Management's discussion and analysis ("MD&A") provides supplemental information, which sets forth the major factors that have affected our financial condition and results of operations and should be read in conjunction with the Consolidated Financial Statements and related notes included in the Annual Report on Form 10-K. The MD&A is divided into subsections entitled "Business Overview," "Financial Overview," "Results of Operations," "Financial Condition," "Liquidity and Capital Resources," "Off-Balance Sheet Arrangements," and "Accounting Policies." The following information should provide a better understanding of the major factors and trends that affect our earnings performance and financial condition, and how our performance during 2008 compares with prior years. Throughout this section, Capital City Bank Group, Inc., and its subsidiary, collectively, are referred to as "CCBG," "Company," "we," "us," or "our."

In this MD&A, we present an operating efficiency ratio and an operating net noninterest expense as a percent of average assets ratio, both of which are not calculated based on accounting principles generally accepted in the United States ("GAAP"), but that we believe provide important information regarding our results of operations. Our calculation of the operating efficiency ratio is computed by dividing noninterest expense less intangible amortization and merger expenses, by the sum of tax equivalent net interest income and noninterest income. We calculate our operating net noninterest expense as a percent of average assets by subtracting noninterest expense excluding intangible amortization and merger expenses from noninterest income. Management uses these non-GAAP measures as part of its assessment of its performance in managing noninterest expenses. We believe that excluding intangible amortization and merger expenses in our calculations better reflect our periodic expenses and is more reflective of normalized operations.

Although we believe the above-mentioned non-GAAP financial measures enhance investors' understanding of our business and performance these non-GAAP financial measures should not be considered an alternative to GAAP. In addition, there are material limitations associated with the use of these non-GAAP financial measures such as the risks that readers of our financial statements may disagree as to the appropriateness of items included or excluded in these measures and that our measures may not be directly comparable to other companies that calculate these measures differently. Our management compensates for these limitations by providing detailed reconciliations between GAAP information and the non-GAAP financial measure as detailed below.

Reconciliation of operating efficiency ratio to efficiency ratio:

                                                             For the Years Ended December 31,
                                                           2008              2007           2006
Efficiency ratio                                             68.09 %           70.13 %        68.87 %
Effect of intangible amortization and merger expenses        (3.19 )%          (3.36 )%       (3.45 )%
Operating efficiency ratio                                   64.91 %           66.77 %        65.42 %

Reconciliation of operating net noninterest expense ratio:

                                                          For the Years Ended December 31,
                                                        2008              2007           2006
Net noninterest expense as a percent of average
assets                                                     2.12 %            2.50 %         2.56 %
Effect of intangible amortization and merger
expenses                                                  (0.22 )%          (0.23 )%       (0.24 )%
Operating net noninterest expense as a percent of
average assets                                             1.90 %            2.27 %         2.32 %

This Annual Report on Form 10-K, including this MD&A section, contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among others, statements about our beliefs, plans, objectives, goals, expectations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors, many of which are beyond our control. The words "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan," "target," "goal," and similar expressions are intended to identify forward-looking statements.

All forward-looking statements, by their nature, are subject to risks and uncertainties. Our actual future results may differ materially from those set forth in our forward-looking statements. Please see the Introductory Note and Item 1A Risk Factors of this Annual Report for a discussion of factors that could cause our actual results to differ materially from those in the forward-looking statements.

However, other factors besides those listed in Item 1A Risk Factors or discussed in this Annual Report also could adversely affect our results, and you should not consider any such list of factors to be a complete set of all potential risks or uncertainties. Any forward-looking statements made by us or on our behalf speak only as of the date they are made. We do not undertake to update any forward-looking statement, except as required by applicable law.

BUSINESS OVERVIEW

We are a financial holding company headquartered in Tallahassee, Florida and we are the parent of our wholly-owned subsidiary, Capital City Bank (the "Bank" or "CCB"). The Bank offers a broad array of products and services through a total of 68 full-service offices located in Florida, Georgia, and Alabama. The Bank offers commercial and retail banking services, as well as trust and asset management, retail securities brokerage and data processing services.

Our profitability, like most financial institutions, is dependent to a large extent upon net interest income, which is the difference between the interest received on earning assets, such as loans and securities, and the interest paid on interest-bearing liabilities, principally deposits and borrowings. Results of operations are also affected by the provision for loan losses, operating expenses such as salaries and employee benefits, occupancy and other operating expenses including income taxes, and noninterest income such as service charges on deposit accounts, asset management and trust fees, retail securities brokerage fees, mortgage banking revenues, bank card fees, and data processing revenues.

Our philosophy is to grow and prosper, building long-term relationships based on quality service, high ethical standards, and safe and sound banking practices. We maintain a locally oriented, community-based focus, which is augmented by experienced, centralized support in select specialized areas. Our local market orientation is reflected in our network of banking office locations, experienced community executives with a dedicated President for each market, and community boards which support our focus on responding to local banking needs. We strive to offer a broad array of sophisticated products and to provide quality service by empowering associates to make decisions in their local markets.

Our long-term vision is to continue our expansion, emphasizing a combination of growth in existing markets and acquisitions. Acquisitions will continue to be focused on a three state area including Florida, Georgia, and Alabama with a particular focus on financial institutions, which are $100 million to $400 million in asset size and generally located on the outskirts of major metropolitan areas. Five markets have been identified, four in Florida and one in Georgia, in which management will proactively pursue expansion opportunities. These markets include Alachua, Marion, and Hernando and Pasco counties in Florida and the western panhandle in Florida and Bibb and surrounding counties in central Georgia. We continue to evaluate de novo expansion opportunities in attractive new markets in the event that acquisition opportunities are not feasible. Other expansion opportunities that will be evaluated include asset management and mortgage banking.

Recent Market Developments

The global and U.S. economies are experiencing significantly reduced business activity as a result of, among other factors, disruptions in the financial system in the past year. In fact, the National Bureau of Economic Research announced that the U.S. had entered into a recession in December 2007. Dramatic declines in the housing market during the past year, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, as well as other areas of the credit market, including investment grade and non-investment grade corporate debt, convertible securities, emerging market debt and equity, and leveraged loans, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail.

The magnitude of these declines led to a crisis of confidence in the financial sector as a result of concerns about the capital base and viability of certain financial institutions. During this period, interbank lending and commercial paper borrowing fell sharply, precipitating a credit freeze for both institutional and individual borrowers. This market turmoil and tightening of credit have led to an increased level of consumer and commercial delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has, in some cases, adversely affected the financial services industry.

Over the course of the past year, the landscape of the U.S. financial services industry changed dramatically, especially during the fourth quarter of 2008. Lehman Brothers Holdings Inc. declared bankruptcy and many major U.S. financial institutions consolidated were forced to merge or were put into conservatorship by the U.S. Federal Government, including The Bear Stearns Companies, Inc., Wachovia Corporation, Washington Mutual, Inc., Federal Home Loan Mortgage Corporation ("Freddie Mac") and Federal National Mortgage Association ("Fannie Mae"). In addition, the U.S. Federal Government provided a sizable loan to American International Group Inc. ("AIG") in exchange for an equity interest in AIG.

Much of our lending operations are in the State of Florida, which has been particularly hard hit in the current U.S. recession. Evidence of the economic downturn in Florida is reflected in current unemployment statistics. The Florida unemployment rate at the end of 2008 increased to 8.1% from 4.7% at the end of 2007, reaching the highest level since September 1992. A worsening of the economic condition in Florida would likely exacerbate the adverse effects of these difficult market conditions on our customers, which may have a negative impact on our financial results.

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the "EESA") was signed into law. Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, the Secretary of the Department of the Treasury announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Troubled Asset Relief Program Capital Purchase Program (the "TARP Capital Purchase Program"), from the $700 billion authorized by the EESA, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock.
In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment.
Participating financial institutions were required to adopt the Treasury's standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. On November 13, 2008, we announced that we would not apply for funds available through the TARP Capital Purchase Program.

On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program ("TLG Program"). The TLG Program was announced by the FDIC on October 14, 2008 as an initiative to counter the system-wide crisis in the nation's financial sector. Under the TLG Program the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009 and (ii) provide full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, Negotiable Order of Withdrawal ("NOW") accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts ("IOLTA") accounts held at participating FDIC insured institutions through December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is 10 basis points per quarter on amounts in covered accounts exceeding $250,000. On December 12, 2008, we announced that we would participate in both guarantee programs.

FINANCIAL OVERVIEW

A summary overview of our financial performance for 2008 versus 2007 is provided below.

2008 Financial Performance Highlights -

· In 2008, we earned $15.2 million, or $0.89 per diluted share, compared to $29.7 million, or $1.66 per diluted share in 2007, decreases of 48.7% and 46.4%, respectively. For the year, turbulent economic and market conditions and an associated increase in the provision for loan losses and the level of nonperforming assets significantly impacted our earnings performance.

· Tax equivalent net interest income fell $3.3 million, or 2.9%, over 2007 due primarily to a higher level of foregone interest associated with an increased level of nonperforming assets which drove compression in our net interest margin of 29 basis points.

· Noninterest income increased $7.7 million, or 13.0%, from 2007 due primarily to a $6.25 million gain from the sale of a portion of our merchant services portfolio ($0.22 per share) and a $2.4 million gain from the redemption of Visa shares ($0.09) related to their initial public offering. Lower asset management revenues (trust fees and retail brokerage fees) and mortgage banking revenues, all related to weak economic conditions and turbulent market conditions during 2008 partially offset the aforementioned gains.

· Noninterest expense declined $0.5 million, or 0.43%, reflecting the impact of the $1.9 million Visa litigation charge in the fourth quarter of 2007 and the reversal of $1.1 million in Visa litigation reserves in the first quarter of 2008. Higher operating expenses primarily for salaries, legal fees and other real estate owned, partially offset the aforementioned favorable variance related to our Visa litigation reserve. The higher level of legal fees and other real estate owned expense was driven by legal support needed for loan workout/resolution and holding costs related to foreclosed properties.

· Loan loss provision increased $26.3 million ($0.95 per share) in 2008 driven primarily by a higher level of required reserves for our consumer and our residential real estate loan portfolios, generally reflective of weak economic conditions and stress in our residential real estate markets. Net loan charge-offs for 2008 were 71 basis points of average loans compared to 27 basis points in 2007. At year-end 2008, the allowance for loan losses was 1.89% of outstanding loans (net of overdrafts) and provided coverage of 38% of nonperforming loans.

· Share repurchase activity continued in 2008 with 90,041 shares being purchased during the year compared to 1,404,364 shares being repurchased during 2007. We remain well-capitalized with a risk based capital ratio of 14.69% and a tangible capital ratio of 7.76%.

RESULTS OF OPERATIONS

Net income for 2008 totaled $15.2 million ($0.89 per diluted share) compared to $29.7 million ($1.66 per diluted share) in 2007 and $33.3 million ($1.79 per diluted share) in 2006. Earnings per share reflect the repurchase of 90,041 common shares during 2008, 1,404,364 common shares during 2007, and 164,596 common shares during 2006.

The reduction in earnings in 2008 of $14.5 million, or $0.77 per diluted share, is primarily due to lower net interest income of $3.4 million, a higher loan loss provision of $26.3 million, partially offset by a $6.25 million gain from the sale of a portion of the bank's merchant services portfolio and a $2.4 million gain from the redemption of Visa Inc. shares related to its initial public offering. Our 2007 earnings include a $1.9 million charge to reserve for Visa litigation and our 2008 earnings include the reversal of $1.1 million of our Visa litigation reserve.

The earnings decline in 2007 of $3.6 million, or $0.13 per diluted share, reflects lower operating revenues (defined as the total of net interest income and noninterest income) of $3.2 million, an increase in the loan loss provision of $4.2 million, and slightly higher noninterest expense of $0.4 million, partially offset by lower income taxes of $4.2 million.

A condensed earnings summary for the last three years is presented in Table 1 below:

Table 1
CONDENSED SUMMARY OF EARNINGS

                                                          For the Years Ended December 31,
(Dollars in Thousands, Except Per Share Data)            2008             2007          2006
Interest Income                                       $   142,866       $ 165,323     $ 165,893
Taxable Equivalent Adjustments                              2,482           2,420         1,812
Total Interest Income (FTE)                               145,348         167,743       167,705
Interest Expense                                           34,000          53,082        46,757
Net Interest Income (FTE)                                 111,348         114,661       120,948
Provision for Loan Losses                                  32,496           6,163         1,959
Taxable Equivalent Adjustments                              2,482           2,420         1,812
Net Interest Income After Provision for Loan Losses        76,370         106,078       117,177
Noninterest Income                                         67,040          59,300        55,577
Noninterest Expense                                       121,472         121,992       121,568
Income Before Income Taxes                                 21,938          43,386        51,186
Income Taxes                                                6,713          13,703        17,921
Net Income                                            $    15,225       $  29,683     $  33,265

Basic Net Income Per Share                            $      0.89       $    1.66     $    1.79
Diluted Net Income Per Share                          $      0.89       $    1.66     $    1.79

Net Interest Income

Net interest income represents our single largest source of earnings and is equal to interest income and fees generated by earning assets, less interest expense paid on interest bearing liabilities. We provide an analysis of our net interest income, including average yields and rates in Tables 2 and 3. We provide this information on a "taxable equivalent" basis to reflect the tax-exempt status of income earned on certain loans and investments, the majority of which are state and local government debt obligations.

In 2008, our taxable equivalent net interest income decreased $3.4 million, or 2.9%. This follows a decrease of $6.3 million, or 5.2%, in 2007, and an increase of $9.7 million, or 8.8%, in 2006. The decrease in our taxable equivalent net interest income in 2008 resulted from a higher level of foregone interest associated with the increased level of nonperforming assets and a decline in loan fees, partially offset by the lower costs of funds for deposits.

For the year 2008, taxable equivalent interest income declined $22.5 million, or 13.4% from 2007 and was constant for the periods in 2007 and 2006. Taxable equivalent interest income was unfavorably impacted by the lower rate environment in 2008 as compared to 2007, the higher level of foregone interest on non-performing loans and a decline in loan fees, all of which resulted in lower yields on our earning assets during 2008. These factors produced a 120 basis point decline in the yield on earning assets, which decreased from 7.68% in 2007 to 6.48% for 2008. This compares to a 26 basis point improvement in 2007 over 2006. Interest income is expected to decline further during 2009, reflecting the lower interest rate environment stemming from reductions in the Federal Reserve's target rate throughout the year and the continued impact of foregone interest income associated with the current level of nonperforming assets.

Interest expense decreased $19.1 million, or 36.0%, from 2007, and $6.3 million, or 13.5%, in 2007 over 2006. The decrease was experienced in interest on deposits and short-term borrowings, primarily as a result of lower average interest rates in 2008 and a favorable shift in the deposit mix. Management responded aggressively to the reductions in the Federal Reserve's target rate, which began in September 2007, and believe we have successfully neutralized the overall impact of the rate reductions by aggressively lowering our deposit rates.

The average rate paid on interest bearing liabilities in 2008 decreased 123 basis points compared to 2007, reflecting the factors mentioned above. Interest expense is expected to trend downward in 2009 driven by the lower rate environment, offset partially by a continued shift to higher yielding deposits.

Our interest rate spread (defined as the taxable equivalent yield on average earning assets less the average rate paid on interest bearing liabilities) increased 2 basis points in 2008 compared to 2007 and decreased 13 basis points in 2007 compared to 2006. The increase in 2008 was primarily attributable to the rapid repricing of our deposit base, which more than offset the adverse impact of lower rates and higher foregone interest.

Our net interest margin (defined as taxable equivalent interest income less interest expense divided by average earning assets) was 4.96% in 2008, compared to 5.25% in 2007 and 5.35% in 2006. In 2008, the decline was a result of a 120 basis point decrease in the yield on earning assets, partially offset by a 91 basis point decrease in the cost of funds. Year over year, the increase in foregone interest coupled with maintaining a higher level of municipal deposits, which produce relatively thin spreads, led to the compression in our net interest margin of 29 basis points.

During 2008, the Federal Reserve reduced the federal funds rate by 400 basis points. Capital City Bank benefited from the influx of NOW deposits, primarily during the first half of 2008, attributable to transfers from the Florida State Board of Administration's Local Government Investment Pool. These new deposits were in the form of negotiated public deposits and resulted in a significant increase in the bank's NOW accounts. These public funds declined throughout the second half of 2008. Overall, by aggressively lowering deposit interest rates, management believes we have been fairly successful in neutralizing the impact of the Federal Reserve's interest rate reductions. While the higher cost public funds have been priced to produce a positive interest rate spread and will add to net interest income, the margin on these accounts are thin, and therefore, due to the volume of these new deposits, we have experienced an adverse impact on our net interest margin percentage.

Table 2
AVERAGE BALANCES AND INTEREST RATES

                                    2008                               2007                               2006
(Taxable Equivalent
Basis - Dollars in
Thousands)              Balance     Interest     Rate      Balance     Interest     Rate      Balance     Interest     Rate
ASSETS
Loans, Net of
Unearned
Interest(1)(2)        $ 1,918,417   $ 133,457     6.96 % $ 1,934,850   $ 155,434     8.03 % $ 2,029,397   $ 157,227     7.75 %
Taxable Investment
Securities                 93,149       3,889     5.04       103,840       4,949     4.76       112,392       4,851     4.31
Tax-Exempt
Investment
Securities(2)              97,010       4,893     4.16        84,849       4,447     5.24        74,634       3,588     4.81
Funds Sold                132,073       3,109     2.32        59,989       2,913     4.79        41,854       2,039     4.81
Total Earning
Assets                  2,240,649     145,348     6.48 %   2,183,528     167,743     7.68 %   2,258,277     167,705     7.42 %
Cash & Due From
Banks                      82,410                             86,692                            100,237
Allowance for Loan
Losses                    (23,015 )                          (17,535 )                          (17,486 )
Other Assets              267,861                            254,532                            240,050
TOTAL ASSETS          $ 2,567,905                        $ 2,507,217                        $ 2,581,078

LIABILITIES
NOW Accounts          $   743,327   $   7,454     1.00 % $  $557,060   $  10,748     1.93 % $   518,671   $   7,658     1.48 %
Money Market
Accounts                  374,278       5,242     1.40       397,193      13,667     3.44       370,257      11,687     3.16
. . .