Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

EXECUTIVE SUMMARY

The following information is intended to provide investors a better understanding of the financial position and the operating results of Community Financial Corporation ("Community" or the "Company" and its subsidiary, Community Bank (the "Bank"). The following is primarily from management's perspective and may not contain all information that is of importance to the reader. Accordingly, the information should be considered in the context of the consolidated financial statements and other related information contained herein.

Net income for the three months ended June 30, 2009 decreased $246,000 or 25.4% to $720,000 compared to $965,000 for the three months ended June 30, 2008. Net income for the quarter ended June 30, 2009 decreased due primarily to increased noninterest expense partially offset by an increase in net interest income.

Net interest income for the quarter ended June 30, 2009 increased $451,000, or 11.2%, to $4,457,000 compared to the quarter ended June 30, 2008. Net interest income, which is the difference between the interest income we earn on our interest-earning assets, such as loans and investment securities, and the interest we pay on interest-bearing liabilities, which are primarily deposits and borrowings, was impacted by both the change in our volume of interest earning assets and the interest rate spread between interest-earning assets and interest-bearing liabilities. The primary factors contributing to the increase in net interest income for the quarter ended June 30, 2009 was the growth in interest-earning assets, primarily loans, and lower rates on interest-bearing liabilities. The increase in net interest income for the current quarter was limited due to the elimination of dividends on the Freddie Mac and Fannie Mae preferred stock and Federal Home Loan Bank common stock owned by the Bank. We did not purchase any investment securities during the three months ended June 30, 2009 and anticipate limited securities purchases during the remainder of the current fiscal year.

Management will continue to monitor asset growth to manage the level of regulatory capital and funds acquisition. We continue to monitor the impact changing interest rates may have on both the growth in interest-earning assets and our interest rate spread. The Bank has approximately $350.6 million in adjustable rate loans or 72.9% of total loans which reprice in five years or less, many of which are subject to annual and lifetime interest rate limits. The pace and extent of future interest rate changes will impact the Company's interest rate spread as well as limitations on interest rate adjustments on certain adjustable rate loans.

Funding for the growth in interest-earning assets combined with a falling interest rate environment has impacted the composition of our interest-bearing liabilities. Deposits were up due to increases in interest and non-interest-bearing transaction accounts and borrowed money offset by decreases in time deposits. Management plans to remain competitive in our deposit pricing and anticipates that deposit growth will be the primary source of funding for asset growth during the remainder of the current fiscal year. Due to relative pricing advantages we have utilized brokered deposits and increased borrowings during the June 30, 2009 quarter. During the June 30, 2009 quarter, we experienced continuing competition for time deposits. Management is cognizant of the potential for additional compression in the Bank's margin related to the need to acquire funds and the pace of interest rate changes. Management will continue to monitor the level of deposits and borrowings in relation to the current interest rate environment.

Growth in our loan portfolio so far this fiscal year has exceeded our expectations. Growth in the Bank's loan portfolio for the June 30, 2009 quarter was primarily in commercial real estate, residential home equity loans and lines, and commercial business loans, offset by a decrease in residential first mortgage loans. We expect to focus our future loan growth primarily in the commercial real estate arena and to slow or moderate our construction loan growth due to a slower economy and underwriting changes to limit funding of speculative construction. We have experienced reduced construction activity in our market areas while existing commercial real estate activity continues to be moderate. At June 30, 2009, our assets totaled $531.4 million, including net loans receivable of $490.1 million, compared to total assets of $512.7 million, including net loans receivable of $477.0 million, at March 31, 2009. Construction loans totaled $63.7 million or 12.5%, commercial real estate were $163.1 million or 32.0%, residential first mortgage loans were $137.8 million or 27.0%, commercial business loans were $56.7 or 11.1%, and home equity loans and lines were $43.5 million or 8.5% of our total loan portfolio at June 30, 2009 compared to construction loans of $62.9 million or 12.7%, commercial real estate of $154.8 or 31.1%, residential first mortgage loans of $140.1 or 28.2%, commercial business $53.4 million or 10.8%, and home equity loans and lines of $41.7 million or 8.4% at March 31, 2009.

At June 30, 2009, non-performing assets totaled approximately $15.6 million or 2.95% of assets compared to $9.0 million or 1.75% of assets at March 31, 2009. Our allowance for loan losses to non-performing assets was 38.7% and to total loans was 1.24% at June 30, 2009 compared to 66.43% and 1.25%, respectively at March 31, 2009. The increase consisted of $5.4 million of nonaccrual loans, which included residential permanent and construction loans, and commercial real estate, and $1.2 million of real estate owned and repossessed assets. Due primarily to the slowing economy, we expect an increase in non-performing assets in the future.

During our fiscal year 2009, we evaluated the benefits of the increased yields on our credit card portfolio with the higher risk and operating costs related to maintaining and servicing an unsecured credit card portfolio. We believed that offering a credit card product was important to our existing customer base and for obtaining new customers. As a result of this evaluation, we entered into an agent-bank relationship with an unaffiliated non-bank pursuant to which our customers can obtain credit cards with the Community Bank brand and for which we earn commissions for new accounts and a percentage of interchange fees, but for which we incur no liability or credit risk. At the same time, we sold our existing credit card portfolio to that unaffiliated organization. During the June 30, 2008 quarter, we sold our credit card portfolio with an approximate loan balance of $500,000, which resulted in a gain of $37,000.

Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. We have experienced stable to moderate declines in real estate values in our market areas. The Company has experienced increases in delinquencies for the 2010 fiscal year. Delinquencies have increased from 3.43% at March 31, 2009 to 4.26% at June 30, 2009. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. While there have been increases in unemployment and announced layoffs by certain employers in our markets, there has not been a dramatic or widespread increase in unemployment to date. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by other financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Other financial institutions have experienced decreased access to deposits or borrowings.

Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more difficult and complex under these difficult market and economic conditions. We

also expect to face increased regulation and government oversight as a result of these downward trends. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. We also may be required to pay even higher FDIC premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions have depleted and may continue to deplete the FDIC insurance fund and reduce the FDIC's ratio of reserves to insured deposits.

We do not expect these difficult conditions to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.

The recently enacted Emergency Economic Stabilization Act of 2008 ("EESA") authorizes the U.S. Department of the Treasury ("Treasury Department") to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program ("TARP"). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department has allocated $250 billion towards the TARP Capital Purchase Program ("CPP"). Under the CPP, Treasury will purchase debt or equity securities from participating institutions. The TARP also will include direct purchases or guarantees of troubled assets of financial institutions. The Company made application to the Treasury Department to participate in this program and received an investment by the Treasury Department of $12,643,000 in the form of preferred stock during the December 31, 2008 quarter. The Company also issued to the U.S. Treasury a warrant to purchase 351,194 shares of common stock at $5.40 per share. EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase is in place until the end of 2013 and is not covered by deposit insurance premiums paid by the banking industry. In addition, the FDIC has implemented two temporary programs to provide deposit insurance for the full amount of most non-interest bearing transaction accounts through the end of 2009 and to guarantee certain unsecured debt of financial institutions and their holding companies through June 2012. We expect to participate only in the program that provides unlimited deposit insurance coverage through December 31, 2009 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Under that program, we will pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. At June 30, 2009, we had $3.9 million in such accounts in excess of $250,000.

The purpose of these legislative and regulatory actions is to stabilize the volatility in the U.S. banking system. EESA, TARP and the FDIC's recent regulatory initiatives may not have the desired effect. If the volatility in the market and the economy continue or worsen, our business, financial condition, results of operations, access to funds and the price of our stock could be materially and adversely impacted.

CRITICAL ACCOUNTING POLICIES

General

The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial

effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard ("SFAS") No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The allowance for loan losses is maintained at a level considered by management to be adequate to absorb future loan losses currently inherent in the loan portfolio. Management's assessment of the adequacy of the allowance is based upon type and volume of the loan portfolio, past loan loss experience, existing and anticipated economic conditions, and other factors which deserve current recognition in estimating future loan losses. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Additions to the allowance are charged to operations. Subsequent recoveries, if any, are credited to the allowance. Loans are charged-off partially or wholly at the time management determines collectibility is not probable. Management's assessment of the adequacy of the allowance is subject to evaluation and adjustment by the Company's regulators.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful or substandard. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers special mention and non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

FINANCIAL CONDITION

The Company's total assets increased $18.7 million to $531.4 million at June 30, 2009 from $512.7 million at March 31, 2009 due to increases in loans receivable of $13.1 million, cash of $2.7 million, real estate owned of $1.2 million, Federal Home Loan Bank Stock of $900,000, and cash consisting of interest bearing deposits at other financial institutions of $600,000. The increase in loans was funded with increases in savings and interest bearing deposits of $5.2 million, non-interest bearings deposits of $4.0 million, increases in FHLB advances and borrowings of $13.6 million and decreases in time deposits of $3.6 million at June 30, 2009 from March 31, 2009. FHLB advances increased by $14.0 million and other borrowings decreased by $300,000. Stockholders' equity increased $562,000 to 46.9 million at June 30, 2009, from $46.3 million at March 31, 2009, due to income for the three months ended June 30, 2009 of $720,000 million offset by cash dividend payments.

At June 30, 2009, non-performing assets totaled approximately $15.6 million or 2.95% of assets compared to $9.0 million or 1.75% of assets at March 31, 2009. Non-performing assets at June 30, 2009 were comprised of repossessed assets of $2.6 million and non accrual loans of $13.0 million. Included in the total non-performing assets at June 30, 2009 was one relationship of approximately $1.6 million which includes $1.4 million of residential lots. At June 30, 2009, our allowance for loan losses to non-performing assets was 38.7% and to total loans was 1.24% compared to 66.43% and 1.25%, respectively at March 31, 2009. At June 30, 2009 the percentage of delinquent loans to total loans was 4.26% compared to 3.43% at March 31, 2009. Our allowance for loan losses to total loans remained relatively unchanged at June 30, 2009 compared to March 31, 2009 because no significant additional specific allowances were considered warranted at June 30, 2009 on the Bank's nonperforming assets and due to the growth in our loan portfolio Based on current market values of the properties securing these loans, management anticipates no significant losses in excess of the allowance for losses previously recorded. Although management believes that it uses the best information available to make such determinations, future adjustments to allowances may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.

As of June 30, 2009, there were also $9.3 million in loans with respect to which known information about the possible credit problems of the borrowers or the cash flows of the security properties have caused management to have doubts as to the ability of the borrowers to comply with present loan repayment terms and which may result in the future inclusion of such items in the non-performing loan categories. These loans are comprised primarily of residential real estate loans. No individual loan in this category has a balance that exceeds $700,000.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of funds are customer deposits, advances from the Federal Home Loan Bank of Atlanta, amortization and prepayment of loans and funds provided from operations. Management maintains investments in liquid assets based upon its assessment of (i) the need for funds, (ii) expected deposit flows, (iii) the yields available on short-term liquid assets, (iv) the liquidity of our loan portfolio and (v) the objectives of our asset/liability management program. Management believes that the Bank will continue to have adequate liquidity for the foreseeable future. Cash flow projections are regularly

reviewed and updated to assure that adequate liquidity is provided. As of June 30, 2009, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings and current borrowings) was 3.2%.

The Bank has a line of credit with the FHLB equal to 26% of the Bank's assets, subject to the amount of collateral pledged. Under the terms of its collateral agreement with the FHLB, the Bank provides a blanket lien covering all of its residential first mortgage loans, home equity lines of credit, multi-family loans and commercial loans. In addition, the Bank pledges as collateral its capital stock in and deposits with the FHLB. Based on the collateral pledged as of June 30, 2009, the total amount of borrowing available under the FHLB line of credit was approximately $134,000,000. At June 30, 2009, principal obligations to the FHLB consisted of $88,000,000 in floating-rate, overnight borrowings, $20,000,000 in fixed-rate convertible advances and a $4,000,000 letter of credit to the Treasurer of Virginia for public deposits. The Company had a loan with a bank in the amount of $750,000 at June 30, 2009.

At June 30, 2009, we had commitments to purchase or originate $22.8 million of loans. Certificates of deposit scheduled to mature in one year or less at June 30, 2009, totaled $252.2 million. Based on our historical experience, management believes that a significant portion of such deposits will remain with us. Management further believes that loan repayments and other sources of funds will be adequate to meet our foreseeable short-term and long-term liquidity needs. At June 30, 2009, we had brokered or internet time deposits of $14.6 million.

The Bank's regulatory capital changed from "adequately capitalized" at September 30, 2008 to "well capitalized" at June 30, 2009 due to the issuance of preferred stock under the U.S. Treasury Capital Purchase Program. The Company received $12,643,000 from the U.S. Treasury through the sale of 12,643 shares of preferred stock. The Company also issued to the U.S. Treasury a warrant to purchase 351,194 shares of common stock at $5.40 per share. The preferred shares pay a cumulative dividend of 5% per year for the first five years and 9% per year thereafter. The preferred shares are callable at 100% of the issue price, subject to the approval of the Company's federal regulator.

RESULTS OF OPERATIONS

Three Months Ended June 30, 2009 and 2008.

General. Net income for the three months ended June 30, 2009 decreased $246,000 or 25.5% to $720,000 from $965,000 for the three months ended June 30, 2008. Net interest income increased $450,000, the provision for loan losses increased 129,000, non-interest income increased $104,000 and non-interest expense increased $689,000 during the three months ended June 30, 2009 compared to the same period in 2008. Return on equity for the three months ended June 30, 2009 was 6.14% compared to 9.86% for the three month period ended June 30, 2008. Return on assets was .55% for quarter ended June 30, 2009 compared to 0.80% for the same period in the previous fiscal year.

Interest Income. Total interest income decreased by $581,000 to $6.9 million for the three months ended June 30, 2009, from $7.5 million for the three months ended June 30, 2008, due to lower yields partially offset by higher average loan balances. Investment securities income decreased by $21,000 due to lower average balances as a result of calls and maturities on securities. Other interest income decreased by $266,000 due to elimination of dividends on Freddie Mac, Fannie Mae and FHLB stocks. The decrease in yields was due to lower market interest rates generally. The average yield earned on interest-earning assets was 5.61% for the three months ended June 30, 2009 compared to 6.45% for the three months ended June 30, 2008.

Interest Expense. Total interest expense decreased by $1.1 million to $2.4 million for the quarter ended June 30, 2009, from $3.5 million for the quarter ended June 30, 2008. Interest on deposits decreased by $682,000 to $2.2 million for the quarter ended June 30, 2009 from $2.9 million for the quarter ended June 30, 2008 due to a decrease in the average rate paid, partially offset by higher average deposit balances. Interest expense on borrowed money decreased by $349,000 to $247,000 for the quarter ended June 30, 2009 compared to $597,000 million for the quarter ended June 30, 2008. A decrease in the average rate paid on borrowings from 2.66% to 0.91% offset by an increase in the average balance of borrowings from $89.6 million for the June 30, 2008 quarter to $108.6 million for the June 30, 2009 quarter accounted for the decrease. The average rate paid on interest-bearing liabilities was 2.07% during the three months ended June 30, 2009 compared to 3.15% for the three months ended June 30, 2008.

Provision for Loan Losses. The provision for loan losses increased $129,000 to $281,000 for the three months ended June 30, 2009, from $152,000 for the three months ended June 30, 2008. The amount of the provision for loan losses for the quarter ended June 30, 2009 was based on management's assessment of the inherent risk associated with the increase in our loan portfolio and the level of our allowance for loan losses. We provide valuation allowances for anticipated losses on loans and real estate when management determines that a significant decline in the value of the collateral or cash flows has occurred, as a result of which the value of the collateral or cash flows is less than the amount of the unpaid principal of the related loan plus estimated costs of acquisition and sale. In addition, we also provide allowances based on the dollar amount and type of collateral securing our loans in order to protect against unanticipated losses. At June 30, 2009, management believes its allowance for loan losses was adequate to absorb any probable losses inherent in the Company's loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to allowances may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.
Noninterest Income. Noninterest income increased by $104,000 to $944,000 for the three months ended June 30, 2009, from $840,000 for the three months ended June 30, 2008 due primarily to mortgage loan origination fees. The Bank has established relationships with other institutions where the Bank receives fees in return for completed customer mortgage loan applications for the institution's approval and funding. We anticipate these relationships will continue to be a source of fee and service charge income for the Bank.

Noninterest Expense. Noninterest expense increased by $689,000 to $3.9 million for the three months ended June 30, 2009 compared to the same period last year. The increase in noninterest expense resulted primarily from compensation related expenses due generally to a contractual payment to a former employee, merit increases, additional retail personnel and increased federal deposit insurance premiums.
Federal deposit insurance premiums during the three months ended June 30, 2009 totaled $314,000, compared to $71,000 for the same period in 2008. Under FDIC's current risk-based assessment rules, assessment rates range from 7 to 77.5 basis points. In addition to the regular assessments, the FDIC has imposed a special assessment of 5 basis points on the amount of each institution's assets reduced by the amount of its Tier 1 capital as of June 30, 2009, to be collected September 30, 2009. The FDIC has announced that one additional special assessment is probable and a second is less certain.

Taxes. Taxes decreased by $18,000 to $465,000 for the three months ended June 30, 2009, from a $483,000 tax provision for the three months ended June 30, 2008. The effective tax rate increased from 33.3% for the June 30, 2008 quarter to 39.3% for the June 30, 2009 quarter due to the significant decrease in tax preference income.

OFF BALANCE SHEET ARRANGEMENTS

There has not been a significant change in our off balance sheet arrangements from the information reported in our annual 10-K for the period ended March 31, 2009.

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