This commentary provides an overview of the Company's financial condition, changes in financial condition and results of operations for the years 2006 through 2008. This section of Form 10-K should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included as Exhibit 99.1 of this Form 10-K.

Forward-Looking Statements and Factors that Could Affect Future Results

Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Act"), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Company's future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Company that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items;
(ii) statements of plans, objectives and expectations of the Company or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as "believes", "anticipates," "expects," "intends," "targeted," "continue," "remain," "will," "should," "may" and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:

• Local, regional, national and international economic conditions and the impact they may have on the Company and its customers and the Company's assessment of that impact.

• Volatility and disruption in national and international financial markets.

• Government intervention in the U.S. financial system.

• Changes in the level of non-performing assets and charge-offs.

• Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements.

• The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board.

• Inflation, interest rate, securities market and monetary fluctuations.

• Political instability.

• Acts of God or of war or terrorism.

• The timely development and acceptance of new products and services and perceived overall value of these products and services by users.

• Changes in consumer spending, borrowings and savings habits.

• Changes in the financial performance and/or condition of the Company's borrowers.

• Technological changes.

• Acquisitions and integration of acquired businesses.

• The ability to increase market share and control expenses.

• Changes in the competitive environment among financial holding companies and other financial service providers.

• The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Company and the Bank must comply.

• The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters.

• Changes in the Company's organization, compensation and benefit plans.

• The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews.

• Greater than expected costs or difficulties related to the integration of new products and lines of business.

• The Company's success at managing the risks involved in the foregoing items.

Forward-looking statements speak only as of the date on which such statements are made. The Company undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events. In addition, while we have not experienced a major increase in loan losses during the current economic climate, a continuation of the recent turbulence in significant portions of the global financial markets, particularly if it worsens, could impact our performance, both directly by affecting our revenues and the value of our assets and liabilities, and indirectly by affecting our counterparties and the economy generally. Dramatic declines in the housing market in the past year have resulted in significant write-downs of asset values by financial institutions in the United States. Concerns about the stability of the U.S. financial markets generally have reduced the availability of funding to certain financial institutions, leading to a tightening of credit, reduction of business activity, and increased market volatility. There can be no assurance that the EESA or the actions taken by the U.S. Treasury thereunder will stabilize the U.S. financial system or alleviate the industry or economic factors that may adversely affect our business. In addition, our business and financial performance could be impacted as the financial industry restructures in the current environment, both by changes in the creditworthiness and performance of our counterparties and by changes in the competitive landscape.

Recent Market Developments

The condition of the residential real estate marketplace and the U.S. economy in 2007 and 2008 has had a significant impact on the financial services industry as a whole, and specifically on the financial results of the Company. Beginning with a pronounced downturn in the residential real estate market in early 2007 that was led by problems in the sub-prime mortgage market, the deterioration of residential real estate values and higher delinquencies and charge-offs of loans continued throughout 2008. The drop in real estate values negatively impacted residential real estate builder and developer businesses. The stress consumers experienced from depreciating home prices, rising unemployment, underemployment and tighter credit conditions resulted in a higher level of bankruptcy filings during the year. With the U.S. economy in recession in 2008, financial institutions were facing higher credit losses from distressed real estate values and borrower defaults, resulting in reduced capital levels. In addition, investment securities backed by residential and commercial real estate were reflecting substantial unrealized losses due to a lack of liquidity in the financial markets and anticipated credit losses. Some financial institutions were forced into liquidation or were merged with stronger institutions as losses increased and the amounts of available funding and capital levels lessened. The Federal National Mortgage Association ("Fannie Mae") and The Federal Home Loan Mortgage Corporation ("Freddie Mac"), two government-sponsored entities, were placed in conservatorship in September 2008 by the U.S. Government. The Federal Reserve also lowered its federal funds target rate six times during 2008, from 4.25% at the beginning of the year to a range of 0% - .25% at December 31, 2008.

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 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 are 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 14, 2008, the Company applied for the maximum funds available through the TARP Capital Purchase Program which was approximately $28.0 million or three percent of our risk-weighted assets. If the Company is approved, the Board will consider the benefits of participating and will decide if we should pursue the transaction and participate.

On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the TLG Program. The TLG Program was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by the Secretary of the Department of Treasury (after consultation with the President), as an initiative to counter the system-wide crisis in the nation's financial sector. The goal of the TLG Program is to reduce the cost of bank funding so that bank lending to consumers and businesses will normalize. The TLG Program is industry funded and does not rely on the DIF to achieve its goals. The TLG Program consists of two components (i) a temporary guarantee, through the earlier of maturity or June 30, 2012, of certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and before June 30, 2009, which on February 10, 2009 the US Treasury, as part of the Financial Stability Plan, extended the TLG Program to October 31, 2009, and
(ii) temporary full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, NOW accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust 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 5, 2008, the Company elected to participate in both guarantee programs.

Results of Operations and Financial Condition

Commonwealth Bankshares, Inc. and Subsidiaries

Overview

Management views 2008 as one of the most challenging periods in our 38 year history. The historical challenges facing the financial markets today are like none we have ever seen before. While we are not immune to the historic challenges facing the financial markets, we remain a well capitalized and sound company. 2008 has brought uncertainty in the economy with the current recession, a slowdown in the housing market, declining real estate values, increased foreclosures and severe turbulence in the financial sector. We are seeing unparalleled events in the current economy and believe there are good reasons to take precautionary and extraordinary actions now. Based on this we have taken a proactive and conservative approach by increasing our provision for loan losses to provide an additional level of reserve for loan losses that could be anticipated in a recessionary environment. For the year ended December 31, 2008 the provision for loan losses was $24.0 million, an increase of $22.3 million over the comparable period in 2007. This unprecedented action was taken in direct response to current market conditions and the deteriorating economic environment. Asset quality remains a top priority for our Company and we will maintain our underwriting standards which have always been very stringent. We are committed to working with our customers and will continue to do so during this downturn in the market.

Although the Company's financial results have been heavily impacted by the economic decline into a recessionary environment during 2008, we have accomplished a great deal. During the third quarter of 2008, the Company reached a significant milestone with total assets surpassing $1.0 billion. Total assets were $1.1 billion at December 31, 2008, an increase of 28.7% or $242.2 million from December 31, 2007. Loans reached a record $1.0 billion while total deposits grew 33.3% to end the year at a record $763.0 million. In addition, we completed the successful execution of our branch expansion strategy by building a franchise and infrastructure that will enhance the investment in our future and that can deliver long-term profitability and value for our shareholders. In 2008, we opened our third branch in North Carolina at 562 Caratoke Highway in Moyock, our sixth branch in Virginia Beach, Virginia in the Redmill section at 2261 Upton Drive, our first branch in Suffolk, Virginia at 221 Western Avenue and our fourth branch in North Carolina at 3732 North Croatan Highway in Kitty Hawk. Over the past three years, we have made a substantial investment in our future. The Company presently has no further plans for branch expansion. During 2009, management will concentrate its efforts on increasing the profitability of these branches by increasing our core deposits and thereby reducing our reliance on other borrowings. The anticipated growth in these core deposits provides a low cost and stable source of funding. Also in 2009, management will concentrate efforts on reducing non-performing assets, monitoring the loan portfolio, maintaining existing relationships, seeking opportunities that will enhance profitability and tempering overall growth. Our strong capital position and solid foundation will be a pillar of strength as we manage through this unprecedented economic climate.

In February 2007, we moved to our permanent branch in the Ocean View section of Norfolk, Virginia, at 1901 E. Ocean View Avenue, as well as our second branch in Portsmouth, Virginia at 1020 London Boulevard. In March 2007, we opened our first branch in North Carolina on Caratoke Highway in Powells Point. In May 2007, we opened our third branch in Chesapeake, Virginia at 2600 Taylor Road, across from the Chesapeake Square Mall. In July 2007, we opened our second branch in North Carolina in the St. Waves Plaza Shopping Center in Waves, North Carolina and our fourth branch in Chesapeake, Virginia at 1304 Greenbrier Parkway. In November 2007, we opened our fifth office in Virginia Beach, Virginia at 5460 Wesleyan Drive. Our second title office opened in May 2007 at 2484 Pruden Boulevard in Suffolk, Virginia.

In June 2006, we opened a private banking center in Norfolk, Virginia. Our mortgage subsidiary, Bank of the Commonwealth Mortgage, has expanded its mortgage lending services to the outer banks of North Carolina. Our fourth mortgage office opened in May 2006 in Kill Devil Hills, North Carolina at 2603 N. Croatan Highway. On October 26, 2006, the Company successfully added $27.5 million in additional capital through a private placement of 1,163,461 shares of newly issued Company common stock allowing us to continue our strong growth momentum and allowing us to better serve our customers by increasing our legal lending limit to over $15.5 million at December 31, 2006.

For the year ended December 31, 2008, the Company reported a loss of $3.7 million, representing a decrease of 133.5% from the record earnings of $11.2 million reported for the comparable period in 2007. Net income in 2007 represented a 10.7% increase from the $10.1 million reported for the year ended December 31, 2006. On a per share basis, diluted earnings per share decreased 133.8% to a loss of $0.54 for the year ended December 31, 2008. Diluted earnings per share were $1.60 for the year ended December 31, 2007 down 5.9% from $1.70 for 2006. Book value per share for 2008, 2007 and 2006 was $15.53, $16.40 and $15.08, respectively. Per share results reflect the issuance of 1,163,461 shares of capital stock sold in the private placement in October 2006. Based on the Company's strong capital and solid foundation, management increased its dividends paid to its shareholders. In 2008, total dividends paid to its shareholders equaled $0.32 per share up 14.3% from $0.28 per share paid in 2007. Dividends paid in 2007 were up 40.6% from the $0.1991 per share paid in 2006.

The Company's key performance measures are down in comparison to prior years as a result of the current economic conditions, but the Company believes they are not reflective of our Company's solid foundation and are down primarily due to the significant increase in the provision for loan losses. Return on average assets equaled (0.39%) in 2008 compared with 1.44% in 2007 and 1.57% in 2006. Return on average equity equaled (3.30%) in 2008 compared with 10.33% in 2007 and 13.72% in 2006. The Company exceeded its goal for asset growth during 2008. As previously mentioned, total assets at December 31, 2008 reached a new high of $1.1 billion, up 28.7% or $242.2 million from $843.1 million at December 31, 2007. Total assets during 2007 grew $127.9 million or 17.9% from $715.2 million at December 31, 2006. Total loans, the Company's largest and most profitable asset, ended the year at a record $1.0 billion, up $236.1 million or 30.0% from December 31, 2007. During 2007, total loans increased $117.4 million or 17.5% from the $669.5 million at December 31, 2006.

Net Interest Income and Net Interest Margin

Net interest income, the fundamental source of the Company's earnings, is defined as the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and investment securities, while deposits and short-term borrowings represent the major portion of interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates when compared to previous periods of operations.

Table 1 presents the average interest earning assets and average interest bearing liabilities, the average yields earned on such assets (on a tax equivalent basis) and rates paid on such liabilities, and the net interest margin for the indicated periods. The variance in interest income and expense caused by differences in average balances and rate is shown in Table 2.

Net interest income, on a taxable equivalent basis, for 2008 decreased 0.4% or $148.6 thousand to $33.8 million. Net interest income for 2007 of $33.9 million increased 12.5% or $3.7 million over 2006. The decrease in net interest income for 2008 was primarily attributable to the strong growth in average interest earning assets, which was offset by the rapidly declining interest rate environment. The increase in net interest income for 2007 was primarily attributable to the strong growth in average interest earning assets.

Average interest earning assets increased $172.7 million in 2008, $120.7 million in 2007 and $180.2 million in 2006. Average loans (excluding loans held for sale), a higher interest earning asset, accounted for 97.8% of average interest earning assets in 2008, 97.6% in 2007 and 97.1% in 2006. Due to the low interest rate environment, the presence in new markets as a result of our branch expansions and the efforts of our experienced loan officers, average loans increased $170.4 million in 2008, $121.3 million in 2007 and $186.0 million in 2006. Average investment securities, a lower yielding asset, increased by $103.5 thousand in 2008, after decreasing by $1.2 million in 2007 and increasing by $2.5 million in 2006.

The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest earning assets, and represents the Company's net yield on its earning assets. Net interest margin is an indicator of the Company's effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competition and the economy. The spread that can be earned between interest earning assets and interest bearing liabilities is also dependent to a large extent on the slope of the yield curve. During 2006, the Federal Reserve increased the federal funds rate 4 times or 100 basis points up to 5.25%. Between the third quarter of 2007 and December 31, 2008, the Federal Reserve decreased the federal funds rate by 500 basis points and have established a target range of 0.0% - 0.25% for the federal funds rate.

As of December 31, 2008, the net interest margin was 3.69% compared to 4.57% recorded in 2007 and 4.86% in 2006. As a result of the rapidly declining interest rate which offset the strong growth in average loans, the yield on our interest earning assets decreased 144 basis points to 6.93% for the year ended December 31, 2008. The average rate paid on our interest bearing liabilities decreased 85 basis points in 2008. Contributing to the compression of our margins was the decrease in interest rates, along with the continued pressure on deposit pricing and the pricing of some deposit products which lag the decrease in the prime rate, which has an immediate affect on variable loans. In addition, the competiveness for deposits resulting from the reduction in liquidity throughout the financial markets has kept rates at a high level relative to loan rates. A shift in the mix of funding sources was also a factor in the decline in the net interest margin. Time deposits, a higher cost funding source, made up 69.5% of the total interest bearing liabilities in 2008 compared to 63.9% in the comparable period in 2007.

As of December 31, 2007, the net interest margin of 4.57% represented a decrease of 29 basis points over the net interest margin of 4.86% recorded in 2006. As a result of the strong growth in average loans and decreased interest rates, the yield on our interest earning assets decreased 15 basis points to 8.37% for the year ended December 31, 2007. The average rate paid on our interest bearing liabilities increased 20 basis points in 2007. Contributing to the increase was the strong competition for local deposits, which lead to increased rates on deposits accounts.

As of December 31, 2008, approximately 18.3% of the loan portfolio consisted of variable rate loans which can be repriced with prime within one year, down from 46.6% as of December 31, 2007. In a rising interest rate environment 18.3% of the variable loans will reprice, having a positive impact on interest income.

Table 1: Average Balance Sheet and Net Interest Margin Analysis

                                                                                                    Years Ended December 31,
                                                            2008                                              2007                                              2006
                                          Average                         Average           Average                         Average           Average                         Average
(dollars in thousands)                   Balance(1)       Interest     Yield/Rate(2)       Balance(1)       Interest     Yield/Rate(2)       Balance(1)       Interest     Yield/Rate(2)
Assets
Interest earning assets:
Loans (3)(4)                            $    894,823      $  62,539             6.99 %    $    724,468      $  61,151             8.44 %    $    603,133      $  51,998             8.62 %
Loans held for sale                               -              -                -                 -              -                -                 -              -                -
Investment securities (3)                      7,402            367             4.96 %           7,298            378             5.18 %           8,525            431             5.06 %
Equity securities                              9,527            390             4.09 %           7,893            472             5.98 %           6,599            383             5.80 %
Federal funds sold                               504              9             1.76 %           1,058             55             5.24 %           1,778             87             4.90 %
Interest bearing deposits in banks               300              7             2.32 %             578             31             5.32 %             546             28             5.13 %
FRB reserve balance                            1,430              3             0.20 %              -              -                -                 -              -                -
Statutory trust                                  619             39             6.39 %             619             39             6.33 %             619             39             6.39 %
Other investments                                213              6             2.73 %             168              3             1.61 %             168              4             2.31 %

Total interest earning assets                914,818         63,360             6.93 %         742,082         62,129             8.37 %         621,368         52,970             8.52 %
Noninterest earning assets:
Cash and due from banks                        5,932                                             9,031                                             8,047
Premises and equipment, net                   33,129                                            18,808                                             9,832
Other assets                                  18,068                                            12,571                                            10,559
Less: allowance for loan losses              (15,078 )                                          (8,736 )                                          (6,764 )

Total assets                            $    956,869                                      $    773,756                                      $    643,042

Liabilities and Stockholders' Equity
Interest bearing liabilities:
Interest bearing demand deposits        $     71,924      $     990             1.38 %    $     86,483      $   2,417             2.79 %    $     69,919      $   1,623             2.32 %
Savings deposits                               6,460             37             0.58 %           6,782             41             0.60 %           7,813             49             0.63 %
Time deposits                                544,801         23,138             4.25 %         389,658         19,151             4.91 %         327,438         15,071             4.60 %
Federal funds purchased                          644             14             2.21 %              -              -                -                 -              -                -
. . .