Summary of COASTAL BANKING CO INC

Item 7.

Management's Discussion and Analysis of Plan of Operation

General

Coastal Banking Company, Inc. (in this Item 7, the "Company") is a bank holding company headquartered in Beaufort, South Carolina organized to own all of the common stock of its subsidiary, CBC National Bank (in this Item 7, "Bank"). The principal activity of the Bank is to provide banking services for its domestic markets. The Bank's primary markets are Beaufort County, South Carolina and Nassau County, Florida. The Bank is primarily regulated by the Office of the Comptroller of the Currency ("OCC") and undergoes periodic examinations by this regulatory agency. The holding company is regulated by the Federal Reserve Board of Governors and also is subject to periodic examinations. The Bank commenced business on May 10, 2000 as Lowcountry National Bank at 36 Sea Island Parkway, Beaufort, South Carolina 29907. First National opened for business July 26, 1999 and was acquired by Coastal through the merger with its holding company, First Capital Bank Holding Corporation ("First Capital") on October 1, 2005. On October 27, 2006 Coastal acquired our Meigs, Georgia office through the merger of Cairo Banking Company, a Georgia state bank with and into First National. On August 10, 2008, Lowcountry National Bank and First National Bank of Nassau County merged into one charter. Immediately after the merger, the name of the surviving bank was changed to CBC National Bank and the main office relocated to 1891 South 14th Street, Fernandina Beach, Nassau County, Florida. The Bank's branches continue to do business under the trade names "Lowcountry National Bank," "First National Bank of Nassau County," and "The Georgia Bank" in their respective markets. The Company also has an investment in Coastal Banking Company Statutory Trust I ("Trust I") and Coastal Banking Company Trust II ("Trust II"). Both trusts are special purpose subsidiaries organized for the sole purpose of issuing trust preferred securities.

The following discussion describes our results of operations for 2008 as compared to 2007 and also analyzes our financial condition as of December 31, 2008 as compared to December 31, 2007. Like most community banks, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

We have included a number of tables to assist in our description of these measures. For example, the "Average Balances" table shows the average balance during 2008 and 2007 of each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest yields than do other types of interest earning assets, which is why we intend to continue to direct a substantial percentage of our earning assets into our loan portfolio. Similarly, the "Volume/Rate Analysis" table helps demonstrate the impact of changing interest rates and changing volume of assets and liabilities during the years shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included a "Sensitivity Analysis Table" to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, and our deposits.

Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb possible losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section we have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses. See comments in the section entitled "Provision and Allowance for Loan Losses."

In addition to earning interest on our loans and investments, we earn income through fees, gains on sales of loans and marketable securities, cash surrender value of life insurance and other service charges to our customers. We describe the various components of this non-interest income, as well as our non-interest expense, in the following discussion.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with the financial statements and the related notes and the other statistical information also included in this report.

Forward-Looking Statements

This report contains "forward-looking statements" relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management. The words "may," "will," "anticipate," "should," "would," "believe," "contemplate," "expect," "estimate," "continue," "may," and "intend," as well as other similar words and expressions of the future, are intended to identify forward-looking statements. Potential risks and uncertainties include, but are not limited to those described under the heading "Risk Factors" in our Form 10-K for the year ended December 31, 2008.

Critical Accounting Policies

We have adopted various accounting policies, which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in Note 1 in the footnotes to the consolidated financial statements at December 31, 2008 included elsewhere in this annual report.

We believe that the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements. Please refer to the portion of management's discussion and analysis of financial condition and results of operations that addresses the allowance for loan losses for a description of our processes and methodology for determining the allowance for loan losses.

Intangible assets, included in Other Assets on the Consolidated Balance Sheets, include goodwill and other identifiable assets, such as core deposits, resulting from acquisitions. Goodwill, in this context, is the excess of the purchase price in an acquisition transaction over the fair market value of the net assets acquired. Core deposit intangibles are amortized on a straight-line basis over such assets' estimated expected life. In accordance with SFAS No. 142, "Goodwill and Other Intangible Asset," goodwill is not amortized but is tested annually for impairment or at any time an event occurs, or circumstances change, that may trigger a decline in the value of the reporting unit. Such impairment testing calculations include estimates. Furthermore, the determination of which intangible assets have finite lives is subjective as is the determination of the amortization period for such intangible assets. The Company tests for goodwill impairment by determining the fair market value for each reporting unit and comparing the fair market value to the carrying amount of the applicable reporting unit. If the carrying amount exceeds fair market value the potential for the impairment exists, and a second step of impairment testing is performed. In the second step, the fair market value of the reporting units' goodwill is determined by allocating the reporting unit's fair market value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair market value of reporting unit goodwill is less than its carrying amount, goodwill is impaired and is written-down to its fair market value. The loss recognized is limited to the carrying amount of goodwill. Once an impairment loss is recognized, future increases in fair market value will not result in the reversal of previously recognized losses. The Company performed its annual test of impairment in the fourth quarter and determined that there was no impairment in the carrying value of goodwill as of December 31, 2008.

Results of Operations

Overview

Net loss for 2008 was $4,838,000 or $1.91 per basic common share compared to net income of $2,632,000 or $1.04 per basic common share, in 2007. In total, our operational results depend to a large degree on net interest income, which is the difference between the interest income received from our investments, such as loans, investment securities, and federal funds sold, and interest expense, paid on deposit liabilities and other borrowings. Net interest income was $10,048,000 for the year ended December 31, 2008 compared to net interest income of $12,183,000 for the year ended December 31, 2007.

The provision for loan losses in 2008 was $7,823,000 compared to $311,000 in 2007. The increase in the provision for loan losses is attributable to weakness in our real estate markets, primarily related to the housing industry. The Bank has a concentration in residential single-family construction loans and residential development loans in Beaufort, South Carolina, Savannah, Georgia and in northeast Florida, principally Nassau, Duval and St. Johns County. These loans types are typically repaid as the completed lots or homes are sold, however the nationwide deterioration in the housing market caused our sources of repayment to slow and accelerated the devaluation of the underlying collateral securing the loans. The provision for loan losses was increased to reflect the amount calculated by our allowance for loan losses methodology which takes into account deteriorating economic conditions and the underlying collateral value of some of our loans. Of the $7,823,000 provision expense for 2008, 37% was related to commercial mortgage loans, 32% was related to construction loans, 27% was related to residential mortgage loans, and 4% was related to all other loans. Of that same amount, 40% of provision expense was related to loans secured by properties in Florida, 31% was related to collateral properties in South Carolina, and 29% was related to collateral properties in Georgia.

Noninterest income for the year ended December 31, 2008 totaled $5,139,000, representing a $2,818,000 increase from December 31, 2007. This increase was associated with an increase in mortgage loan fees and gain on sale of mortgage loans of $2,550,000, a gain on sale of securities of $219,000, and an increase in service charges on deposits and other service charges, commissions and fees of $244,000, offset by a decrease in gain on sale of SBA loans of $62,000. Non-interest expenses in 2008 were $15,358,000; a $4,903,000 increase compared to the 2007 amounts, primarily due to the costs associated with the wholesale mortgage division in Atlanta, Georgia and costs associated with other real estate owned. The Company's efficiency ratio, which is a measure of total non-interest expenses as a percentage of net interest income and non-interest income, increased to 101.13% in 2008 from 72.09% in 2007 due in large part to the previously described increase in noninterest expenses.

In 2008, we recognized an income tax benefit of ($3,156,000) compared to an income tax expense of $1,105,000 in 2007. Our effective tax rate was (39.5%) in 2008 and 29.6% in 2007. The higher effective tax (benefit) rates for 2008 reflect the impact of permanent book-to-tax differences from tax exempt income on bank owned life insurance and municipal securities.

Net Interest Income

For the year ended December 31, 2008, net interest income totaled $10,048,000, as compared to $12,183,000 for the same period in 2007. Interest income from loans, including fees, decreased $2,842,000 to $20,318,000 for the year ended December 31, 2008. The average balance of loans was $325,098,000 in 2008 compared to $282,182,000 in 2007. The weighted average rate earned on loans was 6.25% for 2008 compared to 8.21% in 2007. Interest income from securities decreased $620,000 on a tax equivalent basis. The average balance of investments was $82,401,000 in 2008 compared to $95,715,000 in 2007. The weighted average rate earned on investments was 5.24% for 2008 compared to 5.16% in 2007. This decrease in income was partially offset by decreased interest expense, which totaled $14,388,000 for the year ended December 31, 2008, compared to $16,293,000 in 2007. The net interest margin realized on earning assets and the interest rate spread were 2.52% and 2.12%, respectively, for the year ended December 31, 2008. For the year ended December 31, 2007, the net interest margin was 3.19% and the interest rate spread was 2.75%. Yields on interest earning assets decreased during the year by 136 basis points compared to a decrease in rates on interest bearing liabilities of 73 basis points during the year.

Average Balances and Interest Rates

The table below shows the average balance outstanding for each category of
interest-earning assets and interest-bearing liabilities for 2008 and 2007, and
the average rate of interest earned or paid thereon. Average balances have been
derived from the daily balances throughout the period indicated.


                                                                     For the Years Ended December 31,
                                                            2008                                          2007
                                            Average                        Yield/         Average                        Yield/
(In Thousands)                              Balance        Interest         Rate          Balance        Interest         Rate
Assets:
Interest-earning assets:
Loans (including loan fees)               $   325,098     $    20,318          6.25 %   $   282,182     $    23,160          8.21 %
Taxable investments                            65,702           3,328          5.07 %        79,476           4,022          5.06 %
Tax-free investments                           16,699             988          5.92 %        16,239             914          5.63 %
Interest-bearing deposits in
 other banks                                      678              22          3.24 %         1,667              89          5.34 %
Federal funds sold                              4,674             116          2.48 %        11,719             602          5.14 %
Total interest-earning assets                 412,851          24,772          6.00 %       391,283          28,787          7.36 %
Other non-interest earning assets              30,782                                        33,579
Total assets                              $   443,633                                   $   424,862
Liabilities and shareholders' equity:
Interest-bearing liabilities:
Deposits:
Interest-bearing demand and savings       $   101,895     $     2,442          2.40 %   $   123,922     $     4,467          3.60 %
Time                                          228,355          10,117          4.43 %       194,987          10,012          5.13 %
Other                                          40,671           1,829          4.50 %        34,832           1,814          5.21 %
Total interest-bearing liabilities            370,921          14,388          3.88 %       353,741          16,293          4.61 %
Other non-interest bearing liabilities         27,055                                        26,162
Shareholders' equity                           45,657                                        44,959
Total liabilities and shareholders'
 equity                                   $   443,633                                   $   424,862
Excess of interest-earning assets over
 interest bearing liabilities             $    41,930                                   $    37,542
Ratio of interest-earning assets to
 interest-bearing liabilities                     111 %                                         111 %
Tax equivalent adjustment                                        (336 )                                        (311 )
Net interest income                                       $    10,048                                   $    12,183
Net interest spread                                                            2.12 %                                        2.75 %
Net interest margin                                                            2.52 %                                        3.19 %

Non-accrual loans and the interest income which was recorded on these loans, if any, are included in the yield calculation for loans in all periods reported.

Amounts are presented on a tax equivalent basis.

Volume/Rate Analysis

Net interest income can also be analyzed in terms of the impact of changing rates and changing volume. The following table describes the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. The effect of a change in average balance has been determined by applying the average rate in the earlier year to the change in average balance in the later year, as compared with the earlier year. The effect of a change in the average rate has been determined by applying the average balance in the earlier year to the change in the average rate in the later year, as compared with the earlier year.

                                                             2008 Compared to 2007
                                                     Increase (decrease) due to changes in
(In Thousands)                                   Volume              Rate           Net Change
Interest income on:
Loans (including loan fees)                    $     3,195       $     (6,037 )       $ (2,842 )
Taxable investments                                   (698 )                4             (694 )
Non-taxable investments                                 26                 48               74
Interest bearing deposits in other banks               (40 )              (27 )            (67 )
Federal funds sold                                    (261 )             (225 )           (486 )
Total interest income (tax equivalent basis)         2,222             (6,237 )         (4,015 )
Interest expense on:
Interest-bearing demand and savings                   (702 )           (1,323 )         (2,025 )
Time                                                 1,583             (1,478 )            105
Other                                                  281               (266 )             15
Total interest expense                               1,162             (3,067 )         (1,905 )
Net interest income (tax equivalent basis)     $     1,060       $     (3,170 )       $ (2,110 )

Interest Rate Sensitivity and Asset Liability Management

Interest rate sensitivity measures the timing and magnitude of the repricing of assets compared with the repricing of liabilities and is an important part of asset liability management of a financial institution. The objective of interest rate sensitivity management is to generate stable growth in net interest income, and to control the risks associated with interest rate movements. Management constantly reviews interest rate risk exposure and the expected interest rate environment so that adjustments in interest rate sensitivity can be timely made. Since the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.

Net interest income is the primary component of net income for financial institutions. The timing and magnitude of repricing as well as the mix of interest sensitive and non-interest sensitive assets and liabilities affect net interest income. "Gap" is a static measurement of the difference between the contractual maturities or repricing dates of interest sensitive assets and interest sensitive liabilities within the following twelve months. Gap is an attempt to predict the behavior of our net interest income in general terms during periods of movement in interest rates. In general, if we are asset sensitive, more of our interest sensitive assets are expected to reprice within twelve months than our interest sensitive liabilities over the same period. In a rising interest rate environment, assets repricing more quickly are expected to enhance net interest income. Alternatively, decreasing interest rates would be expected to have the opposite effect on net interest income since assets would theoretically be repricing at lower interest rates more quickly than interest sensitive liabilities. Although it can be used as a general predictor, gap as a predictor of movements in net interest income has limitations due to the static nature of its definition and due to its inherent assumption that all assets will reprice immediately and fully at the contractually designated time. At December 31, 2008, the Company, as measured by gap, is asset sensitive at three months or less and liability sensitive cumulatively at one year. Management has several tools available to it to evaluate and affect interest rate risk, including deposit pricing policies and changes in the mix of various types of assets and liabilities.

The following table summarizes the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2008, that are expected to mature, prepay, or reprice in each of the future time periods shown. Except as stated below, the amount of assets or liabilities that mature or reprice during a particular period was determined in accordance with the contractual terms of the asset or liability. Adjustable rate loans are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due, and fixed-rate loans and mortgage-backed securities are included in the periods in which they are anticipated to be repaid based on scheduled maturities. The Bank's savings accounts and interest-bearing demand accounts (NOW and money market deposit accounts) that are not contractually tied to an adjusting index are grouped into categories based on the company's historical repricing practices. Money market accounts which are contractually tied to repricing indexes reprice monthly and are grouped in the three month or less category. Many of these money market accounts are tied to a Treasury index.

At December 31, 2008

Maturing or Repricing in

(In                                3 Months         4 Months to           1 to 5             Over 5
Thousands)                         or Less           12 Months            Years              Years             Total
Interest-earning assets:
Federal funds sold               $        465      $           -       $          -       $          -      $        465
Deposits in other banks                   111                  -                  -                  -               111
Investment securities                   6,148                790             27,617             54,700            89,255
Loans held for sale                    31,405                  -                  -                  -            31,405
Loans                                 120,785             27,510             99,204             56,920           304,419
Total interest-earning assets         158,914             28,300            126,821            111,620           425,655
Interest-bearing liabilities:
Deposits:
Savings and demand                     24,229             57,656             12,632              4,198            98,715
Time deposits                          72,593            144,580             28,058                 71           245,302
FHLB advances                          24,193             10,000             17,500                  -            51,693
Junior subordinated
debentures                              3,093                  -              4,124                  -             7,217
Total interest-bearing
liabilities                           124,108            212,236             62,314              4,269           402,927
Interest sensitive difference
per period                       $     34,806      $    (183,936 )     $     64,507       $    107,351      $     22,728
Cumulative interest
sensitivity difference           $     34,806      $    (149,130 )     $    (84,623 )     $     22,728
Cumulative difference to
total interest-earning assets             8.2 %            (35.0 )%           (19.9 )%             5.3 %

At December 31, 2008, the Company had $34,806,000 more assets than liabilities repricing or maturing within three months, which indicates that the Company is asset sensitive over this time horizon. When extended out to one year, the Company had $149,130,000 more liabilities than assets repricing or maturing, indicating the Company is liability sensitive over a one-year time period.

Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may reflect changes in market interest rates differently. Additionally, certain assets, such as adjustable-rate mortgages, have features that restrict changes in interest rates, both on a short-term basis and over the life of the asset. Other factors which may affect the assumptions made in the table include options to call a security or borrowing, pre-payment rates, early withdrawal levels, and the ability of borrowers to service their debt. Management uses modeling techniques which attempt to quantify the impacts of interest rates on margin changes. These modeling techniques reflect the effects of these cited shortcomings including the effects of maturity changes that occur as a result of changes in interest rates. These modeling tools indicate that net interest margin would be slightly negatively impacted at twelve months given a 1% decrease in interest rates.

Mortgage Banking Activities

In the third quarter of 2007, First National Bank of Nassau County opened a wholesale residential mortgage lending division headquartered in Atlanta, Georgia to complement the existing retail residential mortgage lending activity conducted through other branch locations. This division originates and funds residential mortgage loans submitted by mortgage brokers and then sells these mortgage loans in the secondary market. This new lending channel subjects us to various risks, including credit, liquidity and interest rate risks. We reduce unwanted credit and liquidity risks by selling virtually all of the mortgage loans originated through this division. From time to time, we may decide to hold . . .