(Dollar amounts are expressed in thousands unless otherwise noted)
Overview
Southeastern Bank Financial Corporation (the "Company") operates two wholly-owned subsidiaries in the Augusta-Richmond County, GA-SC metropolitan area. Georgia Bank & Trust Company (the "Bank") was organized by a group of local citizens and commenced business on August 28, 1989, with one branch location. Today, it is Augusta's largest community banking company operating nine full service branches in Augusta, Martinez, and Evans, Georgia and one branch in Athens, Georgia. Mortgage origination offices are located in Augusta, Savannah and Athens, Georgia. SB&T Capital Corporation (the "LPO") a wholly-owned subsidiary of the Bank, was organized on August 16, 2007 and opened an office in Greenville, South Carolina. Southern Bank & Trust (the "Thrift"), a federally chartered thrift, was organized by the Company during 2005 and 2006 and opened its main office on September 12, 2006. Today it operates three full service branches in North Augusta and Aiken, South Carolina. The Company's Operations Center is located in Martinez, Georgia and services both subsidiaries.
During the second quarter the Company made the decision to cease originations of new loans in its Greenville, South Carolina office and allow the portfolio, primarily real estate loans, to decline over the life of the remaining loans. No exit costs were incurred as a result of the decision.
During the second quarter Georgia Bank & Trust withdrew from its partnership of 30% interest with NMF Asset Management, LLC. As a result the Bank wrote off its investment of $20 in the partnership in the second quarter.
The Company's primary market includes Richmond and Columbia Counties in Georgia and Aiken County in South Carolina, all part of the Augusta-Richmond County, GA-SC metropolitan statistical area (MSA). The 2008 population of the Augusta-Richmond County, GA-SA MSA was 534,218, the second largest in Georgia and fourth largest in South Carolina. The Augusta market area has a diversified economy based principally on government, public utilities, health care, manufacturing, construction, and wholesale and retail trade. Augusta is one of the leading medical centers in the Southeast. The Company entered the Athens, GA market in December 2005. The 2008 population for the Athens-Clarke County, GA MSA was 189,264, ranked fifth in the state of Georgia. The Athens market area has a diversified economy based primarily on government, retail services, tourism, manufacturing, other services, and health care, with the largest share of government jobs in the state.

The Company's services include the origination of residential and commercial real estate loans, construction and development loans, and commercial and consumer loans. The Company also offers a variety of deposit programs, including noninterest-bearing demand, interest checking, money management, savings, and time deposits. In the primary market area, Augusta-Richmond County, GA-SC metropolitan area, the Company had 16.70% of all deposits and was the second largest depository institution at June 30, 2009, as cited from the Federal Deposit Insurance Corporation's website. Securities sold under repurchase agreements are also offered. Additional services include wealth management, trust, retail investment, and mortgage. As a matter of practice, most mortgage loans are sold in the secondary market; however, some mortgage loans are placed in the portfolio based on asset/liability management strategies. The Company continues to concentrate on increasing its market share through various new deposit and loan products and other financial services and by focusing on the customer relationship management philosophy. The Company is committed to building life-long relationships with its customers, employees, shareholders, and the communities it serves.
The Company's primary source of income is from its lending activities followed by interest income from its investment activities, service charges and fees on deposits, and gain on sales of mortgage loans in the secondary market. Interest income on loans decreased during the first nine months of 2009 as compared to the first nine months of 2008 due to lower interest rates and increased levels of loans placed on nonaccrual offset in part by increased volumes. Interest income on investment securities increased primarily due to increased volumes. Service charges and fees on deposits decreased as a result of decreases in NSF income on retail checking accounts due primarily to decreased economic activity and was partially offset by increases in ATM/Debit card income. Declining mortgage rates and a significant increase in mortgage refinancing activity resulted in an increase in gain on sales of loans for the first nine months of 2009 as compared to the same period in 2008. Investment securities gains increased due to $2,268 in gains on sales of securities somewhat offset by an other-than-temporary impairment charge of $475 recognized on two mortgage-backed securities and a $1,033 impairment charge related to investments in the common stock and trust preferred securities of Silverton Financial Services, Inc., parent holding company of Silverton Bank, N.A., which was placed in receivership on May 1, 2009.

                                                   September 30,        December 31,        December 31,
                                                       2009                 2008                2004
                                                                  (Dollars in thousands)
Assets                                            $     1,475,805      $    1,411,039      $      706,517
Loans                                                     983,851           1,005,786             494,170
Deposits                                                1,258,748           1,139,552             556,785

Annualized return on average total assets                    0.13 %              0.57 %              1.29 %
Annualized return on average equity                          1.93 %              8.48 %             15.50 %

The Company continues to experience growth although at a slower rate as evidenced in Table 1 above. The Company has also achieved increases in deposits and continues to provide returns on assets and equity although on a reduced level as noted in the table above. Annualized return on average total assets and annualized return on average equity have declined recently due primarily to increased levels of non-performing assets which have resulted in higher loan loss provisions. Net income for the year ended 2004 was $8.7 million compared to net income of $7.6 million at year end 2008. Net income for the nine months ended September 30, 2009 was $1.4 million compared to $6.9 million for the same period in 2008. Current market conditions along with increases to the provision for loan losses and impairment charges had a significant effect on net income for the year. The Company has paid cash dividends of $0.13 per share each quarter since 2004 but has elected to suspend dividends effective April 24, 2009 to conserve capital. The suspension of the dividend conserves approximately $3.5 million of capital per year.
The Company meets its liquidity needs by managing cash and due from banks, federal funds purchased and sold, maturity of investment securities, principal repayments from mortgage-backed securities, and draws on lines of credit. Additionally, liquidity can be managed through structuring deposit and loan maturities. The Company funds loan and investment growth with core deposits, securities sold under repurchase agreements, Federal Home Loan Bank advances and other wholesale funding including brokered certificates of deposit. During inflationary periods, interest rates generally increase and operating expenses generally rise. When interest rates rise, variable rate loans and investments produce higher earnings; however, deposit and other borrowings interest expense also rise. The Company monitors its interest rate risk as it applies to net income in a ramp up and down annually 200 basis points (2.00%) scenario and as it applies to economic value of equity in a shock up and down 200 (2.00%) basis points scenario. The Company monitors operating expenses through responsibility center budgeting.
Forward-Looking Statements
Southeastern Bank Financial Corporation may, from time to time, make written or oral forward-looking statements, including statements contained in the Company's filings with the Securities and Exchange Commission (the "Commission") and its reports to shareholders. Statements made in such documents, other than those concerning historical information, should be considered forward-looking and subject to various risks and uncertainties. Such forward-looking statements are made based upon management's belief as well as assumptions made by, and information currently available to, management pursuant to "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. The Company's actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors, including unanticipated changes in the Company's local economies, the national economy, governmental monetary and fiscal policies, deposit levels, loan demand, loan collateral values and securities portfolio values; difficulties in interest rate risk management; the effects of competition in the banking business; difficulties in expanding the Company's business into new markets; changes in governmental regulation relating to the banking industry, including regulations relating to branching and acquisitions; failure of assumptions underlying the establishment of reserves for loan losses, including the value of collateral underlying delinquent loans; and other factors. The Company cautions that such factors are not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by, or on behalf of, the Company.

Critical Accounting Estimates
The accounting and financial reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Of these policies, management has identified the allowance for loan losses, determining the fair values of financial instruments, investment securities, income taxes, and other-than-temporary impairment as critical accounting estimates that requires difficult, subjective judgment and are important to the presentation of the financial condition and results of operations of the Company. Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses charged to expense, which affects the Company's earnings directly. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that reflects management's estimate of the level of incurred losses in the portfolio. Factors considered by management in determining the adequacy of the allowance include, but are not limited to:
(1) detailed reviews of individual loans; (2) historical and current trends in loan charge-offs for the various portfolio segments evaluated; (3) the level of the allowance in relation to total loans and to historical loss levels;
(4) levels and trends in non-performing and past due loans; (5) collateral values of properties securing loans; (6) management's assessment of economic conditions. The Company's Board of Directors reviews the recommendations of management regarding the appropriate level for the allowance for loan losses based upon these factors. The provision for loan losses is the charge to operating earnings necessary to maintain an adequate allowance for loan losses. The Company has developed policies and procedures for evaluating the overall quality of its loan portfolio and the timely identification of problem credits. Management continues to review these policies and procedures and makes further improvements as needed. The adequacy of the Company's allowance for loan losses and the effectiveness of the Company's internal policies and procedures are also reviewed periodically by the Company's regulators and the Company's internal loan review personnel. The Company's regulators may advise the Company to recognize additions to the allowance based upon their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result. The Company continues to refine the methodology on which the level of the allowance for loan losses is based, by comparing historical loss ratios utilized to actual experience and by classifying loans for analysis based on similar risk characteristics. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement; however, cash receipts on impaired and nonaccrual loans for which the accrual of interest has been discontinued are applied to principal and interest income depending upon the overall risk of principal loss to the Company.

Fair Value of Financial Instruments
A significant portion of the Company's assets are financial instruments carried at fair value. This includes securities available for sale and certain loans held for sale. At September 30, 2009 and December 31, 2008 the percentage of total assets measured at fair value was 22.65% and 22.56% respectively. The majority of assets carried at fair value are based on either quoted market prices or market prices for similar instruments. At September 30, 2009, 4.48% of assets measured at fair value were based on significant unobservable inputs. This represents approximately 1.01% of the Company's total assets. See Note 4 "Fair Value Measurements" in the "Notes to Consolidated Financial Statements" herein for additional disclosures regarding the fair value of financial instruments.
Investment Securities
The fair values for available-for-sale securities are generally based upon quoted market prices or observable market prices for similar instruments. These values take into account recent market activity as well as other market observable data such as interest rate, spread and prepayment information. When market observable data is not available, which generally occurs due to the lack of liquidity for certain securities, the valuation of the security is subjective and may involve substantial judgment. The Company conducts periodic reviews to identify and evaluate each available-for-sale security that has an unrealized loss for other-than-temporary impairment. An unrealized loss exists when the fair value of an individual security is less than its amortized cost basis. The primary factors the Company considers in determining whether an impairment is other-than-temporary are the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer and the Company's intent and ability to retain its investment in the issuer for a period of time to allow for any anticipated recovery in market value. As of September 30, 2009 the Company had approximately $14,505 of available-for-sale securities, which is approximately 0.981% of total assets, valued using unobservable inputs (Level 3). These securities were primarily non-agency mortgage-backed securities and subordinated debentures issued by financial institutions.
Results of Operations
The Company's net income for the third quarter of 2009 was $740, which was a decrease of $1,135 (60.53%) compared to net income of $1,875 for the third quarter of 2008. Diluted net income per share for the three months ended September 30, 2009 was $0.11 compared to $0.31 for the three months ended September 30, 2008. Net income for the first nine months of 2009 was $1,433, a decrease of $5,485 (79.29%) compared with net income of $6,918 for the first nine months of 2008. The decrease in net income for the three and nine months ended September 30, 2009 as compared with the three and nine months ended September 30, 2008, was primarily a result of increases in the provision for loan losses due to increased levels of nonperforming assets. Interest income on loans decreased due to lower interest rates and increased levels of nonaccrual loans somewhat offset by increased volumes. Interest income on investment securities increased due to increased volumes. Interest expense on deposits, securities sold under repurchase agreements and other borrowings decreased as a result of lower interest rates offset in part by higher volumes of interest bearing liabilities.

Factors contributing to the increase in noninterest income for the nine months ended September 30, 2009, were increases in gain on sales of loans and in net investment securities gains somewhat offset by a decrease in trust service fees and service charges and fees on deposits.
Gain on sales of loans increased substantially as mortgage rates declined and mortgage refinancing activity increased. For the quarter gain on sales of loans increased from $1,529 to $1,945 or 27.21%. Year-to-date gains increased from $4,365 to $6,643 or 52.19%.
Net investment securities gains including OTTI losses for the quarter were $25 which increased $4 over 2008. Year to date net investment gains were $718, an increase of $630 over 2008. The increases are primarily due to $2,268 in gains recognized on sales of investment securities somewhat offset by losses recognized due to the failure of Silverton Bank National Association of $1,033 and other than temporary impairment charges for two securities which totaled $475.
Service charges and fees on deposits for the quarter were $1,846, a decrease of $109 or 5.58%. Year to date service charges were $5,224, a decrease of $222 or 4.08%. The decreases were primarily due to decreases in consumer NSF fees. The decline in NSF income was primarily due to reduced consumer activity which the Company attributes to the economic environment.
Noninterest expense totaled $10,264 for the quarter, an increase of $899 or 9.60%. Year-to-date noninterest expense totaled $30,906, an increase of $3,356 or 12.18%. The increases during the three and nine months ended September 30, 2009 compared to the same periods ended September 30, 2008 were primarily due to increased FDIC insurance expenses and increased commissions paid on mortgage production. For the nine month period FDIC insurance expense increased approximately $1,610 due a special assessment of $670 as well as an increase in the insurance rate over prior year which increased from approximately 7bp to 16bp of insured deposits during the comparable periods. Commissions paid on mortgage production increased approximately $639 as a result of increased mortgage production.

                     Table 2 - Selected Balance Sheet Data

                                        September 30,        December 31,               Variance
                                            2009                 2008            Amount            %
                                                            (Dollars in thousands)
Cash, due from banks and
interest-bearing deposits              $        92,218      $       27,988      $  64,230          229.5 %
Federal funds sold                               7,300               9,780         (2,480 )        (25.4 %)
Investment securities                          313,951             300,028         13,923            4.6 %
Loans                                          983,851           1,005,786        (21,935 )         (2.2 %)
Other real estate owned                         15,619               5,734          9,885          172.4 %
Assets                                       1,475,805           1,411,039         64,766            4.6 %
Deposits                                     1,258,748           1,139,552        119,196           10.5 %
Securities sold under repurchase
agreements                                         860              62,553        (61,693 )        (98.6 %)
Advances from Federal Home Loan
Bank                                            77,000              84,000         (7,000 )         (8.3 %)
Liabilities                                  1,370,318           1,316,388         53,930            4.1 %
Stockholders' equity                           105,487              94,651         10,836           11.4 %

Table 2 highlights significant changes in the balance sheet at September 30, 2009 as compared to December 31, 2008. Assets increased $64,766, primarily the result of higher balances in cash, due from banks and interest-bearing deposits in other banks which increased $64,230 from December 31, 2008 to $92,218 at September 30, 2009, $64,186 of which was held at the Federal Reserve Bank. Management has maintained an increased level of liquid funds in light of current economic conditions and volatility in the banking industry. Gross loans decreased $21,935 due primarily to decreased demand resulting from the slowing economy. The decreased demand caused normal principal repayments to exceed the originations of new loans during the year. In addition, loans decreased due to real estate acquired through foreclosure which increased $9,885. Investment securities increased $13,923 due to in part to the decrease in loans, the growth in deposits and for the purpose of managing the Company's interest rate risk profile. Proceeds from sales and maturities and other purchases were partially reinvested in instruments that required a lower level of regulatory capital and that have lower levels of interest rate risk. The increase in assets was funded by an increase in deposits of $119,196, somewhat offset by decreases in securities sold under repurchase agreements of $61,693. The large increase in deposits included approximately $60,000 in public funds which moved from securities sold under repurchase agreements to NOW accounts.
The annualized return on average assets for the Company was 0.13% for the nine months ended September 30, 2009, compared to 0.71% for the same period last year. While total assets have increased $97,675 since third quarter 2008, net income has decreased $5,485 resulting in a decrease in ROA.
The annualized return on average stockholders' equity was 1.93% for the nine months ended September 30, 2009, compared to 10.39% for the same period last year. The decrease is primarily attributable to the decrease in net income.

Net Interest Income
The primary source of earnings for the Company is net interest income, which is the difference between income on interest-earning assets, such as loans and investment securities, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings. The following table shows the average balances of interest-earning assets and interest-bearing liabilities, annualized average yields earned and rates paid on those respective balances, and the actual interest income and interest expense for the periods indicated. Average balances are calculated based on daily balances, yields on non-taxable investments are not reported on a tax equivalent basis and average balances for loans include nonaccrual loans even though interest was not earned.
Table 3 - Average Balances, Income and Expenses, Yields and Rates

                                               Three Months Ended Sept. 30, 2009                   Three Months Ended Sept. 30, 2008
                                                               Annualized                                          Annualized
                                                                Average         Amount                              Average         Amount
                                            Average             Yield or       Paid or          Average             Yield or       Paid or
                                            Amount                Rate          Earned          Amount                Rate          Earned
                                                                              (Dollars in thousands)
Interest-earning assets:
Loans                                   $       981,976               5.69 %   $ 14,218     $       968,298               6.09 %   $ 15,003
Investment securities
Taxable                                         265,590               4.60 %      3,052             232,366               5.46 %      3,171
Tax-exempt                                       22,123               4.38 %        242              16,032               4.34 %        174
Federal funds sold                                7,300               1.19 %         22              39,133               1.91 %        188
Interest-bearing deposits in other
banks                                            61,940               0.43 %         68                 500               5.40 %          7

Total interest-earning assets           $     1,338,929               5.18 %   $ 17,602     $     1,256,329               5.82 %   $ 18,543


Interest-bearing liabilities:
Deposits                                $     1,079,093               2.08 %   $  5,658     $       962,011               3.09 %   $  7,497
Federal funds purchased / securities
sold under repurchase agreements                 57,907               0.78 %        114              59,266               1.97 %        295
Other borrowings                                101,764               3.93 %      1,009             104,171               3.84 %      1,009

Total interest-bearing liabilities      $     1,238,764               2.17 %   $  6,781     $     1,125,448               3.10 %   $  8,801


Net interest margin/income:                                           3.17 %   $ 10,821                                   3.04 %   $  9,742

       Table 4 - Average Balances, Income and Expenses, Yields and Rates

                                               Nine Months Ended Sept. 30, 2009                    Nine Months Ended Sept. 30, 2008
                                                             Annualized                                           Annualized
                                                               Average         Amount                               Average        Amount
                                           Average            Yield or        Paid or           Average            Yield or       Paid or
                                           Amount               Rate           Earned           Amount               Rate          Earned
                                                                             (Dollars in thousands)
Interest-earning assets:
Loans                                  $       989,637              5.65 %     42,228 $     $       937,175              6.54 %   $ 46,483
. . .