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. 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 quarter ended June 30, 2012 increased $670,000 to $1.2 million compared to $548,000 for the quarter ended June 30, 2011. Net income for the quarter increased primarily due to a $522,000, or 73.9%, decrease in the provision for loan loss and a $1.2 million, or 76.7%, decrease in real estate owned and collection expenses. The decreased provision for the period was primarily related to lower charge-offs and management's analysis of the Bank's loan portfolio. This was partially offset by a $488,000, or 8.3%, decrease in net interest income resulting primarily from a decrease in interest income reflecting the decrease in total loans, especially commercial, construction and development loans that carry a higher interest rate.

Net interest income for the quarter ended June 30, 2012 decreased $488,000, or 8.3%, to $5.4 million compared to the quarter ended June 30, 2011. 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. The primary factor contributing to the decrease in net interest income for the quarter ended June 30, 2012 was lower average balances on interest-bearing assets.

Management will continue to monitor the balance sheet to manage the level of regulatory capital and liquidity requirements. We continue to monitor the impact changing interest rates may have on both our interest-earning assets and our interest rate spread. The Bank has approximately $347.2 million in adjustable rate loans, or 77.9% 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 will limitations on interest rate adjustments on certain adjustable rate loans.

On July 17, 2012, the OCC imposed higher minimum capital ratios on our wholly owned subsidiary Community Bank, and the Bank's capital ratios at June 30, 2012, exceeded those higher requirements. See Note 4 to the Notes to Unaudited Interim Consolidated Financial Statements in this Form 10-Q.

On August 2, 2012, the Company and the its wholly owned subsidiary Community Bank, entered into an Agreement and Plan of Merger with City Holding Company and City National Bank of West Virginia pursuant to which the Company will be merged with and into City Holding Company, and, immediately thereafter, Community Bank will be merged with and into City National Bank of West Virginia. At the effective time of the merger of the Company into City Holding Company, each common stockholder of the Company will receive 0.1753 shares of the common stock, par value $2.50 per share, of City Holding Company, with cash paid in lieu of fractional shares. The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval of the Agreement by the stockholders of the Registrant, and is expected to be completed in early 2013. The Agreement and Plan of Merger is summarized in and included as an exhibit to the Company's Form 8-K Current Report filed on August 3, 2012.

On August 9, 2012, the Community entered into a written agreement with the OCC, which is summarized in Item 5 of and included as Exhibit 10.15 to this Form 10-Q.

Our continued emphasis on acquiring interest and non-interest bearing transaction accounts, combined with a falling interest rate environment, has impacted the composition of our interest-bearing liabilities. Deposits were down approximately $4.3 million, or 1.2%, at June 30, 2012 from March 31, 2011, due to decreases in time deposits, interest bearing transaction accounts, and savings accounts, partially offset by increases in noninterest bearing transaction accounts. Management plans to remain competitive in our deposit pricing; though rates on new time deposits with terms in excess on one year must be approved by our potential acquiror under the Agreement and Plan of Merger. Due to relative pricing advantages, we have utilized brokered deposits and borrowings during the June 30, 2012 quarter. During the June 30, 2012 quarter, we experienced increased competition for time deposits.

Management is cognizant of the potential for 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.

The Bank's loan portfolio decreased $7.1 million from March 31, 2012 to June 30, 2012. This decrease was primarily in commercial real estate loans, construction and land development loans, and consumer loans, partially offset by increases to commercial business loans. We expect any future loan growth to be slow or moderate due to a slower economy and underwriting changes to limit funding of speculative construction loans. We have experienced reduced construction activity in our market areas and existing commercial real estate activity continues to be weak. At June 30, 2012, our assets totaled $498.5 million, including net loans receivable of $438.0 million, compared to total assets of $503.9 million, including net loans receivable of $445.1 million, at March 31, 2012. Commercial real estate loans were $131.6 million or 29.5%, residential real estate loans were $183.1 million or 41.1%, construction and land development loans totaled $43.4 million or 9.7%, and commercial business loans were $54.3 million or 12.2% of our total loan portfolio at June 30, 2012 compared to commercial real estate loans of $137.6 million or 30.3%, residential real estate loans of $182.4 million or 40.2%, construction and land development loans of $50.1 million or 11.1%, and commercial business loans of $48.6 million or 10.7% at March 31, 2012.

At June 30, 2012, non-performing assets totaled $22.7 million or 4.56% of assets compared to $21.6 million or 4.29% of assets at March 31, 2012. Our allowance for loan losses to non-performing loans was 56.54% and to total loans was 1.91% at June 30, 2012 compared to 73.00% and 2.0%, respectively, at March 31, 2012 due primarily to decreased general allowances and increased non-performing assets. The increase in nonperforming assets consisted of a $2.8 million increase in nonaccrual loans, partially offset by a decrease of $1.7 million in real estate owned and repossessed assets. Due primarily to the slow economy, we recognize the possibility of an increase in non-performing assets in the future. Charge-offs of $674,000 during the three month period consisted primarily of $399,000 of residential real estate loans, $82,000 of construction and land development, $103,000 of commercial business loans and $90,000 of automobile loans.

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 declines in real estate values in our market areas. General downward economic trends, reduced availability of commercial credit and continuing high unemployment have negatively impacted the 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 relative to the historical norm, lack of customer confidence, increased market volatility and widespread reduction in general business activity.

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 may be required to pay higher FDIC premiums if financial institution failures 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 Dodd-Frank Wall Street Reform and Consumer Protection Act enacted on July 21, 2010, provides, among other things, for new restrictions and an expanded framework of regulatory oversight for financial institutions and their holding companies, including the Company and the Bank. Under the new law, the Bank's primary regulator, the Office of Thrift Supervision, was eliminated and existing federal thrifts are subject to regulation and supervision by the Office of Comptroller of the Currency, which supervises and regulates all national banks. In addition all financial institution holding companies, including the Company, are now regulated by the Board of Governors of the Federal Reserve System, and this regulation will eventually include the application of federal capital requirements similar to those imposed on all commercial banks and may result in additional restrictions on investments and other holding company activities. The law also created a new consumer financial protection bureau that has the authority to promulgate rules intended to protect consumers in the financial products and services market. The creation of this independent bureau could result in new regulatory requirements and raise the cost of regulatory compliance. In

addition, new regulations mandated by this Act could require changes in regulatory capital requirements, loan loss provisioning practices, and compensation practices and will require holding companies to serve as a source of strength for their financial institution subsidiaries. Effective July 21, 2011, financial institutions may pay interest on demand deposits, which could increase our future interest expense. We cannot determine the impact of the new law on our business and operations at this time. Any legislative or regulatory changes in the future could adversely affect our operations and financial condition.
The federal regulators for the Company and the Bank have proposed new capital regulations that, if enacted, would impose capital requirements directly on the Company for the first time and might increase the Bank's required capital levels.

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 are inherent in our loan portfolio. The allowance is based on generally accepted accounting principles which require that losses be accrued when they are probable of occurring and estimable and 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 qualitative 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 collectability 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. During the June 30, 2012 quarter the Company evaluated and enhanced the relative value of the qualitative factors used in the determination of the unallocated component of the allowance due to the continuing weak economic conditions and increased level of non-performing assets.

A loan is considered impaired when, based on current information and events, it is probable that the Company 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 decreased $5.4 million to $498.5 million at June 30, 2012 from $503.9 million at March 31, 2012 due to decreases in loans receivable of $7.1 million, real estate owned of $1.7 million and cash of $1.4 million, partially offset by increases in investment securities of $6.0 million. As stated above, the decline in our loan portfolio was primarily in commercial real estate loans, construction and land development loans and automobile loans. We expect any future loan growth to be slow or moderate due to a slower economy, underwriting changes to limit funding of speculative construction loans and our higher capital requirements. We have also experienced reduced construction activity in our market areas, while existing commercial real estate activity continues to be weak.

Deposits decreased $4.3 million, or 1.2% to $368.1 million at June 30, 2012, from $372.4 million at March 31, 2012. The decrease was primarily due to a decrease in time deposits of $6.7 million and money market accounts of $3.8 million, partially offset by increases in non-interest bearing checking accounts of $5.5 million, savings accounts of $364,000 and interest bearing checking accounts of $348,000. The decrease in deposits was related to the decrease in our assets and funding needs. The decrease in deposits was generally achieved by lowering the rates offered on our time deposit products. FHLB advances decreased $2.0 million at June 30, 2012 from March 31, 2012.

Stockholders' equity increased by $1.1 million to $51.5 million at June 30, 2012, from $50.4 million at March 31, 2012, due to income for the three months ended June 30, 2012 of $1.2 million, partially offset by cash dividend payments on our preferred stock.

At June 30, 2012, non-performing assets totaled $22.7 million or 4.56% of assets compared to $21.6 million or 4.29% of assets at March 31, 2012. Non-performing assets at June 30, 2012 were comprised of repossessed assets of $7.5 million and non accrual loans of $15.0 million. Included in the total non-performing assets at June 30, 2012, was one single family nonaccrual property totaling $2.1 million, a hotel nonaccrual property totaling $3.1 million and a commercial real estate nonaccrual property totaling $1.3 million. At June 30, 2012, our allowance for loan losses to non-performing loans was 56.54% and to total loans was 1.95% compared to 73.00% and 2.0%, respectively at March 31, 2012. Our allowance for loan losses decreased $400,000 at June 30, 2012 compared to March 31, 2012 due to decreased loan balances. Charged off loans during the June 30, 2012 quarter included loans on which specific reserves had been established at March 31, 2012. Based on current market values of the properties securing our 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. We also had $20.1 million of loans that were classified as Troubled Debt Restructurings (TDRs) at June 30, 2012, of which $8.6 million were included in nonaccrual loans. These loans have had their original terms modified to facilitate payment by the borrower. The loans have been classified as TDRs primarily due to a change to interest only payments and the maturity of these modified loans is primarily less than one year.

As of June 30, 2012, there were $23.4 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 non-owner occupied commercial and residential real estate loans with an average balance of approximately $231,000. The largest individual loan or lending relationship in this category has a balance of $2.0 million and is secured by raw land. This loan is of concern due to cash flow issues. There are also six additional loans with balances greater than $1.0 million. A loan 60 days delinquent is generally included in this category and monitored until it has been current

for six months. Certain loans that are not delinquent may be included due to the nature of the loan's purpose such as construction or where the loan exhibits other potential weaknesses.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of funds are customer deposits, advances from the FHLB 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, 2012, the Bank's liquidity ratio (liquid assets as a percentage of net withdrawable savings and current borrowings) was 6.6% compared to 2.6% for the same quarter last year.
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, 2012, the total amount of borrowing available under the FHLB line of credit was approximately $144.7 million. At June 30, 2012, principal obligations to the FHLB consisted of $76.0 million in fixed-rate short term borrowings, and we had a $4.0 million letter of credit to the Treasurer of Virginia securing public deposits.
At June 30, 2012, we had commitments to purchase or originate $8.7 million of loans. Certificates of deposit scheduled to mature in one year or less at June 30, 2012, totaled $139.4 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. Due to the weak economy, the Bank has experienced reduced loan demand and anticipates a reduced liquidity need for loan funding. At June 30, 2012, we had brokered or internet time deposits of $15.9 million compared to $19.1 million at March 31, 2012.

On July 17, 2012, the OCC imposed an individualized minimum capital requirement ("IMCR") on the Bank, increasing its minimum leverage capital ratio from 4.0% to 8.5% and its total risk-based capital ratio from 8.0% to 12.5%, because of the Bank's condition and risk profile. As noted below, the Bank's capital levels at June 30, 2012, exceeded the ratios required by the IMCR. In addition to these minimum capital requirements, the Bank is required to have the capital ratios noted below to be deemed well-capitalized under the OCC prompt corrective action regulations. The Bank was well-capitalized at June 30, 2012. The Bank's regulatory capital is characterized as well-capitalized 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 redeemable at any time by the Company at 100% of the issue price, subject to the approval of the Company's and the Bank's federal regulators.

The following table presents the Bank's regulatory capital ratios at June 30, 2012:

                                                                                      Minimum Required                Minimum Capital
                            Actual                 Minimum Required at             Capital Levels  Under            Levels to be Deemed
                        Capital Levels                Capital Levels                     the IMCR4                    Well-Capitalized
                      Amount       Ratio          Amount            Ratio           Amount           Ratio          Amount          Ratio
                                                                  (Dollars in thousands)
Leverage
Capital(1)           $ 51,703        10.30 %   $     20,079             4.0 %   $       42,668           8.5 %   $     25,099           5.0 %
Tier 1 Risk-Based
Capital(2)           $ 51,703        12.34 %            N/A             N/A                N/A           N/A     $     25,143           6.0 %
Total Risk-Based
Capital(3)           $ 56,959        13.59 %   $     33,524             8.0 %   $       52,382          12.5 %   $     41,905          10.0 %


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The Company's primary source of funds for the payment of dividends to its common and preferred stockholders is dividends received from the Bank. Under a written agreement between the OCC and the Bank, the Bank must

receive OCC approval before paying a dividend to the Company. In addition, under the Agreement and Plan of Merger with City Holding Company, the Company has agreed not to pay dividends to common stockholders pending the consummation of the acquisition.

RESULTS OF OPERATIONS

Three Months Ended June 30, 2012 and 2011.

General. Net income for the three months ended June 30, 2012 increased $670,000 to $1.2 million from $548,000 for the three months ended June 30, 2011. Net interest income decreased $488,000, the provision for loan losses decreased $522,000, non-interest income decreased $66,000 and non-interest expense decreased $1.2 million during the three months ended June 30, 2012 compared to the same period in 2011. Return on equity for the three months ended June 30, 2012 was 12.29% compared to 4.31% for the three month period ended June 30, 2011. Return on assets was 1.26% for quarter ended June 30, 2012 compared to 0.42% for the same period in the previous fiscal year.

Interest Income. Total interest income decreased $808,000, or 11.7% to $6.1 million for the three months ended June 30, 2012, from $6.9 million for the three months ended June 30, 2011, due to a decrease in the volume of our portfolio. The average yield earned on interest-earning assets was 5.36% for the three months ended June 30, 2012 compared to 5.69% for the three months ended June 30, 2011.

Interest Expense. Total interest expense decreased $320,000, or 32.0% to $680,000 for the quarter ended June 30, 2012, from $999,000 for the quarter ended June 30, 2011. Interest on deposits decreased $322,000 to $632,000 for the quarter ended June 30, 2012 from $954,000 for the quarter ended June 30, 2011 due to a decrease in the average rate paid and lower average deposit balances. The average rate paid on deposits was 0.71% during the three months ended June 30, 2012 compared to 1.02% for the three months ended June 30, 2011. The decrease in the average rate paid on deposits was due primarily to market interest rate changes as well as a change in our deposit mix to more low-cost transaction account deposits and fewer higher-cost certificate accounts. Interest expense on borrowed money increased $2,000 to $47,000 for the quarter ended June 30, 2012 compared to $45,000 for the quarter ended June 30, 2011. An increase in the average rate paid on borrowings from 0.19% for the June 30, 2011 quarter to 0.23% for the June 30, 2012 quarter, offset by a decrease in . . .