General

The sole business of Commonwealth Bankshares, Inc. is to serve as a holding company for Bank of the Commonwealth. The Company was incorporated as a Virginia Company on June 6, 1988, and on November 7, 1988 it acquired the Bank.

Bank of the Commonwealth was formed on August 28, 1970 under the laws of Virginia. Since the Bank opened for business on April 14, 1971, its main banking and administrative offices have been located in Norfolk, Virginia. The Bank currently operates four branches in Norfolk, six branches in Virginia Beach, four branches in Chesapeake, two branches in Portsmouth, one branch in Suffolk, and four branches in North Carolina, located in Powells Point, Waves, Moyock and Kitty Hawk. Bank of the Commonwealth Mortgage currently operates one mortgage branch office in Virginia Beach, one mortgage branch office in Gloucester and one mortgage branch office in Richmond, Virginia. Executive Title Center currently operates one title insurance branch office in Norfolk and one title insurance branch office in Suffolk, Virginia. Commonwealth Financial Advisors currently has two locations, one in Virginia Beach and one in Norfolk, Virginia.

The Company concentrates its marketing efforts in the cities of Norfolk, Virginia Beach, Portsmouth, Chesapeake and Suffolk, Virginia and Northeastern North Carolina. The Company intends to continue concentrating its banking activities in its current markets, which the Company believes are attractive areas in which to operate.

The following discussion provides information about the important factors affecting the consolidated results of operations, financial condition, capital resources and liquidity of the Company. This report identifies trends and material changes that occurred during the reporting period and should be read in conjunction with the Company's annual report on Form 10-K for the year ended December 31, 2008.

Forward-Looking Statements

Some of the matters discussed below and elsewhere in this report include forward-looking statements. These forward-looking statements include statements regarding profitability, liquidity, adequacy of the allowance for loan losses, interest rate sensitivity, market risk and financial and other goals. Forward-looking statements often use words such as "believes," "expects," "plans," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends" or other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts. The forward-looking statements we use in this report are subject to significant risks, assumptions and uncertainties, including among other things, the following important factors that could affect the actual outcome of future events:

• Our dependence on key personnel;

• The high level of competition within the banking industry;

• Our dependence on commercial real estate loans that could be negatively affected by a further downturn in the real estate market;

• Continued unfavorable economic conditions in the overall national economy as well as in our specific market areas within Hampton Roads, Virginia and Northeastern North Carolina;

• Risks inherent in making loans such as repayment risks and fluctuating collateral values;

• The adequacy of our estimate for known and inherent losses in our loan portfolio;

• Changes in interest rates;

• Our ability to manage our growth;

• Our ability to assess and manage our asset quality;

• Our ability to maintain internal control over financial reporting;

• Our ability to raise capital as needed by our business;

• Our reliance on secondary sources, such as Federal Home Loan Bank advances, federal funds lines of credit from correspondent banks and out-of-market time deposits, to meet our liquidity needs;

• Governmental and regulatory changes that may adversely affect our expenses and cost structure; and

• Other factors described from time to time in our Securities and Exchange Commission filings.

Because of these and other uncertainties, our actual results and performance may be materially different from results indicated by these forward-looking statements. In addition, our past results of operations are not necessarily indicative of future performance.

We caution you that the above list of important factors is not all inclusive. These forward-looking statements are made as of the date of this report, and we may not undertake steps to update these forward-looking statements to reflect the impact of any circumstances or events that arise after the date the forward-looking statements are made.

Critical Accounting Policies

Certain critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. The Company's most critical accounting policy relates to the Company's allowance for loan losses, which reflects the estimated losses resulting from the inability of the Company's borrowers to make required loan payments. If the financial condition of the Company's borrowers were to deteriorate, resulting in an impairment of their ability to make payments, the Company's estimates would be updated, and additional provisions for loan losses may be required. See Note 1 - Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2008, for further information related to the allowance for loan losses.

New Accounting Pronouncements

There have been no developments to recently issued accounting standards, including the expected dates of adoption and estimated effects on the Company's consolidated financial statements, from those disclosed in the Company's 2008 Annual Report on form 10-K, except for the following:

In June 2009, the FASB issued SFAS No. 168, "The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles, a Replacement of FASB Statement No. 162" ("SFAS 168"). SFAS 168 replaces SFAS 162, "The Hierarchy of Generally Accepted Accounting Principles" and establishes the FASB Accounting Standards Codification (the "Codification") as the source of authoritative accounting principles recognized by the FASB to be applied by non-governmental entities in the preparation of financial statements in conformity with generally accepted accounting principles. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative guidance for SEC registrants. All guidance contained in the Codification carries an equal level of authority. All non-grandfathered, non-SEC accounting literature not included in the Codification is superseded and deemed non-authoritative. SFAS 168 is effective for the Company's financial statements for periods ending after September 15, 2009. The Company does not anticipate that the adoption of this statement will have a material impact on its consolidated financial statements.

In June 2009, the FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R)" ("SFAS 167"). SFAS 167 amends FIN 46 (Revised December 2003), "Consolidation of Variable Interest Entities," to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity's purpose and design and a company's ability to direct the activities of the entity that most significantly impact the entity's economic performance. SFAS 167 requires additional disclosures about the reporting entity's involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity's financial statements. SFAS 167 will be effective January 1, 2010. The Company does not anticipate that the adoption of this statement will have a material impact on its consolidated financial statements.

In June 2009, the FASB issued SFAS No. 166, "Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140" ("SFAS 166"). SFAS 166 amends SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. SFAS 166 eliminates the concept of a "qualifying special-purpose entity" and changes the requirements for derecognizing financial assets. SFAS 166 also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. SFAS 166 will be effective January 1, 2010. The Company does not anticipate that the adoption of this statement will have a material impact on its consolidated financial statements.

In May 2009, the Financial Accounting Standards Board ("FASB") issued SFAS No. 165, "Subsequent Events" ("SFAS 165"). SFAS 165 is intended to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, it establishes that the Company must evaluate subsequent events through the date the financial statements are issued, the circumstances under which a subsequent event should be recognized, and the circumstances for which a subsequent event should be disclosed. SFAS 165 requires disclosure of the date through which an entity has evaluated subsequent events. SFAS 165 became effective for the Company's financial statements for financial periods ending after June 15, 2009. The adoption of this statement did not have a material impact on the Company's consolidated financial statements.

In April 2009, the FASB issued SFAS No. 157-4, "Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly" ("SFAS 157-4"). Under SFAS 157-4, if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any weight on that transaction price as an indicator of fair value. SFAS 157-4 became effective for the Company's financial statements for financial periods ending after June 15, 2009. The adoption of this statement did not have a material impact on the Company's consolidated financial statements.

In April 2009, the FASB issued SFAS No. 141(R)-1, "Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies" ("SFAS 141(R)-1"), to amend SFAS 141 (revised 2007) "Business Combinations." SFAS 141(R)-1 addresses the initial recognition, measurement and subsequent accounting for assets and liabilities arising from contingencies in a business combination, and requires that such assets acquired or liabilities assumed be initially recognized at fair value at the acquisition date if fair value can be determined during the measurement period. If the acquisition-date fair value cannot be determined, the asset acquired or liability assumed arising from a contingency is recognized only if certain criteria are met. FAS 141(R)-1 also requires that a systematic and rational basis for subsequently measuring and accounting for the assets and liabilities be developed depending on their nature. SFAS 141(R)-1 shall be effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is during or after 2010. The Company does not anticipate that the adoption of this statement will have a material impact on its consolidated financial statements, absent any material business combinations.

In April 2009, the FASB issued SFAS No. 115-2 and SFAS No. 124-2, "Recognition and Presentation of Other-Than-Temporary Impairments" ("SFAS 115-2/124-2"). SFAS 115-2/124-2 requires entities to separate an other-than-temporary impairment of a debt security into two components when there are credit related losses associated with the impaired debt security for which management asserts that it does not have the intent to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of its cost basis. The amount of the other-than-temporary impairment related to a credit loss is recognized in earnings, and the amount of the other-than-temporary impairment related to other factors is recorded in other comprehensive loss. SFAS 115-2/124-2 became effective for the Company's financial statements for financial periods ending after June 15, 2009. The adoption of this statement did not have a material impact on the Company's consolidated financial statements.

In April 2009, the FASB issued SFAS No. 107-1 and APB 28-1, "Interim Disclosures about Fair Value of Financial Instruments" ("SFAS 107-1 and APB 28-1"). SFAS 107-1 and APB 28-1 require disclosures about fair value of financial instruments in interim and annual financial statements. SFAS 107-1 and APB 28-1 became effective for the Company's financial statements for financial periods ending after June 15, 2009. The adoption of this statement did not have a material impact on the Company's consolidated financial statements.

Stock Compensation Plans

The Company adopted the provisions of SFAS No. 123(R), Share-Based Payments, on January 1, 2006 using the modified prospective method. Under this method, stock-based awards that are granted, modified, or settled after December 31, 2005, are measured and accounted for in accordance with the provisions of SFAS No. 123(R). Also under this method, expense is recognized for unvested awards that were granted prior to January 1, 2006, based upon the fair value determined at the grant date under SFAS No. 123, Accounting for Stock-Based Compensation. Share-based compensation expense is recorded in salary and employee benefits. Prior to the adoption of SFAS No. 123(R), the Company accounted for its share-based compensation under the intrinsic value method as permitted by Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. Accordingly, the Company previously recognized no compensation expense for employee stock options that were granted with an exercise price equal to the fair value of the underlying common stock on the date of grant.

Stock option compensation expense is the estimated fair value of options granted on the date of grant using the Black-Scholes option-pricing model.
Substantially, all employee stock options are awarded at the end of the year as part of an employees overall compensation, based on the individual's performance during the year, and either vest immediately or over a nominal vesting period. There were no options granted during the six months ended June 30, 2009 and 2008, respectively. There have been no significant changes in the assumptions for the Black-Scholes option-pricing model previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2008. A summary of the Company's stock option activity and related information for the six months ended June 30, 2009 is as follows:

                                           Stock           Weighted           Remaining         Aggregate
                                          Options          Average         Contractual Life     Intrinsic
                                        Outstanding     Exercise Price       ( in months)         Value
Balance at December 31, 2008                463,732    $          17.36
Granted                                          -                   -
Forfeited                                        -                   -
Exercised                                        -                   -
Expired                                          -                   -

Balance at June 30, 2009                    463,732    $          17.36               66.96    $ (5,674,731 )


Balance exercisable at June 30, 2009        463,732    $          17.36               66.96    $ (5,674,731 )

See Note 19 - Stock Based Compensation Plans, of the Notes to Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2008, for further information related to stock based compensation.

Financial Condition

Total assets at June 30, 2009 were $1.1 billion, up 4.6% or $49.7 million from December 31, 2008. Total loans, the Company's largest and most profitable asset, ended the quarter at a record $1.0 billion, up $33.4 million or 3.3% from December 31, 2008. The continued loan growth was achieved not only by the high loan demand generated by the low interest rate environment, but also by the presence in new markets as a result of our branch expansion, and by the efforts of the Company's loan officers to develop new loan relationships combined with the support of existing customers.

As of June 30, 2009, 83.0% of the Company's loan portfolio consisted of commercial loans, which are considered to provide higher yields, but also generally carry a greater risk. It should be noted that 62.1% of these commercial loans are collateralized with real estate, and accordingly do not represent an unfavorable risk. At June 30, 2009, 67.4% of the Bank's total loan portfolio consisted of loans collateralized with real estate.

Deposits are the most significant source of the Company's funds for use in lending and general business purposes. The Company's strong growth in deposits continued into the second quarter of 2009 with deposits at June 30, 2009 reaching a record $880.4 million, an increase of $117.4 million from December 31, 2008. Noninterest-bearing demand deposits decreased by $127.0 thousand or 0.3% and interest-bearing deposits increased by $117.5 million or 16.4%. Time deposits, excluding broker certificates of deposit, increased $50.0 million during the first six months of 2009, with interest-bearing demand and savings accounts decreasing $7.2 million and increasing $832.8 thousand, respectively. Included in time deposits less than $100,000 as of June 30, 2009 and December 31, 2008 are $436.6 million and $362.7 million, respectively in broker certificates of deposits. The interest rates paid on these deposits are consistent, if not lower, than the market rates offered in our local area. Also included in time deposits less than $100,000 are $1.0 million and $4.7 million in CDARS (Certificate of Deposit Account Registry Service) deposits at June 30, 2009 and December 31, 2008. Management believes the overall growth in deposits is a result of the Company's competitive interest rates on all deposit products, new branch locations, special promotions and product enhancements, as well as the Company's continued marketing efforts. The Company's core deposit base is predominantly provided by individuals and businesses located within communities served.

As of June 30, 2009, short-term borrowings (advances from FHLB and FRB) were $67.6 million, compared to $129.1 million outstanding on December 31, 2008. The decrease in short-term borrowings was due to the $117.4 million or 15.4% increase in deposits for the first six months of 2009. With our deposit growth continuing to outpace our loan growth for the six months ended June 30, 2009, the Company was able to pay down our advances with the FHLB and thus reduce our reliance on borrowings from secondary sources.

Results of Operation

During the first six months of 2009, the Company reported earnings of $1.2 million, a decrease of 75.5% over the $4.8 million reported in the first six months of 2008. Due to the prolonged economic downturn and continued economic uncertainties management elected to provide an additional $7.5 million to its allowance for loan losses during the first six months of 2009. This is an increase of $6.2 million over the comparable period in 2008. On a per share basis, diluted earnings decreased 75.0% to $0.17 for the six months ended June 30, 2009 compared to $0.68 for the same period in 2008. Net income for the quarter ended June 30, 2009 totaled $584.1 thousand, a decrease of 75.7% or $1.8 million over the amount reported in the second quarter of 2008. During the second quarter of 2009, management elected to provide $3.5 million to its allowance for loan losses. This is an increase of $2.7 million over the same period in 2008. Diluted earnings per share equaled $0.09 for the three months ended June 30, 2009 compared to earnings of $0.35 for the same period in 2008.

Profitability as measured by the Company's return on average assets (ROA) was 0.21% and 1.08% for the six months ended June 30, 2009 and 2008, respectively. ROA was impacted by the decrease in net income of 75.5% and by the increase in average assets of $220.0 million or 24.7% from June 30, 2008 to June 30, 2009. The return on average equity (ROE) was 2.20% and 8.31% for the six months ended June 30, 2009 and 2008, respectively. The decrease in ROE is the result of the decrease in net income and the decline in year-to-date average equity of $8.1 million or 7.0% from June 30, 2008 to June 30, 2009. The decrease in year-to-date average equity is the result of our net loss of $3.7 million for the year ended December 31, 2008 and the $2.1 million in common stock repurchased during the same period. For the quarter ended June 30, 2009, ROA was 0.21% and ROE was 2.19%.

A fundamental source of the Company's earnings, net interest income, 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 securities, while deposits, short-term borrowings and long-term debt 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. Net interest income was $18.7 million for the six months ended June 30, 2009, an increase of $2.2 million or 13.3% over the $16.5 million for the six months ended June 30, 2008. For the quarter ended June 30, 2009, net interest income was $9.5 million, an increase of $1.1 million or 12.9% over the comparable period in 2008.

Total interest and dividend income was $33.3 million for the six months ended June 30, 2009, an increase of $2.3 million or 7.5% over the same period of 2008. Interest income on loans, including fees, increased $2.6 million or 8.6% to $33.1 million for the six months ended June 30, 2009 as compared to the same period in 2008. For the quarter ended June 30, 2009, total interest and dividend income was $16.8 million and interest income on loans, including fees, was $16.7 million, an increase of 8.1% and 9.1%, respectively over the comparable period in 2008.

Interest expense was $14.6 million and $14.4 million for the six months ended June 30, 2009 and 2008, respectively. Interest expense for the second quarter of 2009 was $7.3 million, as compared to $7.1 million for the second quarter of 2008. The slight increase in interest expense can be attributed to the increase in the Company's average interest bearing liabilities, which was offset by the decrease in the overall rate paid on these liabilities. Average interest bearing liabilities increased $225.3 million or 31.4% from June 30, 2008 to June 30, 2009. This substantial increase was mostly due to the $199.6 million increase in total deposits as of June 30, 2009 as compared to 2008. The overall rate paid on our interest bearing liabilities decreased 92 basis points between June 30, 2008 and June 30, 2009, which is primarily due to the declining interest rate environment.

The net interest margin, calculated by expressing net interest income as a percentage of average interest earning assets, is an indicator of the Company's effectiveness in generating income from earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competition and the economy. The Company's net interest margin (tax equivalent basis) was 3.53% during the first six months of 2009, as compared to 3.92% for the same period in 2008. The compression of our margins from prior year can be attributed to the Federal Reserve lowering the Federal Funds rate 175 basis points between October 2008 and December 2008, 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 competitiveness for deposits from the reduction in liquidity throughout the financial markets has kept rates at a high level relative to loan rates. Also contributing to the compression of our margins was the increase in the balance of non-accruing loans which further lowered interest income. For the quarter ended June 30, 2009, the net interest margin was 3.52% compared to 3.88% for the second quarter in 2008.

The provision for loan losses is the annual cost of maintaining an allowance for inherent credit losses. The amount of the provision each year and the level of the allowance are matters of judgment and are impacted by many factors, including actual credit losses during the period, the prospective view of credit losses, loan performance measures and trends (such as delinquencies and charge-offs), loan growth, the economic environment and other factors, both internal and external that may affect the quality and future loss experience of the credit portfolio. At June 30, 2009, the Company had total allowance for loan losses of $22.3 million or 2.11% of total loans. As a result of the growth in the loan portfolio as well as the continued economic uncertainties, the Company made provisions for loan losses of $7.5 million for the first six months of 2009, an increase of $6.2 million or 497.6% over the same period of 2008. Loan charge-offs for the six months ended June 30, 2009 totaled $16.4 million and recoveries for the same period totaled $24.5 thousand. Of the $16.4 million in loan charge-offs as of June 30, 2009, substantially all of the amount was comprised of relationships with specific reserve allocations previously established. Net charge-offs as a percentage of average loans outstanding was 1.56% and 0.06% for the six months ended June 30, 2009 and 2008, respectively.

Non-performing assets were $75.5 million or 6.65% of total assets at June 30, 2009 compared to $12.2 million or 1.27% of total assets at June 30, 2008. Non-performing loans increased $14.3 million in the first six months of 2009 to $61.9 million. Non-performing loans at June 30, 2009 were comprised of one hundred twenty-four (124) loans, which is reflective of the impact of the weak housing market and slowing economy. $59.3 million or 95.7% of the total . . .