		-			-			-
Residential housing related		(11,717	)		(3,771	)		(441	)
Owner occupied commercial		(872	)		-			-
Other commercial		(6,769	)		-			(181	)
Other		(341	)		(1,612	)		7
Total chargeoffs		(19,699	)		(5,383	)		(629	)
Recoveries of loans previously charged off		3			29			27
Balance, end of period	$	23,534		$	23,033		$	8,734
Allowance to loans, year end		3.80	%		3.32	%		1.25	%
Net chargeoffs to average loans		5.86	%		0.78	%		0.18	%
Nonaccrual loans	$	106,900		$	69,052		$	24,118
Past due loans in excess of 90 days on accrual status		-			-			-
Other real estate owned		9,666			6,417			8,142
Total nonperforming assets	$	116,566		$	75,469		$	32,260

Generally, a loan is placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. A payment of interest on a loan that is classified as nonaccrual is recognized as income when received. We typically have had low levels of nonperforming loans, but the current economic conditions have increased those levels to $106.9 million in nonaccrual loans as of June 30, 2009. The net chargeoffs to average loans ratio for the six months ended June 30, 2009, was 5.86% as compared to 0.18% for the six months ended June 30, 2008. For the six months ended June 30, 2009, total net chargeoffs were $19.7 million compared to $602,000 for the same period in 2008.

Deposits

Our primary source of funds for loans and investments is our deposits. National and local market trends over the past several years suggest that consumers have moved an increasing percentage of discretionary savings funds into investments such as annuities, stocks, and fixed income mutual funds. Accordingly, it has become more difficult to attract deposits.

The following table shows the average balance amounts and the average rates paid on deposits held by us for the six- month periods ended June 30, 2009 and 2008, and for the year ended December 31, 2008 (dollars in thousands):

	June 30, 2009					December 31, 2008					June 30, 2008
	Amount		Rate			Amount		Rate			Amount		Rate
Demand deposit accounts	$	38,184		-		$	41,920		-		$	42,230		-
NOW accounts		41,351		0.56	%		43,666		1.83	%		44,998		1.55	%
Money market and savings accounts		88,475		1.33	%		121,919		2.62	%		113,928		2.90	%
Time deposits		533,764		3.18	%		435,285		4.13	%		428,622		4.34	%
Total deposits	$	701,774				$	642,790				$	629,778

Core deposits, which exclude time deposits of $100,000 or more and municipal deposits, provide a relatively stable funding source for our loan portfolio and other interest-earning assets. Our core deposits were $305.2 million and $357.1 million as of June 30, 2009, and December 31, 2008, respectively. The maturity distribution of our time deposits of $100,000 or more as of June 30, 2009, is as follows (dollars in thousands):

	As of June 30,
	2009
Three months or less	$	109,960
Over three through six months		56,731
Over six through twelve months		123,506
Over twelve months		106,725
Total	$	396,922

During the first quarter of 2009, we received a final report from our bank’s regulatory safety and soundness examination which was completed in November 2008, and on April 27, 2009 our bank entered into a consent order with the OCC. Additionally, our holding company entered into a written agreement with the FRB which contains provisions similar to the articles in the bank’s consent order with the OCC and is attached hereto as Exhibit 10.1. Our ability to access brokered deposits through the wholesale funding market is now restricted as a result of the consent order that our bank entered with the OCC on April 27, 2009. Our bank is not able to accept, renew or rollover brokered deposits without being granted a waiver of this prohibition by the FDIC. There is no assurance that the FDIC will grant us a waiver. We are using cash and unpledged liquid investment securities as well as retail deposits gathered from our state-wide branch network to fund the maturity of our brokered deposits.

Other Interest-Bearing Liabilities

The following tables outlines our various sources of borrowed funds as of and during the six-month period ended June 30, 2009, and the year ended December 31, 2008, the maximum point for each component during the periods and the average balance for each period, and the average interest rate that we paid for each borrowing source. The maximum balance represents the highest indebtedness for each component of borrowed funds at any time during each of the periods shown (dollars in thousands):

	Ending		Period-End			Maximum		Average for the Period
	Balance		Rate			Balance		Balance		Rate
As of or for the Six Months Ended June 30, 2009
FHLB advances	$	67,064		3.07	%	$	88,309	$	71,481		2.93	%
Federal funds purchased & other borrowings	$	9,641		6.00	%	$	13,641	$	15,397		4.28	%
Junior subordinated debentures	$	13,403		2.83	%	$	13,403	$	13,403		3.69	%
As of or for the Year Ended December 31, 2008
FHLB advances	$	86,363		2.48	%	$	90,849	$	60,538		3.39	%
Federal funds purchased & other borrowings	$	21,373		1.17	%	$	47,845	$	19,365		2.78	%
Junior subordinated debentures	$	13,403		4.52	%	$	13,403	$	13,403		5.51	%

As of June 30, 2009, and December 31, 2008, we had short-term lines of credit with correspondent banks to purchase federal funds totaling $9.0 million and $28.0 million, respectively.

Capital Resources

General

Shareholders’ equity on June 30, 2009, was $18.9 million, as compared to shareholders’ equity on December 31, 2008, of $40.6 million. The decrease between December 31, 2008 and June 30, 2009 reflects the loss recognized for the period ended June 30, 2009, primarily made up of provision for loan losses of $20.2 million due to chargeoffs recognized during the six months ended June 30, 2009 on nonperforming assets

The unrealized gain on securities available for sale as of June 30, 2009 reflects the change in the market value of these securities since December 31, 2008. We believe that the change in the unrealized gain reflected as of June 30, 2009, was attributable to changes in market interest rates. Our securities portfolio includes investments that are direct obligations of the United States (“U.S.”) government, Federal Agency and U.S. Government obligations and various other bank grade investment securities as prescribed by our bank’s Investment Policy. We use securities available for sale to pledge as collateral to secure public deposits and for other purposes required or permitted by law, including as collateral for FHLB advances outstanding and borrowings from the short-term FRB discount window. Due to the availability of various liquidity sources, we intend to hold these securities to maturity.

Regulatory Capital

The Federal Reserve and bank regulatory agencies require bank holding companies and financial institutions to maintain capital at adequate levels based on a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Under the capital adequacy guidelines, capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets, plus qualifying preferred stock and trust preferred securities combined and limited to 45% of Tier 1 capital, with the excess being treated as Tier 2 capital. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the reserve for loan losses subject to certain limitations. As of June 30, 2009, the amount of our reserve for loan losses that was not included due to these limitations was approximately $15.6 million. The bank is also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.

We utilize trust preferred securities to meet our holding company’s capital requirements up to regulatory limits. As of June 30, 2009, we had formed three statutory trust subsidiaries for the purpose of raising capital via this avenue we contributed to our bank subsidiary the $13.0 million in cash proceeds from the sale of these securities. On December 19, 2003, FNSC Capital Trust I, a subsidiary of our holding company, was formed to issue $3 million in floating rate trust preferred securities. On April 30, 2004, FNSC Capital Trust II was formed to issue an additional $3 million in floating rate trust preferred securities. On March 30, 2006, FNSC Statutory Trust III was formed to issue an additional $7 million in floating rate trust preferred securities. These entities are not included in our consolidated financial statements. The trust preferred securities qualify as Tier 1 capital up to 25% or less of Tier 1 capital, and up to 45% of Tier 1 capital when combined with qualifying preferred shares, with the excess includable as Tier 2 capital. As of June 30, 2009, $5.9 million of the trust preferred securities qualified as Tier 1 capital.

Our holding company and our bank are subject to various regulatory capital requirements administered by the federal banking agencies. Under these capital guidelines, to be considered “adequately capitalized,” we must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, we must maintain a minimum Tier 1 leverage ratio of at least 4%. To be considered “well-capitalized,” a bank generally must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. However, so long as our bank is subject to the enforcement action executed with the OCC on April 27, 2009, it will not be deemed to be well-capitalized even if it maintains these minimum capital ratios to be well-capitalized. Our holding company is subject to similar restrictions as part of the formal agreement signed with the FRB on June 15, 2009.

The following table sets forth the holding company’s and the bank’s various capital ratios as of June 30, 2009, and December 31, 2008. On an ongoing basis, we continue to evaluate various options, such as issuing common or preferred stock, to increase the bank’s capital and related capital ratios in order to maintain adequate capital levels.

	As of June 30,						As of December 31,
	2009						2008
	Holding						Holding
	Co.			Bank			Co.			Bank
Total risk-based capital		6.21	%		7.53	%		8.65	%		9.75	%
Tier 1 risk-based capital		3.78	%		6.25	%		6.30	%		8.48	%
Leverage capital		2.68	%		4.42	%		5.20	%		7.23	%

The decrease in our capital ratios from December 31, 2008, to June 30, 2009, is primarily due to the net loss recorded for the period ended June 30, 2009. As a result of the terms of the executed consent order, we would no longer be deemed well-capitalized, regardless of our capital levels. The FRB has also required our bank holding company to enter into a written agreement which contains provisions similar to the articles in the bank’s consent order with the OCC. Please see Regulatory Matters under Note 1 - Nature of Business and Basis for Presentation for further discussion of our capital requirements under the consent order with the OCC and the written agreement with the FRB. Under the FDIC’s “prompt corrective action” regulations, our bank’s capital was classified as less than adequately capitalized due to the level of our total risk-based capital ratios as of June 30, 2009. As a result of this classification we will be required to submit a capital restoration plan to the OCC.

Strategic Capital Plan

We have an active program for managing our shareholder’s equity. Historically, we have used capital to fund organic growth, pay dividends on our preferred stock and repurchase our shares. Our management team is focused on carefully managing the size of our loan portfolio to maintain an asset base that is supported by our capital resources. Our objective is to produce above-market long-term returns by opportunistically using capital when returns are perceived to be high and issuing/accumulating capital when such costs are perceived to be low.

As a result of result of recent market disruptions, the availability of capital (principally to financial services companies like ours) has become significantly restricted. Those companies wishing to survive the current economic environment and prosper will need a strong capital base that supports the asset size of the company. While some companies have been successful at raising capital, the cost of that capital has been substantially higher than the prevailing market rates prior to the volatility. The consent order that we entered into with the OCC on April 27, 2009 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. In addition, as of June 30, 2009, as a result of increased losses in the first half of 2009, our capital levels fell below the minimum regulatory capital ratios for “adequately-capitalized” banks. We are working on efforts to achieve the Tier 1 capital levels imposed under the consent order, including by raising additional capital, limiting our growth, and selling assets, but we do not anticipate achieving these levels by August 25, 2009, the deadline specified in the consent order.

In addition, losses for 2008 and 2009 have adversely impacted our capital position by eroding our capital cushion. We anticipate that we will also need additional capital to take the write-downs incurred as we continue removing our non performing assets from our balance sheet, given the particularly challenging real estate market. As a result, we have been pursuing a plan to increase our capital ratios in order to strengthen our balance sheet and satisfy the commitments we have made to our bank regulator in this area. In light of deteriorating economic conditions in the United States, increased levels of nonperforming assets, and our level of losses, the need to raise capital in the short-term has become more critical to us.

During 2008, we formed a Strategic Planning Committee consisting of five members of our board of directors. This committee meets on a very frequent basis and has been authorized by the board of directors to monitor and make recommendations regarding the capital, liquidity and asset quality of our bank.

Under the terms of the consent order that we entered into with the OCC on April 27, 2009, our board submitted a written strategic plan and capital plan to the OCC on July 24, 2009 covering the three-year period. The plan establishes 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. Once we receive the OCC’s written determination of no supervisory objection, our Board of Directors will adopt and implement the plans.

We are actively pursuing a variety of capital raising efforts. At present, the market for raising new capital for banks is limited and uncertain. Accordingly, we cannot be certain of our ability to raise capital on terms that satisfy our goals with respect to our capital ratios. If we are able to raise additional capital, it will likely be on terms that are substantially dilutive to current common shareholders. Under the terms of the written agreement that we entered into with the FRB on June 15, 2009, we submitted a capital plan to the FRB on July 31, 2009. We will adopt the written plan within 10 days of its approval by the FRB.

Preferred Stock

On July 9, 2007, we closed an underwritten public offering of 720,000 shares of Series A Noncumulative Perpetual Preferred Stock at $25.00 per share. Our net proceeds after payment of underwriting discounts and other expenses of the offering were approximately $16.5 million. We used the net proceeds of the preferred stock offering to provide additional capital to support asset growth, expansion of our bank’s branch network, to pay off the balance of $5 million on a revolving line of credit, and to partially fund the cash portion of the consideration to close the acquisition of Carolina National.

The terms of the preferred stock include the payment of quarterly dividends at an annual interest rate of 7.25%. Under the terms of the preferred stock, dividends are declared each quarter at the discretion of our board of directors. The first quarterly dividend was paid in October 2007, as prescribed in the Certificate of Designation of Series A Preferred Stock, and prior to the first quarter of 2009, we had paid quarterly dividends of $326,250. Our board of directors did not declare a dividend for the first or second quarter of 2009. Under the terms of the written agreement entered into with the FRB on June 15, 2009, we must seek prior written approval of the FRB before declaring or paying any dividends.

Dividends

Since our inception, we have not paid cash dividends on our common stock. Our ability to pay cash dividends is dependent on receiving cash in the form of dividends from our bank. However, restrictions currently exist including in the consent order we signed with the OCC, that prohibit our bank from paying cash dividends to the holding company. All dividends from our bank subsidiary to our holding company are subject to prior approval of the OCC and are payable only from the undivided profits of our bank. We distributed 3-for-2 stock splits on March 1, 2004, and January 18, 2006.

We have also distributed shares of our common stock through stock dividends. On May 16, 2006, we issued a stock dividend of 6% to shareholders of record as of May 1, 2006. On March 30, 2007, we issued a stock dividend of 7% to shareholders of record as of March 16, 2007. We may distribute future stock splits and dividends based on our evaluation of a number of factors, including our financial performance and projected capital and earnings levels.

Employee Share Ownership Programs

We encourage employee share ownership through various programs, including the First National Bancshares, Inc. 2000 Stock Incentive Plan, which absorbed the Carolina National Corporation 2003 Stock Option Plan (together the “Stock Option Plan”) as part of the Carolina National acquisition, our Employee Stock Ownership Plan (“ESOP”), and the First National Bancshares, Inc. 2008 Restricted Stock Plan (the “Restricted Stock Plan”). The Stock Option Plan provides for the issuance of stock options in order to reward the recipients and to promote our growth and profitability through additional employee motivation toward our success. Under the Stock Option Plan, options for 600,341 shares of common stock were authorized for grant including 141,374 stock options from the Carolina National merger. Of this amount, net options of 308,530 have been granted to date, with no shares granted in the quarter ended June 30, 2009.

On November 30, 2005, we loaned our ESOP $600,000 which was used to purchase 42,532 shares of our common stock. As of June 30, 2009, the ESOP owned 44,912 shares of our stock, of which 34,065 shares were pledged to secure the loan. The remainder of the shares is being allocated to individual accounts of participants as the debt is repaid. In accordance with the requirements of the SOP 93-6, we presented the shares that were pledged as collateral as a deduction of $478,000 and $518,000 from shareholders’ equity at June 30, 2009 and December 31, 2008, respectively, as unearned ESOP shares in the accompanying consolidated balance sheets.

The Restricted Stock Plan permits the grant of stock awards to our employees, officers and directors at the discretion of the compensation committee. A total of 320,000 shares of common stock have been reserved for issuance under this plan. To date, no shares have been issued pursuant to the Restricted Stock Plan.

Share Repurchase Program

From time to time, our Board of Directors has authorized us to repurchase shares of our common stock pursuant to a formal share repurchase program which expired November 30, 2008 with 50,019 shares remaining available to repurchase. Currently, we must seek prior written approval of the FRB before repurchasing shares of our stock.

Return on Equity and Assets

The following table shows the return on average assets (net income divided by average total assets), return on average equity (net income divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the six-month periods ended June 30, 2009 and 2008, and for the year ended December 31, 2008:

	Six Months Ended June 30, 2009			Year Ended December 31, 2008			Six Months Ended June 30, 2008
Return on average assets		(5.10	%)		(5.40	%)		0.23	%
Return on average equity		(108.12	%)		(54.00	%)		2.38	%
Equity to assets ratio		4.72	%		10.06	%		9.76	%

The ratios shown above reflect a net loss for the period ended June 30, 2009. The period ended June 30, 2008 reflects the growth in net income and the proportionally greater increase in our assets, as well as the capital raised in the 2007 preferred stock offering. For the year ended December 31, 2008, our return on average equity decreased due to a net loss for the year as well as increased equity due to the Merger. The Merger also led to a slight increased equity to assets ratio for the year ended December 31, 2008.

Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been taken into effect in our financial statements. Rather, the statements have been prepared on an historical cost basis in accordance with accounting principles generally accepted in the United States of America.

Unlike most industrial companies, the assets and liabilities of financial institutions such as our holding company and bank are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest-sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

Off-Balance Sheet Arrangements

Through the operations of our bank, we have made contractual commitments to extend credit in the ordinary course of our business activities to meet the financing needs of customers. Such commitments involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets. These commitments are legally binding agreements to lend money at predetermined interest rates for a specified period of time and generally have fixed expiration dates or other termination clauses. We use the same credit and collateral policies in making these commitments as we do for on-balance sheet instruments.

We evaluate each customer’s creditworthiness on a case-by-case basis and obtain collateral, if necessary, based on our credit evaluation of the borrower. In addition to commitments to extend credit, we also issue standby letters of credit that are assurances to a third party that they will not suffer a loss if our customer fails to meet its contractual obligation to the third party. The credit risk involved in the underwriting of letters of credit is essentially the same as that involved in extending loan facilities to customers.

As of June 30, 2009 and December 31, 2008, we had issued commitments to extend credit of $96.1 million and $145.9 million, respectively, through various types of commercial and consumer lending arrangements, of which the majority are at variable rates of interest. Standby letters of credit totaled $1,526,000 and $2,061,000, as of June 30, 2009 and December 31, 2008, respectively. Past experience indicates that many of these commitments to extend credit will expire unused. However, we believe that we have adequate sources of liquidity to fund commitments that may be drawn upon by borrowers.

As of June 30, 2009, $21.0 million of these commitments were for mortgages with locked interest rates that had not yet funded. We offer a wide variety of conforming and non-conforming loans with fixed and variable rate options. Recent financial media attention has focused on mortgage loans that are considered “sub-prime” (higher credit risk), “Alt-A” (low documentation) and/or “second lien.” Our management has evaluated the loans that have been originated by the bank to date for the purpose of selling in the secondary market and believes that the majority of these loans conform to FHLMC and FNMA standards with the remainder of the loans being jumbo residential mortgages and mortgages with alternative or low documentation. Therefore, we believe that the exposure of this division to the sub-prime and Alt-A segments is low. The division also offers FHA/VA and construction/permanent products with a proven history of salability to its customers. The division's customers are located primarily in South Carolina and include a group of investors with whom we have established relationships. Due to the nature of this division, the loans held for sale typically are held for a seven- to ten-day period. As of June 30, 2009, none of these loans had been on our balance sheet for more than 92 days.

Except as disclosed in this report, we are not involved in off-balance sheet contractual relationships, unconsolidated related entities that have off-balance sheet arrangements, or transactions that could result in liquidity needs or other commitments that could significantly impact earnings.

Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss and to raise additional funds at a reasonable cost by increasing liabilities in a timely manner and without adverse consequences. Liquidity management involves maintaining and monitoring our sufficient and diverse sources and uses of funds in order to meet our day-to-day and long-term cash flow requirements while maximizing profits and maintaining an acceptable level of risk under both normal and adverse conditions. These requirements arise primarily from the withdrawal of deposits, funding loan disbursements and the payment of operating expenses. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of the investment portfolio is fairly predictable and subject to a high degree of control at the time the investment decisions are made. However, net deposit inflows and outflows are far less predictable as they are greatly influenced by general interest rates, economic conditions and competition, and are not subject to nearly the same degree of control. Management has policies and procedures in place governing the length of time to maturity on its earning assets such as loans and investments which state that these assets are not typically utilized for day-to-day liquidity needs. Therefore, our liabilities have generally provided our day-to-day liquidity in the past.

We measure and monitor liquidity on a regular basis, allowing us to better understand, predict and respond to balance sheet trends. A comprehensive liquidity analysis serves management as a vital decision-making tool by providing a summary of anticipated changes in loans, investments, core deposits, wholesale funds and construction commitments for capital expenditures. This internal funding report provides management with the details critical to anticipate immediate and long-term cash requirements, such as expected deposit runoff, loan paydowns and amount and cost of available borrowing sources, including in secured overnight federal funds lines with our various correspondent banks. This liquidity analysis acts as a cash forecasting tool and is subject to certain assumptions based on past market and customer trends, as well as other information currently available regarding current and future funding options and various indicators of future market and customer behaviors. Through consideration of the information provided in this weekly report, management is better able to maximize our earning opportunities by wisely and purposefully choosing our immediate, and more critically, our long-term funding sources.

We operate in a highly-regulated industry and must plan for the liquidity needs of both our bank and our holding company separately. This approach considers the unique funding sources available to each entity, as well as each entity’s capacity to manage through adverse conditions. This approach also recognizes that adverse market conditions or other events could negatively affect the availability or cost of liquidity for either entity. A variety of sources of liquidity are available to us to meet our short-term and long-term funding needs. Although a number of these sources have been limited following execution of the consent order with the OCC, management has prepared forecasts of these sources of funds and our projected uses of funds during 2009 and believes that the sources available are sufficient to meet our projected liquidity needs for this period. Since December 31, 2008, our liquid, unpledged assets have substantially increased as we have executed our strategy to increase our short-term liquidity position.

In addition to our various overnight and short-term borrowing options, we emphasize deposit growth and retention throughout our retail branch network to enhance our liquidity position. We recently have launched several very successful deposit specials to lessen our current and future dependence on overnight borrowings. These specials have lasted a short period of time, have offered attractive terms for new money to the bank, and have produced positive results by increasing market exposure and boosting liquidity. As a result, our cash and due from banks, interest bearing bank balances and federal funds sold had increased to $88.6 million, or 10.5% of total assets as of June 30, 2009 from $7.7 million or 0.91% of total assets as of December 31, 2008.

We are also participating in the FDIC’s Transaction Account Guarantee Program (“TAGP”) which fully insures noninterest bearing deposit transaction accounts, regardless of dollar amount, which is a useful tool in attracting and retaining demand deposit accounts. A 10-basis point surcharge will be added to a participating institution’s current insurance assessment in order to fully cover the noninterest bearing transaction account. We elected to participate in the TAGP to further enhance our existing deposit base and assist us in attracting new deposits.

Investment securities may provide a secondary source of liquidity, net of amounts pledged for deposits and FHLB advances; however, the primary objective for investment securities is to serve as collateral for public deposits, which limits their availability as a liquidity source.

Our ability to maintain and expand borrowing capabilities also serves as a source of liquidity. We have utilized certain nontraditional funding sources as they have been available to us to compensate for this increased liquidity risk. The sources listed below have been deemed acceptable by the bank’s board of directors and are monitored regularly by management and reported on at each formal ALCO meeting:

	·	Federal Funds Purchased – funds are purchased from up-stream correspondent financial institutions when the need for overnight funds exists. These lines are available for short-term funding needs only. They require no collateral and are generally somewhat less expensive than longer-term funding options.

	·	FHLB Advances – this source of borrowing offers both long-term fixed and adjustable borrowings, typically at very competitive rates, as well as overnight borrowing capacity, all subject to available collateral. This source of borrowing requires us to be a member of the FHLB, and as such, to purchase and hold FHLB stock as a percentage of the funds borrowed.

	·	CD Programs – these programs have historically been known as brokered deposits. Various terms are available, and in considering the various CD program options, management balances our current interest rate risk profile with our liquidity demands.

	·	Reverse Repurchase Agreements – this source of funds relies on our investment portfolio as collateral in borrowing from an up-stream correspondent. Reverse repurchase agreements involve overnight borrowings with daily rate changes.

The decrease in our liquidity over the past several years has primarily occurred as a result of funds needed to support the growth of our loan production offices. In addition, the demand for retail deposits has increased in recent months due to the tightness of liquidity in current financial markets, which also creates more liquidity risk. These conditions have challenged us to maximize the various funding options available to us.

We have been notified by the FHLB that it will not allow future advances to us while we are operating under our current regulatory enforcement action. As of June 30, 2009, qualifying loans held by the bank and collateralized by 1-4 family residences, home equity lines of credit (“HELOC’s”) and commercial properties totaling $72,010,000 were pledged as collateral for FHLB advances outstanding of $67,064,000. A key component in borrowing funds from the FHLB is maintaining good quality collateral to pledge against our advances. We primarily rely on our existing loan portfolio for this collateral. We access and monitor current FHLB guidelines to determine the eligibility of loans to qualify as collateral for an FHLB advance. We are subject to the FHLB’s credit risk rating which was effective June 27, 2008. This revised policy incorporated enhancements to the FHLB’s credit risk rating system which assigns member institutions a rating which is reviewed quarterly. The rating system utilizes key factors such as loan quality, capital, liquidity, profitability, etc. Our ability to access our available borrowing capacity from the FHLB in the future is subject to our rating and any subsequent changes based on our financial performance as compared to factors considered by the FHLB in their assignment of our credit risk rating each quarter. In addition, residential collateral discounts have been recently applied which may further reduce our borrowing capacity.

Proactive and well-advised daily cash management ensures that these lines are accessed and repaid with careful consideration of all of our available funding options as well as the associated costs. Our overnight lines historically have been tested at least once quarterly to ensure ease of access, continued availability and that we consistently maintain healthy working relationships with each correspondent.

We recently received the final report from our bank’s regulatory safety and soundness examination which was completed in November 2008. Based on information included in this report and due to the consent order we executed with the OCC on April 27, 2009, our ability to access brokered deposits through the wholesale funding market is restricted. This action restricts our bank’s ability to accept, renew or rollover brokered deposits without being granted a waiver of this prohibition by the FDIC. There is no assurance that the FDIC will grant us a waiver. The FRB has also required our bank holding company to enter into a written agreement which contains provisions similar to the articles in the bank’s consent order with the OCC.

Historically, we had planned to meet our future cash needs through the generation of deposits from retail and wholesale sources, the liquidation of temporary investments, and the maturities of investment securities as well as these nontraditional funding sources. However, in recent months, the effects of the credit crisis have impacted liquidity for the banking industry. As a result, most of the sources of liquidity that we rely on have been significantly disrupted. In the future, we plan to reduce our reliance on the wholesale funding market for deposits and capitalize on existing and new retail deposit markets through our statewide network of twelve full-service branches. In addition, the bank maintains federal funds lines of credit with correspondent banks that totaled $9.0 million and $28.0 million as of June 30, 2009 and December 31, 2008, respectively.

We have revised our comprehensive liquidity risk management program as required by the consent order with the OCC. This program assesses our current and projected funding needs to ensure that sufficient funds or access to funds exist to meet those needs. The program also includes effective methods to achieve and maintain sufficient liquidity and to measure and monitor liquidity risk including the preparation and submission of liquidity reports on a regular basis to the board of directors and the OCC. The program also contains a contingency funding plan that forecasts funding needs and funding sources under different stress scenarios. This plan details how the bank will comply with the restrictions in the order, including the restriction against brokered deposits, as well as requires reports detailing all funding sources and obligations under best case and worse case scenarios.

Our liquidity contingency plan is designed to successfully respond to an overall decline in the economic environment, the banking industry or a problem specific to our liquidity, outlined in a formal Contingency Funding Policy approved by the Asset Liability Management Committee (“ALCO”) of our board of directors. This policy contains requirements for contingency funding planning and analysis, including reporting under a number of different contingency funding conditions. The three conditions are described as follows:

	·	Stage One Condition – During this stage, core deposits are not affected and the institution remains “well-capitalized,” but additional loan loss provisions may result in weak or negative quarterly earnings. The ability to quickly open new full-service branches may be limited by our internal evaluations of our ability to successfully expand further. In addition, external funding lines could be reduced.

	·	Stage Two Condition – At this level, the institution has become “adequately capitalized,” with serious asset-quality deterioration and reduced deposits overall. At Stage Two, a meaningful level of uncertainty and vulnerability exists. External funding lines would likely be reduced. External factors, such as adverse general industry or market conditions and reputation risk, may also impact liquidity.

Stage Three Condition - At this point, the institution has significant earnings deterioration, in part due to significantly increased provisions for loan losses, and impaired residual assets. External funding lines would be greatly reduced, and the institution has become “undercapitalized.”

In addition, a liquidity crisis action plan is in place, which may be followed in reaction to or in anticipation of a financial shock to the banking industry, generally, or us, specifically, which results in strains or expectations of strains on the bank’s normal funding activities.

We rely on dividends from our bank as our holding company’s primary source of liquidity. The holding company is a legal entity separate and distinct from the bank. Various legal limitations restrict the bank from lending or otherwise supplying funds to the holding company to meet its obligations, including paying dividends. In addition, the terms of the consent order further limit the bank's ability to pay dividends to the holding company to satisfy its funding needs. As part of the acquisition of Carolina National Corporation, the holding company had entered into a loan agreement in December 2007 with a correspondent bank for a line of credit to finance a portion of the cash paid in the transaction and to fund operating expenses of the holding company including interest and dividend payments on its noncumulative preferred stock and trust preferred securities. The holding company pledged all of the stock of the bank as collateral for the line of credit which had an outstanding balance of $9.64 million as of June 30, 2009.

The line of credit, in an amount up to $15,000,000, has a twelve-year final maturity with interest payable quarterly at a floating rate tied to the Wall Street Journal Prime Rate with a floor of 6.00%. The terms of the line include two years of quarterly interest payments followed by ten years of annual principal payments plus quarterly interest payments on the outstanding principal balance as of December 31, 2009.

Because of our unusually high amount of nonperforming loans and assets as of December 31, 2008 and our reduced profitability for 2008, we were out of compliance with several covenants governing the line of credit. We continue to be out of compliance with these covenants as of June 30, 2009. The lender had previously granted us a waiver of the covenants through June 30, 2009, of its right to pursue the collateral underlying the line of credit. We are pursuing an extension of this waiver with our lender. All other terms and conditions of the loan documents continue to exist and may be exercised at any time.

We believe that our existing liquidity sources are sufficient to meet our short-term liquidity needs. We continue to evaluate other sources of liquidity to ensure our long-term funding needs are met that may also qualify as regulatory capital, such as trust preferred securities, subordinated debt and common stock. However, further market disruption may reduce the cost effectiveness and availability of our funding sources for a prolonged period of time which may require management to more aggressively pursue other funding alternatives. We have historically met our bank’s daily liquidity needs through changes in deposit levels, borrowings under our federal funds purchased facilities and other short-term borrowing sources.

Interest Rate Sensitivity

Asset liability management is the process by which we monitor and control the mix and maturities of our assets and liabilities. The essential purposes of asset liability management are to ensure adequate liquidity and to maintain an appropriate balance between interest-sensitive assets and liabilities to minimize the potentially adverse impact on earnings from changes in market interest rates. Our asset liability management committee (“ALCO”) monitors and manages our exposure to interest rate risk through the use of a simulation model that projects the impact of rate shocks, rate cycles, and rate forecast estimates on the net interest income and economic value of equity (the net present value of expected cash flows from assets and liabilities) These simulations provide a test for embedded interest rate risk and take into consideration factors such as maturities, reinvestment rates, prepayment speeds, repricing limits, decay rates and other factors. The results are compared to risk tolerance limits set by ALCO policy. The ALCO meets quarterly and consists of members of the board of directors and senior management of the bank. The ALCO is charged with the responsibility of managing our exposure to interest rate risk by maintaining the level of interest rate sensitivity of the bank’s interest-sensitive assets and liabilities within board-approved limits. Interest rate risk can be measured by analyzing the extent to which the repricing of assets and liabilities are mismatched to create an interest sensitivity “gap.” An asset or liability is considered to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest earning assets maturing or repricing within a specific time period and the amount of interest bearing liabilities maturing or repricing within that same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. During a period of rising interest rates, therefore, a negative gap would tend to adversely affect net interest income. Conversely, during a period of falling interest rates a negative gap position would tend to result in an increase in net interest income.

We have adopted a revised interest rate risk program to comply with the consent order with the OCC. The program establishes adequate management reports on which to base sound interest rate risk management decisions as well as sets the strategic direction and tolerance for interest rate risk. The program also requires tools to measure and monitor performance and the overall interest rate risk profile to be implemented while utilizing competent personnel and setting prudent limits on interest rate risk.

The following table sets forth information regarding our interest rate sensitivity as of June 30, 2009, for each of the time intervals indicated. The information in the table may not be indicative of our interest rate sensitivity position at other points in time. In addition, the maturity distribution indicated in the table may differ from the contractual maturities of the interest-earning assets and interest-bearing liabilities presented due to consideration of prepayment speeds under various interest rate change scenarios in the application of the interest rate sensitivity methods described above (dollars in thousands).

	Within three months			After three but within twelve months			After one but within five years			After five years			Total
Interest-earning assets
Federal funds sold and other	$	86,990		$	-		$	-		$	-		$	86,990
Investment securities		62,215			9,934			19,839			17,803			109,791
Loans		425,952			40,340			150,615			9,216			626,123
Total interest-earning assets	$	575,157		$	50,274		$	170,454		$	27,019		$	822,904
Interest-bearing liabilities
NOW accounts	$	96,795		$	-		$	-		$	-		$	96,795
Time deposits		173,861			296,836			114,681			203			585,581
FHLB advances		-			11,000			36,064			20,000			67,064
Junior subordinated debentures and long-term debt		23,044			-			-			-			23,044
Total interest-bearing liabilities	$	293,700		$	307,836		$	150,745		$	20,203		$	772,484
Period gap	$	281,457		$	(257,562	)	$	19,709		$	6,816		$
Cumulative gap	$	281,457		$	23,895		$	43,604		$	50,420		$
Ratio of cumulative gap to total interest-earning assets		34.20	%		2.90	%		5.30	%		6.13	%

Quantitative and Qualitative Disclosures about Market Risk

Market risk is the potential loss arising from adverse changes in market prices and rates that principally arises from interest rate risk inherent in our lending, investing, deposit gathering, and borrowing activities. It is our policy to maintain an acceptable level of interest rate risk over a range of possible changes in interest rates while remaining responsive to market demand for loan and deposit products. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not normally arise in the normal course of our business. We actively monitor and manage our interest rate risk exposure.

The principal interest rate risk monitoring technique we employ is the measurement of our interest sensitivity “gap,” which is the positive or negative dollar difference between assets and liabilities that are subject to interest rate repricing within a given time period. Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available for sale, replacing an asset or liability at maturity, or adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities repricing in this same time interval helps to hedge the risk and minimize the impact of rising or falling interest rates on net interest income. We generally would benefit from increasing market rates of interest when we have an asset-sensitive gap position and generally would benefit from decreasing market rates of interest when we are liability-sensitive.

As of June 30, 2009, we were asset sensitive over a one-year time frame. However, our gap analysis is not a precise indicator of our interest sensitivity position. The analysis presents only a static view of the timing of maturities and repricing opportunities, without taking into consideration that changes in interest rates do not affect all assets and liabilities equally. For example, rates paid on a substantial portion of core deposits may change contractually within a relatively short time frame, but those rates are viewed by management as significantly less interest-sensitive than market-based rates such as those paid on non-core deposits. Net interest income may be impacted by other significant factors in a given interest rate environment, including changes in the volume and mix of interest-earning assets and interest-bearing liabilities.

Recently Issued Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that affect accounting, reporting, and disclosure of financial information.

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162,” (“SFAS 168”). SFAS 168 establishes the FASB Accounting Standards Codification TM (“Codification”) as the source of authoritative generally accepted accounting principles (“GAAP”) for nongovernmental entities. The Codification does not change GAAP. Instead, it takes the thousands of individual pronouncements that currently comprise GAAP and reorganizes them into approximately 90 accounting Topics, and displays all Topics using a consistent structure. Contents in each Topic are further organized first by Subtopic, then Section and finally Paragraph. The Paragraph level is the only level that contains substantive content. Citing particular content in the Codification involves specifying the unique numeric path to the content through the Topic, Subtopic, Section and Paragraph structure. FASB suggests that all citations begin with “FASB ASC,” where ASC stands for Accounting Standards Codification. SFAS 168, (FASB ASC 105-10-05, 10, 15, 65, 70) is effective for interim and annual periods ending after September 15, 2009 and will not have an impact on our financial position but will change the referencing system for accounting standards. The following pronouncements provide citations to the applicable Codification by Topic, Subtopic and Section in addition to the original standard type and number.

FSP EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20,” (FASB ASC 325-40-65) (“FSP EITF 99-20-1”) was issued in January 2009. Prior to the FSP, other-than-temporary impairment was determined by using either Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transferor in Securitized Financial Assets,” (“EITF 99-20”) or SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” (“SFAS 115”) depending on the type of security. EITF 99-20 required the use of market participant assumptions regarding future cash flows regarding the probability of collecting all cash flows previously projected. SFAS 115 determined impairment to be other than temporary if it was probable that the holder would be unable to collect all amounts due according to the contractual terms. To achieve a more consistent determination of other-than-temporary impairment, the FSP amends EITF 99-20 to determine any other-than-temporary impairment based on the guidance in SFAS 115, allowing management to use more judgment in determining any other-than-temporary impairment. The FSP was effective for reporting periods ending after December 15, 2008. Management has reviewed our security portfolio and, after evaluating the portfolio for any other-than-temporary impairments, determined that this FSP had no impact on our financial statements.

On April 9, 2009, the FASB issued three staff positions related to fair value which are discussed below.

FSP SFAS 115-2 and SFAS 124-2 (FASB ASC 320-10-65), “Recognition and Presentation of Other-Than-Temporary Impairments,” (“FSP SFAS 115-2 and SFAS 124-2”) categorizes losses on debt securities available-for-sale or held-to-maturity determined by management to be other-than-temporarily impaired into losses due to credit issues and losses related to all other factors. Other-than-temporary impairment (OTTI) exists when it is more likely than not that the security will mature or be sold before its amortized cost basis can be recovered. An OTTI related to credit losses should be recognized through earnings. An OTTI related to other factors should be recognized in other comprehensive income. The FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. Annual disclosures required in SFAS 115 and FSP SFAS 115-1 and SFAS 124-1 are also required for interim periods (including the aging of securities with unrealized losses).

FSP SFAS 157-4 (FASB ASC 820-10-65), “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly” recognizes that quoted prices may not be determinative of fair value when the volume and level of trading activity has significantly decreased. The evaluation of certain factors may necessitate that fair value be determined using a different valuation technique. Fair value should be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction, not a forced liquidation or distressed sale. If a transaction is considered to not be orderly, little, if any, weight should be placed on the transaction price. If there is not sufficient information to conclude as to whether or not the transaction is orderly, the transaction price should be considered when estimating fair value. An entity’s intention to hold an asset or liability is not relevant in determining fair value. Quoted prices provided by pricing services may still be used when estimating fair value in accordance with SFAS 157; however, the entity should evaluate whether the quoted prices are based on current information and orderly transactions. Inputs and valuation techniques are required to be disclosed in addition to any changes in valuation techniques.

FSP SFAS 107-1 and APB 28-1 (FASB ASC 825-10-65), “Interim Disclosures about Fair Value of Financial Instruments” requires disclosures about the fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements and also requires those disclosures in summarized financial information at interim reporting periods A publicly traded company includes any company whose securities trade in a public market on either a stock exchange or in the over-the-counter market, or any company that is a conduit bond obligor. Additionally, when a company makes a filing with a regulatory agency in preparation for sale of its securities in a public market it is considered a publicly traded company for this purpose.

The three staff positions are effective for periods ending after June 15, 2009, with early adoption of all three permitted for periods ending after March 15, 2009. We adopted the staff positions for our second quarter 10-Q. The staff positions had no material impact on our financial statements. Additional disclosures have been provided where applicable.

Also, on April 1, 2009, the FASB issued FSP SFAS 141(R)-1 (FASB ASC 805-20-25, 30, 35, 50), “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies.” The FSP requires that assets acquired and liabilities assumed in a business combination that arise from a contingency be recognized at fair value. If fair value cannot be determined during the measurement period as determined in SFAS 141 (R), the asset or liability can still be recognized if it can be determined that it is probable that the asset existed or the liability had been incurred as of the measurement date and if the amount of the asset or liability can be reasonably estimated. If it is not determined to be probable that the asset/liability existed/was incurred or no reasonable amount can be determined, no asset or liability is recognized. The entity should determine a rational basis for subsequently measuring the acquired assets and assumed liabilities. Contingent consideration agreements should be recognized initially at fair value and subsequently reevaluated in accordance with guidance found in paragraph 65 of SFAS 141 (R). The FSP is effective for business combinations with an acquisition date on or after the beginning of our first annual reporting period beginning on or after December 15, 2008. We will assess the impact of the FSP if and when a future acquisition occurs.

The Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 111 (FASB ASC 320-10-S99-1) on April 9, 2009 to amend Topic 5.M., “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities” and to supplement FSP SFAS 115-2 and SFAS 124-2. SAB 111 maintains the staff’s previous views related to equity securities; however debt securities are excluded from its scope. The SAB provides that “other-than-temporary” impairment is not necessarily the same as “permanent” impairment and unless evidence exists to support a value equal to or greater than the carrying value of the equity security investment, a write-down to fair value should be recorded and accounted for as a realized loss. The SAB was effective upon issuance and had no impact on our financial position.

SFAS 165 (FASB ASC 855-10-05, 15, 25, 45, 50, 55), “Subsequent Events,” (“SFAS 165”) was issued in May 2009 and provides guidance on when a subsequent event should be recognized in the financial statements. Subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet should be recognized at the balance sheet date. Subsequent events that provide evidence about conditions that arose after the balance sheet date but before financial statements are issued, or are available to be issued, are not required to be recognized. The date through which subsequent events have been evaluated must be disclosed as well as whether it is the date the financial statements were issued or the date the financial statements were available to be issued. For nonrecognized subsequent events which should be disclosed to keep the financial statements from being misleading, the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannot be made, should be disclosed. The standard is effective for interim or annual periods ending after June 15, 2009. See Note 8 – Subsequent Events for our evaluation of subsequent events.

The FASB issued SFAS 166 (not yet reflected in FASB ASC), “Accounting for Transfers of Financial Assets – an amendment of FASB Statement No. 140,” (“SFAS 166”) in June 2009. SFAS 166 limits the circumstances in which a financial asset should be derecognized when the transferor has not transferred the entire financial asset by taking into consideration the transferor’s continuing involvement. The standard requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. The concept of a qualifying special-purpose entity is removed from SFAS 140 along with the exception from applying FIN 46(R). The standard is effective for the first annual reporting period that begins after November 15, 2009, for interim periods within the first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. We do not expect the standard to have any impact on our financial position.

SFAS 167 (not yet reflected in FASB ASC), “Amendments to FASB Interpretation No. 46(R),” (“SFAS 167”) was also issued in June 2009. The standard amends FIN 46(R) to require a company to analyze whether its interest in a variable interest entity (“VIE”) gives it a controlling financial interest. A company must assess whether it has an implicit financial responsibility to ensure that the VIE operates as designed when determining whether it has the power to direct the activities of the VIE that significantly impact its economic performance. Ongoing reassessments of whether a company is the primary beneficiary is also required by the standard. SFAS 167 amends the criteria to qualify as a primary beneficiary as well as how to determine the existence of a VIE. The standard also eliminates certain exceptions that were available under FIN 46(R). SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. Comparative disclosures will be required for periods after the effective date. We do not expect the standard to have any impact on our financial position.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

See “Market Risk” in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our current disclosure controls and procedures are effective as of June 30, 2009. There have been no significant changes in our internal controls over financial reporting during the fiscal quarter ended June 30, 2009, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

There are no material pending legal proceedings to which the company or any of its subsidiaries is a party or of which any of their property is the subject.

Item 1A. Risk Factors.

Not applicable.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3. Defaults Upon Senior Securities.

None

Item 4. Submission of Matters to a Vote of Security Holders.

Our Bylaws provide that the Board of Directors shall be divided into three classes with staggered terms, so that the terms of approximately one-third of the members expire at each annual meeting. The Class I directors were re-elected at the annual meeting, held on July 29, 2009, to a three-year term and the election results were recorded in the company’s minute book from the annual meeting of shareholders. There were 5,514,255 votes cast during the election. The votes represented 86.1% of total shares outstanding. Of the votes submitted, 5,323,266 or 96.5%, were cast for the election of all of the nominated directors, with the remaining votes either withheld or voted against one of more of the nominees.

The current Class directors are Mellnee G. Buchheit, Jerry L. Calvert, W. Russel Floyd, Jr., I.S. Leevy Johnson, Norman F. Pulliam and Robert E. Staton, Sr.. The current Class II directors are Benjamin R. Hines, Joel A. Smith, III, William H. Stern, Peter E. Weisman and Donald B. Wildman. The current Class III directors are C. Dan Adams, Martha Cloud Chapman, Dr. Tyrone C. Gilmore, Sr. and Coleman L. Young, Jr. The terms of the Class II directors will expire in 2010 and the terms of the Class III directors will expire at the 2011 Annual Shareholders’ Meeting.

The Company’s shareholders approved the proposal to increase the number of authorized common shares from 10,000,000 to 100,000,000 with 5,165,937 votes cast in favor, 329,076 against and 19,242 abstained.

The Company’s shareholders approved the proposal to adjourn the annual meeting to allow time for further solicition of proxies if necessary with 5,130,019 votes cast in favor, 368,887 against and 15,349 abstained.

There were no other matters voted on by the company’s shareholders at our annual meeting held on July 29, 2009.

Item 5. Other Information.

On August 13, 2009 the company filed an Amendment to its Articles of Incorporation pursuant to the shareholder approval of the proposal to increase its authorized common shares from 10,000,000 to 100,000,000. The Amendment is attached as Exhibit 10.2

Item 6. Exhibits.

31.1		Rule 13a-14(a) Certification of the Chief Executive Officer.

31.2		Rule 13a-14(a) Certification of the Chief Financial Officer.

32		Section 1350 Certifications.

10.1		Written Agreement by and between First National Bancshares, Inc. and the Federal Reserve Bank of Richmond dated June 15, 2009.

10.2		Amendment to Articles of Incorporation dated August 13, 2009.

SIGNATURES

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

	FIRST NATIONAL BANCSHARES, INC.

Date: September 11, 2009	By:	/s/ Jerry L. Calvert
		Jerry L. Calvert
		President and Chief Executive Officer


Date: September 11, 2009	By:	/s/ Kitty B. Payne
		Kitty B. Payne
		Executive Vice President/Chief Financial Officer

INDEX TO EXHIBITS


31.1		Rule 13a-14(a) Certification of the Chief Executive Officer.

31.2		Rule 13a-14(a) Certification of the Chief Financial Officer.

32		Section 1350 Certifications.

10.1		Written Agreement by and between First National Bancshares, Inc. and the Federal Reserve Bank of Richmond dated June 15, 2009.

10.2		Amendment to Articles of Incorporation dated August 13, 2009.

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