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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(MARK ONE)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period ended September 30, 2008

or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from                   to

Commission File No. 000-28344

FIRST COMMUNITY CORPORATION

(Exact name of registrant as specified in its charter)

5455 Sunset Boulevard, Lexington, South Carolina  29072

(Address of principal executive offices)    (Zip Code)

(803) 951-2265

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:  On October 31, 2008, 3,221,199 shares of the issuer’s common stock, par value $1.00 per share, were issued and outstanding.

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PART I

FINANCIAL INFORMATION

Item 1.  Financial Statements.

FIRST COMMUNITY CORPORATION

CONSOLIDATED BALANCE SHEETS

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FIRST COMMUNITY CORPORATION

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

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FIRST COMMUNITY CORPORATION

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

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FIRST COMMUNITY CORPORATION

Statement of Changes in Shareholders’ Equity and Comprehensive Income (Loss)

Nine Months ended September 30, 2008 and September 30, 2007

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FIRST COMMUNITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

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Notes to Consolidated Financial Statements

Note 1  - Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated balance sheets, the consolidated statements of income (loss), the consolidated statements of changes in shareholders’ equity, and the consolidated statements of cash flows of First Community Corporation (“the Company”) present fairly in all material respects the Company’s financial position at September 30, 2008 and December 31, 2007, the Company’s results of operations for the nine and three months ended September 30, 2008 and 2007, and the Company’s cash flows for the nine months ended September 30, 2008 and 2007. The results of operations for the nine and three months ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

In the opinion of management, all adjustments necessary to fairly present the consolidated financial position and consolidated results of operations have been made. All such adjustments are of a normal, recurring nature.  All significant intercompany accounts and transactions have been eliminated in consolidation. The consolidated financial statements and notes thereto are presented in accordance with the instructions for Form 10-Q.  The information included in the Company’s 2007 Annual Report on Form 10-K should be referred to in connection with these unaudited interim financial statements.

Note 2 – Earnings Per Share

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

Note 3 – Acquisition

On September 15, 2008, the Company completed the acquisition of two financial planning and investment advisory firms.  These firms had combined assets under management of approximately $40 million.    This new division of the bank, First Community Financial Consultants, combines the investment services unit already in place at First Community with the added capabilities of holistic financial planning and investment advisory services.  In addition, over time we believe the business will provide a consistent non-interest income revenue stream.  The total purchase price for the two companies was approximately $601,000 in cash and 16,250 shares of common stock valued at $195,000.  The common stock issued in connection with the acquisition is restricted and will vest at the end of two years.  The purchase price of these two acquisitions is deemed not to be material to the Company’s balance sheet.

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Note 4 –SFAS No. 159 (“SFAS 159”) “The Fair Value Option for Financial assets and Financial Liabilities”

The Company adopted the provisions of SFAS 159 effective January 1, 2007 which became effective in February 2007.  SFAS 159 generally permits the measurement of selected eligible financial instruments at fair value at specified election dates.  This election can generally be applied on an instrument by instrument basis.  Following the initial measurement date, ongoing unrealized gains or losses on these securities as well as other financial instruments for which fair value reporting is elected are reported in earnings at each subsequent reporting date.

The following tables reflect the changes in fair values for the three-month and nine-month periods ended September 30, 2008 and 2007 and where these changes are included in the income statement:

There were no gains or losses on sale of trading securities in nine or three months ended September 30, 2008.  During the nine and three months ended September 30, 2007 a gain on sale of trading securities in the amount of $69,405 is included in “gain (loss) on sale of securities” in the consolidated statement of income (loss).

In connection with the adoption of SFAS 159, the Company was required to adopt SFAS No. 157, “Fair Value Measurement” (“SFAS 157”).   SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.

Effective January 1, 2007, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) which provides a framework for measuring and disclosing fair value under generally accepted accounting principles. SFAS 157 requires disclosures about the fair value of assets and liabilities recognized in the balance sheet in periods subsequent to initial recognition, whether the measurements are made on a recurring basis (for example, available-for-sale investment securities) or on a nonrecurring basis (for example, impaired loans).

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

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FASB Staff Position No. FAS 157-2 delays the implementation of SFAS 157 until the first quarter of 2009 with respect to goodwill, other intangible assets, real estate and other assets acquired through foreclosure and other non-financial assets measured at fair value on a nonrecurring basis.

The following table summarizes quantitative disclosures about the fair value measurement for each category of assets carried at fair value as of September 30, 2008.

The Company has a large percentage of loans with real estate serving as collateral. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair values of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 2 inputs. The aggregate carrying amount of impaired loans at September 30, 2008 and 2007 was $1,732,000 and $557,000 respectively.

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The following table reconciles the changes in Level 3 financial instruments for the nine months ended September 30, 2008 and 2007:

Note 5 - Recently Issued Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations,” (“SFAS 141(R)”) which replaces SFAS 141. SFAS 141(R) establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any controlling interest; recognizes and measures goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. FAS 141(R) is effective for acquisitions by the Company taking place on or after January 1, 2009. Early adoption is prohibited. Accordingly, a calendar year-end company is required to record and disclose business combinations following existing accounting guidance until January 1, 2009. The Company will assess the impact of SFAS 141(R) if and when a future acquisition occurs.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Before this statement, limited guidance existed for reporting noncontrolling interests (minority interest). As a result, diversity in practice exists. In some cases minority interest is reported as a liability and in others it is reported in the mezzanine section between liabilities and equity. Specifically, SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains its controlling financial interest. In addition, this statement requires that a parent recognize gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interests. SFAS 160 is effective for the Company on January 1, 2009.   Earlier adoption is prohibited. The Company is currently evaluating the impact, if any, the adoption of SFAS 160 will have on its financial position, results of operations and cash flows.

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In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”).  SFAS 161 requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improving the transparency of financial reporting.  It is intended to enhance the current disclosure framework in SFAS 133 by requiring that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. This disclosure better conveys the purpose of derivative use in terms of the risks that the entity is intending to manage. SFAS 161 is effective for the Company on January 1, 2009. This pronouncement does not impact accounting measurements but will result in additional disclosures if the Company is involved in material derivative and hedging activities at that time.

In February 2008, the FASB issued FASB Staff Position No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions” (“FSP 140-3”).  This FSP provides guidance on accounting for a transfer of a financial asset and the transferor’s repurchase financing of the asset.  This FSP presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement (linked transaction) under SFAS No. 140. However, if certain criteria are met, the initial transfer and repurchase financing are not evaluated as a linked transaction and are evaluated separately under Statement 140.  FSP 140-3 will be effective for financial statements issued for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years and earlier application is not permitted. Accordingly, this FSP is effective for the Company on January 1, 2009.  The Company is currently evaluating the impact, if any, the adoption of FSP 140-3 will have on its financial position, results of operations and cash flows.

In April 2008, the FASB issued FASB Staff Position No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP 142-3”).  This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets”.  The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R), “Business Combinations,” and other U.S. generally accepted accounting principles.  This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and early adoption is prohibited.  Accordingly, this FSP is effective for the Company on January 1, 2009.  The Company does not believe the adoption of FSP 142-3 will have a material impact on its financial position, results of operations or cash flows.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”).  SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy).  SFAS No. 162 will be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board’s amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.”  The FASB has stated that it does not expect SFAS No. 162 will result in a change in current practice. The application of SFAS No. 162 will have no effect on the Company’s financial position, results of operations or cash flows.

The FASB issued FASB Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP No. APB 14-1”). This FSP specifies that issuers of convertible debt instruments that may be settled in cash upon conversion should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods.  FSP No. APB 14-1 provides guidance for initial and subsequent measurement as well as derecognition provisions.  This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is not permitted.  The adoption of FSP No. APB 14-1 will have no material effect on the Company’s financial position, results of operations or cash flows.

In September 2008, the FASB issued FASB Staff Position No. EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” (“FSP EITF 03-6-1”).  This FSP provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and must be included in the earnings per share computation.  FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period earnings per share data presented must be adjusted retrospectively. Early application is not permitted.

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The adoption of FSP EITF 03-6-1 will have no material effect on the Company’s financial position, results of operations or cash flows.

FSP SFAS 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,” (“FSP SFAS 133-1 and FIN 45-4”) was issued September 2008, effective for reporting periods (annual or interim) ending after November 15, 2008.  FSP SFAS 133-1 and FIN 45-4 amends SFAS 133 to require the seller of credit derivatives to disclose the nature of the credit derivative, the maximum potential amount of future payments, fair value of the derivative, and the nature of any recourse provisions.  Disclosures must be made for entire hybrid instruments that have embedded credit derivatives.

The staff position also amends FIN 45 to require disclosure of the current status of the payment/performance risk of the credit derivative guarantee.  If an entity utilizes internal groupings as a basis for the risk, how the groupings are determined must be disclosed as well as how the risk is managed.

The staff position encourages that the amendments be applied in periods earlier than the effective date to facilitate comparisons at initial adoption.  After initial adoption, comparative disclosures are required only for subsequent periods.

FSP SFAS 133-1 and FIN 45-4 clarifies the effective date of SFAS 161 such that required disclosures should be provided for any reporting period (annual or quarterly interim) beginning after November 15, 2008.  The adoption of this Staff Position will have no material effect on the Company’s financial position, results of operations or cash flows.

The SEC’s Office of the Chief Accountant and the staff of the FASB issued press release 2008-234 on September 30, 2008 (“Press Release”) to provide clarifications on fair value accounting.  The press release includes guidance on the use of management’s internal assumptions and the use of “market” quotes.  It also reiterates the factors in SEC Staff Accounting Bulletin (“SAB”) Topic 5M which should be considered when determining other-than-temporary impairment: the length of time and extent to which the market value has been less than cost; financial condition and near-term prospects of the issuer; and the intent and ability of the holder to retain its investment for a period of time sufficient to allow for any anticipated recovery in market value.

On October 10, 2008, the FASB issued FSP SFAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP SFAS 157-3”). This FSP clarifies the application of SFAS No. 157, “Fair Value Measurements” (see Note 4) in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that asset is not active.  The FSP is effective upon issuance, including prior periods for which financial statements have not been issued. For the Company, this FSP is effective for the quarter ended September 30, 2008.

The Company considered the guidance in the Press Release and in FSP SFAS 157-3 when conducting its review for other-than-temporary impairment as of September 30, 2008 and determined that it did not result in a change to its impairment estimation techniques.

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

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

This Report contains statements which constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are based on many assumptions and estimates and are not guarantees of future performance.  Our actual results may differ materially from those projected in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors, which are beyond our control.  The words “may,”  “would,” “could,” “will,” “expect,” “anticipate,” “believe,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements.  Potential risks and uncertainties include, but are not limited to, the following:

·                  increases in competitive pressure in the banking and financial services industries;

·                  changes in the interest rate environment which could reduce anticipated or actual margins;

·                  changes in political conditions or the legislative or regulatory environment;

·                  general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a deterioration in credit quality;

·                  changes occurring in business conditions and inflation;

·                  changes in technology;

·                  changes in deposit flows;

·                  the adequacy of our level of allowance for loan loss;

·                  the rate of delinquencies and amounts of charge-offs;

·                  the rates of loan growth;

·                  adverse changes in asset quality and resulting credit risk-related losses and expenses;

·                  changes in monetary and tax policies;

·                  loss of consumer confidence and economic disruptions resulting from terrorist activities;

·                  changes in the securities markets; and

·                  other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

These risks are exacerbated by the recent developments in national and international financial markets, and we are unable to predict what effect these uncertain market conditions will have on the Company.  During 2008, the capital and credit markets have experienced extended volatility and disruption. In the last 90 days, the volatility and disruption have reached unprecedented levels.  There can be no assurance that these unprecedented recent developments will not materially and adversely affect our business, financial condition and results of operations.

We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Overview

We are a bank holding company registered under the Bank Holding Company Act of 1956, and were incorporated under the laws of South Carolina in 1994 primarily to own and control all of the capital stock of First Community Bank, N.A. (the “bank”), which commenced operations in August 1995. On October 1, 2004, we completed our acquisition of DutchFork Bancshares, Inc. and its wholly-owned subsidiary, Newberry Federal Savings Bank. During the second quarter of 2006, we completed our acquisition of DeKalb Bankshares, Inc., the holding company for The Bank of Camden. We engage in a commercial banking business from our main office in Lexington, South Carolina and our 11 full-service offices are located in Lexington (two), Forest Acres, Irmo, Cayce-West Columbia, Gilbert, Chapin, Northeast Columbia, Prosperity, Newberry and Camden. We offer a wide-range of traditional banking products and services for professionals and small-to medium-sized businesses, including consumer and commercial, mortgage, brokerage and investment, and insurance services. We also offer online banking to our customers.

The following discussion describes our results of operations for the three-month and nine-month periods ended September 30, 2008 as compared to the three-month and nine-month periods ended September 30, 2007, and also analyzes our financial condition as of September 30, 2008 as compared to December 31, 2007.  Like most community banks, we derive most of our income from interest we receive on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference

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between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

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

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

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with the financial statements and the related notes and the other statistical information also included in this report.

Emergency Economic Stabilization Act of 2008

In response to financial conditions affecting the banking system and financial markets and the potential threats to the solvency of investment banks and other financial institutions, the United States government has taken unprecedented actions. On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”).  Pursuant to the EESA, the U.S. Treasury will have the authority to, among other things, purchase mortgages, mortgage-backed securities, and other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On October 14, 2008, the U.S. Department of Treasury, which we refer to as the Treasury, announced the Capital Purchase Program under the EESA, pursuant to which the Treasury intends to make senior preferred stock investments in participating financial institutions.  Regardless of our participation, governmental intervention and new regulations under these programs could materially and adversely affect our business, financial condition and results of operations.

On November 6, 2008, the Treasury informed us that we had received preliminary approval to participate in the Capital Purchase Program.  Under the Capital Purchase Program, the Treasury would purchase up to approximately $11.3 million of our senior preferred stock and would receive warrants to purchase shares of our common stock.  While we can provide no assurance that we will close on this investment by the Treasury, we currently anticipate that we will close on the Treasury’s investment under the Capital Purchase Program during 2008.  Under the Capital Purchase Program, each senior preferred share purchased by the Treasury would have a liquidation value of $1,000 per share.  We would pay a cumulative dividends at a rate of 5% per annum on these senior preferred shares for the first five years and 9% per annum thereafter, payable quarterly. For 3 years following issue of the senior preferred shares we would be restricted in our ability to, among other things, (i) increase common dividends, (ii) repurchase common shares and (iii) redeem the senior preferred shares.  Participation in the Capital Purchase Program would subject us to restrictions on payment and deduction of executive compensation.  Pursuant to an interim final rule issued by the Board of Governors of the Federal Reserve System on October 16, 2008, bank holding companies that issue senior preferred stock to the Treasury under the Capital Purchase Program are permitted to include such capital instruments in Tier 1 capital for purposes of the Board’s risk-based and leverage capital rules and guidelines for bank holding companies.

Under the Capital Purchase Program, we would also issue warrants to the Treasury to purchase shares of our common stock having an aggregate market price, as of the date of Treasury’s investment in our senior preferred stock, equal to 15% of the amount of the Treasury’s investment in our senior preferred stock.  The exercise price of the common stock subject to these warrants would be set based on a 20-day trailing average price for our common stock and the warrants would be exercisable for a period of 10 years following issue.  More details of the Capital Purchase Program may be found in the public term sheet, application documents and other materials found at the Treasury’s website: http://www.treas.gov.

Another aspect of the EESA (in addition to the Capital Purchase Plan described above) which became effective on October 3, 2008 is a temporary increase of the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor.  The basic deposit insurance limit will return to $100,000 after December 31, 2009 In addition, the bank anticipates participating in the FDIC’s Temporary Liquidity Guarantee Program which was

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announced October 14, 2008 as part of the EESA.  This guarantee applies to the following transactions:

·              Newly issued senior unsecured debt (up to $1.5 trillion) issued on or before June 30, 2009, including promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. For eligible debt issued on or before June 30, 2009, coverage would only be provided for three years beyond that date, even if the liability has not matured; and

·              Funds in non-interest-bearing transaction deposit accounts (up to $500 billion) held by FDIC-insured banks until December 31, 2009.

All FDIC institutions are covered until December 5, 2008 at no cost.  After this initial period expires, the institution must opt out if it no longer wishes to participate in the program; otherwise, it will be assessed for future participation. There will be a 75-basis point fee to protect new debt issues and an additional 10-basis point fee to fully cover non-interest bearing deposit transaction accounts.

Critical Accounting Policies

We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the notes to our unaudited consolidated financial statements as of September 30, 2008 in this report and our notes included in the consolidated financial statements in our 2007 Annual Report on Form 10-K as filed with the Securities and Exchange Commission.

Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Comparison of Results of Operations for Nine Months Ended September 30, 2008 to the Nine Months Ended September 30, 2007:

Net Income (loss)

Our net loss for the nine months ended September 30, 2008 was $6.3 million, or $1.97 diluted loss per share, as compared to net income of $2.8 million, or $.84 diluted earnings per share, for the nine months ended September 30, 2007.  The net loss for the nine months ended September 30, 2008 included a charge to recognize an “other-than-temporary-impairment”  in the amount of $14.3 million on our investment in a preferred stock issue of the Federal Home Loan Mortgage Corporation (“Freddie Mac”), a government sponsored enterprise (“GSE”) reflecting a write-down of substantially all of its carrying value.  During the second quarter we made a decision to recognize an unrealized mark-to-market loss on this previously investment grade security in the amount of $6.2 million as an other-than-temporary impairment (“OTTI”) charge based on the significant decline in the market value of the security caused by potential deterioration of Freddie Mac’s financial condition, and the then current lack of clarity about the impact of an announced plan (which was approved by the House and Senate and signed into law by the President) that provided support for Freddie Mac as well as other GSE’s.  On September 7, 2008, the Secretary of the Treasury announced a decision to place Freddie Mac into conservatorship and as part of that decision the dividend payments on existing preferred shares would be terminated for an unspecified period of time.  As a result of that decision we took an additional $8.1 million OTTI charge in the third quarter of 2008 to write off substantially all of

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the remaining investment in this Freddie Mac security.  The preferred stock issue was purchased in 2003 and acquired by the Company in the 2004 merger with Dutchfork Bankshares.  This Freddie Mac preferred stock, which has a current cost basis of $3.0 thousand, is included in the available-for-sale securities portfolio. If at some time in the future quarterly dividend payments are resumed these securities may recover some or all of their value.  We had operating earnings for the nine months ended September 30, 2008 of $3.5 million or $1.09 per share as compared to $2.7 million or $0.82 per share for the nine months ended September 30, 2007.

Another significant decision that impacted our results for the nine and three months ended September 30, 2008 was the implementation of a leverage strategy during the second quarter of 2008  whereby we acquired approximately $63.2 million in certain non-agency mortgage backed securities and collateralized mortgage obligations.   We initiated this strategy because we believe the pricing levels of these securities and related funding opportunities provided the ability to realize significant interest rate spreads not typically available in leverage strategies.  The weighted average yield on the investment securities purchased was approximately 6.82%. All of the mortgage assets acquired were classified as prime or ALT-A securities and represent the senior or super-senior tranches of the securities.  The assets acquired as part of this strategy have been classified as held-to-maturity in the investment portfolio.  The securities were acquired on the open market through securities dealers. Prior to initiating each transaction, we performed a thorough analysis, evaluating the associated credit risk, interest rate risk, liquidity and capital risk as well as related funding options.  We continue to perform an evaluation of these securities and the related risk on a monthly basis.  The funding for this strategy was provided through Federal Home Loan Bank Advances in the amount of $36.0 million and brokered certificates of deposit in the amount of $23.0 million.  The weighted average cost of funding was approximately 4.28%.  We believe this opportunity existed as a result of the ongoing volatility in this market sector and the economic value of these securities was not reflected at the pricing levels.

The increase in operating earnings is primarily due to an increase in net interest income resulting primarily from an increase in the level of average earning assets for the nine months ended September 30, 2008, as compared to the same period in 2007, reflecting the continued growth of our bank including the above mentioned leverage strategy.  Average earning assets were $537.1 million during the nine months ended September 30, 2008, as compared to $469.2 million during the nine months ended September 30, 2007, an increase of $67.9 million.  This increase in average earning assets was the primary factor responsible for the increase in net interest income of $1.6 million in the first nine months of 2008 as compared to the first nine months of 2007.  As a result of the OTTI charge, we had a non-interest income loss during the first nine months of 2008 of $10.3 million.  Non-interest income (excluding the OTTI charge and gains and losses on sale of securities) was $4.0 million for the nine months ended September 30, 2008 as compared to $3.5 million for the same period in 2007.  This increase of $504,000, or 14.2%, also contributed to the increase in operating income in the first nine months of 2008 as compared to the same period in 2007.   Non-interest expense increased by $685,000, or 6.5%, in the first nine months of 2008, as compared to the same period in 2007.

Please refer to the table at the end of this Item 2 for the yield and rate data for interest-bearing balance sheet components during the nine-month periods ended September 30, 2008 and 2007, along with average balances and the related interest income and interest expense amounts.

Net interest income was $12.9 million for the nine months ended September 30, 2008 as compared to $11.3 million for the nine months ended September 30, 2007.  This increase was primarily due to an increase in the level of earning assets.  The yield on earning assets decreased by 35 basis points during the nine months ended September 30, 2008 as compared to the same period in 2007.   The cost of interest-bearing liabilities decreased by 44 basis points during these two periods.  Interest rates decreased significantly during the last quarter of 2007 and first quarter of 2008.  The larger decline in our funding cost as compared to our earning asset yields results from our balance sheet mix being liability sensitive.  The net interest margin on a taxable equivalent basis was 3.27% for the nine months ended September 30, 2008 as compared to 3.30% during the same period in 2007.

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Reconciliations

The following is a reconciliation for both the nine- and three-month periods ended September 30, 2008 and 2007, of net income (loss) as reported for generally accepted accounting principles (“GAAP”) and the non-GAAP measure referred to throughout our discussion of “operating earnings”.