Overview
Management's Discussion and Analysis is provided to assist in understanding and evaluating our results of operations and financial condition. The following discussion is intended to provide a general overview of our performance for the three-month period ended March 31, 2009. Readers seeking more in-depth information should read the more detailed discussions below as well as the condensed consolidated financial statements and related notes included under Item 1 of this quarterly report. All information presented is consolidated data unless otherwise specified. Uncertainty and future events could cause changes in accounting estimates that have material effects on the financial position and results of operations in future periods.
Our net loss of $4.2 million for the three-month period ended March 31, 2009, compared to net income of $1.7 million for the same period in 2008, primarily resulted from a decline in net interest income largely attributable to lower loan income, a higher loan loss provision and an other-than-temporary impairment loss on investments in securities available for sale. The decline in loan income was principally due to a combination of lower loan yields on our variable rate loans and higher levels of nonperforming assets. Our net interest margin decreased primarily related to continued rate reductions without comparable decreases in funding costs. We had a slight decrease in other expenses for the first quarter of 2009 compared to 2008. An income tax benefit relating to the net loss for the first quarter of 2009 was not recorded because it is more likely than not that the tax benefit will not be realized.
During the first quarter of 2009 Granite Mortgage changed its business model from lender/seller to a broker operation primarily because of the cost of outside funding. As a result of the change, the mortgage pipeline was liquidating at March 31. Derivative activity associated with pipeline management was also in process of closing existing positions. The liquidating pipeline reduced the related level of warehouse borrowing. At March 31, 2009, Granite Mortgage's warehouse borrowing was $11.9 million, and this amount was subsequently paid in full in April 2009. Also, as a result of this change, a significant part of Granite Mortgage's net loss for the three months ended March 31, 2009 was attributable to severance payments and the final settlement of employment contracts.

Financial Highlights for
  the Quarterly Periods

                                                      Three Months
                                                     Ended March 31,
    (In thousands except per share amounts)       2009            2008         % change
    Earnings
    Net interest income                       $     7,522     $    10,293        -26.9 %
    Provision for loan losses                       3,770           1,411        167.2 %
    Other income                                    1,485           3,278        -54.7 %
    Other expense                                   9,462           9,659         -2.0 %
    Net income (loss)                              (4,225 )         1,715       -346.4 %

    Per share
    Net income (loss)
    - Basic                                   $     (0.27 )   $      0.11       -345.5 %
    - Diluted                                       (0.27 )          0.11       -345.5 %

    Average for period
    Assets                                    $ 1,167,664     $ 1,214,147         -3.8 %
    Loans                                         938,745         948,732         -1.1 %
    Deposits                                    1,003,380         988,626          1.5 %
    Stockholders' equity                           74,432         117,681        -36.8 %

    Ratios
    Return on average assets                        -1.47 %          0.57 %
    Return on average equity                       -23.02 %          5.86 %
    Average equity to average assets                 6.37 %          9.69 %
    Efficiency ratio (1)                           103.21 %         70.16 %

(1) Calculated by dividing noninterest expense by the sum of tax equivalent net interest income and noninterest income.

Critical Accounting Policies
The accounting and reporting policies of the Company and its subsidiaries are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The critical accounting and reporting policies include our accounting for securities, loans, the allowance for loan losses, and income taxes. In particular, our accounting policies relating to the allowance for loan losses and investment securities involve the use of estimates and require significant judgments to be made by management. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Please see the discussions below under the captions "Provisions and Allowance for Loan Losses" and "Investment Securities-Valuation." See also Note 1 in the "Notes to Consolidated Financial Statements" under Item 8, "Financial Statements & Supplementary Data" in our Annual Report on Form 10-K for the year ended December 31, 2008 on file with the Securities and Exchange Commission for additional information regarding all of our critical and significant accounting policies.
LOANS - Loans that management has the intent and ability to hold for the foreseeable future are reported at their outstanding principal balances adjusted for any deferred fees or costs. Substantially all loans earn interest on the level yield method based on the daily outstanding balance.
PROVISIONS AND ALLOWANCE FOR LOAN LOSSES - The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to a balance considered adequate to absorb probable losses incurred in the portfolio at the date of the financial statements.
Management's determination of the adequacy of the allowance for loan loss is based on ongoing quarterly assessments of the collectibility and historical loss experience of the loan portfolio. We also evaluate other factors and trends in the economy related to specific loan groups in the portfolio, trends in delinquencies and results of periodic loan reviews.
The methodology for determining the allowance for loan losses is based on historical loss rates, current credit grades, specific allocation for impaired loans and an unallocated amount. The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance for loan losses in the accounting period in which they are determined by management to be uncollectible. We periodically revise historical loss factors for different segments of the portfolio to be more reflective of current market conditions.
Large commercial loans that exhibit probable or observed credit weaknesses are subject to individual review for impairment. When individual loans are impaired, the impairment allowance is measured in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." The predominant measurement method for the Bank is the evaluation of the fair value of the underlying collateral. Our policy for the recognition of interest income on impaired loans is the same as our interest recognition policy for all non-accrual loans. Accrued interest is reversed to income to the extent it relates to the current year and charged off otherwise.
The evaluations described above are inherently subjective, as they require the use of material estimates. Unanticipated future adverse changes in borrower or economic conditions could result in material adjustments to our allowance for loan losses that could adversely impact our earnings in future periods.

INVESTMENT SECURITIES-VALUATION - Securities not classified as either "held to maturity" securities or trading securities, and equity securities not classified as trading securities, are classified as "available for sale securities" and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of consolidated stockholders' equity. The fair values of these securities are based on quoted market prices, dealer quotes and prices obtained from independent pricing services. Available for sale and held to maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review is inherently subjective as it requires material estimates and judgments, including an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security's performance, the credit worthiness of the issuer and our intent and ability to hold the security to maturity. Declines in the fair value of the individual securities below their costs that are other-than-temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in consolidated earnings as realized losses.
MORTGAGE LOANS HELD FOR SALE - We originate certain residential mortgage loans with the intent to sell. Mortgage loans held for sale are reported at the lower of cost or market value on an aggregate loan portfolio basis. Gains or losses realized on sales of mortgage loans are recognized at the time of sale and are determined by the difference between the net sales proceeds and the carrying value of the loans sold, adjusted for any servicing assets or liabilities related to the loans sold. Gains and losses on sales of mortgage loans are included in other noninterest income. As discussed above, during the first quarter of 2009, Granite Mortgage changed its business model from lender/seller to a broker operation, thereby discontinuing the need for derivative activity associated with mortgage pipeline management.
FAIR VALUE MEASUREMENTS - The Company's fair value measurements are determined in accordance with SFAS No. 157, "Fair Value Measurements," which we adopted during the first quarter of 2008 and apply to fair value valuations for investment securities available for sale, mortgage loans held for sale, impaired loans, and other real estate owned.
Changes in Financial Condition
March 31, 2009 Compared With December 31, 2008 The following table reflects the changes in our assets as of March 31, 2009 compared with December 31, 2008.

                                     March 31,      December 31,
    (In thousands)                     2009             2008         $ Change      % Change
    Total assets                   $ 1,164,369      $ 1,146,955     $  17,414          1.5 %
    Earning assets                   1,078,217        1,069,941         8,276          0.8 %
    Cash and cash equivalents           88,453           48,983        39,470         80.6 %
    Investment securities               88,391           82,203         6,188          7.5 %
    Gross loans                        913,277          948,149       (34,872 )       -3.7 %
    Mortgage loans held for sale        13,751           16,770        (3,019 )      -18.0 %
    Other assets                        36,800           25,299        11,501         45.5 %

The increase in cash and cash equivalents for the period ended March 31, 2009 compared with December 31, 2008 was primarily due to a $44.4 million increase in interest-bearing deposits, partially offset by a $4.4 million decrease in federal funds sold, principally due to efforts by the Bank to increase its liquid assets. Of the $11.5 million increase in other assets as of March 31, 2009 compared to December 31, 2008, $10.7 million relates to the increase in foreclosed properties.

Loans at March 31, 2009 and December 31, 2008 were as follows:

                                                    March 31,                 December 31,
(In thousands)                                         2009                       2008                   $ Change            % Change
Real estate - Construction                      $        133,677            $        146,167          $     (12,490 )           -8.5 %
Real estate - Mortgage                                   584,551                     593,233                 (8,682 )           -1.5 %
Commercial, financial and agricultural                   186,829                     199,370                (12,541 )           -6.3 %
Consumer                                                   9,490                      10,713                 (1,223 )          -11.4 %
All other loans                                              200                         258                    (58 )          -22.5 %

                                                         914,747                     949,741                (34,994 )           -3.7 %
Deferred origination fees, net                            (1,470 )                    (1,592 )                  122             -7.7 %

Total loans                                     $        913,277            $        948,149          $     (34,872 )           -3.7 %


Mortgage loans held for sale                    $         13,751            $         16,770          $      (3,019 )          -18.0 %

The following table reflects the changes in our liabilities and equity as of March 31, 2009 compared with December 31, 2008.

                                                    March 31,                 December 31,
(In thousands)                                         2009                       2008                   $ Change            % Change
Total liabilities                               $      1,094,557            $      1,072,785          $      21,772              2.0 %
Deposits                                               1,009,593                     991,822                 17,771              1.8 %
Non-interest-bearing demand deposits                     111,970                     117,168                 (5,198 )           -4.4 %
Interest-bearing demand deposits                         365,230                     357,552                  7,678              2.1 %
NOW accounts                                             148,927                     153,444                 (4,517 )           -2.9 %
Money market accounts                                    216,303                     204,108                 12,195              6.0 %
Savings deposits                                          20,811                      19,674                  1,137              5.8 %
Time deposits                                            511,582                     497,428                 14,154              2.8 %
Overnight and short-term borrowings                       41,510                      48,947                 (7,437 )          -15.2 %
Long-term borrowings                                      31,066                      14,075                 16,991            120.7 %
Other liabilities                                         12,388                      17,941                 (5,553 )          -31.0 %

Total capital                                             69,812                      74,170                 (4,358 )           -5.9 %
Retained earnings                                         73,703                      77,928                 (4,225 )           -5.4 %
Accumulated other comprehensive loss                      (1,212 )                    (1,077 )                 (135 )           12.5 %

The Company's loan to deposit ratio was 90.46% as of March 31, 2009 compared to 95.60% as of December 31, 2008, and the Bank's loan to deposit ratio was 88.65% compared to 93.14% when comparing the same dates.
In addition to deposits, we have sources of funding in the form of overnight and other short-term borrowings, as well as longer-term borrowings. Overnight borrowings are primarily in the form of federal funds purchased and commercial deposit products that sweep balances overnight into securities sold under agreements to repurchase or commercial paper issued by us. From December 31, 2008 to March 31, 2009, short-term borrowings decreased $3.0 million for the Bank, and $3.0 million for Granite Mortgage when comparing the same periods. The Bank's long-term borrowings from the Federal Home Loan Bank increased $17.0 million during the first quarter of 2009.
Other liabilities of the Bank decreased $2.6 million related to the payout of accrued retirement benefits during the first quarter of 2009.

Liquidity, Interest Rate Sensitivity and Other Risks The objectives of our liquidity management policy include providing adequate funds to meet the cash needs of both depositors and borrowers, as well as providing funds to meet the needs of our ongoing operations. Depositor cash needs, particularly those of commercial depositors, can fluctuate significantly depending on both business and economic cycles, while both retail and commercial deposits can fluctuate significantly based on the yields and returns available from alternative investment opportunities.
Additionally, our liquidity is affected by off-balance sheet commitments to lend in the forms of unfunded commitments to extend credit and standby letters of credit. As of March 31, 2009, such unfunded commitments to extend credit were $149.7 million, and commitments in the form of standby letters of credit totaled $5.3 million.
Neither the Company nor our subsidiaries have historically incurred off-balance sheet obligations through the use of or investment in other off-balance sheet derivative financial instruments or structured finance or special purpose entities. The Bank and Granite Mortgage both had contractual off-balance sheet obligations in the form of noncancelable operating leases as of March 31, 2009, and December 31, 2008, though such obligations and the related lease expenses were not material to our financial condition on such dates or results of operations for the periods then ended.
Liquidity requirements of the Bank are primarily met through two categories of funding. The first is core deposits, which includes demand deposits, savings accounts and certificates of deposits. We consider these to be a stable portion of the Bank's liability mix and the result of ongoing consumer and commercial banking relationships. At March 31, 2009, our core deposits, defined as total deposits excluding time deposits of $100 thousand or more, totaled $791.6 million, or 78.4% of our total deposits, compared to $783.8 million, or 79.0%, of our total deposits as of December 31, 2008.
The other principal methods of funding used by the Bank are large denomination certificates of deposit, federal funds purchased, repurchase agreements and other short and intermediate term borrowings. The Bank's policy is to emphasize core deposit growth rather than growth through purchased or brokered time deposits because core deposits tend to be a more stable source of funding, and purchased or brokered time deposits often have a higher cost of funds. However, the Bank participates in the Certificate of Deposit Account Registry Service ("CDARS") through which the Bank's customers may obtain fully-insured time deposits distributed among other participating banks while the Bank receives reciprocal deposits from other participating banks. The Bank's deposits in the CDARS program totaled $45.7 million at March 31, 2009, a decrease of $7.1 million compared to December 31, 2008. Because CDARS program deposits are classified by current regulations as brokered deposits, the Bank's ability to continue its participation in the CDARS program is based on the Bank's regulatory capital levels as discussed above. During periods of weak demand for its deposit products, the Bank maintains credit facilities under which it may borrow on a short-term basis. As of March 31, 2009, the Bank had an unsecured line of overnight borrowing capacity with its correspondent bank, which totaled $15.0 million. In addition, the Bank uses its capacity to pledge assets to serve as collateral to borrow on a secured basis. As of March 31, 2009, the Bank had investment securities pledged to secure an overnight funding line of approximately $8.8 million with the Federal Reserve Bank. The Bank also has significant capacity to pledge its loans secured by first liens on residential and commercial real estate as collateral for additional borrowings from the Federal Home Loan Bank ("FHLB") during periods when loan demand exceeds deposit growth or when the interest rates on such borrowings compare favorably to interest rates on deposit products. As of March 31, 2009, the Bank had a line of credit with the FHLB totaling approximately $88.0 million collateralized by its pledged residential and commercial real estate loans with $41.0 million outstanding, of which $10.0 million was in overnight and short-term borrowings and $31.0 million was in long-term borrowings, leaving approximately $47.0 million in remaining capacity to borrow.

Prior to March 31, 2009, Granite Mortgage temporarily funded its mortgages and construction loans, from the time of origination until the time of sale, through the use of a line of credit from one of our correspondent financial institutions. As of March 31, 2009 and December 31, 2008, this line of credit was $15.0 million and $30.0 million, respectively. As of March 31, 2009, the line was secured by approximately $11.9 million of the mortgage loans closed by Granite Mortgage. This line of credit was terminated and paid in full in April 2009. Granite Mortgage also obtained a line of credit with the Bank during the first quarter of 2009 for $9.0 million, of which $5.0 million was outstanding as of March 31, 2009, and secured by approximately $6.3 million of mortgage loans closed by Granite Mortgage.
We also have a $2.5 million unsecured line of credit from one of our correspondent banks. The line matures June 30, 2009, bearing an interest rate of one-month LIBOR plus 120 basis points, with interest payable quarterly. As of March 31, 2009, we owed $2.5 million under this line of credit. The Company was not in compliance with all of the financial covenants under this line of credit as of March 31, 2009, but has received waivers from the lender for such noncompliance.
The majority of our deposits are rate-sensitive instruments with rates that tend to fluctuate with market rates. These deposits, coupled with our short-term certificates of deposit, have increased the opportunities for deposit repricing. We place great significance on monitoring and managing our asset/liability position. Our policy for managing our interest margin (or net yield on interest-earning assets) is to maximize net interest income while maintaining a stable deposit base. Our deposit base is generally not subject to the level of volatility experienced in national financial markets in recent years; however, we do realize the importance of minimizing such volatility while at the same time maintaining and improving earnings. A common method used to manage interest rate sensitivity is to measure the difference or gap between the volume of interest-earning assets and interest-bearing liabilities repricing over a specific time period. However, this method addresses only the magnitude of funding mismatches and does not address the magnitude or relative timing of rate changes. Therefore, on a regular basis, we prepare earnings projections based on a range of interest rate scenarios of rising, flat and declining rates in order to more accurately measure interest rate risk.
Interest-bearing liabilities and variable rate loans are generally repriced to current market rates. Because a significant portion of our deposits are variable rate, they generally reprice more rapidly than our rate sensitive assets. During periods of rising rates, this results in decreased net interest income, assuming similar growth rates and stable product mixes in loans and deposits. The opposite occurs during periods of declining rates. While our analysis indicates that our balance sheet is liability-sensitive, the market pricing for recent periods creates a relatively inelastic environment for liabilities, thus resulting in asset-sensitivity.
We use interest sensitivity analysis to measure the sensitivity of projected earnings to changes in interest rates. The sensitivity analysis takes into account the current contractual agreements that we have on deposits, borrowings, loans, investments, and any commitments to enter into those transactions. We monitor interest sensitivity by means of computer models that incorporate the current volumes, average rates, scheduled maturities and payments, and repricing opportunities of asset and liability portfolios. Using this information, our model estimates earnings based on projected portfolio balances under multiple interest rate scenarios. In an effort to estimate the effects of pure interest-rate risk, we assume no growth in our balance sheet, because doing otherwise could have the effect of distorting the balance sheet's sensitivity to changing interest rates. We simulate the effects of interest rate changes on our earnings by assuming no change in interest rates as our base case scenario and either (1) gradually increasing or decreasing interest rates by 3% over a twelve-month period or (2) immediately increasing or decreasing interest rates by 1%, 2%, 3% and 4%, as discussed below. Although these methods are subject to the accuracy of the assumptions that underlie the process and do not take into account the pricing strategies that we would undertake in response to sudden interest rate changes, we believe that these methods provide a better indication of the sensitivity of earnings to changes in interest rates than other analyses.