Cautionary Statement Regarding Forward-Looking Statements

The Company makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

• the ability to raise capital as needed;

• adverse economic conditions in the market area and the impact on credit quality and risks inherent in the loan portfolio such as repayment risk and fluctuating collateral values;

• additional future losses if our levels of non-performing assets do not moderate and if the proceeds we receive upon liquidation of assets are less than the carrying value of such assets;

• further increases of non-performing assets may reduce interest income and increase net charge-offs, provision for loan losses, and operating expenses;

• the adequacy of the allowance for loan losses related to specific reserves on impaired loans, and changes in factors considered such as general economic and business conditions in the market area and overall asset quality;

• the adequacy of the valuation allowance for other real estate owned related to changes in economic conditions and local real estate activity;

• loss or retirement of key executives;

• the ability to compete effectively in the highly competitive banking industry;

• legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses that the Company is engaged in;

• the ability to implement various technologies into our operations may impact the Company's ability to operate profitably;

• the ability of the Company to implement its disaster recovery plan in the event of a natural disaster;

• risks related to the timing of the recoverability of the deferred tax asset, which is subject to considerable judgment, and the risk that even after the recovery of the deferred tax asset balance under GAAP, there will remain limitations on the ability to include our deferred tax assets for regulatory capital purposes;

• increases in FDIC insurance premiums could adversely affect the Company's profitability;

• the ability to retain customers and secondary funding sources if the Bank's reputation would become damaged;

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

• changes in interest rates could have a negative impact on the Company's net interest income and an unfavorable impact on the Bank's customers' ability to repay loans; and

• other factors identified in Item 1A. Risk Factors of the Company's Form 10-K for the year ending December 31, 2011.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at June 30, 2012 and results of operations of the Company for the three and six month periods ended June 30, 2012 and 2011 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2011. The results of operations for the three and six month periods ended June 30, 2012 may not be indicative of the results to be achieved for the year.

Executive Overview

The Company

First National Corporation (the Company) is the bank holding company of:

• First Bank (the Bank). The Bank owns:

• First Bank Financial Services, Inc.

• Shen-Valley Land Holdings, LLC

• First National (VA) Statutory Trust II (Trust II)

• First National (VA) Statutory Trust III (Trust III)

First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities.

Products, Services, Customers and Locations

Our primary market area is located within an hour commute of the Washington, D.C. Metropolitan Area. The Bank's office locations are well-positioned in strong markets along the Interstate 81 and Interstate 66 corridors in the northern Shenandoah Valley region of Virginia, which include the City of Winchester, Frederick County, Warren County and Shenandoah County. Within the market area there are various types of industry including medical and professional services, manufacturing, retail and higher education. Customers include individuals, small and medium-sized businesses, local governmental entities and non-profit organizations.

The Bank provides loan, deposit, investment, trust and asset management and other products and services in the northern Shenandoah Valley region of Virginia. Loan products and services include personal loans, residential mortgages, home equity loans and commercial loans. Deposit products and services include checking, savings, NOW accounts, money market accounts, IRA accounts, certificates of deposit and cash management accounts. The Bank offers other services, including internet banking, mobile banking, remote deposit capture and other traditional banking services.

The Bank's Trust and Asset Management Department offers a variety of trust and asset management services including estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, estate settlement and benefit plans. The Bank offers financial planning and brokerage services for its customers through its investment division, First Financial Advisors.

The Bank's products and services are provided through 10 branch offices, 26 ATMs and its website, www.fbvirginia.com. The Bank operates six of its offices under the "Financial Center" concept. A Financial Center offers all of the Bank's financial services at one location. This concept allows loan, deposit, trust and investment advisory personnel to be readily available to serve customers throughout the Bank's market area. The location and general character of these properties is further described in Part I, Item 2 of Form 10-K for the year ended December 31, 2011.

Revenue Sources and Expense Factors

The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 75% to 80% of the Company's total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank's interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on loans and deposits and fees earned from other services. The Bank generates fee income from other services that include trust and investment advisory services and through the origination and sale of residential mortgages.

The provision for loan losses and noninterest expense are the two major expense categories. The provision is determined by factors that include net charge-offs, asset quality, economic conditions and loan growth. Changing economic conditions caused by inflation, recession, unemployment or other factors beyond the Company's control have a direct correlation with asset quality, net charge-offs and ultimately the required provision for loan losses. The largest component of noninterest expense for the six month period ended June 30, 2012 was salaries and employee benefits, comprising 51% of noninterest expenses, followed by occupancy and equipment expense, comprising 14% of expenses and provision and expenses for other real estate owned, comprising 10% of expenses.

Quarterly Performance

For the three months ended June 30, 2012, net income totaled $694 thousand compared to a loss of $945 thousand for the same period in 2011. After the effective dividend on preferred stock, net income available to common shareholders was $467 thousand, or $0.16 per basic and diluted share, compared to net loss available to common shareholders of $1.2 million, or $0.40 per basic and diluted share, for the same period in 2011. The significant increase in earnings was primarily attributable to a $2.9 million decrease in the provision for loan losses when comparing the periods. Net interest income was 6%, or $288 thousand, lower than for the second quarter of 2011. Noninterest income was 2%, or $23 thousand, lower than the second quarter of 2011. Noninterest expense was 2%, or $82 thousand, lower when comparing the two periods. Return on average assets and return on average equity were 0.53% and 7.21%, respectively, for the second quarter of 2012 compared to -0.69% and -7.68% for the same quarter in 2011.

Net interest income totaled $4.8 million for the second quarter of 2012, which was a 6% decrease when comparing the second quarter of 2012 to the same period a year ago. The net interest margin decreased to 3.88% from 4.00%. The net interest margin compression resulted from higher balances of investment securities combined with lower loan balances. A change in the loan mix also had an impact on the margin as commercial real estate loan balances decreased while residential real estate loans, which tend to have lower yields, increased.

The provision for loan losses was $650 thousand, which resulted in a total allowance for loan losses of $14.0 million or 3.64% of total loans at June 30, 2012. This compared to a provision for loan losses of $3.6 million and an allowance for loan losses of $13.8 million, or 3.32% of total loans, at the end of the same quarter in 2011. The lower provision was a result of lower charge-offs and specific reserves on impaired loans when comparing the two periods. Net charge-offs for the second quarter of 2012 declined to $287 thousand from $2.9 million for the same quarter of 2011.

Noninterest income totaled $1.5 million for the second quarter of 2012, which was 2% lower compared to the same quarter of 2011. Higher revenues from fees for other customer services, including loan fees, and from gains on sales of loans were partially offset by decreases in service charges on deposit accounts, ATM and check card fee income, and trust and investment advisory revenue, when comparing the periods.

Noninterest expense was $4.4 million for the second quarter of 2012, a decrease of $82 thousand, or 2%, compared to $4.5 million for the same quarter of 2011. The provision for other real estate owned, which represents write-downs of carrying values on foreclosed properties, totaled $168 thousand for the second quarter compared to $46 thousand for the same period in the prior year. Net gains on sale of other real estate owned totaled $160 thousand for the second quarter of 2012 compared to net losses of $8 thousand for the same period in 2011.

Year-to-Date Performance

For the six months ended June 30, 2012, net income was $1.2 million compared to $58 thousand for the same period in 2011. After the effective dividend on preferred stock, net income available to common shareholders was $718 thousand, or $0.24 per basic and diluted share, compared to net loss available to common shareholders of $388 thousand, or $0.13 per basic and diluted share, for the same period in 2011. The significant difference in earnings was primarily attributable to a $1.2 million decrease in the provision for loan losses and a $1.1 million increase in gains on sale of securities. Return on average assets was 0.44% for the six months ended June 30, 2012 compared to 0.02% for the same period in 2011, and return on average equity was 6.17% for the six months ended June 30, 2012 compared to 0.24% for the same period in 2011.

Net interest income was $143 thousand, or 1%, lower at $9.9 million for the six months ended June 30, 2012 compared to $10.0 million for the same period in 2011. The net interest margin was 7 basis points higher and average interest-earning assets were $19.5 million lower when comparing the two periods. The net interest margin was 4.01% for the six months ended June 30, 2012, compared to 3.94% for the same period in 2011. For the six months ended June 30, 2012, the loan loss provision totaled $2.7 million compared to $3.8 million for the same period in 2011. During 2012, the provision for loan losses resulted from specific reserves on impaired loans and general reserves driven by the loss history component of the allowance for loan losses. Net charge-offs were $1.6 million for the first half of 2012 compared to $6.1 million for the same period in 2011. During 2011, the provision for loan losses resulted from unfavorable economic conditions, declines in collateral values and specific reserves on impaired loans.

Noninterest income increased $1.2 million to $4.0 million for the six months ended June 30, 2012, compared to $2.8 million for the same period in 2011, primarily from gains on sales of securities. Noninterest income, excluding gains on sales of securities, increased 3% to $2.9 million for the six months ended June 30, 2012 from $2.8 million for the same period in 2011. Revenues from fees for other customer services and gains on sales of loans increased while ATM and check card fee income, trust and investment advisory revenue and service charges on deposit accounts decreased slightly when comparing the periods. Noninterest expense was 3% higher for the six months ended June 30, 2012, compared to the same period in 2011. The provision for other real estate owned totaled $569 thousand for the six months ended June 30, 2012 compared to $176 thousand for the same period in 2011. Net gains on sale of other real estate owned totaled $250 thousand for the six months ended June 30, 2012 compared to net losses of $8 thousand for the same period in 2011.

Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income excluding securities gains and losses. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with U.S. generally accepted accounting principles (GAAP) and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the table below.

                                                                    Efficiency Ratio
                                                                     (in thousands)
                                            For the three months ended               For the six months ended
                                          June 30,              June 30,            June 30,           June 30,
                                            2012                  2011                2012               2011

Noninterest expense                     $      4,434          $      4,516        $      9,338         $   9,071
Less: provision for other real
estate owned                                     168                    46                 569               176
Less: net (gains) losses on sale of
other real estate owned                         (160 )                   8                (250 )               8

                                        $      4,426          $      4,462        $      9,019         $   8,887

Tax-equivalent net interest income      $      4,839          $      5,160        $      9,979         $  10,170
Noninterest income                             1,462                 1,485               3,976             2,825
Less: securities gains                             1                    41               1,118                41

                                        $      6,300          $      6,604        $     12,837         $  12,954


Efficiency ratio                               70.25 %               67.57 %             70.26 %           68.60 %

This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for each of 2012 and 2011 is 34%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below.

                                               Reconciliation of Net Interest Income to Tax-Equivalent
                                                                 Net Interest Income
                                                                   (in thousands)

                                          For the three months ended              For the six months ended
                                         June 30,            June 30,             June 30,           June 30,
                                           2012                2011                 2012               2011
GAAP measures:
Interest income - loans                $      5,265        $      5,818        $       10,812        $  11,651
Interest income - investments and
other                                           615                 719                 1,276            1,324
Interest expense - deposits                     959               1,303                 1,945            2,606
Interest expense - other
borrowings                                       66                  42                   146              133
Interest expense - other                         60                 109                   122              218

Total net interest income              $      4,795        $      5,083        $        9,875        $  10,018

Non-GAAP measures:
Tax benefit realized on
non-taxable interest income -
loans                                  $          7        $         15        $           15        $      26
Tax benefit realized on
non-taxable interest income -
municipal securities                             37                  62                    89              126

Total tax benefit realized on
non-taxable interest income            $         44        $         77        $          104        $     152

Total tax-equivalent net interest
income                                 $      4,839        $      5,160        $        9,979        $  10,170

Critical Accounting Policies

General

The Company's consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the 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. The Bank uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change. For further information about the Bank's loans and the allowance for loan losses, see Notes 3 and 4 to consolidated financial statements, included in Item 1 of this Form 10-Q.

Presented below is a discussion of those accounting policies that management believes are the most important ("Critical Accounting Policies") to the portrayal and understanding of the Company's financial condition and results of operations. The Critical Accounting Policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company's loans and the allowance for loan losses, see Notes 3 and 4.

The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse

situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance represents an amount that, in management's judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management's judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower's ability to repay and the value of the collateral, overall portfolio quality and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:

• Residential mortgage loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.

• Real estate construction loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure unrelated to the project.

• Commercial real estate and commercial and industrial loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability.

• Consumer and other loans carry risk associated with the continued credit-worthiness of the borrower and the value of the collateral, i.e. rapidly depreciating assets such as automobiles, or lack thereof. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy, or other changes in circumstances.

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal will be ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.

The general component relates to loans that are not considered impaired. These unimpaired loans are segregated by loan segment and allowance factors are assigned by management based on a three-year loss history, delinquencies, national and local economic trends, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan segment. The general component acknowledges potential losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management's assessment of the above described factors and the relative weights given to each factor.

Lending Policies

General

The principal risk associated with each of the categories of loans in the Bank's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased, depending on prevailing economic conditions. The risk associated with real estate mortgage loans, commercial and consumer loans varies, based on economic conditions, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness. The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

In an effort to manage risk, the Bank's loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and . . .