M&F BANCORP INC /NC/ - Quarter Report: 2008 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2008

Commission file number 0-27307

M&F BANCORP, INC.

(Exact name of registrant as specified in its charter)

2634 Durham Chapel Hill Blvd., Durham, NC 27707-2800

(Address of Principal Executive Offices)

(919) 683-1521

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company” in rule 12b-2 of the Exchange Act. (Check One)

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  x

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

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

Common Stock no par value 2,031,337

Outstanding at May 19, 2008

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PART I

FINANCIAL INFORMATION

Item 1 — Consolidated Financial Statements

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

See notes to consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

See notes to consolidated financial statements

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Notes to Consolidated Financial Statements

Basis of Presentation

The consolidated financial statements include the accounts and transactions of M&F Bancorp, Inc. (the “Company”) and its wholly-owned bank subsidiary, Mechanics & Farmers Bank (the “Bank”). All significant inter-company accounts and transactions have been eliminated in consolidation. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) for interim financial statements and in accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X. The accompanying interim consolidated financial statements are unaudited except for the balance sheet as of December 31, 2007, which was derived from the Company’s audited consolidated Annual Report on Form 10-KSB.

The consolidated financial statements included herein do not include all the information and notes required by U.S. GAAP and should be read in conjunction with the consolidated financial statements and the related notes thereto included in the Company’s Annual Report on Form 10-KSB as of and for the year ended December 31, 2007.

In the opinion of management, the interim financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the financial position, results of operations and cash flows in the accompanying unaudited consolidated financial statements. The unaudited operating results for the periods presented may not be indicative of annual results.

New Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) ratified the Emerging Issues Task Force (“EITF”) conclusion under EITF Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements (“EITF 06-4”). EITF 06-4 requires that endorsement split-dollar life insurance arrangements which provide a postretirement benefit to an employee be recorded in accordance with FASB Statement No. 106, Employer’s Accounting for Postretirement Benefits Other Than Pensions or APB Opinion No. 12, Omnibus Opinion—1967, based on the substance of the agreement with the employee. Under the provision of these Statements, a liability should be accrued equal to the actuarial present value of the future death benefit over the service period. EITF 06-4 is effective for fiscal years beginning after December 15, 2007. The effects of adopting EITF 06-4 can be recorded either as (i) a change in accounting principle through a cumulative-effect adjustment to retained earnings or to other components of equity as of the beginning of the year of adoption, or (ii) a change in accounting principle through retrospective application to all prior periods. The Company adopted EITF 06-4 as of January 1, 2008; adoption of these provision resulted in an increase in other liabilities of approximately $158 thousand with the offset reflected as a cumulative-effect adjustment to retained earnings.

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS No. 157 became effective for the Company beginning January 1, 2008. Certain requirements of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The effective date for other requirements of SFAS No. 157, which is elective, has been deferred for one year by the FASB. On January 1, 2008, the Company adopted SFAS No. 157, which has not had a material impact on the Company’s financial condition or results of operations.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to elect to follow fair value accounting for certain financial assets and liabilities in an effort to mitigate volatility in earnings without having to apply complex hedge accounting provisions. The standard also establishes presentation and disclosure requirements designed to facilitate comparison between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. On January 1, 2008, the Company adopted SFAS No. 159, which has not had a material impact on the Company’s financial condition or results of operations because the Company has not elected to include any items under its provisions.

In December 2007, the FASB issued Statement of SFAS No. 141 (revised 2007), Business Combinations. SFAS No. 141(R), among other things, establishes principles and requirements for how the acquirer in a business combination (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquired business, (ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase, and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business

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Notes to Consolidated Financial Statements, Continued

combination. SFAS No. 141(R) is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. The Company is required to adopt SFAS No. 141(R) for all business combinations for which the acquisition date is on or after January 1, 2009. This standard will change our accounting treatment for business combinations on a prospective basis.

In December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in Consolidated Financial Statements, an Amendment of ARB No. 51. SFAS No. 160 establishes accounting and reporting standards for non-controlling interests in a subsidiary and for the deconsolidation of a subsidiary. Minority interests will be re-characterized as non-controlling interests and classified as a component of equity. It also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary and requires expanded disclosures. This statement is effective for fiscal years beginning on or after December 15, 2008, with early adoption prohibited. The Company is currently evaluating the requirements of SFAS No. 160 but does not expect adoption to have any impact on its financial position, results of operation, or cash flows.

On March 28, 2008 the Company completed the acquisition of 100% of the outstanding stock of MCSB. The consolidated statements of income do not include the operations for MCSB prior to the acquisition on March 28, 2008.

The acquisition was accounted for as a purchase by the Company of MCSB using the purchase method of accounting; accordingly, the assets and liabilities of MCSB have been recorded at their respective fair values on the date the acquisition was completed. The acquisition was effected by the issuance of shares of the Company’s common stock to MCSB shareholders, subject to the assertion of dissenter’s rights. Each share of MCSB common stock was exchanged for one share of the Company’s common stock. The shares of the Company’s common stock issued were recorded at $8.73 per share. This represented the average closing share prices of the Company’s common stock on the day of, and for the period two days prior and two days after August 10, 2007, the day of the announcement of the acquisition.

In the acquisition, shareholders of MCSB received 345,691 shares of the Company’s stock valued at $3.0 million, a liability was established for dissenter’s rights payments totaling $0.2 million, and purchase price consideration was reduced by registration costs of $0.2 million. In addition, the Company incurred $0.8 million in direct acquisition costs which are included in other liabilities. Included in this amount is a severance benefit for MCSB employees terminated within 60 days after the acquisition, equal to two weeks salary plus a further one week’s salary for each year of credited service with MCSB in excess of two years, with the minimum severance of four weeks’ salary. Purchase price allocation is as follows:

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Notes to Consolidated Financial Statements, Continued

The aggregate value of the Company common stock exchanged and cash consideration paid was less than the fair value of the net assets of MCSB, resulting in a “credit excess” which was allocated on a pro rata basis against amounts assigned to the acquired assets except (i) financial assets other than investments accounted for by the equity method, (ii) assets to be disposed of by sale, (iii) deferred tax assets, (iv) prepaid assets relating to pension or other postretirement benefits, and (v) any other current assets. The credit excess remaining after reducing to zero the amounts that otherwise would have been assigned to those assets has been recognized as an extraordinary gain in the Company’s statement of operations. In accordance with the purchase method of accounting, the Company’s financial statements for periods before consummation of the acquisition were not restated to reflect MCSB’s historical financial position or results of operations.

The results of the fair market valuation indicated that there would be no core deposit intangible, and in accordance with SFAS No. 141 the fair value of premises and equipment of $1.0 million was eliminated against the initial calculation of the credit excess. Any remaining credit was recorded as extraordinary gain. The allocations made are preliminary and such amounts are subject to adjustments as additional analysis is performed or obtained from other third party sources. Any such adjustments would impact the extraordinary gain recognized herein.

On April 10, 2008, a dissenting MCSB shareholder demanded payment of the fair value of his 18,028 shares of MCSB common stock. The Company has tendered payment to the dissenting MCSB shareholder of the amount it estimates to be the fair value of his shares, plus accrued interest, in accordance with the terms of Article 13 of the North Carolina Business Corporation Act. The dissenting shareholder has subsequently notified the Company of his own estimate of the fair value and accrued interest and has demanded payment of the difference between this figure and the amount tendered by the Company. In accordance with Article 13, if this demand for payment remains unsettled, the dissenting shareholder may, within a specified period of time, commence legal proceedings to determine the fair value of the shares and accrued interest. Accordingly, at this time, the final payment cannot be determined. Ultimate resolution may impact the extraordinary gain recognized herein.

The following pro-forma information, for the three-month periods ended March 31, 2008 and 2007, reflects the Company’s estimated consolidated results of operations as if the acquisition occurred at January 1 of the respective periods, unadjusted for any anticipated cost savings resulting from the acquisition. Unaudited pro forma data is not necessarily indicative of the results that would have occurred had the acquisition taken place at the beginning of the periods presented, nor of future results.

Basic earnings per share (“EPS”) computations are based upon the weighted average number of shares outstanding during the periods. Diluted earnings per share computations are based upon the weighted average number of shares outstanding during each period plus the dilutive effect of outstanding stock options. The weighted average shares and effect of dilutive stock options are included in the following table, which provides a reconciliation of the number of shares between the computation of basic EPS and diluted EPS:

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Notes to Consolidated Financial Statements, Continued

The Company had 25,200 and no stock options which were anti-dilutive for the three-month periods ended March 31, 2008 and 2007, respectively.

Loans are made primarily to customers in the Company’s market areas within North Carolina. The Company’s loans, classified by type were as follows:

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Notes to Consolidated Financial Statements, Continued

Allowances for loan losses consisted of the following:

On March 25, 2008, the Company’s Board of Directors declared a quarterly cash dividend of $0.05 per share to all shareholders of record on March 25, 2008, payable on April 10, 2008. The dividend was accrued on the March 25, 2008 declaration date and, accordingly, reduced shareholders’ equity by approximately $0.1 million.

The Company sponsors a non-contributory qualified defined benefit retirement (pension) plan for substantially all full-time employees. The Company also sponsors a non-qualified, unfunded Supplemental Executive Retirement Plan that provides benefits to certain current and former executives.

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Notes to Consolidated Financial Statements, Continued

The components of the net periodic benefit cost for the three months ended March 31, 2008 and 2007 were as follows:

The Company provides certain post-retirement benefits to specific former executive officers. In 2008, a liability was established to record certain split-dollar insurance contract benefits to specified current and former executive officers. As of March 31, 2008, the amount of this liability was $0.2 million and reflected in other liabilities.

During the first quarter of each year, the Company develops an initial estimate of its expected annual effective income tax rate pursuant to SFAS No. 109, Accounting for Income Taxes, (“Annual Effective Tax Rate”). Factors affecting estimation of the Effective Tax Rate include the expected amount of pre-tax income adjusted for permanent differences (including investment income not subject to federal and/or state income taxes). Underlying tenets of the Company’s investment strategy are to focus on credit quality and to maximize yield (as measured on a fully taxable equivalent basis). Investment income from the Company’s bank-owned life insurance policies and certain debt investment securities represent permanent differences. The Company regularly reviews its estimate of the Annual Effective Tax Rate and will revise this estimate if assumptions change or actual results warrant.

On January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value under U.S. GAAP, and enhances disclosures about fair value measurements. The Company elected not to delay the application of SFAS No. 157 to non-financial assets and non-financial liabilities, as allowed by FASB Staff Position SFAS 157-2. SFAS No. 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value and, therefore, does not expand the use of fair value in any new circumstances. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. SFAS No. 157 requires fair value measurements to be separately disclosed by level within the fair value hierarchy. Under SFAS No. 157, the Company bases fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in SFAS No. 157.

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values.

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Notes to Consolidated Financial Statements, Continued

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Under SFAS No. 157, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. The Company has none of these instruments at March 31, 2008.

Level 2 — Valuations are obtained from readily available pricing sources via independent providers for market transactions involving similar assets or liabilities. The company’s principal market for these securities is the secondary institutional markets and valuations are based on observable market data in those markets. Level 2 securities include U. S. Government agency obligations, state and municipal bonds and mortgage-backed securities. The Company has Level 2 securities at March 31, 2008.

Level 3 — Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. The Company has Level 3 assets and liabilities at March 31, 2008.

Impaired loans: Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or market value. Market value is measured based on the value of the collateral securing these loans and is classified at a level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The value of business equipment, inventory, and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Other real estate owned: Assets are adjusted to fair value upon transfer of the loans to other real estate owned. Subsequently, other real estate owned are carried at the lower of the carrying value or the fair value. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the other real estate owned as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the other real estate owned as nonrecurring Level 3.

The following table summarizes quantitative about the fair value measurement for each category of assets carried at fair value as of March 31, 2008.

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Notes to Consolidated Financial Statements, Continued

The following discussion relates to the acquisition fair values:

Loans: Valuation experts performed a discounted cash flow analysis to determine the present value of the loans acquired from MCSB. The discount rate utilized was based on the weighted average coupon rate of each loan category in the acquired portfolio compared to current market rates for similar loans as suggested by SFAS No. 107 – “Disclosures about Fair Value of Financials Instruments” as amended by SFAS No. 157. Since market quotes for the valuation date are not readily available for all of the various categories of loans acquired, the valuation was based on MCSB’s posted rates for similar loan categories as of the acquisition date (Level 1 inputs). For commercial loans, the most current interest rate information on the measurement date for commercial and industrial loans made by small domestic banks was from the Federal Reserve’s E. Survey of Terms of Business Lending released on March 14, 2008 which included averages for more than $19 billion dollars of new loans for the measurement period dated February 4-8, 2008. In addition, Freddie Mac’s Weekly Primary Mortgage Market Survey for the week ending March 27, 2008 was utilized (Level 2 inputs).

These assumptions resulted in the fair value shown above, equating to a weighted rate reduction of 17 basis points in a replacement scenario. The Loan portfolio has been reflected in the table above as Level 2.

Fixed assets: Real estate appraisers analyzed the value of the buildings acquired utilizing market and cash flow assumptions. All other fixed assets, which were insignificant, were reflected at book value. With the mix of book and appraised values, fixed assets have been reflected as Level 3 assets.

Deposits: The fair value of core deposits as determined by the valuation experts utilized a discounted cash flow analysis of the deposits acquired from MCSB compared to alternative funding sources available to the Company to support the deposits acquired. Paragraph 12 of SFAS No. 107, for deposit liabilities with no defined maturities, defines the fair value of deposits as the amount payable on demand at the reporting date; therefore no mark-to-market adjustment is required. The fair value determination involves a number of underlying inputs and input levels:

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Notes to Consolidated Financial Statements, Continued

These assumptions did not provide a positive core deposit intangible premium value primarily as a result of the excessive overhead cost burden associated with multiple branch locations with a very small core deposit base. Given the mix of Level 2 and Level 3 inputs, the full fair value for deposits has been reflected in the table above as Level 3.

FHLB of Atlanta Borrowing Valuation: A discounted cash flow analysis was utilized to determine the present value of the borrowings from FHLB acquired in the transaction pursuant to SFAS No. 107 as amended by SFAS No. 157. The fair value of borrowed funds due within one year is the amount payable at the reporting date. The fair value of long term borrowed funds is estimated by discounting the future cash flows using the current rates at which similar loans could be obtained with similar credit ratings and for the same remaining maturities. FHLB advances are unique in that funds are available to member banks based on established size limitations and are not subject to pricing variations based on traditional credit ratings of the borrower as in a typical borrower/lender relationship. Consequently, the fair value adjustment only needs to take into account interest rate variations from the last date of pricing until the next re-pricing date in the case of adjustable rate credits and the next maturity date in the case of a fixed rate credit. Given the ready market information available to all member banks, this has been reflected in the table above as a Level 2.

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Notes to Consolidated Financial Statements, Continued

Commitments to Extend Credit

In the normal course of business, the Company has various commitments to extend credit, which are not reflected in the consolidated financial statements. As of March 31, 2008 and December 31, 2007, the Company had outstanding loan commitments (including available lines of credit) of approximately $25.7 million and $17.2 million, respectively. Commitments under standby letters of credit and financial guarantees amounted to approximately $0.8 million and $3.3 million as of March 31, 2008 and December 31, 2007, respectively. These letters of credit and financial guarantees represent agreements whereby the Company commits to lend funds to customers up to a predetermined maximum amount during a certain period.

The Company approves lines of credit to consumer customers through home equity and consumer overdraft protection loans, all of which are included in the above commitments to extend credit. As of March 31, 2008 and December 31, 2007, in addition to actual advances made on such loans, the Company’s consumer customers have available additional lines of credit on home equity and consumer overdraft protection loans. Available amounts on home equity lines as of March 31, 2008 and December 31, 2007 were approximately $2.2 million and $0.8 million, respectively. In addition, the available amounts on consumer overdraft protection loans were $0.7 million as of March 31, 2008 and December 31, 2007.

No significant losses are anticipated as a result of these transactions.

Fed Funds Line

As of March 31, 2008, the Company has available for use Federal Funds Lines (“Fed Funds”) aggregating $16.5 million from four money center banks. The Fed Funds Lines are renewed annually. Interest rates are stated as variable on a daily basis. No amounts were outstanding under the Fed Funds arrangements as of March 31, 2008, nor were any amounts drawn down during the three-month period ended March 31, 2008.

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Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Management’s Discussion and Analysis is provided to assist readers in understanding and evaluating the Company’s results of operations and financial condition. The following discussion is intended to provide a general overview of the Company’s performance for the three months ended March 31, 2008, with the same period in 2007. Readers seeking a more in-depth discussion are invited to read the more detailed discussions below, as well as the consolidated financial statements and related notes included under Item 1 of this Quarterly Report on Form 10-Q. All information presented is consolidated data unless otherwise specified.

Financial Highlights for the Quarterly Periods

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Forward-Looking Statements

When used in this Quarterly Report on Form 10-Q, the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project” or other similar expressions or the negative thereof are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties including changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans and deposits in the Company’s market area, and competition that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which are only as of the date they were made. The Company wishes to advise readers that such risks and uncertainties, including the factors listed above could affect the Company’s financial performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions, which may be made to any forward-looking statements to reflect events or occurrences after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

Critical Accounting Policies

The accounting and reporting policies of the Company are in accordance with U.S. GAAP and conform to general practices within the banking industry. The significant accounting policies of the Company are discussed in detail in Note 1 to the consolidated financial statements included in the Company’s 2007 Annual Report on Form 10-KSB. The following is a summary of certain of those policies.

Certain accounting policies require the Company to make significant estimates and assumptions, which have a material impact on the carrying value of certain assets and liabilities, and it considers these to be critical accounting policies. Four of the more critical accounting and reporting policies include the Company’s accounting for the allowances for loan losses, investment securities, periodic cost attributable to certain employees’ benefits and income taxes. The estimates and assumptions used by the Company are based on historical experience, current information and other factors, which it believes to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities as of the balance sheet dates and the results of operations for the reporting periods.

Allowance for Loan Losses

In originating loans, the Company recognizes that credit losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the quality of the collateral for the loan, as well as general economic conditions. It is management’s policy to maintain an adequate allowance for loan losses based on, among other things, the Company’s historical loan loss experience, evaluation of economic conditions and regular review of delinquencies and loan portfolio quality.

The Company prepares a quarterly analysis of the allowance for loan losses, with the objective of quantifying portfolio risk as a dollar amount. The determination of the allowance for loan losses is based on eight qualitative factors and one quantitative factor for each category and type of loan, along with any specific allowance for adversely classified loans within each category. Each factor is assigned a percentage weight and that total weight is applied to each loan category. Factors and associated weighting are different for each category. Qualitative factors include: levels and trends of delinquencies and non-accrual loans; trends in volumes and terms of loans; effects of any changes in lending policies; the experience, ability and depth of management; national and local economic trends and conditions; concentrations of credit; quality of the Company’s loan review system; and regulatory requirements. The total allowance thus changes as the percentage weight assigned to each factor is increased or decreased due to the particular circumstances, as the various types and categories of loans change as a percentage of total loans and as specific allowances are required due to increases in adversely classified loans. See Note 1 to the consolidated financial statements for the year ended December 31, 2007 in the Company’s 2007 Annual Report on Form 10-KSB for additional information regarding the determination of the provision and allowance for loan losses.

The Company follows the guidance of SFAS No. 5, Accounting for Contingencies and SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan—Income Recognition and Disclosures. SFAS No. 5 requires that losses be accrued when they are probable of occurring and estimatable. SFAS No. 114 requires that impaired loans, within its scope, be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan’s observable

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market price, or the fair value of the collateral, if the loan is collateral dependent. SFAS No. 114 excludes, from impairment reporting, smaller balance and homogeneous loans, which are collectively evaluated for impairment. Therefore, the Company has designated consumer and residential mortgage loans to be excluded for this purpose. From the remaining loan portfolio, loans rated as doubtful, non-accrual, or troubled debt restructurings are evaluated for impairment.

Loans are evaluated for non-accrual status when principal or interest is delinquent for 90 days or more and are placed on non-accrual status when a loan is specifically determined to be impaired. Any unpaid interest previously accrued on those loans is reversed from income. Any subsequent payments are applied to income on a cash basis unless, in management’s opinion, a potential for loss remains, until such loans are restored to accrual status. The loan will return to accrual status once the borrower has given evidence of the ability to resume payment on the impaired loan, as stated in the original contract.

Management actively monitors the Company’s asset quality, charges off loans against the allowance for loan losses and provides specific loss reserves when appropriate. Although management believes it uses the best current information available to make determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic or other qualitative and quantitative factors differ substantially from the conditions in the assumptions used in making the initial determinations.

Investment Securities

Debt securities, not classified as either “held to maturity” securities or “trading” securities, and equity securities, not classified as trading securities, are classified as “available for sale securities” and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of consolidated shareholders’ equity in accumulated other comprehensive income (loss). The fair values of these securities are based on quoted market prices, dealer quotes and prices obtained from independent pricing services. Available for sale and held to maturity securities, as well as investments included within other invested assets, are reviewed quarterly for possible other-than-temporary decline in value. The review is inherently subjective as it requires material estimates and judgments, including an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer and the Company’s ability and intent to hold the security to maturity. Declines in the fair value of the individual held to maturity and available for sale securities below their costs that are other than temporary, would result in write-downs of the individual securities to their respective fair value. Any related write-downs would be included in consolidated earnings as realized losses. As of March 31, 2008 and December 31, 2007, the Company had no held to maturity or trading securities.

Defined Benefit Plans

The Company sponsors a qualified defined benefit cash balance pension plan (the “Qualified Plan”), which covers substantially all full-time employees and a Supplemental Executive Retirement Plan (“SERP”), a non-qualified, unfunded plan to provide benefits to a select group of current and former, highly compensated employees. The SERP provides benefits that would otherwise be provided under the Qualified Plan but for maximum benefit and compensation limits applicable under the Internal Revenue Code of 1986, as amended.

The benefit cost and obligation are dependent on numerous factors resulting from actual plan experience and assumptions of future experiences. The assumptions include discount rates, inflation, salary growth and long-term return on plan assets.

Income Taxes

During the first quarter of each year, the Company develops its expected annual effective income tax rate (the “Annual Effective Tax Rate”). Provisions for interim period income taxes are based on amounts reported in the consolidated statements of operations (after exclusion of non-taxable income such as interest on state and municipal securities) utilizing the Annual Effective Tax Rate, unless circumstances change during the year, in which case the expected effective tax rate is adjusted.

The Company makes judgments regarding the recoverability of its recorded deferred tax assets. In accordance with SFAS 109, Accounting for Income Taxes, the carrying value of the net deferred tax assets is based on the belief that it is “more likely than not” that the Company will generate sufficient future taxable income to realize these deferred tax assets after consideration of all available evidence. The Company regularly reviews its deferred tax assets for recoverability considering historical profitability, projected future taxable income, and the expected timing of the reversals of existing temporary differences and tax planning strategies.

Valuation allowances for deferred tax assets which the Company believes do not meet the “more likely than not” criteria established by SFAS 109 have been established. If the Company is subsequently able to utilize all or a portion of the deferred tax assets for which a valuation allowance has been established, then the Company may be required to recognize these deferred tax assets through the reduction of the valuation allowance which would result in a benefit to its results of operations in the period in which the benefit is

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determined, excluding the recognition of the portion of the valuation allowance which relates to net deferred tax assets acquired in a business combination, were created as a result of share-based payments or were associated with components of Other Comprehensive Income (Loss) (“OCI”).

Executive Overview

The Company generated the majority of its interest and non-interest income in the first three months of 2008 and 2007 from traditional banking services—lending and deposit services. The Company continued to execute management’s strategy of targeting commercial business, diversifying the customer base, pursuing strategic relationships for deposits and increasing variable rate products.

As management looks to the remainder of 2008, it remains focused on the following areas:

Financial Condition

The asset, liability, and capital growths are primarily the result of the acquisition of MCSB in March 2008, as outlined in Note 2 to the Consolidated Financial Statements.

Total assets increased 24.62%, or $54.7 million, to $276.9 million as of March 31, 2008 from $222.2 million at December 31, 2007. Total assets acquired from MCSB were $64.6 million. Cash and cash equivalents increased $8.3 million or 45.92%, to $26.5 million as of March 31, 2008, compared to $18.2 million at December 31, 2007. Cash acquired from MCSB was $13.9 million. Loans increased 32.4%, or $47.3 million, to $193.4 million as of March 31, 2008, from $146.1 million as of December 31, 2007. Gross loans acquired from MCSB were $43.8 million.

The investment portfolio balance as of March 31, 2008 was $40.1 million compared to $43.6 million as of December 31, 2007, a net decrease of $3.5 million, or 7.96%. The entire investment portfolio was classified as available-for-sale and was comprised of investment-grade securities. No securities were purchased during the three months ended March 31, 2008.

Deposits increased 28.85%, or $49.6 million, to $221.7 million as of March 31, 2008 from $172.1 million at December 31, 2007. Total deposits acquired from MCSB were $49.3 million.

Total other borrowings increased $9.3 million or 66.72% at March 31, 2008 as compared to December 31, 2007. $0.3 million of the increase was the result of the company activating its line of credit for acquisition related expenditures. Further, $9.1 million of other borrowings were assumed from MCSB.

Total shareholders’ equity increased to $26.7 million as of March 31, 2008, compared with $22.2 million as of December 31, 2007. The increase was composed of net income of $1.6 million for the three months ended March 31, 2008, an increase of shares issued, net of registration costs, valued at $3.0 million in connection with the MCSB acquisition, and OCI of $0.2 million. The increase was offset by dividends declared of $0.1 million and a change in accounting principle related to split-dollar contract life insurance of $0.2 million.

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Results of Operations

Net income for the three months ended March 31, 2008, increased $1.2 million, or 281.12%, to $1.6 million, compared to net income of $0.4 million for the same period in 2007. The increase is primarily a result of a $1.8 million extraordinary gain from application of a credit excess in the purchase of MCSB. Net income from operations decreased $0.6 million to a loss of $0.2 million primarily as a result of a $0.3 million decrease in net interest income and a $0.4 million decrease in non-interest income.

Total interest income decreased $0.9 million or 24.00%, to $ 3.1 million for the three months ended March 31, 2008, compared to $4.0 million for the comparable period in 2007. Interest income on loans decreased $0.4 million primarily due to a decrease in average loans outstanding to $147.8 million from $153.8 million, coupled with a decrease in yield from 7.58% to 6.79% for the three months ended March 31, 2007 and 2008, respectively. Interest income on securities decreased $0.2 million or 33.88%, when comparing the three months ended March 31, 2008 with the same period in 2007.

Total interest expense decreased by $0.7 million for the three months ended March 31, 2008 as compared to the same period in 2007. During the three months ended March 31, 2008, the Company modestly decreased the loan loss provision from the three months ended March 31, 2007. The provision for loan losses is the result of management’s assessment of the Company’s delinquency ratios, non-performing assets, charge-off history, and composition of loans in the portfolio.

Non-interest income decreased $0.4 million or 47.14% for the three months ended March 31, 2008 as compared to the same period in 2007. The decrease was primarily a result of a $0.1 million decrease in realized gain on the sale of loans and a $0.2 million decrease in net realized gains on sale of available for sale securities.

Non-interest expense increased $0.2 million for the three months ended March 31, 2008 as compared to the same period in 2007. This increase was primarily the result of a $0.2 million increase in professional fees. Information technology expenses increased $0.1 million for the three months March 31, 2008 as compared to the same period in 2007.

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