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. For example, we may use historical loss factors as one of the many factors and estimates utilized in determining the inherent losses that may be present in our loan portfolio. Actual losses could differ substantially from the historical factors that we use. 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. A summary of the significant accounting policies of the Company is set forth in Note 1 to the Company's consolidated financial statements.

Allowance for loan losses: The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. 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 Bank will be unable to collect all amounts 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 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.

Use of Certain Non-GAAP Financial Measures

In addition to results presented in accordance with United States generally accepted accounting principles (GAAP), we have presented certain non-GAAP financial measures for the three and nine month periods ended September 30, 2008 throughout this Form-10Q, which are reconciled to GAAP financial measures below. We believe these non-GAAP financial measures provide information useful to investors in understanding the Company's performance trends and facilitate comparisons with its peers. Specifically, we believe the exclusion of the write-down of other than temporary impairment of securities in a single accounting period permits a comparison of results for ongoing business operations. Further, we believe that including the federal income tax effect of these losses in the current period indicates the net impact of these losses in the period incurred. It is on this basis that we assess the Company's performance for 2008 and establish goals for future periods. Although we believe the non-GAAP financial measures presented in this Form 10-Q enhance investors' understandings of the Company's performance, these non-GAAP financial measures should not be considered a substitute for GAAP financial measures.

                                                 For the Three Months        For the Nine Months
                                                  Ended September 30,        Ended September 30,
(Dollars in thousands, except for per     **      2008          2007         2008          2007
share data)
Net Income and Earnings Per Share
   Net income (loss) (GAAP)                 A   $(16,894)       $ 1,107    $(15,089)       $ 2,979
   Loss on write-down of other than
   temporary impairment of securities (1)          17,513             -       17,513             -
   Net income excluding write-down          B       $ 619       $ 1,107      $ 2,424       $ 2,979

   Net income (loss) (GAAP)                     $(16,894)       $ 1,107    $(15,089)       $ 2,979
   Income tax effect if loss on
   write-down of other than temporary
   impairment of securities was fully tax
   deductible                                       5,732             -        5,732             -
   Net income (loss) including full tax
   deductibility of loss on write-down      E   $(11,162)       $ 1,107    $ (9,357)       $ 2,979

   Weighted average shares-basic (GAAP)     C   2,581,760     2,556,772    2,576,578     2,551,283
   Weighted average shares-assuming             2,581,760     2,587,388    2,576,578     2,581,126
   dilution (GAAP)                          D
   Earnings per share-basic GAAP           A/C   $ (6.56)        $ 0.44     $ (5.86)        $ 1.17
   Excluding loss on write-down of other
   than temporary impairment of
   securities                              B/C     $ 0.24        $ 0.44       $ 0.94        $ 1.17
   Including loss as a deduction for
   federal income tax purposes             E/C   $ (4.32)        $ 0.44     $ (3.63)        $ 1.17
   Earnings per share-assuming dilution
   GAAP                                    A/D   $ (6.56)        $ 0.42     $ (5.86)        $ 1.15
   Excluding loss on write-down of other
   than temporary impairment of
   securities                              B/D     $ 0.24        $ 0.42       $ 0.94        $ 1.15
   Including loss as a deduction for
   federal income tax purposes             E/D   $ (4.32)        $ 0.42     $ (3.63)        $ 1.15

The following discussion is intended to assist in understanding the results of operations and financial condition of the Company. This discussion should be read in conjunction with the accompanying consolidated financial statements.

The Bank began investing in the preferred stocks of the Federal Home Loan Mortgage Association (Freddie Mac, FHLMC) and the Federal National Mortgage Association (Fannie Mae, FNMA) in 1998 and continued through 2003. Two of these purchases were called in 2007 and replaced with newer issuances at that time. The total book value of the accumulated shares was approximately $17.8 million. When these entities were taken into conservatorship by the Federal Housing Finance Agency on September 7, 2008, the Company and Bank had ten years of experience in holding these securities. Dividends had always been paid on time. The yield on these securities was enhanced by the fact that the dividends qualified for the 70 percent dividend exclusion for federal income tax purposes. Market value fluctuations during this holding period as the result of changing interest rates over time were the only negative aspects of this investment prior to September 7, 2008. The suspension of dividends and the concern over these Government Sponsored Entities' (GSE's) ability to return to private ownership sent the price of these shares plummeting. As of September 30, 2008, the Bank wrote down the book value of these shares by $16,815,786. Similarly, a much smaller holding of Freddie Mac shares purchased in 2000 and held in the parent company was written down by $42,400. On September 15, 2008, Lehman Brothers, an investment firm founded in 1850, filed for bankruptcy protection. A $1 million 6.5% corporate bond issued by Lehman in 2007 and purchased by the Bank at that time was written off entirely at a book value of $992,662 at September 30, 2008. The results of these events and the effects these and other events have had on the global economy have caused the Company to report a loss for the first time in 35 years.

For the quarter ended September 30, 2008, the Company reported a loss of $16,893,841 or ($6.56) per both basic and diluted shares. This compares to earnings of $1,106,514 in the quarter ended September 30, 2007, or $.42 per diluted share and $.44 per basic share. For the nine month period in 2008, the loss was $15,088,759 or ($5.86) per both basic and diluted shares compared to $2,979,172 in earnings and $1.15 and $1.17 per share respectively in 2007. While these losses in the third quarter were substantial and would be in any reporting period, a portion of this loss is expected to be recouped during the fourth quarter of 2008 as described below.

Preferred stocks are considered to be capital assets for federal income tax purposes. Losses on capital assets can only be offset against capital gains on corporate tax returns. Banks are limited by federal regulations as to the types of investment instruments they can purchase. Therefore, the Company did not expect to incur capital gains sufficient to offset a significant portion of its GSE losses. The Emergency Economic Stability Act was passed and signed into law on October 3, 2008. Included in this legislation was a provision which allows qualified financial institutions to deduct the GSE losses as ordinary rather than capital losses. Due to the fact that the law was not enacted in the third quarter, Generally Accepted Accounting Principles (GAAP) precludes including the effect of this legislation in the third quarter financial results. However, in the fourth quarter of 2008, a reduction in the income tax provision and a similar deferred tax asset in the amount of approximately $5.73 million will be recorded. Had this tax effect been included in the third quarter results, the loss for the quarter would have been $11.1 million or ($4.32) per both basic and diluted shares while the loss for the nine months would have been reduced to ($3.63) for both basic and diluted shares.

Excluding the loss on the write-down of securities, net income for the quarter ended September 30, 2008 was $619,504 or $.24 per both basic and diluted shares. This compares to net income of $1,106,514 or $.44 and $.42 per share, respectively in the third quarter of 2007. This decline in net income of $487,010 or 44.0 percent, excluding the loss on the write-down of securities, is the result of a

All per share data reported herein, has been adjusted to reflect the effect of the 5 percent stock dividend paid to stockholders on June 13, 2008.

Net Interest Income. The Company's net interest income was $3,563,609 in the third quarter of 2008, compared to $3,842,591 for the third quarter of 2007, a decrease of $278,982 or 7.3 percent. This decrease is primarily the result of the effect of shrinking interest margins. The net interest margin for the third quarter of 2008 was 3.09 percent compared to 3.72 percent in 2007. Average earning assets were $479.3 million at September 30, 2008, an increase of $47.9 million from $431.4 million one year earlier. However, the tax-equivalent yield on these assets dropped to 6.21 percent in 2008 from 7.45 percent in 2007 resulting in a decrease of $558,506 in total interest income. Interest expense also decreased as the yield on interest-bearing liabilities decreased to 3.53 percent in 2008 compared to 4.26 percent in 2007 resulting in a decrease of $279,524 in total interest expense. This decrease in total interest expense occurred in spite of an increase in average interest-bearing liabilities of $46.3 million or 12.3 percent to $423.9 million in 2008 compared to $377.6 million in 2007. The changes in average interest-bearing liabilities were in interest-bearing deposits, down $13.6 million or 4.1 percent; FHLB advances up $24.4 million or 69.8 percent; federal funds purchased up $3.4 million or 65.3 percent; and repurchase agreements up $32.0 million or 1,887.5 percent. These additional funds were utilized to fund loan growth, the average of which was up $52.2 million or 21.3 percent.

For the nine month period ended September 30, 2008, net interest income totaled $11,072,965, a slight increase of 0.15 percent or $17,127 compared to $11,055,838 for the same period in 2007. The net interest margin for the 2008 period was 3.26 percent compared to 3.64 percent in 2007, a decrease of 10.2 percent. Interest and fees on loans increased $549,542 or3.9 percent as the volume of loans increased $48.7 million, or 19.6 percent, from September 30, 2007 to September 30, 2008. This increase was offset by a $54,417 decrease in interest on securities and a $511,191 decrease in interest on federal funds sold. Combined, total interest income was down $16,078 or .07 percent. Total interest expense decreased .29 percent as interest on deposits decreased $1,032,071 or 10.3 percent as the volume of deposits decreased 6.5 percent. Interest on borrowings increased $998,868, or 63.6 percent as short-term borrowings have been utilized to fund the growth in loans.

The net interest margin is a measure of net interest income performance. It represents the difference between interest income, including net loan fees earned, and interest expense, reflected as a percentage of average interest earning assets. The Company's tax equivalent net interest margin decreased in each of the periods reported, to 3.09 percent from 3.72 percent in the third quarter of 2008 and to 3.26 percent from 3.64 percent in the year to date period. The Company continues to be asset sensitive, although less so than in the past, as many of its loans are tied to prime or other indices and have repriced down faster than the interest rates on its deposits and other funding sources resulting in compression of the net interest margin. The Company has been successful in allowing the higher rate retail deposits to run off and replacing this funding source with variable rate overnight borrowings, which will more closely match the future changes in the prime rate, thereby minimizing the extent of margin compression.

Average interest earning assets totaled $479.3 million in the third quarter of 2008, an increase of $47.9 million or 11.1 percent from $431.4 million in the third quarter of 2007. During the third quarter of

The following table sets forth the Company's average interest earning assets (on a taxable equivalent basis) and average interest bearing liabilities, the average yields earned on such assets and rates paid on such liabilities, and the net interest margin, for the periods indicated.

                                                      Three Months ended          Three Months ended
                                                      September 30, 2008          September 30, 2007
                                                    Average           Yield/    Average           Yield/
                                                    Balance  Interest  Rate     Balance  Interest  Rate
Interest-earning assets:                                         ($ amounts in thousands)
Federal funds sold                                      $ 32      $ -  1.80%       $ 372      $ 5  5.38%
Securities:
U. S. government agencies and corporations            96,815    1,301  5.38%     107,785    1,466  5.44%
States and political subdivisions                     16,920      274  6.48%      19,126      308  6.44%
Other securities                                      71,358      989  5.54%      62,118    1,067  6.87%
Total securities                                     185,093    2,564  5.54%     189,029    2,841  6.01%
Loans                                                294,170    4,875  6.63%     242,005    5,191  8.58%
Total interest-earning assets                        479,295  $ 7,439  6.21%     431,406  $ 8,037  7.45%
Allowance for loan losses                            (3,473)                     (2,828)
Cash and other non interest-earning assets            21,497                      32,239
Total Assets                                       $ 497,319                   $ 460,817

Interest-bearing liabilities:
Deposits:
Interest bearing demand and MMDA                    $ 64,734    $ 300  1.85%    $ 60,157    $ 341  2.27%
Savings                                               31,960      121  1.51%      33,704      127  1.51%
Other time                                           220,151    2,421  4.40%     236,580    2,975  5.03%
Total deposits                                       316,845    2,842  3.59%     330,441    3,443  4.17%

Fed funds purchased and securities sold under REPO    42,408      260  2.45%       6,964       85  3.32%
FHLB Term advances                                    45,000      478  4.25%      35,000      388  4.43%
FHLB Overnight advances                               14,445       89  2.46%           -        -      -
Loan payable                                              76        1  5.26%           -        -      -
Capital trust preferred securities                     5,155       72  5.59%       5,155      105  8.15%
Total borrowings                                     107,084      900  3.36%      47,119      578  4.91%
Total interest-bearing liabilities                   423,929    3,742  3.53%     377,560    4,021  4.26%
Demand deposits                                       40,463                      43,396
Other non interest bearing liabilities                 3,173                       2,729
Total Liabilities                                    467,565                     423,685
Stockholders' Equity                                  29,754                      37,132
Total Liabilities and Stockholders' Equity         $ 497,319                   $ 460,817
Net interest spread                                           $ 3,697  2.68%              $ 4,016  3.19%
Net interest margin                                                    3.09%                       3.72%

                                                       Nine Months ended           Nine Months ended
                                                      September 30, 2008          September 30, 2007
                                                    Average           Yield/    Average           Yield/
                                                    Balance  Interest  Rate     Balance  Interest  Rate
Interest earning assets:                                         ($ amounts in thousands)
Federal funds sold                                      $ 88      $ 2  2.43%    $ 13,005    $ 513  5.26%
Securities:
 U. S. government agencies and corporations           99,024    4,019  5.41%     105,574    4,280  5.41%
 States and political subdivisions                    18,382      886  6.43%      19,947      961  6.42%
 Other securities                                     72,322    3,406  6.28%      61,017    3,157  6.90%
Total securities                                     189,728    8,311  5.84%     186,538    8,398  6.00%
Loans                                                282,984   14,863  7.00%     224,930   14,300  8.48%
  Total interest-earning assets                      472,800 $ 23,176  6.54%     424,473 $ 23,211  7.29%
Allowance for loan losses                            (3,220)                     (2,854)
Cash and other non-interest earning assets            26,748                      32,984
Total Assets                                       $ 496,328                   $ 454,603

Interest bearing liabilities:
Deposits:
 Interest bearing demand and MMDA                   $ 62,414    $ 860  1.84%    $ 59,659    $ 993  2.22%
 Savings                                              32,213      364  1.51%      34,554      388  1.50%
 Other time                                          226,930    7,811  4.59%     234,105    8,686  4.95%
  Total deposits                                     321,557    9,035  3.75%     328,318   10,067  4.09%

Fed funds purchased and securities sold under REPO    34,724      710  2.73%       2,736       99  4.82%
FHLB Term advances                                    45,000    1,389  4.12%      35,000    1,161  4.42%
FHLB Overnight advances                               11,755      231  2.62%           -        -      -
Loan payable                                              26        1  5.13%           -        -      -
Capital trust preferred securities                     5,155      239  6.18%       5,155      311  8.04%
  Total borrowings                                    96,660    2,570  3.55%      42,891    1,571  4.88%
  Total interest-bearing liabilities                 418,217   11,605  3.70%     371,209   11,638  4.18%
Demand deposits                                       40,564                      43,319
Other non interest bearing liabilities                 3,084                       2,529
Total Liabilities                                    461,865                     417,057
Stockholder's Equity                                  34,463                      37,546
Total Liabilities and Stockholder's Equity         $ 496,328                   $ 454,603
Net interest spread                                          $ 11,571  2.84%             $ 11,573  3.11%
Net interest margin                                                    3.26%                       3.64%

Non-Interest Income. The Company's non-interest income for the third quarter of 2008 was $889,814, an increase of $9,594 or 1.1 percent from $880,220 in the same period of 2007. Deposit fees and charges decreased 5.2 percent or $26,392 to $477,632 as the number of overdraft fees decreased. Securities gains increased $39,153 or 224.9 percent to $21,747, due largely to the increase in the number of agency securities called at par that had been purchased at a discount and despite accretion were still carried at a book value below par resulting in a gain when called by the issuer. Income recognized on the increase in cash surrender value of life insurance decreased 23.4 percent or $29,342 to $95,670. Secondary market mortgage loan fees increased $14,983 or 197.6 percent to $22,564 as the majority of

Year to date 2008 non-interest income totaled $2,685,271, an increase of $163,754 or 6.5 percent when compared to $2,521,517 in the first nine months of 2007. The categories with the most significant year to date increases or decreases were deposit fees and charges, up 5.7 percent; secondary market mortgage fees, down 43.9 percent due to the slow down in the housing market; net gains on sales of securities was up 2,680.9 percent due to a higher volume of sales as well as a higher volume of calls at par of agency securities originally purchased at a discount; other income was down 6.8 percent largely due to lower earnings from an investment in a title company which was negatively affected by the slowdown in mortgage loan originations.

Non-Interest Expenses. Total non-interest expense for the third quarter of 2008 was $21,243,584, an increase of $17,931,134 compared to $3,312,450 in the comparable period in 2007. Excluding the write-down of securities previously discussed of $17,850,850, non-interest expenses were $3,392,734, an increase of $80,284, or 2.4 percent as cost control and efficiency continue to be stressed by the Company wherever possible and practicable. Salaries and benefits totaled $1,894,439, a decrease of $53,054 or 2.7 percent compared to $1,947,493 in third quarter 2007. The decrease reflects lower staffing levels offsetting a portion of the impact of normal annual increases combined with lower benefit accruals. Legal and professional fees totaled $67,300, a decline of $22,624 or 25.2 percent from the third quarter of last year's total of $89,924 largely due to the absence of consulting fees related to compliance with Section 404 of the . . .