Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

EXECUTIVE SUMMARY

The following information is intended to provide investors a better understanding of the financial position and the operating results of Community Financial Corporation ("Community" or the "Company" and its subsidiary, Community Bank (the "Bank"). The following is primarily from management's perspective and may not contain all information that is of importance to the reader. Accordingly, the information should be considered in the context of the consolidated financial statements and other related information contained herein.

Net income (loss) for the six months ended September 30, 2008 decreased $11,431,000 or 599.82% to ($9,525,000) compared to $1,906,000 for the six months ended September 30, 2008. Net income for the six months decreased due primarily to an Other Than Temporary Impairment (OTTI) adjustment on our FHLMC and FNMA Available for Sale securities of $11,053,000, provision for loan loss increase, and increases in noninterest expense resulting from higher expenses associated with compensation and federal insurance premiums. Net income for the six months ended September 30, 2008 excluding the OTTI would have been $1,528,000.

Net income (loss) for the three months ended September 30, 2008 decreased $11,367,000 or 1,296.3% to ($10,490,000) compared to $877,000 for the three months ended September 30, 2008. Net income for the quarter ended September 30, 2008 decreased due primarily to an Other Than Temporary Impairment charge on our FHLMC and FNMA Available for Sale securities of $11,053,000, an increase in the provision for loan loss, and increases in noninterest expense resulting from higher expenses associated with compensation and federal insurance premiums. Net income for the quarter ended September 30, 2008 excluding the OTTI would have been $563,000.

Subsequent to the September 30, 2008 quarter, the Emergency Economic Stabilization Act was passed by Congress and signed by the President which permitted the OTTI loss to be deducted as an ordinary loss for income tax purposes. This will result in a tax benefit in the December 31, 2008 quarter of approximately $4.2 million.

Net interest income for the quarter ended September 30, 2008 increased $205,000, or 5.4%, to $4.0 million compared to the quarter ended September 30, 2007. Net interest income, which is the difference between the interest income we earn on our interest-earning assets, such as loans and investment securities, and the interest we pay on interest-bearing liabilities, which are primarily deposits and borrowings, was impacted by both the change in our volume of interest earning assets and the interest rate spread between interest-earning assets and interest-bearing liabilities. The primary factor contributing to the increase in net interest income for the quarter ended September 30, 2008 was the growth in interest-earning assets, primarily loans, and lower rates on interest-bearing liabilities. The increase in net interest income for the current quarter was limited due to the elimination of dividends on the Freddie Mac preferred owned by the Bank. We had no purchases of investment securities during the three months ended September 30, 2008 and anticipate limited securities purchases during the remainder of the current fiscal year.

Management will continue to monitor asset growth to manage the level of regulatory capital and funds acquisition. We continue to monitor the impact changing interest rates may have on both the growth in interest-earning assets and our interest rate spread. The Bank has approximately $323.1 million in adjustable rate loans or 70.5% of total loans which reprice in five years or less, many of which are subject to annual and lifetime interest rate limits. The pace and extent of future interest rate changes will impact the Company's interest rate spread as well as limitations on interest rate adjustments on certain adjustable rate loans.

Funding for the growth in interest-earning assets combined with a falling interest rate environment has impacted the composition of our interest-bearing liabilities. The primary source of funding for increases in assets during the September 30, 2008 quarter was borrowed funds. Deposits were down due primarily to the seasonal nature of non-interest bearing transaction accounts. Management plans to remain competitive in our deposit pricing and anticipates that deposit growth will be the primary source of funding for asset growth during the remainder of the current fiscal year. During the September 30, 2008 quarter, we experienced increased competition for time deposits primarily from financial institutions which reported reduced capital as the result of losses related to subprime lending. These institutions' sources of funding have been reduced due to their reduced capital positions. Management is cognizant of the potential for additional compression in the Bank's margin related to the need to acquire funds and the pace of

interest rate changes. Management will continue to monitor the level of deposits and borrowings in relation to the current interest rate environment.

Growth in our loan portfolio so far this fiscal year has exceeded our expectations. Growth in the Bank's loan portfolio for the September 30, 2008 quarter was primarily in construction, residential first mortgage and home equity loans and lines, offset by a decrease in commercial real estate loans. We anticipate that future loan growth will be primarily in commercial real estate. At September 30, 2008, our assets totaled $490.9 million, including net loans receivable of $458.2 million, compared to total assets of $491.2 million, including net loans receivable of $437.2 million, at March 31, 2008. Construction loans totaled $64.1 million or 13.5%, residential first mortgage loans were $132.4 million or 27.8% and home equity loans and lines were $38.0 million or 8.0% of our total loan portfolio at September 30, 2008 compared to construction loans of $53.9 million or 11.9%, residential first mortgage loans of $122.6 or 27.1%, and home equity loans and lines of $32.8 million or 7.2% at March 31, 2008.

At September 30, 2008, non-performing assets totaled approximately $4.5 million or .92% of assets compared to $1.6 million or .33% of assets at March 31, 2008. Our allowance for loan losses to non-performing assets was 74.0% and to total loans was .73% at September 30, 2008.

During our fiscal year 2008, we evaluated the benefits of the increased yields on our credit card portfolio with the higher risk and operating costs related to maintaining and servicing an unsecured credit card portfolio. We believed that offering a credit card product was important to our existing customer base and for obtaining new customers. As a result of this evaluation, we entered into an agent-bank relationship with an unaffiliated non-bank pursuant to which our customers can obtain credit cards with the Community Bank brand and for which we earn commissions for new accounts and a percentage of interchange fees, but for which we incur no liability or credit risk. At the same time, we sold our existing credit card portfolio to that unaffiliated organization. During the September 30, 2007 quarter, we sold our credit card portfolio with an approximate loan balance of $500,000, which resulted in a gain of $37,000.

Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to deposits or borrowings.

Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more difficult and complex under these difficult market and economic conditions. We also expect to face increased regulation and government oversight as a result of these downward trends. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. We also may be required to pay even higher FDIC premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions have depleted and may continue to deplete the FDIC insurance fund and reduce the FDIC's ratio of reserves to insured deposits.

We do not expect these difficult conditions to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.

The recently enacted Emergency Economic Stabilization Act of 2008 ("EESA") authorizes the U.S. Department of the Treasury ("Treasury Department") to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program ("TARP"). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department has allocated $250 billion towards the TARP Capital Purchase Program ("CPP"). Under the CPP,

Treasury will purchase debt or equity securities from participating institutions. The TARP also will include direct purchases or guarantees of troubled asset of financial institutions. The Company anticipates it will make application to the Treasury Department to participate in this program.

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase is in place until the end of 2009 and is not covered by deposit insurance premiums paid by the banking industry. In addition, the FDIC has implemented two temporary programs to provide deposit insurance for the full amount of most non-interest bearing transaction accounts through the end of 2009 and to guarantee certain unsecured debt of financial institutions and their holding companies through June 2012. Financial institutions have until December 5, 2008 to opt out of these two programs. We expect to participate only in the program that provides unlimited deposit insurance coverage through December 31, 2009 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Under that program, we will pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. At September 30, 2008, we had $1.5 million in such accounts in excess of $250,000.

The purpose of these legislative and regulatory actions is to stabilize the volatility in the U.S. banking system. EESA, TARP and the FDIC's recent regulatory initiatives may not have the desired effect. If the volatility in the market and the economy continue or worsen, our business, financial condition, results of operations, access to funds and the price of our stock could be materially and adversely impacted.

CRITICAL ACCOUNTING POLICIES

General

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard ("SFAS") No.5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance for loan losses is maintained at a level considered by management to be adequate to absorb future loan losses currently inherent in the loan portfolio. Management's assessment of the adequacy of the allowance is based upon type and volume of the loan portfolio, past loan loss experience, existing and anticipated economic conditions, and other factors which deserve current recognition in estimating future loan losses. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Additions to the allowance are charged to operations. Subsequent recoveries, if any, are credited to the allowance. Loans are charged-off partially or wholly at the time management determines collectibility is not probable. Management's assessment of the adequacy of the allowance is subject to evaluation and adjustment by the Company's regulators.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

FINANCIAL CONDITION

The Company's total assets decreased $302,000 to $490.9 million at September 30, 2008 from $491.2 million at March 31, 2008 due to decrease in cash of $2.0 million, interest bearing deposits of $11.6 million and securities available for sale of $8.9 million, offset by an increase in loans receivable of $21.0 million. The increase in loans was funded with an increase in FHLB Advances and borrowings of $8.2 million and decreases in cash of $2.0 million and interest bearing deposits of $11.6 million at September 30, 2008 from March 31, 2008. FHLB Advances increased by $4.0 million and other borrowings increased by $4.2 million. Stockholders' equity decreased $8.6 million to $30.1 million at September 30, 2008, from $38.7 million at March 31, 2008, due to the loss for the six months of $9.5 million and cash dividend payments, offset by the elimination of unrealized losses on securities.

At September 30, 2008, non-performing assets totaled approximately $4.5 million or .92% of assets compared to $1.6 million or .33% of assets at March 31, 2008. Non-performing assets at September 30, 2008 were comprised of repossessed assets of $2.1million and non accrual loans of $2.4 million. Included in the total non-performing assets at September 30, 2008 was one relationship of approximately $2.1 million which includes $1.5 million of residential lots. At September 30, 2008, our allowance for loan losses to non-performing assets was 74.0% and to total loans was .73% compared to 313.3% and .73%, respectively at March 31, 2008. At September 30, 2008 delinquent loans to total loans was 1.38% compared to .86% at March 31, 2008. Based on current market values of the properties securing these loans, management anticipates no significant losses in excess of the allowance for losses previously recorded.

As of June 30, 2008, there were also $6.1 million in loans with respect to which known information about the possible credit problems of the borrowers or the cash flows of the security properties have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing loan categories. These loans are comprised primarily of residential real estate loans. No individual loan in this category has a balance that exceeds $300,000.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of funds are customer deposits, advances from the Federal Home Loan Bank of Atlanta, amortization and prepayment of loans and funds provided from operations. Management maintains investments in liquid assets based upon its assessment of (i) our need for funds, (ii) expected deposit flows, (iii) the yields available on short-term liquid assets, (iv) the liquidity of our loan portfolio and (v) the objectives of our asset/liability management program. Management believes that the Bank will continue to have adequate liquidity for the foreseeable future. Cash flow projections are regularly reviewed and updated to assure that adequate liquidity is provided. As of September 30, 2008, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings and current borrowings) was 3.8%.

The Bank has a line of credit with the FHLB equal to 26% of the Bank's assets, subject to the amount of collateral pledged. Under the terms of its collateral agreement with the FHLB, the Bank provides a blanket lien covering all of its residential first mortgage loans, home equity lines of credit, multi-family loans and commercial loans. In addition, the Bank pledges as collateral its capital stock in and deposits with the FHLB. Based on the collateral pledged as of September 30, 2008, the total amount of borrowing available under the FHLB line of credit was approximately $129,590,000. At September 30, 2008, principal obligations to the FHLB consisted of $72,000,000 in floating-rate, overnight borrowings and $20,000,000 in fixed-rate convertible advances.

The Company had a line of credit with a bank in the amount of $5,000,000 at September 30, 2008 of which $4,000,000 had been drawn on the line.

At September 30, 2008 we had commitments to purchase or originate $21.7 million of loans. Certificates of deposit scheduled to mature in one year or less at September 30, 2008, totaled $215.1 million. Based on our historical experience, management believes that a significant portion of such deposits will remain with us. Management further believes that loan repayments and other sources of funds will be adequate to meet our foreseeable short-term and long-term liquidity needs. At September 30, 2008, we had brokered or internet time deposits of $6.3 million.

The Bank's regulatory capital changed from "well capitalized" at June 30, 2008 to "adequately capitalized" at September 30, 2008 due to the OTTI charge related to its Fannie Mae and Freddie Mac preferred stock. The Company is considering the alternatives to regain the "well capitalized" capital status including participation in the U.S. Treasury Capital Purchase Program. The maximum available under this program is approximately $12.8 million of preferred stock.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2008 and 2007.

General. Net income (loss) for the three months ended September 30, 2008 decreased $11,367,000 or 1,296.3% to ($10,490,000) from $877,000 for the three months ended September 30, 2007. Net interest income increased $205,000, the provision for loan losses increased $383,000, non-interest income decreased $11,061,000 and non-interest expense increased $252,000 during the three months ended September 30, 2008 compared to the same period in 2008. Return on equity for the three months ended September 30, 2008 was (121.6)% compared to 8.96% for the three month period ended September 30, 2008. Return on assets was (8.51)% for quarter ended September 30, 2008 compared to 0.74% for the same period in the previous fiscal year.

Interest Income. Total interest income decreased by $842,000 to $7.3 million for the three months ended September 30, 2008, from $8.2 million for the three months ended September 30, 2008, due to lower yields partially offset by higher average loan balances. Investment securities income decreased by $208,000 due to lower average balances as a result of calls and maturities on securities. Other interest income decreased due to elimination of dividends on FHLMC common and preferred stock and a lower yield on FHLB stock. The decrease in yields was due to lower market interest rates generally. The average yield earned on interest-earning assets was 6.39% for the three months ended September 30, 2008 compared to 7.12% for the three months ended September 30, 2007.

Interest Expense. Total interest expense decreased by $1,047,000 to $3.3 million for the quarter ended September 30, 2008, from $4.4 million for the quarter ended September 30, 2008. Interest on deposits decreased by $486,000 to $2.6 million for the quarter ended September 30, 2008 from $3.1 million for the quarter ended June 30, 2008 due to a decrease in the average rate paid partially offset by higher average deposit balances. Interest expense on borrowed money decreased by $561,000 to $691,000 for the quarter ended September 30, 2008 compared to the quarter ended September 30, 2007. A decrease in the average rate paid on borrowings from 5.23% to 2.65% offset by an increase in the average balance of borrowings from $97.2 million for the September 30, 2007 quarter to $104.5 million for the September 30, 2008 quarter accounted for the decrease. The average rate paid on interest-bearing liabilities was 3.08% during the three months ended September 30, 2008 compared to 3.99% for the three months ended September 30, 2007.

Provision for Loan Losses. The provision for loan losses increased by $383,000 to $601,000 for the three months ended September 30, 2008, from $217,000 for the three months ended September 30, 2007. The amount of the

provision for loan losses for the quarter ended September 30, 2008 was based on management's assessment of the inherent risk associated with the increase in our loan portfolio and the level of our allowance for loan losses. We provide valuation allowances for anticipated losses on loans and real estate when management determines that a significant decline in the value of the collateral or cash flows has occurred, as a result of which the value of the collateral or cash flows is less than the amount of the unpaid principal of the related loan plus estimated costs of acquisition and sale. In addition, we also provide allowances based on the dollar amount and type of collateral securing our loans in order to protect against unanticipated losses. At September 30, 2008, management believes its allowance for loan losses was adequate to absorb any probable losses inherent in the Company's loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to allowances may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.

Noninterest Income. Noninterest income (loss) decreased by $11,061,000 to ($10,205,000) for the three months ended September 30, 2008, from $857,000 for the three months ended September 30, 2007 due primarily to an Other Than Temporary Impairment adjustment on our FHLMC and FNMA available for sale securities of $11,053,000. The Bank has established relationships with other institutions where the Bank receives fees in return for completed customer mortgage loan applications for the institution's approval and funding. We anticipate this relationship will continue to be a source of fee and service charge income for the Bank.

Noninterest Expense. Noninterest expense increased by $252,000 to $3.4 million for the three months ended September 30, 2008 compared to the same period last year. The increase in noninterest expense resulted primarily from compensation related expenses due generally to merit increases, additional loan and retail personnel and federal deposit insurance premiums.

Federal deposit insurance premiums during the three months ended September 30, 2008 totaled $99,000, compared to $10,000 for the same period in 2007. These premiums are expected to increase in 2009 due to recent strains on the Federal Deposit Insurance Corporation ("FDIC") deposit insurance fund due to the cost of large bank failures and increase in the number of troubled banks. The current rates for FDIC assessments have ranged from 5 to 43 basis points, depending on the health of the insured institution. The FDIC has proposed increasing the current deposit insurance assessment rates uniformly for all institutions by 7 basis points (to a range from 12 to 50 basis points) for the first quarter of 2009. The proposed rule would also alter the way the FDIC calculates federal deposit insurance assessment rates beginning in the second quarter of 2009 and thereafter. The FDIC also proposed that it could increase assessment rates in the future without formal rulemaking.

Taxes. Taxes decreased by $124,000 to $289,000 for the three months ended September 30, 2008, from $413,000 for the three months ended September 30, 2007. The effective tax rate increased from 32.0% for the September 30, 2007 quarter to 33.9% for the September 30, 2008 quarter.

Six Months Ended September 30, 2008 and 2007.

General. Net income (loss) for the six months ended September 30, 2008 decreased $7,619,000 or 399.8% compared to $1,906,000 for the six months ended September 30, 2007. Net income for the six months decreased due primarily to an Other Than Temporary Impairment adjustment on our FHLMC and FNMA Available for Sale securities of $11,053,000, an increase in the provision for loan loss and increases in noninterest expense resulting from higher expenses associated with . . .