General

The sole business of Commonwealth Bankshares, Inc. is to serve as a holding company for Bank of the Commonwealth. The Company was incorporated as a Virginia Company on June 6, 1988, and on November 7, 1988 it acquired the Bank.

Bank of the Commonwealth was formed on August 28, 1970 under the laws of Virginia. Since the Bank opened for business on April 14, 1971, its main banking and administrative offices have been located in Norfolk, Virginia. The Bank currently operates four branches in Norfolk, six branches in Virginia Beach, four branches in Chesapeake, two branches in Portsmouth, one branch in Powells Point, North Carolina, one branch in Waves, North Carolina and one branch in Moyock, North Carolina. Bank of the Commonwealth Mortgage currently operates one mortgage branch office in Virginia Beach, one mortgage branch office in Gloucester and one mortgage branch office in Richmond, Virginia. Executive Title Center currently operates one title insurance branch office in Norfolk and one title insurance branch office in Suffolk, Virginia. Commonwealth Financial Advisors currently has two locations, one in Virginia Beach and one in Norfolk, Virginia.

The Company concentrates its marketing efforts in the cities of Norfolk, Virginia Beach, Portsmouth and Chesapeake, Virginia and Northeastern North Carolina. The Company intends to continue concentrating its banking activities in its current markets, which the Company believes are attractive areas in which to operate.

The following discussion provides information about the important factors affecting the consolidated results of operations, financial condition, capital resources and liquidity of the Company. This report identifies trends and material changes that occurred during the reporting period and should be read in conjunction with the Company's annual report on Form 10-K for the year ended December 31, 2007.

Forward-Looking Statements

Some of the matters discussed below and elsewhere in this report include forward-looking statements. These forward-looking statements include statements regarding profitability, liquidity, adequacy of the allowance for loan losses, interest rate sensitivity, market risk and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts. The forward-looking statements we use in this report are subject to significant risks, assumptions and uncertainties, including among other things, the following important factors that could affect the actual outcome of future events:

• Our dependence on key personnel;

• The high level of competition within the banking industry;

• Our dependence on commercial real estate loans that could be negatively affected by a downturn in the real estate market;

• Adverse changes in the overall national economy as well as adverse economic conditions in our specific market areas within Hampton Roads, Virginia and Northeastern North Carolina;

• Risks inherent in making loans such as repayment risks and fluctuating collateral values;

• The adequacy of our estimate for known and inherent losses in our loan portfolio;

• Changes in interest rates;

• Our ability to manage our growth;

• Impacts of implementing various accounting standards;

• Governmental and regulatory changes that may adversely affect our expenses and cost structure; and

• Other factors described from time to time in our Securities and Exchange Commission filings.

Because of these and other uncertainties, our actual results and performance may be materially different from results indicated by these forward-looking statements. In addition, our past results of operations are not necessarily indicative of future performance.

We caution you that the above list of important factors is not all inclusive. These forward-looking statements are made as of the date of this report, and we may not undertake steps to update these forward-looking statements to reflect the impact of any circumstances or events that arise after the date the forward-looking statements are made.

Critical Accounting Policies

Certain critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. The Company's most critical accounting policy relates to the Company's allowance for loan losses, which reflects the estimated losses resulting from the inability of the Company's borrowers to make required loan payments. If the financial condition of the Company's borrowers were to deteriorate, resulting in an impairment of their ability to make payments, the Company's estimates would be updated, and additional provisions for loan losses may be required. See Note 1 - Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2007, for further information related to the allowance for loan losses.

New Accounting Pronouncements

On February 15, 2007, the Financial Accounting Standards Board ("FASB") issued SFAS No. 159-The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115 ("SFAS 159"), which permits companies to choose to measure many financial instruments and certain other items at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. The Company adopted SFAS 159 effective January 1, 2008, as required, but has not elected to measure any permissible items at fair value. As a result, the adoption of SFAS 159 did not have any impact on the Companys' financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007) - Business Combinations ("Statement 141R"). Statement 141R significantly changes the way companies account for business combinations and will generally require more assets acquired and liabilities assumed to be measured at their acquisition-date fair value. Under Statement 141R, legal fees and other transaction-related costs are expensed as incurred and are no longer included in goodwill as a cost of acquiring the business. Statement 141R also requires, among other things, acquirers to estimate the acquisition-date fair value of any contingent consideration and to recognize any subsequent changes in the fair value of contingent consideration in earnings. In addition, restructuring costs the acquirer expected, but was not obligated to incur, will be recognized separately from the business acquisition. This accounting standard is effective for fiscal years beginning on or after December 15, 2008. The Company is currently evaluating the impact of Statement 141R on its financial statements.

In December 2007, the FASB issued SFAS No. 160 - Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 ("Statement 160"). Statement 160 requires all entities to report noncontrolling interests in subsidiaries as a separate component of equity in the consolidated financial statements. Statement 160 establishes a single method of accounting for changes in a parent's ownership interest in a subsidiary that do not result in deconsolidation. Companies will no longer recognize a gain or loss on partial disposals of a subsidiary where control is retained. In addition, in partial acquisitions, where control is obtained, the acquiring company will recognize and measure at fair value 100 percent of the assets and liabilities, including goodwill, as if the entire target company had been acquired. This accounting standard is effective for fiscal years beginning on or after December 15, 2008. The Company is currently evaluating the impact of Statement 160 on its financial statements.

In March 2008, the FASB issued SFAS No. 161 - Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133 ("Statement 161"). Statement 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity's financial position, financial performance, and cash flows. The statement also improves transparency about the location and amounts of derivative instruments in an entity's financial statements; how derivative instruments and related hedged items are accounted for under Statement 133; and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows. This accounting standard is effective for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently evaluating the impact of Statement 161 on its financial statements.

In April 2008, the FASB issued FASB Staff Position No. 142-3 - Determination of the Useful Life of Intangible Assets ("FSP No. 142-3") 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 intangible asset (under SFAS No. 141(R)). FSP No. 142-3 amends the factors to be considered when developing renewal or extension assumptions that are used to estimate an intangible asset's useful life under SFAS No. 142. The guidance in the new staff position is to be applied prospectively to intangible assets acquired after December 31, 2008. In addition, FSP No. 142-3 increases the disclosure requirements related to renewal or extension assumptions. The Company is currently evaluating the impact of FSP No. 142-3 on its financial statements.

In May 2008, the FASB issued SFAS No. 162 - The Hierarchy of Generally Accepted Accounting Principles ("Statement 162"). Statement 162 identifies the sources of accounting principles and the framework for selecting the principles to be 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). This statement is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411-The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company is currently evaluating the impact of Statement 162 on its financial statements.

In May 2008, the FASB issued SFAS No. 163 - Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60 ("Statement 163"). Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit

deterioration has occurred in an insured financial obligation. This Statement also clarifies how Statement 60 applies to financial guarantee insurance contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities. This statement is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. The Company is currently evaluating the impact of Statement 163 on its financial statements.

Stock Compensation Plans

The Company adopted the provisions of SFAS No. 123(R), Share-Based Payments, on January 1, 2006 using the modified prospective method. Under this method, stock-based awards that are granted, modified, or settled after December 31, 2005, are measured and accounted for in accordance with the provisions of SFAS No. 123(R). Also under this method, expense is recognized for unvested awards that were granted prior to January 1, 2006, based upon the fair value determined at the grant date under SFAS No. 123, Accounting for Stock-Based Compensation. Share-based compensation expense is recorded in salary and employee benefits. Prior to the adoption of SFAS No. 123(R), the Company accounted for its share-based compensation under the intrinsic value method as permitted by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. Accordingly, the Company previously recognized no compensation expense for employee stock options that were granted with an exercise price equal to the fair value of the underlying common stock on the date of grant.

Stock option compensation expense is the estimated fair value of options granted on the date of grant using the Black-Scholes option-pricing model.
Substantially, all employee stock options are awarded at the end of the year as part of an employees overall compensation, based on the individual's performance during the year, and either vest immediately or over a nominal vesting period. There were no options granted during the nine months ended September 30, 2008 and 2007, respectively. There have been no significant changes in the assumptions for the Black-Scholes option-pricing model previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. A summary of the Company's stock option activity and related information for the nine months ended September 30, 2008 is as follows:

                                         Stock           Weighted           Remaining         Aggregate
                                        Options          Average         Contractual Life     Intrinsic
                                      Outstanding     Exercise Price       ( in months)         Value
Balance at December 31, 2007              489,396    $          16.86
Granted                                        -                   -
Forfeited                                      -                   -
Exercised                                  15,682                7.47
Expired                                        -                   -

Balance at September 30, 2008             473,714    $          17.17               74.42    $ (1,409,702 )

Balance exercisable at
September 30, 2008                        473,714    $          17.17               74.42    $ (1,409,702 )

See Note 20 - Stock Based Compensation Plans, of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2007, for further information related to stock based compensation.

Financial Condition

Total assets at September 30, 2008 reached a new high of $1.0 billion, up 21.0% or $176.6 million from $843.1 million at December 31, 2007. Total loans, the Company's largest and most profitable asset, ended the quarter at a record $962.8 million, up $175.9 million or 22.3% from December 31, 2007. The expansion of our footprint into new markets, the low interest rate environment, and the efforts of our experienced loan officers to develop new loan relationships combined with the support of existing customers continue to generate record loan demand for the Company.

As of September 30, 2008, 82.0% of the Company's loan portfolio consisted of commercial loans, which are considered to provide higher yields, but also generally carry a greater risk. It should be noted that 57.3% of these commercial loans are collateralized with real estate, and accordingly do not represent an unfavorable risk. At September 30, 2008, 63.6% of the Bank's total loan portfolio consisted of loans collateralized with real estate.

Deposits are the most significant source of the Company's funds for use in lending and general business purposes. The Company's strong growth in deposits continued into the third quarter of 2008 with deposits at September 30, 2008 reaching a record $752.1 million, an increase of $179.8 million from December 31, 2007. Noninterest-bearing demand deposits increased by $8.3 million or 20.1% and interest-bearing deposits increased by $171.5 million or 32.3%. Included in time deposits less than $100,000 as of September 30, 2008 and December 31, 2007 are $337.6 million and $160.5 million, respectively in broker certificates of deposits. The interest rates paid on these deposits are consistent, if not lower, than the market rates offered in our local area. Management believes the growth in deposits is a result of the Company's competitive interest rates on all deposit products, new branch locations, special promotions and product enhancements, as well as the Company's marketing efforts. The Company's deposits are predominantly provided by individuals and businesses located within communities served.

As of September 30, 2008, short-term borrowings (advances from FHLB) were $73.5 million, compared to $69.2 million outstanding on December 31, 2007. The increase in short-term borrowings was primarily a result of our loan demand continuing to increase at a faster pace than our deposit growth.

Results of Operation

During the first nine months of 2008, the Company had a net loss of $4.3 million, a decrease of 151.2% from the earnings of $8.5 million reported in the first nine months of 2007. Due to continued economic uncertainties management elected to provide an additional $20.0 million to its allowance for loan losses in the third quarter of 2008, which lead to the loss. This unprecedented action was taken primarily in response to the current market and the current economic climate. On a per share basis, the diluted loss was $0.63 for the nine months ended September 30, 2008, down $1.84 or 152.1% from the earnings of $1.21 reported in the comparable period of 2007. Net loss for the quarter ended September 30, 2008 totaled $9.1 million, a decrease of 428.2% or $11.9 million over the amount reported in the third quarter of 2007. The diluted loss per share equaled $1.33 for the three months ended September 30, 2008 compared to earnings of $0.40 for the same period in 2007.

Profitability as measured by the Company's return on average assets (ROA) was (0.63%) and 1.49% for the nine months ended September 30, 2008 and 2007, respectively. ROA was impacted by the decrease in net income and by the increase in year to date average assets of $165.4 million or 21.8% from September 30, 2007 to September 30, 2008. The return on average equity (ROE) was 5.01%) and 10.58% for the nine months ended September 30, 2008 and 2007, respectively. The decrease in ROE is the result of the decrease in net income and the growth in year to date average equity of $8.6 million or 8.0% from September 30, 2007 to September 30, 2008. For the quarter ended September 30, 2008, ROA was (3.66%) and ROE was (31.16%).

A fundamental source of the Company's earnings, net interest income, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities, while deposits and short-term borrowings represent the major portion of interest- bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations. Net interest income was $25.8 million for the nine months ended September 30, 2008, an increase of $583.0 thousand or 2.3% over the $25.3 million for the nine months ended September 30, 2007. For the quarter ended September 30, 2008, net interest income was $9.3 million, an increase of $759.7 thousand or 8.9% over the comparable period in 2007.

Total interest and dividend income was $47.7 million for the nine months ended September 30, 2008, an increase of $1.8 million or 3.9% over the same period of 2007. Interest income on loans, including fees, increased $1.8 million or 4.1% to $47.1 million for the nine months ended September 30, 2008. For the quarter ended September 30, 2008, total interest and dividend income was $16.8 million and interest income on loans, including fees, was $16.6 million, an increase of 6.4% and 6.7%, respectively over the comparable period in 2007.

Interest expense of $21.9 million for the nine months ended September 30, 2008 represented a $1.2 million or 5.9% increase from the comparable period in 2007. Interest expense for the third quarter of 2008 was $7.5 million, up $251.7 thousand from the quarter ended September 30, 2007. The increase was primarily attributable to the substantial increase in the Company's average interest bearing liabilities as a result of the $197.3 million increase in total deposits as of September 30, 2008 as compared to 2007. Average interest bearing liabilities increased $153.4 million or 25.8% from September 30, 2007 to September 30, 2008, while the overall rate paid on these liabilities decreased 74 basis points as a result of the declining interest rate environment.

The net interest margin, calculated by expressing net interest income as a percentage of average interest earning assets, is an indicator of the Company's effectiveness in generating income from earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competition and the economy. The Company's net interest margin (tax equivalent basis) was 3.93% during the first nine months of 2008, as compared to 4.65% for the same period in 2007. The compression of our margins can be attributed to the Federal Reserve lowering the Federal Funds rate 100 basis points in the last four months of 2007 and 225 basis points in the first nine months of 2008, along with the continued pressure on deposit pricing and the pricing of some deposit products, which lag the decrease in the prime rate, which has an immediate affect on variable loans. In addition, the competitiveness for deposits resulting from the reduction in liquidity throughout the financial markets has kept rates at a high level relative to loan rates. For the quarter ended September 30, 2008, the net interest margin was 3.95% compared to 4.54% for the third quarter in 2007.

The provision for loan losses is the annual cost of maintaining an allowance for inherent credit losses. The amount of the provision each year and the level of the allowance are matters of judgment and are impacted by many factors, including actual credit losses during the period, the prospective view of credit losses, loan performance measures and trends (such as delinquencies and charge-offs), loan growth, and other factors, both internal and external that may affect the quality and future loss experience of the credit portfolio. Due to continued economic uncertainties management elected to provide an additional $20 million to its allowance for loan losses in the third quarter of 2008. This unprecedented action was taken primarily in response to current market conditions and the current economic climate. At September 30, 2008, the Company had total allowance for loan losses of $30.1 million or 3.12% of total loans. As a result of the growth in the loan portfolio as well as the uncertainty in the economy, the slowdown in the housing market, declining real estate values, increased foreclosures, the turbulence in the financial sector and the current regulatory environment management has scrutinized the loan portfolio and have taken a proactive and conservative action in establishing the additional reserve. For the nine months ended September 30, 2008, the Company made provisions for loan losses of $21.3 million, an increase of 1,859.0% over the same period of 2007. Loan charge-offs for the nine months ended September 30, 2008 totaled $630.4 thousand and recoveries for the same period totaled $3.9 thousand. Net charge-offs as a percentage of year to date average loans outstanding was relatively low at 0.07% and 0.05% for the period ended September 30, 2008 and 2007, respectively.

Non-performing assets were $33.1 million or 3.24% of total assets at September 30, 2008 compared to $5.0 million or 0.62% of total assets at September 30, 2007. Non-performing loans increased $26.3 million in the first nine months of 2008 to $31.3 million. Non-performing loans at September 30, 2008 consist of sixty-eight (68) loans. $29.8 million or 95.2% of the total consists of fifty-one (51) loans which are secured by real estate. The remaining $1.5 million in non-performing loans represents seventeen (17) loans, with the majority making monthly payments and in most cases are secured with workout arrangements currently in place. As all non-performing loans are deemed impaired, management has individually reviewed the underlying collateral (less cost to sell) on each of these loans as part of its analysis of impaired loans. As a result of this comprehensive analysis, a $5.8 million specific reserve for loans losses was established for non-performing loans. Based on current collateral values, management believes the specific reserve is adequate to cover any short falls resulting from the sale of the underlying collateral. Based on current accounting and regulatory guidelines the Company has provided a reserve based on current market values for these impaired loans however, management plans to work with our customers to get through these unprecedented economic conditions and to minimize any potential credit exposure. Management has taken a proactive approach to monitoring these loans and will

continue to actively manage these credits to minimize loss. Other real estate owned ("OREO") is included in other assets and totaled $1.8 million and $717.4 thousand at September 30, 2008 and December 31, 2007, respectively. The balance at September 30, 2008 includes five residential properties. During the quarter ended September 30, 2008, two OREO properties were sold and resulted in a net loss of $40.4 thousand. All other real estate owned properties are being actively marketed. Management does not anticipate any material losses associated with these properties. Asset quality remains a top priority for the Company. We continue to allocate significant resources to the expedient disposition and collection of non-performing and other lower quality assets. Individual action plans have been developed for each non-performing asset. Based on current expectations relative to portfolio characteristics and performance measures including loss projections, management considers the level of the allowance to be adequate.

Noninterest income for the nine months ended September 30, 2008 and 2007 equaled $3.7 million. Revenues generated from the Bank's mortgage, title and investment subsidiaries for the nine months ended September 30, 2008 was $1.8 million as compared to $2.3 million for the same period in 2007, a net decrease of $581.2 thousand or 24.9%. Offsetting the reduction in subsidiary revenues for the nine months ended September 30, 2008 was a 37.2% and 23.8% increase in service charges on deposit accounts and other service charges and fees, respectively. Included in service charges on deposit accounts for the nine months ended September 30, 2008 and 2007 were $929.5 thousand and $608.8 thousand, respectively, in non-sufficient funds ("NSF") fees. Included in other service charges and fees for the nine months ended September 30, 2008 and 2007 were . . .