The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company's consolidated financial statements and notes thereto on pages A-27 through A-56 of the Company's 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders.

Introduction
Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. Peoples Bancorp is the parent company of Peoples Bank (the "Bank") and a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the "Federal Reserve"). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the "FDIC").

Overview
Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses, and changes in these economic conditions could result in increases or decreases to the provision for loan losses.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Company qualified as an accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934, effective December 31, 2006. Therefore, the Company was subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 ("SOX 404"). The Company incurred additional consulting and audit expenses in becoming compliant with SOX 404, and will continue to incur additional audit expenses to comply with SOX 404 when SOX 404 becomes applicable to smaller reporting companies. Management does not expect expenses related to SOX 404 to have a material impact on the Company's financial statements. The Company qualified as a smaller reporting company effective June 30, 2008, due to a decrease in market capitalization. Management does not expect significant cost savings from this change in filing status, as certification of the effectiveness of internal controls by management will still be required.

The Emergency Economic Stabilization Act of 2008 was enacted in October 2008 in response to the current financial crisis. Two key components of this act are the Troubled Assets Relief Program ("TARP") and the Capital Purchase Program ("CPP"). The TARP allows financial institutions to sell troubled assets to the U.S. Treasury. The Company will not participate in the TARP. The CPP allows qualifying financial institutions to issue senior preferred shares to the Treasury. The senior preferred shares will qualify as Tier 1 capital and will pay a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The senior

preferred shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years. Prior to the end of three years, the senior preferred may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Treasury may also transfer the senior preferred shares to a third party at any time. In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average. Companies participating in the CPP must adopt the Treasury's standards for executive compensation and corporate governance. The Company is currently evaluating its participation in the CPP.

The Bank opened a new office in Mecklenburg County, in Cornelius, North Carolina in June 2007 and a new office in Iredell County, in Mooresville, North Carolina in January 2008. Also in January 2008, the Bank opened a new Banco de la Gente office in Wake County, in Raleigh, North Carolina in a continuing effort to serve the Latino community. While there are no additional traditional offices planned in 2008, management will consider opening at least one new traditional office in Mecklenburg or Iredell counties in the next two to three years and additional Banco de la Gente offices in metropolitan areas in North Carolina.

Summary of Significant Accounting Policies The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with the Bank's wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition. Many of the Company's accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. A more complete description of the Company's significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company's 2007 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008 Annual Meeting of Shareholders. The following is a summary of the more subjective and complex accounting policies of the Company.

Many of the Company's assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectibility of loans is reflected through the Company's estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectibility. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company's internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management's discussion and analysis and the notes to the consolidated financial statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." For a more complete discussion of policies, see the notes to the consolidated financial statements.

In September 2006, the Financial Accounting Standard Board ("FASB") ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." This issue requires companies to recognize an obligation for either the present value of the entire promised death benefit or the annual "cost of insurance" required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. During first quarter 2008, the Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement. During the third quarter of 2008, the Company recognized $14,000 in expense associated with EITF 06-4. The Company has recognized $45,000 in expense associated with EITF 06-4 for the nine months ended September 30, 2008.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS 157 was effective for the Company as of January 1, 2008. This standard had no

effect on the Company's financial position or results of operations.

SFAS 157 establishes a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The Company's fair value measurements for items measured at fair value at September 30, 2008 included:

                                                 Fair Value
                                                Measurements
                                               September 30,      Level 1      Level 2     Level 3
                                                    2008         Valuation    Valuation   Valuation
Investment securities available for sale      $    115,845,961   1,304,428   113,291,533   1,250,000
Market value of derivatives (in other assets) $      2,354,133           -     2,354,133           -

Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities. Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the nine months ended September 30, 2008:

                                                                        Investment
                                                                        Securities
                                                                       Available for
                                                                           Sale
                                                                         Level 3
                                                                        Valuation
Balance, beginning of period                                          $      250,000
Change in book value                                                               -
Change in gain/(loss) realized and unrealized                                      -
Purchases/(sales)                                                          1,000,000
Transfers in and/or out of Level 3                                                 -
Balance, end of period                                                $    1,250,000

Change in unrealized gain/(loss) for assets still held in Level 3     $            0

In accordance with the provisions of SFAS 114, the Company has specific loan loss reserves for loans that management has determined to be impaired. These specific reserves are determined on an individual loan basis based on management's current evaluation of the Company's loss exposure for each credit, given the appraised value of any underlying collateral. At September 30, 2008, the Company had specific reserves of $867,000 in the allowance for loan losses on loans totaling $7.3 million. The Company's September 30, 2008 fair value measurement for impaired loans is presented below:

                                                                                      Total
                                                                                  Gains/(Losses)
                                                                                     for the
                               Fair Value                                          Nine Months
                              Measurements                                            Ended
                             September 30,     Level 1     Level 2     Level 3    September 30,
                                  2008        Valuation   Valuation   Valuation        2008
Impaired loans               $    6,406,548           -           -   6,406,548                -
Other Real Estate            $    3,025,921           -           -   3,025,921                -

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" (SFAS 159), which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS 159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS 159 did not have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 140-3, "Accounting for Transfers of Financial Assets and Repurchase Financing Transactions." This FSP provides guidance on accounting for a transfer of a financial asset and a repurchase financing under SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and

Extinguishments of Liabilities." This FSP is not expected to have a material effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-1, "Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13." This FSP amends SFAS No. 157, "Fair Value Measurements," to exclude SFAS No. 13, "Accounting for Leases" and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS No. 13. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-2, "Effective Date of FASB Statement No. 157." This FSP delays the effective date of SFAS No. 157, "Fair Value Measurements," for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities," (SFAS 161). SFAS 161 is an amendment to SFAS No. 133, which provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity's financial statements. SFAS 161 is effective for the Company as of January 1, 2009. As this is a disclosure related standard, this standard is not expected to have any effect on the Company's financial position or results of operations, and will result in additional disclosures related to the Company's derivatives.

In September 2008, the FASB issued FASB Staff Position (FSP) FAS No. 133-1 and FIN 45-4, "Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 and Clarification of the Effective Date of FASB Statement No. 161." This FSP is an amendment to SFAS No. 133, which provides for enhanced disclosure requirements for credit risk derivatives. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In October 2008, the FASB issued FSP FAS No. 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active." This FSP clarifies the application of SFAS No. 157, "Fair Value Measurements," in a market that is not active. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.

Results of Operations
Summary. Net earnings for the third quarter of 2008 were $1.7 million, or $0.31 basic and diluted net earnings per share as compared to $2.6 million, or $0.46 basic net earnings per share and $0.45 diluted net earnings per share for the same period one year ago. The decrease in net earnings is attributable to a decrease in net interest income, an increase in provision for loan losses and an in increase in non-interest expense, which were partially offset by an increase in non-interest income.

The annualized return on average assets was 0.74% for the three months ended September 30, 2008 compared to 1.22% for the same period in 2007, and annualized return on average shareholders' equity was 9.40% for the three months ended September 30, 2008 compared to 15.35% for the same period in 2007.

Net earnings for the nine months ended September 30, 2008 were $6.0 million, or $1.07 basic net earnings per share and $1.06 diluted net earnings per share as compared to $8.0 million, or $1.40 basic net earnings per share and $1.37 diluted net earnings per share for the same period in 2007. The decrease in net earnings for the nine-month period ended September 30, 2008 is primarily attributable to a decrease in net interest income, an increase in the provision for loan losses and an increase in non-interest expense, which were partially offset by an increase in non-interest income.

The annualized return on average assets was 0.87% and 1.28% for the nine months ended September 30, 2008 and 2007, respectively. Annualized return on average shareholders' equity was 10.56% for the nine months ended September 30, 2008 compared to 15.41% for the same period in 2007.

Net Interest Income. Net interest income, the major component of the Company's net earnings, was $8.5 million for the three months ended September 30, 2008, a decrease of 1% from the $8.6 million earned in the same period in 2007.

This decrease is primarily attributable to a 275 basis point reduction in the Bank's prime commercial lending rate from September 30, 2007 to September 30, 2008. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments.

Interest income decreased $1.5 million or 10% for the three months ended September 30, 2008 compared with the same period in 2007. The decrease was due to a 275 basis point reduction in the Bank's prime commercial lending rate, which was partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Net income from derivative instruments was $907,000 for the three months ended September 30, 2008 when compared to a net loss of $114,000 for the same period in 2007. The average yield on earning assets for the quarters ended September 30, 2008 and 2007 was 6.43% and 7.82%, respectively. During the quarter ended September 30, 2008, average loans increased $84.8 million to $757.4 million from $672.6 million for the three months ended September 30, 2007. During the quarter ended September 30, 2008, average investment securities available-for-sale decreased $7.0 million to $113.5 million from $120.5 million for the three months ended September 30, 2007.

Interest expense decreased $1.4 million or 20% for the three months ended September 30, 2008 compared with the same period in 2007. The average rate paid on interest-bearing checking and savings accounts was 1.57% for the three months ended September 30, 2008 as compared to 2.27% for the same period of 2007. The average rate paid on certificates of deposits was 3.40% for the three months ended September 30, 2008 compared to 4.86% for the same period one year ago.

Net interest income for the nine-month period ended September 30, 2008 was $24.7 million, a decrease of 4% from net interest income of $25.9 million for the nine months ended September 30, 2007. This decrease is primarily attributable to a reduction in the Bank's prime commercial lending rate. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments.

Interest income decreased $3.5 million or 8% to $42.7 million for the nine months ended September 30, 2008 compared to $46.3 million for the same period in 2007. The decrease was primarily due to a decrease in the average yield received on loans resulting from Federal Reserve interest rate decreases, which were partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Net income from derivative instruments was $2.2 million for the nine months ended September 30, 2008 compared to a net loss of $323,000 for the same period of 2007. The average yield earned on loans, including fees, was 6.95% for the nine months ended September 30, 2008 as compared to 8.47% for the same period of 2007. During the nine months ended September 30, 2008, average loans increased $83.8 million to $738.0 million from $654.2 million for the same period in 2007. Average investment securities available for sale decreased $4.5 million to $115.9 million in the nine months ended September 30, 2008 compared to the same period in 2007. All other interest-earning assets including federal funds sold decreased to an average of $12.6 million in the nine months ended September 30, 2008 from $17.5 million in the same period in 2007. The tax equivalent yield on average earning assets decreased to 6.68% for the nine months ended September 30, 2008 as compared to 7.92% for the nine months ended September 30, 2007.

Interest expense decreased 12% to $18.0 million for the nine months ended September 30, 2008 compared to $20.4 million for the corresponding period in 2007. The decrease in interest expense was due to a decrease in the cost of funds to 3.29% for the nine months ended September 30, 2008 from 4.15% for the same period in 2007, partially offset by an increase in the volume of interest-bearing liabilities. The decrease in the cost of funds is primarily attributable to decreases in the average rate paid on interest-bearing deposits. The average rate paid on interest-bearing checking and savings accounts was 1.67% for the nine months ended September 30, 2008 as compared to 2.17% for the same period in 2007. The average rate paid on certificates of deposits was 3.83% for the nine months ended September 30, 2008 from 4.83% for the same period one year ago.

Provision for Loan Losses. For the three months ended September 30, 2008, a contribution of $1.0 million was made to the provision for loan losses compared to $296,000 for the same period one year ago. The increase in provision for loan losses is primarily attributable to a $5.2 million increase in non-performing assets from September 30, 2007 to September 30, 2008, an increase in net charge-offs to $914,000 from $123,000 and increased loan growth. Net charge-offs in the quarter ended September 30, 2008 included charge-offs of $501,000 on loans to a local builder whose loans were foreclosed upon in the same quarter. The Bank had $3.2 million in Other Real Estate Owned at September 30, 2008, of which $2.2 million was from loans to a local builder on three residential properties. The largest property is a home with a current book value of $1.3 million after the Bank paid $1.0 million to the holder of the first mortgage at foreclosure.

. . .