UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2007

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number 0-18279

Tri-County Financial Corporation

(Exact name of registrant as specified in its charter)

3035 Leonardtown Road, Waldorf, Maryland		20601
(Address of principal executive offices)		(Zip Code)

(301) 645-5601

Not applicable

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.)

Large accelerated filer o       Accelerated filer o       Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of October 31, 2007, the registrant had 2,652,659 shares of common stock outstanding.

 

 

TRI-COUNTY FINANCIAL CORPORATION

FORM 10-Q

INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Balance Sheets – September 30, 2007 and December 31, 2006			3
Consolidated Statements of Income and Comprehensive Income - Three and Nine Months Ended September 30, 2007 and 2006			4-5
Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2007 and 2006			6-7
Notes to Consolidated Financial Statements			8-10
Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations			11-20
Item 3 - Quantitative and Qualitative Disclosures about Market Risk			20-21
Item 4 – Controls and Procedures			21
PART II — OTHER INFORMATION
Item 1 – Legal Proceedings			22
Item 1.A – Risk Factors			22
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds			22
Item 3 – Defaults Upon Senior Securities			23
Item 4 – Submission of Matters to a Vote of Security Holders			23
Item 5 – Other Information			23
Item 6 – Exhibits			23
SIGNATURES
EX-10 AMENDMENT TO 2005 EQUITY COMPENSATION PLAN
EX-31 SECTION 302 CERTIFICATIONS OF THE CEO AND CFO
EX-32 SECTION 906 CERTIFICATIONS OF THE CEO AND CFO

PART I FINANCIAL STATEMENTS

See notes to consolidated financial statements

TRI-COUNTY FINANCIAL CORPORATION

			Share and per share data have been adjusted to reflect the three for two common stock split effected in November 2006 as if it had occurred on January 1, 2006.
	5.		STOCK-BASED COMPENSATION
			The Company has stock option and incentive plans to attract and retain key personnel in order to promote the success of the business. These plans are described in note 12 to the financial statements included in our Annual Report to Stockholders for the year ended December 31, 2006. $264,786 of compensation expense related to stock options has been recognized in the nine months ended September 30, 2007. No expense was recognized in the nine months ended September 30, 2006.
			The Company and the Bank currently maintain incentive plans which provide for payments to be made in either cash or stock options. The Company has accrued the full amounts due under these plans, but currently it is not possible to identify the portion that will be paid out in the form of stock options. On July 17, 2007, the Company issued 21,811 in options to purchase shares with a weighted average exercise price per share of $27.70 and a 10-year term expiring July 17, 2017. These options vest immediately and had an estimated fair value of $12.14 per share. Stock-based compensation expense related to this grant was $264,786.
			A summary of the Company’s stock option plans as of September 30, 2007 and changes during the nine-month period then ended is presented below:

			Share and per share data have been adjusted to reflect the three for two common stock split effected in November 2006 as if it had occurred on January 1, 2006.
	6.		FORECLOSED REAL ESTATE
			As of September 30, 2007, the Bank has no foreclosed real estate. The Bank previously sold property with a carrying value of $460,884, with net proceeds to the Bank of approximately $1,733,045. Total pretax profit on these sales was approximately $1,272,161.

	7.		NEW ACCOUNTING STANDARDS
			In September 2006, the FASB issued SFAS 157, Fair Value Measurements . SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies to existing accounting pronouncements that require or permit fair value measurements in which FASB had previously concluded fair value is the most relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, with early adoption encouraged. The Company is currently evaluating the impact the adoption of this standard will have on its financial condition and results of operations.
			In February 2007, FASB issued SFAS No. 159, “ The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 .” SFAS 159 permits entities to choose to measure eligible items at fair value at specified election dates. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date. The fair value option (i) may be applied instrument by instrument, with certain exceptions, (ii) is irrevocable (unless a new election date occurs) and (iii) is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for the Company on January 1, 2008 and is not expected to have a significant impact on the Company’s financial statements.
			In September 2006, the FASB ratified the consensus reached by the EITF on Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. EITF 06-4 requires the recognition of a liability and related compensation costs for endorsement split-dollar life insurance policies that provide a benefit to an employee that extends to postretirement periods as defined in SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. The EITF reached a consensus that Bank Owned Life Insurance policies purchased for this purpose do not effectively settle the entity’s obligation to the employee in this regard and, thus, the entity must record compensation costs and a related liability. Entities should recognize the effects of applying this Issue through either, (a) a change in accounting principle through a cumulative-effective adjustment to retained earnings or to other components of equity or net assets in the balance sheet as of the beginning of the year of adoption, or (b) a change in accounting principle through retrospective application to all prior periods. This Issue is effective for fiscal years beginning after December 15, 2007. Management is currently evaluating the impact of adopting this Issue on the Company’s financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This document contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including discussions of Tri-County Financial Corporation’s (the “Company”) goals, strategies and expected outcomes; estimates of risks and future costs; and reports of the Company’s ability to achieve its financial and other goals. Forward-looking statements are generally preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions. These forward-looking statements are subject to significant known and unknown risks and uncertainties because they are based upon future economic conditions, particularly interest rates, competition within and outside of the banking industry, changes in laws and regulations applicable to the Company, changes in accounting principles, and various other matters. Additional factors that may affect our results are discussed in the Company’s Annual Report on Form 10-K (the “Form 10-K”), including under “Item 1.A. Risk Factors,” and in its other Securities and Exchange Commission reports. Because of these uncertainties, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. The Company does not undertake – and specifically disclaims any obligation – to publicly release the result of any revisions that may be made to any forward-looking statement to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

GENERAL

The Company is a bank holding company organized in 1989 under the laws of the State of Maryland. It owns all the outstanding shares of capital stock of Community Bank of Tri-County (the “Bank”), a Maryland-chartered commercial bank. The Company engages in no significant activity other than holding the stock of the Bank, paying the interest on its subordinated debt, and directing the business of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank serves the Southern Maryland area through its main office and eight branches located in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, Prince Frederick and California, Maryland. Currently, the Bank is constructing a ninth branch in Lusby, Maryland and is replacing its existing branch in Leonardtown. The Bank is engaged in the commercial and retail banking business as authorized by the banking statutes of the State of Maryland and applicable Federal regulations. The Bank accepts demand and time deposits and uses these funds along with borrowings from the Federal Home Loan Bank (the “FHLB”), to fund loans to individuals, associations, partnerships and corporations. The Bank makes real estate loans including construction, acquisition and development, residential first and second mortgage loans, home equity lines of credit and commercial mortgage loans. The Bank also makes commercial loans including secured and unsecured loans. The Bank is a member of the Federal Reserve and FHLB Systems. The Federal Deposit Insurance Corporation provides deposit insurance coverage up to applicable limits.

Since its conversion to a state chartered commercial bank in 1997, the Bank has sought to increase its commercial, commercial real estate, construction, second mortgage, home equity, and consumer lending business as well as the level of transactional deposits to levels consistent with similarly sized commercial banks. As a result of this emphasis, the Bank’s percentage of assets invested in residential first mortgage lending has declined since 1997. Conversely, targeted loan types have increased. The Bank has also seen an increase in transactional deposit accounts while the percentage of total liabilities represented by certificates of deposits has declined. Management believes that these changes will enhance the Bank’s overall long-term financial performance.

Management recognizes that the shift in composition of the Bank’s loan portfolio away from residential first mortgage lending will tend to increase its exposure to credit losses. The Bank continues to evaluate its allowance for loan losses and the associated provision to compensate for the increased risk. Any evaluation of the allowance for loan losses is inherently inexact and reflects management’s expectations as to future economic conditions in the Southern Maryland area as well as individual borrower’s circumstances. Management believes that its allowance for loan losses is adequate. For further information on the Bank’s allowance for loan losses see the discussion in the sections captioned “Financial Condition” and “Critical Accounting Policies” as well as the relevant discussions in the Form 10-K and Annual Report for the year ended December 31, 2006.

Local and national economic conditions affect the current and future financial results of the Company. The current crisis in subprime and other non-traditional mortgage lending activities has been reflected in a volatile stock market and reduced home sales. Major mortgage lenders have gone bankrupt, slashed operations, and announced poor financial results. In the last three months, the Federal Reserve has acknowledged this widespread weakness in housing and other real estate markets by reducing the Federal Funds rate by 75 basis points, by encouraging advances from the discount window, and through other measures. Some market participants continue to believe that the Federal Reserve will be forced to cut rates again in the future, as many economists and market observers believe that the economy is displaying increasing signs of weakness. The number and size of additional rate cuts is unknown as the Federal Reserve has indicated it is still concerned about inflation and the falling value of the US dollar, both of which factors tend to argue against rate cuts. For further discussion on how local and national factors and their possible effect on our financial results see the discussion in Part II of this document entitled risk factors as well as the risk factors discussed in Part I, “Item 1A. Risk Factors” in the Form 10-K.

For the nine-month period ended September 30, 2007, interest income increased due to higher average balances of earning assets and higher rates earned on these assets. The Bank continued to increase balances of loans which tend to have higher yields. Interest expense increased as the result of higher average deposit balances and higher rates. These increases were partially offset by lower average balances of short and long-term borrowings. Although overall rates paid on interest earning liabilities increased, the Bank’s continued shifting from wholesale liabilities to retail deposits helped to control the overall amount of interest expense.

Provision for loan losses increased to $659,288 for the nine months ended September 30, 2007 from $289,135 for the nine-month period ended September 30, 2006. The increase in the provision was caused by the increases in the Bank’s loan portfolio, especially in residential construction and commercial loans, which tend to have a higher risk of default than one- to- four family residential real estate loans. The provision expense was also affected by the Bank’s assessment that the overall economic risks of certain types of construction lending have substantially increased due to nationwide and local economic factors. The Bank’s overall delinquency rate has declined since December 31, 2006, but the Bank has experienced an increase in loan charge-offs primarily in consumer loans, during the first nine months of 2007 compared to the same period in 2006. The Bank experienced $149,821 of loan charge-offs in the current period compared to $8,182 in the corresponding period in 2006. Higher charge-offs were caused by developments in certain individual loans and do not appear to indicate systemic weaknesses in our loan standards. Management will continue to periodically review its allowance for loan losses and the related provision and adjust as deemed necessary. This review will continue to include a review of economic conditions nationally and locally, as well as a review of the performance of significant major loans and the overall portfolio.

Loan appraisal, credit, and miscellaneous charges decreased based upon changes in local market conditions which have made it harder for the Bank to charge for certain fees based upon competition from other banks. The increase in gain on the sale of foreclosed property reflects sale of property for $1,733,045 in 2007 compared to no foreclosed property sold in the prior year. Income from bank owned life insurance reflects a higher average balance of bank owned life insurance in the current year which was partially offset by a lower average earning rate. The change in gain on sale of investment securities reflects the sale of $233,743 in investment securities in 2007 compared to no investment sales in the same period of 2006. The Bank sold these particular investments because the Bank wished to focus on other security classes in the future. The increase in service charges reflects higher transaction account balances as well as increased fees.

Salary and employee benefits costs increased because of increases in the number of personnel employed by the Bank and increased benefits costs. Employees were added to staff some administrative and sales positions. In addition, the Bank’s average cost per employee has increased in the last year due to tight labor markets and the need to add highly skilled employees as the Bank grows in size and complexity. Occupancy expense increased as the Bank opened temporary space in connection with the rebuilding of a branch, as well as increases in land rentals on certain properties. Advertising expenses decreased as the Bank has deferred certain advertising activities to later in the year. The drop in data processing expense reflects improved pricing in this area from certain vendors. The declines in legal and professional fees reflect the high level of Sarbanes-Oxley preparation activity in the prior year compared to the current year. Depreciation expense includes increases due to a remodeled home office and additional branch and data processing equipment. ATM expenses reflect the replacement of older machines at some locations and additional usage of existing machines.

Income tax expense increased to $2,500,790, or 37.11% of pretax income, in the current year, from $1,629,543, or 34.20% of pretax income, in the prior year due to increase in pretax income and decreases in the amount of income which was considered tax exempt at the state or federal level. The higher tax expense for the 2007 periods reflects the elimination of certain state tax benefits the Company had previously qualified for, which approximated $200,000 on an annual basis. It is not anticipated that the Company will again qualify for these benefits.

Interest income increased due to higher average balances of assets combined with a higher interest rate environment for certain assets. In addition, in 2007, the Bank continued to increase balances of loans which tend to have higher yields and move assets out of lower-yielding cash and investments into higher-yielding loans. Similarly interest expense increased as the Bank had higher average balances of liabilities during the three-month period than it did in the same period in 2006. In addition, increases in rates paid on liabilities due to expiring long term borrowings and more competitive market conditions increased the Bank’s costs for deposits. Short-term borrowing expense declined as average balances of short term borrowings declined in 2007. Increases in the provision for loan losses were due to increases in loan balances and increases in write-offs compared to the same period in 2006. As noted in the discussion of the nine-month period ending September 30, 2007, the Bank determined that general economic conditions as well as increased charge-offs made an increased allowance for loan losses necessary to maintain. The increase in the allowance is reflected in higher provision expense for the three-month period ended September 30, 2007 compared to the same period in the prior year.

Loan appraisal, credit, and miscellaneous charges increased over the three-month period ended September 30, 2007 because of increased loan origination activity. Increase in the gain on sale of foreclosed property resulted from the sale of property in the three-month period ending September 30, 2007 compared to no sales in the same period in 2006. The increase in income from bank owned life insurance resulted from a higher average balance of bank owned life insurance in the current year compared to the same three-month period in the prior year. Service charges increased, as the Bank has increased the number and size of customer checking accounts, while also increasing certain fees.

Salary and employee benefits increased due to increases in the number of personnel and increased benefit costs. Advertising expenses declined as the Bank elected to decrease advertising efforts in the current quarter to defer them later in the year. Data processing expenses declined due to the renegotiation of expiring contracts. Legal and professional fees increased in 2007 as the 2006 total reflected an adjustment to previously billed invoices by our providers. Depreciation expense increased due to the equipment purchases in the current year which increased depreciation expense. ATM expenses increased due to higher usage by customers as well as increased fees to third parties related to data security. Other expenses decreased due to decreases in certain costs including stationery, printing, and the charitable contributions.

Income tax expense increased due to the increase in pretax income and a decrease in the amount of tax exempt income at the state and federal levels.

Cash and due from banks, Federal Funds sold and interest-bearing deposits with banks increased due to the growth in deposit accounts. Investment securities, including both the available for sale and held to maturity portfolios, decreased because the Bank has continued to use investment repayments, which have lower yields, as a source of funds to build its loan portfolio, which have higher yields, and to pay down short-term borrowings. The Bank’s holdings of Federal Reserve and Federal Home Loan Bank stock decreased because the Bank has decreased its borrowings from the Federal Home Loan Bank system, which decreased its stock ownership requirements. The loan portfolio increased as a result of growth in the Bank’s portfolio of residential construction loans, residential first mortgage loans, and commercial equipment loans. The Bank experienced declines in commercial real estate, second mortgage, consumer loans, and commercial lines of credit due to increased loan prepayments and the effects of tightening of credit standards. The Bank has targeted commercial real estate loans and commercial lines of credit for growth. Management believes that the declines in these portions of the loan portfolio are not indicative of a long term trend but instead reflect the circumstances of a few individual loans. Premises and equipment increased with additional purchases related to the construction of two branches in Lusby and Leonardtown. Investment in bank owned life insurance increased due to an additional purchase to cover employees and accumulated monthly earnings on the policies.

Details of the Bank’s loan portfolio are presented below:

At September 30, 2007, the Bank’s allowance for loan losses totaled $4,293,382, or 0.96% of loan balances as compared to $3,783,721, or 0.89% of loan balances at December 31, 2006. Management’s determination of the adequacy of the allowance is based on a periodic evaluation of the portfolio with consideration given to the overall loss experience; current, local, and national economic conditions; volume, growth and composition of the loan portfolio; financial condition of the borrowers; and other relevant factors that, in management’s judgment, warrant recognition in providing an adequate allowance. Management believes that the allowance is adequate. Additional loan information for prior years is presented in the Form 10-K.

The following table summarizes changes in the allowance for loan losses for the periods indicated.

The following table provides information with respect to our non-performing loans at the dates indicated.

No loans were considered impaired under SFAS 114 as of December 31, 2006 or September 30, 2007.

Deposit balances increased due to the Bank’s continuing efforts to increase its market share in southern Maryland through advertising, branch improvements, and other marketing efforts. The increases in deposits and proceeds of maturing securities were used to reduce the balances of long-term debt and short-term borrowings. Accrued expenses and other liabilities declined due to the payment of incentives after year end and the payment of certain tax obligations.

Common stock decreased due to the repurchase of shares offset by shares issued for exercise of stock options. Additional paid in captial increased primarily due to the issuance of stock options. Retained earnings increased because of earnings, offset by the dividends paid of $1,062,064. The accumulated other comprehensive loss increased because interest rates have moved slightly higher increasing the market value loss on certain securities available for sale in the Bank’s portfolio. Book value per share increased from $14.28 per share to $15.50 reflecting the total change in equity.

LIQUIDITY AND CAPITAL RESOURCES

The Company currently has no business other than holding the stock of the Bank, paying interest on its subordinated debentures, and directing the business of the Bank. Its primary uses of funds are for the payment of dividends, the payment of interest and principal on debentures, and the repurchase of common shares. The Company’s principal sources of liquidity are cash on hand and dividends received from the Bank. The Bank is subject to various regulatory restrictions on the payment of dividends.

The Bank’s principal sources of funds for investments and operations are net income, deposits from its primary market area, the net proceeds of short and long-term borrowings, principal and interest payments on loans, interest received on investment securities and proceeds from the sale and maturity of investment securities. Its principal funding commitments are for the origination or purchase of loans, the purchase of investment securities and the payment of maturing deposits. Deposits are considered a primary source of funds supporting the Bank’s lending and investment activities. The Bank also uses various wholesale funding instruments including FHLB advances and reverse repurchase agreements. The Bank may borrow up to 40% of consolidated Bank assets on a line of credit available from the FHLB. As of September 30, 2007, the maximum available under this line was $239 million, while outstanding advances totaled $81 million. In order to draw on this line the Bank must have sufficient collateral. Qualifying collateral includes residential 1-4 family first mortgage loans, certain second mortgage loans, certain commercial real estate loans, and various investment securities. At September 30, 2007, the Bank had pledged collateral sufficient to draw $163 million under the line.

The Bank’s most liquid assets are cash and cash equivalents, which are cash on hand, amounts due from financial institutions, Federal Funds sold, and money market mutual funds. The levels of such assets are dependent on the Bank’s operating, financing and investment activities at any given time. The variations in levels of cash and cash equivalents are influenced by deposit flows and anticipated future deposit flows.

Cash, cash equivalents, and interest-bearing deposits with banks as of September 30, 2007 totaled $32,197,089, an increase of $14,006,583, or 77.00%, from the December 31, 2006 total of $18,190,506. This increase was due primarily to additional deposits.

The Bank’s principal sources of cash flows are its financing activities including deposits and borrowings. During the first nine months of 2007, all financing activities provided $17,644,743 in cash compared to $20,927,446 for the first nine months of 2006. The decrease in cash flows from financing activities during the most recent period was principally due to decreases in proceeds from long-term debt partially offset by a net increase in deposits. Proceeds from long-term debt had no activity compared to an increase of $10,260,000 for the first nine months of 2006. Deposits increased by $38,969,588 in the first nine months of 2007 compared to an increase of $37,002,149 for the first nine months of 2006. Investing activities used cash of $7,710,756 for the first nine months of 2007 compared to cash used of $32,032,534 for the first nine months of 2006. The principal difference in the use of cash was the much higher amount of principal collected on loans in the first nine months of 2007, $118,447,387, compared to $87,407,839 in the first nine months of 2006. This increase in cash was partially offset by an increase in cash used by operating activities which provided $4,072,596 in cash from for the first nine months of 2007 compared to $4,498,470 in the first nine months of 2006. The decrease in cash flows from operating activities was principally due to decrease in gain on foreclosed real estate offset by an increase in provision for loan loss. Gain on foreclosed real estate used cash of $1,272,161 for the first nine months of 2007 compared to no activity for the first nine months of 2006. Provision for loan losses increase from $289,135 for the first nine months of 2006 compared to $659,288 for the first nine months of 2007.

REGULATORY MATTERS

The Bank is subject to Federal Reserve Board capital requirements as well as statutory capital requirements imposed under Maryland law. At September 30, 2007, the Bank’s tangible, leverage and risk-based capital ratios were 8.77%, 11.21% and 12.13%, respectively. These levels are in excess of the required 4.0%, 4.0% and 8.0% ratios required by the Federal Reserve Board as well as the 5.0%, 5.0%, and 10% ratios required to be considered well capitalized. At September 30, 2007, the Company’s tangible, leverage and risk-based capital ratios were 8.96%, 11.43% and 12.36%, respectively. These levels are also in excess of the 4.0%, 4.0% and 8.0% ratios required by the Federal Reserve Board as well as the 5.0%, 5.0%, and 10% ratios required to be considered well capitalized.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and the general practices of the United States banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. The Company considers its determination of the allowance for loan losses and the valuation allowance on its foreclosed real estate to be critical accounting policies. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When these sources are not available, management makes estimates based upon what it considers to be the best available information.

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two principles of accounting: (a) Statement on Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and are estimable and (b) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued when it is probable that the Company will not collect all principal and interest payments according to the contractual terms of the loan. The loss, if any, is determined by the difference between the loan balance and the value of collateral, the present value of expected future cash flows, or values observable in the secondary markets.

The loan loss allowance balance is an estimate based upon management’s evaluation of the loan portfolio. Generally the allowance is comprised of a specific and a general component. The specific component consists of management’s evaluation of certain loans and their underlying collateral. Loans are examined to determine the specific allowance based upon the borrower’s payment history, economic conditions specific to the loan or borrower, or other factors that

would impact the borrower’s ability to repay the loan on its contractual basis. Management assesses the ability of the borrower to repay the loan based upon any information available. Depending on the assessment of the borrower’s ability to pay the loan as well as the type, condition, and amount of collateral, management will establish an allowance amount specific to the loan.

In establishing the general component of the allowance, management analyzes non-classified and non-impaired loans in each loan category of the portfolio including changes in the amount and type of loans. Management also examines the Bank’s history of write-offs and recoveries within each loan category. The state of the local and national economy is also considered. Based upon these factors, the Bank’s loan portfolio is categorized and a loss factor is applied to each category. These loss factors may be higher or lower than the Bank’s actual recent average losses in any particular loan category, particularly in loan categories where the Bank is rapidly increasing the size of its portfolio. Based upon these factors, the Bank will adjust the loan loss allowance by increasing or decreasing the provision for loan losses.

Management has significant discretion in making the judgments inherent in the determination of the provision and allowance for loan losses, including in connection with the valuation of collateral, a borrower’s prospects of repayment, and in establishing allowance factors on the general component of the allowance. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management’s perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs. For additional information regarding the allowance for loan losses, refer to Notes 1 and 4 to the Consolidated Financial Statements as presented in the Company’s annual report on Form 10-K.

In addition to the loan loss allowance, the Company also maintains a valuation allowance on its foreclosed real estate. As with the allowance for loan losses, the valuation allowance on foreclosed real estate is based on SFAS No. 5, “Accounting for Contingencies,” as well as SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” These statements require that the Company establish a valuation allowance when it has determined that the carrying amount of a foreclosed asset exceeds its fair value. Fair value of a foreclosed asset is measured by the cash flows expected to be realized from its subsequent disposition. These cash flows should be reduced for the costs of selling or otherwise disposing of the asset.

In estimating the cash flows from the sale of foreclosed real estate, management must make significant assumptions regarding the timing and amount of cash flows. In cases where the real estate acquired is undeveloped land, management must gather the best available evidence regarding the market value of the property, including appraisals, cost estimates of development, and broker opinions. Due to the highly subjective nature of this evidence, as well as the limited market, long time periods involved, and substantial risks, cash flow estimates are highly subjective and subject to change. Errors regarding any aspect of the costs or proceeds of developing, selling, or otherwise disposing of foreclosed real estate could result in the allowance being inadequate to reduce carrying costs to fair value and may require an additional provision for valuation allowances.

liabilities repricing during a particular time period, and measuring the amount that the estimated market value of assets and liabilities would change given specific changes in interest rates. Modeling these calculations is inherently complex, as many important factors in these calculations are estimates of future consumer behavior based upon historical patterns. The Company uses a steady state balance sheet and parallel rate shifts in interest rates as the basis of many simulations. The Company also looks at results under non-parallel rate shifts.

Presented below are the projected changes in NII given the parallel changes noted above:

Projected Percentage Change in Net Interest Income at September 30, 2007

The rate scenarios noted above show slight changes for the scenarios noted. These results vary with those obtained in December 31, 2006. Slight improvements were the result of the continued maturity of certain instruments which would cause the largest declines in the Bank’s net interest income. Most of the declines in net interest income are small relative to the Company’s net income and primarily result from the projected actions of customers and others taking advantage of the optionality built into the various financial instruments which make up the Company’s assets and liabilities. The Company will continue to evaluate possible courses of action to control the risk of large interest rate declines on its operations.

Management will continue to analyze, simulate, and control interest rate risk as the Company grows. The Company may from time to time determine that the use of different financial instruments including interest rate caps, floors, swaps, long term borrowings, or other arrangements may be prudent. It is management’s belief that the changes in the Company’s balance sheet, including the increased emphasis on commercial lines of credit and certain other loans which tend to rapidly adjust to interest rate changes, and the declining importance of certain liabilities such as short-term borrowings including reverse repurchase agreements and other short term liabilities, will decrease the negative effects of changing interest rates on NII. However, these loans carry an increased risk of default.

PART II — OTHER INFORMATION

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.