• Changes in interest rates could reduce income.

• Competitive pressures among financial institutions may increase.

• The businesses that we are engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards.

• New products developed or new methods of delivering products could result in a reduction in our business and income.

• Adverse changes may occur in the securities market.

• Other factors described from time to time in our reports with the Securities and Exchange Commission.

This section should be read in conjunction with the description of our "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those applications of accounting principles or practices that require considerable judgment, estimation, or sensitivity analysis by management. In the financial service industry, examples, though not an all inclusive list, of disclosures that may fall within this definition are the determination of the adequacy of the allowance for loan losses, valuation of mortgage servicing rights, valuation of derivatives or securities without a readily determinable market value, and the valuation of the fair value of intangibles and goodwill. Except for the determination of the adequacy of the allowance for loan losses and fair value estimations related to foreclosed real estate, we do not believe there are other practices or policies that require significant sensitivity analysis, judgments, or estimations.

Our financial statements are prepared in accordance with 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 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.
Our critical accounting policies are listed below. A summary of our significant accounting policies is set forth in Item 8, Note 1 of our Annual Report on Form 10-K for the year ended December 31, 2011. Allowance for Loan Losses
Our allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on GAAP guidance which requires that losses be accrued when they have a probability of occurring and are 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.
Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses along with various economic factors and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur may be mitigated. The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified loans. Historical loss information, expected cash flows and fair value of collateral are used to estimate these losses. The unallocated allowance captures losses whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance. The use of these values is inherently subjective, and our actual losses could be greater or less than the estimates. Derivative Financial Instruments
We use derivatives to manage risks related to interest rate movements. Interest rate swap contracts designated and qualifying as cash flow hedges are reported at fair value. The gain or loss on the effective portion of the hedge initially is included as a component of other comprehensive income and is subsequently reclassified into earnings when interest on the related debt is paid. We document our risk management strategy and hedge effectiveness at the inception of and during the term of each hedge. Our interest rate risk management strategy is to stabilize cash flow requirements by maintaining interest rate swap contracts to convert variable-rate debt to a fixed rate. We do not hold or issue derivative financial instruments for trading purposes.
Periodically, we participate in a "mandatory" delivery program for mortgage loans. Under the mandatory delivery system, loans with interest rate locks are paired with the sale of a notional security bearing similar attributes. Interim income or loss on the pairing of the loans and securities is recorded in mortgage banking income on our income statement. In addition, at the time the loan is delivered to an investor, matched securities are repurchased and a gain or loss on the pairing is recorded in mortgage banking income on our income statement. Management has elected to limit our exposure to this form of delivery to $50 million in outstanding loans. We were not participating in the mandatory delivery program at September 30, 2012 or December 31, 2011. Fair Value Measurements
Under GAAP we are permitted to choose to measure many financial instruments and certain other items at fair value. The estimation of fair value is significant to certain assets, including loans held-for-sale, available-for-sale securities, and foreclosed real estate owned. These assets are recorded at fair value or lower of cost or fair value, as applicable. The fair values of loans held-for-sale are based on commitments from investors. The fair values of available-for-sale securities are based on published market or dealer quotes for similar securities. The fair values of rate lock commitments are based on net fees currently charged to enter into similar agreements. The fair value of foreclosed real estate owned is estimated based on current appraisals, but may be further adjusted based upon our evaluation of the fair value of similar properties.
Fair values can be volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates, and market conditions, among others. Since these factors can change significantly and rapidly, fair values are difficult to predict and subject to material changes that could impact our financial condition and results of operation.

RESULTS OF OPERATIONS
Net Income
Our consolidated financial statements include the accounts of the Company, the Bank and its subsidiaries, after all significant inter-company transactions have been eliminated. Net income attributable to our non-controlling interests of $367 thousand and $88 thousand, respectively, are deducted for the quarters ended September 30, 2012 and 2011, and $677 thousand and $340 thousand, respectively, are deducted for the first nine months of 2012 and 2011, after the income tax provision, to arrive at net income attributable to Monarch Financial Holdings, Inc. The ensuing references and ratios are related to net income attributable to Monarch Financial Holdings, Inc., (hereon referred to as "net income") after net income attributable to non-controlling interests has been deducted.
Net income for the quarter ended September 30, 2012 was $3.8 million, an increase of $1.6 million or 76.1% over the same quarter in 2011. Basic earnings per share for the third quarter of 2012 and 2011 were $0.47 and $0.24, respectively, while diluted earnings per share were $0.37 and $0.21 for the same periods. Net income for the first nine months of 2012 was $9.1 million compared to net income of $5.2 million for the same period in 2011, an increase of $3.9 million or 75.1%. For the nine months ended September 30, 2012 and 2011 basic earnings per share were $1.09 and $0.56, respectively, while diluted earnings per share were $0.89 and $0.50 for the same periods.
Two important and commonly used measures of profitability are return on assets (net income as a percentage of average total assets) and return on equity (net income as a percentage of average stockholders' equity). Our annualized return on assets ("ROA") was 1.43% and 1.04% for the three month periods ended September 30, 2012 and September 30, 2011. For the nine month periods ended September 30, 2012 and 2011 our annualized ROA was 1.25% and 0.88%, respectively. Our annualized return on equity ("ROE") for the third quarter of 2012 and 2011, respectively, was 18.24% and 11.39%. Our ROE for the first nine months of 2012 and 2011 was 15.23% and 9.46%, respectively.
Growth in mortgage banking income, the largest component of non-interest income, was the primary source of the improvement in our measures of profitability and net income. Continued elevated mortgage activity resulted in higher outstanding volume in our loans held for sale and led to significant growth in non-interest income. Net interest income growth was also a contributing factor. Growth in our loans held for sale coupled with lower funding costs improved net interest income.
Net interest income increased $1.9 million, to $10.4 million in the third quarter of 2012, when compared to $8.5 million in 2011. In the first nine months of 2012 net interest income was $29.5 million compared to $24.1 million in 2011, an increase of $4.8 million or 23.8%. Non-interest income increased $10.4 million in the third quarter of 2012 to $26.6 million, when compared to $16.2 million one year prior. Non-interest income in the first nine months of 2012 was $64.9 million, an increase of $27.1 million or 71.5%, over $37.8 million in the first nine months of 2011. In the third quarter of 2012, non-interest expense grew $10.4 million to $29.8 million, absorbing much of the increase in non-interest income for the quarter, with personnel expenses the primary source of the increase. In the first nine months of 2012 non-interest expense was $75.2 million, an increase of $25.2 million over the same period in 2011, but $2.4 million less than the growth in non-interest income for an improvement to net overhead of $1.8 million, year to date.
Our provision for loan losses in the third quarter and first nine months of 2012 was $899 thousand and $4.3 million compared to $1.7 million and $3.8 million for the same periods in 2011. Net charge offs in the third quarter of 2012 were $733 thousand compared to $919 thousand in 2011. Year to date net charge offs were $3.4 million in 2012 compared to $2.6 million in 2011. Net Interest Income
Net interest income, which is the excess of interest income over interest expense, is a major source of banking revenue. A number of factors influence net interest income, including the interest rates earned on earning assets, and the interest rates paid to obtain funding to support the assets, the average volume of interest-earning assets and interest bearing liabilities, and the mix of interest-earning assets and interest bearing liabilities.
Interest rates have been at a record low since December 2008, when the federal funds rate that is set by the Federal Reserve Bank's Federal Open Market Committee was reduced to 0.25%. The Wall Street Journal Prime Rate ("WSJ"), which generally moves with the federal funds rate, has been 3.25% since December 2008, as well. With rates low but stable, we believe we have been able to position our balance sheet to respond quickly in the future when rates begin to rise, and thereby buffer the potential impact of those rising rates. Net interest income was $10.4 million and $29.5 million for the third quarter and first nine months of 2012, compared to $8.5 million and $24.1 million in 2011. Total interest income was $11.8 million in the third quarter of 2012 compared to $10.2 million in 2011, while total interest expense was $1.4 million compared $1.7 million for the same periods. Total interest income

in the first nine months of 2012 was $33.8 million compared to $29.5 million in 2011 and total interest expense was $4.3 million compared to $5.3 million for the same periods.
Increased loan volume was the source of the improvement to interest income in both periods, while lower interest rates were the source of improvement to interest expense. Although asset yield has declined 51 basis points quarter over quarter, to 4.89%, liability costs have declined 37 basis points for the same period, to 0.74%. These changes resulted in a 21 basis point improvement in net interest margin to 4.30%.
Year to date, asset yield has declined 39 basis points to 5.02% and liability costs have declined 39 basis points to 0.81% for a 6 basis point decline in interest margin to 4.38%. However, interest spread has remained consistent between periods, increasing 1 basis point to 4.22% in 2012 compared to 4.21% in 2011.
Quarter over quarter, average earning asset volume increased $212 million when comparing 2012 to 2011. Average growth in our loan portfolios is the source of this increase. Our loan portfolio is comprised of two major classifications of loans: loans held for sale and loans held for investment. Average loans held for sale have increased $209 million, quarter over quarter, and average loans held for investment have increased $26.0 million. Year to date average earning asset volume increased $170 million when comparing 2012 to 2011. Year to date average loans held for sale have increased $158 million and average loans held for investment have increased $36 million. Year over year ending balances have also increased. Loans held for sale grew $224 million and loans held for investment grew $31 million in the first nine months of 2012 compared to 2011. Loans held for sale, which are residential mortgages originated by our mortgage division and sold to investors, earn interest while on our books but are currently at rates lower than our loans held for investment portfolio. Interest income in the third quarter of 2012 on loans held for sale was $3.0 million, a $1.8 million or 141% increase over third quarter 2011 income of $1.2 million. Interest income on loans held for sale for the first nine months of 2012 was $7.5 million, a $4.0 million or 113% increase over 2011 income of $3.5 million. Although the normal holding period for these loans is typically 35 to 45 days, the current period of high production has created an investor backlog which has increased the holding period to 45 to 60 days. This portfolio is subject to greater fluctuations in outstanding balances due to a combination of market demand, economic conditions and the prevailing mortgage rates. Residential mortgage rates have declined when compared to 2011. The third quarter yield on our loans held for sale portfolio was 3.69%, 55 basis points below the third quarter 2011 yield of 4.24%. Year to date, the yield on our loans held for sale portfolio have declined 58 basis points, from 4.35% to 3.77%. These declines in yield have been outpaced by higher production levels in the third quarter and first nine months of 2012 resulting in the higher income reported. Loans held for investment are commercial, real estate, and consumer loans originated and maintained on the Bank's books. Interest income on our loans held for investment portfolio for the third quarter of 2012 was $8.7 million, compared to $8.8 million in 2011, a marginal decrease. Year to date 2012, interest income on loans held for investment was $25.9 million, a $300 thousand increase over $25.6 million in 2011. The yield on loans held for investment declined when compared to prior year. Loans held for investment had a blended yield in the quarter ended September 30, 2012 of 5.65%, 34 basis points below the third quarter 2011 yield of 5.99%. The 2012 year to date yield on this portfolio was 5.73% or 29 basis points below the 2011 yield of 6.02%. Market competition has increased for commercial and some real estate loans, driving loan pricing down. This downward pressure has resulted in lower income in the third quarter of 2012 compared to 2011. Year to date, interest income from growth in our loans held for sale portfolio has outpaced the decline in yield to increase interest income. Growth in our loans held for investment portfolio occurred in the commercial and commercial real estate portfolios.
Average federal funds sold have declined $11.0 million in the third quarter and $17.3 million in the first nine months of 2012 compared to 2011, as we redeployed funds from a low yielding asset to higher yielding loan assets. Average balances in all other categories of interest earning assets have declined slightly in the third quarter of 2012 compared to 2011 for a $9 thousand decrease in interest income. Year to date, bank owned life insurance is the only other earning asset to show an increase. The year to date impact of the decline in non-loan assets is a decrease in interest income of $16 thousand. Average interest bearing liabilities outstanding increased $158.9 million in the third quarter and $125.7 million in the first nine months of 2012 compared to 2011. Average interest bearing deposits increased $128.1 million and average borrowings increased $30.8 million in the third quarter of 2012. Year over year, average interest bearing deposits increased $105.9 million and average borrowings have increased $19.8 million. Period end interest bearing deposits balances at September 30, 2012 were $705.6 million compared to $592.1 million at September 30, 2011, an increase of 19.2% or $113.5 million. At September 30, 2012, period end borrowings were $120.0 million, an increase of $85.6 million over period end borrowings of $34.4 million one year prior. Pricing on interest bearing deposits, quarter over quarter, and year over year, have declined for all deposit types. Despite this decline, our deposit pricing is market competitive.
Time deposits have shown the greatest decline in pricing. In the third quarter of 2012 time deposits pricing declined 68 basis points to 0.85% when compared to 1.53% in the third quarter of 2011. Time deposits pricing declined 80 basis points, to 0.92% from 1.72%, in the first nine months of 2012 compared to 2011. Average time deposits outstanding increased $104.0 million

in the third quarter and $102.0 million in the first nine months of 2012 compared to 2011, while period end time deposits have only increased $52 million compared to year end 2011 and $67 million compared to September 2011. Time deposits include both bank, or core balances, and brokered deposits. Brokered deposits are utilized to provide funding for our loans held for sale portfolio which, as noted earlier, has shown significant growth on average and at period end. These brokered deposits are available through a program called Certificate of Deposit Account Registry Service® ("CDARS") and through other markets. We have used CDARS more heavily in 2012 because the program allows us to add deposits to our balance sheet for short periods, typically 28 days, at low rates and without brokerage fees. The shorter maturity of these CDARS deposits are closer to the holding period of our loans available for sale, and provide funding flexibility to mirror demand. Average outstanding CDARs deposit balances were $132.5 million for the first nine months of 2012 compared to $29.2 million in the first nine months of 2011, an increase of $103.3 million. The average cost of these deposits has declined 10 basis points year over year, from 0.49% to 0.39%. Additionally, due to growth in non-interest bearing deposits, we have elected to allow high priced core time deposits to mature without replacement. Average borrowings increased $30.8 million to $46.3 million in the third quarter of 2012 compared to 2011 and $19.8 million to $33.8 million in the first nine months of 2012 compared to 2011. Period end borrowings were $120.0 million, an increase of $39.1 million when compared to $80.9 million at December 31, 2011 and an increase of $85.6 million compared to $34.4 million at September 30, 2011. Borrowing costs declined 192 basis points to 1.92% in the third quarter and 193 basis points to 2.25% in the first nine months of 2012 compared to 2011. For analytical purposes, net interest income is adjusted to a taxable equivalent basis to recognize the income tax savings on tax-exempt assets, such as bank owned life insurance ("BOLI") and state and municipal securities. A tax rate of 34% was used in adjusting interest on BOLI, tax-exempt securities and loans to a fully taxable equivalent basis. The difference between rates earned on interest-earning assets (with an adjustment made to tax-exempt income to provide comparability with taxable income, i.e. the "FTE" adjustment) and the cost of the supporting funds is measured by net interest margin.
Our net interest rate spread on a tax-equivalent basis decreased 13 basis points to 4.16% for third quarter of 2012, when compared to the same period in 2011. For the first nine months of 2012 our net interest spread was 4.22%, an increase of 1 basis points over the same period in 2011. Our net interest margin for the third quarter and first nine months of 2012 was 4.30% and 4.38%, respectively. This represents a third quarter decline of 21 basis points from 4.51% in 2011 and a nine month decline of 6 basis points from 4.44% in 2011.
Bank Owned Life Insurance (BOLI) has been included in interest earning assets. We purchased $6.0 million in BOLI during the fourth quarter of 2005. The income on BOLI is not subject to federal income tax, giving it a tax-effective yield of 5.36% for 2012 compared to 5.77% in 2011.
In July, 2006, we increased capital through the issuance of $10,000,000 in trust preferred securities. These securities are treated as subordinated debt and have been included in borrowings. The cost on trust preferred securities is fixed at 4.86%. In June 2012, we added a short term holding company loan from PNC Bank for $5.0 million. The current term on this line is 6 months and the rate is 2.74%. This line, which qualifies as Tier 1 capital for the Bank, is carried in short term borrowings.
The following tables set forth average balances of total interest earning assets and total interest bearing liabilities for the periods indicated, showing the average distribution of assets, liabilities, stockholders' equity and the related income, expense and corresponding weighted average yields and costs.

The following is an analysis of net interest income, on a taxable equivalent basis.

                          NET INTEREST INCOME ANALYSIS
                                                   For Three Months Period Ended September 30, 2012
                                                    Average                Income/              Yield
                                                    Balance                Expense            Rate (1)
ASSETS
Securities, at amortized cost (2)             $     10,714,301       $           57,701            2.14 %
Loans, held for investment, net                    611,428,509                8,680,212            5.65 %
Loans, held for sale                               327,378,497                3,039,637            3.69 %
Federal funds sold                                   6,387,562                    3,973            0.25 %
Dividend-earning restricted equity securities        5,818,964                   38,500            2.63 %
Deposits in other banks                                858,147                    4,713            2.18 %
Bank owned life insurance (2)                        7,100,941                   95,698            5.36 %
Total earning assets                               969,686,921               11,920,434            4.89 %
Less: Allowance for loan losses                    (10,891,069 )
Nonperforming loans                                  5,299,071
Total non-earning assets                            80,870,611
Total assets                                  $  1,044,965,534
LIABILITIES and STOCKHOLDERS' EQUITY
Interest-bearing deposits:
Checking                                      $     39,082,800       $           18,302            0.19 %
Regular savings                                     20,810,485                   21,336            0.41 %
Money market savings                               317,758,686                  434,884            0.54 %
Time deposits                                      341,162,378                  732,482            0.85 %
Total interest-bearing deposits                    718,814,349                1,207,004            0.67 %
Borrowings                                          46,319,743                  223,145            1.92 %
Total interest-bearing liabilities                 765,134,092       $        1,430,149            0.74 %
Non-interest-bearing liabilities
Demand deposits                                    171,957,704
Other non-interest-bearing liabilities              25,804,088
Total liabilities                                  962,895,884
Stockholders' equity                                82,069,650
. . .