The following discussion and analysis is intended to aid the reader in understanding and evaluating the results of operations and financial condition of the Company and its consolidated subsidiaries. As described above, the Trusts are not consolidated with the financial statements of the Company pursuant to the provisions of FIN 46R. This discussion is designed to provide more comprehensive information about the major components of the Company's results of operations and financial condition, liquidity, and capital resources than can be obtained from reading the financial statements alone. This discussion should be read in conjunction with, and is qualified in its entirety by reference to, the Company's consolidated financial statements, including the related notes thereto presented elsewhere in this report.

Overview

Capital Bank is a full-service state chartered community bank conducting business throughout North Carolina. The Bank operates through four North Carolina regions: Triangle, Sandhills, Triad and Western. The Bank was incorporated on May 30, 1997 and opened its first branch in June of that same year in Raleigh. In 1999, the shareholders of the Bank approved the reorganization of the Bank into a bank holding company. In 2001, the Company received approval to become a financial holding company. As of December 31, 2008, the Company conducted no business other than holding stock in the Bank and each of the Trusts.

The Bank's business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans, single-family residential mortgage loans and home equity lines. As a community bank, the Bank's profitability depends primarily upon its levels of net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The Bank's profitability is also affected by its provision for loan losses, noninterest income and other operating expenses. Noninterest income primarily consists of service charges and ATM fees, fees generated from originating mortgage loans that are sold, commission income generated from brokerage activity, and the increase in cash surrender value of bank-owned life insurance. Operating expenses primarily consist of compensation and benefits, occupancy related expenses, advertising, data processing, professional fees, telecommunication and other non-interest expenses.

The Bank's operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The Bank's cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. Lending activities are affected by the demand for financing, which in turn is affected by the prevailing interest rates.

The banking industry, including the Company, is operating in a challenging and volatile economic environment. The effects of the downturn in the housing market have adversely impacted credit markets, consumer confidence and the broader economy. Along with other financial institutions, the Company's stock price has suffered as a result. Management cannot predict when these market difficulties will subside. While the current economic downturn and the difficulties it presents for the Company and others in the banking industry are unprecedented, management believes that the business is cyclical and must be viewed and measured over time. The Company's primary focus at this time is to manage the business safely during the economic downturn and be poised to take advantage of any market opportunities that may arise.

Because of the current economic situation, U.S. and foreign governments have acted in attempt to stabilize the financial system. For example, the U.S. government enacted the EESA, which, among other things, authorized the U.S. Treasury Department to establish the TARP, of which the TCPP is a part. Under the TCPP, certain U.S. financial institutions may sell senior preferred stock and issue warrants to purchase an institution's common stock to the Treasury in exchange for a capital infusion. See "Capital Resources" below for a more detailed discussion of the Company's participation in the TCPP. It is not clear at this time what impact these measures will have on the on the Company or the financial markets as a whole. Management will continue to monitor the effects of these programs as they relate to the Company and its financial operations.

Non-GAAP Financial Measures

Included within this management discussion and analysis section, management presents earnings and earnings per common share excluding a goodwill impairment charge recorded in 2008. The goodwill impairment charge is included in financial results presented in accordance with U.S. GAAP. The Company believes the exclusion of the goodwill impairment charge in expressing earnings and earnings per common share in 2008 provides a meaningful base for period-to-period comparison, which management believes will assist investors in analyzing the operating results of the Company and predicting future performance. These non-GAAP financial measures are also used by management to assess the performance of the Company's business, because management does not consider the goodwill impairment charge to be relevant to ongoing operating results. These non-GAAP financial measures do not impact any balances presented for the years ended December 31, 2007 and 2006.

The following table represents a "GAAP to Non-GAAP Reconciliation" of the net loss for the year ended December 31, 2008 on a GAAP basis to earnings excluding the goodwill impairment charge, which is a non-GAAP financial measure.

                                                                Year Ended
                                                             December 31, 2008
  (Dollars in thousands)

  Net loss (GAAP)                                           $           (55,684 )
  Goodwill impairment charge                                             65,191
  Reduction in deferred taxes                                            (3,180 )
  Net income before goodwill impairment charge (Non-GAAP)   $             6,327

The following table represents a "GAAP to Non-GAAP Reconciliation" of the loss per share for the year ended December 31, 2008 on a GAAP basis to earnings per share excluding the goodwill impairment charge, which is a non-GAAP financial measure. Because of the net loss attributable to common shareholders in 2008, the GAAP earnings per common share calculation excludes potential shares, such as stock options and stock warrants, since the effect of those potential shares would have been antidilutive to the per share amounts.

                                                               GAAP          Non-GAAP
(Dollars in thousands except share data)

Net (loss) income                                          $    (55,684 )  $      6,327
Dividends and accretion on preferred stock                          124             124
Net (loss) income attributable to common shareholders           (55,808 )         6,203

Shares used in the computation of (loss) earnings per
share:
Weighted average number of shares outstanding - basic        11,302,769      11,302,769
Incremental shares from assumed exercise of stock
options and warrants                                                  -         122,798
Weighted average number of shares outstanding - diluted      11,302,769      11,425,567

(Loss) earnings per common share - basic                   $      (4.94 )  $       0.55
(Loss) earnings per common share - diluted                 $      (4.94 )  $       0.54

Critical Accounting Policies and Estimates

The following discussion and analysis of the Company's financial condition and results of operations are based on the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). The preparation of these financial statements requires the Company to make estimates and judgments regarding uncertainties that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to the allowance for loan losses, investment and intangible asset values, income taxes, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. However, because future events and their effects cannot be determined with certainty, actual results may differ from these estimates under different assumptions or conditions, and the Company may be exposed to gains or losses that could be material.

The Company's significant accounting policies are discussed below and in Item 8. Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements - Note 1. Summary of Significant Accounting Policies. Management believes that the following accounting policies are the most critical to aid in fully understanding and evaluating the Company's reported financial results, and they require management's most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and related disclosures with the Audit Committee of the Board of Directors.

• Allowance for Loan Losses - The Company records an estimated allowance for loan losses based on known problem loans and estimated risk in the existing loan portfolio. The allowance calculation takes into account historical write-off trends and current market and economic conditions. If economic conditions were to decline significantly or the financial condition of the Bank's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional increases to the allowance may be required.

• Investments - The Company records an investment impairment charge when it believes an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions and associated market values of investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment's current carrying value, thereby possibly requiring an impairment charge in the future.

• Valuation Allowances - The Company assesses the need to record a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. The Company considers anticipated future taxable income and ongoing prudent and feasible tax planning strategies in determining the need for the valuation allowance which, at this time, it deems not to be necessary. In the event the Company were to determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

• Goodwill - Goodwill is not amortized, but is reviewed for possible impairment on an annual basis at the reporting unit level. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. Historically, the major assumptions used in the impairment testing process included the estimated future cash flows of the reporting unit and the discount rate. The discount rate was unique to the Company's business and was based upon the cost of capital specific to the banking industry. However, due to the current economic conditions and the decline in the Company's stock price below tangible book value, a market valuation approach that utilizes the current stock price as the primary indicator of fair market value was used for the 2008 annual impairment test. Based on the impairment testing process, the Company recorded a goodwill impairment charge of $65.2 million in 2008.

• Impairment of Long-Lived Assets - Long-lived assets, including identified intangible assets, are evaluated for impairment if events or circumstances indicate a possible impairment. Such evaluations are based on undiscounted cash flow projections. The disposal of long-lived assets is measured based on the lower of the book or fair value less the costs to sell.

As discussed in more detail below, the following is a brief summary of our significant results for the year ended December 31, 2008.

• The Company reported a net loss for the year ended December 31, 2008 of $55.7 million, or $4.94 per diluted share, compared to net income of $7.9 million, or $0.68 per diluted share, for the year ended December 31, 2007. Prior to a $65.2 million goodwill impairment charge in 2008, which was partially offset by a reduction in deferred taxes of $3.2 million, net income was $6.3 million, or $0.54 per diluted share, for 2008. See "Non-GAAP Financial Measures" for a reconciliation of net loss and loss per common share on a GAAP basis to earnings and earnings per common share excluding the goodwill impairment charge, and related tax effect, on a non-GAAP basis for the year ended December 31, 2008. The decline in earnings to a net loss in 2008 is primarily attributed to the $65.2 million goodwill impairment charge recorded to noninterest expense. Further decreasing earnings was a $1.5 million decrease in net interest income, a $270 thousand increase in the provision for loan losses, and an additional $2.4 million increase in noninterest expense not related to the goodwill impairment charge. Partially offsetting the earnings decline was a $1.5 million increase in noninterest income. Income taxes decreased by $4.3 million due to the goodwill impairment charge and decline in net income before tax expense.

• Net interest income for the years ended December 31, 2008 and 2007 was $42.6 million and $44.1 million, respectively, representing a 3.4% decrease over the period. This decrease was primarily due to a decline in the Company's net interest margin from 3.53% in 2007 to 3.08% in 2008. The lower net interest margin was largely due to steps taken by the Federal Reserve to stimulate the national economy. One of the significant actions taken to address the national recession and persisting credit crisis was the Federal Open Market Committee's ("FOMC") reduction of the Prime Rate by a cumulative 400 basis points ("bps") during the year. This rapid decline in rates, coupled with competitive pressures in the marketplace for retail deposits, compressed net interest income during the year. The margin compression was partially offset by 9.6% growth in average earning assets over the same period.

• The provision for loan losses for the year ended December 31, 2008 was $3.9 million compared to $3.6 million for the year ended December 31, 2007. The increase in the provision was partially due to loan growth and softening credit quality but was also partially due to enhancements in the methodology for calculating the allowance for loan losses, which reduced the allowance and related provision during the second quarter of 2007. The enhancements to the allowance methodology were implemented during 2007 based on updated guidance issued through an interagency policy statement by the FDIC, Federal Reserve, and other regulatory agencies. Nonperforming assets, which includes loans on nonaccrual and other real estate owned, increased to 0.61% of total assets at the end of December 2008 from 0.50% at the end of December 2007. In addition, past due loans increased to 1.09% of total loans at the end of December 2008 from 0.98% at the end of December 2007. Allowance for loan losses totaled 1.18% and 1.24% of total loans as of December 31, 2008 and 2007, respectively. Further, the allowance for loan losses as a percent of nonperforming loans decreased to 162% at the end of 2008 from 227% at the end of 2007.

• Noninterest income rose from $9.5 million in 2007 to $11.1 million in 2008 despite a $976 thousand decline in mortgage fees and revenues. Service charges, other loan fees, and bank card services increased a combined $1.5 million primarily as a result of management's continued emphasis on increasing income from these sources. Gains recognized on the sale of investments and the sale of a branch added $298 thousand and $374 thousand, respectively, to noninterest income during this period.

• Noninterest expense increased $67.6 million during the year ended December 31, 2008 from the same period in 2007 primarily related to a goodwill impairment charge of $65.2 million resulting from the Company's annual goodwill impairment test. In addition, salaries and employee benefits, furniture and equipment, data processing and telecommunications, directors fees and FDIC insurance costs contributed a combined $3.1 million to the increase in noninterest expense. Salaries and employee benefits increased primarily due to routine annual compensation adjustments and staffing needs at branches opened in Asheville (May 2008), Clayton (December 2008) and Zebulon (December 2007); furniture and equipment increased partially due to equipment and building upgrades as well as higher maintenance costs; data processing and communications increased primarily due to system upgrades and enhancements to support growth in the Company's primary business lines; directors fees increased as mark-to-market adjustments from the decline in the Company's stock price decreased expense more in 2007 than in 2008; and FDIC deposit insurance costs rose as the regulatory agency increased premiums to cover higher monitoring costs and claims. Partially offsetting the increase in noninterest expense was a decline in occupancy expense of $439 thousand over the same periods. This decrease was primarily due to increased rent expense and depreciation of leasehold improvements during 2007 from changes in the remaining economic life of certain leased facilities, reflecting management's plans to close or restructure the facilities.

Year Ended December 31, 2008 Compared with Year Ended December 31, 2007

The Company reported a net loss for the year ended December 31, 2008 of $55.7 million, or $4.94 per diluted share, compared to net income of $7.9 million, or $0.68 per diluted share, for the year ended December 31, 2007. Prior to a $65.2 million goodwill impairment charge in 2008, which was partially offset by a reduction in deferred taxes of $3.2 million, net income was $6.3 million, or $0.54 per diluted share, for 2008. See "Non-GAAP Financial Measures" for a reconciliation of net loss and loss per common share on a GAAP basis to earnings and earnings per common share excluding the goodwill impairment charge, and related tax effect, on a non-GAAP basis for the year ended December 31, 2008. The decline in earnings to a net loss in 2008 is primarily attributed to the $65.2 million goodwill impairment charge recorded to noninterest expense. Further decreasing earnings was a $1.5 million decrease in net interest income, a $270 thousand increase in the provision for loan losses, and an additional $2.4 million increase in noninterest expense not related to the goodwill impairment charge. Partially offsetting the earnings decline was a $1.5 million increase in noninterest income. Income taxes decreased by $4.3 million due to the goodwill impairment charge and decline in net income before tax expense.

Net Interest Income. Net interest income is the difference between total interest income and total interest expense and is the Company's principal source of earnings. The amount of net interest income is determined by the volume of interest-earning assets, the level of rates earned on those assets, and the volume and cost of supporting funds. Net interest income decreased from $44.1 million for the year ended December 31, 2007 to $42.6 million for the year ended December 31, 2008. Net interest spread is the difference between rates earned on interest-earning assets and the interest paid on deposits and other borrowed funds. Net interest margin is the total of net interest income divided by average earning assets. Average interest-earning assets for the year ended December 31, 2008 were $1.43 billion compared to $1.31 billion for the year ended December 31, 2007, an increase of 9.5%. On a fully taxable equivalent ("TE") basis, net interest spread was 2.75% and 3.04% for the years ended December 31, 2008 and 2007, respectively. The net interest margin on a fully TE basis decreased by 45 bps to 3.08% for the year ended December 31, 2008 from 3.53% for the year ended December 31, 2007. The yield on average interest-earning assets declined to 6.04% from 7.38% for the years ended December 31, 2008 and 2007, respectively, while the interest rate on average interest-bearing liabilities for those periods declined to 3.30% from 4.34%, respectively.

The decrease in the net interest margin is attributable to a rapid decline in the prime lending rate coupled with competitive pressures in the marketplace for retail deposits. The FOMC made seven downward adjustments to the benchmark federal funds rate during 2008, three of which occurred during the fourth quarter. These rate cuts decreased the benchmark rate from 4.25% at the end of 2007 to a target range of 0.00% to 0.25% by the end of 2008. The prime lending rate, which generally tracks against the federal funds rate, declined from 7.25% at the end of 2007 to 3.25% by the end of 2008. The Company's balance sheet remains asset sensitive and, in a declining rate environment, its interest-earning assets reprice downward faster than its interest-bearing liabilities. Liquidity concerns at several national and regional financial institutions prompted those institutions to maintain relatively high interest rates on retail deposit products, thus creating competitive pricing pressures in the marketplace which further slowed the downward repricing of the Company's interest-bearing liabilities. At its December 16, 2008 meeting where the benchmark rate was cut to a range of 0.00% to 0.25%, the committee anticipates that financial markets remain quite strained and credit conditions remain tight. The committee anticipates that weakened economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. While management is taking steps to mitigate the impact of exceptionally low interest rates on the loan portfolio, such as increasing spreads and including interest rate floors on prime-based commercial loans, low yields on the loan portfolio will likely persist well into 2009.

The following two tables set forth certain information regarding the Company's yield on interest-earning assets and cost of interest-bearing liabilities and the component changes in net interest income. The first table, Average Balances, Interest Earned or Paid, and Interest Yields/Rates, reflects the Company's effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. Changes in net interest income from year to year can be explained in terms of fluctuations in volume and rate. The second table, Rate and Volume Variance Analysis, presents further information on those changes. For each category of interest-earning asset and interest-bearing liability, we have provided information on changes attributable to:

• changes in volume, which are changes in average volume multiplied by the average rate for the previous period;

• changes in rates, which are changes in average rate multiplied by the average volume for the previous period;

• changes in rate/volume, which are changes in average rate multiplied by the changes in average volume; and

• total change, which is the sum of the previous columns.

Average Balances, Interest Earned or Paid, and Interest Yields/Rates
For the Years Ended December 31, 2008, 2007 and 2006
Tax Equivalent Basis 1
                                                 2008                                                2007                                                2006
(Dollars in thousands)                           Amount                                              Amount                                              Amount
                            Average Balance      Earned       Average Rate      Average Balance      Earned       Average Rate      Average Balance      Earned       Average Rate
Assets
Loans receivable: 2
Commercial                 $       1,017,157    $  62,678              6.16 %  $         877,876    $  69,203              7.88 %  $         796,808    $  62,801              7.88 %
Consumer                              46,767        3,542              7.57               40,579        3,459              8.52               23,604        2,205              9.34
Home equity lines                     83,511        4,602              5.51               80,177        6,682              8.33               93,140        7,599              8.16
Mortgage 3                            27,435        1,672              6.09               43,227        2,722              6.30               53,563        3,575              6.67
Total loans                        1,174,870       72,494              6.17            1,041,859       82,066              7.88              967,115       76,180              7.88
Investment securities 4              251,224       14,026              5.58              246,736       13,476              5.46              199,917       10,310              5.16
Federal funds sold and
other interest on
short-term investments                 7,888          128              1.62               20,417        1,052              5.15               33,566        1,598              4.76
Total interest earning
assets                             1,433,981    $  86,648              6.04 %          1,309,012    $  96,594              7.38 %          1,200,598    $  88,088              7.34 %
. . .