exhibit13.htm

EXHIBIT (13)

Appendix A to the Proxy Statement for the 2009 Annual Meeting of Shareholders

APPENDIX A

PEOPLES BANCORP OF NORTH CAROLINA, INC.

General Description of Business

Peoples Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”). The Company is a bank holding company 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 principal source of income is any dividends, which are declared and paid by the Bank on its capital stock. The Company has no operations and conducts no business of its own other than owning the Bank. Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated.

The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 21 banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory, Charlotte, Monroe, Cornelius, Mooresville and Raleigh North Carolina. The Bank also operates a loan production office in Denver, North Carolina. At December 31, 2008, the Company had total assets of $968.8 million, net loans of $770.2 million, deposits of $721.1 million, total securities of $131.2 million, and shareholders’ equity of $101.1 million.

The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans. Real estate loans are predominately variable rate commercial property loans, which include residential development loans to commercial customers. Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio. The majority of the Bank's deposit and loan customers are individuals and small to medium-sized businesses located in the Bank's market area. The Bank’s loan portfolio also includes Individual Taxpayer Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco de le Gente offices. Additional discussion of the Bank’s loan portfolio and sources of funds for loans can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-29 of the Annual Report, which is included in this Form 10-K as Exhibit 13.

The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the "Commissioner").

At December 31, 2008, the Bank employed 270 full-time equivalent employees.

Subsidiaries

The Bank is a subsidiary of the Company. The Bank has two subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank's customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services. Real Estate Advisory Services, Inc., provides real estate appraisal and real estate brokerage services.

In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used in December 2006 to repay the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

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This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of Peoples Bancorp of North Carolina, Inc. (the “Company”). These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions. 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. Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank (the “Bank”), (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission. The Company undertakes no obligation to update any forward-looking statements.

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SELECTED FINANCIAL DATA

Dollars in Thousands Except Per Share Amounts

	2008		2007	2006	2005	2004
Summary of Operations
Interest income	$	56,323	61,732	55,393	41,913	35,095
Interest expense		23,527	27,585	23,110	15,429	12,335

Net interest income		32,796	34,147	32,283	26,484	22,760
Provision for loan losses		4,794	2,038	2,513	3,110	3,256

Net interest income after provision for loan losses		28,002	32,109	29,770	23,374	19,504
Non-interest income		10,495	8,816	7,554	6,668	6,000
Non-interest expense		28,893	25,993	22,983	20,330	18,840

Income before taxes		9,604	14,932	14,341	9,712	6,664
Income taxes		3,213	5,340	5,170	3,381	2,233
Net income	$	6,391	9,592	9,171	6,331	4,431

Selected Year-End Balances
Assets	$	968,762	907,262	818,948	730,280	686,348
Available for sale securities		124,916	120,968	117,581	115,158	105,598
Loans, net		770,163	713,174	643,078	559,239	527,419
Mortgage loans held for sale		-	-	-	2,248	3,783
Interest-earning assets		921,101	853,878	780,082	692,835	653,111
Deposits		721,062	693,639	633,820	582,854	556,522
Interest-bearing liabilities		758,334	718,870	650,364	576,681	553,135
Shareholders' equity	$	101,128	70,102	62,835	54,353	50,938
Shares outstanding*		5,539,056	5,624,234	5,745,951	5,677,328	5,689,763

Selected Average Balances
Assets	$	929,799	846,836	772,585	706,843	684,385
Available for sale securities		115,853	120,296	118,137	108,690	93,770
Loans		747,203	665,379	604,427	550,545	547,753
Interest-earning assets		876,425	801,094	732,244	668,614	650,528
Deposits		720,918	659,174	605,407	570,997	558,142
Interest-bearing liabilities		740,478	665,727	613,686	563,210	553,880
Shareholders' equity	$	76,241	70,586	62,465	55,989	51,978
Shares outstanding*		5,588,314	5,700,860	5,701,829	5,692,290	5,707,975

Profitability Ratios
Return on average total assets		0.69%	1.13%	1.19%	0.90%	0.65%
Return on average shareholders' equity		8.38%	13.59%	14.68%	11.31%	8.52%
Dividend payout ratio		41.93%	24.30%	20.78%	22.34%	28.37%

Liquidity and Capital Ratios (averages)
Loan to deposit		103.65%	100.94%	99.84%	96.42%	98.14%
Shareholders' equity to total assets		8.20%	8.34%	8.09%	7.92%	7.59%

Per share of common stock*
Basic net income	$	1.14	1.68	1.61	1.11	0.77
Diluted net income	$	1.13	1.65	1.58	1.09	0.77
Cash dividends	$	0.48	0.41	0.33	0.25	0.22
Book value	$	13.73	12.46	10.94	9.57	8.95

*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividend during first quarter 2005, a 10% stock dividend during second quarter 2006 and a 3-for-2 stock split during second quarter 2007.

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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-30 through A-61.

Introduction

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company, for the years ended December 31, 2008, 2007 and 2006. The Company is a registered bank holding company operating under the supervision of the Federal Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview

Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by 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”), inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and small businesses and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Federal Reserve has decreased the Federal Funds Rate 4.00% since December 31, 2007 with the rate set at 3.25% as of December 31, 2008. These decreases had a negative impact on 2008 earnings and will continue to have a negative impact on the Bank’s net interest income in the future periods. The negative impact from the decrease in the Federal Funds Rate has been partially offset by the increase in earnings realized on interest rate contracts, including both interest rate swaps and interest rate floors, utilized by the Company. Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”

On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”). Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and warrants to purchase 357,234 shares of common stock associated with the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”). Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale. Of the $25.1 million in

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proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant. The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield. No dividends were declared or paid on the Series A preferred stock during 2008, and cumulative undeclared dividends at December 31, 2008 were $28,000. The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate. Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things. Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.

The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends. Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital. However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator. The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000. There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.

It is the intent of the Company to utilize CPP funds to make loans to qualified borrowers in the Bank’s market area. The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure. The Bank is also working with its current builders and contractors to provide financing for potential buyers who may not be able to qualify for financing in the current mortgage market in order to help these customers sell existing single family homes. The Bank will also use the CPP capital infusion as additional Tier I capital to protect the Bank from potential losses that may be incurred during this current recessionary period.

The Company qualified as an accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934, effective December 31, 2006. Therefore, the Company was subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”). The Company incurred additional consulting and audit expenses in becoming compliant with SOX 404, and will continue to incur additional audit expenses to comply with SOX 404 when SOX 404 becomes applicable to smaller reporting companies. Management does not expect expenses related to SOX 404 to have a material impact on the Company’s financial statements. The Company qualified as a smaller reporting company effective June 30, 2008, due to a decrease in market capitalization. Management does not expect significant cost savings from this change in filing status, as certification of the effectiveness of internal controls by management will still be required.

The Bank opened a new office in Iredell County, in Mooresville, North Carolina in January 2008. Also in January 2008, the Bank opened a new Banco de la Gente office in Wake County, in Raleigh, North Carolina in a continuing effort to serve the Latino community. While there are no additional offices planned in 2009, management will continue to look for branching opportunities in nearby markets.

Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more

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complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2008 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 7, 2009 Annual Meeting of Shareholders.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to consolidated financial statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” For a more complete discussion of policies, see the notes to consolidated financial statements.

In September 2006, the Financial Accounting Standard Board (“FASB”) ratified the conclusions reached by the Emerging Issues Task Force (“EITF”) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue requires companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. During first quarter 2008, the Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 was effective for the Company as of January 1, 2008. This standard had no effect on the Company's financial position or results of operations.

SFAS No. 157 establishes a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The Company’s fair value measurements for items measured at fair value at December 31, 2008 included:

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916,349	935,032	122,731,317	1,250,000
Market value of derivatives (in other assets)	$	4,980,701	-	4,980,701	-

Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

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The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2008:

	Investment Securities Available for Sale
	Level 3 Valuation
Balance, beginning of period	$	250,000
Change in book value		-
Change in gain/(loss) realized and unrealized		-
Purchases/(sales)		1,000,000
Transfers in and/or out of Level 3		-
Balance, end of period	$	1,250,000

Change in unrealized gain/(loss) for assets still held in Level 3	$	0

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation	Total Gains/(Losses) for the Year Ended December 31, 2008
Impaired loans	$	7,073,045	-	5,902,848	1,170,197	(345,000)
Other real estate	$	1,866,971	-	1,866,971	-	(165,630)

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS No. 159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS No. 159 did not have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” This FSP provides guidance on accounting for a transfer of a financial asset and a repurchase financing under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” This FSP is not expected to have a material effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13.” This FSP amends SFAS No. 157, “Fair Value Measurements,” to exclude SFAS No. 13, “Accounting for Leases” and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS No. 13. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-2, “Effective Date of FASB Statement No. 157.” This FSP delays the effective date of SFAS No. 157, “Fair Value Measurements,” for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In October 2008, the FASB issued FSP FAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” This FSP clarifies the application of SFAS No. 157, “Fair Value Measurements,” in a market that is not active. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

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In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” SFAS No. 161 is an amendment to SFAS No. 133, which provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements. SFAS No. 161 is effective for the Company as of January 1, 2009. As this is a disclosure related standard, this standard is not expected to have any effect on the Company's financial position or results of operations. SFAS No. 161 will result in additional disclosures related to the Company’s derivatives.

In September 2008, the FASB issued FSP FAS No. 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 and Clarification of the Effective Date of FASB Statement No. 161.” This FSP is an amendment to SFAS No. 133, which provides for enhanced disclosure requirements for credit risk derivatives. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In December 2008, the FASB issued FSP FAS No. 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets.” This FSP amends SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.

The remainder of management’s discussion and analysis of the Company’s results of operations and financial position should be read in conjunction with the consolidated financial statements and related notes presented on pages A-30 through A-62.

Results of Operations

Summary. The Company reported earnings of $6.4 million in 2008, or $1.14 basic net earnings per common share and $1.13 diluted net earnings per common share, a 33% decrease as compared to $9.6 million, or $1.68 basic net earnings per common share and $1.65 diluted net earnings per common share, for 2007. The Company’s decrease in net earnings for 2008 is primarily attributable to a decrease in net interest income, an increase in provision for loan losses and an increase in non-interest expense, which was partially offset by an increase in non-interest income.

Net earnings for 2007 represented an increase of 5% as compared to 2006 net earnings of $9.2 million or $1.61 basic net earnings per common share and $1.58 diluted net earnings per common share. The increase in 2007 net earnings was primarily attributable to growth in interest-earning assets, which contributed to increases in net interest income and an increase in non-interest income. In addition, the Company had a decrease in the provision for loan losses for the year ended December 31, 2007 as compared to the same period in 2006. The increases in net interest income and non-interest income and the decrease in the provision for loan losses were partially offset by an increase in non-interest expense.

The return on average assets in 2008 was 0.69%, compared to 1.13% in 2007 and 1.19% in 2006. The return on average shareholders’ equity was 8.38% in 2008 compared to 13.59% in 2007 and 14.68% in 2006.

Net Interest Income. Net interest income, the major component of the Company's net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them. Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid. Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.

Net interest income was $32.8 million for 2008 or a 4% decrease from net interest income of $34.1 million in 2007. The decrease was primarily attributable to a reduction in the Bank’s prime commercial lending rate. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments. Net income from derivative instruments was $3.4 million for the year ended December 31, 2008 compared to a net loss of $406,000 for the same period in 2007. Net interest income increased 6% in 2007 from $32.3 million in 2006.

Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2008, 2007 and 2006. The table also sets forth the average rate earned on total interest-earning assets, the

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average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities. Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.

Table 1- Average Balance Table

	December 31, 2008							December 31, 2007						December 31, 2006
(Dollars in thousands)	Average Balance			Interest		Yield / Rate		Average Balance		Interest		Yield / Rate		Average Balance		Interest		Yield / Rate
Interest-earning assets:

Loans	$	747,203			46,808	6.26	%	665,379		55,109		8.28	%	604,427		49,665		8.22	%
Interest rate derivative contracts		-			3,403	0.45	%	-		(406	)	-0.06	%	-		(698	)	-0.12	%
Loan fees		-			393	0.05	%	-		698		0.10	%	-		701		0.12	%
Total loans		747,203			50,604	6.77	%	665,379		55,401		8.33	%	604,427		49,668		8.22	%

Investments - taxable		26,591			1,253	4.71	%	20,305		868		4.27	%	29,784		1,306		4.38	%
Investments - nontaxable*		89,262			4,924	5.52	%	99,991		5,470		5.47	%	88,353		4,642		5.25	%
Federal funds sold		3,050			55	1.80	%	7,378		383		5.19	%	1,766		85		4.81	%
Other		10,319			293	2.84	%	8,041		444		5.52	%	7,914		424		5.36	%

Total interest-earning assets		876,425			57,129	6.52	%	801,094		62,566		7.81	%	732,244		56,125		7.66	%

Cash and due from banks		21,331						20,081						17,022
Other assets		41,626						34,287						31,218
Allowance for loan losses		(9,583	)					(8,626	)					(7,899	)

Total assets	$	929,799						846,836						772,585


Interest-bearing liabilities:

NOW accounts	$	92,612			1,269	1.37	%	79,550		1,127		1.42	%	87,329		1,214		1.39	%
Regular savings accounts		17,423			50	0.29	%	18,685		54		0.29	%	19,768		57		0.29	%
Money market accounts		93,564			1,930	2.06	%	87,916		2,918		3.32	%	66,035		1,789		2.71	%
Time deposits		406,127			15,008	3.70	%	361,859		17,430		4.82	%	335,092		14,189		4.23	%
FHLB / FRB borrowings		79,417			3,616	4.55	%	80,058		3,759		4.70	%	74,082		3,588		4.84	%
Demand notes payable to U.S. Treasury		859			14	1.63	%	814		39		4.79	%	722		34		4.71	%
Trust preferred securities		20,619			1,016	4.93	%	20,619		1,476		7.16	%	24,878		1,963		7.89	%
Other		29,857			624	2.09	%	16,226		782		4.82	%	5,780		276		4.78	%

Total interest-bearing liabilities		740,478			23,527	3.18	%	665,727		27,585		4.14	%	613,686		23,110		3.77	%

Demand deposits		111,192						111,164						97,183
Other liabilities		4,021						3,022						3,044
Shareholders' equity		76,241						70,586						62,465

Total liabilities and shareholder's equity	$	931,932						850,499						776,378

Net interest spread				$	33,602	3.36	%			34,981		3.67	%			33,015		3.89	%

Net yield on interest-earning assets						3.83	%					4.37	%					4.51	%

Taxable equivalent adjustment
Investment securities				$	806					834						731

Net interest income				$	32,796					34,147						32,284

*Includes U.S. government sponsored enterprises that are non-taxable for state income tax purposes of $63.6 million in 2008, $74.9 million in 2007 and $65.9 million in 2006. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities.

Changes in interest income and interest expense can result from variances in both volume and rates. Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

A-9

Table 2 - Rate/Volume Variance Analysis-Tax Equivalent Basis


	December 31, 2008							December 31, 2007
(Dollars in thousands)	Changes in average volume			Changes in average rates		Total Increase (Decrease)		Changes in average volume		Changes in average rates		Total Increase (Decrease)
Interest Income:

Loans: Net of unearned income	$	6,177		(10,974	)	(4,797	)	5,042		691		5,733

Investments - taxable		282		102		384		(411	)	(27	)	(438	)
Investments - nontaxable		(589	)	43		(546	)	624		204		828
Federal funds sold		(151	)	(177	)	(328	)	281		17		298
Other		95		(246	)	(151	)	7		13		20

Total interest income		5,814		(11,252	)	(5,438	)	5,543		898		6,441

Interest expense:

NOW accounts		182		(40	)	142		(109	)	22		(87	)
Regular savings accounts		(4	)	0		(4	)	(3	)	0		(3	)
Money market accounts		152		(1,140	)	(988	)	660		469		1,129
Time deposits		1,884		(4,306	)	(2,422	)	1,211		2,030		3,241
FHLB / FRB Borrowings		(30	)	(113	)	(143	)	285		(114	)	171
Demand notes payable to
U.S. Treasury		1		(27	)	(26	)	4		1		5
Trust Preferred Securities		0		(459	)	(459	)	(320	)	(167	)	(487	)
Other		471		(629	)	(158	)	501		5		506

Total interest expense		2,656		(6,714	)	(4,058	)	2,229		2,246		4,475

Net interest income	$	3,158		(4,538	)	(1,380	)	3,314		(1,348	)	1,966

Net interest income on a tax equivalent basis totaled $33.6 million in 2008, decreasing 4% or $1.4 million from 2007. The decrease was attributable to a reduction in the Bank’s prime commercial lending rate. The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.36% in 2008, a decrease from the 2007 net interest spread of 3.67%. The net yield on interest-earning assets in 2008 decreased to 3.83% from the 2007 net interest margin of 4.37%.

Tax equivalent interest income decreased $5.4 million or 9% in 2008 primarily due to a reduction in the Bank’s prime commercial lending rate. The yield on interest-earning assets decreased to 6.52% in 2008 from 7.81% in 2007 as a result of a decrease in the average yield received on loans resulting from Federal Reserve interest rate decreases, which were partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Average interest-earning assets increased $75.3 million primarily as the result of an $81.8 million increase in average loans. Average investment securities in 2008 increased 4% to $115.9 million when compared to 2007. All other interest-earning assets including federal funds sold were $13.4 million in 2008 and $15.4 million in 2007.

Interest expense decreased $4.1 million or 15% in 2008 due to a decrease in the average rate paid on interest-bearing liabilities. The cost of funds decreased to 3.18% in 2008 from 4.14% in 2007. This decrease in the cost of funds was primarily attributable to decreases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit. The $74.8 million growth in average interest-bearing liabilities was primarily attributable to an increase in time deposits of $44.3 million to $406.1 million in 2008 from $361.9 million in 2007 and an increase in interest-bearing checking and savings accounts of $17.4 million to $203.6 million in 2008 from $186.2 million in 2007.

A-10

In 2007 net interest income on a tax equivalent basis increased $2.0 million or 6% to $35.0 million in 2007 from $33.0 million in 2006. The interest rate spread was 3.67% in 2007, a decrease from the 2006 net interest spread of 3.89%. The net yield on interest-earning assets in 2007 decreased to 4.37% from the 2006 net interest margin of 4.51%.

Provision for Loan Losses. Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Company’s loan portfolio, including the valuation of impaired loans in accordance with SFAS No. 114 and No. 118, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.

The provision for loan losses was $4.8 million, $2.0 million, and $2.5 million for the years ended December 31, 2008, 2007 and 2006, respectively. The increase in the provision for loan losses for 2008 is primarily attributable to an increase in non-performing assets, net charge-offs and increased loan growth. Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.

Non-Interest Income. Non-interest income for 2008 totaled $10.5 million, an increase of $1.7 million or 19% from non-interest income of $8.8 million for 2007. The increases in non-interest income for 2008 are primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in mortgage banking income and a decrease in the loss on sale and write-down of securities for the year ended December 31, 2008 when compared to the same period last year. These increases in non-interest income were partially offset by a decrease in insurance and brokerage commissions and a net increase in losses and write-downs on foreclosed property for the year ended December 31, 2008 as compared to the same period last year. Non-interest income for 2007 increased $1.2 million or 17% from non-interest income of $8.8 million for 2006. The increase in non-interest income for 2007 is primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in insurance and brokerage commissions, an increase in mortgage banking income and an increase in miscellaneous income.

Service charges on deposit accounts totaled $5.2 million during 2008, an increase of $925,000, or 22% over 2007. Service charge income increased $349,000, or 9% in 2007 compared to 2006. These increases are primarily attributable to growth in the deposit base coupled with normal pricing changes, which resulted in an increase in account maintenance fees.

Other service charges and fees increased 24% to $2.4 million for the year ended December 31, 2008 as compared to $1.9 million for the same period one year ago. This increase is primarily attributable to fee income from growth in the deposit base coupled with normal pricing changes.

The Company reported net losses on sale and write-downs of securities of $167,000, $562,000 and $592,000 in 2008, 2007 and 2006, respectively. The Company periodically evaluates its investments for any impairment which would be deemed other than temporary. As part of its evaluation in 2008, the Company determined that the fair value of one investment was less than the original cost of the investment and that the decline in fair value was not temporary in nature. As a result, the Company wrote down its original investment by $300,000. The remaining fair value of the investment at December 31, 2008 was $22,000. Similarly, as part of its evaluation in 2007, the Company wrote down two investments by $430,000. The remaining fair value of the investments at December 31, 2007 was $348,000.

Mortgage banking income increased to $660,000 in 2008 from $560,000 in 2007 primarily due to an increase in brokered loan activity. During 2007 mortgage banking income increased $271,000 from the $289,000 reported in 2006. The increase in mortgage banking income for 2007 was primarily attributable to the $185,000 write-down of the Bank’s mortgage servicing asset in 2006. This write-down was due to Management’s assessment that there was minimal fair value in the mortgage servicing rights due to the small remaining balance in the loans serviced for others.

Net losses on other real estate and repossessed assets were $287,000 and $118,000 for 2008 and 2007, respectively. During 2006 a net loss on other real estate and repossessed assets of $108,000 was recognized. The increase in net losses on other real estate and repossessed assets during 2008 was primarily attributable to a $170,000 net increase in losses and write-downs on foreclosed property for the year ended December 31, 2008 as compared to the same period last year. Management determined that the market value of these assets had decreased significantly and charges were appropriate for 2008.

Miscellaneous income for 2008 totaled $2.3 million, an increase of 3% from $2.2 million for 2007. During 2007, miscellaneous income increased 4% from $2.1 million for 2006.

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Table 3 presents a summary of non-interest income for the years ended December 31, 2008, 2007 and 2006.

Table 3 - Non-Interest Income

(Dollars in thousands)	2008			2007		2006
Service charges	$	5,203		4,279		3,930
Other service charges and fees		2,399		1,938		1,540
Gain (loss) on sale of securities		(167	)	(562	)	(592	)
Mortgage banking income		660		560		289
Insurance and brokerage commissions		426		521		389
Loss on foreclosed and repossessed assets		(287	)	(118	)	(108	)
Miscellaneous		2,261		2,198		2,106
Total non-interest income	$	10,495		8,816		7,554

Non-Interest Expense. Total non-interest expense amounted to $28.9 million for 2008, an increase of 11% from 2007. Non-interest expense for 2007 increased 13% to $26.0 million from non-interest expense of $23.0 million for 2006.

Salary and employee benefit expense was $15.2 million in 2008, compared to $13.9 million during 2007, an increase of $1.3 million or 9%, following a $2.1 million or 18% increase in salary and employee benefit expense in 2007 over 2006. The increase in salary and employee benefits in 2008 and 2007 is primarily due to normal salary increases and expense associated with additional staff for new branches.

The Company recorded occupancy expenses of $5.0 million in 2008, compared to $4.8 million during 2007, an increase of $278,000 or 6%, following an increase of $571,000 or 14% in occupancy expenses in 2007 over 2006. The increases in 2008, 2007 and 2006 are primarily due to an increase in furniture and equipment expense and lease expense associated with new branches.

The total of all other operating expenses increased $1.3 million or 18% to $8.7 million during 2008. The increase in other expense for 2008 is primarily attributable to an increase in of $407,000 in FDIC insurance expense, an increase of $309,000 in deposit program expense and an increase of $133,000 in foreclosure expense. Other operating expense increased $336,000 or 5% in 2007 over 2006. The increase in other expense for 2007 is primarily attributable to increases of $215,000 in advertising expense.

Table 4 presents a summary of non-interest expense for the years ended December 31, 2008, 2007 and 2006.

Table 4 - Non-Interest Expense

(Dollars in thousands)	2008		2007	2006
Salaries and wages	$	11,591	10,276	9,368
Employee benefits		3,603	3,612	2,417
Total personnel expense		15,194	13,888	11,785
Occupancy expense		5,029	4,751	4,180
Office supplies		564	554	436
FDIC deposit insurance		547	140	75
Professional services		422	400	239
Postage		360	320	307
Telephone		476	405	338
Director fees and expense		450	499	423
Advertising		1,076	988	772
Consulting fees		385	460	575
Taxes and licenses		193	272	293
Other operating expense		4,197	3,316	3,560
Total non-interest expense	$	28,893	25,993	22,983

Income Taxes. Total income tax expense was $3.2 million in 2008 compared with $5.3 million in 2007 and $5.2 million in 2006. The primary reason for the decrease in taxes for 2008 as compared to 2007 and 2006 was the decrease in pretax income. The Company’s effective tax rates were 33.46%, 35.76% and 36.05% in 2008, 2007 and 2006, respectively.

A-12

Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of December 31, 2008 such unfunded commitments to extend credit were $158.9 million, while commitments in the form of standby letters of credit totaled $4.3 million.

The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of December 31, 2008, the Company’s core deposits totaled $497.2 million, or 69% of total deposits.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings. The Bank is also able to borrow from the Federal Reserve on a short-term basis.

At December 31, 2008, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $61.0 million, which mature over the next two years. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits. For additional information, please see the section below entitled “Deposits.”

The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $77.0 million at December 31, 2008. The remaining availability at FHLB was $71.2 million at December 31, 2008. At December 31, 2008, the carrying value of loans pledged as collateral to the FHLB totaled approximately $244.9 million. The Bank had $5.0 million in borrowings from the Federal Reserve Bank (“FRB”) at December 31, 2008. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009. The FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2008, the carrying value of loans pledged as collateral to the FRB totaled approximately $280.8 million.

The Bank also had the ability to borrow up to $38.0 million for the purchase of overnight federal funds from four correspondent financial institutions as of December 31, 2008.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 26.80% at December 31, 2008, 28.04% at December 31, 2007 and 31.15% at December 31, 2007. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $10.7 million during 2008. Net cash used in investing activities of $65.7 million consisted primarily of a net increase in loans of $65.2 million. Net cash provided by financing activities amounted to $53.1 million, primarily from a $27.4 million net increase in deposits and the $25.1 issuance of Series A preferred stock.

Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 5 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2008.

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Table 5 - Interest Sensitivity Analysis

(Dollars in thousands)	Immediate		1-3 months		4-12 months		Total Within One Year		Over One Year & Non-sensitive	Total
Interest-earning assets:
Loans	$	520,141	6,239		16,599		542,979		238,209	781,188
Investment securities		-	4,354		3,596		7,950		116,966	124,916
Federal funds sold		6,733	-		-		6,733		-	6,733
Interest-bearing deposit accounts		1,453	-		-		1,453		-	1,453
Other interest-earning assets		-	-		-		-		6,811	6,811

Total interest-earning assets		528,327	10,593		20,195		559,115		361,986	921,101

Interest-bearing liabilities:
NOW, savings, and money market deposits		210,058	-		-		210,058		-	210,058
Time deposits		47,003	145,974		175,522		368,499		38,057	406,556
Other short term borrowings		1,600	-		-		1,600		-	1,600
FRB borrowings		-	5,000		-		5,000		-	5,000
FHLB borrowings		-	5,000		-		5,000		72,000	77,000
Securities sold under
agreement to repurchase		37,501	-		-		37,501		-	37,501
Trust preferred securities		-	20,619		-		20,619		-	20,619

Total interest-bearing liabilities		296,162	176,593		175,522		648,277		110,057	758,334

Interest-sensitive gap	$	232,165	(166,000	)	(155,327	)	(89,162	)	251,929	162,767

Cumulative interest-sensitive gap	$	232,165	66,165		(89,162	)	(89,162	)	162,767

Interest-earning assets as a percentage of
interest-bearing liabilities		178.39%	6.00%		11.51%		86.25%		328.91%

The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. As shown in Table 5, the Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates. Rate sensitive assets at December 31, 2008 totaled $921.1 million, exceeding rate sensitive liabilities of $758.3 million by $162.8 million.

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company. As of December 31, 2008, the Company had cash flow hedges with a notional amount of $165.0 million. These derivative instruments consist of three interest rate floor contracts and one interest rate swap contract. The interest rate floor contracts are used to hedge future cash flows from payments on the first $115.0 million of certain variable rate loans

A-14

against the downward effects of their repricing in the event of a decreasing rate environment during the terms of the interest rate floor contracts. If the prime rate falls below the contract rate during the term of the contract, the Company will receive payments based on notional amount times the difference between the contract rate and the weighted average prime rate for the quarter. No payments will be received by the Company if the weighted average prime rate is equal to or higher than the contract rate. The interest rate floor contracts in effect at December 31, 2008 will expire in 2009. The interest rate swap contract is used to convert $50.0 million of variable rate loans to a fixed rate. Under the swap contract, the Company receives a fixed rate of 6.245% and pays a variable rate based on the current prime rate (3.25% at December 31, 2008) on the notional amount of $50.0 million. The swap agreement matures in June 2011. The Company recognized $3.4 million in interest income, net of premium amortization, from interest rate derivative contracts during the year ended December 31, 2008. Based on the current interest rate environment, it is expected the Company will continue to receive income on these interest rate contracts throughout 2009.

Tables 6 and 7 present additional information on the Company’s derivative financial instruments as of December 31, 2008.

Table 6 - Derivative Instruments
(Dollars in thousands)
Type of Derivative	Notional Amount		Contract Rate	Premium		Year-to-date Income (Net of Premium Amortization)
Interest rate floor contact*	$	-	-	$	-	$	151
Interest rate floor contact*		-	-		-		456
Interest rate floor contact expiring 01/24/09		45,000	7.500%		562		871
Interest rate floor contact expiring 06/02/09		35,000	8.000%		399		914
Interest rate floor contact expiring 12/01/09		35,000	7.250%		634		523
Interest rate swap contact expiring 06/01/11		50,000	6.245%		-		488
	$	165,000		$	1,595	$	3,403

* Interest rate floor contracts expired during 2008

Table 7 - Fair Values of Derivative Instruments

	Asset Derivatives				Liability Derivatives
(Dollars in thousands)	As of December 31, 2008		As of December 31, 2007		As of December 31, 2008		As of December 31, 2007
	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value
Interest rate derivative
contracts	Other assets	$ 4,981	Other assets	$ 1,907	N/A	$ -	N/A	$ -

Included in the rate sensitive assets are $506.2 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”). The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At December 31, 2008, the Bank had $149.0 million in loans with interest rate floors. The floors were in effect on $147.0 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 1.59% higher than the indexed rate on the promissory notes without interest rate floors.

An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities. A discussion of these changes and trends follows.

Analysis of Financial Condition

Investment Securities. All of the Company’s investment securities are held in the available-for-sale (“AFS”) category. At December 31, 2008 the market value of AFS securities totaled $124.9 million, compared to $121.0 million and $117.6 million at December 31, 2007 and 2006, respectively. The increase in 2008 investment securities is the result of net securities purchases that are part of management’s objective to grow the investment portfolio in an effort to manage the credit risk in the balance sheet. This increase in AFS securities was partially offset by paydowns on mortgage-backed securities, calls and maturities. Table 8 presents the market value of the AFS securities held at December 31, 2008, 2007 and 2006.

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Table 8 - Summary of Investment Portfolio

(Dollars in thousands)	2008		2007	2006
Obligations of United States government
sponsored enterprises	$	58,487	76,992	72,744

Obligations of states and political subdivisions		26,973	25,905	24,366

Mortgage-backed securities		37,271	16,271	19,220

Trust preferred securities		1,250	250	750

Equity securities		935	1,550	501

Total securities	$	124,916	120,968	117,581

The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.

The Company’s investment portfolio consists of U.S. government sponsored enterprise securities, municipal securities, U.S. government enterprise sponsored mortgage-backed securities, and trust preferred securities and equity securities. AFS securities averaged $115.9 million in 2008, $120.3 million in 2007 and $118.1 million in 2006. Table 9 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2008. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields are calculated on a tax equivalent basis. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.

Table 9 - Maturity Distribution and Weighted Average Yield on Investments

				After One Year		After 5 Years
	One Year or Less			Through 5 Years		Through 10 Years		After 10 Years		Totals
(Dollars in thousands)	Amount		Yield	Amount	Yield	Amount	Yield	Amount	Yield	Amount	Yield
Book value:

United States Government	$	3,500	4.60%	33,885	4.88%	11,817	5.08%	6,021	5.52%	55,223	4.98%
sponsored enterprises

States and political subdivisions		2,405	5.21%	10,282	4.77%	7,202	6.09%	6,759	6.57%	26,648	5.62%

Mortgage backed securities		-	-	521	4.54%	11,256	4.68%	24,780	5.35%	36,557	5.13%

Trust preferred securities		-	-	-	-	1,000	3.35%	250	8.13%	1,250	4.31%

Equity securities		-	-	-	-	-	-	1,382	1.49%	1,382	1.49%

Total securities	$	5,905	4.85%	44,688	4.85%	31,275	5.11%	39,192	5.47%	121,060	5.12%

Loans. The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties in North Carolina. Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. In management’s opinion, there are no significant concentrations of credit with particular borrowers engaged in similar activities.

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Real estate mortgage loans include both commercial and residential mortgage loans. At December 31, 2008, the Company had $108.6 million in residential mortgage loans, $93.3 million in home equity loans and $272.8 million in commercial mortgage loans, which include $218.0 million using commercial property as collateral and $54.8 million using residential property as collateral. At December 31, 2008, real estate construction loans included $126.5 million in speculative construction and development loans.

Residential mortgage loans include $51.0 million made to customers in the Company’s traditional banking offices and $57.6 million in mortgage loans originated in the Company’s Latino banking operations. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization. Also, the Company does not have credit exposure for residential mortgage loans originated that are not reflected in the Company’s assets.

The mortgage loans originated in the traditional banking offices are generally 15 to 30 year fixed rate loans with attributes that cause the loans to not be sellable in the secondary market. These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type and are generally made to existing Bank customers. These loans have been originated throughout the Company’s five county service area, with no geographic concentration. At December 31, 2008 there were 12 loans with an outstanding balance of $1.1million 30 days or more past due and no loans more than 90 days past due.

The mortgage loans originated in the Company’s Latino operations are primarily adjustable rate mortgage loans that adjust annually after the end of the first five years of the loan. The loans are tied to the one-year T-Bill index and, if they were to adjust at December 31, 2008, would have a reduction in the interest rate on the loan. The underwriting on these loans includes both full income verification and no income verification, with loan-to-value ratios of up to 95% without private mortgage insurance. A majority of these loans would be considered subprime loans, as they were underwritten using stated income rather than fully documented income verification. No other loans in the Company’s portfolio would be considered subprime. The majority of these loans have been originated within the Charlotte, NC metro area. At this time, Charlotte has begun to experience a decline in values within the residential real estate market. At December 31, 2008 there were 96 loans with an outstanding balance of $10.8 million 30 days or more past due and four loans more than 90 days past due totaling $514,000. Total losses on this portfolio, since the first loans were originated in 2004 have amounted to approximately $348,000 through December 31, 2008.

As a recipient of CPP funds, the Bank will strive to work with delinquent borrowers in an attempt to mitigate foreclosure. The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.

The composition of the Company’s loan portfolio is presented in Table 10.

Table 10 - Loan Portfolio

	2008			2007		2006		2005		2004
(Dollars in thousands)	Amount		% of Loans	Amount	% of Loans	Amount	% of Loans	Amount	% of Loans	Amount	% of Loans
Breakdown of loan receivables:
Commercial	$	76,945	9.85%	82,190	11.38%	85,064	13.06%	79,902	14.10%	79,189	14.79%
Real estate - mortgage		474,732	60.77%	417,709	57.83%	364,595	55.97%	330,227	58.28%	312,988	58.45%
Real estate - construction		216,188	27.67%	209,644	29.03%	187,960	28.86%	141,420	24.96%	127,042	23.73%
Consumer		13,323	1.71%	12,734	1.76%	13,762	2.11%	15,115	2.66%	16,249	3.03%

Total loans	$	781,188	100.00%	722,277	100.00%	651,381	100.00%	566,664	100.00%	535,468	100.00%

Less: Allowance for loan losses		11,025		9,103		8,303		7,425		8,049

Net loans	$	770,163		713,174		643,078		559,239		527,419

As of December 31, 2008, gross loans outstanding were $781.2 million, an increase of $58.9 million or 8% from the December 31, 2007 balance of $722.3 million. Commercial loans decreased $5.2 million in 2008. Real estate mortgage loans grew $57.0 million when compared to 2007 due to an increase in non-conforming mortgage loans and commercial real estate loans. Real estate construction loans increased $6.5 million in 2008 as a result of an increase in real estate development loans. Consumer loans increased $589,000 in 2008.

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Table 11 identifies the maturities of all loans as of December 31, 2008 and addresses the sensitivity of these loans to changes in interest rates.

Table 11 - Maturity and Repricing Data for Loans

(Dollars in thousands)	Within one year or less		After one year through five years	After five years	Total loans
Commercial	$	62,205	13,187	1,553	76,945
Real estate - mortgage		272,873	149,612	52,247	474,732
Real estate - construction		201,041	9,805	5,342	216,188
Consumer		6,860	6,258	205	13,323

Total loans	$	542,979	178,862	59,347	781,188

Total fixed rate loans	$	22,816	125,666	59,347	207,829
Total floating rate loans		520,163	53,196	-	573,359

Total loans	$	542,979	178,862	59,347	781,188

In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2008, outstanding loan commitments totaled $158.9 million. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Additional information regarding commitments is provided below in the section entitled “Contractual Obligations” and in Note 10 to the Consolidated Financial Statements.

Allowance for Loan Losses. The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·	the Bank’s loan loss experience;

·	the amount of past due and non-performing loans;

·	specific known risks;

·	the status and amount of other past due and non-performing assets;

·	underlying estimated values of collateral securing loans;

·	current and anticipated economic conditions; and

·	other factors which management believes affect the allowance for potential credit losses.

Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of nine risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan as well as the level of reserves deemed appropriate for the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million. The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.

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Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below. At December 31, 2008 and 2007, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $7.5 million and $8.0 million, respectively, with related allowance for loan losses of approximately $462,000 and $1.2 million for December 31, 2008 and 2007, respectively.

The general allowance reflects reserves established under the provisions of SFAS No. 5, “Accounting for Contingencies” for collective loan impairment. These reserves are based upon historical net charge-offs using the last three years’ experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions that adversely affect the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2008 as compared to the year ended December 31, 2007. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

Net charge-offs for 2008 were $2.9 million. The ratio of net charge-offs to average total loans was 0.38% in 2008, 0.19% in 2007 and 0.27% in 2006. Management expects the ratio of net charge-offs to average total loans to increase again in 2009 due to the recessionary economic conditions and the decline in real estate values and new home sales. The allowance for loan losses increased to $11.0 million or 1.41% of total loans outstanding at December 31, 2008. For December 31, 2007 and 2006, the allowance for loan losses amounted to $9.1 million or 1.26% of total loans outstanding and $8.3 million, or 1.27% of total loans outstanding, respectively. Management would expect the percentage of the allowance for loan losses to total loans to increase in 2009 if non-performing loans continue to increase as a result of the current recessionary economic conditions.

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Table 12 presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at December 31, 2008 and 2007.

Table 12 - Loan Risk Grade Analysis
	Percentage of Loans
	By Risk Grade*
Risk Grade	2008	2007
Risk 1 (Excellent Quality)	4.08%	11.06%
Risk 2 (High Quality)	17.95%	14.06%
Risk 3 (Good Quality)	63.08%	62.53%
Risk 4 (Management Attention)	10.42%	9.51%
Risk 5 (Watch)	2.14%	1.57%
Risk 6 (Substandard)	0.80%	0.13%
Risk 7 (Low Substandard)	0.00%	0.03%
Risk 8 (Doubtful)	0.00%	0.00%
Risk 9 (Loss)	0.00%	0.00%

* Excludes non-accrual loans

Table 13 presents an analysis of the allowance for loan losses, including charge-off activity.

Table 13 - Analysis of Allowance for Loan Losses

(Dollars in thousands)	2008		2007	2006	2005	2004
Reserve for loan losses at beginning	$	9,103	8,303	7,425	8,049	9,722

Loans charged off:
Commercial		249	414	505	293	1,004
Real estate - mortgage		1,506	471	568	2,141	3,842
Real estate - construction		644	252	250	1,250	4
Consumer		748	489	636	516	535

Total loans charged off		3,147	1,626	1,959	4,200	5,385

Recoveries of losses previously charged off:
Commercial		87	86	64	144	162
Real estate - mortgage		8	21	108	162	144
Real estate - construction		30	102	2	-	-
Consumer		150	179	150	160	150

Total recoveries		275	388	324	466	456

Net loans charged off		2,872	1,238	1,635	3,734	4,929

Provision for loan losses		4,794	2,038	2,513	3,110	3,256

Reserve for loan losses at end of year	$	11,025	9,103	8,303	7,425	8,049

Loans charged off net of recoveries, as
a percent of average loans outstanding		0.38%	0.19%	0.27%	0.68%	0.90%

Non-performing Assets. Non-performing assets, comprised of non-accrual loans, other real estate owned, other repossessed assets and loans for which payments are more than 90 days past due totaled $14.2 million at December 31, 2008 compared to $8.5 million at December 31, 2007. Non-accrual loans were $11.8 million at December 31, 2008, an increase of $3.8 million from non-accruals of $8.0 million at December 31, 2007. As a percentage of loans outstanding, non-accrual loans were 1.51% and 1.11% at December 31, 2008 and 2007, respectively. The Bank had $514,000 in loans 90 days past due and still accruing at December 31, 2008 as compared to no loans for the same period in 2007. Other real estate owned totaled $1.9 million and $483,000 as of December 31, 2008 and 2007, respectively. The Bank had no repossessed assets as of December 31, 2008 and 2007.

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At December 31, 2008, the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $12.3 million or 1.58% of total loans. Non-performing loans for 2007 were $8.0 million, or 1.11% of total loans and $7.6 million, or 1.17% of total loans for 2006. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2008, 2007 and 2006, had they performed in accordance with their original terms, amounted to approximately $850,000, $693,000 and $429,000, respectively. Interest income on impaired loans included in the results of operations for 2008, 2007, and 2006 amounted to approximately $65,000, $29,000 and $144,000, respectively.

Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing. Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans. Management anticipates continued weakness in the housing market, which combined with the current recessionary economic conditions will, in all likelihood, result in higher levels of non-performing loans in 2009.

It is the general policy of the Company to stop accruing interest income and place the recognition of interest on a cash basis when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income. Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.

A summary of non-performing assets at December 31 for each of the years presented is shown in Table 14.

Table 14 - Non-performing Assets

(Dollars in thousands)	2008		2007	2006	2005	2004
Non-accrual loans	$	11,815	7,987	7,560	3,492	5,097
Loans 90 days or more past due and still accruing		514	-	78	946	245
Total non-performing loans		12,329	7,987	7,638	4,438	5,342
All other real estate owned		1,867	483	344	531	682
All other repossessed assets		-	-	-	-	-
Total non-performing assets	$	14,196	8,470	7,982	4,969	6,024

As a percent of total loans at year end
Non-accrual loans		1.51%	1.11%	1.16%	0.62%	0.95%
Loans 90 days or more past due and still accruing		0.07%	0.00%	0.01%	0.17%	0.05%
Total non-performing assets		1.82%	1.17%	1.23%	0.88%	1.12%

Deposits. The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2008, total deposits were $721.1 million, an increase of $27.5 million or 4% increase over the December 31, 2007 balance of $693.6 million. Core deposits, which include demand deposits, savings accounts and certificates of deposits of denominations less than $100,000, increased to $497.2 million at December 31, 2008 from $490.1 million at December 31, 2007.

Time deposits in amounts of $100,000 or more totaled $220.4 million, $203.5 million and $194.2 million at December 31, 2008, 2007 and 2006, respectively. At December 31, 2008, brokered deposits amounted to $61.0 million as compared to $53.9 million at December 31, 2007. Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market. Brokered deposits outstanding as of December 31, 2008 have a weighted average rate of 3.25% with a weighted average original term of 8 months.

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Table 15 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2008.

Table 15 - Maturities of Time Deposits over $100,000

(Dollars in thousands)	2008
Three months or less	$	106,166
Over three months through six months		58,526
Over six months through twelve months		40,819
Over twelve months		14,864
Total	$	220,375

Borrowed Funds. The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions. At December 31, 2008, FHLB borrowings totaled $77.0 million compared to $87.5 million at December 31, 2007 and $89.3 million at December 31, 2006. Average FHLB borrowings for 2008 were $79.2 million, compared to average balances of $80.1 million for 2007 and $74.1 million for 2006. The maximum amount of outstanding FHLB borrowings was $97.6 million in 2008, and $95.0 in 2007 and $99.5 in 2006. The FHLB borrowings outstanding at December 31, 2008 had both fixed and adjustable interest rates ranging from 3.71% to 6.49%. At December 31, 2008, all of the Bank’s FHLB borrowings had maturities exceeding one year. The FHLB has the option to convert $72.0 million of the total borrowings to a floating rate and, if converted, the Bank may repay borrowings without a prepayment fee. The Company also has an additional $5.0 million in variable rate convertible borrowings, which may be repaid without a prepayment fee if converted by the FHLB. Additional information regarding FHLB borrowings is provided in Note 6 to the Consolidated Financial Statements.

The Bank had $5.0 million in borrowings from the FRB at December 31, 2008. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009.

Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from customers, amounted to approximately $1.6 million at December 31, 2008, 2007 and 2006.

Securities sold under agreements to repurchase amounted to $37.5 million, $27.6 million and $6.4 million as of December 31, 2008, 2007 and 2006, respectively.

Junior Subordinated Debentures (related to Trust Preferred Securities). In June 2006 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations and other commitments as of December 31, 2008 are summarized in Table 16 below. The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.

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Table 16 - Contractual Obligations and Other Commitments

(Dollars in thousands)	Within One Year		One to Three Years	Three to Five Years	Five Years or More	Total
Contractual Cash Obligations
Long-term borrowings	$	-	12,000	-	65,000	77,000
Junior subordinated debentures		-	-	-	20,619	20,619
Operating lease obligations		769	1,191	701	1,893	4,554

Total	$	769	13,191	701	87,512	102,173

Other Commitments
Commitments to extend credit	$	54,767	14,566	2,336	87,270	158,939
Standby letters of credit
and financial guarantees written		4,294	22	-	-	4,316

Total	$	59,061	14,588	2,336	87,270	163,255

The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-13 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.

Capital Resources. Shareholders’ equity at December 31, 2008 was $101.1 million compared to $70.1 million at December 31, 2007 and $62.8 million at December 31, 2006. Unrealized gains and losses, net of taxes, at December 31, 2008 and 2007 amounted to gains of $5.5 million and $1.7 million, respectively. At December 31, 2006, unrealized gains and losses, net of taxes, amounted to a loss of $771,000. Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength. Average shareholders’ equity as a percentage of total average assets was 8.20%, 8.34% and 8.09% for 2008, 2007 and 2006. The return on average shareholders’ equity was 8.38% at December 31, 2008 as compared to 13.59% and 14.68% as of December 31, 2007 and December 31, 2006, respectively. Total cash dividends paid during 2008 amounted to $2.7 million. Cash dividends totaling $2.3 million and $1.9 million were paid during 2007 and 2006, respectively.

In November 2006, the Company’s Board of Directors authorized the repurchase of up to $2.0 million in common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of November 2007. During 2007, the Company repurchased 100,000 shares, or $1,938,000, of its common stock under this plan.

In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008. The Company repurchased 50,497 shares, or $873,000, of its common stock under this plan during 2007. The Company repurchased 25,000 shares, or $350,000, of its common stock under this plan during 2008. The Board of Directors ratified the purchase of 497 additional shares in March 2008.

In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009. The Company has repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008. Because of the Company’s participation in the CPP, discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without UST approval.

On December 23, 2008, the Company entered into a Purchase Agreement with the UST. Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and warrants to purchase 357,234 shares of common stock associated with the Company’s participation in the CPP under the TARP. Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair

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values at the time of the sale. Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant. The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield. No dividends were declared or paid on the Series A preferred stock during 2008, and cumulative undeclared dividends at December 31, 2008 were $28,000. The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate. Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things. Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.

The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends. Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital. However, with the enactment of the ARRA, the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator. The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

Under regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital at December 31, 2008, 2007 and 2006 includes $20.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 13.65%, 11.03% and 11.70% at December 31, 2008, 2007 and 2006, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 14.90%, 12.16% and 12.86% at December 31, 2008, 2007 and 2006, respectively. In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 12.40%, 10.43% and 10.80% at December 31, 2008, 2007 and 2006, respectively.

The Bank’s Tier 1 risk-based capital ratio was 9.85%, 9.80% and 10.21% at December 31, 2008, 2007 and 2006, respectively. The total risk-based capital ratio for the Bank was 11.10%, 10.93% and 11.37% at December 31, 2008, 2007 and 2006, respectively. The Bank’s Tier 1 leverage capital ratio was 8.94%, 9.26% and 9.41% at December 31, 2008, 2007 and 2006 respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at December 31, 2008, 2007 and 2006.

The Company’s key equity ratios as of December 31, 2008, 2007 and 2006 are presented in Table 17.

Table 17 - Equity Ratios

	2008	2007	2006
Return on average assets	0.69%	1.13%	1.19%
Return on average equity	8.38%	13.59%	14.68%
Dividend payout ratio	41.93%	24.30%	20.78%
Average equity to average assets	8.20%	8.34%	8.09%

A-24

Quarterly Financial Data. The Company’s consolidated quarterly operating results for the years ended December 31, 2008 and 2007 are presented in Table 18.

Table 18 - Quarterly Financial Data

	2008						2007
Dollars in thousands, except
per share amounts)	First		Second	Third	Fourth		First		Second	Third	Fourth

Total interest income	$	14,553	14,072	14,122	13,576		$	15,200	15,446	15,625	15,461
Total interest expense		6,680	5,700	5,627	5,520			6,607	6,735	7,038	7,205

Net interest income		7,873	8,372	8,495	8,056			8,593	8,711	8,587	8,256

Provision for loan losses		391	681	1,035	2,687			323	634	296	785
Other income		2,607	2,802	2,506	2,580			2,122	2,139	2,007	2,548
Other expense		6,930	7,113	7,278	7,572			6,021	6,180	6,214	7,578

Income before income taxes		3,159	3,380	2,688	377			4,371	4,036	4,084	2,441
Income taxes		1,103	1,188	942	(20	)		1,584	1,446	1,471	839

Net earnings	$	2,056	2,192	1,746	397		$	2,787	2,590	2,613	1,602

Basic earnings per share	$	0.37	0.39	0.31	0.07		$	0.49	0.45	0.46	0.28
Diluted earnings per share	$	0.36	0.39	0.31	0.07		$	0.48	0.44	0.45	0.28

A-25

QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates. This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.

The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely (positively) impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off-balance sheet derivative instruments. During the years ended December 31, 2008, 2007 and 2006, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management.”

Table 19 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments and the notional amount and estimated fair value of the Company’s off-balance sheet derivative instruments at their expected maturity dates for the period ended December 31, 2008. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2008. As of December 31, 2008, all fixed rate advances are callable at the option of FHLB. For core deposits without contractual maturity (i.e. interest bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.

Table 19 - Market Risk Table

(Dollars In thousands)	Principal/Notional Amount Maturing in Year Ended December 31,
Loans Receivable	2009			2010		2011		2012 & 2013		Thereafter		Total	Fair Value
Fixed rate	$	33,980		32,285		20,804		80,068		40,692		207,829	210,922
Average interest rate		7.25	%	7.00	%	6.97	%	6.86	%	7.34	%
Variable rate	$	241,262		84,819		31,616		50,428		165,234		573,359	573,359
Average interest rate		4.09	%	3.98	%	4.39	%	4.33	%	5.99	%
												781,188	784,281
Investment Securities		.
Interest bearing cash	$	-		-		-		-		1,453		1,453	1,453
Average interest rate		-		-		-		-		0.03	%
Federal funds sold	$	6,733		-		-		-		-		6,733	6,733
Average interest rate		0.10	%	-		-		-		-
Securities available for sale	$	22,806		21,907		34,228		14,346		31,629		124,916	126,539
Average interest rate		4.95	%	4.80	%	4.38	%	4.77	%	4.66	%
Nonmarketable equity securities	$	-		-		-		-		6,303		6,303	6,303
Average interest rate		-		-		-		-		3.52	%

Debt Obligations
Deposits	$	368,469		23,198		12,805		2,249		314,341		721,062	716,678
Average interest rate		3.17	%	3.02	%	2.50	%	3.09	%	4.08	%
Advances from FHLB	$	-		7,000		5,000		15,000		50,000		77,000	83,038
Average interest rate		-		6.05	%	4.21	%	4.19	%	4.27	%
Federal Reserve Borrowings	$	5,000		-		-		-		-		5,000	4,999
Average interest rate		0.28	%	-		-		-		-
Demand notes payable to U.S. Treasury	$	1,600		-		-		-		-		1,600	1,600
Average interest rate		0.12	%	-		-		-		-
Securities sold under agreement to repurchase	$	37,501										37,501	37,501
Average interest rate		1.34	%
Junior subordinated debentures	$	-		-		-		-		20,619		20,619	20,619
Average interest rate		-		-		-		-		3.63	%

Derivative Instruments (notional amount)
Interest rate floor contracts	$	115,000		-		-		-		-		115,000	2,254
Average interest rate		7.58	%	-		-		-		-
Interest rate swap contracts	$	-		-		50,000		-		-		50,000	2,727
Average interest rate		-		-		6.25	%	-		-

A-26

Table 20 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps.” The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1% and 2% as compared to the estimated theoretical impact of rates remaining unchanged. The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the theoretical impact of rates remaining unchanged. The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates. This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes. Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.

Table 20 - Interest Rate Risk

(Dollars in thousands)
		Estimated Resulting Theoretical Net Interest Income
Hypothetical rate change (ramp over 12 months)		Amount		% Change
	+2%	$	32,175		3.95%
	+1%	$	31,476		1.70%
	0%	$	30,951		0.00%
	-1%	$	30,455		-1.60%
	-2%	$	29,832		-3.62%



		Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)		Amount		% Change
	+2%	$	92,797		-10.94%
	+1%	$	98,019		-5.92%
	0%	$	104,192		0.00%
	-1%	$	106,142		1.87%
	-2%	$	108,667		4.30%

A-27

MARKET FOR THE COMPANY’S COMMON EQUITY

AND RELATED SHAREHOLDER MATTERS

Peoples Bancorp common stock is traded on the over-the-counter (OTC) market and quoted on the Nasdaq Global Market, under the symbol “PEBK.” Market makers for the Company’s shares include Scott and Stringfellow, Inc. and Sterne Agee & Leach.

Although the payment of dividends by the Company is subject to certain requirements and limitations of North Carolina corporate law, 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 and repurchase shares may be dependent upon the Company’s receipt of dividends from the Bank. The Bank’s ability to pay dividends is limited. North Carolina commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. Dividends may be paid by the Bank from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by North Carolina law. Also, 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). Based on its current financial condition, the Bank does not expect that this provision will have any impact on the Bank’s ability to pay dividends. Due to the Company’s participation in the CPP, the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders and UST approval is required for any increase in common dividends per share.

As of March 10, 2009, the Company had 707 shareholders of record, not including the number of persons or entities whose stock is held in nominee or street name through various brokerage firms or banks. The market price for the Company’s common stock was $5.55 on March 10, 2009.

Table 21 presents certain market and dividend information for the last two fiscal years. Over-the-counter quotations reflect inter-dealer prices, without retail mark-up, mark down or commission and may not necessarily represent actual transactions.

Table 21 - Market and Dividend Data

				Cash Dividend
2008	Low Bid		High Bid	Per Share
First Quarter	$	12.20	15.50	0.12

Second Quarter	$	9.56	14.19	0.12

Third Quarter	$	7.36	13.14	0.12

Fourth Quarter	$	8.51	12.00	0.12


				Cash Dividend
2007	Low Bid		High Bid	Per Share
First Quarter	$	17.37	19.26	0.08

Second Quarter	$	17.89	21.15	0.09

Third Quarter	$	17.13	20.03	0.12

Fourth Quarter	$	14.75	18.00	0.12

A-28

STOCK PERFORMANCE GRAPH

The following graph compares the Company’s cumulative shareholder return on its Common Stock with a NASDAQ index and with a southeastern bank index. The graph was prepared by SNL Securities, L.C., Charlottesville, Virginia, using data as of December 31, 2008.

COMPARISON OF SIX-YEAR CUMULATIVE TOTAL RETURNS

Performance Report for

Peoples Bancorp of North Carolina, Inc.

A-29

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Financial Statements
December 31, 2008, 2007 and 2006


INDEX

	PAGE(S)

Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements	A-31

Financial Statements
Consolidated Balance Sheets at December 31, 2008 and December 31, 2007	A-32

Consolidated Statements of Earnings for the years ended December 31, 2008, 2007 and 2006	A-33

Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2008, 2007 and 2006	A-34

Consolidated Statements of Comprehensive Income for the years ended December 31, 2008, 2007 and 2006	A-35

Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006	A-36 - A-37

Notes to Consolidated Financial Statements	A-38 - A-61

A-30

Porter Keadle Moore, LLP

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and shareholders

Peoples Bancorp of North Carolina, Inc.

Newton, North Carolina

We have audited the accompanying consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Bancorp of North Carolina and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.

We were not engaged to examine management's assessment of the effectiveness of Peoples Bancorp of North Carolina, Inc’s. internal control over financial reporting as of December 31, 2008, included in the accompanying Management’s Report of Internal Controls Over Financial Reporting and, accordingly, we do not express an opinion thereon.

/s/ Porter Keadle Moore, LLP

Atlanta, Georgia

March 6, 2009

Certified Public Accountants

___________________________________________________________________________________________________________________________________________

Suite 1800 Ÿ 235 Peachtree Street NE Ÿ Atlanta, Georgia 30303 Ÿ Phone 404-588-4200 Ÿ Fax 404-588-4222 Ÿ www.pkm.com

A-31

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2008 and 2007

Assets	2008			2007


Cash and due from banks, including reserve requirements	$	19,743,047			26,108,437
of $7,257,000 and $7,439,000
Interest bearing deposits		1,452,825			1,539,190
Federal funds sold		6,733,000			2,152,000
Cash and cash equivalents		27,928,872			29,799,627

Investment securities available for sale		124,916,349			120,968,358
Other investments		6,302,809			6,433,947
Total securities		131,219,158			127,402,305

Loans		781,188,082			722,276,948
Less allowance for loan losses		(11,025,516	)		(9,103,058	)
Net loans		770,162,566			713,173,890

Premises and equipment, net		18,296,895			18,234,393
Cash surrender value of life insurance		7,019,478			6,776,379
Accrued interest receivable and other assets		14,135,328			11,875,202
Total assets	$	968,762,297			907,261,796

Liabilities and Shareholders' Equity

Deposits:
Non-interest bearing demand	$	104,448,128			112,071,090
NOW, MMDA & savings		210,057,612			196,959,895
Time, $100,000 or more		220,374,302			203,499,504
Other time		186,182,341			181,108,214
Total deposits		721,062,383			693,638,703

Demand notes payable to U.S. Treasury		1,600,000			1,600,000
Securities sold under agreement to repurchase		37,500,738			27,583,263
Short-term Federal Reserve Bank borrowings		5,000,000			-
FHLB borrowings		77,000,000			87,500,000
Junior subordinated debentures		20,619,000			20,619,000
Accrued interest payable and other liabilities		4,851,750			6,219,248
Total liabilities		867,633,871			837,160,214

Shareholders' equity:

Series A preferred stock, $1,000 stated value; authorized
5,000,000 shares; issued and outstanding
25,054 shares in 2008 and no shares
outstanding in 2007		24,350,219			-
Common stock, no par value; authorized
20,000,000 shares; issued and
outstanding 5,539,056 shares in 2008
and 5,624,234 shares in 2007		48,268,525			48,651,895
Retained earnings		22,985,694			19,741,876
Accumulated other comprehensive income		5,523,988			1,707,811
Total shareholders' equity		101,128,426			70,101,582

Total liabilities and shareholders' equity	$	968,762,297			907,261,796

See accompanying notes to consolidated financial statements.

A-32

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

For the Years Ended December 31, 2008, 2007 and 2006

	2008			2007			2006


Interest income:
Interest and fees on loans	$	50,603,885			55,400,514			49,667,700
Interest on federal funds sold		54,765			383,492			85,307
Interest on investment securities:
U.S. Government sponsored enterprises		4,392,356			4,571,571			4,321,346
States and political subdivisions		904,432			887,584			798,185
Other		367,423			488,465			521,077
Total interest income		56,322,861			61,731,626			55,393,615

Interest expense:
NOW, MMDA & savings deposits		3,248,844			4,098,892			3,060,201
Time deposits		15,008,193			17,430,012			14,188,623
FHLB borrowings		3,616,018			3,758,996			3,588,169
Junior subordinated debentures		1,016,361			1,475,701			1,962,692
Other		637,201			821,331			310,188
Total interest expense		23,526,617			27,584,932			23,109,873

Net interest income		32,796,244			34,146,694			32,283,742

Provision for loan losses		4,794,000			2,038,000			2,513,282

Net interest income after provision for loan losses		28,002,244			32,108,694			29,770,460

Other income:
Service charges		5,202,972			4,278,238			3,929,956
Other service charges and fees		2,399,051			1,938,137			1,539,367
Loss on sale and write-down of securities		(167,048	)		(561,832	)		(591,856	)
Mortgage banking income		660,288			560,291			289,293
Insurance and brokerage commissions		425,653			521,095			388,559
Loss on sale and write-down of
other real estate and repossessed assets		(287,431	)		(117,880	)		(107,712	)
Miscellaneous		2,261,104			2,197,645			2,106,188
Total other income		10,494,589			8,815,694			7,553,795

Other expense:
Salaries and employee benefits		15,194,393			13,887,841			11,785,094
Occupancy		5,029,096			4,750,634			4,180,058
Other		8,669,465			7,354,401			7,017,986
Total other expenses		28,892,954			25,992,876			22,983,138

Earnings before income taxes		9,603,879			14,931,512			14,341,117

Income taxes		3,213,316			5,339,541			5,170,300

Net earnings	$	6,390,563			9,591,971			9,170,817

Basic earnings per common share	$	1.14			1.68			1.61
Diluted earnings per common share	$	1.13			1.65			1.58
Cash dividends declared per common share	$	0.48			0.41			0.33


See accompanying notes to consolidated financial statements.

A-33

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Changes in Shareholders' Equity

For the Years Ended December 31, 2008, 2007 and 2006

														Accumulated
														Other
	Stock Shares					Stock Amount					Retained			Comprehensive
	Preferred		Common			Preferred		Common			Earnings			Income (Loss)			Total
Balance, December 31, 2005		-		3,440,805		$	-		41,096,500			14,656,160			(1,399,666	)		54,352,994
10% stock dividend		-		343,850			-		9,430,532			(9,430,532	)		-			-
Cash paid in lieu of
fractional shares		-		-			-		-			(6,426	)		-			(6,426	)
Cash dividends declared		-		-			-		-			(1,905,556	)		-			(1,905,556	)
Repurchase and retirement of
common stock		-		(19,250	)		-		(425,000	)		-			-			(425,000	)
Exercise of stock options		-		65,229			-		771,325			-			-			771,325
Stock option tax benefit		-		-			-		243,100			-			-			243,100
Stock option compensation
expense		-		-			-		5,690			-			-			5,690
Net earnings		-		-			-		-			9,170,817			-			9,170,817
Change in accumulated other
comprehensive income
(loss), net of tax		-		-			-		-			-			628,429			628,429
Balance, December 31, 2006		-		3,830,634			-		51,122,147			12,484,463			(771,237	)		62,835,373

3 for 2 stock split		-		1,915,147			-		-			-			-			-
Cash paid in lieu of
fractional shares		-		-			-		-			(3,355	)		-			(3,355	)
Cash dividends declared		-		-			-		-			(2,331,203	)		-			(2,331,203	)
Repurchase and retirement of
common stock		-		(150,497	)		-		(2,810,907	)		-			-			(2,810,907	)
Exercise of stock options		-		28,950			-		239,182			-			-			239,182
Stock option tax benefit		-		-			-		91,815			-			-			91,815
Stock option compensation
expense		-		-			-		9,658			-			-			9,658
Net earnings		-		-			-		-			9,591,971			-			9,591,971
Change in accumulated other
comprehensive income
(loss), net of tax		-		-			-		-			-			2,479,048			2,479,048
Balance, December 31, 2007		-		5,624,234			-		48,651,895			19,741,876			1,707,811			70,101,582

Cumulative effect of
adoption of EITF 06-4		-		-			-		-			(466,917	)		-			(466,917	)
Issuance of Series A
preferred stock		25,054		-			24,350,219		703,781			-			-			25,054,000
Cash dividends declared on
common stock		-		-			-		-			(2,679,828	)		-			(2,679,828	)
Repurchase and retirement of
common stock		-		(90,500	)		-		(1,126,275	)		-			-			(1,126,275	)
Exercise of stock options		-		5,322			-		43,948			-			-			43,948
Stock option compensation
expense		-		-			-		(4,824	)		-			-			(4,824	)
Net earnings		-		-			-		-			6,390,563			-			6,390,563
Change in accumulated other
comprehensive income
(loss), net of tax		-		-			-		-			-			3,816,177			3,816,177
Balance, December 31, 2008		25,054		5,539,056		$	24,350,219		48,268,525			22,985,694			5,523,988			101,128,426
See accompanying notes to consolidated financial statements.

A-34

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

For the Years Ended December 31, 2008, 2007 and 2006

	2008		2007		2006


Net earnings	$	6,390,563		9,591,971		9,170,817

Other comprehensive income:
Unrealized holding gains on securities
available for sale		2,144,591		1,964,861		197,569
Reclassification adjustment for losses on sales and
write-downs of securities available for sale included
in net earnings		167,048		561,832		591,856
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		3,743,982		1,244,910		(345,049	)
Reclassification adjustment for losses on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		-		-		386,285

Total other comprehensive income,
before income taxes		6,055,621		3,771,603		830,661

Income tax expense related to other
comprehensive income:

Unrealized holding gains on securities
available for sale		835,318		765,313		76,953
Reclassification adjustment for losses on sales and
write-downs of securities available for sale included
in net earnings		65,065		218,834		230,528
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		1,339,061		308,408		(255,707	)
Reclassification adjustment for losses on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		-		-		150,458

Total income tax expense related to
other comprehensive income		2,239,444		1,292,555		202,232

Total other comprehensive income,
net of tax		3,816,177		2,479,048		628,429

Total comprehensive income	$	10,206,740		12,071,019		9,799,246

See accompanying notes to consolidated financial statements.

A-35

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2008, 2007 and 2006

	2008			2007			2006
Cash flows from operating activities:
Net earnings	$	6,390,563			9,591,971			9,170,817
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion		1,678,913			1,553,251			1,616,558
Provision for loan losses		4,794,000			2,038,000			2,513,282
Deferred income taxes		(485,137	)		(479,806	)		(615,626	)
Loss on sale and write-down of investment securities		167,048			561,832			591,856
Recognition of gain on sale of
derivative instruments		-			-			386,285
Loss (gain) on sale of premises and equipment		1,404			(10,337	)		(20,896	)
Loss (gain) on sale of repossessed assets		46,801			83,294			(2,288	)
Write-down of other real estate and repossessions		240,630			34,586			110,000
Amortization of deferred issuance costs on
junior subordinated debentures		-			-			461,298
Stock option compensation expense		12,434			9,658			5,690
Change in:
Mortgage loans held for sale		-			-			2,247,900
Cash surrender value of life insurance		(243,099	)		(243,973	)		(220,649	)
Other assets		(19,918	)		(1,013,866	)		(1,206,937	)
Other liabilities		(1,851,672	)		2,403,990			(230,144	)

Net cash provided by operating activities		10,731,967			14,528,600			14,807,146

Cash flows from investing activities:
Purchases of investment securities available for sale		(41,658,966	)		(15,858,155	)		(30,579,262	)
Proceeds from calls and maturities of investment securities
available for sale		16,488,469			7,470,991			8,562,058
Proceeds from sales of investment securities available
for sale		23,448,161			8,362,525			19,871,979
Purchases of other investments		(4,179,862	)		(8,356,900	)		(12,748,200	)
Proceeds from sale of other investments		4,311,000			8,424,000			11,263,500
Net change in loans		(65,188,183	)		(72,815,928	)		(86,825,349	)
Purchases of premises and equipment		(1,857,429	)		(7,672,018	)		(1,624,299	)
Proceeds from sale of premises and equipment		33,545			55,630			-
Proceeds from sale of repossessed assets		2,867,543			425,158			825,115
Purchases of derivative financial instruments		-			(634,000	)		(961,500	)

Net cash used by investing activities		(65,735,722	)		(80,598,697	)		(92,215,958	)

Cash flows from financing activities:
Net change in deposits		27,423,680			59,818,414			50,966,628
Net change in demand notes payable to U.S. Treasury		-			-			126,307
Net change in securities sold under agreement to repurchase		9,917,475			21,165,460			5,436,753
Proceeds from FHLB borrowings		97,100,000			275,300,000			700,800,000
Repayments of FHLB borrowings		(107,600,000	)		(277,100,000	)		(683,100,000	)
Proceeds from FRB borrowings		5,000,000			-			-
Proceeds from issuance of junior subordinated debentures		-			-			20,619,000
Repayments of junior subordinated debentures		-			-			(14,433,000	)
Proceeds from issuance of Series A preferred stock		25,054,000			-			-
Proceeds from exercise of stock options		43,948			330,997			1,014,425
Common stock repurchased		(1,126,275	)		(2,810,907	)		(425,000	)
Cash paid in lieu of fractional shares		-			(3,355	)		(6,426	)
Cash dividends paid		(2,679,828	)		(2,331,203	)		(1,905,556	)

Net cash provided by financing activities		53,133,000			74,369,406			79,093,131

Net change in cash and cash equivalent		(1,870,755	)		8,299,309			1,684,319

Cash and cash equivalents at beginning of period		29,799,627			21,500,318			19,815,999

Cash and cash equivalents at end of period	$	27,928,872			29,799,627			21,500,318

A-36

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows, continued

For the Years ended December 31, 2008, 2007 and 2006


	2008		2007		2006


Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	23,799,196		27,420,245		23,171,572
Income taxes	$	4,165,800		5,689,500		6,398,100

Noncash investing and financing activities:
Change in unrealized gain on investment securities
available for sale, net	$	1,411,256		1,542,546		481,944
Change in unrealized gain on derivative financial
instruments, net	$	2,404,921		936,502		146,485
Transfer of loans to other real estate and repossessions	$	4,538,987		681,735		746,004
Financed portion of sale of other real estate	$	1,133,480		-		273,000
Reclassification of an investment from other assets
to securities available for sale	$	-		499,995		-
Reclassification of a security from other investments
to securities available for sale	$	-		600,000		-
Transfer of retained earnings to common stock for
issuance of stock dividend	$	-		-		9,430,532
Deferred gain rolled into cost basis of
acquired building	$	-		539,815		-
Cumulative effect of adoption of EITF 06-4	$	466,917		-		-


See accompanying notes to consolidated financial statements.

A-37

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Notes to Consolidated Financial Statements

(1)	Summary of Significant Accounting Policies

Organization

Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999. Bancorp is primarily regulated by the Board of Governors of the Federal Reserve System, and serves as the one-bank holding company for Peoples Bank.

Peoples Bank (the “Bank”) commenced business in 1912 upon receipt of its banking charter from the North Carolina State Banking Commission (the “SBC”). The Bank is primarily regulated by the SBC and the Federal Deposit Insurance Corporation and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg, Iredell, Union and Wake counties in North Carolina.

Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.

Real Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.

Principles of Consolidation

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

Basis of Presentation

The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.

Cash and Cash Equivalents

Cash and due from banks and federal funds sold are considered cash and cash equivalents for cash flow reporting purposes. Generally, federal funds are sold for one-day periods.

Investment Securities

The Company classifies its securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2008 and 2007, the Company classified all of its investment securities as available for sale.

Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.

A decline in the market value of any available for sale investment below cost that is deemed other than temporary is charged to earnings and establishes a new cost basis for the security.

Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to the yield. Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

Other Investments

Other investments include equity securities with no readily determinable fair value. These investments are carried at cost.

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Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. The recognition of certain loan origination fee income and certain loan origination costs is deferred when such loans are originated and amortized over the life of the loan.

Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected.

Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings and interest is recognized on a cash basis when such loans are placed on non-accrual status.

Allowance for Loan Losses

The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·	the Bank’s loan loss experience;

·	the amount of past due and non-performing loans;

·	specific known risks;

·	the status and amount of other past due and non-performing assets;

·	underlying estimated values of collateral securing loans;

·	current and anticipated economic conditions; and

·	other factors which management believes affect the allowance for potential credit losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting By Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.

A-39

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.

Mortgage Banking Activities

Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Company’s origination of single-family residential mortgage loans.

Mortgage servicing rights (“MSR's”) represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee. MSRs are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans. During the year ended December 31, 2006, the Company fully amortized the remaining balance of the Bank’s MSRs. Management determined there was minimal fair value in the MSRs due to the small remaining balance in the loans serviced for others. The Company amortized approximately $227,000 during 2006. No new servicing assets were recognized during 2008, 2007 and 2006.

Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $9.3 million, $12.1 million and $14.8 million at December 31, 2008, 2007 and 2006, respectively.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for the period. The cost of maintenance and repairs that do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:

Buildings and improvements		10 - 50 years
Furniture and equipment		3 - 10 years

Foreclosed Assets

Foreclosed assets include all assets received in full or partial satisfaction of a loan and include real and personal property. Foreclosed assets are reported at the lower of carrying amount or net realizable value, and are included in other assets on the balance sheet.

Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that the realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.

In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be

A-40

realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.

Derivative Financial Instruments and Hedging Activities

In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.

On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.

If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.

The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.

Advertising Costs

Advertising costs are expensed as incurred.

Accumulated Other Comprehensive Income

At December 31, 2008, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $2.3 million and net unrealized gains on derivatives of $3.2 million. At December 31, 2007, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $943,000 and net unrealized gains on derivatives of $765,000.

Stock-Based Compensation

The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. A total of 636,687 shares are currently reserved for possible issuance under this Plan. All rights must be granted or awarded within ten years from the May 13, 1999 effective date of the plan.

Under the Plan, the Company has granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant. The options granted in 1999 vested over a five-year period. Options granted subsequent to 1999 vest over a three-year period.

A-41

All options expire after ten years. A summary of the activity in the Plan is presented below:

Stock Option Activity
For the years ended December 31, 2008, 2007 and 2006

	Shares			Weighted Average Option Price Per Share		Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding, December 31, 2005		319,692		$	8.13

Granted during the period		-		$	-
Forfeited during the period		(164	)	$	7.38
Exercised during the period		(97,854	)	$	7.87

Outstanding, December 31, 2006		221,674		$	8.24

Granted during the period		-		$	-
Forfeited during the period		-		$	-
Exercised during the period		(28,949	)	$	8.26

Outstanding, December 31, 2007		192,725		$	8.24

Granted during the period		-		$	-
Forfeited during the period		(2,458	)	$	8.02
Exercised during the period		(5,322	)	$	8.26

Outstanding, December 31, 2008		184,945		$	8.24	3.08	$ 174,002

Exercisable, December 31, 2008		184,945		$	8.24	3.08	$ 174,002

Options outstanding at December 31, 2008 are exercisable at option prices ranging from $6.99 to $10.57. Such options have a weighted average remaining contractual life of approximately three years.

The Company adopted SFAS No. 123(R), “Share-Based Payment” (SFAS 123(R)), on January 1, 2006 using the “modified prospective” method. Under this method, awards that are granted, modified, or settled after December 31, 2005, are measured and accounted for in accordance with SFAS 123(R). Also under this method, expense is recognized for unvested awards that were granted prior to January 1, 2006, based upon the fair value determined at the grant date under SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). The Company recognized compensation expense for employee stock options and restricted stock awards of $12,000 and $10,000 for the years ended December 31, 2008 and 2007, respectively. As of December 31, 2008 and 2007, there was no unrecognized compensation cost related to nonvested employee stock options.

No options were granted during the years ended December 31, 2008 and 2007. The total intrinsic value (amount by which the fair market value of the underlying stock exceeds the exercise price of an option on exercise date) of options exercised during the years ended December 31, 2008 and 2007 was $26,000 and $285,000, respectively. There were no options vested during the year ended December 31, 2008 and 2,420 options vested during the year ended December 31, 2007. Cash received from option exercises for the years ended December 31, 2008 and 2007 was $44,000 and $239,000, respectively. There were no tax deductions from options exercised for the year ended December 31, 2008. The tax benefit for the tax deductions from option exercises totaled $92,000 for the year ended December 31, 2007.

The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock at a grant date fair value of $12.80 per share during third quarter 2008 and 2,000 shares of restricted stock at a fair value of $11.37 per share during fourth quarter 2008. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date). The amount of expense recorded each period reflects the changes in the Company’s stock price during the period. As of December 31, 2008 and 2007, there was $47,000 and $48,000 of total unrecognized compensation cost related to restricted stock grants, respectively, which is expected to be recognized over a period of three years.

A-42

Net Earnings Per Share

Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share. The average market price during the year is used to compute equivalent shares.

The reconciliations of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the years ended December 31, 2008, 2007 and 2006 are as follows:

For the year ended December 31, 2008:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	6,390,563	5,588,314	$	1.14
Effect of dilutive securities:
Stock options		-	58,980
Diluted earnings per common share	$	6,390,563	5,647,294	$	1.13

For the year ended December 31, 2007:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	9,591,971	5,700,860	$	1.68
Effect of dilutive securities:
Stock options		-	109,455
Diluted earnings per common share	$	9,591,971	5,810,315	$	1.65

For the year ended December 31, 2006:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	9,170,817	5,701,829	$	1.61
Effect of dilutive securities:
Stock options		-	100,495
Diluted earnings per common share	$	9,170,817	5,802,324	$	1.58

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS No.159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS No. 159 did not have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FASB Staff Position (‘FSP”) FAS No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” This FSP provides guidance on accounting for a transfer of a financial asset and a repurchase financing under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” This FSP is not expected to have a material effect on the Company's financial position, results of operations or disclosures.

A-43

In September 2008, the FASB FSP FAS No. 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 and Clarification of the Effective Date of FASB Statement No. 161.” This FSP is an amendment to SFAS No. 133, which provides for enhanced disclosure requirements for credit risk derivatives. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

(2)	Investment Securities

Investment securities available for sale at December 31, 2008 and 2007 are as follows:

	December 31, 2008
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value

Mortgage-backed securities	$	36,556,684		854,237		139,840		37,271,081
U.S. government sponsored enterprises		55,222,788		3,266,198		2,324		58,486,662
State and political subdivisions		26,648,553		459,546		134,525		26,973,574
Trust preferred securities		1,250,000		-		-		1,250,000
Equity securities		1,382,184		-		447,152		935,032

Total	$	121,060,209		4,579,981		723,841		124,916,349

	December 31, 2007
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value

Mortgage-backed securities	$	16,469,053		6,423		204,509		16,270,967
U.S. government sponsored enterprises		75,155,693		1,839,143		3,035		76,991,801
State and political subdivisions		25,856,311		250,483		201,406		25,905,388
Trust preferred securities		250,000		-		-		250,000
Equity securities		1,692,799		246,000		388,597		1,550,202

Total	$	119,423,856		2,342,049		797,547		120,968,358

The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2008 and 2007 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.

A-44

	December 31, 2008
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

Mortgage-backed securities	$	10,017,250		139,840		-		-		10,017,250		139,840
U.S. government sponsored enterprises		-		-		614,289		2,324		614,289		2,324
State and political subdivisions		2,748,094		75,172		2,373,145		59,353		5,121,239		134,525
Equity securities		528,000		72,000		407,032		375,152		935,032		447,152

Total	$	13,293,344		287,012		3,394,466		436,829		16,687,810		723,841

	December 31, 2007
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

Mortgage-backed securities	$	24,591		104		14,320,043		204,405		14,344,634		204,509
U.S. government sponsored enterprises		-		-		689,775		3,035		689,775		3,035
State and political subdivisions		2,059,746		33,781		11,188,720		167,625		13,248,466		201,406
Equity securities		425,620		88,134		278,581		300,463		704,201		388,597

Total	$	2,509,957		122,019		26,477,119		675,528		28,987,076		797,547

At December 31, 2008, unrealized losses in the investment securities portfolio related to debt securities totaled $277,000. The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary. From the December 31, 2008 tables above, 13 out of 74 securities issued by state and political subdivisions contained unrealized losses and 7 out of 59 securities issued by U.S. government sponsored enterprises, including mortgage-backed securities, contained unrealized losses. These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.

The Company periodically evaluates its investments for any impairment which would be deemed other than temporary. As part of its evaluation in 2008, the Company determined that the fair value of one investment was less than the original cost of the investment and that the decline in fair value was not temporary in nature. As a result, the Company wrote down its original investment by $300,000. The remaining fair value of the investment at December 31, 2008 was $22,000. Similarly, as part of its evaluation in 2007, the Company wrote down two investments by $430,000. The remaining fair value of the investments at December 31, 2007 was $348,000.

The amortized cost and estimated fair value of investment securities available for sale at December 31, 2008, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Estimated Fair Value

Due within one year	$	5,904,880		6,015,036
Due from one to five years		44,167,067		46,804,084
Due from five to ten years		20,019,656		20,602,860
Due after ten years		13,029,738		13,288,256
Mortgage-backed securities		36,556,684		37,271,081
Equity securities		1,382,184		935,032

Total	$	121,060,209		124,916,349

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Proceeds from sales of securities available for sale during 2008 were $23.4 million and resulted in a gross gain of $160,000. During 2007 and 2006, the proceeds from sales of securities available for sale were $8.4 million and $19.9 million, respectively. Gross losses of $132,000 and $592,000 for 2007 and 2006, respectively, were realized on those sales.

Securities with a fair value of approximately $65.2 million and $50.4 million at December 31, 2008 and 2007, respectively, were pledged to secure public deposits and for other purposes as required by law.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 was effective for the Company as of January 1, 2008. This standard had no effect on the Company's financial position or results of operations.

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916,349	935,032	122,731,317	1,250,000
Market value of derivatives (in other assets)	$	4,980,701	-	4,980,701	-

The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2008:

	Investment Securities Available for Sale
	Level 3 Valuation
Balance, beginning of period	$	250,000
Change in book value		-
Change in gain/(loss) realized and unrealized		-
Purchases/(sales)		1,000,000
Transfers in and/or out of Level 3		-
Balance, end of period	$	1,250,000

Change in unrealized gain/(loss) for assets still held in Level 3	$	0

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(3)

Loans

Major classifications of loans at December 31, 2008 and 2007 are summarized as follows:

	2008		2007

Commercial	$	76,945,143	82,190,391
Real estate - mortgage		474,732,433	417,708,750
Real estate - construction		216,187,811	209,643,836
Consumer		13,322,695	12,733,971

Total loans		781,188,082	722,276,948

Less allowance for loan losses		11,025,516	9,103,058

Total net loans	$	770,162,566	713,173,890

The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

In accordance with the provisions of SFAS No. 114, the Company has specific loan loss reserves for loans that management has determined to be impaired. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. At December 31, 2008 and 2007, the recorded investment in loans that were considered to be impaired was approximately $7.5 million and $8.0 million, respectively. In addition, the Company had approximately $514,000 and $0 in loans past due more than ninety days and still accruing interest at December 31, 2008 and 2007, respectively. The Company had specific reserves on impaired loans of $462,000 and $1.2 million at December 31, 2008 and 2007, respectively. The average recorded investment in impaired loans for the twelve months ended December 31, 2008 and 2007 was approximately $8.8 million and $7.3 million, respectively. For the years ended December 31, 2008, 2007 and 2006, the Company recognized approximately $57,000, $29,000 and $144,000, respectively, of interest income on impaired loans.

The Company’s December 31, 2008 fair value measurement for impaired loans is presented below:

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation	Total Gains/(Losses) for the Year Ended December 31, 2008
Impaired loans	$	7,073,045	-	5,902,848	1,170,197	(345,000)
Other real estate	$	1,866,971	-	1,866,971	-	(165,630)

Changes in the allowance for loan losses were as follows:

	2008			2007		2006

Balance at beginning of year	$	9,103,058		8,303,432		7,424,782
Amounts charged off		(3,146,939	)	(1,626,458	)	(1,958,551	)
Recoveries on amounts previously charged off		275,397		388,084		323,919
Provision for loan losses		4,794,000		2,038,000		2,513,282

Balance at end of year	$	11,025,516		9,103,058		8,303,432

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(4)	Premises and Equipment

Major classifications of premises and equipment are summarized as follows:

	2008		2007

Land	$	3,572,799	3,572,241
Buildings and improvements		14,709,218	14,700,078
Furniture and equipment		17,156,190	15,496,630

Total premises and equipment		35,438,207	33,768,949

Less accumulated depreciation		17,141,312	15,534,556

Total net premises and equipment	$	18,296,895	18,234,393

Depreciation expense was approximately $1.8 million for the year ended December 31, 2008. The Company recognized approximately $1.7 and $1.5 million in depreciation expense for the years ended December 31, 2007 and 2006.

(5)	Time Deposits

At December 31, 2008, the scheduled maturities of time deposits are as follows:

2009	$	368,499,249
2010		23,010,748
2011		12,797,281
2012		1,156,885
2013 and thereafter		1,092,480

Total	$	406,556,643

At December 31, 2008 and 2007, the Company has approximately $61.0 million and $53.9 million, respectively, in time deposits purchased through third party brokers. The weighted average rate of brokered deposits as of December 31, 2008 and 2007 was 3.25% and 5.06%, respectively.

(6)	Federal Home Loan Bank and Federal Reserve Bank Borrowings

The Bank has borrowings from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly or quarterly interest payments at December 31, 2008. The FHLB borrowings are collateralized by a blanket assignment on all residential first mortgage loans, commercial real estate loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns. At December 31, 2008, the carrying value of loans pledged as collateral totaled approximately $244.9 million.

Borrowings from the FHLB outstanding at December 31, 2008 consist of the following:

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Maturity Date	Call Date	Rate	Rate Type	Amount

March 30, 2010	September 30, 2000 and every
	three months thereafter	5.880%	Convertible		5,000,000

May 24, 2010	May 24, 2001 and every three
	months thereafter	6.490%	Convertible		2,000,000

June 24, 2015	June 24, 2010	3.710%	Convertible		5,000,000

March 25, 2019	March 25, 2009	4.360%	Convertible		5,000,000

March 31, 2016	March 31, 2009 and every three
	months thereafter	4.620%	Convertible		5,000,000

October 5, 2016	October 5, 2009	4.450%	Convertible		5,000,000

December 12, 2011	December 12, 2007 and every	4.210%	Convertible		5,000,000
	three months thereafter

January 30, 2017	October 30, 2008 and every	4.500%	Convertible		5,000,000
	three months thereafter

June 8, 2017	December 8, 2008 and every	4.713%	Convertible		15,000,000
	three months thereafter

June 9, 2014	February 11, 2008 and every	4.685%	Convertible		15,000,000
	month thereafter


July 11, 2017	January 11, 2008 and every	4.440%	Convertible		5,000,000
	three months thereafter

July 24, 2017	April 24, 2008 and every	4.420%	Convertible		5,000,000
	month thereafter

				$	77,000,000

The FHLB has the option to convert $72.0 million of the total borrowings to a floating rate and, if converted, the Bank may repay borrowings without payment of a prepayment fee. The Company also has an additional $5.0 million in variable rate convertible borrowings, which may be repaid without a prepayment fee if converted by the FHLB.

The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. At December 31, 2008 and 2007, the Bank owned FHLB stock amounting to $5.1 million and $5.4 million, respectively.

The Bank had $5.0 million in borrowings from the Federal Reserve Bank (“FRB”) at December 31, 2008. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009. The FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2008, the carrying value of loans pledged as collateral totaled approximately $280.8 million.

(7)	Junior Subordinated Debentures

In June 2006, the Company formed a second wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

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preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

(8)	Income Taxes

The provision for income taxes in summarized as follows:

	2008			2007		2006
Current	$	3,698,453		5,819,347		5,785,926
Deferred		(485,137	)	(479,806	)	(615,626	)
Total	$	3,213,316		5,339,541		5,170,300

The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:

	2008			2007		2006
Pre-tax income at statutory rates (34%)	$	3,265,319		5,076,714		4,875,980
Differences:
Tax exempt interest income		(313,083	)	(307,169	)	(280,826	)
Nondeductible interest and other expense		59,310		55,871		45,872
Cash surrender value of life insurance		(82,654	)	(82,951	)	(75,021	)
State taxes, net of federal benefits		257,213		559,905		576,444
Other, net		27,211		37,170		27,851
Total	$	3,213,316		5,339,541		5,170,300

The following summarized the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities. The net deferred tax asset is included as a component of other assets at December 31, 2008 and 2007.

	2008		2007
Deferred tax assets:
Allowance for loan losses	$	4,280,854	3,531,076
Amortizable intangible assets		43,703	76,398
Accrued retirement expense		1,184,373	819,246
Income from non-accrual loans		36,973	50,219
Unrealized loss on cash flow hedges		-	20,525
Premises and equipment		-	9,757
Total gross deferred tax assets		5,545,903	4,507,221

Deferred tax liabilities:
Deferred loan fees		1,654,311	1,346,322
Premises and equipment		194,463	-
Unrealized gain on available for sale securities		1,501,966	601,583
Unrealized gain on cash flow hedges		1,318,536	-
Other		84,100	12,482
Total gross deferred tax liabilities		4,753,376	1,960,387
Net deferred tax asset	$	792,527	2,546,834

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(9) Related Party Transactions

The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers are made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2008:

Beginning balance	$	5,615,899
New loans		3,734,377
Repayments		3,692,009

Ending balance	$	5,658,267

At December 31, 2008 and 2007, the Company had deposit relationships with related parties of approximately $20.0 million and $15.7 million, respectively.

(10)	Commitments and Contingencies

The Company leases various office spaces for banking and operational facilities and equipment under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2008 are as follows:

Year ending December 31,
2009	$	769,569
2010		626,965
2011		563,901
2012		444,834
2013		255,909
Thereafter		1,893,313

Total minimum obligation	$	4,554,491

Total rent expense was approximately $1.0 million, $1.1 million and $959,000 for 2008, 2007 and 2006, respectively.

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

In most cases, the Company requires collateral or other security to support financial instruments with credit risk.

	Contractual Amount
	2008		2007
Financial instruments whose contract amount represent credit risk:

Commitments to extend credit	$	158,939,113	190,653,583

Standby letters of credit and financial guarantees written	$	4,316,012	3,894,259

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $163.3 million does not necessarily represent future cash requirements.

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Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Company’s delineated market area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.

The Company has an overall interest rate-risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company attempts to minimize the credit risk in derivative instruments by entering into transactions with counterparties that are reviewed periodically by the Company and are believed to be of high quality.

In the normal course of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Bank or the Company.

The Company has employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive stock option, and change in control provisions.

The Company has $38.0 million available for the purchase of overnight federal funds from four correspondent financial institutions.

(11)	Derivative Financial Instruments and Hedging Transactions

As of December 31, 2008, the Company had cash flow hedges with a notional amount of $165.0 million. These derivative instruments consist of three interest rate floor contracts and one interest rate swap contract. The interest rate floor contracts are used to hedge future cash flows from payments on the first $115.0 million of certain variable rate loans against the downward effects of their repricing in the event of a decreasing rate environment during the terms of the interest rate floor contracts. If the prime rate falls below the contract rate during the term of the contract, the Company will receive payments based on notional amount times the difference between the contract rate and the weighted average prime rate for the quarter. No payments will be received by the Company if the weighted average prime rate is equal to or higher than the contract rate. The interest rate floor contracts in effect at December 31, 2008 will expire in 2009. The interest rate swap contract is used to convert $50.0 million of variable rate loans to a fixed rate. Under the swap contract, the Company receives a fixed rate of 6.245% and pays a variable rate based on the current prime rate (3.25% at December 31, 2008) on the notional amount of $50.0 million. The swap agreement matures in June 2011. The Company recognized $3.4 million in interest income, net of premium amortization, from interest rate derivative contracts during the year ended December 31, 2008. Based on the current interest rate environment, it is expected the Company will continue to receive income on these interest rate contracts throughout 2009.

The following tables present additional information on the Company’s derivative financial instruments as of December 31, 2008.

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Type of Derivative	Notional Amount		Contract Rate		Premium		Year-to-date Income (Net of Premium Amortization)
Interest rate floor contact*	$	-		-	$	-	$	151,180
Interest rate floor contact*		-		-		-		455,766
Interest rate floor contact expiring 01/24/09		45,000,000		7.500%		562,000		870,517
Interest rate floor contact expiring 06/02/09		35,000,000		8.000%		399,000		914,017
Interest rate floor contact expiring 12/01/09		35,000,000		7.250%		634,000		523,191
Interest rate swap contact expiring 06/01/11		50,000,000		6.245%		-		488,451
	$	165,000,000			$	1,595,000	$	3,403,122

* Interest rate floor contracts expired during 2008

Fair values of derivatives designated as hedging instruments under SFAS 133 are as follows:

	Asset Derivatives				Liability Derivatives
	As of December 31, 2008		As of December 31, 2007		As of December 31, 2008		As of December 31, 2007
	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value
Interest rate
derivative
contracts	Other assets	$ 4,981,000	Other assets	$ 1,907,000	N/A	$ -	N/A	$ -

(12)	Employee and Director Benefit Programs

The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under this plan, the Company matches employee contributions to a maximum of five percent of annual compensation. The Company’s contribution pursuant to this formula was approximately $483,000, $424,000 and $405,000 for the years of 2008, 2007 and 2006, respectively. Investments of the plan are determined by the compensation committee consisting of selected outside directors and senior executive officers. No investments in Company stock have been made by the plan. The vesting schedule for the plan begins at 20 percent after two years of employment and graduates 20 percent each year until reaching 100 percent after six years of employment.

In September 2006, the FASB released SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” which requires employers to recognize the overfunded or underfunded status of defined benefit postretirement plans. The effective date for public companies was for years ending after December 15, 2006. Management has compared the accrued postretirement benefit expense and the charge to other comprehensive income, as calculated in accordance with prior accounting standards to the requirement under SFAS 158 and determined that the difference is immaterial.

In December 2001, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries. Under the plan, the Company purchased life insurance contracts on the lives of the key officers and each director. The increase in cash surrender value of the contracts constitutes the Company’s contribution to the plan each year. Plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to this plan, which include EITF 06-4 expense, were approximately $365,000, $258,000 and $240,000 during 2008, 2007 and 2006, respectively.

The Company is currently paying medical benefits for certain retired employees. Postretirement benefits expense, including amortization of the transition obligation, as applicable, was approximately $23,000 for the years ended December 31, 2008, 2007 and 2006.

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The following table sets forth the change in the accumulated benefit obligation for the Company’s two postretirement benefit plans described above:

	2008

Benefit obligation at beginning of period	$	1,528,488
Service cost		180,162
Interest cost		99,569
Benefits paid		(28,931	)
Benefit obligation at end of period	$	1,779,288

The amounts recognized in the Company’s consolidated balance sheet as of December 31, 2008 are shown in the following two tables:

	2008

Benefit obligation	$	1,779,288
Fair value of plan assets		-

	2008

Funded status	$	(1,779,288	)
Unrecognized prior service cost/benefit		-
Unrecognized net actuarial loss		-
Net amount recognized	$	(1,779,288	)

Unfunded accrued liability	$	(1,779,288	)
Intangible assets		-
Net amount recognized	$	(1,779,288	)

Net periodic benefit cost of the Company's two post retirement benefit plans for the year ended December 31, 2008 consisted of the following:

	2008

Service cost	$	180,162
Interest cost		99,569
Net periodic cost	$	279,731

Weighted average discount rate assumption used to
determine benefit obligation		6.68%

During the year ended December 31, 2008, the Company paid benefits totaling $46,000. Information about the expected benefit payments for the Company’s two postretirement benefit plans is as follows:

Year ending December 31,
2009	$	58,713
2010	$	62,690
2011	$	86,858
2012	$	199,328
2013	$	204,735
Thereafter	$	9,459,971

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Members of the Board of Directors are eligible to participate in the Company’s Omnibus Stock Ownership and Long Term Incentive Plan (the “Stock Benefits Plan”). Each director has been awarded 9,737 book value shares (adjusted for stock dividends and stock splits) under the Stock Benefits Plan. The book value of the shares awarded range from $6.31 to $8.64. All book value shares will be fully vested on May 6, 2009. The Company recorded expenses of approximately $136,000, $159,000 and $128,000 associated with the benefits of this plan in the years ended December 31, 2008, 2007 and 2006, respectively.

A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2008, 2007 and 2006 is presented below.

	2008			2007			2006
	Shares	Weighted Average Price of Book Value Shares		Shares	Weighted Average Price of Book Value Shares		Shares	Weighted Average Price of Book Value Shares
Outstanding, beginning of period	97,377	$	7.38	97,377	$	7.38	97,377	$	7.38
Exercised during the period	-	$	-	-	$	-	-	$	-

Outstanding, end of period	97,377	$	7.38	97,377	$	7.38	97,377	$	7.38

Number of shares exercisable	89,580	$	7.27	81,791	$	7.89	73,998	$	6.98

In September 2006, the FASB ratified the conclusions reached by the Emerging Issues Task Force (“EITF”) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue requires companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. The Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement.

(13)	Regulatory Matters

The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 Capital consists of the allowance for loan losses up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2008, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2008, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.

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The Company’s and the Bank’s actual capital amounts and ratios are presented below:

	Actual			For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions

	Amount		Ratio	Amount	Ratio	Amount	Ratio
	(dollars in thousands)

As of December 31, 2008:

Total Capital (to Risk-Weighted Assets)
Consolidated	$	125,871	14.90%	67,589	8.00%	N/A	N/A
Bank	$	93,530	11.10%	67,411	8.00%	84,264	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	115,332	13.65%	33,794	4.00%	N/A	N/A
Bank	$	82,991	9.85%	33,705	4.00%	50,558	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$	115,332	12.40%	37,192	4.00%	N/A	N/A
Bank	$	82,991	8.94%	37,137	4.00%	46,421	5.00%

As of December 31, 2007:

Total Capital (to Risk-Weighted Assets)
Consolidated	$	97,410	12.16%	64,071	8.00%	N/A	N/A
Bank	$	87,393	10.93%	63,940	8.00%	79,926	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	88,307	11.03%	32,035	4.00%	N/A	N/A
Bank	$	78,290	9.80%	31,970	4.00%	47,955	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$	88,307	10.43%	33,873	4.00%	N/A	N/A
Bank	$	78,290	9.26%	33,827	4.00%	42,284	5.00%

(14)	Shareholders’ Equity

On April 19, 2007, the Board of Directors of the Company authorized a 3-for-2 stock split that was paid in conjunction with the Company’s regular cash dividend for the second quarter of 2007. As a result of the stock split, each shareholder received three new shares of stock for every two shares of stock they held as of the record date. Shareholders received a cash payment in lieu of any fractional shares resulting from the stock split. The cash dividend was paid based on the number of shares held by shareholders as adjusted by the stock split. All previously reported per share amounts have been restated to reflect this stock split.

In November 2006, the Company’s Board of Directors authorized the repurchase of up to $2.0 million in common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of November 2007. No shares of common stock were repurchased under this plan during 2006. During 2007 the Company repurchased 100,000 shares, or $1,938,000, of its common stock under this plan.

In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009. The Company has repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008. Because of the Company's participation inthe U.S. Treasury Department's Capital Purchase Program ("CPP"), discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without United States Department of the Treasury ("UST") approval.

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The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.

On December 23, 2008, the Company entered into a Letter Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”). Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and warrants to purchase 357,234 shares of common stock associated with the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”). Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale. Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant. The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield. No dividends were declared or paid on the Series A preferred stock during 2008, and cumulative undeclared dividends at December 31, 2008 were $28,000. The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate. Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things. Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000. There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP.

The Board of Directors of the Bank may declare a dividend of all of its retained earnings as it may deem appropriate, subject to the requirements of the General Statutes of North Carolina, without prior approval from the requisite regulatory authorities. As of December 31, 2008, this amount was approximately $37.8 million.

(15)	Other Operating Expense

Other operating expense for the years ended December 31 included the following items that exceeded one percent of total revenues:

	2008		2007	2006

Advertising	$	1,076,461	988,116	772,917

(16)	Fair Value of Financial Instruments

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation

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value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.

Cash and Cash Equivalents

For cash, due from banks, interest bearing deposits and federal funds sold, the carrying amount is a reasonable estimate of fair value.

Investment Securities Available for Sale

Fair values for investment securities are based on quoted market prices.

Other Investments

For other investments, the carrying value is a reasonable estimate of fair value.

Loans

The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.

Cash Surrender Value of Life Insurance

For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Derivative Instruments

For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.

Deposits and Demand Notes Payable

The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Securities Sold Under Agreements to Repurchase

For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.

FHLB and Short-term FRB Borrowings

The fair value of FHLB and FRB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.

Junior Subordinated Debentures

Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit

Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax

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ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2008 and 2007 are as follows:

	2008			2007
	Carrying Amount		Estimated Fair Value	Carrying Amount	Estimated Fair Value
	(dollars in thousands)

Assets:
Cash and cash equivalents	$	27,929	27,929	29,800	29,800
Investment securities available for sale	$	124,916	126,539	120,968	120,968
Other investments	$	6,303	6,303	6,434	6,434
Loans, net	$	770,163	773,256	713,174	713,689
Cash surrender value of life insurance	$	7,019	7,019	6,776	6,776
Derivative instruments	$	4,981	4,981	1,907	1,907

Liabilities:
Deposits and demand notes payable	$	722,662	718,278	695,239	695,659
Securities sold under agreements
to repurchase	$	37,501	37,501	27,583	27,583
Short-term FRB borrowings	$	5,000	4,999	-	-
FHLB borrowings	$	77,000	83,038	87,500	90,223
Junior subordinated debentures	$	20,619	20,619	20,619	20,619

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(17) Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements

Balance Sheets

December 31, 2008 and 2007

Assets	2008		2007

Cash	$	25,599,529	725,416
Interest-bearing time deposit		5,000,000	8,000,000
Investment in subsidiaries		89,406,831	80,703,540
Investment securities available for sale		1,811,123	1,374,581
Other assets		415,483	251,724

Total assets	$	122,232,966	91,055,261

Liabilities and Shareholders' Equity

Accrued expenses	$	485,540	334,679
Junior subordinated debentures		20,619,000	20,619,000
Shareholders' equity		101,128,426	70,101,582

Total liabilities and shareholders' equity	$	122,232,966	91,055,261


Statements of Earnings

For the Years Ended December 31, 2008, 2007 and 2006

Revenues:	2008			2007			2006

Dividends from subsidiaries	$	1,929,455			4,811,203			3,855,556
Interest and dividend income		442,693			463,866			672,922
Loss on sale of securities		(327,013	)		(235,950	)		-

Total revenues		2,045,135			5,039,119			4,528,478

Expenses:

Interest		1,016,361			1,475,701			1,962,692
Other operating expenses		243,849			266,146			786,014

Total expenses		1,260,210			1,741,847			2,748,706

Earnings before income tax benefit and equity in
undistributed earnings of subsidiaries		784,925			3,297,272			1,779,772

Income tax benefit		389,200			514,800			705,800

Earnings before undistributed earnings in subsidiaries		1,174,125			3,812,072			2,485,572

Equity in undistributed earnings in subsidiaries		5,216,438			5,779,899			6,685,245

Net earnings	$	6,390,563			9,591,971			9,170,817

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Statements of Cash Flows

For the Years Ended December 31, 2008, 2007 and 2006

	2008			2007		2006
Cash flows from operating activities:

Net earnings	$	6,390,563		9,591,971		9,170,817
Adjustments to reconcile net earnings to net
cash provided by operating activities:
Amortization		-		-		461,298
Book value shares accrual		136,130		158,678		128,444
Equity in undistributed earnings of subsidiaries		(5,216,438	)	(5,779,899	)	(6,685,245	)
Deferred income tax benefit		(52,855	)	(61,551	)	(49,520	)
Loss on sale of investment securities		327,013		235,950		-
Change in:
Other assets		(3,167	)	-		-
Accrued income		(16,876	)	1,603		(1,421	)
Accrued expense		14,731		(253,748	)	25,975

Net cash provided by operating activities		1,579,101		3,893,004		3,050,348

Cash flows from investing activities:

Proceeds from sales of investment securities available for sale		3,167		-		(6,000,000	)
Purchases of investment securities available for sale		(1,000,000	)	-		-
Net change in interest-bearing time deposit		3,000,000		-		(6,000,000	)
Purchases of other investments		-		-		(600,000	)
Purchase of equity in PEBK Capital Trust II		-		-		(619,000	)
Proceeds from liquidation of PEBK Capital Trust I		-		-		433,000

Net cash used by investing activities		2,003,167		-		(6,786,000	)

Cash flows from financing activities:

Proceeds from issuance of trust preferred securities		-		-		20,619,000
Repayments of trust preferred securities		-		-		(14,433,000	)
Proceeds from issuance of preferred stock		25,054,000		-		-
Cash dividends paid		(2,679,828	)	(2,331,203	)	(1,905,556	)
Cash paid in lieu of fractional shares		-		(3,355	)	(6,426	)
Common stock repurchased		(1,126,275	)	(2,810,907	)	(425,000	)
Proceeds from exercise of stock options		43,948		330,997		1,014,425

Net cash provided (used) by financing activities		21,291,845		(4,814,468	)	4,863,443

Net change in cash		24,874,113		(921,464	)	1,127,791

Cash at beginning of year		725,416		1,646,880		519,089

Cash at end of year	$	25,599,529		725,416		1,646,880

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DIRECTORS AND OFFICERS OF THE COMPANY

DIRECTORS

Robert C. Abernethy – Chairman

Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;

President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)

James S. Abernethy

President and Assistant Secretary, Midstate Contractors, Inc. (paving company)

Douglas S. Howard

Vice President, Howard Ventures, Inc. (private equity firm)

John W. Lineberger, Jr.

President, Lincoln Bonded Warehouse Company (commercial warehousing facility)

Gary E. Matthews

President and Director, Matthews Construction Company, Inc. (general contractor)

Billy L. Price, Jr. MD

Practicing Internist and Partner, Catawba Valley Internal Medicine, PA

Larry E. Robinson

President and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and wine distributor)

William Gregory (Greg) Terry

Executive Vice President, Drum & Willis-Reynolds Funeral Homes and Crematory

Dan Ray Timmerman, Sr.

President/CEO, Timmerman Manufacturing, Inc. (wrought iron furniture, railings and gates manufacturer)

Benjamin I. Zachary

President, Treasurer and Director, Alexander Railroad Company

OFFICERS

Tony W. Wolfe

President and Chief Executive Officer

A. Joseph Lampron

Executive Vice President, Chief Financial Officer and Corporate Treasurer

Joseph F. Beaman, Jr.

Executive Vice President and Corporate Secretary

Lance A. Sellers

Executive Vice President and Assistant Corporate Secretary

William D. Cable, Sr.

Executive Vice President and Assistant Corporate Treasurer

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