The Bank operates a Wealth Management Services ("WMS" or "Wealth Management") division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services. The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company; Infinex Investments, Inc., a full service broker/dealer; and Bankers Title Shenandoah, LLC, a title insurance company. Bankers Insurance consists of a consortium of 36 Virginia community bank owners; Infinex is owned by 57 banks in various states; and Bankers Title Shenandoah is owned by 17 Virginia community banks. On April 30, 2008, the Bank's ownership of stock in BI Investments, LLC was exchanged for Infinex stock as part of a merger. The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank's lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank ("FHLB") of Atlanta. Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank's principal expenses are the interest paid on deposits and operating and general administrative expenses.
As is the case with banking institutions generally, the Bank's operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System ("Federal Reserve"). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Virginia State Corporation Commission. Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. Please see "Risk Factors" in Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2007.
As of September 30, 2008, the Company had total consolidated assets of $499.8 million, total loans net of allowance for loan losses of $423.1 million, total consolidated deposits of $405.6 million, and total consolidated shareholders' equity of $40.6 million.
CRITICAL ACCOUNTING POLICIES
GENERAL. The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the Company's transactions could change.
ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) Statement of Financial Accounting Standards ("SFAS") No. 5, "Accounting for Contingencies," which requires that losses be accrued when they are probable of occurring and estimable, (ii) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) SEC Staff Accounting Bulletin No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues," which requires adequate documentation to support the allowance for loan losses estimate.

The Company's allowance for loan losses has two basic components: the specific allowance and the general allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans. The specific allowance uses various techniques to arrive at an estimate of loss. First, analysis of the borrower's overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Then the migration of historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not allocated a specific allowance upon their review. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical and peer group delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the specific allowances.
EXECUTIVE OVERVIEW
This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report. The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community. The Company and the Bank's primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management.
Net income of $935,000 for the third quarter of 2008 was a 22.7% decrease from the net income for the third quarter of 2007 of $1.21 million. Loans, net of reserve, totaling $423.1 million at September 30, 2008, increased 3.4% when compared with December 31, 2007, and increased 4.1% when compared with September 30, 2007. Deposits increased 0.3% compared with year-end 2007, and increased 1.8% when compared with September 30, 2007. Assets under WMS management, totaling $273.7 million in market value at September 30, 2008, declined 7.9% from $297.1 million in market value at September 30, 2007, primarily due to the decline in valuations of common stock under management. For example, from September 30, 2007 to September 30, 2008, stocks measured in the Standard & Poors' 500 index declined by approximately 24.6%.
Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, competition for loans and deposits, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management's current projections, net interest income may increase in 2008 and beyond as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank's net interest margin resulting from competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income.

During the third quarter of 2008, the Bank has seen its competition for deposits increase significantly. The pricing of retail deposits, which traditionally has been at an interest rate less than the interest rate on a FHLB of Atlanta advance of similar term, has exceeded the corresponding FHLB rate by 50 to 100 basis points or more. The increased cost of deposits has resulted in less net interest income and a narrower net interest margin. The intensified competition for deposits is, for the most part, the result of liquidity and capitalization pressures faced by many of the large multi-state financial institutions who compete in the Bank's market area.
The Bank's non-performing assets totaled $4.6 million or 1.07% of total loans at September 30, 2008, as compared with $2.1 million or 0.51% of total loans at December 31, 2007, and $1.38 million or 0.34% of total loans at September 30, 2007. The provision for loan losses was $431,000 for the third quarter of 2008 compared with $120,000 for the third quarter of 2007. Loan chargeoffs, net of recoveries, totaled $1.22 million or 0.29% of total loans for the first nine months of 2008, compared with $417,000 or 0.11% of total loans for the first nine months of 2007. The $311,000 increase in the provision for loan losses from third quarter 2007 to third quarter 2008 was largely in response to the increase in net loans and non-performing assets. Total allowance for loan losses was $4.7 million or 1.10% of total loans at September 30, 2008 compared with $4.2 million or 1.01% of loans at December 31, 2007.
Management seeks to continue the expansion of its branch network. The Bank has leased properties in Haymarket, Virginia and Bristow, Virginia, where it plans to build its ninth and tenth full-service branch offices, respectively, both scheduled to open in 2009. The Bank is looking toward these new retail markets for growth in deposits and WMS income. Management seeks to increase the level of its fee income from deposits and WMS through the increase of its market share within its marketplace.
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2008 AND SEPTEMBER 30, 2007
NET INCOME
Net income was $935,000 for the third quarter of 2008, a 22.7% decrease from the third quarter of 2007 net income of $1.21 million. Earnings per share on a fully diluted basis were $0.26 in 2008 compared to $0.34 in 2007. Profitability as measured by return on average equity decreased from 11.68% in the third quarter of 2007 to 8.85% for the same period in 2008. Profitability as measured by return on average assets decreased from 0.99% to 0.73% over the same respective quarters in 2007 and 2008. The decline in net income and the corresponding profitability measures was primarily due to the increase in the provision for loan losses of $311,000 in the third quarter of 2008 compared with the third quarter of 2007, as well as a $298,000 permanent impairment loss on the Bank's investment in Freddie Mac preferred stock.
NET INTEREST INCOME AND EXPENSE
Net interest income increased $241,000 or 5.2% to $4.85 million for the quarter ended September 30, 2008 from $4.61 million for the quarter ended September 30, 2007. The increase in net interest income was due to the Company's net interest margin increasing from 4.02% in the third quarter of 2007 to 4.10% in the third quarter of 2008, primarily due to the positively sloped yield curve during the third quarter of 2008 compared with the flat and inverted yield curve during the third quarter of 2007. (A positively sloped yield curve is where the interest rate on longer-termed financial instruments exceeds the interest rate on shorter-termed financial instruments, all other factors being equal, while with an inverted yield curve, shorter-termed financial instruments have higher interest rates than longer-termed financial instruments.) The benefit of the positively sloped yield curve was partially offset by competitive pricing pressures, particularly on deposits. In addition, net interest income increased due to the impact of total average earning assets increasing from $454.0 million during the third quarter of 2007 to $470.9 million during the third quarter of 2008.

The net interest margin pressure caused by the economic environment of a flat and inverted yield curve proved to be challenging for the Bank during much of 2007. At September 30, 2004, just as the Federal Reserve's Federal Open Market Committee (the "FMOC") began raising the federal funds rate, the yield on a three month maturity treasury bond was 1.37% or 253 basis points below the 3.90% yield on a five year treasury and 332 basis points below the 4.69% yield on a 10 year treasury. At October 30, 2006, that yield had inverted to the point that a three month treasury was yielding 5.12%, while the five year and ten year treasury were yielding 4.74% and 4.77%, respectively. The yield curve changed from a more than 250 basis point premium for a longer investment to a position where there is no premium or, in fact, a discount. This presented funding and interest margin management pressures, as a flat or inverted yield curve significantly increased competition for deposits and their cost. While deposit costs rapidly increased, the lack of a similar movement in longer-term rates limited the yield increase on fixed rate loans.
The economic environment changed direction during the fourth quarter of 2007, when the FMOC began lowering the federal funds rate, and the shape of the yield curve became less flat and more positively sloped. Through September 30, 2008, the FMOC has continued the reduction of the federal funds rate. At September 30, 2008, the yield on a three month maturity treasury security was 0.92% or 206 basis points below the 2.98% yield on a five year treasury and 293 basis points below the 3.85% yield on a 10 year treasury. As a result, the Company's net interest margin improved from 4.02% for the third quarter of 2007 to 4.10% for the third quarter of 2008. Offsetting the benefit of the positively sloped yield curve during the third quarter of 2008 has been the significant increase in competitive pricing for retail deposits.
Total interest income decreased $505,000 or 6.6% to $7.20 million for the third quarter of 2008 from $7.71 million for the third quarter of 2007. This decrease was primarily due to the 65 basis point decrease in the yield on average assets from third quarter 2007 to third quarter 2008. This was partially offset by the increase in total average earning assets of $16.9 million or 3.7%. The average yield on loans decreased to 6.17% for the third quarter of 2008 compared with 6.90% for the third quarter of 2007. Average loan balances increased 4.0% from $412.7 million during the third quarter of 2007 to $429.4 million during the third quarter of 2008. Together, this resulted in a $527,000 or 7.3% decrease in interest and fee income from loans for the third quarter of 2008 compared with the same period in 2007.
Average investment security balances decreased $1.1 million from $39.3 million in the third quarter of 2007 to $38.2 million in the third quarter of 2008. The tax-equivalent average yield on investments increased from 4.85% for the third quarter of 2007 to 5.39% for the third quarter of 2008. Together, there was an increase in interest and dividend income on security investments of $27,000 or 5.9%, from $458,000 for the third quarter of 2007 to $485,000 for the third quarter of 2008. Interest income on federal funds sold decreased $15,000 from the third quarter of 2007 to the third quarter of 2008, reflecting a decline in the average balances from $1.3 million to nothing.
Total interest expense decreased $746,000 or 24.1% from $3.10 million for the third quarter of 2007 to $2.35 million for the third quarter of 2008 primarily due to the overall decline in shorter-term market interest rates. Interest paid on deposits decreased $781,000 or 30.7% from $2.54 million for the third quarter of 2007 to $1.76 million for the third quarter of 2008. Average Premium money market account balances decreased $9.6 million from third quarter 2007 to third quarter 2008, while their average rate decreased from 4.10% to 2.07% over the same period resulting in a decrease of $453,000 of interest expense for the third quarter of 2008. Average time deposit balances increased $1.9 million from third quarter of 2007 to the third quarter of 2008 while the average rate on time deposits decreased from 4.43% to 3.52% resulting in a decrease of $267,000 in interest expense for the third quarter of 2008. Average NOW deposit balances increased $11.7 million from the third quarter of 2007 to the third quarter of 2008 while the average rate on NOW accounts decreased from 1.30% to 0.90% resulting in a reduction of $45,000 in NOW interest expense for the third quarter of 2008.
Interest expense on federal funds purchased decreased $22,000 for the third quarter of 2008 when compared to the third quarter of 2007 due to the decline in the average fed funds rate from 5.76% to 2.40%, partially offset by the $807,000 increase in average federal funds purchased. Interest expense on FHLB of Atlanta advances increased $84,000 from the third quarter of 2007 to the third quarter of 2008 due to the increase in average FHLB advance balances of $25.7 million, mostly offset by the decrease in the average rate paid on FHLB advances from 5.30% to 3.51%. The average rate on total interest-bearing liabilities decreased from 3.32% for the third quarter of 2007 to 2.36% for the third quarter of 2008.

The following table sets forth information relating to the Company's average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

      AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
                             (Dollars in Thousands)

                                                         Three Months Ended September 30, 2008                     Three Months Ended September 30, 2007
                                                       Average             Income/          Average              Average             Income/          Average
                                                      Balances             Expense           Rate               Balances             Expense           Rate
ASSETS:
Loans
Taxable                                            $       417,624       $      6,596           6.19 %       $       404,429       $      7,137           6.90 %
Tax-exempt (1)                                               8,642                159           7.21 %                 7,536                139           7.17 %
Nonaccrual (2)                                               3,089                  -                                    744                  -

Total Loans                                                429,355              6,755           6.17 %               412,709              7,276           6.90 %


Securities
Taxable                                                     32,970                427           5.17 %                36,024                420           4.66 %
Tax-exempt (1)                                               5,265                 88           6.71 %                 3,299                 57           6.94 %

Total securities                                            38,235                515           5.39 %                39,323                477           4.85 %


Deposits in banks                                            3,269                 15           1.83 %                   641                  5           3.25 %
Federal funds sold                                               -                  -                                  1,289                 15           4.69 %

Total earning assets                                       470,859              7,285           6.08 %               453,962              7,773           6.72 %


Less: Reserve for loan losses                               (4,491 )                                                  (4,414 )
Cash and due from banks                                     14,658                                                    14,292
Bank premises and equipment, net                             8,451                                                     7,350
Other assets                                                17,501                                                    16,093


Total Assets                                       $       506,978                                           $       487,283