The following presents management's discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of operations of FNB United.

Executive Overview

Description of Operations

FNB United is a bank holding company with a full-service subsidiary bank, CommunityONE Bank, National Association, which offers a complete line of consumer, mortgage and business banking services, including loan, deposit, cash management, investment management and trust services, to individual and business customers. The Bank has offices in Alamance, Alexander, Ashe, Catawba, Chatham, Gaston, Guilford, Iredell, Mecklenburg, Montgomery, Moore, Orange, Randolph, Richmond, Rowan, Scotland, Watauga and Wilkes counties in North Carolina.

The Bank has a mortgage banking subsidiary, Dover Mortgage Company, that originates, underwrites and closes loans for sale into the secondary market. Dover has a retail origination network based in Charlotte and conducts current wholesale operations in North Carolina, South Carolina, Georgia, Tennessee, Virginia, and Maine.

Acquisitions

On November 4, 2005, FNB United completed a merger for the acquisition of United Financial, Inc. ("United"), holding company for Alamance Bank, headquartered in Graham, North Carolina. The merger transaction was accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of United were recorded based on estimated fair values as of November 4, 2005, with the estimate of goodwill being subject to possible adjustment during the one-year period from that date. The adjustments recorded during that one-year period, including the purchase price adjustment noted above, resulted in a net $264,000 reduction in the amount initially recorded for goodwill.

On April 28, 2006, FNB United completed a merger for the acquisition of Integrity Financial Corporation ("Integrity"), headquartered in Hickory, North Carolina and the holding company for First Gaston Bank of North Carolina, including its divisions Catawba Valley Bank and Northwestern Bank. At the date of the merger, First Gaston Bank operated 17 offices and, based on estimated fair values, had approximately $728.7 million in total assets, $475.3 million in net loans and $563.3 million in deposits. On August 1, 2006, First Gaston Bank was merged into the Bank. Each share of Integrity common stock was converted in the merger into 0.8743 shares of FNB United common stock and $5.20 in cash. The aggregate purchase price was $127.2 million, consisting of $27.7 million in cash payments to Integrity shareholders, 4,654,504 shares of FNB United common stock valued at $94.8 million, outstanding Integrity stock options valued at $3.3 million and transaction costs of $1.4 million. The merger transaction has been accounted for using the purchase method of accounting for business combinations, and accordingly, the assets and liabilities of Integrity were recorded based on estimated fair values as of April 28, 2006, with the estimate of goodwill being subject to possible adjustment during the one-year period from that date. The net of all such adjustments during the one-year period amounted to a $76,000 reduction in goodwill. The consolidated financial statements include the results of operations of Integrity since April 28, 2006.

Primary Financial Data for 2008

FNB United experienced a loss of $59.8 million in 2008, a 584% decrease from net income of $12.4 million in 2007. Basic and diluted earnings (loss) per share decreased 581% from $1.09 in 2007 to $(5.24) in 2008. Total assets were $2.04 billion at December 31, 2008, up 7% from year-end 2007. Loans amounted to $1.59 billion at December 31, 2008, increasing 10% from the prior year. Total deposits grew $73.7 million, to $1.51 billion in 2008. As noted above, First Gaston Bank and Alamance Bank were acquired through mergers effective April 28, 2006 and November 4, 2005, respectively, impacting both net income and the calculation of earnings per share since the acquisition dates and the comparability of operating results on a year-to-year basis for years between 2008 and 2004. The First Gaston Bank acquisition added $728.7 million or approximately 66% to total assets at the time of acquisition, while the earlier Alamance Bank acquisition added $163.7 million or approximately 18% to total assets at the time of acquisition.

Significant Factors Affecting Earnings in 2008

2008 presented challenges for FNB United as well as for the entire banking industry. The strains in the local and national financial and housing markets presented a challenging environment during 2008, particularly in the fourth quarter. This difficult environment required a significant increase in FNB United's loan loss provision, which depressed operating results but was a necessary response to increased non-performing loans. FNB United has not originated any subprime real estate loans or loans outside its market areas.

The provision for loan losses was $27.8 million in 2008, compared to $5.5 million in 2007, an increase of 403%. This increase resulted primarily from deteriorating asset quality. Nonperforming assets increased 372%, to $102.6 million during 2008 from $21.8 million at the close of 2007. Net loan charge-offs increased to $10.4 million in 2008, compared to $3.8 million in 2007. The provision also grew slightly as a result of growth in the loan portfolio. Loans held for investment grew $139.1 million during 2008, accounting for approximately $1.7 million of the increased provision. The allowance for loan losses was increased to 2.19% of loans held for investment at December 31, 2008. The allowance was 1.20% at December 31, 2007 and 1.22% at December 31, 2006.

Net interest income was impacted by measures utilized by the Federal Reserve for monetary policy purposes addressing the current recession. Net interest income has declined due in part to interest-bearing assets repricing down faster than interest-bearing liabilities as the Federal Reserve reduced the Fed funds target rate from 4.25% to 0.25% in 2008. See "Net Interest Income" for additional discussion on interest rate changes. Net interest income decreased $3.6 million, or 5.6%, in 2008 compared to 2007, reflecting the effect of a decrease in the net interest margin, stated on a taxable equivalent basis, from 4.01% in 2007, to 3.40% in 2008. This decrease was partially offset by an 11% increase in the level of average earning assets.

Noninterest income increased 6.1% to $22.9 million, compared to $21.6 million in 2007. Of this increase, $1.2 million resulted from adopting SAB 109 in the first quarter of 2008. Cardholder and merchant services income increased $517,000 due to increased interchange fees and surcharge fees. Other income decreased $1.4 million in 2008 due to the credit card portfolio sold in 2007 for a net gain of $1.3 million. Noninterest income was also significantly affected in 2007 by the recovery of $300,000 on the sale of previously charged-off loans partially offset by a mortgage servicing rights impairment charge of $271,000.

Noninterest expense was significantly impacted in 2008 and 2007 by goodwill impairment charges of $57.8 million and $358,000, respectively, as discussed in Note 3 to the Consolidated Financial Statements. Excluding the goodwill impairment charges, noninterest expense was $60.3 million, compared to $60.7 million in 2007. The company undertook a major noninterest expense improvement project during the second half of 2008, including consolidation of operational functions, strong vendor management and tighter staffing models. In addition, due to higher costs in 2007 associated with rebranding initiatives, marketing expenses declined by $545,000 in 2008.

Earnings Review

FNB United's net loss of $59.8 million in 2008 compared to net income of $12.4 million in 2007 is primarily a result of $3.6 million of reduced interest margin, increased provision for loan losses of $22.2 million, and higher goodwill impairment charges of $57.4 million. These losses were partially offset by $9.4 million in lower income taxes. Certain factors specifically affecting the elements of income and expense and the comparability of operating results on a year-to-date basis between 2008 and 2007 are discussed in the "Overview - Significant Factors Affecting Earnings in 2008."

FNB United's net income in 2007 was $12.4 million compared to $12.2 million in 2006. Earnings were positively impacted in 2007 by increases of $7.4 million, or 13%, in net interest income and $2.4 million in noninterest income, which were more than offset by a $3.0 million increase in the provision for loan losses and a $7.6 million increase in noninterest expense.

Return on average assets was (2.93)% in 2008, compared to 0.66% in 2007 and 0.77% in 2006. Return on average shareholders' equity decreased from 7.00% in 2006 to 5.81% in 2007 and (27.74)% in 2008. In 2008, return on tangible assets and equity (calculated by deducting average goodwill and core deposit premiums from average assets and from average equity) amounted to (3.11)% and (59.78)%, respectively, compared to 0.71% and 12.99% in 2007 and 0.82% and 14.75% in 2006.

Net Interest Income

Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits. Changes in net interest income result from changes in interest rates and in the volume, or average dollar level, and mix of earning assets and interest-bearing liabilities.

Table 1
Average Balance Sheet and Net Interest/Dividend Income Analysis
Fully Taxable Equivalent Basis

                                                                                Year Ended December 31,
(dollars in
thousands)                                2008                                            2007                                            2006
                                                        Average                                         Average                                         Average
                        Average         Income /        Yield /         Average         Income /        Yield /         Average         Income /        Yield /
                      Balance (3)       Expense          Rate         Balance (3)       Expense          Rate         Balance (3)       Expense          Rate
Interest earning
assets:
Loans (1)(2)          $  1,577,038     $  103,567            6.57 %   $  1,376,883     $  115,101            8.36 %   $  1,142,350     $   92,746            8.12 %
Taxable investment
securities                 152,436          7,820            5.13          149,153          7,613            5.10          130,147          6,334            4.87
Tax-exempt
investment
securities (1)              52,454          3,138            5.98           55,527          3,225            5.81           54,831          3,202            5.84
Other earning
assets                      21,044            810            3.85           37,611          2,051            5.45           49,093          2,389            4.87
Total earning
assets                   1,802,972        115,335            6.40        1,619,174        127,990            7.90        1,376,421        104,671            7.60

Non-earning assets:
Cash and due from
banks                       29,121                                          33,316                                          27,864
Goodwill and core
deposit premium            115,520                                         117,691                                          91,495
Other assets, net           92,591                                          92,421                                          79,527
Total assets          $  2,040,204                                    $  1,862,602                                    $  1,575,307

Interest-bearing
liabilities:
Interest-bearing
demand deposits            168,395          2,007            1.19          164,032          2,643            1.61          156,837          2,592            1.65
Savings deposits            40,803            113            0.28           47,189            130            0.28           52,827            182            0.34
Money market
deposits                   274,818          6,389            2.32          256,841         10,395            4.05          180,513          6,766            3.75
Time deposits              841,741         33,702            4.00          813,337         39,426            4.85          685,270         29,025            4.24
Retail repurchase
agreements                  29,954            651            2.17           28,783          1,317            4.58           21,134            923            4.37
Federal Home Loan
Bank advances              204,877          7,223            3.53           80,111          3,468            4.33           80,410          3,387            4.21
Federal funds
purchased                   21,310            501            2.35            3,102            162            5.22              696             40            5.75
Other borrowed
funds                       66,502          3,432            5.16           76,794          5,487            7.15           64,266          4,240            6.60
Total
interest-bearing
liabilities              1,648,400         54,018            3.28        1,470,189         63,028            4.29        1,241,953         47,155            3.80

Other liabilities
and shareholders'
equity:
Noninterest-bearing
demand deposits            157,992                                         159,205                                         142,624
Other liabilities           18,241                                          20,367                                          16,595
Shareholders'
equity                     215,571                                         212,841                                         174,135
Total liabilities
and equity            $  2,040,204                                    $  1,862,602                                    $  1,575,307

Net interest income
and net yield on
earning assets (4)                     $   61,317            3.40 %                    $   64,962            4.01 %                    $   57,516            4.18 %

Interest rate
spread (5)                                                   3.12 %                                          3.62 %                                          3.81 %

(1) The fully tax equivalent basis is computed using a federal tax rate of 35%.
(2) The average loan balances include nonaccruing loans.
(3) The average balances for all years include market adjustments to fair value for securities and loans available/held for sale.
(4) Net yield on earning assets is computed by dividing net interest income by average earning assets.
(5) Earning asset yield minus interest bearing liabilities rate.

Table 1 sets forth for the periods indicated information with respect to FNB United's average balances of assets and liabilities, as well as the total dollar amounts of interest income (taxable equivalent basis) from earning assets and interest expense on interest-bearing liabilities, resultant rates earned or paid, net interest income, net interest spread and net yield on earning assets. Net interest spread refers to the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. Net yield on earning assets, or net interest margin, refers to net interest income divided by average earning assets and is influenced by the level and relative mix of earning assets and interest-bearing liabilities.

Net interest income was $60.0 million in 2008, compared to $63.6 million in 2007. The decrease of $3.6 million, or 5.7%, resulted primarily from a decline in the net yield on earning assets, or net interest margin, from 4.01% in 2007 to 3.40% in 2008 partially offset by an 11% increase in the level of average earning assets. In 2007, the increase in net interest income of $7.4 million, or 13%, resulted primarily from an 18% increase in the level of average earning assets offset by a decline in the net yield on earning assets, or net interest margin, from 4.18% in 2006 to 4.01% in 2007. On a taxable equivalent basis, the changes in net interest income in 2008 and 2007 were $3.6 million $7.4 million, respectively reflecting changes in the relative mix of taxable and non-taxable earning assets in each year.

The 2008 and 2007 changes in net interest income on a taxable equivalent basis, as measured by volume and rate variances, are analyzed in Table 2. Volume refers to the average dollar level of earning assets and interest-bearing liabilities.

Table 2
Volume and Rate Variance Analysis
Years Ended December 31, 2008 and 2007

(dollars in
thousands)                           2008 vs 2007                                2007 vs 2006
                          Volume         Rate          Total         Volume          Rate          Total
                         Variance      Variance      Variance       Variance       Variance       Variance
Interest income:
Loans, net              $   16,732     $ (28,267 )   $ (11,535 )   $   19,041     $    3,314     $   22,355
Taxable investment
securities                     168            39           207            925            354          1,279
Tax exempt investment
securities                    (178 )          92           (86 )           41            (18 )           23
Other earning assets          (903 )        (338 )      (1,241 )         (559 )          221           (338 )
Total interest income       15,819       (28,474 )     (12,655 )       19,448          3,871         23,319

Interest expense:
Interest-bearing
demand deposits                 70          (706 )        (636 )          119            (68 )           51
Savings deposits               (18 )           1           (17 )          (19 )          (33 )          (52 )
Money market deposits          728        (4,734 )      (4,006 )        2,861            768          3,629
Time deposits                1,377        (7,101 )      (5,724 )        5,424          4,977         10,401
Retail repurchase
agreements                      54          (664 )        (610 )          334             60            394
Federal Home Loan
Bank advances                5,401        (1,639 )       3,762            (13 )           94             81
Federal funds
purchased                      951          (668 )         283            138            (16 )          122
Other borrowed funds          (735 )      (1,327 )      (2,062 )          827            420          1,247
Total interest
expense                      7,828       (16,838 )      (9,010 )        9,671          6,202         15,873
Increase (decrease)
in net interest
income                  $    7,991     $ (11,636 )   $  (3,645 )   $    9,777     $   (2,331 )   $    7,446

In 2008, the net interest spread decreased by 50 basis points from 3.62% in 2007, to 3.12% in 2008, reflecting the net effect of decreases in both the average total yield on earning assets and the average rate paid on interest-bearing liabilities, or cost of funds. The yield on earning assets decreased by 150 basis points, from 7.90% in 2007 to 6.40% in 2008, while the cost of funds decreased by 101 basis points, from 4.29% to 3.28%. In 2007, the 19 basis points decrease in net interest spread resulted from a 30 basis points increase in the yield on earning assets, which was more than offset by a 49 basis points increase in the cost of funds.

Changes in the net interest margin and net interest spread tend to correlate with movements in the prime rate of interest. There are variations, however, in the degree and timing of rate changes, compared to prime, for the different types of earning assets and interest-bearing liabilities.

As a result, interest-bearing assets repriced downward faster than interest-bearing liabilities. Due to concern about increasing inflationary pressures, the Federal Reserve took action by raising the level of interest rates during 2006, by 25 basis points in each of the first six months of 2006. Interest rates remained constant for more than a year until the Federal Reserve, responding to recessionary concerns, exacerbated by the subprime mortgage crisis, cut the target fed funds rate by 50 basis points in September 2007. This action was followed by two additional cuts of 25 basis points each in October and December 2007, to 4.00% at December 31, 2007. Regular cuts to the target federal funds rate continued throughout 2008 with year-end rates at 0.25%.

Provision for Loan Losses

This provision is the charge against earnings to provide an allowance for probable losses inherent in the loan portfolio. The amount of each year's charge is affected by several considerations including management's evaluation of various risk factors in determining the adequacy of the allowance (see "Asset Quality"), actual loan loss experience and loan portfolio growth. The provision for loan losses was $27.8 million in 2008, $5.5 million in 2007 and $2.5 million in 2006. This increase in the level of the provision for loan losses is discussed and analyzed in detail as part of the discussions in the "Overview - Significant

Factors Affecting Earnings in 2008", and "Asset Quality" sections.

Noninterest Income

Noninterest income increased $1.3 million, or 6%, in 2008, due primarily to $1.2 million recognized from the adoption of SAB 109 as well as $0.5 million of increased interchange fees and surcharge fees in 2008 offset by the $1.3 million sale of the credit card portfolio in 2007. Additional information concerning factors which specifically affected noninterest income in 2008 is discussed in the "Overview - Significant Factors Affecting Earnings in 2008."

Noninterest income increased $2.4 million, or 12%, in 2007, due primarily to the recognition of a $1.3 million gain on the sale of the credit card portfolio in the third quarter 2007 and the loss of $559,000 on the sale of securities in the third quarter 2006.

Noninterest Expense

Noninterest expense was $57.1 million, or 93%, higher in 2008 due primarily to $57.8 million of goodwill impairment charges. FNB United undertook a major noninterest expense improvement project during the second half of 2008, including consolidation of operational functions, strong vendor management and tighter staffing models. Excluding the goodwill impairment charges, noninterest expense was $383,000 lower in 2008 than in 2007.

Noninterest expense was $7.6 million, or 14%, higher in 2007. The major components of the increase from 2006 to 2007 were a $5.1 million increase in personnel expense, a $1.5 million increase in net occupancy expense, an $0.8 million increase in furniture and equipment expense, a $1.1 million increase in other expenses and an $0.5 million decrease in data processing costs. The increases versus 2006 were largely driven by the fact that noninterest expense for 2007 included Integrity for the entire year, compared to only eight months in 2006.

As a result of the imposition by the FDIC of a proposed special assessment as a part of their Deposit Insurance Fund restoration plan, the Bank may be required to pay an emergency special assessment of 20 basis points. Based on average deposits for the fourth quarter of 2008, this assessment would approximate $2.9 million. This may significantly impact noninterest expense and the results of operations of the Company for 2009.

Provision for Income Taxes

The effective income tax rate decreased from 33.7% in 2007 to 4.95% in 2008 due principally to lower net interest income and the higher level of nondeductible expenses in 2008. Nondeductible expenses included a goodwill impairment charge of $57.8 million in 2008 compared to $0.4 million in 2007. The effective income tax rate decreased from 37.4% in 2006 to 33.7% in 2007 due principally to a lower level of nondeductible expenses in 2007, including a goodwill impairment charge of $0.4 million in 2007 compared to $1.6 million in 2006. FNB United's federal income tax rate was 35% in 2008 and 35% in 2007 and 2006.

Liquidity

Liquidity for the Bank refers to its continuing ability to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses and provide funds to FNB United for payment of dividends, debt service and other operational requirements. Liquidity is immediately available from five major sources: (a) cash on hand and on deposit at other banks, (b) the outstanding balance of federal funds sold, (c) lines for the purchase of federal funds from other banks, (d) the line of credit established at the Federal Home Loan Bank, less charges against that line for existing advances and letters of credit used to secure public funds on deposit, and (e) the investment securities portfolio.

Consistent with the general approach to liquidity, loans and other assets of the Bank are based primarily on a core of local deposits and the Bank's capital position. To date, the steady increase in deposits, supplemented by Federal Home Loan Bank advances, federal funds purchased, and a modest amount of brokered deposits, has been adequate to fund loan demand in the Bank's market area, while maintaining the desired level of immediate liquidity and a substantial investment securities portfolio available for both immediate and secondary liquidity purposes.

Liquidity for Dover refers to its continuing ability to fund mortgage loan commitments and pay operating expenses. Liquidity is principally available from a line of credit with the Bank, established in 2007. Prior to that date, the line of credit was with a large national bank.

Contractual Obligations

Under existing contractual obligations, FNB United will be required to make
payments in future periods. Table 3 presents aggregated information about the
payments due under such contractual obligations at December 31,
2008. Transaction deposit accounts with indeterminate maturities have been
classified as having payments according to an expected decay rate. Benefit plan
payments cover estimated amounts due through 2018.

Table 3
Contractual Obligations

(dollars in thousands)                              Payments Due by Period at December 31, 2008
                                      One year        One to         Three to       Over Five
                                      or less       Three Years     Five Years        Years           Total
Deposits                             $  800,781     $   250,651     $   122,871     $  340,444     $ 1,514,747
Retail repurchase agreements             18,145               -               -              -          18,145
. . .