Overview
Management's Discussion and Analysis is provided to assist in understanding and evaluating our results of operations and financial condition. The following discussion is intended to provide a general overview of our performance for the three-month and nine-month periods ended September 30, 2008. Readers seeking more in-depth information should read the more detailed discussions below as well as the condensed consolidated financial statements and related notes included under Item 1 of this quarterly report. All information presented is consolidated data unless otherwise specified. Uncertainty and future events could cause changes in accounting estimates that have material effects on the financial position and results of operations in future periods. Our losses decreased in both the three and nine-month periods ended September 30, 2008 when compared to the same periods in 2007, primarily due to lower loan loss provisions, partially offset by decreases in interest and fee income from loans. The decline in loan income was due to a combination of lower loan yields on our variable rate loans and higher levels of nonperforming loans. Our net interest margin decreased as a result of lower loan income without comparable decreases in funding costs. Our other expenses increased for the nine-month period ending September 30, 2008 compared to 2007, primarily due to higher professional fees and FDIC deposit insurance premiums. However, for the three-month period ended September 30, 2008, our other expenses decreased, primarily due to reductions in personnel costs and lower losses on sales of foreclosed properties.

    Financial Highlights for                          Three Months
    the Quarterly Periods                          Ended September 30,
    (in thousands except per share amounts)       2008            2007         % change
    Earnings
    Net interest income                       $     9,486     $    12,517        -24.2 %
    Provision for loan losses                       3,581          42,737        -91.6 %
    Other income                                    2,494           3,193        -21.9 %
    Other expense                                   8,775           9,380         -6.4 %
    Net loss                                         (271 )       (22,016 )      -98.8 %

    Per share
    Net loss
    - Basic                                   $     (0.02 )   $     (1.40 )      -98.6 %
    - Diluted                                       (0.02 )         (1.40 )      -98.6 %

    Average for period
    Assets                                    $ 1,181,505     $ 1,212,281         -2.5 %
    Loans                                         958,033         942,154          1.7 %
    Deposits                                      980,633         977,049          0.4 %
    Stockholders' equity                          110,616         143,726        -23.0 %

    Ratios
    Return on average assets                        -0.09 %         -7.21 %
    Return on average equity                        -0.97 %        -60.77 %
    Average equity to average assets                 9.36 %         11.86 %
    Efficiency ratio (1)                            72.22 %         58.94 %

(1) Calculated by dividing noninterest expense by the sum of tax equivalent net interest income and noninterest income.

    Financial Highlights for                           Nine Months
    the Year-to-Date Periods                       Ended September 30,
    (in thousands except per share amounts)       2008            2007         % change
    Earnings
    Net interest income                       $    29,661     $    39,708        -25.3 %
    Provision for loan losses                      13,437          52,125        -74.2 %
    Other income                                    8,875           9,644         -8.0 %
    Other expense                                  28,843          26,505          8.8 %
    Net loss                                       (1,918 )       (17,235 )      -88.9 %

    Per share
    Net loss
    - Basic                                   $     (0.12 )   $     (1.09 )      -89.0 %
    - Diluted                                       (0.12 )         (1.09 )      -89.0 %

    Average for period
    Assets                                    $ 1,200,537     $ 1,208,255         -0.6 %
    Loans                                         955,173         934,682          2.2 %
    Deposits                                      986,273         969,327          1.7 %
    Stockholders' equity                          114,614         147,338        -22.2 %

    Ratios
    Return on average assets                        -0.21 %         -1.91 %
    Return on average equity                        -2.24 %        -15.64 %
    Average equity to average assets                 9.55 %         12.19 %
    Efficiency ratio (1)                            73.80 %         53.00 %

(1) Calculated by dividing noninterest expense by the sum of tax equivalent net interest income and noninterest income.

Critical Accounting Policies
The accounting and reporting policies of the Company and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. The critical accounting and reporting policies include our accounting for investment securities, mortgage loans held for sale, derivatives, and the allowance for loan losses. In particular, our accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Please see the discussions below under the captions "Provisions and Allowance for Loan Losses" and "Investment Securities." See also Note 1 in the "Notes to Consolidated Financial Statements" under Item 8, "Financial Statements & Supplementary Data" in our Annual Report on Form 10-K/A for the year ended December 31, 2007 on file with the Securities and Exchange Commission for additional information regarding all of our critical and significant accounting policies.
LOANS - Loans that management has the intent and ability to hold for the foreseeable future are reported at their outstanding principal balances adjusted for any deferred fees or costs. Substantially all loans earn interest on the level yield method based on the daily outstanding balance.
PROVISIONS AND ALLOWANCE FOR LOAN LOSSES - The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to a balance considered adequate to absorb probable losses incurred in the portfolio at the date of the financial statements.

Management's determination of the adequacy of the allowance for loan loss is based on ongoing quarterly assessments of the collectibility and historical loss experience of the loan portfolio. We also evaluate other factors and trends in the economy related to specific loan groups in the portfolio, trends in delinquencies and results of periodic loan reviews.
The methodology for determining the allowance for loan losses is based on historical loss rates, current credit grades, specific allocation for impaired loans and an unallocated amount. The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance for loan losses in the accounting period in which they are determined by management to be uncollectible. We periodically revise historical loss factors for different segments of the portfolio to be more reflective of current market conditions.
Large commercial loans that exhibit probable or observed credit weaknesses are subject to individual review for impairment. When individual loans are impaired, the impairment allowance is measured in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." The predominant measurement method for the Bank is the evaluation of the fair value of the underlying collateral. Our policy for the recognition of interest income on impaired loans is the same as our interest recognition policy for all non-accrual loans. Accrued interest is reversed to income to the extent it relates to the current year and is charged off otherwise.
The evaluations described above are inherently subjective, as they require the use of material estimates. Unanticipated future adverse changes in borrower or economic conditions could result in material adjustments to our allowance for loan losses that could adversely impact our earnings in future periods. We have also identified material weaknesses in internal controls relating to lending practices and policies and monitoring controls used to identify and quantify the risk in problem loans. Additional information about our material weaknesses in internal control and our Remediation Plan is provided in Item 4, "Controls and Procedures."
INVESTMENT SECURITIES - Non-equity securities not classified as either "held to maturity" securities or trading securities, and equity securities not classified as trading securities, are classified as "available for sale securities" and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of consolidated stockholders' equity. The fair values of these securities are based on quoted market prices, dealer quotes and prices obtained from independent pricing services. Available for sale and held to maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review is inherently subjective as it requires material estimates and judgments, including an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security's performance, the credit worthiness of the issuer and our ability and intent to hold the security to maturity. Declines in the fair value of the individual held to maturity and available for sale securities below their costs that are other-than-temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in consolidated earnings as realized losses.

MORTGAGE LOANS HELD FOR SALE - We originate certain residential mortgage loans with the intent to sell. Mortgage loans held for sale are reported at the lower of cost or market value on an aggregate loan portfolio basis. Gains or losses realized on sales of mortgage loans are recognized at the time of sale and are determined by the difference between the net sales proceeds and the carrying value of the loans sold, adjusted for any servicing assets or liabilities related to the loans sold. Gains and losses on sales of mortgage loans are included in other noninterest income.
DERIVATIVES AND HEDGING ACTIVITIES - We enter into derivative contracts to hedge certain assets, liabilities, and probable forecasted transactions. On the date we enter into a derivative contract, the derivative instrument is designated as:
(1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a "fair value" hedge); (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a forecasted transaction (a "cash flow" hedge); or
(3) held for other risk management purposes ("risk management derivatives"). Our primary derivative transactions involve risk management derivatives. See "Liquidity, Interest Rate Sensitivity and Other Risks" below. GOODWILL - See our discussion above on goodwill in Note 5 in the "Notes to Condensed Consolidated Financial Statements." Changes in Financial Condition September 30, 2008 Compared With December 31, 2007 Our total assets decreased $59.2 million, or 4.9%, from December 31, 2007 to September 30, 2008. Earning assets decreased $48.7 million, or 4.4%, over the same nine-month period. As reflected in the table below, loans, our largest earning asset, increased $5.3 million, or 0.6%, primarily due to a $8.6 million increase in loans of the Bank, partially offset by a $3.3 million decrease in construction, bridge, and other loans of Granite Mortgage. Mortgage loans held for sale by Granite Mortgage decreased by $0.6 million, or 4.1%, due to lower mortgage origination activities and refinancing activities, primarily because of a weak housing market. Cash and cash equivalents increased $5.8 million, or 17.4%. Investment securities decreased $58.0 million, or 40.6%, primarily due to $60.6 million in called or matured debt securities, partially offset by purchases of debt and equity securities. Other assets decreased $10.8 million, or 30.1%, due to decreases in income taxes receivable. Accrued interest receivable decreased $1.8 million, or 25.9%, due to lower yields on lower volumes of interest-earning assets. Loans at September 30, 2008 and December 31, 2007 were as follows:

                                                September 30,      December 31,
      (in thousands)                                 2008              2007
      Real estate - Construction                $     181,661      $    182,457
      Real estate - Mortgage                          554,459           513,140
      Commercial, financial and agricultural          204,000           238,469
      Consumer                                         12,943            13,481
      All other loans                                     268               567

                                                      953,331           948,114
      Deferred origination fees, net                   (1,666 )          (1,788 )

      Total loans                               $     951,665      $    946,326


      Mortgage loans held for sale              $      14,688      $     15,319

Our deposits decreased $2.8 million, or 0.3%, from December 31, 2007 to September 30, 2008. Interest-bearing demand deposits decreased $20.9 million, or 5.6%, reflecting a $29.1 million, or 12% decrease in money market deposits, partially offset by a $8.2 million, or 6.3%, increase in NOW account deposits. Noninterest-bearing demand deposits decreased $15.1 million, or 10.5%. Time deposits increased $33.3 million, or 7.7%, primarily in other time deposits. The Company's loan to deposit ratio was 98.19% as of September 30, 2008 compared to 97.36% as of December 31, 2007, and the Bank's loan to deposit ratio was 94.95% compared to 92.93% when comparing the same dates.
In addition to deposits, we have sources of funding in the form of overnight and other short-term borrowings, as well as other longer-term borrowings. Overnight borrowings are primarily in the form of federal funds purchased and commercial deposit products that sweep balances overnight into securities sold under agreements to repurchase or commercial paper issued by us. From December 31, 2007 to September 30, 2008, overnight and short-term borrowings decreased $47.0 million, or 46.9%, primarily due to a decrease of $41.2 million in overnight borrowings of the Bank, a $5.7 million decrease in overnight borrowings of the Company, and a decrease of $5.1 million in other short-term borrowings by Granite Mortgage, partially offset by a $5.0 million increase in other short-term borrowings of the Bank. Long-term borrowings decreased $1.0 million, or 5.8%.
Our total capital decreased $6.6 million, or 5.7% for the nine months ended September 30, 2008. Earnings retained declined $5.9 million for the first nine months of 2008 after paying cash dividends of $4.0 million. During the third quarter of 2008, we suspended our cash dividend in an effort to preserve capital. Accumulated other comprehensive loss related to securities available for sale, net of deferred income taxes, increased $0.8 million from December 31, 2007 to September 30, 2008, largely due to significant declines in market value resulting from thinly traded equity securities, net of realized impairment and other losses.
Liquidity, Interest Rate Sensitivity and Other Risks The objectives of our liquidity management policy include providing adequate funds to meet the cash needs of both depositors and borrowers, as well as providing funds to meet the needs of our ongoing operations and regulatory requirements. Depositor cash needs, particularly those of commercial depositors, can fluctuate significantly depending on both business and economic cycles, while both retail and commercial deposits can fluctuate significantly based on the yields and returns available from alternative investment opportunities. Borrower cash needs are also often dependent upon business and economic cycles. In addition, our liquidity is affected by off-balance sheet commitments to lend in the forms of unfunded commitments to extend credit and standby letters of credit. As of September 30, 2008, such unfunded commitments to extend credit were $174.9 million, and commitments in the form of standby letters of credit totaled $5.4 million.
We previously suspended our common stock repurchase plan, which we have historically used (1) to reduce the number of shares outstanding when our share price in the market makes repurchases advantageous and (2) to manage capital levels. Although shares repurchased are available for reissuance, we have not historically reissued, nor do we currently anticipate reissuing, repurchased shares. See Part II, Item 2, "Unregistered Sales of Equity Securities and Use of Proceeds."

For approximately 50% of its mortgage loans, Granite Mortgage waits until the loans close to arrange for their sale. This method allows Granite Mortgage to bundle mortgage loans and obtain better pricing compared with the sale of individual mortgage loans. However, this method also introduces interest rate risk to Granite Mortgage's loans in process because rates may fluctuate subsequent to Granite Mortgage's rate commitment to the mortgage customer. In order to minimize the risk that interest rates may move against Granite Mortgage subsequent to the rate commitment, Granite Mortgage enters into hedge contracts to "forward sell" mortgage-backed securities at the same time as the rate commitment. When the mortgage loans are ultimately sold, Granite Mortgage then buys the mortgage-backed security, thereby completing the hedge contract. Except as discussed above regarding Granite Mortgage's hedging program, neither the Company nor our subsidiaries have historically incurred off-balance sheet obligations through the use of or investment in other off-balance sheet derivative financial instruments or structured finance or special purpose entities. The Bank and Granite Mortgage both had contractual off-balance sheet obligations in the form of noncancelable operating leases as of September 30, 2008, and December 31, 2007, though such obligations and the related lease expenses were not material to our financial condition on such dates or results of operations for the periods then ended.
Liquidity requirements of the Bank are primarily met through two categories of funding. The first is core deposits, which includes demand deposits, savings accounts and certificates of deposits. We consider these to to be a stable portion of the Bank's liability mix and the result of ongoing consumer and commercial banking relationships. At September 30, 2008, our core deposits, defined as total deposits excluding time deposits of $100,000 or more, totaled $761.2 million, or 78.5% of our total deposits, compared to $763.7 million, or 78.6% of our total deposits as of December 31, 2007.
The other principal methods of funding used by the Bank are large denomination certificates of deposit, federal funds purchased, repurchase agreements and other short and intermediate term borrowings. The Bank's policy is to emphasize core deposit growth rather than growth through purchased or brokered time deposits because core deposits tend to be a more stable source of funding, and purchased or brokered time deposits often have a higher cost of funds. During periods of weak demand for its deposit products, the Bank maintains credit facilities under which it may borrow on a short-term basis. As of September 30, 2008, the Bank had an unsecured line of overnight borrowing capacity with its correspondent bank, which totaled $15 million. In addition, the Bank uses its capacity to pledge assets to serve as collateral to borrow on a secured basis. As of September 30, 2008, the Bank had investment securities pledged to secure an overnight funding line of approximately $8.3 million with the Federal Reserve Bank. The Bank also has significant capacity to pledge its loans secured by first liens on residential and commercial real estate as collateral for additional borrowings from the Federal Home Loan Bank ("FHLB") during periods when loan demand exceeds deposit growth or when the interest rates on such borrowings compare favorably to interest rates on deposit products. As of September 30, 2008, the Bank had a line of credit with the FHLB totaling approximately $72.3 million collateralized by its pledged residential and commercial real estate loans with $27 million outstanding, of which $13 million were in overnight and short-term borrowings and $14 million were in long-term borrowings, leaving approximately $45.3 million in remaining capacity to borrow. Granite Mortgage temporarily funds its mortgages and construction loans, from the time of origination until the time of sale, through the use of a line of credit from one of our correspondent financial institutions. As of September 30, 2008 and December 31, 2007, this line of credit was $35 million and $40 million, respectively. Granite Mortgage requests changes in the amount of the line of credit based on its estimated funding needs. As of September 30, 2008, the line was secured by approximately $21.1 million of the mortgage loans closed by Granite Mortgage. The Company serves as guarantor under the terms of this line. As of September 30, 2008, the Company was not in compliance with all of the financial covenants under this line of credit, but has received waivers from the lender for such noncompliance. As a condition to the waiver, the amount of the line was decreased from $35 million to $30 million.

We also have a $10 million unsecured line of credit from one of our correspondent banks. The line matures June 30, 2009, bearing an interest rate of one-month LIBOR plus 120 basis points, with interest payable quarterly. As of September 30, 2008, we owed $2.5 million under this line of credit. The Company was not in compliance with all of the financial covenants under this line of credit as of September 30, 2008, but has received waivers from the lender for such noncompliance.
The majority of our deposits are rate-sensitive instruments with rates that tend to fluctuate with market rates. These deposits, coupled with our short-term certificates of deposit, have increased the opportunities for deposit repricing. We place great significance on monitoring and managing our asset/liability position. Our policy for managing our interest margin (or net yield on interest-earning assets) is to maximize net interest income while maintaining a stable deposit base. Our deposit base is generally not subject to the level of volatility experienced in national financial markets in recent years; however, we do realize the importance of minimizing such volatility while at the same time maintaining and improving earnings. A common method used to manage interest rate sensitivity is to measure the difference or gap between the volume of interest-earning assets and interest-bearing liabilities repricing over a specific time period. However, this method addresses only the magnitude of funding mismatches and does not address the magnitude or relative timing of rate changes. Therefore, on a regular basis, we prepare earnings projections based on a range of interest rate scenarios of rising, flat and declining rates in order to more accurately measure interest rate risk.
Interest-bearing liabilities and variable rate loans are generally repriced to current market rates. Based on our analysis, we believe that our balance sheet is liability-sensitive, meaning that in a given period there will be more liabilities than assets subject to immediate repricing as the market rates change. Because a significant portion of our deposits are variable rate, they generally reprice more rapidly than our rate sensitive assets. During periods of rising rates, this results in decreased net interest income, assuming similar growth rates and stable product mixes in loans and deposits. The opposite occurs during periods of declining rates. While the Bank is liability-sensitive and has the opportunity to reprice its deposits, we decided not to lower our deposit rates during the first nine months of 2008 to the extent asset rates were lowered, due to competitive pressures in the deposit marketplace. We use interest sensitivity analysis to measure the sensitivity of projected earnings to changes in interest rates. The sensitivity analysis takes into account the current contractual agreements that we have on deposits, borrowings, loans, investments, and any commitments to enter into those transactions. We monitor interest sensitivity by means of computer models that incorporate the current volumes, average rates, scheduled maturities and payments, and repricing opportunities of asset and liability portfolios. Using this information, our model estimates earnings based on projected portfolio balances under multiple interest rate scenarios. In an effort to estimate the effects of pure interest-rate risk, we assume no growth in our balance sheet, because doing otherwise could have the effect of distorting the balance sheet's sensitivity to changing interest rates. We simulate the effects of interest rate changes on our earnings by assuming no change in interest rates as our base case scenario and either (1) gradually increasing or decreasing interest rates by 3% over a twelve-month period or (2) immediately increasing or decreasing interest rates by 1%, 2%, 3% and 4%, as discussed below. Although these methods are subject to the accuracy of the assumptions that underlie the process and do not take into account the pricing strategies that we would undertake in response to sudden interest rate changes, we believe that these methods provide a better indication of the sensitivity of earnings to changes in interest rates than other analyses.

Income simulation through modeling is one tool that we use in the asset/liability management process. We also consider a number of other factors in determining our asset/liability and interest rate sensitivity management strategies. We strive to determine the most likely outlook for the economy and interest rates by analyzing external factors, including published economic projections and data, the effects of likely monetary and fiscal policies, and any enacted or prospective regulatory changes. Our current and prospective liquidity position, current balance sheet volumes and projected growth, and accessibility of funds for short-term needs and capital maintenance are also . . .