(Dollar amounts are expressed in thousands unless otherwise noted)
Overview
Southeastern Bank Financial Corporation (the "Company") operates two wholly-owned subsidiaries in the Augusta-Richmond County, GA-SC metropolitan area. Georgia Bank & Trust Company (the "Bank") was organized by a group of local citizens and commenced business on August 28, 1989, with one branch location. Today, it is Augusta's largest community banking company operating nine full service branches in Augusta, Martinez, and Evans, Georgia and one branch in Athens, Georgia. Mortgage origination offices are located in Augusta, Savannah and Athens, Georgia. SB&T Capital Corporation (the "LPO") a wholly-owned subsidiary of the Bank, was organized on August 16, 2007 and opened an office in Greenville, South Carolina. On November 1, 2007 the Bank entered into an Operating Agreement with NMF Asset Management LLC ("NMF") whereby the Bank became a 30% partner. NMF is an investment management firm that provides services to individuals, trusts, pensions, nonprofit organizations as well as other institutions. Southern Bank & Trust (the "Thrift"), a federally chartered thrift, operates three full service branches in North Augusta and Aiken, South Carolina. Effective first quarter 2008 the Thrift began originating mortgage loans to be sold in the secondary market. The Company's Operations Center is located in Martinez, Georgia and services both subsidiaries.
The Company's primary market includes Richmond and Columbia Counties in Georgia and Aiken County in South Carolina, all part of the Augusta-Richmond County, GA-SC metropolitan statistical area (MSA).
The Company's services include the origination of residential and commercial real estate loans, construction and development loans, and commercial and consumer loans. The Company also offers a variety of deposit programs, including noninterest-bearing demand, interest checking, money management, savings, and time deposits. In the primary market area, Augusta-Richmond County, GA-SC metropolitan area, the Company had 15.62% of all deposits and was the second largest depository institution at June 30, 2008, as cited from the Federal Deposit Insurance Corporation's website. Securities sold under repurchase agreements are also offered. Additional services include wealth management, trust, retail investment, and mortgage. As a matter of practice, most mortgage loans are sold in the secondary market; however, some mortgage loans are placed in the portfolio based on asset/liability management strategies. The Company continues to concentrate on increasing its market share through various new deposit and loan products and other financial services and by focusing on the customer relationship management philosophy. The Company is committed to building life-long relationships with its customers, employees, shareholders, and the communities it serves.

The Company's primary source of income is from its lending activities followed by interest income from its investment activities, service charges and fees on deposits, and gain on sales of mortgage loans in the secondary market. Interest income on loans decreased for the three and nine months ended September 30, 2008 as compared with the three and nine months ended September 30, 2007 due to lower interest rates and increased nonaccruals offset in part by increased volumes. Interest income on investment securities increased due to higher interest rates and increased volumes. Service charges and fees on deposits increased as a result of increases in NSF income on both retail and business checking accounts and ATM/Debit card income. The introduction of risk based pricing, which has resulted in higher coupon rates, resulted in an increase in gain on sales of loans for the three and nine months ended September 30, 2008 as compared with the three and nine months ended September 30, 2007.

                                                   September 30,        December 31,        December 31,
                                                       2008                 2007                2003
                                                                  (Dollars in thousands)

Assets                                            $     1,378,130      $    1,212,980      $      630,633
Loans                                                   1,000,426             882,743             432,679
Deposits                                                1,125,785             952,166             483,952

Annualized return on average total assets                    0.71 %              1.04 %              1.31 %
Annualized return on average equity                         10.39 %             14.03 %             15.62 %

The Company continues to experience steady growth as evidenced in Table 1 above. The Company has also achieved significant increases in loans and deposits and continues to provide returns on assets and equity as noted in the table above. Annualized return on average total assets and annualized return on average equity have declined recently due primarily to increased levels of non-performing assets which have resulted in higher loan loss provision. Net income for the year ended 2003 was $7.9 million compared to net income of $11.8 million at year end 2007. Net income for the nine months ended September 30, 2008 was $6.9 million. Current market conditions along with increases to the provision for loan losses had a significant affect on net income for the third quarter 2008. The Company has paid cash dividends of $0.13 per share each quarter since 2004.
The Company meets its liquidity needs by managing cash and due from banks, federal funds purchased and sold, maturity of investment securities, principal repayments from mortgage-backed securities, and draws on lines of credit. Additionally, liquidity can be managed through structuring deposit and loan maturities. The Company funds loan and investment growth with core deposits, securities sold under repurchase agreements, Federal Home Loan Bank advances and other wholesale funding including brokered certificates of deposit. During inflationary periods, interest rates generally increase and operating expenses generally rise. When interest rates rise, variable rate loans and investments produce higher earnings; however, deposit and other borrowings interest expense also rise. The Company monitors its interest rate risk as it applies to net income in a ramp up and down annually 200 basis points (2%) scenario and as it applies to economic value of equity in a shock up and down 200 (2%) basis points scenario. The Company monitors operating expenses through responsibility center budgeting.

Forward-Looking Statements
Southeastern Bank Financial Corporation may, from time to time, make written or oral forward-looking statements, including statements contained in the Company's filings with the Securities and Exchange Commission (the "Commission") and its reports to shareholders. Statements made in such documents, other than those concerning historical information, should be considered forward-looking and subject to various risks and uncertainties. Such forward-looking statements are made based upon management's belief as well as assumptions made by, and information currently available to, management pursuant to "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The Company's actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors, including unanticipated changes in the Company's local economies, the national economy, governmental monetary and fiscal policies, deposit levels, loan demand, loan collateral values and securities portfolio values; difficulties in interest rate risk management; the effects of competition in the banking business; difficulties in expanding the Company's business into new markets; changes in governmental regulation relating to the banking industry, including regulations relating to branching and acquisitions; failure of assumptions underlying the establishment of reserves for loan losses, including the value of collateral underlying delinquent loans; and other factors. The Company cautions that such factors are not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by, or on behalf of, the Company. Critical Accounting Estimates
The accounting and financial reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Of these policies, management has identified the allowance for loan losses as a critical accounting estimate that requires difficult, subjective judgment and is important to the presentation of the financial condition and results of operations of the Company.
The allowance for loan losses is established through a provision for loan losses charged to expense, which affects the Company's earnings directly. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that reflects management's estimate of the level of inherent losses in the portfolio. Factors considered by management in determining the adequacy of the allowance include, but are not limited to:
(1) detailed reviews of individual loans; (2) historical and current trends in loan charge-offs for the various portfolio segments evaluated; (3) the level of the allowance in relation to total loans and to historical loss levels;
(4) levels and trends in non-performing and past due loans; (5) collateral values of properties securing loans; (6) management's assessment of economic conditions. The Company's Board of Directors reviews the recommendations of management regarding the appropriate level for the allowance for loan losses based upon these factors.

The provision for loan losses is the charge to operating earnings necessary to maintain an adequate allowance for loan losses. The Company has developed policies and procedures for evaluating the overall quality of its loan portfolio and the timely identification of problem credits. Management continues to review these policies and procedures and makes further improvements as needed. The adequacy of the Company's allowance for loan losses and the effectiveness of the Company's internal policies and procedures are also reviewed periodically by the Company's regulators and the Company's internal loan review personnel. The Company's regulators may advise the Company to recognize additions to the allowance based upon their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result. The Company continues to refine the methodology on which the level of the allowance for loan losses is based, by comparing historical loss ratios utilized to actual experience and by classifying loans for analysis based on similar risk characteristics. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement; however, cash receipts on impaired and nonaccrual loans for which the accrual of interest has been discontinued are applied to principal and interest income depending upon the overall risk of principal loss to the Company. Performance Overview
The Company's net income for the third quarter of 2008 was $1,875, which was a decrease of $1,481 (44.12%) compared to net income of $3,356 for the third quarter of 2007. Diluted net income per share for the three months ended September 30, 2008 was $0.31 compared to $0.56 for the three months ended September 30, 2007. Net income for the first nine months of 2008 was $6,918, a decrease of $2,169 (23.86%) compared with net income of $9,087 for the first nine months of 2007. The decrease in net income for the three and nine months ended September 30, 2008 as compared with the three and nine months ended September 30, 2007, was primarily a result of increases in the provision for loan losses due to increased levels of nonperforming assets. Interest income on loans decreased due to lower interest rates and increased levels of nonaccrual loans somewhat offset by increased volumes. Interest income on investment securities increased due to increased volumes and higher interest rates. Interest expense on deposits, securities sold under repurchase agreements and other borrowings decreased as a result of lower interest rates.
Factors contributing to the increase in noninterest income for the nine months ended September 30, 2008, were increases in service charges and fees on deposits, gain on sales of loans, and net investment securities gains somewhat offset by a decrease in gain on sale of fixed assets. Service charges and fees on deposits increased primarily due to increases in NSF income and ATM/Debit card income. The increased gain on sales of loans was due to the introduction of risk based pricing. Gain on sale of fixed assets decreased from 2007 due to a $1,097 gain on the sale of property recorded in August 2007. Noninterest expense increased during the three and nine months ended September 30, 2008 compared to the same periods ended September 30, 2007, primarily due to increases in salaries and occupancy expense related to Company growth and other operating expenses. Significant changes in other operating expenses during the three and nine month periods include increases in processing, marketing, IT maintenance expense, communications, professional fees, and insurance and tax expense.

                     Table 2 - Selected Balance Sheet Data

                                        September 30,        December 31,               Variance
                                            2008                 2007            Amount            %
                                                            (Dollars in thousands)
Cash and due from banks                $        28,712      $       24,558      $   4,154           16.9 %
Federal funds sold                              43,210                   -         43,210            N/A
Investment securities                          241,605             246,864         (5,259 )         (2.1 %)
Loans                                        1,000,426             882,743        117,683           13.3 %
Assets                                       1,378,130           1,212,980        165,150           13.6 %
Deposits                                     1,125,785             952,166        173,619           18.2 %
Securities sold under repurchase
agreements                                      48,607              81,166        (32,559 )        (40.1 %)
Advances from Federal Home Loan
Bank                                            84,000              59,000         25,000           42.4 %
Liabilities                                  1,287,569           1,123,222        164,347           14.6 %
Stockholders' equity                            90,561              89,758            803            0.9 %

Table 2 highlights significant changes in the balance sheet at September 30, 2008 as compared to December 31, 2007. Assets increased $165,150, primarily the result of higher balances for fed funds sold and loans. The $117,683 increase in loans included the purchase of a $29,000 loan portfolio. The increase in assets was funded by an increase in deposits of $173,619 along with increases in Federal Home Loan Bank advances, somewhat offset by decreases in securities sold under repurchase agreements. Net income of $6,918 less dividends paid of $2,185 also contributed to the funding. The bank enhanced its liquidity position by increasing cash and cash equivalents $47,000 in light of current economic conditions and volatility in the banking industry.
The annualized return on average assets for the Company was 0.71% for the nine months ended September 30, 2008, compared to 1.10% for the same period last year. While total assets have increased $190,210 since third quarter 2007, net income has decreased $2,169 resulting in a decrease in ROA.
The annualized return on average stockholders' equity was 10.39% for the nine months ended September 30, 2008, compared to 14.77% for the same period last year. The decrease is primarily attributable to the decrease in net income and increases in accumulated other comprehensive income.

Net Interest Income
The primary source of earnings for the Company is net interest income, which is the difference between income on interest-earning assets, such as loans and investment securities, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings. The following table shows the average balances of interest-earning assets and interest-bearing liabilities, annualized average yields earned and rates paid on those respective balances, and the actual interest income and interest expense for the periods indicated. Average balances are calculated based on daily balances, yields on non-taxable investments are not reported on a tax equivalent basis and average balances for loans include nonaccrual loans even though interest was not earned.
Table 3 - Average Balances, Income and Expenses, Yields and Rates

                                             Three Months Ended Sept. 30, 2008                             Three Months Ended Sept. 30, 2007
                                                          Annualized                                                    Annualized
                                                           Average                                                       Average
                                      Average              Yield or          Amount Paid            Average              Yield or          Amount Paid
                                      Amount                 Rate             or Earned             Amount                 Rate             or Earned
                                                                                 (Dollars in thousands)
Interest-earning assets:
Loans                             $       968,298                6.09 %     $      15,003       $       826,787                8.14 %     $      17,139
Investment securities                     248,398                5.39 %             3,345               230,660                5.23 %             3,016
Federal funds sold                         39,133                1.91 %               188                16,237                5.38 %               220
Interest-bearing deposits in
other banks                                   500                5.40 %                 7                   500                5.40 %                 6

Total interest-earning assets     $     1,256,329                5.82 %     $      18,543       $     1,074,184                7.47 %     $      20,381


Interest-bearing liabilities:
Deposits                          $       962,011                3.09 %     $       7,497       $       803,509                4.29 %     $       8,688
Federal funds purchased /
securities sold under
repurchase agreements                      59,266                1.97 %               295                63,581                5.18 %               830
Other borrowings                          104,171                3.84 %             1,009                78,618                5.69 %             1,127

Total interest-bearing
liabilities                       $     1,125,448                3.10 %     $       8,801       $       945,708                4.47 %     $      10,645


Net interest margin/income:                                      3.04 %     $       9,742                                      3.54 %     $       9,736

       Table 4 - Average Balances, Income and Expenses, Yields and Rates

                                             Nine Months Ended Sept. 30, 2008                              Nine Months Ended Sept. 30, 2007
                                                         Annualized                                                    Annualized
                                                           Average                                                       Average
                                       Average            Yield or         Amount Paid               Average            Yield or         Amount Paid
                                       Amount               Rate            or Earned                Amount               Rate            or Earned
                                                                                 (Dollars in thousands)
Interest-earning assets:
Loans                              $       937,175              6.54 %    $      46,483          $       793,660              8.18 %    $      49,042
Investment securities                      249,490              5.31 %            9,944                  221,027              5.16 %            8,548
Federal funds sold                          24,632              2.03 %              375                   22,802              5.29 %              902
Interest-bearing deposits in
other banks                                    500              5.00 %               18                      508              5.31 %               20

Total interest-earning assets      $     1,211,797              6.20 %    $      56,820          $     1,037,997              7.47 %    $      58,512


Interest-bearing liabilities:
Deposits                           $       918,478              3.27 %    $      22,539          $       764,128              4.26 %    $      24,346
Federal funds purchased /
securities sold under
repurchase agreements                       62,043              2.49 %            1,160                   63,889              5.23 %            2,499
Other borrowings                            96,969              4.22 %            3,072                   79,223              5.72 %            3,391

Total interest-bearing
liabilities                        $     1,077,490              3.31 %    $      26,771          $       907,240              4.46 %    $      30,236


Net interest margin/income:                                     3.25 %    $      30,049                                       3.57 %    $      28,276

Net interest income increased $6 (0.06%) during the three month period and $1,773 (6.27%) during the nine month period as compared to the same period in 2007. Loan interest income decreased $2,136 and $2,559 in the three and nine month periods as a result of decreasing interest rates and increased nonaccruals offset in part by the continued growth of account balances. Deposit interest expense decreased $1,191 and $1,807 in the three and nine month periods as a result of decreasing interest rates offset in part by the continued growth of account balances. The annual average balance for loans was $937,175 at September 30, 2008 with an annualized average yield of 6.54% compared to $793,660 at September 30, 2007 with an annualized average yield of 8.18%. Interest-bearing deposits had an annual average balance of $918,478 with an annualized average rate of 3.27% at September 30, 2008 compared to $764,128 and 4.26% at September 30, 2007. Other contributing factors during both the three and nine month periods included increases in interest income on investment securities and decreases in interest expense on securities sold under repurchase agreements.
The Company's net interest margin for the three and nine months ended September 30, 2008 was 3.04% and 3.25%, respectively, as compared to 3.54% and 3.57% for the three and nine months ended September 30, 2007, respectively. This decrease in the net interest margin for the three and nine month periods was impacted by increased levels of nonaccrual loans which resulted in the reversal of $365 in interest income. The Company presently expects this trend of increasing nonaccrual loans and the resultant impact on net interest income to continue until property values in the Company's primary market stabilize. The rate for earning assets decreased 165 basis points and 127 basis points for the three and nine month periods, with lower average yields on loans and federal funds sold accounting for most of the decrease. The cost to fund earning assets decreased 137 basis points and 115 basis points for the three and nine month periods, respectively, primarily due to lower rates on deposits and securities sold under repurchase agreements.

Noninterest Income
                          Table 5 - Noninterest Income

                         Three Months Ended                                         Nine Months Ended
                           September 30,                   Variance                   September 30,                  Variance
                         2008           2007         Amount          %             2008           2007         Amount          %
                                     (Dollars in thousands)                                    (Dollars in thousands)
Service charges
and fees on
deposits              $    1,955       $ 1,675      $    280          16.7 %     $   5,446      $  4,654      $    792          17.0 %
Gain on sales of
loans                      1,529         1,350           179          13.3 %         4,365         3,954           411          10.4 %
Gain on sale of
fixed assets                  (1 )       1,095        (1,096 )      (100.1 %)            7         1,032        (1,025 )       (99.3 %)
Investment
securities gains
(losses), net                 21          (278 )         299        (107.6 %)           88          (245 )         333        (135.9 %)
Retail investment
income                       277           296           (19 )        (6.4 %)          841           894           (53 )        (5.9 %)
Trust services
fees                         288           271            17           6.3 %           873           830            43           5.2 %
Increase in cash
surrender value of
bank-owned life
insurance                    190           169            21          12.4 %           548           495            53          10.7 %
Miscellaneous
income                       178           168            10           6.0 %           652           497           155          31.2 %

Total noninterest
income                $    4,437       $ 4,746      $   (309 )        (6.5 %)    $  12,820      $ 12,111      $    709           5.9 %

Noninterest income decreased $309 (6.51%) during the three month period and increased $709 (5.85%) during the nine month period. The most significant changes for the three and nine month periods were a decrease in gain on sale of fixed assets offset by increases in service charges and fees on deposits, gain on sales of loans, and net investment securities gains. Gain on sale of fixed assets is down in 2008 as compared to 2007 due to a $1,097 gain on the sale of the Operations Campus located in Augusta, Georgia in August 2007. Service charges and fees on deposits increased primarily due to increases in NSF income . . .