M&F BANCORP INC /NC/ - Annual Report: 2008 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT UNDER SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008

Commission file number 027307

(Exact name of registrant as specified in charter)

(919) 687-7800

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K.  ¨

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one):

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

M&F BANCORP, INC. AND SUBSIDIARY

The aggregate market value of the registrant’s common stock, no par value per share, as of June 30, 2008, held by those persons deemed by the registrant to be nonaffiliates was approximately $11,440,623 (shares held by nonaffiliates at $7.98 per share). For purposes of the foregoing calculation only, all directors, executive officers, and 5% stockholders of the registrant have been deemed affiliates.

As of March 31, 2009 there were 2,031,337 shares outstanding of the registrant’s common stock, no par value.

DOCUMENTS INCORPORATED BY REFERENCE

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M&F BANCORP, INC. AND SUBSIDIARY

Annual Report on Form 10-K for the Year Ended December 31, 2008

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Forward-looking Statements

This Annual Report on Form 10-K contains and incorporates by reference statements relating to future results of M&F Bancorp, Inc. (the “Company”) that are considered “forward-looking” within the meaning of Section 27A of the Securities Act of 1933, as amended, (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements represent expectations and beliefs of the Company, including but not limited to the Company’s operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, “estimates”, “believes” and variations of these words and other similar statements. For this purpose, any statements contained in this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. These forward-looking statements involve estimates, assumptions, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation: (i) in October of 2008, the Emergency Economic Stabilization Act of 2008 was signed into law, followed in February 2009 by the American Recovery and Reinvestment Act of 2009. In addition, the U.S. Department of the Treasury and federal banking regulators are implementing a number of programs to address capital and liquidity issues in the banking system, all of which may have significant effects on the Company and the banking industry, the exact nature and extent of which cannot be determined at this time; (ii) the strength of the United States economy generally, and the strength of the local economies in which the Company conducts operations, may be different than expected, resulting in, among other things, a continued deterioration in credit quality, including the resultant effect on the Company’s loan portfolio and allowance for credit losses; (iii) the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”); (iv) inflation, deflation, interest rate, market and monetary fluctuations; (v) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate and market liquidity conditions) and the impact of such conditions on the Company’s capital markets and capital management activities; (vi) the timely development of competitive new products and services by the Company and the acceptance of these products and services by new and existing customers; (vii) the willingness of customers to accept third party products marketed by the Company; (viii) the willingness of customers to substitute competitors’ products and services for the Company’s products and services and vice versa; (ix) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (x) technological changes; (xi) changes in consumer spending and saving habits; (xii) the effect of corporate restructurings, acquisitions and/or dispositions, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (xiii) the current stresses in the financial and real estate markets, including possible continued deterioration in property values; (xiv) unanticipated regulatory or judicial proceedings; (xv) the impact of changes in accounting policies by the Securities and Exchange Commission (the “SEC”); (xvi) adverse changes in financial performance and/or condition of the Company’s borrowers which could impact repayment of such borrowers’ outstanding loans; and (xvii) the Company’s success at managing the risks involved in the foregoing. the Company cautions that the foregoing list of important factors is not exhaustive. See also “Risk Factors” which begins on page 11. The Company undertakes no obligation to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

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Notes to Consolidated Financial Statements

PART I

GENERAL

Headquartered in Durham, North Carolina (“NC”), M&F Bancorp, Inc. (the “Company”) is a bank holding company incorporated under the laws of NC in 1999, and is registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). The Company’s primary function is to serve as the holding company for its wholly-owned subsidiary, Mechanics and Farmers Bank (the “Bank”), a NC-chartered commercial bank that was organized in 1907 and began operations in 1908. The Company provides services and assistance to the Bank.

As of December 31, 2008, the company had assets of approximately $271.6 million, with gross loans of approximately $208.4 million and deposits of approximately $216.6 million. The Company’s corporate office is located at 2634 Durham Chapel Hill Boulevard, Durham, NC, 27707, and its telephone number is 919-687-7800. In addition to its corporate office, the Company has 9 branch offices in NC: three in Durham, two in Raleigh, two in Charlotte, one in Winston-Salem, and one in Greensboro.

On March 28, 2008, the Company completed the acquisition (the “Acquisition”) of Mutual Community Savings Bank, Inc., SSB (“MCSB”), which was merged into the Bank. All non-dissenting MCSB stockholders received one share of the Company’s stock in exchange for each share of MCSB stock tendered. One MCSB shareholder dissented to the Acquisition, and received the fair value of his 18,028 shares of MCSB stock.

The Company’s principal source of income is from dividends declared and paid by the Bank on its issued and outstanding capital stock. The Company uses such income to pay dividends to stockholders and fund its expenses. The majority of the Company’s operations occur at the Bank level. Throughout this Annual Report on Form 10-K, results of operations will be discussed by referring to the Bank’s operations, unless a specific reference is made to the Company and its operating results apart from those of the Bank.

The Bank is a community bank engaged in the general banking business in Wake, Durham, Guilford, Forsyth, and Mecklenburg Counties and the surrounding areas. The Bank is designated by the United States Department of the Treasury (the “Treasury”) as a Community Development Financial Institution (“CDFI”). As defined by the Treasury, a CDFI is a community-based organization that provides credit, financial services, and other related services in low-income urban and rural communities across America. These organizations have a common mission of working toward revitalizing economically depressed communities or communities underserved by mainstream financial institutions and improving the quality of life of those who live and work in these communities. CDFIs operate in communities for the benefit of people who live in them. In turn, these CDFIs provide financing to: residents who want to buy their first home, individuals who may want to start their own business and owners of existing businesses who would like to expand their businesses (helping to create new jobs). In addition, CDFIs work with individuals on improving their credit ratings or helping them to create monthly budgets.

The Bank offers a full range of banking services, including the following: checking accounts; savings accounts; NOW accounts; money market accounts; certificates of deposit; individual retirement accounts; loans for real estate, construction, businesses, personal use, home improvement and automobiles; equity lines of credit; credit lines; consumer loans; credit cards; safe deposit boxes; bank money orders; internet banking; electronic funds transfer services including wire transfers; traveler’s checks; and notary services. In addition, the Bank provides automated teller machine access to its customers for cash withdrawals through nationwide ATM networks. At present, the Bank does not provide the services of a trust department.

GENERAL DESCRIPTION OF MARKET AREAS

The Bank has three offices in Durham, NC, two offices in Raleigh, NC, two offices in Charlotte, NC, one office in Winston-Salem, NC, and one office in Greensboro, NC. All offices are located in metropolitan areas with employment spread primarily among service, manufacturing and governmental activities. All offices are located in areas of high competition among financial service providers.

COMPETITION

Commercial banking in North Carolina is extremely competitive. The Bank competes in its market areas with some of the largest banking organizations in the state and the country, other community financial institutions, such as federally and state-chartered savings and loan institutions, credit unions, consumer finance companies, mortgage companies and other lenders engaged in the business of extending credit. Many of the Bank’s competitors have broader geographic markets, easier access to capital, lower cost of funding, and higher lending limits than the Bank, and are able to provide more services, and make greater use of media advertising.

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Despite the strong competition in its market areas, the Bank believes that it has certain competitive advantages that distinguish it from its competition. The Bank believes that its primary competitive advantages are its 100-year legacy, strong local identity and affiliation with the communities it serves, and its emphasis on providing specialized services to small- and medium-sized business and special purposes enterprises, and individuals. The Bank offers customers modern, high-tech banking without compromising community values such as prompt, personal service and friendliness. The Bank offers personalized services and attracts customers by being responsive and sensitive to their individual needs. The Bank relies on goodwill and referrals from stockholders, board members, employees, and satisfied customers, as well as traditional methods to attract new customers. To enhance a positive image in the communities in which it has branches, the Bank supports and participates in select local events and many of its officers and directors serve on boards of local civic and charitable organizations.

The ability of the Bank to attract and retain deposits generally depends on its ability to provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. As of June 30, 2008, based on the FDIC Summary of Deposits Report, the Bank’s market share of the total deposits in Durham, NC was approximately 1.34%, and less than one percent in each of Raleigh, Charlotte, Greensboro and Winston-Salem, NC. Management believes that the Company is not dependent upon any single customer, or a few customers, the loss of which would have a material adverse effect on the Company’s operations. However, the Company does serve a specialized niche market (churches), the loss of which could have a material adverse effect on the Company’s operations.

EMPLOYEES

As of December 31, 2008, the Company and the Bank had a total of 94 employees, including 86 full-time equivalent employees. No employees are represented by a collective bargaining unit or agreement. Management considers relations with employees to be good.

EXECUTIVE OFFICERS

Kim D. Saunders serves as President and Chief Executive Officer for the Company and the Bank, overseeing the day to day operations of the Bank. Ms. Saunders joined the Company in 2007. She previously served as President and Chief Executive Officer of Consolidated Bank and Trust Company from 2003 to 2007, and Executive Vice President and Chief Lending Officer for City First Bank from 1998 to 2003. Lyn Hittle serves as Senior Vice President and Chief Financial Officer for the Company and the Bank, overseeing the financial operations of the Company and the Bank. Ms. Hittle joined the Company in 2008, previous to which she was the Chief Accounting Officer of Capital Bank in Raleigh, NC from 2007 to 2008, Vice President Finance/Controller for Eos Airlines from 2006 to 2007, and Chief Financial Officer for Harrington Bank in Chapel Hill, NC from 2001 to 2005.

AVAILABLE INFORMATION

The Company makes its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, available free of charge on its internet website www.mfbonline.com, as soon as reasonably practicable after the reports are electronically filed with the SEC. Any materials that the Company files with the SEC may be read and/or copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. These filings are accessible on the SEC’s website at www.sec.gov.

The Company’s corporate governance policies, including its Codes of Ethics and the charters of the Audit, Compensation, and Corporate Governance and Nominating Committees, may be found under the “Investor Relations” section of the Company’s website. The Company elects to disclose any amendments to or waivers of any provisions of its Code of Ethics applicable to its principal executive officers and senior financial officers on its website. A written copy of the foregoing corporate governance policies is available upon written request to the Company.

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SUPERVISION AND REGULATION

Bank holding companies and commercial banks are subject to extensive federal and state governmental regulation and supervision. The following is a brief summary of certain statutes and regulations that apply to the Company and Bank. This summary is qualified in its entirety by reference to the particular statute and regulatory provisions cited below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than stockholders of the Company.

Statutes and regulations, which contain wide-ranging proposals for altering the structures, regulations, and competitive relationship of financial institutions are introduced regularly. The Company cannot predict whether or in what form any proposed statute or regulation may be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.

Insured depository institutions under common control are required to reimburse the Federal Deposit Insurance Corporation (the “FDIC”) for any loss suffered by its deposit insurance fund as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interests of the deposit insurance fund. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

Monetary Policy and Economic Controls

The Company and the Bank are directly affected by governmental policies and regulatory measures affecting the banking industry in general. Of primary importance is the Federal Reserve, whose actions directly affect the money supply which, in turn, affects banks’ lending abilities by increasing or decreasing the cost and availability of funds to banks. The Federal Reserve regulates the availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in United States government securities, changes in the discount rate on bank borrowings, changes in reserve requirements against bank deposits, and limitations on interest rates that banks may pay on time and savings deposits.

Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks has eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates has generally increased banks’ cost of funds and made them more sensitive to fluctuations in money market rates. In view of the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of the Bank or the Company. As a result, banks, including the Bank, face a significant challenge to maintain acceptable net interest margins.

Company Regulation

General. The Company is a bank holding company registered with the Federal Reserve under the BHCA. As such, the Company is subject to the supervision, examination and reporting requirements contained in the BHCA and the regulation of the Federal Reserve. Despite prior approval, the Federal Reserve has the power to order a bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when it believes that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company.

Mergers and Acquisitions. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “IBBEA”) permits interstate acquisitions of banks and bank holding companies without geographic limitation, subject to any state requirement that the bank has been organized for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to, or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the U.S. and no more than 30% of such deposits in any state (or such lesser or greater amount set by state law).

In addition, the IBBEA permits a bank to merge with a bank in another state as long as neither of the states has opted out of the IBBEA prior to May 31, 1997. The state of North Carolina not opted out of the IBBEA. In addition, the IBBEA provides that a bank may establish and operate a de novo branch in a state in which the bank does not maintain a branch if that state expressly permits de novo interstate branching. NC law permits interstate de novo branching where the bank’s home state has reciprocal provisions.

Federal Securities Law. The Company’s common stock is registered with the SEC pursuant to Section 12(g) of the Exchange Act. As a result of that registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act are applicable to the Company. The regulatory compliance burden of being a publicly traded company has increased significantly over the last several years.

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The Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act, (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority presents the Company with new challenges as its larger competitors are able to expand their services and products into areas that are not feasible for smaller, community-oriented financial institutions. The GLB Act has had a significant economic impact on the banking industry and on competitive conditions in the financial services industry generally.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act was signed into law in 2002 (“Sarbanes-Oxley”) and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of Sarbanes-Oxley has been wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements. Some of the provisions of Sarbanes-Oxley became effective immediately while other provisions have subsequently been implemented or will be implemented in the future.

In general, Sarbanes-Oxley mandated important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It established new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and created a new regulatory body to oversee auditors of public companies. It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created new criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

The economic and operational effects of this legislation on public companies, including the Company, have been and will continue to be significant in terms of the time, resources and costs associated with complying with its requirements. Because Sarbanes-Oxley, for the most part, applies equally to larger and smaller public companies, the Company will be presented with additional challenges as a smaller financial institution seeking to compete with larger financial institutions in its market. In accordance with the requirements of Section 404(a), management’s report on internal control is included herein as Item 9A(T). In June 2008, the SEC announced (with respect to certain categories of reporting companies, including the Company) a delay in requiring the filing of an attestation of the Company’s registered public accounting firm regarding internal control over financial reporting until the first fiscal year ending after December 15, 2009.

Prohibited and permissible activities of Bank Holding Companies. The BHCA generally prohibits a bank holding company, with certain exceptions, from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be closely related to banking. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity may be reasonably expected to produce benefits to the public, such as greater convenience, increased competition or gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.

Banking, operating a thrift institution, extending credit or servicing loans, leasing real or personal property, providing securities brokerage services, providing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance underwriting activities have been determined by regulations of the Federal Reserve to be permissible activities.

Pursuant to delegated authority, the Federal Reserve Bank of Richmond has authority to approve certain activities of holding companies within its district, including the Company, provided the nature of the activity has been approved by the Federal Reserve.

Additional Restrictions and Oversight. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve on any extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or securities thereof and the acceptance of such stock or securities as collateral for loans to any borrower. A bank holding company and its subsidiaries are prevented from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. An example of a prohibited tie-in would be any arrangement that would condition the provision or cost of services on a customer obtaining additional services from the bank holding company or any of its other subsidiaries.

The Federal Reserve may issue cease and desist orders against bank holding companies and non-bank subsidiaries to stop actions believed to present a serious threat to a subsidiary bank. The Federal Reserve regulates certain debt obligations, changes in control of bank holding companies, and capital requirements.

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As a result of the Company’s ownership of the Bank, the Company is registered under the bank holding company laws of NC. Accordingly, the Company is subject to supervision and regulation by the NC Commissioner of Banks (the “Commissioner”).

Capital Requirements. The Federal Reserve has established risk-based capital guidelines for bank holding companies and banks that are members of the Federal Reserve System and that have consolidated assets of $500 million or more. The minimum standard for the ratio of capital to risk-weighted assets (including certain off-balance-sheet obligations, such as standby letters of credit) is eight percent. At least half of this capital must consist of common equity, retained earnings, and a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain goodwill items and other adjustments (“Tier 1 capital”). The remainder (“Tier 2 capital”) may consist of mandatorily redeemable debt securities, a limited amount of other preferred stock, subordinated debt, and loan loss reserves.

In addition, the Federal Reserve has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum leverage ratio (“Leverage Ratio”) of Tier 1 capital to adjusted average quarterly assets less certain amounts equal to three percent for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies will generally be required to maintain a Leverage Ratio of between four percent and five percent.

The guidelines provide that bank holding companies experiencing significant growth, whether through internal expansion or acquisitions, are expected to maintain strong capital ratios well above the minimum supervisory levels without significant reliance on intangible assets. The same heightened requirements apply to bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as to other banking institutions if warranted by particular circumstances or the institution’s risk profile. Furthermore, the guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 Leverage Ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity. The Federal Reserve has not advised the Company of any specific minimum Leverage Ratio or tangible Tier 1 Leverage Ratio applicable to it.

As of December 31, 2008, the Company had Tier 1 risk-adjusted, total regulatory capital and leverage capital of approximately 9.36%, 10.62% and 8.41%, respectively, all in excess of the minimum requirements. Those same ratios as of December 31, 2007 were 13.82%, 14.98% and 9.12%, respectively.

Dividend and Repurchase Limitations. The Company must obtain Federal Reserve approval prior to repurchasing its common stock for consideration in excess of 10% of its net worth during any 12-month period unless the Company (i) both before and after the redemption satisfies capital requirements for “well capitalized” state bank holding companies; (ii) received a “one” or “two” rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues.

Although the payment of dividends and repurchase of stock by the Company are subject to certain requirements and limitations of NC corporate law, except as set forth in the next paragraph, neither the Commissioner nor the FDIC have promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares. However, the ability of the Company to pay dividends or repurchase shares is entirely dependent upon the Company’s receipt of dividends from the Bank.

Under NC corporation laws, the Company may not pay a dividend or distribution, if after giving its effect, the Company would not be able to pay its debts as they become due in the usual course of business or the Company’s total assets would be less than its liabilities. In general, the Company’s ability to pay cash dividends is dependent upon the amount of dividends paid to the Company by the Bank. NC commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. The Bank may pay dividends from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by NC law. In addition, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is defined in the applicable law and regulations). The Bank is currently restricted from paying dividends to the Company unless it receives advance approval from the FDIC and the Commissioner.

Changes in Control. The BHCA prohibits the Company from acquiring direct or indirect control of more than five percent of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating with another bank holding company or savings bank holding company without prior approval of the Federal Reserve. Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of the Company. Control is conclusively presumed to exist if, among other things, a person acquires more than 25% of any class of voting stock of the Company or controls in any manner the election of a majority of the directors of the Company. Control is presumed to exist if a person acquires more than 10% of any class of voting stock, the stock is registered under Section 12 of the Exchange Act, and the acquirer will be the largest shareholder after the acquisition.

Bank Regulation

The Bank is subject to numerous state and federal statutes and regulations that affect its business, activities, and operations, and is supervised and examined by the Commissioner and the FDIC. The FDIC and the Commissioner regularly examine the operations of

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banks over which they exercise jurisdiction. They have the authority to approve or disapprove the establishment of branches, mergers, consolidations and other similar corporate actions. They have authority to prevent the continuance or development of unsafe or unsound banking practices and other violations of law. The FDIC and the Commissioner regulate and monitor all areas of the operations of banks and their subsidiaries, including loans, mortgages, capital adequacy, loss reserves and compliance with the CRA as well as other laws and regulations. Interest and certain other charges collected and contracted for by banks are subject to state usury laws and certain federal laws concerning interest rates.

Federal Deposit Insurance. The FDIC issues regulations and conducts periodic examinations, requires the filing of reports and generally supervises the operations of its insured banks. This supervision and regulation is intended primarily for the protection of depositors. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies and directives may be sanctioned for noncompliance.

The Bank is subject to insurance assessments imposed by the FDIC. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. In addition, in the case of those institutions in the lowest risk category, the FDIC further determines its assessment rate based on certain specified financial ratios or, if applicable, its long-term debt ratings. On December 16, 2008, the FDIC adopted a final rule increasing risk-based assessment rates uniformly by 7 basis points, on an annual basis, for the first quarter of 2009. During 2007 and 2008, banks paid between 5 and 43 basis points of the value of their domestic deposits for FDIC insurance. Under the final rule, risk-based rates would range between 12 and 50 basis points (annualized) for the first quarter 2009 assessment, depending on the insured institution’s risk category as described above. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits. The FDIC has published guidelines under the Reform Act on the adjustment of assessment rates for certain institutions. Under the current system, premiums are assessed quarterly. The Reform Act also provides for a one-time premium assessment credit for eligible insured depository institutions, including those institutions in existence and paying deposit insurance premiums on December 31, 1996, or certain successors to any such institution. The assessment credit is determined based on the eligible institution’s deposits at December 31, 1996 and is applied automatically to reduce the institution’s quarterly premium assessments to the maximum extent allowed, until the credit is exhausted. In addition, insured deposits have been required to pay a pro rata portion of the interest due on the obligations issued by the Financing Corporation (“FICO”) to fund the closing and disposal of failed thrift institutions by the Resolution Trust Corporation.

On February 27, 2009, the FDIC adopted an interim rule, with request for comment, which would institute a one-time special assessment of 20 cents per $100 of domestic deposits on FDIC insured institutions. The assessment would be payable on September 30, 2009. On March 5, 2009, the chairman of the FDIC announced that the regulatory agency intends to lower the special assessment from 20 cents to 10 cents per $100 of insured deposits. The approval of this reduction is contingent on whether the U.S. Congress passes legislation that would expand the FDIC’s line of credit with the Treasury to $100 billion. The assessment rates, including the special assessment, are subject to change at the discretion of the Board of Directors of the FDIC. If the special assessment is approved at 10 cents per $100 of insured deposits, the Bank estimates that its assessment will be approximately $0.2 million based on the December 31, 2008 deposits subject to assessment.

In 2008, the FDIC increased the insurance limits under the Deposit Insurance Fund (the “DIF”) up to a maximum of $250,000 from the previous maximum of $100,000 per insured depositor. The new limit is effective until December 31, 2009 when the maximum is scheduled to revert to $100,000, except on certain retirement accounts that are expected to retain the $250,000 limit. The Company and the Bank have “opted in” to the Temporary Liquidity Guarantee Program (“TLGP”), established by the FDIC on October 14, 2008 to provide unlimited FDIC insurance on non-interest bearing deposit accounts and NOW accounts paying interest at a rate no higher than 50 basis points (“bp”). This program continues until December 31, 2009.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) provides for, among other things, (i) publicly available annual financial condition and management reports for certain financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a “prompt corrective action” system of regulatory supervision and intervention, based on capitalization levels, with greater scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver, and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA provides for increased funding of the FDIC insurance funds and the implementation of risk-based premiums.

A central feature of FDICIA is the requirement that the federal banking agencies take “prompt corrective action” with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” An institution may be

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deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. FDICIA authorized the FDIC to revise the risk-based assessment system, subject to notice and comment and caps the amount of the DIF at 1.50% of domestic deposits. The FDIC must issue cash dividends, awarded on a historical basis, for the amount of the DIF over the 1.50% ratio. Additionally, if the DIF exceeds 1.35% of domestic deposits at year-end, the FDIC must issue cash dividends, awarded on a historical basis, for half of the amount of the excess.

Capital Requirements for the Bank. The Bank, as a NC commercial bank, is required to maintain a surplus account equal to 50% or more of its paid-in capital stock. As a NC chartered, FDIC-insured commercial bank, which is not a member of the Federal Reserve System, the Bank is also subject to capital requirements imposed by the FDIC. Under the FDIC’s regulations, state nonmember banks that (i) receive the highest rating during the examination process and (ii) are not anticipating or experiencing any significant growth, are required to maintain a minimum leverage ratio of 3% of total consolidated assets; all other banks are required to maintain a minimum ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. The Bank exceeded all applicable capital requirements as of December 31, 2008.

Community Reinvestment. Under the CRA, as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate-income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions’ records of meeting the credit needs of their communities, using the ratings of “outstanding”, “satisfactory”, “needs to improve”, or “substantial noncompliance”, and to take that record into account in its evaluation of certain applications by those institutions. The CRA assessment is required of any bank which has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office, or (v) merge or consolidate with, acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. All institutions are required to make public disclosure of their CRA performance ratings. The Bank received an “outstanding” rating in its last CRA examination, which was conducted during October 2003.

The GLB Act’s “CRA Sunshine Requirements” call for financial institutions to disclose publicly certain written agreements made in fulfillment of the CRA. Banks that are parties to such agreements must report to federal regulators the amount and use of any funds expended under such agreements on an annual basis, along with such other information as regulators may require.

USA Patriot Act. The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in New York, Pennsylvania and Washington, D.C. on September 11, 2001. The Act was intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contained sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Federal Home Loan Bank System. The Federal Home Loan Bank system provides a central credit facility for member institutions. As a member of the FHLB of Atlanta (“FHLB”), the Bank is required to own capital stock in the FHLB in an amount at least equal to 0.18% (or 18 basis points) of the Bank’s total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB of Atlanta under the new activity-based stock ownership requirement. On December 31, 2008, the Bank was in compliance with this requirement.

Restrictions on Transactions with Affiliates. The Bank is subject to the provisions of Sections 23A and 23B of the Federal Reserve Act and Regulation W. Section 23A places limits on the amount of:

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The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must meet specified collateral requirements. The Bank must comply with other provisions designed to avoid the transfer of low-quality assets from an affiliate.

The Bank is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits a bank from engaging in the above transactions with its affiliates unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Under Section 22(h), loans to directors, executive officers and stockholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution’s loans-to-one-borrower limit (as discussed below). Section 22(h) prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and stockholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any “interested” director may not participate in the voting. The FDIC has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of directors approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the Federal Reserve requires that loans to directors, executive officers, and principal stockholders be made on terms substantially the same as offered in comparable transactions with non-executive employees of the Bank. The FDIC has imposed additional limits on the amount a bank can loan to an executive officer.

Emergency Economic Stabilization Act of 2008. In response to recent unprecedented market turmoil, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted on October 3, 2008. EESA authorizes the Treasury to purchase or guarantee up to $700 billion in troubled assets from financial institutions under the Troubled Asset Relief Program (“TARP”). Pursuant to authority granted under EESA, the Treasury has created the TARP Capital Purchase Program (“TCPP”) under which the Treasury is investing up to $250 billion in senior preferred stock of U.S. banks and savings associations or their holding companies. Qualifying financial institutions may issue senior preferred stock with a value equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion or 3% of risk-weighted assets.

With limited exceptions, institutions participating in the TCPP are required to issue warrants for common or preferred stock or senior debt to the Treasury. As a CDFI, the Company would not be required to issue warrants if it participates in TARP. If an institution participates in the TCPP or if the Treasury acquires a meaningful equity or debt position in the institution as a result of TARP participation, the institution is required to meet certain standards for executive compensation and corporate governance, including a prohibition against incentives that encourage senior executive officers to take unnecessary and excessive risks that threaten the value of the institution, recovery of bonuses paid to senior executives based on materially inaccurate earnings or other statements and a prohibition against agreements for the payment of golden parachutes. As of December 31, 2008, the Company was not a participant in the TARP or TCPP programs.

Comprehensive Financial Stability Plan of 2009. On February 10, 2009, the Secretary of the Treasury announced a new comprehensive financial stability plan (the “Financial Stability Plan”), which builds upon existing programs and earmarks the second $350 billion of unused funds originally authorized under the EESA. The major elements of the Financial Stability Plan include: (i) a capital assistance program that will invest in convertible preferred stock of certain qualifying institutions, (ii) a consumer and business lending initiative to fund new consumer loans, small business loans and commercial mortgage asset-backed securities issuances, (iii) a new public-private investment fund that will leverage public and private capital with public financing to purchase $500 billion to $1 trillion of legacy troubled assets from financial institutions, and (iv) assistance for homeowners by providing up to $75 billion to reduce mortgage payments and interest rates and establishing loan modification guidelines for government and private programs. Institutions receiving assistance under the Financial Stability Plan going forward will be subject to higher transparency and accountability standards, including restrictions on dividends, acquisitions and executive compensation and additional disclosure requirements. The Company cannot predict at this time the effect that the Financial Stability Plan may have on it or its business, financial condition or results of operations.

Limits on Rates Paid on Deposits and Brokered Deposits. FDIC regulations limit the ability of insured depository institutions to accept, renew or roll-over deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution’s normal market area. Under these regulations, “well capitalized” depository institutions may accept, renew or roll-over such deposits without restriction, “adequately capitalized” depository institutions may accept, renew or roll-over such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and “undercapitalized” depository institutions may not accept, renew, or roll-over such deposits. Definitions of “well capitalized,” “adequately capitalized” and “undercapitalized” are the same as the definitions adopted by the FDIC to implement the prompt corrective action provisions discussed above.

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Other. Additional regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state chartered institutions examined by state regulators. Additional regulations establish operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards.

The Bank is subject to examination by the FDIC and the Commissioner. In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. The Bank, as an insured NC commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.

Under Chapter 53 of the NC General Statutes, if the capital stock of a NC commercial bank is impaired by losses or otherwise, the Commissioner is authorized to require payment of the deficiency by assessment upon the bank’s stockholders, pro rata, and to the extent necessary, if any such assessment is not paid by any shareholder, upon 30 days notice, to sell as much as is necessary of the stock of such shareholder to make good the deficiency.

An investment in the Company’s common stock is subject to risks inherent in the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider these risks and uncertainties, together with all of the other information included or incorporated by reference in this Annual Report on Form 10-K. These risks and uncertainties are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s common stock could decline significantly, and you could lose all or part of your investment.

The Company’s business has been and may continue to be adversely affected by current conditions in the financial markets and economic conditions generally. The capital and credit markets have been experiencing unprecedented levels of volatility and disruption for more than a year. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. As a consequence of the recession that the United States now finds itself in, business activity across a wide range of industries face serious difficulties due to the lack of consumer spending and the extreme lack of liquidity in the global credit markets. Unemployment has also increased significantly. A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which we do business could have one or more of the following adverse effects on our businesses:

Current market developments may adversely affect our industry, business and results of operations. Declines in the housing market during 2008, with falling home prices and increasing foreclosures and unemployment, have resulted in, and may continue to result in, significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers including financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting lack of available credit, lack of confidence in the financial sector, increased volatility in the financial markets and reduced business activity could materially and adversely affect our business, financial condition and results of operations. Further negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provisions for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial services industry.

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The soundness of other financial institutions could adversely affect us. Since mid-2007, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence. The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the loan due us. There is no assurance that any such losses would not materially and adversely affect our businesses, financial condition or results of operations.

There can be no assurance that the EESA and other recently enacted government programs will help stabilize the U.S. financial system. On October 3, 2008, President Bush signed into law the EESA. The Treasury and federal banking regulators are implementing a number of programs under this legislation to address capital and liquidity issues in the banking system, including the TCPP, in which the Company participated. In addition, other regulators have taken steps to attempt to stabilize and add liquidity to the financial markets, such as the FDIC’s TLGP. The number of delinquencies, bankruptcies or defaults could result in a higher level of nonperforming assets, net charge-offs, provision for loan losses, and valuation adjustments on loans. On February 10, 2009, the Secretary of the Treasury announced the Financial Stability Plan, which earmarks the second $350 billion originally authorized under the EESA. The Financial Stability Plan is intended to, among other things, make capital available to financial institutions, purchase certain legacy loans and assets from financial institutions, restart securitization markets for loans to consumers and businesses and relieve certain pressures on the housing market, including the reduction of mortgage payments and interest rates. In addition, the ARRA, which was signed into law on February 17, 2009, includes, among other things, extensive new restrictions on the compensation arrangements of financial institutions participating in the TCPP. There can be no assurance, however, as to the actual impact that the EESA, as supplemented by the Financial Stability Plan, the ARRA and other programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the EESA, the ARRA, the Financial Stability Plan and other programs to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our businesses, financial condition, results of operations, access to credit or the trading price of our common stock. The EESA, ARRA and the Financial Stability Plan are relatively new initiatives and, as such, are subject to change and evolving interpretation. There can be no assurances as to the effects that any further changes will have on the effectiveness of the government’s efforts to stabilize the credit markets or on our businesses, financial condition or results of operations.

The Company is subject to extensive governmental regulation, which could have an adverse impact on our operations. The banking industry is extensively regulated and supervised under both federal and state law. Current and future legislation and the policies established by federal and state regulatory authorities will affect the Company’s operations. The Company is subject to supervision and periodic examination by the Federal Reserve and the Commissioner. The Bank, as a state chartered non-member commercial bank, receives regulatory scrutiny from the FDIC and the Commissioner. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you as an investor in the Company, by restricting the Company’s activities, such as: the Company cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on its business. Given the current disruption in the financial markets and regulatory initiatives that are likely to be proposed by the new administration and Congress, new regulations and laws that may affect us are increasingly likely. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities. Also, participation in specific programs may subject us to additional restrictions. We cannot assure you that such modifications or new laws will not adversely affect:

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Our regulatory position is discussed in greater detail under Item 1. “Business—Supervision and Regulation” of this Annual Report on Form 10-K. In addition, the Company will be required to pay significantly higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

We may need to raise additional capital in the future and such capital may not be available when needed or at all. We may need additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. The ongoing liquidity crisis and the loss of confidence in financial institutions may increase our cost of funding and limit our access to some of our customary sources of capital, including, but not limited to, inter-bank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve. We cannot assure you that such capital will be available to us on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on our businesses, financial condition and results of operations.

The Company Relies on Dividends from the Bank for Most of its Revenue. The Company is a separate and distinct legal entity from the Bank. It receives substantially all of its revenue from dividends received from the Bank. These dividends are the principal source of funds to pay dividends on the Company’s common stock, and interest and principal on its outstanding debt securities. Various federal and/or state laws and regulations limit the amount of dividends that the Bank may pay to the Company. In the event the Bank is unable to pay dividends to the Company, the Company may not be able to service debt, pay obligations, or pay dividends on the Company’s common stock. The inability to receive dividends from the Bank could have a material adverse effect on the Company’s business, financial condition and results of operations. See Item 1 “Business — Supervision and Regulation”.

The Bank may have higher loan losses than the Bank’s allowance for loan losses. The Bank maintains an allowance for credit losses, which is a reserve established through a provision for credit losses charged to expense that represents management’s best estimate of probable losses that will be incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated credit losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific loan risks; credit loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for credit losses inherently involves a high degree of subjectivity and requires management to make significant estimates of current loan risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Bank’s control, may require an increase in the allowance for credit losses. Repayment of such loans is generally considered more subject to market risk than residential mortgage loans. In addition, bank regulatory agencies periodically review the Bank’s allowance for credit losses and may require an increase in the provision for credit losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for credit losses, the Bank will need additional provisions to increase the allowance for credit losses. Any increases in the allowance for credit losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Company’s financial condition and results of operations. See Provision and Allowance for Loan Losses in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations for further discussion related to the Bank’s process for determining the appropriate level of the allowance for loan losses.

The Company’s growth strategy may not be successful. As a strategy, the Company seeks to increase the size of its franchise by pursuing business development opportunities. The Company can provide no assurance that it will be successful in increasing the volume of the Company’s loans and deposits at acceptable risk levels and upon acceptable terms, expanding its asset base while managing the costs and implementation risks associated with this growth strategy. There can be no assurance that any expansion will be profitable or that the Company will be able to sustain its growth, either through internal growth or through successful expansions of its banking markets, or that the Company will be able to maintain capital sufficient to support its continued growth.

The Bank is Subject to Interest Rate Risk. The Bank’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and investment securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Bank’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Bank receives on loans and investment securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Bank’s ability to originate loans and obtain deposits, (ii) the fair value of the Bank’s financial assets and liabilities, and (iii) the average duration of certain of the Bank’s interest-rate sensitive assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Bank’s net interest income and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. In addition, there are costs associated with the Bank’s risk management techniques, and these costs

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could be material. Fluctuations in interest rates are not predictable or controllable and, therefore, there can be no assurances of the Bank’s ability to continue to maintain a consistent, positive spread between the interest earned on the Bank’s earning assets and the interest paid on the Bank’s interest-bearing liabilities. See Asset/Liability Management in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Company’s management of interest rate risk.

If the Bank loses key employees with significant business contacts in its market areas, its business may suffer. The Bank’s success is largely dependent on the personal contacts of our officers and employees in its market areas. If the Bank loses key employees temporarily or permanently, this could have a material adverse effect on the business. The Bank could be particularly hurt if its key employees go to work for competitors. The Bank’s future success depends on the continued contributions of its existing senior management personnel, many of whom have significant local experience and contacts in its market areas.

The Company’s operating results and financial condition would likely suffer if there is deterioration in the general economic condition of the areas in which the Bank does business. Unlike larger national or other regional banks that are more geographically diversified, the Bank primarily provides services to customers located in the Raleigh, Durham, Winston-Salem, Greensboro, and Charlotte areas of NC. Because the Bank’s lending and deposit-gathering activities are concentrated in these markets, the Bank will be affected by the business activity, population, income levels, deposits and real estate activity in these markets. Adverse developments in local industries have had and could continue to have a negative effect on the Bank’s financial condition and results of operations. Even though the Bank’s customers’ business and financial interest may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce the Bank’s growth rate, affect the ability of the Bank’s customers to repay their loans and generally affect the Company’s financial condition and results of operations. A significant decline in general economic conditions in the Bank’s market areas, or the entire country, caused by inflation, recession, unemployment or other factors which are beyond the Bank’s control would also impact these local economic conditions and could have an adverse affect on the Company’s financial condition and results of operations.

The Company is subject to security and operational risks related to the technology the Company uses that could result in a loss of customers, increased costs and other damages which could be material. The Company depends on data processing, software and communication and information exchange on a variety of platforms, networks and over the internet. Despite safeguards, the Company cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. Any failure or interruptions or breach of security of these systems could result in failures or disruptions in its customer relationships, general ledger, deposits and servicing or loan origination systems. The occurrence of any such failures or difficulties could result in a loss of customer business, damage the Bank’s reputation, subject the Bank to additional regulatory scrutiny or expose the Bank to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s results of operations and financial condition.

The Bank faces strong competition in our market areas, which may limit our asset growth and profitability. The banking business in the Bank’s market areas is very competitive, and the level of competition facing the Bank may increase further, which may limit the Bank’s asset growth and/or profitability. The Bank experiences competition in both lending and attracting deposits from other banks and nonbank financial institutions located within its market areas, some of which are significantly larger institutions and may have more financial resources than the Bank. Such competitors primarily include national, regional and local financial institutions within the Bank’s market areas. Additionally, various out-of-state banks have begun to enter or have announced plans to enter the market areas in which the Bank currently operates. Nonbank competitors for deposits and deposit-type accounts include savings associations, credit unions, savings banks, securities firms, money market funds, life insurance companies and the mutual funds industry. For loans, the Bank encounters competition from other banks, savings associations, finance companies, mortgage bankers and brokers, insurance companies, small loan and credit card companies, credit unions, pension trusts, securities firms and major retail stores that offer competing financial services. Many of these competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Bank can offer.

The Company could violate debt covenants. The Company entered into a $5.0 million revolving line of credit (“the Line of Credit”) with a correspondent bank in 2008, primarily to fund the Acquisition. The Line of Credit is secured by a pledge of Bank stock. During 2008, the maximum outstanding balance on under the Line of Credit was $0.8 million, with $0.5 million outstanding as of December 31, 2008. The Line of Credit agreement requires the Company to satisfy certain fiscal and regulatory criteria for the term of the Line of Credit, including a minimum loan-to-book value, maintaining well-capitalized status, minimum levels of equity capital, annualized earnings and return on average asset ratios, and other specific ratios related to the loan portfolio. In the event that the Company fails to comply with some or all of these requirements, it has undertaken not to pay any dividends, except with the prior approval of the correspondent bank. Also, the lender may declare the Company to be in default, in which case it may accelerate payment of the Line of Credit and sell the pledged Bank stock (subject to its receipt of necessary regulatory approvals). As of December 31, 2008, the Company was not in compliance with some of these requirements, and requested and received a waiver of certain conditions in order to pay its stockholders a dividend for the fourth quarter. In the event that the Company defaults on the Line of Credit again, the lender may choose not to waive the requirements or the default, and choose instead to accelerate payment of the

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Line of Credit and sell the pledged Bank stock and/or deny the Company’s request to pay a dividend, any of which would have a material adverse effect on the Company. To mitigate this risk, the Company intends to seek to renegotiate some of the terms of the Line of Credit, but no assurance can be given that it will be successful in so doing.

The Bank is Subject to Environmental Liability Risk Associated with Lending Activities. A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.

The Company’s common stock is not FDIC insured. The Company’s common stock is not a savings or deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental agency and is subject to investment risk, including the possible loss of principal. Investment in the Company’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any the Company. As a result, holders of the Company’s common stock may lose some or all of their investment.

None

At December 31, 2008, the Company conducted its business from the headquarters office in Durham, NC, and its nine branch offices in Durham, Raleigh, Charlotte, Greensboro and Winston-Salem, NC.

The following table sets forth certain information regarding the Bank’s properties as of December 31, 2008. Rent expense incurred by the Bank under ongoing leases totaled approximately $55 thousand for the year ended December 31, 2008. Total rent expense for the year ended December 31, 2008 totaled $166 thousand, which included rental of the former MCSB corporate center which was consolidated into a nearby branch in September 2008.

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Management considers all properties to be in good condition and adequately covered by insurance. Additional information about the Company’s property is set forth in Notes 7 and 9 to the Consolidated Financial Statements, included in Item 8 herein.

From time to time, the Company may become involved in legal proceedings occurring in the ordinary course of business. However, subject to the uncertainties inherent in any litigation, management believes there currently are no pending or threatened proceedings that are reasonably likely to result in a material adverse change in the Company’s consolidated financial condition or operations.

No matter was submitted to a vote of the Company’s stockholders during the quarter ended December 31, 2008.

PART II

The Company’s common stock is quoted on the OTC Bulletin Board under the symbol “MFBP”.

As of March 10, 2009, there were 2,031,337 shares of the Company’s common stock outstanding, which were held by 1,088 stockholders of record, (not including persons or entities whose stock is held in nominee or ‘street’ name through various brokerage firms or banks). The following table shows the high and low sale price of the Company’s common stock for the previous eight quarters, as well as the per share amount of cash dividends paid per share for the same periods. These quotations reflect inter-dealer prices, without retail mark up, mark down or commission and may not represent actual transactions. No stock dividend was declared or paid during any of the fiscal quarters listed.

Dividends. See “Item 1. Description of Business – Supervision and Regulation – Dividend and Repurchase Limitations” above for regulatory restrictions, which limit the ability of the Company to pay dividends. The Company entered into a $5.0 million revolving line of credit with a correspondent bank in 2008, primarily to fund the Acquisition. The Company is required to satisfy certain fiscal and regulatory criteria for the term of the line of credit, failing which it has undertaken not to pay any dividends, except with the prior approval of the correspondent bank. As of December 31, 2008, the Company was not in compliance with some of these requirements, and requested and received a waiver of certain conditions in order to pay its stockholders a dividend for the fourth quarter. See Note 10 for a more detailed discussion concerning the line of credit.

Dividend Policy. The Company’s stockholders are entitled to receive such dividends or distributions as the Board of Directors declares in its discretion. During fiscal year 2008, the Company declared and paid to its stockholders dividends totaling $0.20 per share (see chart above for declared quarterly dividends). The Company will continue to pay stockholders in the form of quarterly cash dividends if such cash dividends, if doing so is considered to be in the best interest of the Company and consistent with maintaining the Company’s status as a “well capitalized” institution under applicable banking laws and regulations. In 2008, the dividends awarded to stockholders accounted for 43.5% of fully diluted earnings per share. The declaration of any future dividends and the establishment of the record dates related thereto remains subject to further action by the Company’s Board of Directors, as well as the limitations discussed above.

Recent Sales of Unregistered Securities. The Company did not sell any securities within the last three fiscal years that were not registered under the Securities Act.

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Purchases of Equity Securities by the Issuer and Affiliated Purchasers. The Company did not repurchase any shares of its common stock within the fourth quarter of 2008.

Equity Compensation Plan. The Company has a stock option plan providing for the issuance of up to 171,000 options to purchase shares of the Company’s stock. As of December 31, 2008, options for 145,800 shares of common stock remained available for future issuance. Grants of options are made by the Board of Directors or the Compensation/Personnel Committee. All grants must be at no less than fair market value on the date of grant, must be exercised no later than 10 years from the date of grant, and may be subject to some vesting provisions. All options outstanding as of December 31, 2008 were fully vested.

The following table sets forth information as of December 31, 2008, regarding equity compensation plans under which equity securities of the Company are authorized for issuance:

The following table sets forth selected financial information for the Company, including balance sheet and operational data as of and for the years ended December 31, 2008, 2007, and 2006 portions of which have been derived from, and is qualified by reference to, the Consolidated Financial Statements and notes thereto included elsewhere in this report, which should be read in conjunction with such Consolidated Financial Statements and notes thereto. The comparability of financial data for these periods has been significantly impacted by the Acquisition of MCSB in 2008.

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INTRODUCTION

The following discussion and analysis is intended to aid the reader in understanding and evaluating the Company’s consolidated results of operations and financial condition. This discussion is designed to provide more comprehensive information about the major components of the Company’s results of operations and financial condition, liquidity, and capital resources than can be obtained from reading the financial statements alone. This discussion should be read in conjunction with, and is qualified in its entirety by reference to, the Company’s Consolidated Financial Statements, including the related notes thereto presented elsewhere in this report.

OVERVIEW

The Bank is a full-service state chartered bank conducting business in the four largest urban areas of NC: Raleigh, the State’s Capitol, Durham, Winston-Salem, Greensboro, and Charlotte. Beginning in 2007, the Bank celebrated the 100^th anniversary of its founding in 1907 and the opening of its first branch in 1908 on Parrish Street in Durham where the Bank continues to operate a branch. In 1999 the Company was created as a bank holding company. As of December 31, 2008 the Company conducted no business other than providing services and assistance to the Bank, its wholly owned subsidiary.

On March 28, 2008, the Company completed the Acquisition of MCSB, which had opened its original operation in a teller window of the Bank 84 years previously. Additional information about the Acquisition is set forth in Note 2 to the Consolidated Financial Statements, included in Item 8. The Acquisition affects the comparability of the results of operations and balance sheets as of and for the years ended December 31, 2008 and 2007.

The Bank’s business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans, single-family residential mortgage loans, and home equity lines. As a community bank, the Bank’s profitability depends primarily upon its levels of net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Bank’s profitability is affected by its provision for loan losses, noninterest income, and other operating expenses. Noninterest income primarily consists of service charges and ATM fees, rental income, and the increase in cash surrender value of bank-owned life insurance. Operating expenses primarily consist of compensation and benefits, occupancy related expenses, marketing, data processing, professional fees, telecommunication and other non-interest expenses.

The Bank’s operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The Bank’s costs of funds are influenced by interest rates on deposits and borrowing rates offered by competing financial institutions in our market area, as well as general market interest rates. Lending activities are affected by the demand for financing, which in turn is affected by the prevailing interest rates.

EXECUTIVE SUMMARY

Impact of Recent Developments on the Banking Industry

The banking industry, including the Company, is operating in a challenging and volatile economic environment. The effects of the downturn in the housing market have adversely impacted credit markets, consumer confidence and the broader economy. Along with other financial institutions, the Company’s stock price has suffered as a result. Management cannot predict when these market difficulties will subside. While the current economic downturn and the difficulties it presents for the Company and others in the banking industry are unprecedented, management believes that the business is cyclical and must be viewed and measured over time. The Company’s primary focus at this time is to manage the business safely during the economic downturn and be poised to take advantage of any market opportunities that may arise.

Because of the current economic situation, U.S. and foreign governments have acted in attempts to stabilize the financial system. For example, the U.S. government enacted the EESA, which, among other things, authorized the Treasury to establish the TARP, of which the TCPP is a part. Under the TCPP, certain qualifying U.S. financial institutions may sell senior preferred stock and warrants to purchase common stock to the Treasury in exchange for a capital infusion. It is not clear at this time what impact these measures will have on the on the Company or the financial markets as a whole. Management will continue to monitor the effects of these programs as they relate to the Company and its financial operations.

As discussed in more detail below, the following is a brief summary of the Company’s significant results for the year ended December 31, 2008.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The following discussion and analysis of the Company’s financial condition and results of operations are based on the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments regarding uncertainties that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to the allowance for loan losses, investment and intangible asset values, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. However, because future events and their effects cannot be determined with certainty, actual results may differ from these estimates under different assumptions or conditions, and the Company may be exposed to gains or losses that could be material.

The Company’s significant accounting policies are discussed below and in Item 8. Financial Statements and Supplementary Data — Notes to Consolidated Financial Statements – Note 1. Summary of Significant Accounting Policies. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating the Company’s reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Board of Directors.

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RESULTS OF OPERATIONS

Year Ended December 31, 2008 Compared with Year Ended December 31, 2007

Net Interest Income. Net interest income, the difference between total interest income from loans and investments and total interest expenses from deposits and borrowings, is the Company’s principal source of earnings. The amount of net interest income is determined by the volume of interest-earning assets, the level of rates earned on those assets, and the volume and cost of underlying funding. Net interest income before provision for loan losses increased $1.2 million, or 13.9%, from $8.9 million for the year ended December 31, 2007, to $10.1 million for the year ended December 31, 2008. Net interest spread is the difference between rates earned on interest-earning assets and the interest paid on deposits and borrowed funds. Net interest margin is the total of net interest income divided by average earning assets. Average earning assets for the year ended December 31, 2008 were $235.4 million, up 3.6% compared to $227.3 million for the year ended December 31, 2007. On a fully taxable equivalent (“TE”) basis, net interest margin was 4.44% and 4.08% for the years ended December 31, 2008 and 2007, respectively. The net interest spread on a fully TE basis increased by 49 bps to 3.96% for the year ended December 31, 2008 from 3.47% for the year ended December 31, 2007. The yield on average interest-earning assets was 6.36% and 6.91% for the years ended December 31, 2008 and 2007, respectively, a decrease of 55 bps, while the interest rate on average interest-bearing liabilities for those periods was 2.40% and 3.44%, respectively, a decrease of 104 bps.

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The Company’s balance sheet remains asset sensitive and, as a result, its interest-earning assets reprice faster than its interest-bearing liabilities. As time deposits mature and reprice, the margin has been and may continue to be negatively impacted based on pricing competition to retain these deposits. With the continuing recession and the uncertainty in the markets, the Company expects to experience margin compression throughout 2009. The Company cannot be certain of the future direction of the benchmark Fed Funds rates as set by the FOMC.

Interest income decreased 4.17% for the year ended December 31, 2008 to $14.7 million, from $15.3 million for the year ended December 31, 2007. The average balances of loans, which had overall yields of 6.72% for the year ended December 31, 2008 and 7.51% for the year ended December 31, 2007, respectively, increased 25.43% from $149.4 million for the year ended December 31, 2007 to $187.4 million for the year ended December 31, 2008. The average balance of investment securities decreased 36.21% from $57.4 million for the year ended December 31, 2007 to $36.6 million for the year ended December 31, 2008. The TE yield on investment securities decreased from 6.51% for the year ended December 31, 2007 to 6.14% for the year ended December 31, 2008. The average balances of federal funds and other short-term investments decreased 44.57% from $20.5 million for the year ended December 31, 2007 to $11.3 million for the year ended December 31, 2008, and the average yield in this category decreased 275 bps from 4.92% to 2.17% over the same time period as a result of the decrease in short-term interest rates during 2008.

Interest expense decreased 29.40% for the year ended December 31, 2008 to $4.5 million, from $6.4 million for the year ended December 31, 2007. Average total interest-bearing deposits, including savings, interest-bearing demand deposits and time deposits decreased 0.31% from $167.8 million for the year ended December 31, 2007 to $167.2 million for the year ended December 31, 2008. The average rate paid on interest-bearing deposits decreased 102 bps from 3.32% for the year ended December 31, 2007 to 2.30% for the year ended December 31, 2008, primarily in response to the decreases in rates by the FOMC discussed above.

The average rate on borrowings decreased from 4.56% for the year ended December 31, 2007 to 3.20% for the year ended December 31, 2008. The average borrowings outstanding increased 15.87% from $17.7 million for the year ended December 31, 2007 to $20.5 million for the year ended December 31, 2008. The interest expense on borrowed funds decreased 18.69% from $0.8 million in 2007 to $0.7 million in 2008, reflecting lower rates partially offset by higher average balances. Borrowings assumed from MCSB totaled $9.1 million.

The following table, Average Balances, Interest Earned or Paid, and Interest Yields/Rates reflects the Company’s effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. Changes in net interest income from year to year can be explained in terms of fluctuations in volume and rate. In the tables, the amount earned on nontaxable securities is reflected as actual, whereas the rate on nontaxable securities is stated at the TE rate.

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Average Balances, Interest Earned or Paid, and Interest Yields/Rates

For the Years Ended December 31, 2008 and 2007

The following table shows the Average Balances, Interest Earned or Paid, and Interest Yields/Rates for the years ending December 31, 2007 and 2006.

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Average Balances, Interest Earned or Paid, and Interest Yields/Rates

For the Years Ended December 31, 2007 and 2006

The following table, Rate and Volume Variance Analysis, presents further information on those changes. For each category of interest-earning asset and interest-bearing liability, we have provided information on changes attributable to:

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Rate and Volume Variance Analysis

Provision and Allowance for Loan Losses. The provision for loan losses is the amount charged against earnings for the purpose of establishing an adequate allowance for loan losses. Loan losses are, in turn, charged to this allowance rather than reported as a direct expense. For the year ended December 31, 2008, the allowance for loan losses was $3.0 million compared to $1.9 million for the year ended December 31, 2007, an increase of $1.1 million, which represented approximately 1.42% and 1.30% of total loans outstanding on those respective dates. Nonperforming assets at December 31, 2008 were 2.13% of total assets compared to 0.85 % at December 31, 2007. Nonperforming loans as percentage of total loans at the end of 2008 was 2.77% compared to 1.29% at December 31, 2007.

The amount of the allowance for loan losses is established based on management’s estimate of the inherent risks associated with lending activities, estimated fair value of collateral, past experience and present indicators such as delinquency rates and current market conditions. In 2008, in connection with the MCSB acquisition, the Company added MCSB’s recorded allowance for loan losses, which totaled $0.7 million.

Management has allocated the allowance for loan losses by category, as shown in the following table. This allocation is based on management’s assessment of the risks associated with the different types of lending activities.

The Company experienced $0.4 million in net loans charged-off for the year ended December 31, 2008 compared to $0.3 million in net loan charge-offs for the year ended December 31, 2007. Net loan charge-offs as a percent of average loan balances outstanding increased from 0.20% for the year ended December 31, 2007 to 0.23% for the year ended December 31, 2008.

The following table shows changes in the allowance for loan losses arising from loans charged off and recoveries on loans previously charged off by loan category and additions to the allowance that have been charged to expenses.

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