UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission file number 000-28344

FIRST COMMUNITY CORPORATION
(Exact name of registrant as specified in its charter)

5455 Sunset Boulevard, Lexington, South Carolina 29072
(Address of Principal Executive Offices)

(803) 951-2265
(Registrant's Telephone Number, Including Area Code)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

        Indicated by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   X    No      

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes        No  X  

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

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

2,846,978 shares of common stock, par value $1.00 per share, were issued and outstanding as of October 31, 2005

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION
Item 1.  Financial Statements.
                    Consolidated Balance Sheets
                    Consolidated Statements of Income
                    Consolidated Statements of Shareholders' Equity and Comprehensive Income (loss)
                    Consolidated Statements of Cash Flows
                    Notes to Consolidated Financial Statements
Item 2.  Managements Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
Item 4.  Controls and Procedures

PART II – OTHER INFORMATION
Item 1.  Legal Proceedings
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.  Defaults Upon Securities
Item 4.  Submission of Matters to a Vote of Security Holders
Item 5.  Other Information
Item 6.  Exhibits
INDEX TO EXHIBITS
SIGNATURES

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PART 1 – FINANCIAL INFORMATION
Item 1.  Financial Statements

FIRST COMMUNITY CORPORATION
CONSOLIDATED BALANCE SHEETS

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FIRST COMMUNITY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME

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FIRST COMMUNITY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME

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FIRST COMMUNITY CORPORATION
Statement of Changes in Shareholder’s Equity and Comprehensive Income (Loss)
Nine Months ended September 30, 2005 and September 30, 2004

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FIRST COMMUNITY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS

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Note 1 – Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated balance sheets, the consolidated statements of income, the consolidated statements of changes in shareholders’ equity, and the consolidated statements of cash flows of First Community Corporation (“the company”), present fairly in all material respects the company’s financial position at September 30, 2005 and December 31, 2004, the company’s results of operations for the three and nine months ended September 30, 2005 and 2004 and its cash flows for the nine months ended September 30, 2005 and 2004. The results of operations for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

In the opinion of management, all adjustments necessary to fairly present the consolidated financial position and consolidated results of operations have been made. All such adjustments are of a normal recurring nature. All significant intercompany accounts and transactions have been eliminated in consolidation.

The consolidated financial statements and notes thereto are presented in accordance with the instructions for Form 10-Q. The information included in the company’s 2004 Annual Report on Form 10-KSB should be referred to in connection with these unaudited interim financial statements. As of December 31, 2004, the company no longer met the requirements to qualify as a small business issuer as defined in Rule 12b-2 of the Securities Exchange Act of 1934 (the “Exchange Act”).  All reports of the company, beginning with the Form 10-Q for the quarter ended March 31, 2005, are presented in accordance with Regulation S-K.  The company, however, is not an accelerated filer as defined in Rule 12b-2 of the Exchange Act.  As a result, the company qualifies for the extended compliance period with respect the accountants report on management’s assessment of internal control over financial reporting and management’s annual report on internal control over financial reporting required by PCAOB Auditing Standards No.2.

Note 2 – Earnings Per Share

The following reconciles the numerator and denominator of the basic and diluted earnings per share computation:

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Note 3 – Stock Based Compensation

The company has stock based compensation plans as of September 30, 2005. The accounting for the plan is based on Accounting Principles Board Opinion No. #25 (APB 25). Accordingly, no compensation cost has been recognized in the financial statements. In accordance with Statement of Financial Accounting Standard No. 123 ” Accounting for Stock Based Compensation,” (SFAS 123) the company has elected to provide the disclosure-only option provided for by SFAS 123.

Note 4 – Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)”). SFAS No. 123(R) will require companies to measure all employee stock-based compensation awards using a fair value method and record such expense in its financial statements. In addition, the adoption of SFAS No. 123(R) requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. SFAS No. 123(R) is effective beginning as of the first interim or annual reporting period beginning after December 15, 2005. The company has evaluated the impact of this pronouncement on net income based on options granted through September 30, 2005. It is estimated that the compensation expense recognized will have a net of income tax effect of approximately $80,000 in 2006, $49,000 in 2007 and $30,000 in 2008. This does not include the impact of any future grants.

In December 2003, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position No. 03-3 (SOP No. 03-3), “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” SOP No. 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer or business combination if those differences are attributable, at least in part, to credit quality. SOP No. 03-3 prohibits the carry over or creation of valuation allowances in the initial accounting of all loans acquired that are within the scope of the SOP. SOP No. 03-3 is effective for loans acquired in years beginning after December 15, 2004, with early adoption encouraged. SOP 03-3 is not expected to have a material impact on the Company’s results of operations or financial condition. The impact of SOP No. 03-3 will be meaningful if in the future the Company enters into a business combination with a financial institution and/or acquires a future loan portfolio.

On November 13, 2003, the Emerging Issues Task Force (EITF) issued EITF Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” This guidance was to be applied in other-than-temporary impairment evaluations performed in reporting periods beginning after June 15, 2004. Disclosures were effective in annual financial statements for fiscal years ended after December 15, 2003, for investments accounted for under Financial Accounting Standards Board (FASB) Statements No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and No. 124, “Accounting for Certain Investments Held by Not-for-Profit Organizations.” The disclosure requirements for all other investments were effective in annual financial statements for fiscal years ended after June 15, 2004. In September 2004, the FASB issued FASB Staff Position (FSP) EITF Issue 03-1-1 which sets aside the measurement and recognition guidance set forth in paragraphs 10-20 of EITF Issue No. 03-1. The FASB has indicated that new measurement and recognition guidance will not be issued. A new FSP FAS 115-1 and FAS 124-1, was issued on November 3, 2005 clarifying existing guidance. The Company expects that adoption of the effective provisions of EITF Issue No. 03-1 will not have a material impact on its financial statements and is in the process of evaluating clarifying guidance included in the FSP FAS 115-1 and FAS 124-1.

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Note 5 – Significant Contract

On June 28, 2005 the Bank entered into a construction contract to have a 27,000 square foot administrative center built for approximately $3.4 million. The administrative center will provide the needed space for deposit and loan operations as well as other administrative functions. The total cost including furniture and equipment is estimated to be $4.3 million.

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Part I.
Item 2.   Management’s Discussion and Analysis

        This Report contains statements that constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those projected in the forward-looking statements, as they will depend on many factors, which are beyond our control. The words “may,” “would,” “could,” “will,” “expect,” “anticipate,” “believe,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risk and uncertainties include but are not limited to:

Overview

        The following discussion describes the our results of operations for the quarter ended September 30, 2005 as compared to the quarter ended September 30, 2004 as well as results for the nine months ended September 30, 2005 and 2004, and also analyzes our financial condition as of September 30, 2005 as compared to December 31, 2004. Like most community banks, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

        Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section, we have included a detailed discussion of this process.

        In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this non-interest income, as well as our non-interest expense, in the following discussion.

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        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.

Critical Accounting Policies

        We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2004, as filed in our annual report on Form 10-KSB.

        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 accounting policies to be critical accounting policies. The judgment 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 judgment 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.

        We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, 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. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Comparison of Results of Operations for Nine Months Ended September 30, 2005 to the Nine Months Ended September 30, 2004

The company’s results for the nine and three months ended September 30, 2005 reflect the merger of First Community Corporation and the former DutchFork Bancshares, Inc. which closed on October 1, 2004. The merger was accounted for in accordance with Statement of Financial Accounting Standards No. 141 “Business Combinations”. Periods prior to October 1, 2004 do not include the effect of the merger and, as a result, the nine and three months ended September 30, 2004 do not reflect any results from the former DutchFork Bancshares.

Net Income

The company’s net income for the nine months ended September 30, 2005 was $2.2 million, or $.76 diluted earnings per share, as compared to $1.3 million or $.80 diluted earnings per share, for the nine months ended September 30, 2004. The increase in net income is primarily due an increase in net interest income due to additional earning assets from the DutchFork merger as well as organic growth in the offices that existed prior to the merger. Average earning assets were $390.4 million during the nine months ended September 30, 2005 as compared to $208.5 million during the nine months ended September 30, 2004. The increase in average earning assets resulted in an increase in net interest income of $3.4 million in the first nine months of 2005 as compared to the first nine months of 2004. In addition, non-interest income increased $930,000 in the first nine months of 2005 as compared to the first nine months of 2004 largely due to the addition of the former DutchFork Bancshares. In addition, there were gains on the sale of securities available-for-sale in the amount of $188,000 in the first nine months of 2005 and none during the same period of 2004.

The table on page 21shows yield and rate data for interest-bearing balance sheet components during the nine month periods ended September 30, 2005 and 2004, along with average balances and the related interest income and interest expense amounts.

Net interest income was $9.6 million for the nine months ended September 30, 2005 as compared to $6.2 million for the nine months ended September 30, 2004. This again was primarily due to the increase in the level of earning assets. The yield on earning assets increased by 19 basis points due to increasing rates during the first nine months of 2005 offset by a change in the mix of the portfolios. The investment portfolio and short term investments represented 49.4% of the interest earning assets in the nine months ended September 30, 2005 as compared to 38.5% during the comparable period in 2004. This change in the mix of the earning asset portfolio is primarily a result of the size of the investment portfolio we acquired in the DutchFork

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merger as well as our restructuring of this investment portfolio during the fourth quarter of 2004 and during the first three months of 2005. The objective of the restructuring was to shorten the maturity and purchase investments that provided ongoing cash flow. Yields on loans are typically higher then yields on other types of earning assets and thus one of the company’s goals continues to be to grow the loan portfolio as a percentage of earning assets. It is believed that the restructuring of the investment portfolio provides the necessary cash flow to meet the objective of growing the loan portfolio.

The yield on earning assets for the nine months ended September 30, 2005 and 2004 was 5.32% and 5.13%, respectively. The cost of interest-bearing liabilities during the first nine months of 2005 was 2.25% as compared to 1.47% in the same period of 2004. The increase in the cost of interest-bearing liabilities was a result of increasing interest rates during the first nine months of 2005 as well as having larger percentage of borrowed funds as a total of interest–bearing funding sources in the nine months of 2005 as compared to the same period in 2004. The net interest margin was 3.30% for the nine months ended September 30, 2005 as compared to 3.97% during the nine months ended September 30, 2004. On a fully taxable equivalent basis, the net interest margin was 3.44% and 4.02% for the nine months ended September 30, 2005 and 2004, respectively.

Provision and Allowance for Loan Losses

At September 30, 2005, the allowance for loan losses amounted to $2.7 million, or 1.29% of total loans, as compared to $2.8 million, or 1.48% of total loans, at December 31, 2004. The company’s provision for loan loss was $217,000 for the nine months ended September 30, 2005 as compared to $170,000 for the nine months ended September 30, 2004. The provision was made based on management’s assessment of general loan loss risk and asset quality. The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about future events, which we believe to be reasonable, but which may or may not prove to be accurate. Our determination of the allowance for loan losses is based on evaluations of the collectibility 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 also consider subjective issues such as changes in the lending policies and procedures, changes in the local/national economy, changes in volume or type of credits, changes in volume/severity of problem loans, quality of loan review, board of director oversight, and concentrations of credit. Periodically, we adjust the amount of the allowance based on changing circumstances. We charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses.

Management performs an analysis quarterly to assess the risk within the loan portfolio. The portfolio is segregated into similar risk components for which historical loss ratios are calculated and adjusted for identified changes in current portfolio characteristics. Historical loss ratios are calculated by product type and by regulatory credit risk classification. The allowance consists of an allocated and unallocated allowance. The allocated portion is determined by types and ratings of loans within the portfolio. The unallocated portion of the allowance is established for losses that exist in the remainder of the portfolio and compensates for uncertainty in estimating the loan losses.

There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period. The allowance is also subject to examination and testing for adequacy by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions. Such regulatory agencies could require us to adjust our allowance based on information available to them at the time of their examination.

At September 30, 2005 the company had $19,000 in loans delinquent more than 90 days and still accruing interest, and loans totaling $291,000 that were delinquent 30 days to 89 days. The company had two loans in a nonaccrual status in the amount of $14,000 at September 30, 2005. Management continuously monitors non-performing, classified and past due loans to identify deterioration regarding the condition of these loans. Management has identified five classified loans totaling $200,000 that are not included in non-performing assets that could be potential problem loans.

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Allowance for Loan Losses

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The following allocation of the allowance to specific components is not necessarily indicative of future losses or future allocations. The entire allowance is available to absorb losses in the portfolio.

Composition of the Allowance for Loan Losses

Accrual of interest is discontinued on loans when management believes, after considering economic and business conditions and collection efforts that a borrower’s financial condition is such that the collection of interest is doubtful. A delinquent loan is generally placed in nonaccrual status when it becomes 90 days or more past due. At the time a loan is placed in nonaccrual status, all interest, which has been accrued on the loan but remains unpaid is reversed and deducted from earnings as a reduction of reported interest income. No additional interest is accrued on the loan balance until the collection of both principal and interest becomes reasonably certain.

Non-interest Income and Expense

Non-interest income during the first nine months of 2005 was $2.2 million as compared to $1.2 million during the same period in 2004. The growth in non-interest income consisted of increases during the nine month period ended September 30, 2005 as compared to the nine-month period ended September 30, 2004 in each of the following categories: deposit service charges of $326,000, mortgage origination fees of $81,000, gain on the sale of securities of $188,000 and other non interest income of $335,000. The increase in deposit service charges resulted from organic growth in deposit accounts as well as the growth resulting from the DutchFork merger. Mortgage origination fees increased due to the continued low rate environment as well as continued emphasis on this source of revenue. During the first nine months of 2005, the company added two additional mortgage originators for a total of four originators. Continued rising interest rates could result in this source of income leveling off or declining in future periods. During the first nine months of 2005, the company realized gains on the sale of securities in the amount of $188,000, with $181,000 realized in the first quarter of 2005. Subsequent to the merger with DutchFork, management began restructuring the combined investment portfolio. This restructuring continued into the first quarter of 2005. Although the portfolio acquired from DutchFork had a large percentage of investments with variable interest rates, the investments did not provide significant cash flow. The objective of the restructuring was to shorten the maturity and purchase investments that provide ongoing cash flow. Management will continue to take advantage of opportunities to restructure portions of the portfolio, but it is not anticipated that the volume of sales that the company experienced in the fourth quarter of 2004 and the first quarter of 2005 will continue. The increase in other non interest income of $335,000 during the nine months of 2005 as compared to the same period in 2004 is primarily a result of the merger with DutchFork in October 2004 and the inclusion of non-interest income for the three new offices acquired in the merger.

Total non-interest expense increased by $3.4 million during the first nine months of 2005 as compared to the same period of 2004. The DutchFork acquisition added three new offices and approximately 32 additional employees. In addition, the bank opened a new banking office in April 2004 and February 2005. The increases in all non-interest expense categories are primarily a result of the merger as well as these de-novo branch expansions. Salaries and employee benefits increased $1.9 million in the first nine months of 2005 as compared to the same period in 2004. At September 30, 2005, the company had approximately 121 full time equivalent employees as compared to 76 full time equivalent employees at September 30, 2004. Occupancy expense increased $250,000 in the first nine months of 2005 as compared to the same period in 2004. The three offices acquired in the merger and the two de-novo office expansions account for this increase. Equipment expense increased to

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$937,000 in the first nine months of 2005 as compared to $678,000 in the first nine months of 2004. This increase resulted from the additional equipment acquired as a result of the additional branches as well as upgrades to certain item processing hardware and software needed to process the higher volume of activity subsequent to the DutchFork merger. Expense related to amortization of intangibles increased from $134,000 in the first nine months of 2004 to $446,000 in the comparable period in 2005. The core deposit intangible acquired in the DutchFork acquisition amounted to $2.9 million and is being amortized on a straight-line basis over seven years. The amortization in the first nine months of 2004 relates to core deposit premium acquired in a branch acquisition in 2001. Prior core deposit premium is also amortized on a straight-line basis over seven years. There was a $620,000 increase in other expenses in the first six months of 2005 as compared to the same period in 2004. All components of other expense increased due to the significant growth the company experienced as a result of the merger with DutchFork.

The following is a summary of the components of the other category of non-interest expense:

Comparison of Results of Operations for Three Months Ended September 30, 2005 to the Three Months Ended September 30, 2004

Net income for the third quarter of 2005 was $752,000, or $0.25 per diluted share, as compared to $493,000, or $0.29 per diluted share during the comparable period in 2004. Net interest income increased by $1.0 million for the three months ended September 30, 2005 from $2.2 million in 2004 to $3.2 million in 2005. The increase in net interest income is primarily due to the addition of the former DutchFork Bancshares. Average earning assets were $396.8 million during the third quarter of 2005 as compared to $224.4 million during the third quarter of 2004. The table on page 23 shows yield and rate data for interest-bearing balance sheet components during the three month periods ended September 30, 2005 and 2004, along with average balances and the related interest income and interest expense amounts. The yield on average earning assets increased to 5.43% in the third quarter of 2005 as compared to 5.05% in the third quarter of 2004. The cost of interest bearing liabilities was 2.50% in third quarter of 2005 as compared to 1.51% in the third quarter of 2004.

Non-interest income increased by $362,000 from $420,000 for the three months ended September 30, 2004 to $782,000 in the same period of 2005. Deposit service charges increased by $136,000, mortgage loan fees increased by $43,000 and other income increased $183,000 in the three months ended September 30, 2005 as compared to the same period in 2004. As previously discussed, the addition of the three former DutchFork branches and the two de-novo branch expansions are the significant contributors to the increases in each of these non-interest income categories. The increase in mortgage origination fees of $43,000 in the third quarter of 2005 is a result of increasing the number of mortgage originators as previously discussed and the continued low mortgage loan rate environment. In the three months ended September 30, 2005 other income includes a gain on the sale of other real estate in the amount of $26,000. In addition, other income includes a $15,000 increase in the value of the interest rate contract discussed under “Market Risk Management” below.

Total non-interest expense increased by $1.1 million in the third quarter of 2005 as compared to the same quarter of 2004. This increase is the result of a $668,000 increase in salary and benefits expense, an $85,000 increase in occupancy expense, a $53,000 increase in equipment expense, a $104,000 increase in amortization of intangibles and a $173,000 increase in other expenses. All of these increases are primarily a result of the company’s merger with DutchFork Bancshares on October 1, 2004.

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Financial Position

Assets totaled $463.5 million at September 30, 2005 as compared to $455.7 million at December 31, 2004, an increase of $7.8 million, or 1.7%. At September 30, 2005, loans accounted for 53.0% of earning assets, as compared to 47.6% at December 31, 2004. Loans grew by $24.3 million during the nine months ended September 30, 2005 from $186.8 million at December 31, 2004 to $211.1 million at September 30, 2005. The loan to deposit ratio at September 30, 2005 was 62.8% as compared to 55.4% at December 31, 2004. In evaluating the merger with DutchFork, management considered the need to leverage the existing deposit base in the Newberry County market through quality growth of the loan portfolio. The growth of the loan portfolio both in total dollars and as a percentage of total earning assets will continue to be a major focus throughout 2005 and thereafter. It is anticipated that this ratio will continue to increase as management continues to emphasize investing more of its assets in the higher earning loan portfolio as compared to the investment portfolio. Deposits decreased $1.3 million from $337.1 million at December 31, 2004 to $335.8 million at September 30, 2005. Investments securities decreased $13.8 million from $196.0 million at December 31, 2004 to $182.2 million at September 30, 2005. The decrease in the portfolio was used to fund loan growth and reflects additional unrealized losses in the available-for-sale portfolio resulting from rising interest rates. As previously discussed, during the first quarter of 2005, the company continued restructuring portions of the combined investment portfolio.

        The following table shows the composition of the loan portfolio by category:

In the context of this discussion, a real estate mortgage loan is defined as any loan, other than loans for construction purposes and advances on home equity lines of credit, secured by real estate, regardless of the purpose of the loan. Advances on home equity lines of credit are included in consumer loans. The company follows the common practice of financial institutions in the company’s market area of obtaining a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to reinforce the likelihood of the ultimate repayment of the loan and tends to increase the magnitude of the real estate loan components. Generally, the company limits the loan-to-value ratio to 80%.

Market Risk Management

The effective management of market risk is essential to achieving the company’s strategic financial objectives. The company’s most significant market risk is interest rate risk. The company has established an Asset/Liability Management Committee (“ALCO”) to monitor and manage interest rate risk. The ALCO monitors and manages the pricing and maturity of its assets and liabilities in order to diminish the potential adverse impact that changes in interest rates could have on its net interest income. The ALCO has established policy guidelines and strategies with respect to interest rate risk exposure and liquidity.

A monitoring technique employed by the ALCO is the measurement of the company’s 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 period of time. Also, asset/liability simulation modeling is performed by the company to assess the impact varying interest rates and balance sheet mix assumptions will have on net interest income. Interest rate sensitivity can be managed by repricing assets or liabilities, selling securities available-for-sale, replacing an asset or liability at maturity or by adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities repricing in the same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates. Neither the “gap” analysis nor asset/liability modeling is a precise indicator of the interest sensitivity position of the company due to the many factors that affect net interest income, including changes in the volume and mix of earning assets and interest-bearing liabilities. The company’s gap analysis indicates a slight asset sensitive position over the one and two year lives of the portfolio. For a twelve month period, the gap analysis indicates an asset sensitive position as of September 30, 2005 of $5.8 million. The company’s gap analysis and simulation modeling are not precise indicators of its interest sensitivity position. Net interest income is also

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impacted by other significant factors, including changes in the volume and mix of earning assets and interest-bearing liabilities. Through simulation modeling, management monitors the effect that an immediate and sustained change in interest rates of 100 basis points and 200 basis points up and down will have on net-interest income over the next twelve months.

During the quarter ended September 30, 2005, the company entered into an interest rate cap agreement with a notional amount of $10.0 million expiring on September 1, 2009. The cap rate of interest is 4.50% and the index is the three month LIBOR. The agreement was entered into to protect assets and liabilities from the negative effects of increasing interest rates. The agreement provides for a payment to the bank of the difference between the cap rate of interest and the market rate of interest. The bank’s exposure to credit risk is limited to the ability of the counterparty to make potential future payments required pursuant to the agreement. The bank’s exposure to market risk of loss is limited to the market value of the cap. At September 30, 2005, the market value of this cap was $170,000. Any gain or loss on the value of this contract is recognized in earnings on a current basis. The bank has not received any payments under the terms of the contract. During the three months ended September 30, 2005, the bank recognized $15,000 in other income to reflect the increase in the value of the contract.

Based on the many factors and assumptions used in simulating the effect of changes in interest rates, the following table estimates the percentage change in net interest income at March 31, 2005, June 30, 2005, September 30, 2005 and December 31, 2004 over the next twelve months.

Net Interest Income Sensitivity