Management's Discussion and Analysis of Plan of Operation

General

Coastal Banking Company, Inc. (in this Item 6, the "Company") is a bank holding company headquartered in Beaufort, South Carolina organized to own all of the common stock of its subsidiaries, Lowcountry National Bank (in this Item 6, "Lowcountry") and First National Bank of Nassau County, Florida (in this Item 6, "First National"). The principal activity of the Banks is to provide banking services for their domestic markets. Lowcountry's primary market is Beaufort County, South Carolina. First National's primary market is Nassau County, Florida. The Banks are primarily regulated by the Office of the Comptroller of the Currency ("OCC") and undergo periodic examinations by this regulatory agency. The holding company is regulated by the Federal Reserve Board of Governors and also is subject to periodic examinations. Lowcountry opened for business on May 10, 2000 at 36 Sea Island Parkway, Beaufort, South Carolina 29907. First National opened for business July 26, 1999 and was acquired by Coastal through the merger with its holding company, First Capital Bank Holding Corporation ("First Capital") on October 1, 2005. On October 27, 2006 Coastal acquired our Meigs, Georgia office through the merger of Cairo Banking Company, a Georgia state bank with and into First National. The Company also has an investment in Coastal Banking Company Statutory Trust I ("Trust I") and Coastal Banking Company Trust II ("Trust II"). Both trusts are special purpose subsidiaries organized for the sole purpose of issuing trust preferred securities.

In the merger with First Capital, each outstanding share of First Capital common stock was converted into 1.054 shares of Coastal stock at the time of the merger. Each outstanding share of Coastal common stock prior to the merger remained outstanding as a share of common stock after the merger.

The following discussion describes our results of operations for 2007 as compared to 2006 and also analyzes our financial condition as of December 31, 2007 as compared to December 31, 2006. Like most community banks, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

We have included a number of tables to assist in our description of these measures. For example, the "Average Balances" table shows the average balance during 2007 and 2006 of each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest yields than do other types of interest earning assets, which is why we intend to continue to direct a substantial percentage of our earning assets into our loan portfolio.
Similarly, the "Rate/Volume Analysis" table helps demonstrate the impact of changing interest rates and changing volume of assets and liabilities during the years shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included a "Sensitivity Analysis Table" to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, and our deposits.

Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb possible 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, as well as several tables describing our allowance for loan losses. See comments in the section entitled "Provision and Allowance for Loan Losses."

In addition to earning interest on our loans and investments, we earn income through fees, cash surrender value of life insurance and other service charges 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.

Forward-Looking Statements

This report contains "forward-looking statements" relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management. The words "may," "will," "anticipate," "should," "would," "believe," "contemplate," "expect," "estimate," "continue," "may," and "intend," as well as other similar words and expressions of the future, are intended to identify forward-looking statements. Potential risks and uncertainties include, but are not limited to those described under the heading "Risk Factors" in our Form 10-K for the year ended December 31, 2007.

Critical Accounting Policies

We have adopted various accounting policies, which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in Note 1 in the footnotes to the consolidated financial statements at December 31, 2007 included elsewhere in this annual report.

We believe that the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements. Please refer to the portion of management's discussion and analysis of financial condition and results of operations that addresses the allowance for loan losses for a description of our processes and methodology for determining the allowance for loan losses.

Intangible assets, included in Other Assets on the Consolidated Balance Sheets, include goodwill and other identifiable assets, such as core deposits, resulting from acquisitions. Goodwill, in this context, is the excess of the purchase price in an acquisition transaction over the fair market value of the net assets acquired. Core deposit intangibles are amortized on a straight-line basis over such assets' estimated expected life. In accordance with SFAS No. 142, "Goodwill and Other Intangible Asset," goodwill is not amortized but is tested annually for impairment or at any time an event occurs, or circumstances change, that may trigger a decline in the value of the reporting unit. Such impairment testing calculations include estimates. Furthermore, the determination of which intangible assets have finite lives is subjective as is the determination of the amortization period for such intangible assets. The Company tests for goodwill impairment by determining the fair market value for each reporting unit and comparing the fair market value to the carrying amount of the applicable reporting unit. If the carrying amount exceeds fair market value the potential for the impairment exists, and a second step of impairment testing is performed. In the second step, the fair market value of the reporting units' goodwill is determined by allocating the reporting unit's fair market value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair market value of reporting unit goodwill is less than its carrying amount, goodwill is impaired and is written-down to its fair market value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair market value will not result in the reversal of previously recognized losses. The Company performed its annual test of impairment in the fourth quarter and determined that there was no impairment in the carrying value of goodwill as of October 1, 2007.

Results of Operations

Overview

Net income for 2007 was $2,632,000 or $1.04 per basic common share compared to $3,360,000 or $1.34 per basic common share, in 2006. In total, our operational results depend to a large degree on net interest income, which is the difference between the interest income received from our investments, such as loans, investment securities, and federal funds sold, and interest expense, paid on deposit liabilities and other borrowings. Net interest income was $12,183,000 for the year ended December 31, 2007 compared to net interest income of $12,589,000 for the year ended December 31, 2006.

The provision for loan losses in 2007 was $310,500 compared to $726,700 in 2006. The decrease in the provision for loan losses was attributable to management's assessment of credit quality, stabilized loan growth, and other economic factors. The provision for loan losses continues to reflect our estimate of potential losses inherent in the loan portfolio and the creation of an allowance for loan losses adequate to absorb such losses.

Noninterest income for the year ended December 31, 2007 totaled $2,321,000, representing a $281,000 increase from December 31, 2006. This increase was associated with an increase in mortgage loan fees and gain on sale of loans of $246,000, a gain on sale of securities of $121,000, and an increase in service charges on deposits and other service charges, commissions and fees of $162,000, offset by a gain on sale of real estate in 2006 of $321,000. Non-interest expenses in 2007 were $10,456,000; a $1,561,000 increase compared to the 2006 amounts, primarily due to the costs associated with the opening of locations in Port Royal, South Carolina and Atlanta, Georgia. The Company's efficiency ratio, which is a measure of total non-interest expenses as a percentage of net interest income and non-interest income, increased to 72.88% in 2007 from 62.55% in 2006 due in large part to the previously described increase in noninterest expenses.

In 2007, we recognized $1,105,000 of income tax expense compared to an income tax expense of $1,647,000 in 2006. Our effective tax rate was 29.6% in 2007 and 32.9% in 2006. This decrease is due to nontaxable income on municipal securities increasing slightly during 2007 compared to 2006, while total net income decreased during 2007 compared to 2006.

Net Interest Income

For the year ended December 31, 2007, net interest income totaled $12,183,000, as compared to $12,589,000 for the same period in 2006. Interest income from loans, including fees, increased $1,213,000 to $23,160,000 for the year ended December 31, 2007. The average balance of loans was $282,182,000 in 2007 compared to $273,022,000 in 2006. The weighted average rate earned on loans was 8.21% for 2007 compared to 8.04% in 2006. Interest income from securities increased $1,246,000 on a tax equivalent basis. The average balance of investments was $95,715,000 in 2007 compared to $75,310,000 in 2006. The weighted average rate earned on investments was 5.16% for 2007 compared to 4.90% in 2006. This increase in income was offset by increased interest expense, which totaled $16,293,000 for the year ended December 31, 2007, compared to $13,461,000 in 2006. The net interest margin realized on earning assets and the interest rate spread were 3.19% and 2.75%, respectively, for the year ended December 31, 2007. For the year ended December 31, 2006, the net interest margin was 3.54% and the interest rate spread was 3.10%. Yields on interest earning assets increased during the year by nine basis points compared to an increase in rates on interest bearing liabilities of 44 basis points during the year.

Average Balances and Interest Rates


The table below shows the average balance outstanding for each category of
interest-earning assets and interest-bearing liabilities for 2007 and 2006, and
the average rate of interest earned or paid thereon. Average balances have been
derived from the daily balances throughout the period indicated.


                                                                For the Years Ended December 31,
                                                2007                                              2006
                                  Average                    Yield/            Average                                Yield/
                                  Balance    Interest         Rate             Balance          Interest               Rate
(In Thousands)
Assets:
Interest-earning assets:
Loans (including loan
fees)                         $   282,182   $   23,160      8.21 %            $ 273,022         $   21,947              8.04 %
Taxable investments                79,476        4,022      5.06 %               65,924              3,054              4.63 %
Tax-free investments               16,239          914      5.63 %                9,386                636              6.78 %
Interest-bearing
deposits in
  other banks                       1,667           89      5.34 %                1,755                 92              5.24 %
Federal funds sold                 11,716          602      5.14 %               11,333                537              4.74 %
Total interest-earning
assets                            391,283       28,786      7.36 %              361,420             26,266              7.27 %
Other non-interest
earning assets                     33,579                                        30,692
Total assets                  $   424,862                                     $ 392,112
Liabilities and
shareholders' equity:
Interest-bearing
liabilities:
Deposits:
Interest-bearing demand
and savings                   $   123,922        4,467      3.44 %            $ 122,167              4,204              3.44 %
Time                              194,987       10,012      5.13 %              167,451              7,641              4.56 %
Other                              34,832        1,814      5.21 %               33,217              1,616              4.86 %
Total interest-bearing
liabilities                       353,741       16,293      4.61 %              322,835             13,461              4.17 %
Other non-interest
bearing liabilities                26,162                                        28,914
Shareholders' equity               44,959                                        40,363
Total liabilities and
shareholders'
  equity                      $   424,862                                     $ 392,112
Excess of
interest-earning assets
over
  interest bearing
liabilities                   $    37,542                                     $  38,585
Ratio of
interest-earning assets
to
  interest-bearing
liabilities                           111 %                                         112 %
Tax equivalent
adjustment                                        (311 )                                              (216 )
Net interest income                         $   12,183                                          $   12,589
Net interest spread                                         2.75 %                                                      3.10 %
Net interest margin                                         3.19 %                                                      3.54 %

Non-accrual loans and the interest income which was recorded on these loans, if any, are included in the yield calculation for loans in all periods reported.

Amounts are presented on a tax equivalent basis.

Volume/Rate Analysis

Net interest income can also be analyzed in terms of the impact of changing rates and changing volume. The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. The effect of a change in average balance has been determined by applying the average rate in the earlier year to the change in average balance in the later year, as compared with the earlier year. The effect of a change in the average rate has been determined by applying the average balance in the earlier year to the change in the average rate in the later year, as compared with the earlier year.

                                                             2007 Compared to 2006
                                                     Increase (decrease) due to changes in
(In Thousands)                                   Volume            Rate             Net Change
Interest income on:
Loans (including loan fees)                    $       764     $         191          $     955
Taxable investments                                    668               300                968
Non-taxable investments                                401              (123 )              278
Interest bearing deposits in other banks                (5 )               2                 (3 )
Federal funds sold                                      19                45                 64
Total interest income (tax equivalent basis)         1,847               415              2,262
Interest expense on:
Interest-bearing demand and savings                     61               202                263
Time                                                 1,346             1,025              2,371
Other                                                   81               117                198
Total interest expense                               1,488             1,344              2,832
Net interest income (tax equivalent basis)     $       359     $        (929 )        $    (570 )

Interest Rate Sensitivity and Asset Liability Management

Interest rate sensitivity measures the timing and magnitude of the repricing of assets compared with the repricing of liabilities and is an important part of asset liability management of a financial institution. The objective of interest rate sensitivity management is to generate stable growth in net interest income, and to control the risks associated with interest rate movements. Management constantly reviews interest rate risk exposure and the expected interest rate environment so that adjustments in interest rate sensitivity can be timely made. Since the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

Net interest income is the primary component of net income for financial institutions. The timing and magnitude of repricing as well as the mix of interest sensitive and non-interest sensitive assets and liabilities affect net interest income. "Gap" is a static measurement of the difference between the contractual maturities or repricing dates of interest sensitive assets and interest sensitive liabilities within the following twelve months. Gap is an attempt to predict the behavior of our net interest income in general terms during periods of movement in interest rates. In general, if we are asset sensitive, more of our interest sensitive assets are expected to reprice within twelve months than our interest sensitive liabilities over the same period. In a rising interest rate environment, assets repricing more quickly are expected to enhance net interest income. Alternatively, decreasing interest rates would be expected to have the opposite effect on net interest income since assets would theoretically be repricing at lower interest rates more quickly than interest sensitive liabilities. Although it can be used as a general predictor, gap as a predictor of movements in net interest income has limitations due to the static nature of its definition and due to its inherent assumption that all assets will reprice immediately and fully at the contractually designated time. At December 31, 2007, the Company, as measured by gap, is asset sensitive at three months or less and liability sensitive cumulatively at one year. Management has several tools available to it to evaluate and affect interest rate risk, including deposit pricing policies and changes in the mix of various types of assets and liabilities.

The following table summarizes the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2007, that are expected to mature, prepay, or reprice in each of the future time periods shown. Except as stated below, the amount of assets or liabilities that mature or reprice during a particular period was determined in accordance with the contractual terms of the asset or liability. Adjustable rate loans are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due, and fixed-rate loans and mortgage-backed securities are included in the periods in which they are anticipated to be repaid based on scheduled maturities. The Banks' savings accounts and interest-bearing demand accounts (NOW and money market deposit accounts) that are not contractually tied to an adjusting index are grouped into categories based on the company's historical repricing practices. Money market accounts which are contractually tied to repricing indexes reprice monthly and are grouped in the three month or less category. Many of these money market accounts are tied to a Treasury index.

                           3 Months        4 Months to      1 to 5       Over 5
(In Thousands)              or Less         12 Months        Years       Years        Total
Interest-earning
assets:
Federal funds sold        $     4,710    $          -     $       -      $      -   $   4,710
Deposits in other banks         1,564             500             -             -       2,064
Investment securities             997           2,995         8,677        78,185      90,854
Loans held for sale            20,553               -             -             -      20,553
Loans                         134,478          28,089        75,345        43,379     281,291
Total interest-earning
assets                        162,302          31,584        84,022       121,564     399,472
Interest-bearing
liabilities:
Deposits:
Savings and demand            105,626               -             -             -     105,626
Time deposits                  14,072         171,080        29,921             -     215,073
Securities sold under
  agreements to
repurchase                      2,000               -             -             -       2,000
FHLB advances                   4,300           1,500        20,973             -      26,773
Junior subordinated
debentures                      3,093               -         4,124             -       7,217
Total interest-bearing
liabilities                   129,091         172,580        55,018             -     356,689
Interest sensitive
difference per
  period                  $    33,211    $   (140,996 )   $  29,004    $  121,564   $  42,783
Cumulative interest
sensitivity
  difference              $    33,211    $   (107,785 )   $ (78,781 )  $   42,783
Cumulative difference
to total
  interest-earning
assets                            8.3 %         (27.0 )%      (19.7 )%       10.7 %

At December 31, 2007, the Company had $33,211,000 more assets than liabilities repricing or maturing within three months, which indicates that the Company is asset sensitive over this time horizon. When extended out to one year, the Company had $107,785,000 more liabilities than assets repricing or maturing, indicating the Company is liability sensitive over a one-year time period

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may reflect changes in market interest rates differently. Additionally, certain assets, such as adjustable-rate mortgages, have features that restrict changes in interest rates, both on a short-term basis and over the life of the asset. Other factors which may affect the assumptions made in the table, include options to call a security or borrowing, pre-payment rates, early withdrawal levels, and the ability of borrowers to service their debt. Management uses modeling techniques which attempt to quantify the impacts of interest rates on margin changes. These modeling techniques reflect the effects of these cited shortcomings including the effects of maturity changes that occur as a result of changes in interest rates. These modeling tools indicate that net interest margin would be slightly negatively impacted at twelve months given a 1% decrease in interest rates.

Mortgage Banking Activities

In the third quarter of 2007, First National Bank of Nassau County opened a wholesale residential mortgage lending division headquartered in Atlanta, Georgia to compliment the existing retail residential mortgage lending activity conducted through other branch locations. This division originates and funds residential mortgage loans submitted by mortgage brokers and then sells these mortgage loans in the secondary market. This new lending channel subjects us to various risks, including credit, liquidity and interest rate risks. We reduce unwanted credit and liquidity risks by selling virtually all of the mortgage loans originated through this division. From time to time, we may decide to hold loans originated through this division as additions to our residential real estate loan portfolio. We determine whether the loans will be held in our portfolio or sold in the secondary market at the time of origination. We may subsequently change our intent to hold loans in portfolio and subsequently sell some or all of these wholesale loans from our portfolio as part of our corporate asset/liability management strategy.

While credit and liquidity risks have historically been relatively low for mortgage banking activities, interest rate risk can be substantial. Changes in interest rates will impact the value of mortgages held for sale (MHFS) which are carried at the lower of cost or market value (LOCOM), as well as the associated income and loss reflected in mortgage banking noninterest income, the income and expense associated with instruments (economic hedges) used to hedge changes in the LOCOM value of MHFS, and the value of derivative loan commitments extended . . .