PEOPLES BANCORP OF NORTH CAROLINA INC (Form: 10-K, Received: 03/20/2009 11:25:15)

PART I

ITEM 1. BUSINESS

General

Peoples Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”). The Company is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). The Company’s principal source of income is any dividends, which are declared and paid by the Bank on its capital stock. The Company has no operations and conducts no business of its own other than owning the Bank. Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated.

The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 21 banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory, Charlotte, Monroe, Cornelius, Mooresville and Raleigh North Carolina. The Bank also operates a loan production office in Denver, North Carolina. At December 31, 2008, the Company had total assets of $968.8 million, net loans of $770.2 million, deposits of $721.1 million, total securities of $131.2 million, and shareholders’ equity of $101.1 million.

The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans. Real estate loans are predominately variable rate commercial property loans, which include residential development loans to commercial customers. Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio. The majority of the Bank's deposit and loan customers are individuals and small to medium-sized businesses located in the Bank's market area. The Bank’s loan portfolio also includes Individual Taxpayer Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco de le Gente offices. Additional discussion of the Bank’s loan portfolio and sources of funds for loans can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-29 of the Annual Report, which is included in this Form 10-K as Exhibit 13.

The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the "Commissioner").

At December 31, 2008, the Bank employed 270 full-time equivalent employees.

Subsidiaries

The Bank is a subsidiary of the Company. The Bank has two subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank's customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services. Real Estate Advisory Services, Inc. provides real estate appraisal and real estate brokerage services.

In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used in December 2006 to repay the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

Market Area

The Bank's primary market consists of the communities in an approximately 50-mile radius around its headquarters office in Newton, North Carolina. This area includes Catawba County, Alexander County, Lincoln County, Iredell County and portions of northeast Gaston County. The Bank is located only 40 miles north of Charlotte, North Carolina and the Bank's primary market area is and will continue to be significantly affected by its close proximity to this major metropolitan area. The Bank has two offices in Mecklenburg County, one office in Union County and one office in Wake County specifically designed to serve the growing Latino market.

Employment in the Bank's primary market area is diversified among manufacturing, retail and wholesale trade, technology, services and utilities. Catawba County’s largest employers include Catawba County Schools, Frye Regional Medical Center, CommScope, Inc. (manufacturer of fiber optic cable and accessories), Merchant Distributors, Inc (wholesale food distributor), Hickory Springs (manufacturer of foam rubber cushions), Catawba Valley Medical Center, Catawba County, Sherrill Furniture Company, CV Industries (furniture manufacturer), McCreary Modern (furniture manufacturer) and Garbage Disposal Service (garbage disposal and recycling)

Competition

The Bank has operated in the Catawba Valley region for more than 95 years and is the only financial institution headquartered in Newton. Nevertheless, the Bank faces strong competition both in attracting deposits and making loans. Its most direct competition for deposits has historically come from other commercial banks, credit unions and brokerage firms located in its primary market area, including large financial institutions. One national money center commercial bank is headquartered in Charlotte, North Carolina. Based upon June 30, 2008 comparative data, the Bank had 21.88% of the deposits in Catawba County, placing it second in deposit size among a total of 13 banks with branch offices in Catawba County; 9.90% of the deposits in Lincoln County, placing it sixth in deposit size among a total of nine banks with branch offices in Lincoln County and 13.01% of the deposits in Alexander County, placing it fifth in deposit size among a total of seven banks with branch offices in Alexander County.

The Bank also faces additional significant competition for investors' funds from short-term money market securities and other corporate and government securities. The Bank's deposit base has grown principally due to economic growth in the Bank's market area coupled with the implementation of new and competitive deposit products. The ability of the Bank to attract and retain deposits depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities.

The Bank experiences strong competition for loans from commercial banks and mortgage banking companies. The Bank competes for loans primarily through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Competition is increasing as a result of the continuing reduction of restrictions on the interstate operations of financial institutions.

Supervision and Regulation

Bank holding companies and commercial banks are extensively regulated under both federal and state law. The following is a brief summary of certain statutes and rules and regulations that affect or will affect the Company, the Bank and any subsidiaries. This summary is qualified in its entirety by reference to the particular statute and regulatory provisions cited below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than shareholders of the Company.

Statutes and regulations which contain wide-ranging proposals for altering the structures, regulations and competitive relationship of financial institutions are introduced regularly. The Company cannot predict whether or in what form any proposed statute or regulation will be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.

General . There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance funds in the event the depository institution becomes in danger of default or in default. For example, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” with the terms of the capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the bank's total assets at the time the bank became undercapitalized or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all acceptable capital standards as of the time the bank fails to comply with such capital restoration plan. The Company, as a registered bank holding company, is subject to the regulation of the Federal Reserve. Under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve under the BHCA also has the authority to require a bank holding company to terminate any activity or to relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.

In addition, insured depository institutions under common control are required to reimburse the FDIC for any loss suffered by its deposit insurance funds as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the deposit insurance funds. The FDIC's claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

As a result of the Company's ownership of the Bank, the Company is also registered under the bank holding company laws of North Carolina. Accordingly, the Company is also subject to regulation and supervision by the Commissioner.

Capital Adequacy Guidelines for Holding Companies . The Federal Reserve has adopted capital adequacy guidelines for bank holding companies and banks that are members of the Federal Reserve System and have consolidated assets of $150 million or more. Bank holding companies subject to the Federal Reserve’s capital adequacy guidelines are required to comply with the Federal Reserve's risk-based capital guidelines. Under these regulations, the minimum ratio of total capital to risk-weighted assets is 8%. At least half of the total capital is required to be “Tier I capital,” principally consisting of common stockholders' equity, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less certain goodwill items. The remainder (“Tier II capital”) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier I capital (leverage) ratio, under which a bank holding company must maintain a minimum level of Tier I capital to average total consolidated assets of at least 3% in the case of a bank holding company which has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a Tier I capital (leverage) ratio of at least 1% to 2% above the stated minimum.

Capital Requirements for the Bank. The Bank, as a North Carolina commercial bank, is required to maintain a surplus account equal to 50% or more of its paid-in capital stock. As a North Carolina chartered, FDIC-insured commercial bank which is not a member of the Federal Reserve System, the Bank is also subject to capital requirements imposed by the FDIC. Under the FDIC's regulations, state nonmember banks that (a) receive the highest rating during the examination process and (b) are not anticipating or experiencing any significant growth, are required to maintain a minimum leverage ratio of 3% of total consolidated assets; all other banks are required to maintain a minimum ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. The Bank exceeded all applicable capital requirements as of December 31, 2008. At December 31, 2008, the Company’s Tier I risk-based capital and total risk-based capital were 13.65% and 14.90%, respectively.

Dividend and Repurchase Limitations . The Company must obtain Federal Reserve approval prior to repurchasing its Common Stock in excess of 10% of its net worth during any twelve-month period unless the Company (i) both before and after the redemption satisfies capital requirements for "well capitalized" state member banks; (ii) received a one or two rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues. Due to the Company's participation in the Capital Purchase Program ("CPP"), United States Treasury ("UST") approval is required for the Company to repurchase shares of outstanding common stock.

Although the payment of dividends and repurchase of stock by the Company are subject to certain requirements and limitations of North Carolina corporate law, except as set forth in this paragraph, neither the Commissioner nor the FDIC have promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares. However, the ability of the Company to pay dividends or repurchase shares may be dependent upon the Company's receipt of dividends from the Bank.

North Carolina commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. Dividends may be paid by the Bank from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by North Carolina law. Also, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is defined in the applicable law and regulations).

Under the terms of the CPP, the UST has a preferential right to the payment of cumulative dividends on the CPP Series A preferred stock. No dividends are permitted to be paid to common shareholders unless all accrued and unpaid dividends for all past dividend periods on the CPP preferred stock were fully paid. Any increase in dividends to common shareholders above the amount last declared prior to October 14, 2008 ($0.12 per share quarterly in the case of the Company) is subject to the consent of the UST for the first three years of the CPP preferred stock investment.

Deposit Insurance . The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund, or DIF, of the FDIC. The DIF is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006. The Bank’s deposits, therefore, are subject to FDIC deposit insurance assessment.

The FDIC amended its risk-based deposit assessment system in 2007 to implement authority granted by the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned. Risk Category I, which contains the least risky depository institutions, is expected to include more than 90% of all institutions. Unlike the other categories, Risk Category I contains further risk differentiation based on the FDIC’s analysis of financial ratios, examination component ratings and other information. Assessment rates are determined by the FDIC and currently range from five to seven basis points for the healthiest institutions (Risk Category I) to 43 basis points of assessable deposits for the riskiest (Risk Category IV). The Bank was assessed at an average rate of 6.09 basis points in 2008. The FDIC may adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points.

The FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.5% of estimated insured deposits, in contrast to the statutorily fixed ratio of 1.25% under the old system. The ratio, which is viewed by the FDIC as the level that the funds should achieve, was established by the agency at 1.25% for 2007. The Reform Act also provided for the possibility that the FDIC may pay dividends to insured institutions once the DIF reserve ratio equals or exceeds 1.35% of estimated insured deposits. The Reform Act also provided for a one-time credit for eligible institutions based on their assessment base as of December 1996. Subject to certain limitations with respect to institutions that are exhibiting weaknesses, credits can be used to offset future assessments until exhausted.

The FDIC has issued rules increasing the assessment rates banks pay for deposit insurance in order to restore the deposit insurance fund. The final rules uniformly raised rates for the first quarter of 2009 by 7 basis points, on an annual basis, for all banks. The FDIC also issued proposed rules where future rates would be based on an institution’s risk, with riskier institutions bearing a greater share of the proposed increase. Final rules on the risk-based premium assessment are expected in the first quarter of 2009.

FDIC Temporary Liquidity Guarantee Program. On October 14, 2008, the FDIC announced its Temporary Liquidity Guarantee Program (“TLGP”), which is comprised of the Debt Guarantee Program (“DGP”) and the Transaction Account Guarantee Program (“TAGP”).

The TAGP provides unlimited deposit insurance coverage through December 31, 2009, for non-interest bearing transaction accounts and certain interest-bearing accounts (negotiable order of withdrawal (NOW) accounts with interest rates of 0.50% or less and lawyers trust accounts) at FDIC-insured depository institutions. Depository institutions participating in the TAGP will be assessed, on a quarterly basis, an annualized 10 basis points fee on the balance of each covered account in excess of the existing FDIC deposit insurance limit of $250,000 that was established on a temporary basis, through December 31, 2009, by the Emergency Economic Stabilization Act of 2008.

The DGP provides an FDIC guarantee of certain senior unsecured debt of FDIC-insured institutions and their holding companies. The unsecured debt must be issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date or June 30, 2012. The DGP coverage limit is generally 125% of the eligible entity’s eligible debt outstanding on September 30, 2008 and scheduled to mature on or before June 30, 2009 or, for certain insured institutions, 2% of their liabilities as of September 30, 2008. The proceeds of debt guaranteed under the DGP may not be used to prepay debt that is not guaranteed by the FDIC. Depending on the term of the debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) for covered debt outstanding until the earlier of maturity or June 30, 2012.

The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008. The Company is participating in the TAGP and is eligible to participate in the DGP although the Company has not chosen to issue any debt under the program at this time.

Federal Home Loan Bank System . The FHLB system provides a central credit facility for member institutions. As a member of the FHLB of Atlanta, the Bank is required to own capital stock in the FHLB of Atlanta in an amount at least equal to 0.20% (or 20 basis points) of the Bank’s total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB of Atlanta under the new activity-based stock ownership requirement. On December 31, 2008, the Bank was in compliance with this requirement.

Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those institutions. All institutions are required to make public disclosure of their CRA performance ratings. The Bank received an “outstanding” rating in its last CRA examination, which was conducted during March 2007.

Prompt Corrective Action. The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions. The extent of these powers will depend upon whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." Under the regulations, an institution is considered: (A) "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier I risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure; (B) "adequately capitalized" if it has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of an institution with the highest examination rating); (C)"undercapitalized" if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (D) "significantly undercapitalized" if it has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3%; and (E) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets equal to or less than 2%.

Changes in Control. The BHCA prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating with another bank holding company or savings bank holding company without prior approval of the Federal Reserve. Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of the Company. Control is conclusively presumed to exist if, among other things, a person acquires more than 25% of any class of voting stock of the Company or controls in any manner the election of a majority of the directors of the Company. Control is presumed to exist if a person acquires more than 10% of any class of voting stock

and the stock is registered under Section 12 of the Securities Exchange Act of 1934 or the acquiror will be the largest shareholder after the acquisition.

Federal Securities Law . The Company has registered its Common Stock with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934. As a result of such registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act are applicable to the Company.

Transactions with Affiliates. Under current federal law, depository institutions are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act with respect to loans to directors, executive officers and principal shareholders. Under Section 22(h), loans to directors, executive officers and shareholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution's loans-to-one-borrower limit (as discussed below). Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and shareholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any "interested" director may not participate in the voting. The FDIC has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the Federal Reserve requires that loans to directors, executive officers, and principal shareholders be made on terms substantially the same as offered in comparable transactions with non-executive employees of the Bank. The FDIC has imposed additional limits on the amount a bank can loan to an executive officer.

Loans to One Borrower. The Bank is subject to the Commissioner's loans to one borrower limits which are substantially the same as those applicable to national banks. Under these limits, no loans and extensions of credit to any borrower outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the unimpaired capital and unimpaired surplus of the bank. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of unimpaired capital and unimpaired surplus.

Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority also may present us with new challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. The GLB Act likely will have a significant economic impact on the banking industry and on competitive conditions in the financial services industry generally.

USA Patriot Act of 2001 . In 2001, Congress enacted the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (the “Patriot Act”). The Patriot Act is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and contains various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Sarbanes-Oxley Act of 2002 . The Sarbanes-Oxley Act of 2002 is sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act became effective immediately while others are still being implemented.

In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new regulatory body to oversee auditors of public companies. It backs these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal penalties for document and record destruction in connection with federal investigations. It also

increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

The economic and operational effects of this new legislation on public companies, including us, will be significant in terms of the time, resources and costs associated with complying with the new law. Because the Sarbanes-Oxley Act, for the most part, applies equally to larger and smaller public companies, we will be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.

The Company qualified as an accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934, effective December 31, 2006. Therefore, the Company was subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”). The Company incurred additional consulting and audit expenses in becoming compliant with SOX 404, and will continue to incur additional audit expenses to comply with SOX 404 when SOX 404 becomes applicable to smaller reporting companies. Management does not expect expenses related to SOX 404 to have a material impact on the Company’s financial statements. The Company qualified as a smaller reporting company effective June 30, 2008, due to a decrease in market capitalization. Management does not expect significant cost savings from this change in filing status, as certification of the effectiveness of internal controls by management will still be required.

Emergency Economic Stabilization Act of 2008. The Emergency Economic Stabilization Act of 2008 (“EESA”)was enacted in October 2008 in response to the financial crisis. Under the EESA, the UST has the authority to take actions to restore liquidity and stability to the U.S. financial system. The CPP was the first program under the UST’s Troubled Assets Relief Program (“TARP”). The CPP is a voluntary program in which selected, healthy financial institutions were encouraged to participate. Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things. Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy. On December 23, 2008, the Company entered into a Securities Purchase Agreement with the UST. Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of common stock associated with the Company’s participation in the CPP under the TARP. Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale. Of the $25.1 million in proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant. The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield. No dividends were declared or paid on the Series A preferred stock during 2008, and cumulative undeclared dividends at December 31, 2008 were $28,000.

American Recovery and Reinvestment Act of 2009. The American Recovery and Reinvestment Act of 2009 was enacted in February 2009 to provide a stimulus to the U.S. economy in the wake of the economic downturn brought about by the financial crisis and the resulting credit crunch. The Company does not expect any significant impact from this legislation other the restrictions on executive compensation for companies participating in the TARP.

Government Monetary Policies and Economic Controls. Our earnings and growth, as well as the earnings and growth of the banking industry, are affected by the credit policies of monetary authorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the national supply of bank credit in order to combat recession and curb inflationary pressures. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. government securities, changes in reserve requirements against member bank deposits, and changes in the Federal Reserve discount rate. These means are used in varying combinations to influence overall growth of bank loans, investments, and deposits, and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.

In view of changing conditions in the national economy and in money markets, as well as the effect of credit policies by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, and loan demand, or their effect on our business and earnings or on the financial condition of our various customers.

Other. Additional regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state chartered institutions examined by state regulators. Additional regulations also establish operational and managerial, asset quality,

earnings and stock valuation standards for insured depository institutions, as well as compensation standards.

The Bank is subject to examination by the FDIC and the Commissioner. In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. The Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.

Under Chapter 53 of the North Carolina General Statutes, if the capital stock of a North Carolina commercial bank is impaired by losses or otherwise, the Commissioner is authorized to require payment of the deficiency by assessment upon the bank's shareholders, pro rata, and to the extent necessary, if any such assessment is not paid by any shareholder, upon 30 days notice, to sell as much as is necessary of the stock of such shareholder to make good the deficiency.

ITEM 1A. RISK FACTORS

The following are potential risks that management considers material and that could affect the future operating results and financial condition of the Bank and the Company. The risks are not listed in any particular order of importance, and there is the potential that there are other risks that have either not been identified or that management believed to be immaterial but which could in fact adversely affect the Bank’s operating results and financial condition.

Loss of key personnel could adversely impact results

The success of the Bank has been and will continue to be greatly influenced by the ability to retain the services of existing senior management. The Bank has benefited from consistency within its senior management team, with its top five executives averaging over 16 years of service with the Bank. The Company has entered into employment contracts with each of these top management officials. Nevertheless, the unexpected loss of the services of any of the key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse impact on the business and financial results of the Bank.

A significant amount of the Bank’s business is concentrated in lending which is secured by property located in the Catawba Valley and surrounding areas

In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures its loans with real estate collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If the Bank is required to liquidate the collateral securing a loan during a period of reduced real estate values to satisfy the debt, the Bank’s earnings and capital could be adversely affected.

Additionally, with most of the Bank’s loans concentrated in the Catawba Valley and surrounding areas, a decline in local economic conditions could adversely affect the values of the Bank’s real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on the Bank’s earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse.

An inadequate allowance for loan losses would reduce our earnings

The risk of credit losses on loans varies with, among other things, general economic conditions, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Considering such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances within assigned risk grades and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb future losses, or if the bank regulatory authorities require the Bank to increase the allowance for loan losses as a part of their examination process, the Bank’s earnings and capital could be significantly and adversely affected. For further discussion related to our process for determining the appropriate level of the allowance for loan losses, see “Allowance for Loan Losses” within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results and Operation” of this Annual Report, which is included in this Form 10-K as Exhibit 13.

Changes in interest rates affect profitability and assets

Changes in prevailing interest rates may hurt the Bank’s business. The Bank derives its income primarily from the difference or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. In general, the larger the spread, the more the Bank earns. When market rates of interest change, the interest the Bank receives on its assets and the interest the Bank pays on its liabilities will fluctuate. This can cause decreases in the “spread” and can adversely affect the Bank’s income. Changes in market interest rates could reduce the value of the Bank’s financial assets. Fixed-rate investments, mortgage-backed and related securities and mortgage loans generally decrease in value as interest rates rise. In addition, interest rates affect how much money the Bank lends. For example, when interest rates rise, the cost of borrowing increases and the loan originations tend to decrease. If the Bank is unsuccessful in managing the effects of changes in interest rates, the financial condition and results of operations could suffer.

We measure interest rate risk under various rate scenarios using specific criteria and assumptions. A summary of this process, along with the results of our net interest income simulations is presented within “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” of this Annual Report which is included in this Form 10-K as Exhibit 13.

The Company’s Business May Be Adversely Affected by Conditions in the Financial Markets and Economic Conditions

Since December 2007, the United States has been in a recession. Business activity across a wide range of industries and regions is greatly reduced and local governments and many businesses are in serious difficulty due to the lack of consumer spending and the lack of liquidity in the credit markets. Unemployment has increased significantly.

Since mid-2007, and particularly during the second half of 2008, the financial services industry and the securities markets generally were materially and adversely affected by significant declines in the values of nearly all asset classes and by a serious lack of liquidity. This was initially triggered by declines in home prices and the values of subprime mortgages, but spread to all mortgage and real estate asset classes, to leveraged bank loans and to nearly all asset classes, including equities. The global markets have been characterized by substantially increased volatility and short-selling and an overall loss of investor confidence, initially in financial institutions, but more recently in companies in a number of other industries and in the broader markets.

Market conditions have also led to the failure or merger of a number of prominent financial institutions. Financial institution failures or near-failures have resulted in further losses as a consequence of defaults on securities issued by them and defaults under contracts entered into with such entities as counterparties. Furthermore, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to increase credit default swap spreads, to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions. Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of some financial institutions worldwide. In 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, including investing approximately $200 billion in the equity of other banking organizations, but asset values have continued to decline and access to liquidity continues to be very limited.

The Company’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, is highly dependent upon on the business environment in the markets where the Company operates, in the State of North Carolina and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by: declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; natural disasters; or a combination of these or other factors.

Overall, during 2008, the business environment has been adverse for many households and businesses in the United States and worldwide. The business environment in North Carolina and the markets in which the Company operates has been less adverse than in the United States generally but continues to deteriorate. It is expected that the business environment in the State of North Carolina, the United States and worldwide will continue to deteriorate for the foreseeable future. There can be no assurance that these conditions will improve in the near term. Such conditions could adversely affect the credit quality of the Company’s loans, results of operations and financial condition.

The Bank faces strong competition from other banks and financial institutions which can hurt its business

The financial services industry is highly competitive. The Bank competes against commercial banks, savings banks, savings and loan associations, credit unions, mortgage banks, brokerage firms, investment advisory firms, insurance companies and other financial institutions. Many of these entities are larger organizations with significantly greater financial, management and other resources than the Bank has. Moreover, one national money center commercial bank is headquartered in Charlotte, North Carolina, only 40 miles from the Bank's primary market area.

While management believes it can and does successfully compete with other financial institutions in our market, we may face a competitive disadvantage as a result of our smaller size and lack of geographic diversification.

Government regulations and policies impose limitations and may result in higher operating costs and competitive disadvantages

The Bank is subject to extensive federal government supervision and regulation that is intended primarily to protect depositors and the FDIC’s Bank Insurance Fund, rather than the Company’s shareholders. Existing banking laws subject the Bank to substantial limitations with respect to loans, the purchase of securities, the payment of dividends and many other aspects of banking business. Some of the banking laws may increase the cost of doing business or otherwise adversely affect the Bank and create competitive advantages for non-bank competitors. There can be no assurance that future legislation or government policy will not adversely affect the banking industry or the Bank’s operations. Federal economic and monetary policy may also affect the Bank’s ability to attract deposits, make loans and achieve satisfactory interest spreads.

The Government has the ability to change the terms of the TARP agreement at any time. Future changes in the TARP agreement could adversely affect the Company.

Changes in technology may impact the Bank’s business

The Bank uses various technologies in its business and the banking industry is undergoing rapid technological changes. The effective use of technology increases efficiency and enables financial institutions to reduce costs. The Bank’s future success will depend in part on its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in the Bank’s operations. The Bank’s competitors may have substantially greater resources to invest in technological improvements.

The trading volume in our common stock is less than that of larger public companies which can cause price volatility

The trading history of our common stock has been characterized by relatively low trading volume. The value of a shareholder’s investment may be subject to sudden decreases due to the volatility of the price of our common stock, which trades on the NASDAQ Global Market.

The market price of our common stock may be volatile and subject to fluctuations in response to numerous factors, including, but not limited to, the factors discussed in other risk factors and the following:

·	actual or anticipated fluctuation in our operating results;

·	changes in interest rates;

·	changes in the legal or regulatory environment in which we operate;
●	press releases, announcements or publicity relating to us or our competitors or relating to trends in our industry;

·	changes in expectations as to our future financial performance, including financial estimates or recommendations by securities analysts and investors;
●	future sales of our common stock;
●	changes in economic conditions in our market, general conditions in the U.S. economy, financial markets or the banking industry; and
●	other developments affecting our competitors or us.

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent a shareholder from selling common stock at or above the current market price.

We may be subject to examinations by taxing authorities which could adversely affect our results of operations

In the normal course of business, we may be subject to examinations from federal and state taxing authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we are engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. The challenges made by taxing authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have an adverse effect on our financial condition and results of operations.

We may not be able to pay dividends in the future in accordance with past practice

We have in the past paid a quarterly dividend to shareholders. However, we are dependent primarily upon the Bank for our earnings and funds to pay dividends on our common stock. The payment of dividends also is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on the Bank’s earnings, capital requirements, financial condition and other factors considered relevant by our Board of Directors.

Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition

Our accounting policies are fundamental to understanding our financial results and condition. Some of these policies require use of estimates and assumptions that may affect the value of our assets or liabilities and financial results. Some of our accounting policies are critical because they require management to make difficult, subjective and complex judgments about matters that are inherently uncertain and because it is likely that materially different amounts would be reported under different conditions or using different assumptions.

From time to time the Financial Accounting Standards Board (FASB) and the SEC change the financial accounting and reporting standards or the interpretation of those standards that govern the preparation of our external financial statements. These changes are beyond our control, can be hard to predict and could materially impact how we report our results of operations and financial condition. We could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements in material amounts.

Our internal controls may be ineffective

Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations, and financial condition.

Impairment of investment securities or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations

In assessing the impairment of investment securities, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issues, and the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.

We rely on other companies to provide key components of our business infrastructure

Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to

our customers and otherwise to conduct our business. Replacing these third party vendors could also entail significant delay and expense.

Our information systems may experience an interruption or breach in security

We rely heavily on communications and information systems to conduct our business. Any failure, interruption, or breach in security or operational integrity of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption, or security breach of our information systems, we cannot assure you that any such failures, interruptions, or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions, or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

New requirements under EESA and changes in the TARP CPP regulations may adversely affect our operations and financial condition

Given the current international, national and regional economic climate, it is unclear what effect the provisions of the EESA will have with respect to our profitability and operations. In addition, the US government, either through the UST or some other federal agency, may also advance additional programs that could materially impact our profitability and operations.

Liquidity is essential to our businesses

Our liquidity could be impaired by an inability to access the capital markets or unforeseen outflows of cash. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us. Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger unfavorable contractual obligations.

Negative publicity could damage our reputation

Reputation risk, or the risk to our earnings and capital from negative public opinion, is inherent in our business. Negative public opinion could adversely affect our ability to keep and attract customers and expose us to adverse legal and regulatory consequences. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, corporate governance, regulatory compliance, mergers and acquisitions, and disclosure, sharing or inadequate protection of customer information, and from actions taken by government regulators and community organizations in response to that conduct.

Financial services companies depend on the accuracy and completeness of information about customers and counterparties

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

At December 31, 2008, the Bank conducted its business from the headquarters office in Newton, North Carolina, its Banco de la Gente administrative office and its 21 other branch offices in Lincolnton, Hickory, Newton, Catawba, Conover, Claremont, Maiden, Denver, Triangle, Hiddenite, Charlotte, Monroe, Cornelius, Mooresville and Raleigh, North Carolina. The Bank also operates a loan production office in Denver, North Carolina. The following table sets forth certain information regarding the Bank's properties at December 31, 2008.

Owned

Corporate Office

518 West C Street

Newton, North Carolina 28658

420 West A Street

Newton, North Carolina 28658

2619 North Main Avenue

Newton, North Carolina 28658

213 1st Street, West

Conover, North Carolina 28613

3261 East Main Street

Claremont, North Carolina 28610

6125 Highway 16 South

Denver, North Carolina 28037

5153 N.C. Highway 90E

Hiddenite, North Carolina 28636

200 Island Ford Road

Maiden, North Carolina 28650

3310 Springs Road NE

Hickory, North Carolina 28601

142 South Highway 16

Denver, North Carolina 28037

106 North Main Street

Catawba, North Carolina 28609

2050 Catawba Valley Boulevard

Hickory, North Carolina 28601

800 E. Arrowood Road

Charlotte, NC 28217

1074 River Highway

Mooresville, NC, 28117

Leased

1333 2nd Street NE

Hickory, North Carolina 28601

1910 East Main Street

Lincolnton, North Carolina 28092

760 Highway 27 West

Lincolnton, North Carolina 28092

102 Leonard Avenue

Newton, North Carolina 28658

6300 South Boulevard

Suite 100

Charlotte, North Carolina 28217

4451 Central Avenue

Suite A

Charlotte, North Carolina 28205

3752/3754 Highway 16 North

Denver, North Carolina 28037

501 West Roosevelt Boulevard

Monroe, NC 28110

9624-I Bailey Road

Cornelius, North Carolina 28031

4011 Capital Boulevard

Raleigh, NC 27604

ITEM 3. LEGAL PROCEEDINGS

In the opinion of management, the Company is not involved in any material pending legal proceedings other than routine proceedings occurring in the ordinary course of business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submitted to a vote of the Company’s shareholders during the quarter ended December 31, 2008.

PART II

ITEM 5.

MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The information required by this Item is set forth under the section captioned "Market for the Company’s Common Equity and Related Shareholder Matters" on page A-28 of the Annual Report. The Annual Report is included in this Form 10-K as Exhibit (13). See "Item 1. BUSINESS--Supervision and Regulation" above for regulatory restrictions which limit the ability of the Company to pay dividends.

The information required by Item 201(d) concerning securities authorized for issuance under equity compensation plans is set forth in Item 12 hereof .

ISSUER PURCHASES OF EQUITY SECURITIES

Period	Total Number of Shares Purchased	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs*

January 1 - 31, 2008	-	$	-	-	24,503	(1)

February 1 - 28, 2008	26,256		14.00	25,000	-

March 1 - 31, 2008	-		-	-	100,000	(2)

April 1 - 30, 2008	-		-	-	100,000	(2)

May 1 - 31, 2008	1,215		14.03	-	100,000	(2)

June 1 - 30, 2008	15,875		12.83	15,500	84,500	(2)

July 1 - 31, 2008	-		-	-	84,500	(2)

August 1 - 31, 2008	-		-	-	84,500	(2)

September 1 - 30, 2008	2,510		11.59	-	84,500	(2)

October 1 - 31, 2008	-		-	-	84,500	(2)

November 1 - 30, 2008	904		11.26	-	84,500	(2)

December 1 - 31, 2008	50,425		11.54	50,000	34,500	(2)

Total	97,185	$	12.45	90,500

(1) Reflects number of shares that may yet be purchased under the Stock Repurchase Plan through the end of August 31, 2008 as authorized by the Company's Board of Directors in August 2007.

(2) Reflects number of shares that may yet be purchased under the Stock Repurchase Plan through the end of March 31, 2009 as authorized by the Company's Board of Directors in March 2008.

*Due to the Company's participation in the CPP, UST approval is required for the Company to repurchase
shares of outstanding common stock.

The information required by Item 201(e), the Performance Graph, is set forth in the section captioned “Stock Performance Graph” on page A-29 of the Annual Report, which is included in this Form 10-K as Exhibit (13).

On December 23, 2008, the Company issued 25,054 shares of Series A preferred stock and a warrant to purchase 357,234 shares of the Company's common stock to the United States Department of the Treasury through a private placement. This issuance of shares was not registered under the Securities Act of 1933 in reliance on the exemption set for in Section 4(2) thereof.

ITEM 6. SELECTED FINANCIAL DATA

The information required by this Item is set forth in the table captioned "Selected Financial Data" on page A-3 of the Annual Report, which table is included in this Form 10-K as Exhibit (13).

ITEM 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The information required by this Item is set forth in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-29 of the Annual Report, which section is included in this Form 10-K as Exhibit (13).

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this Item is set forth in the section captioned “Quantitative and Qualitative Disclosures About Market Risk” on page A-26 of the Annual Report, which section is included in this Form 10-K as Exhibit (13).

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of the Company and supplementary data set forth on pages A-30 through A-61 of the Annual Report are included in this Form 10-K as Exhibit (13).

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 9A.

CONTROLS AND PROCEDURES

The Company’s management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer of the Company have concluded, based on their evaluation as of the end of the period covered by this Report, that the Company’s disclosure controls and procedures (as defined in Rule 13A-15(e) promulgated under the Exchange Act) are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms.

There have been no significant changes in internal control over financial reporting during the quarter ended December 31, 2008 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

MANAGEMENT’S REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and depositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of the internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2008.

The Company’s independent registered public accountants have issued an audit report on our assessment of the company’s internal control over financial reporting. Their report is included herein.

/s/ Tony W. Wolfe		/s/ A. Joseph Lampron
Tony W. Wolfe		A. Joseph Lampron
Chief Executive Officer		Chief Financial Officer
March 20, 2009		March 20, 2009

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

ITEM 9B. OTHER INFORMATION

None

PART III

ITEM 10.

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item regarding directors and executive officers of the Company is set forth under the sections captioned “Proposal 1 - Election of Directors - Nominees” contained in the Proxy Statement and “Proposal 1 - Election of Directors - Executive Officers” contained in the Proxy Statement, which sections are incorporated herein by reference.

The information required by this Item regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth under the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” contained in the Proxy Statement, which section is incorporated herein by reference.

The information required by this Item regarding identification of members of the Company’s Audit Committee is set forth under the section captioned “Proposal 1 - Election of Directors” contained in the Proxy Statement, which section is incorporated herein by reference.

The Company has adopted a Code of Ethics that applies to the Company’s employees, including the principal executive officer and principal financial officer. The Company has also adopted a written charter for the Audit Committee, which is reviewed annually, and amended as needed, by the Committee. The Company will provide to any person, without charge, upon request, a copy of these documents. To request a copy, a written request should be submitted to the Company’s corporate headquarters, addressed to the attention of A. Joseph Lampron, Chief Financial Officer. These documents are also available on the Bank’s website (www.peoplesbanknc.com) under “Investor Relations.”

ITEM 11.

EXECUTIVE COMPENSATION

The information required by this Item is set forth under the sections captioned “Proposal 1 - Election of Directors” contained in the Proxy Statement, which sections are incorporated herein by reference.

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated by reference from the section captioned “Security Ownership of Certain Beneficial Owners and Management” contained in the Proxy Statement and the section captioned “Equity Compensation Plan Information” contained in the Proxy Statement.

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

See the section captioned “Proposal 1 - Election of Directors - Indebtedness of and Transactions with Management and Directors” contained in the Proxy Statement, which section is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

See the section captioned “Proposal 4 - Ratification of Selection of Independent Auditor” contained in the Proxy Statement, which section is incorporated herein by reference.

PART IV

ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

15(a)1.	Consolidated Financial Statements (contained in the Annual Report attached hereto as Exhibit (13)
	and incorporated herein by reference)

	(a)	Report of Independent Registered Public Accounting Firm

	(b)	Consolidated Balance Sheets as of December 31, 2008 and 2007

	(c)	Consolidated Statements of Earnings for the Years Ended December 31, 2008, 2007 and
		2006

	(d)	Consolidated Statements of Changes in Shareholders' Equity for the Years Ended
		December 31, 2008, 2007 and 2006

	(e)	Consolidated Statements of Comprehensive Income for the Years Ended December 31,
		2008, 2007 and 2006

	(f)	Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007
		and 2006

	(g)	Notes to Consolidated Financial Statements

15(a)2.	Consolidated Financial Statement Schedules

	All schedules have been omitted, as the required information is either inapplicable or included in
	the Notes to Consolidated Financial Statements.

15(a)3.	Exhibits

	Exhibit (3)(1)	Articles of Amendment dated December 19, 2008, regarding the Series A
		Preferred Stock, incorporated by reference to Exhibit (3)(1) to the Form 8-
		K filed with the Securities and Exchange Commissionon December 29,
		2008

	Exhibit (3)(i)	Articles of Incorporation of Peoples Bancorp of North Carolina, Inc.,
		incorporated by reference to Exhibit (3)(i) to the Form 8-A filed with the
		Securities and Exchange Commission on September 2, 1999

	Exhibit (3)(ii)	Amended and Restated Bylaws of Peoples Bancorp of North Carolina,
		Inc., incorporated by reference to Exhibit (3)(ii) to the Form 10-Q filed
		with the Securities and Exchange Commission on November 7, 2007

	Exhibit (4)	Specimen Stock Certificate, incorporated by reference to Exhibit (4) to the
		Form 8-A filed with the Securities and Exchange Commission on
		September 2, 1999

	Exhibit (4)(1)	Form of Certificate for the Series A Preferred Stock, incorporated by
		reference to Exhibit (4)(1) to the Form 8-K filed with the Securities and
		Exchange Commission on December 29, 2008

	Exhibit (4)(2)	Warrant dated December 23, 2008, for the purchase of shares of Common
		Stock, incorporated by reference to Exhibit (4)(2) to the Form 8-K filed
		with the Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(1)	Letter Agreement dated December 23, 2008 between the Registrant and the
		United States Department of the Treasury, incorporated by reference to
		Exhibit (10)(1) to the Form 8-K filed with the Securities and Exchange
		Commission on December 29, 2008

	Exhibit (10)(a)(i)	Employment Letter Agreement dated December 23, 2008 between Peoples
		Bancorp of North Carolina, Inc. and Tony W. Wolfe, incorporated by
		reference to Exhibit (10)(a)(i) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(a)(ii)	Amendment to Employment Agreement between Peoples Bank and Tony
		W. Wolfe dated December 18, 2008, incorporated by reference to Exhibit
		(10)(a)(ii) to the Form 8-K filed with the Securities and Exchange
		Commission on December 29, 2008

	Exhibit (10)(a)(iii)	Amended and Restated Executive Salary Continuation Agreement between
		Peoples Bank and Tony W. Wolfe dated December 18, 2008, incorporated
		by reference to Exhibit (10)(a)(iii) to the Form 8-K filed with the
		Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(b)(i)	Employment Letter Agreement dated December 23, 2008 between Peoples
		Bancorp of North Carolina, Inc. and Joseph F. Beaman, Jr., incorporated by
		reference to Exhibit (10)(b)(i) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(b)(ii)	Amendment to Employment Agreement between Peoples Bank and Joseph
		F. Beaman, Jr. dated December 18, 2008, incorporated by reference to
		Exhibit (10)(b)(ii) to the Form 8-K filed with the Securities and Exchange
		Commission on December 29, 2008

	Exhibit (10)(b)(iii)	Amended and Restated Executive Salary Continuation Agreement between
		Peoples Bank and Joseph F. Beaman, Jr. dated December 18, 2008,
		incorporated by reference to Exhibit (10)(b)(iii) to the Form 8-K filed with
		the Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(c)(i)	Employment Letter Agreement dated December 23, 2008 between Peoples
		Bancorp of North Carolina, Inc. and William D. Cable, Sr., incorporated
		by reference to Exhibit (10)(c)(i) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(c)(ii)	Amendment to Employment Agreement between Peoples Bank and
		William D. Cable, Sr. dated December 18, 2008, incorporated by
		reference to Exhibit (10)(c)(ii) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(c)(iii)	Amended and Restated Executive Salary Continuation Agreement between
		Peoples Bank and William D. Cable, Sr. dated December 18, 2008,
		incorporated by reference to Exhibit (10)(c)(iii) to the Form 8-K filed with
		the Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(d)(i)	Employment Letter Agreement dated December 23, 2008 between Peoples
		Bancorp of North Carolina, Inc. and Lance A. Sellers, incorporated by
		reference to Exhibit (10)(d)(i) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(d)(ii)	Amendment to Employment Agreement between Peoples Bank and Lance
		A.. Sellers dated December 18, 2008, incorporated by reference to Exhibit
		(10)(d)(ii) to the Form 8-K filed with the Securities and Exchange
		Commission on December 29, 2008

	Exhibit (10)(d)(iii)	Amended and Restated Executive Salary Continuation Agreement between
		Peoples Bank and Lance A. Sellers dated December 18, 2008,
		incorporated by reference to Exhibit (10)(d)(iii) to the Form 8-K filed with
		the Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(e)	Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership and
		Long Term Incentive Plan incorporated by reference to Exhibit (10)(f) to
		the Form 10-K filed with the Securities and Exchange Commission on
		March 30, 2000

	Exhibit (10)(e)(i)	Amendment No. 1 to the Peoples Bancorp of North Carolina, Inc.
		Omnibus Stock Ownership and Long Term Incentive Plan incorporated by
		reference to (10)(e)(i) to the Form 10-K filed with the Securities
		and Exchange Commission on March 15, 2007

	Exhibit (10)(f)(i)	Employment Letter Agreement dated December 23, 2008 between Peoples
		Bancorp of North Carolina, Inc. and A. Joseph Lampron, incorporated by
		reference to Exhibit (10)(f)(i) to the Form 8-K filed with the Securities
		and Exchange Commission on December 29, 2008

	Exhibit (10)(f)(ii)	Amendment to Employment Agreement between Peoples Bank and A.
		Joseph Lampron dated December 18, 2008, incorporated by reference to
		Exhibit (10)(f)(ii) to the Form 8-K filed with the Securities and Exchange
		Commission on December 29, 2008

	Exhibit (10)(f)(iii)	Amended and Restated Executive Salary Continuation Agreement between
		Peoples Bank and A. Joseph Lampron dated December 18, 2008,
		incorporated by reference to Exhibit (10)(f)(iii) to the Form 8-K filed with
		the Securities and Exchange Commission on December 29, 2008

	Exhibit (10)(g)	Peoples Bank Directors' and Officers' Deferral Plan, incorporated by
		reference to Exhibit (10)(h) to the Form 10-K filed with the Securities
		and Exchange Commission on March 28, 2002

	Exhibit (10)(h)	Rabbi Trust for the Peoples Bank Directors' and Officers' Deferral Plan,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 28, 2002

	Exhibit (10)(i)	Description of Service Recognition Program maintained by Peoples Bank,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 27, 2003

	Exhibit (10)(j)	Capital Securities Purchase Agreement dated as of June 26, 2006, by and
		among Peoples Bancorp of North Carolina, Inc., PEBK Capital Trust II
		and Bear, Sterns Securities Corp. incorporated by reference to Exhibit
		10(j) to the Form 10-Q filed with the Securities and Exchange
		Commission on November 13, 2006

	Exhibit (10)(k)	Amended and Restated Trust Agreement of PEBK Capital Trust II, dated
		as of June 28, 2006 incorporated by reference to Exhibit (10)(k) to the
		Form 10-Q filed with the Securities and Exchange Commission on
		November 13, 2006

	Exhibit (10)(l)	Guarantee Agreement of Peoples Bancorp of North Carolina, Inc. dated as
		of June 28, 2006 incorporated by reference to Exhibit (10)(l) to the Form
		10-Q filed with the Securities and Exchange Commission on November
		13, 2006

	Exhibit (10)(m)	Indenture, dated as of June 28, 2006, by and between Peoples Bancorp of
		North Carolina, Inc. and LaSalle Bank National Association, as Trustee,
		relating to Junior Subordinated Debt Securities Due September 15, 2036,
		incorporated by reference to Exhibit (10)(m) to the Form 10-Q filed with the
		Securities and Exchange Commission on November 13, 2006

	Exhibit (10)(n)	Form of Amended and Restated Director Supplemental Retirement
		Agreement between Peoples Bank and Directors Robert C. Abernethy,
		James S. Abernethy, Douglas S. Howard, John W. Lineberger, Jr., Gary E.
		Matthews, Dr. Billy L. Price, Jr., Larry E. Robinson, W. Gregory Terry,
		Dan Ray Timmerman, Sr., and Benjamin I. Zachary, incorporated by
		reference to Exhibit (10)(n) to the Form 8-K filed with the Securities and
		Exchange Commission on December 29, 2008

	Exhibit (10)(o)	2009 Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership
		and Long Term Incentive Plan

	Exhibit (11)	Statement regarding computation of per share earnings

	Exhibit (12)	Statement regarding computation of ratios

	Exhibit (13)	2008 Annual Report of Peoples Bancorp of North Carolina, Inc.

	Exhibit (14)	Code of Business Conduct and Ethics of Peoples Bancorp of North
		Carolina, Inc., incorporated by reference to Exhibit (14) to the Form 10-K
		filed with the Securities and Exchange Commission on March 25, 2005

	Exhibit (21)	Subsidiaries of the Registrant

	Exhibit (23)	Consent of Porter Keadle Moore, LLP

	Exhibit (31)(a)	Certification of principal executive officer pursuant to section 302 of the
		Sarbanes-Oxley Act of 2002

	Exhibit (31)(b)	Certification of principal financial officer pursuant to section 302 of the
		Sarbanes-Oxley Act of 2002

	Exhibit (32)	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
		Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

		PEOPLES BANCORP OF NORTH CAROLINA, INC.
		(Registrant)


		By:	/s/ Tony W. Wolfe
		Tony W. Wolfe
		President and Chief Executive Officer

		Date: March 20, 2009

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

Signature	Title	Date

/s/ Tony W. Wolfe	President and Chief Executive Officer	March 20, 2009
Tony W. Wolfe	(Principal Executive Officer)

/s/ James S. Abernethy	Director	March 20, 2009
James S. Abernethy

/s/ Robert C. Abernethy	Chairman of the Board and Director	March 20, 2009
Robert C. Abernethy

/s/ Douglas S. Howard	Director	March 20, 2009
Douglas S. Howard

/s/ A. Joseph Lampron	Executive Vice President and Chief	March 20, 2009
A. Joseph Lampron	Financial Officer (Principal Financial
	and Principal Accounting Officer)

/s/ John W. Lineberger, Jr.	Director	March 20, 2009
John W. Lineberger, Jr.

/s/ Gary E. Matthews	Director	March 20, 2009
Gary E. Matthews

/s/ Billy L. Price, Jr., M.D.	Director	March 20, 2009
Billy L. Price, Jr., M.D.

/s/ Larry E. Robinson	Director	March 20, 2009
Larry E. Robinson

/s/ William Gregory Terry	Director	March 20, 2009
William Gregory Terry

/s/ Dan Ray Timmerman, Sr.	Director	March 20, 2009
Dan Ray Timmerman, Sr.

/s/ Benjamin I. Zachary	Director	March 20, 2009
Benjamin I. Zachary

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors and the Company’s consolidated financial statements and notes thereto on pages A-30 through A-61.

Introduction

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company, for the years ended December 31, 2008, 2007 and 2006. The Company is a registered bank holding company operating under the supervision of the Federal Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Union and Wake counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview

Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and small businesses and (2) commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Federal Reserve has decreased the Federal Funds Rate 4.00% since December 31, 2007 with the rate set at 3.25% as of December 31, 2008. These decreases had a negative impact on 2008 earnings and will continue to have a negative impact on the Bank’s net interest income in the future periods. The negative impact from the decrease in the Federal Funds Rate has been partially offset by the increase in earnings realized on interest rate contracts, including both interest rate swaps and interest rate floors, utilized by the Company. Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”

On December 23, 2008, the Company entered into a Securities Purchase Agreement (“Purchase Agreement”) with the United States Department of the Treasury (“UST”). Under the Purchase Agreement, the Company agreed to issue and sell 25,054 shares of Series A preferred stock and warrants to purchase 357,234 shares of common stock associated with the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”) under the Troubled Asset Relief Program (“TARP”). Proceeds from this issuance of preferred shares were allocated between preferred stock and the warrant based on their relative fair values at the time of the sale. Of the $25.1 million in

A-4

proceeds, $24.4 million was allocated to the Series A preferred stock and $704,000 was allocated to the common stock warrant. The discount recorded on the preferred stock that resulted from allocating a portion of the proceeds to the warrant is being accreted directly to retained earnings over a five-year period applying a level yield. No dividends were declared or paid on the Series A preferred stock during 2008, and cumulative undeclared dividends at December 31, 2008 were $28,000. The CPP, created by the UST, is a voluntary program in which selected, healthy financial institutions were encouraged to participate. Approved use of the funds includes providing credit to qualified borrowers, either as companies or individuals, among other things. Such participation is intended to support the economic development of the community and thereby restore the health of the local and national economy.

The Series A preferred stock qualifies as Tier 1 capital and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. The Series A preferred stock may be redeemed at the stated amount of $1,000 per share plus any accrued and unpaid dividends. Under the terms of the original Purchase Agreement, the Company could not redeem the preferred shares until December 23, 2011 unless the total amount of the issuance, $25.1 million, was replaced with the same amount of other forms of capital that would qualify as Tier 1 capital. However, with the enactment of the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company can now redeem the preferred shares at any time, if approved by the Company’s primary regulator. The Series A preferred stock is non-voting except for class voting rights on matters that would adversely affect the rights of the holders of the Series A preferred stock.

The exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Company is subject to the following restrictions while the Series A preferred stock is outstanding: 1) UST approval is required for the Company to repurchase shares of outstanding common stock; 2) the full dividend for the latest completed CPP dividend period must declared and paid in full before dividends may be paid to common shareholders; 3) UST approval is required for any increase in common dividends per share; and 4) the Company may not take tax deductions for any senior executive officer whose compensation is above $500,000. There were additional restrictions on executive compensation added in the ARRA for companies participating in the TARP, including participants in the CPP.

It is the intent of the Company to utilize CPP funds to make loans to qualified borrowers in the Bank’s market area. The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure. The Bank is also working with its current builders and contractors to provide financing for potential buyers who may not be able to qualify for financing in the current mortgage market in order to help these customers sell existing single family homes. The Bank will also use the CPP capital infusion as additional Tier I capital to protect the Bank from potential losses that may be incurred during this current recessionary period.

The Bank opened a new office in Iredell County, in Mooresville, North Carolina in January 2008. Also in January 2008, the Bank opened a new Banco de la Gente office in Wake County, in Raleigh, North Carolina in a continuing effort to serve the Latino community. While there are no additional offices planned in 2009, management will continue to look for branching opportunities in nearby markets.

Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more

A-5

complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2008 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 7, 2009 Annual Meeting of Shareholders.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to consolidated financial statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” For a more complete discussion of policies, see the notes to consolidated financial statements.

In September 2006, the Financial Accounting Standard Board (“FASB”) ratified the conclusions reached by the Emerging Issues Task Force (“EITF”) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue requires companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. EITF 06-4 was effective for the Company as of January 1, 2008. During first quarter 2008, the Company made a $467,000 reduction to retained earnings for the cumulative effect of EITF 06-4 as of January 1, 2008 pursuant to the guidance of this pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 was effective for the Company as of January 1, 2008. This standard had no effect on the Company's financial position or results of operations.

SFAS No. 157 establishes a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The Company’s fair value measurements for items measured at fair value at December 31, 2008 included:

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916,349	935,032	122,731,317	1,250,000
Market value of derivatives (in other assets)	$	4,980,701	-	4,980,701	-

Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Fair values of derivative instruments are determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.

A-6

The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2008:

	Investment Securities Available for Sale
	Level 3 Valuation
Balance, beginning of period	$	250,000
Change in book value		-
Change in gain/(loss) realized and unrealized		-
Purchases/(sales)		1,000,000
Transfers in and/or out of Level 3		-
Balance, end of period	$	1,250,000

Change in unrealized gain/(loss) for assets still held in Level 3	$	0

In accordance with the provisions of SFAS No. 114, the Company has specific loan loss reserves for loans that management has determined to be impaired. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the appraised value of any underlying collateral. At December 31, 2008, the Company had specific reserves of $462,000 in the allowance for loan losses on loans totaling $7.5 million. The Company’s December 31, 2008 fair value measurement for impaired loans is presented below:

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation	Total Gains/(Losses) for the Year Ended December 31, 2008
Impaired loans	$	7,073,045	-	5,902,848	1,170,197	(345,000)
Other real estate	$	1,866,971	-	1,866,971	-	(165,630)

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” which permits entities to choose to measure financial instruments and certain other instruments at fair value. SFAS No. 159 was effective for the Company as of January 1, 2008. The Company did not choose this option for any asset or liability, and therefore SFAS No. 159 did not have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS No. 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” This FSP provides guidance on accounting for a transfer of a financial asset and a repurchase financing under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” This FSP is not expected to have a material effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13.” This FSP amends SFAS No. 157, “Fair Value Measurements,” to exclude SFAS No. 13, “Accounting for Leases” and other accounting pronouncements that address fair value measurements for purposes of lease classification or measurement under SFAS No. 13. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In February 2008, the FASB issued FSP FAS No. 157-2, “Effective Date of FASB Statement No. 157.” This FSP delays the effective date of SFAS No. 157, “Fair Value Measurements,” for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In October 2008, the FASB issued FSP FAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” This FSP clarifies the application of SFAS No. 157, “Fair Value Measurements,” in a market that is not active. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

A-7

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” SFAS No. 161 is an amendment to SFAS No. 133, which provides for enhanced disclosures about how and why an entity uses derivatives and how and where those derivatives and related hedged items are reported in the entity’s financial statements. SFAS No. 161 is effective for the Company as of January 1, 2009. As this is a disclosure related standard, this standard is not expected to have any effect on the Company's financial position or results of operations. SFAS No. 161 will result in additional disclosures related to the Company’s derivatives.

In September 2008, the FASB issued FSP FAS No. 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45 and Clarification of the Effective Date of FASB Statement No. 161.” This FSP is an amendment to SFAS No. 133, which provides for enhanced disclosure requirements for credit risk derivatives. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

In December 2008, the FASB issued FSP FAS No. 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets.” This FSP amends SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. This FSP is not expected to have any effect on the Company's financial position, results of operations or disclosures.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.

The remainder of management’s discussion and analysis of the Company’s results of operations and financial position should be read in conjunction with the consolidated financial statements and related notes presented on pages A-30 through A-62.

Results of Operations

Summary. The Company reported earnings of $6.4 million in 2008, or $1.14 basic net earnings per common share and $1.13 diluted net earnings per common share, a 33% decrease as compared to $9.6 million, or $1.68 basic net earnings per common share and $1.65 diluted net earnings per common share, for 2007. The Company’s decrease in net earnings for 2008 is primarily attributable to a decrease in net interest income, an increase in provision for loan losses and an increase in non-interest expense, which was partially offset by an increase in non-interest income.

Net earnings for 2007 represented an increase of 5% as compared to 2006 net earnings of $9.2 million or $1.61 basic net earnings per common share and $1.58 diluted net earnings per common share. The increase in 2007 net earnings was primarily attributable to growth in interest-earning assets, which contributed to increases in net interest income and an increase in non-interest income. In addition, the Company had a decrease in the provision for loan losses for the year ended December 31, 2007 as compared to the same period in 2006. The increases in net interest income and non-interest income and the decrease in the provision for loan losses were partially offset by an increase in non-interest expense.

The return on average assets in 2008 was 0.69%, compared to 1.13% in 2007 and 1.19% in 2006. The return on average shareholders’ equity was 8.38% in 2008 compared to 13.59% in 2007 and 14.68% in 2006.

Net Interest Income. Net interest income, the major component of the Company's net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them. Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid. Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.

Net interest income was $32.8 million for 2008 or a 4% decrease from net interest income of $34.1 million in 2007. The decrease was primarily attributable to a reduction in the Bank’s prime commercial lending rate. The decrease in loan interest income resulting from a decline in prime rate was partially offset by an increase in income from derivative instruments. Net income from derivative instruments was $3.4 million for the year ended December 31, 2008 compared to a net loss of $406,000 for the same period in 2007. Net interest income increased 6% in 2007 from $32.3 million in 2006.

Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2008, 2007 and 2006. The table also sets forth the average rate earned on total interest-earning assets, the

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average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities. Non-accrual loans and the interest income that was recorded on these loans, if any, are included in the yield calculations for loans in all periods reported.

Table 1- Average Balance Table

	December 31, 2008							December 31, 2007						December 31, 2006
(Dollars in thousands)	Average Balance			Interest		Yield / Rate		Average Balance		Interest		Yield / Rate		Average Balance		Interest		Yield / Rate
Interest-earning assets:

Loans	$	747,203			46,808	6.26	%	665,379		55,109		8.28	%	604,427		49,665		8.22	%
Interest rate derivative contracts		-			3,403	0.45	%	-		(406	)	-0.06	%	-		(698	)	-0.12	%
Loan fees		-			393	0.05	%	-		698		0.10	%	-		701		0.12	%
Total loans		747,203			50,604	6.77	%	665,379		55,401		8.33	%	604,427		49,668		8.22	%

Investments - taxable		26,591			1,253	4.71	%	20,305		868		4.27	%	29,784		1,306		4.38	%
Investments - nontaxable*		89,262			4,924	5.52	%	99,991		5,470		5.47	%	88,353		4,642		5.25	%
Federal funds sold		3,050			55	1.80	%	7,378		383		5.19	%	1,766		85		4.81	%
Other		10,319			293	2.84	%	8,041		444		5.52	%	7,914		424		5.36	%

Total interest-earning assets		876,425			57,129	6.52	%	801,094		62,566		7.81	%	732,244		56,125		7.66	%

Cash and due from banks		21,331						20,081						17,022
Other assets		41,626						34,287						31,218
Allowance for loan losses		(9,583	)					(8,626	)					(7,899	)

Total assets	$	929,799						846,836						772,585


Interest-bearing liabilities:

NOW accounts	$	92,612			1,269	1.37	%	79,550		1,127		1.42	%	87,329		1,214		1.39	%
Regular savings accounts		17,423			50	0.29	%	18,685		54		0.29	%	19,768		57		0.29	%
Money market accounts		93,564			1,930	2.06	%	87,916		2,918		3.32	%	66,035		1,789		2.71	%
Time deposits		406,127			15,008	3.70	%	361,859		17,430		4.82	%	335,092		14,189		4.23	%
FHLB / FRB borrowings		79,417			3,616	4.55	%	80,058		3,759		4.70	%	74,082		3,588		4.84	%
Demand notes payable to U.S. Treasury		859			14	1.63	%	814		39		4.79	%	722		34		4.71	%
Trust preferred securities		20,619			1,016	4.93	%	20,619		1,476		7.16	%	24,878		1,963		7.89	%
Other		29,857			624	2.09	%	16,226		782		4.82	%	5,780		276		4.78	%

Total interest-bearing liabilities		740,478			23,527	3.18	%	665,727		27,585		4.14	%	613,686		23,110		3.77	%

Demand deposits		111,192						111,164						97,183
Other liabilities		4,021						3,022						3,044
Shareholders' equity		76,241						70,586						62,465

Total liabilities and shareholder's equity	$	931,932						850,499						776,378

Net interest spread				$	33,602	3.36	%			34,981		3.67	%			33,015		3.89	%

Net yield on interest-earning assets						3.83	%					4.37	%					4.51	%

Taxable equivalent adjustment
Investment securities				$	806					834						731

Net interest income				$	32,796					34,147						32,284

*Includes U.S. government sponsored enterprises that are non-taxable for state income tax purposes of $63.6 million in 2008, $74.9 million in 2007 and $65.9 million in 2006. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities.

Changes in interest income and interest expense can result from variances in both volume and rates. Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

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Table 2 - Rate/Volume Variance Analysis-Tax Equivalent Basis


	December 31, 2008							December 31, 2007
(Dollars in thousands)	Changes in average volume			Changes in average rates		Total Increase (Decrease)		Changes in average volume		Changes in average rates		Total Increase (Decrease)
Interest Income:

Loans: Net of unearned income	$	6,177		(10,974	)	(4,797	)	5,042		691		5,733

Investments - taxable		282		102		384		(411	)	(27	)	(438	)
Investments - nontaxable		(589	)	43		(546	)	624		204		828
Federal funds sold		(151	)	(177	)	(328	)	281		17		298
Other		95		(246	)	(151	)	7		13		20

Total interest income		5,814		(11,252	)	(5,438	)	5,543		898		6,441

Interest expense:

NOW accounts		182		(40	)	142		(109	)	22		(87	)
Regular savings accounts		(4	)	0		(4	)	(3	)	0		(3	)
Money market accounts		152		(1,140	)	(988	)	660		469		1,129
Time deposits		1,884		(4,306	)	(2,422	)	1,211		2,030		3,241
FHLB / FRB Borrowings		(30	)	(113	)	(143	)	285		(114	)	171
Demand notes payable to
U.S. Treasury		1		(27	)	(26	)	4		1		5
Trust Preferred Securities		0		(459	)	(459	)	(320	)	(167	)	(487	)
Other		471		(629	)	(158	)	501		5		506

Total interest expense		2,656		(6,714	)	(4,058	)	2,229		2,246		4,475

Net interest income	$	3,158		(4,538	)	(1,380	)	3,314		(1,348	)	1,966

Net interest income on a tax equivalent basis totaled $33.6 million in 2008, decreasing 4% or $1.4 million from 2007. The decrease was attributable to a reduction in the Bank’s prime commercial lending rate. The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.36% in 2008, a decrease from the 2007 net interest spread of 3.67%. The net yield on interest-earning assets in 2008 decreased to 3.83% from the 2007 net interest margin of 4.37%.

Tax equivalent interest income decreased $5.4 million or 9% in 2008 primarily due to a reduction in the Bank’s prime commercial lending rate. The yield on interest-earning assets decreased to 6.52% in 2008 from 7.81% in 2007 as a result of a decrease in the average yield received on loans resulting from Federal Reserve interest rate decreases, which were partially offset by an increase in the average outstanding balance of loans and income from interest rate derivative contracts. Average interest-earning assets increased $75.3 million primarily as the result of an $81.8 million increase in average loans. Average investment securities in 2008 increased 4% to $115.9 million when compared to 2007. All other interest-earning assets including federal funds sold were $13.4 million in 2008 and $15.4 million in 2007.

Interest expense decreased $4.1 million or 15% in 2008 due to a decrease in the average rate paid on interest-bearing liabilities. The cost of funds decreased to 3.18% in 2008 from 4.14% in 2007. This decrease in the cost of funds was primarily attributable to decreases in the average rate paid on interest-bearing checking and savings accounts and certificates of deposit. The $74.8 million growth in average interest-bearing liabilities was primarily attributable to an increase in time deposits of $44.3 million to $406.1 million in 2008 from $361.9 million in 2007 and an increase in interest-bearing checking and savings accounts of $17.4 million to $203.6 million in 2008 from $186.2 million in 2007.

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In 2007 net interest income on a tax equivalent basis increased $2.0 million or 6% to $35.0 million in 2007 from $33.0 million in 2006. The interest rate spread was 3.67% in 2007, a decrease from the 2006 net interest spread of 3.89%. The net yield on interest-earning assets in 2007 decreased to 4.37% from the 2006 net interest margin of 4.51%.

Provision for Loan Losses. Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Company’s loan portfolio, including the valuation of impaired loans in accordance with SFAS No. 114 and No. 118, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.

The provision for loan losses was $4.8 million, $2.0 million, and $2.5 million for the years ended December 31, 2008, 2007 and 2006, respectively. The increase in the provision for loan losses for 2008 is primarily attributable to an increase in non-performing assets, net charge-offs and increased loan growth. Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.

Non-Interest Income. Non-interest income for 2008 totaled $10.5 million, an increase of $1.7 million or 19% from non-interest income of $8.8 million for 2007. The increases in non-interest income for 2008 are primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in mortgage banking income and a decrease in the loss on sale and write-down of securities for the year ended December 31, 2008 when compared to the same period last year. These increases in non-interest income were partially offset by a decrease in insurance and brokerage commissions and a net increase in losses and write-downs on foreclosed property for the year ended December 31, 2008 as compared to the same period last year. Non-interest income for 2007 increased $1.2 million or 17% from non-interest income of $8.8 million for 2006. The increase in non-interest income for 2007 is primarily due to an increase in service charges and fees resulting from growth in deposit base coupled with normal pricing changes, an increase in insurance and brokerage commissions, an increase in mortgage banking income and an increase in miscellaneous income.

Service charges on deposit accounts totaled $5.2 million during 2008, an increase of $925,000, or 22% over 2007. Service charge income increased $349,000, or 9% in 2007 compared to 2006. These increases are primarily attributable to growth in the deposit base coupled with normal pricing changes, which resulted in an increase in account maintenance fees.

Other service charges and fees increased 24% to $2.4 million for the year ended December 31, 2008 as compared to $1.9 million for the same period one year ago. This increase is primarily attributable to fee income from growth in the deposit base coupled with normal pricing changes.

The Company reported net losses on sale and write-downs of securities of $167,000, $562,000 and $592,000 in 2008, 2007 and 2006, respectively. The Company periodically evaluates its investments for any impairment which would be deemed other than temporary. As part of its evaluation in 2008, the Company determined that the fair value of one investment was less than the original cost of the investment and that the decline in fair value was not temporary in nature. As a result, the Company wrote down its original investment by $300,000. The remaining fair value of the investment at December 31, 2008 was $22,000. Similarly, as part of its evaluation in 2007, the Company wrote down two investments by $430,000. The remaining fair value of the investments at December 31, 2007 was $348,000.

Mortgage banking income increased to $660,000 in 2008 from $560,000 in 2007 primarily due to an increase in brokered loan activity. During 2007 mortgage banking income increased $271,000 from the $289,000 reported in 2006. The increase in mortgage banking income for 2007 was primarily attributable to the $185,000 write-down of the Bank’s mortgage servicing asset in 2006. This write-down was due to Management’s assessment that there was minimal fair value in the mortgage servicing rights due to the small remaining balance in the loans serviced for others.

Net losses on other real estate and repossessed assets were $287,000 and $118,000 for 2008 and 2007, respectively. During 2006 a net loss on other real estate and repossessed assets of $108,000 was recognized. The increase in net losses on other real estate and repossessed assets during 2008 was primarily attributable to a $170,000 net increase in losses and write-downs on foreclosed property for the year ended December 31, 2008 as compared to the same period last year. Management determined that the market value of these assets had decreased significantly and charges were appropriate for 2008.

Miscellaneous income for 2008 totaled $2.3 million, an increase of 3% from $2.2 million for 2007. During 2007, miscellaneous income increased 4% from $2.1 million for 2006.

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Table 3 presents a summary of non-interest income for the years ended December 31, 2008, 2007 and 2006.

Table 3 - Non-Interest Income

(Dollars in thousands)	2008			2007		2006
Service charges	$	5,203		4,279		3,930
Other service charges and fees		2,399		1,938		1,540
Gain (loss) on sale of securities		(167	)	(562	)	(592	)
Mortgage banking income		660		560		289
Insurance and brokerage commissions		426		521		389
Loss on foreclosed and repossessed assets		(287	)	(118	)	(108	)
Miscellaneous		2,261		2,198		2,106
Total non-interest income	$	10,495		8,816		7,554

Non-Interest Expense. Total non-interest expense amounted to $28.9 million for 2008, an increase of 11% from 2007. Non-interest expense for 2007 increased 13% to $26.0 million from non-interest expense of $23.0 million for 2006.

Salary and employee benefit expense was $15.2 million in 2008, compared to $13.9 million during 2007, an increase of $1.3 million or 9%, following a $2.1 million or 18% increase in salary and employee benefit expense in 2007 over 2006. The increase in salary and employee benefits in 2008 and 2007 is primarily due to normal salary increases and expense associated with additional staff for new branches.

The Company recorded occupancy expenses of $5.0 million in 2008, compared to $4.8 million during 2007, an increase of $278,000 or 6%, following an increase of $571,000 or 14% in occupancy expenses in 2007 over 2006. The increases in 2008, 2007 and 2006 are primarily due to an increase in furniture and equipment expense and lease expense associated with new branches.

The total of all other operating expenses increased $1.3 million or 18% to $8.7 million during 2008. The increase in other expense for 2008 is primarily attributable to an increase in of $407,000 in FDIC insurance expense, an increase of $309,000 in deposit program expense and an increase of $133,000 in foreclosure expense. Other operating expense increased $336,000 or 5% in 2007 over 2006. The increase in other expense for 2007 is primarily attributable to increases of $215,000 in advertising expense.

Table 4 presents a summary of non-interest expense for the years ended December 31, 2008, 2007 and 2006.

Table 4 - Non-Interest Expense

(Dollars in thousands)	2008		2007	2006
Salaries and wages	$	11,591	10,276	9,368
Employee benefits		3,603	3,612	2,417
Total personnel expense		15,194	13,888	11,785
Occupancy expense		5,029	4,751	4,180
Office supplies		564	554	436
FDIC deposit insurance		547	140	75
Professional services		422	400	239
Postage		360	320	307
Telephone		476	405	338
Director fees and expense		450	499	423
Advertising		1,076	988	772
Consulting fees		385	460	575
Taxes and licenses		193	272	293
Other operating expense		4,197	3,316	3,560
Total non-interest expense	$	28,893	25,993	22,983

Income Taxes. Total income tax expense was $3.2 million in 2008 compared with $5.3 million in 2007 and $5.2 million in 2006. The primary reason for the decrease in taxes for 2008 as compared to 2007 and 2006 was the decrease in pretax income. The Company’s effective tax rates were 33.46%, 35.76% and 36.05% in 2008, 2007 and 2006, respectively.

A-12

Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of December 31, 2008 such unfunded commitments to extend credit were $158.9 million, while commitments in the form of standby letters of credit totaled $4.3 million.

The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and certificates of deposits of denominations less than $100,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of December 31, 2008, the Company’s core deposits totaled $497.2 million, or 69% of total deposits.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings. The Bank is also able to borrow from the Federal Reserve on a short-term basis.

At December 31, 2008, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $61.0 million, which mature over the next two years. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits. For additional information, please see the section below entitled “Deposits.”

The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $77.0 million at December 31, 2008. The remaining availability at FHLB was $71.2 million at December 31, 2008. At December 31, 2008, the carrying value of loans pledged as collateral to the FHLB totaled approximately $244.9 million. The Bank had $5.0 million in borrowings from the Federal Reserve Bank (“FRB”) at December 31, 2008. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009. The FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2008, the carrying value of loans pledged as collateral to the FRB totaled approximately $280.8 million.

The Bank also had the ability to borrow up to $38.0 million for the purchase of overnight federal funds from four correspondent financial institutions as of December 31, 2008.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 26.80% at December 31, 2008, 28.04% at December 31, 2007 and 31.15% at December 31, 2007. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $10.7 million during 2008. Net cash used in investing activities of $65.7 million consisted primarily of a net increase in loans of $65.2 million. Net cash provided by financing activities amounted to $53.1 million, primarily from a $27.4 million net increase in deposits and the $25.1 issuance of Series A preferred stock.

Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 5 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2008.

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Table 5 - Interest Sensitivity Analysis

(Dollars in thousands)	Immediate		1-3 months		4-12 months		Total Within One Year		Over One Year & Non-sensitive	Total
Interest-earning assets:
Loans	$	520,141	6,239		16,599		542,979		238,209	781,188
Investment securities		-	4,354		3,596		7,950		116,966	124,916
Federal funds sold		6,733	-		-		6,733		-	6,733
Interest-bearing deposit accounts		1,453	-		-		1,453		-	1,453
Other interest-earning assets		-	-		-		-		6,811	6,811

Total interest-earning assets		528,327	10,593		20,195		559,115		361,986	921,101

Interest-bearing liabilities:
NOW, savings, and money market deposits		210,058	-		-		210,058		-	210,058
Time deposits		47,003	145,974		175,522		368,499		38,057	406,556
Other short term borrowings		1,600	-		-		1,600		-	1,600
FRB borrowings		-	5,000		-		5,000		-	5,000
FHLB borrowings		-	5,000		-		5,000		72,000	77,000
Securities sold under
agreement to repurchase		37,501	-		-		37,501		-	37,501
Trust preferred securities		-	20,619		-		20,619		-	20,619

Total interest-bearing liabilities		296,162	176,593		175,522		648,277		110,057	758,334

Interest-sensitive gap	$	232,165	(166,000	)	(155,327	)	(89,162	)	251,929	162,767

Cumulative interest-sensitive gap	$	232,165	66,165		(89,162	)	(89,162	)	162,767

Interest-earning assets as a percentage of
interest-bearing liabilities		178.39%	6.00%		11.51%		86.25%		328.91%

The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets monthly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. As shown in Table 5, the Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as interest rates change in the market. Because most of the Company’s loans are tied to the prime rate, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates. Rate sensitive assets at December 31, 2008 totaled $921.1 million, exceeding rate sensitive liabilities of $758.3 million by $162.8 million.

The Company has an overall interest rate risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company. As of December 31, 2008, the Company had cash flow hedges with a notional amount of $165.0 million. These derivative instruments consist of three interest rate floor contracts and one interest rate swap contract. The interest rate floor contracts are used to hedge future cash flows from payments on the first $115.0 million of certain variable rate loans

A-14

against the downward effects of their repricing in the event of a decreasing rate environment during the terms of the interest rate floor contracts. If the prime rate falls below the contract rate during the term of the contract, the Company will receive payments based on notional amount times the difference between the contract rate and the weighted average prime rate for the quarter. No payments will be received by the Company if the weighted average prime rate is equal to or higher than the contract rate. The interest rate floor contracts in effect at December 31, 2008 will expire in 2009. The interest rate swap contract is used to convert $50.0 million of variable rate loans to a fixed rate. Under the swap contract, the Company receives a fixed rate of 6.245% and pays a variable rate based on the current prime rate (3.25% at December 31, 2008) on the notional amount of $50.0 million. The swap agreement matures in June 2011. The Company recognized $3.4 million in interest income, net of premium amortization, from interest rate derivative contracts during the year ended December 31, 2008. Based on the current interest rate environment, it is expected the Company will continue to receive income on these interest rate contracts throughout 2009.

Tables 6 and 7 present additional information on the Company’s derivative financial instruments as of December 31, 2008.

Table 6 - Derivative Instruments
(Dollars in thousands)
Type of Derivative	Notional Amount		Contract Rate	Premium		Year-to-date Income (Net of Premium Amortization)
Interest rate floor contact*	$	-	-	$	-	$	151
Interest rate floor contact*		-	-		-		456
Interest rate floor contact expiring 01/24/09		45,000	7.500%		562		871
Interest rate floor contact expiring 06/02/09		35,000	8.000%		399		914
Interest rate floor contact expiring 12/01/09		35,000	7.250%		634		523
Interest rate swap contact expiring 06/01/11		50,000	6.245%		-		488
	$	165,000		$	1,595	$	3,403

* Interest rate floor contracts expired during 2008

Table 7 - Fair Values of Derivative Instruments

	Asset Derivatives				Liability Derivatives
(Dollars in thousands)	As of December 31, 2008		As of December 31, 2007		As of December 31, 2008		As of December 31, 2007
	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value
Interest rate derivative
contracts	Other assets	$ 4,981	Other assets	$ 1,907	N/A	$ -	N/A	$ -

Included in the rate sensitive assets are $506.2 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”). The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At December 31, 2008, the Bank had $149.0 million in loans with interest rate floors. The floors were in effect on $147.0 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 1.59% higher than the indexed rate on the promissory notes without interest rate floors.

An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities. A discussion of these changes and trends follows.

Analysis of Financial Condition

Investment Securities. All of the Company’s investment securities are held in the available-for-sale (“AFS”) category . At December 31, 2008 the market value of AFS securities totaled $124.9 million, compared to $121.0 million and $117.6 million at December 31, 2007 and 2006, respectively. The increase in 2008 investment securities is the result of net securities purchases that are part of management’s objective to grow the investment portfolio in an effort to manage the credit risk in the balance sheet. This increase in AFS securities was partially offset by paydowns on mortgage-backed securities, calls and maturities. Table 8 presents the market value of the AFS securities held at December 31, 2008, 2007 and 2006.

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Table 8 - Summary of Investment Portfolio

(Dollars in thousands)	2008		2007	2006
Obligations of United States government
sponsored enterprises	$	58,487	76,992	72,744

Obligations of states and political subdivisions		26,973	25,905	24,366

Mortgage-backed securities		37,271	16,271	19,220

Trust preferred securities		1,250	250	750

Equity securities		935	1,550	501

Total securities	$	124,916	120,968	117,581

The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.

The Company’s investment portfolio consists of U.S. government sponsored enterprise securities, municipal securities, U.S. government enterprise sponsored mortgage-backed securities, and trust preferred securities and equity securities. AFS securities averaged $115.9 million in 2008, $120.3 million in 2007 and $118.1 million in 2006. Table 9 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2008. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields are calculated on a tax equivalent basis . Yields and interest income on tax-exempt investments have been adjusted to tax equivalent basis using an effective tax rate 38.55% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.

Table 9 - Maturity Distribution and Weighted Average Yield on Investments

				After One Year		After 5 Years
	One Year or Less			Through 5 Years		Through 10 Years		After 10 Years		Totals
(Dollars in thousands)	Amount		Yield	Amount	Yield	Amount	Yield	Amount	Yield	Amount	Yield
Book value:

United States Government	$	3,500	4.60%	33,885	4.88%	11,817	5.08%	6,021	5.52%	55,223	4.98%
sponsored enterprises

States and political subdivisions		2,405	5.21%	10,282	4.77%	7,202	6.09%	6,759	6.57%	26,648	5.62%

Mortgage backed securities		-	-	521	4.54%	11,256	4.68%	24,780	5.35%	36,557	5.13%

Trust preferred securities		-	-	-	-	1,000	3.35%	250	8.13%	1,250	4.31%

Equity securities		-	-	-	-	-	-	1,382	1.49%	1,382	1.49%

Total securities	$	5,905	4.85%	44,688	4.85%	31,275	5.11%	39,192	5.47%	121,060	5.12%

Loans. The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Union and Wake counties in North Carolina. Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. In management’s opinion, there are no significant concentrations of credit with particular borrowers engaged in similar activities .

A-16

Real estate mortgage loans include both commercial and residential mortgage loans. At December 31, 2008, the Company had $108.6 million in residential mortgage loans, $93.3 million in home equity loans and $272.8 million in commercial mortgage loans, which include $218.0 million using commercial property as collateral and $54.8 million using residential property as collateral. At December 31, 2008, real estate construction loans included $126.5 million in speculative construction and development loans.

Residential mortgage loans include $51.0 million made to customers in the Company’s traditional banking offices and $57.6 million in mortgage loans originated in the Company’s Latino banking operations. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization. Also, the Company does not have credit exposure for residential mortgage loans originated that are not reflected in the Company’s assets.

The mortgage loans originated in the traditional banking offices are generally 15 to 30 year fixed rate loans with attributes that cause the loans to not be sellable in the secondary market. These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type and are generally made to existing Bank customers. These loans have been originated throughout the Company’s five county service area, with no geographic concentration. At December 31, 2008 there were 12 loans with an outstanding balance of $1.1million 30 days or more past due and no loans more than 90 days past due.

The mortgage loans originated in the Company’s Latino operations are primarily adjustable rate mortgage loans that adjust annually after the end of the first five years of the loan. The loans are tied to the one-year T-Bill index and, if they were to adjust at December 31, 2008, would have a reduction in the interest rate on the loan. The underwriting on these loans includes both full income verification and no income verification, with loan-to-value ratios of up to 95% without private mortgage insurance. A majority of these loans would be considered subprime loans, as they were underwritten using stated income rather than fully documented income verification. No other loans in the Company’s portfolio would be considered subprime. The majority of these loans have been originated within the Charlotte, NC metro area. At this time, Charlotte has begun to experience a decline in values within the residential real estate market. At December 31, 2008 there were 96 loans with an outstanding balance of $10.8 million 30 days or more past due and four loans more than 90 days past due totaling $514,000. Total losses on this portfolio, since the first loans were originated in 2004 have amounted to approximately $348,000 through December 31, 2008.

As a recipient of CPP funds, the Bank will strive to work with delinquent borrowers in an attempt to mitigate foreclosure. The funds will also be used to absorb losses incurred when modifying loans or making concessions to borrowers in order to keep borrowers out of foreclosure.

The composition of the Company’s loan portfolio is presented in Table 10.

Table 10 - Loan Portfolio

	2008			2007		2006		2005		2004
(Dollars in thousands)	Amount		% of Loans	Amount	% of Loans	Amount	% of Loans	Amount	% of Loans	Amount	% of Loans
Breakdown of loan receivables:
Commercial	$	76,945	9.85%	82,190	11.38%	85,064	13.06%	79,902	14.10%	79,189	14.79%
Real estate - mortgage		474,732	60.77%	417,709	57.83%	364,595	55.97%	330,227	58.28%	312,988	58.45%
Real estate - construction		216,188	27.67%	209,644	29.03%	187,960	28.86%	141,420	24.96%	127,042	23.73%
Consumer		13,323	1.71%	12,734	1.76%	13,762	2.11%	15,115	2.66%	16,249	3.03%

Total loans	$	781,188	100.00%	722,277	100.00%	651,381	100.00%	566,664	100.00%	535,468	100.00%

Less: Allowance for loan losses		11,025		9,103		8,303		7,425		8,049

Net loans	$	770,163		713,174		643,078		559,239		527,419

As of December 31, 2008, gross loans outstanding were $781.2 million, an increase of $58.9 million or 8% from the December 31, 2007 balance of $722.3 million. Commercial loans decreased $5.2 million in 2008. Real estate mortgage loans grew $57.0 million when compared to 2007 due to an increase in non-conforming mortgage loans and commercial real estate loans. Real estate construction loans increased $6.5 million in 2008 as a result of an increase in real estate development loans. Consumer loans increased $589,000 in 2008.

A-17

Table 11 identifies the maturities of all loans as of December 31, 2008 and addresses the sensitivity of these loans to changes in interest rates.

Table 11 - Maturity and Repricing Data for Loans

(Dollars in thousands)	Within one year or less		After one year through five years	After five years	Total loans
Commercial	$	62,205	13,187	1,553	76,945
Real estate - mortgage		272,873	149,612	52,247	474,732
Real estate - construction		201,041	9,805	5,342	216,188
Consumer		6,860	6,258	205	13,323

Total loans	$	542,979	178,862	59,347	781,188

Total fixed rate loans	$	22,816	125,666	59,347	207,829
Total floating rate loans		520,163	53,196	-	573,359

Total loans	$	542,979	178,862	59,347	781,188

In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2008, outstanding loan commitments totaled $158.9 million. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Additional information regarding commitments is provided below in the section entitled “Contractual Obligations” and in Note 10 to the Consolidated Financial Statements.

Allowance for Loan Losses. The allowance for loan losses reflects management's assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

·	the Bank’s loan loss experience;

·	the amount of past due and non-performing loans;

·	specific known risks;

·	the status and amount of other past due and non-performing assets;

·	underlying estimated values of collateral securing loans;

·	current and anticipated economic conditions; and

·	other factors which management believes affect the allowance for potential credit losses.

Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of nine risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan as well as the level of reserves deemed appropriate for the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates all loan relationships greater than $1.0 million. The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.

A-18

Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below. At December 31, 2008 and 2007, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $7.5 million and $8.0 million, respectively, with related allowance for loan losses of approximately $462,000 and $1.2 million for December 31, 2008 and 2007, respectively.

The general allowance reflects reserves established under the provisions of SFAS No. 5, “Accounting for Contingencies” for collective loan impairment. These reserves are based upon historical net charge-offs using the last three years’ experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, this unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions that adversely affect the operating results of the Company.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2008 as compared to the year ended December 31, 2007. Such revisions, estimates and assumptions are made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.

Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

Net charge-offs for 2008 were $2.9 million. The ratio of net charge-offs to average total loans was 0.38% in 2008, 0.19% in 2007 and 0.27% in 2006. Management expects the ratio of net charge-offs to average total loans to increase again in 2009 due to the recessionary economic conditions and the decline in real estate values and new home sales. The allowance for loan losses increased to $11.0 million or 1.41% of total loans outstanding at December 31, 2008. For December 31, 2007 and 2006, the allowance for loan losses amounted to $9.1 million or 1.26% of total loans outstanding and $8.3 million, or 1.27% of total loans outstanding, respectively. Management would expect the percentage of the allowance for loan losses to total loans to increase in 2009 if non-performing loans continue to increase as a result of the current recessionary economic conditions.

A-19

Table 12 presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at December 31, 2008 and 2007.

Table 12 - Loan Risk Grade Analysis
	Percentage of Loans
	By Risk Grade*
Risk Grade	2008	2007
Risk 1 (Excellent Quality)	4.08%	11.06%
Risk 2 (High Quality)	17.95%	14.06%
Risk 3 (Good Quality)	63.08%	62.53%
Risk 4 (Management Attention)	10.42%	9.51%
Risk 5 (Watch)	2.14%	1.57%
Risk 6 (Substandard)	0.80%	0.13%
Risk 7 (Low Substandard)	0.00%	0.03%
Risk 8 (Doubtful)	0.00%	0.00%
Risk 9 (Loss)	0.00%	0.00%

* Excludes non-accrual loans

Table 13 presents an analysis of the allowance for loan losses, including charge-off activity.

Table 13 - Analysis of Allowance for Loan Losses

(Dollars in thousands)	2008		2007	2006	2005	2004
Reserve for loan losses at beginning	$	9,103	8,303	7,425	8,049	9,722

Loans charged off:
Commercial		249	414	505	293	1,004
Real estate - mortgage		1,506	471	568	2,141	3,842
Real estate - construction		644	252	250	1,250	4
Consumer		748	489	636	516	535

Total loans charged off		3,147	1,626	1,959	4,200	5,385

Recoveries of losses previously charged off:
Commercial		87	86	64	144	162
Real estate - mortgage		8	21	108	162	144
Real estate - construction		30	102	2	-	-
Consumer		150	179	150	160	150

Total recoveries		275	388	324	466	456

Net loans charged off		2,872	1,238	1,635	3,734	4,929

Provision for loan losses		4,794	2,038	2,513	3,110	3,256

Reserve for loan losses at end of year	$	11,025	9,103	8,303	7,425	8,049

Loans charged off net of recoveries, as
a percent of average loans outstanding		0.38%	0.19%	0.27%	0.68%	0.90%

Non-performing Assets. Non-performing assets, comprised of non-accrual loans, other real estate owned, other repossessed assets and loans for which payments are more than 90 days past due totaled $14.2 million at December 31, 2008 compared to $8.5 million at December 31, 2007. Non-accrual loans were $11.8 million at December 31, 2008, an increase of $3.8 million from non-accruals of $8.0 million at December 31, 2007. As a percentage of loans outstanding, non-accrual loans were 1.51% and 1.11% at December 31, 2008 and 2007, respectively. The Bank had $514,000 in loans 90 days past due and still accruing at December 31, 2008 as compared to no loans for the same period in 2007. Other real estate owned totaled $1.9 million and $483,000 as of December 31, 2008 and 2007, respectively. The Bank had no repossessed assets as of December 31, 2008 and 2007.

A-20

At December 31, 2008, the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $12.3 million or 1.58% of total loans. Non-performing loans for 2007 were $8.0 million, or 1.11% of total loans and $7.6 million, or 1.17% of total loans for 2006. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2008, 2007 and 2006, had they performed in accordance with their original terms, amounted to approximately $850,000, $693,000 and $429,000, respectively. Interest income on impaired loans included in the results of operations for 2008, 2007, and 2006 amounted to approximately $65,000, $29,000 and $144,000, respectively.

Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing. Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans. Management anticipates continued weakness in the housing market, which combined with the current recessionary economic conditions will, in all likelihood, result in higher levels of non-performing loans in 2009.

It is the general policy of the Company to stop accruing interest income and place the recognition of interest on a cash basis when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income. Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.

A summary of non-performing assets at December 31 for each of the years presented is shown in Table 14.

Table 14 - Non-performing Assets

(Dollars in thousands)	2008		2007	2006	2005	2004
Non-accrual loans	$	11,815	7,987	7,560	3,492	5,097
Loans 90 days or more past due and still accruing		514	-	78	946	245
Total non-performing loans		12,329	7,987	7,638	4,438	5,342
All other real estate owned		1,867	483	344	531	682
All other repossessed assets		-	-	-	-	-
Total non-performing assets	$	14,196	8,470	7,982	4,969	6,024

As a percent of total loans at year end
Non-accrual loans		1.51%	1.11%	1.16%	0.62%	0.95%
Loans 90 days or more past due and still accruing		0.07%	0.00%	0.01%	0.17%	0.05%
Total non-performing assets		1.82%	1.17%	1.23%	0.88%	1.12%

Deposits. The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2008, total deposits were $721.1 million, an increase of $27.5 million or 4% increase over the December 31, 2007 balance of $693.6 million. Core deposits, which include demand deposits, savings accounts and certificates of deposits of denominations less than $100,000, increased to $497.2 million at December 31, 2008 from $490.1 million at December 31, 2007.

Time deposits in amounts of $100,000 or more totaled $220.4 million, $203.5 million and $194.2 million at December 31, 2008, 2007 and 2006, respectively. At December 31, 2008, brokered deposits amounted to $61.0 million as compared to $53.9 million at December 31, 2007. Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market. Brokered deposits outstanding as of December 31, 2008 have a weighted average rate of 3.25% with a weighted average original term of 8 months.

A-21

Table 15 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2008.

Table 15 - Maturities of Time Deposits over $100,000

(Dollars in thousands)	2008
Three months or less	$	106,166
Over three months through six months		58,526
Over six months through twelve months		40,819
Over twelve months		14,864
Total	$	220,375

Borrowed Funds. The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions. At December 31, 2008, FHLB borrowings totaled $77.0 million compared to $87.5 million at December 31, 2007 and $89.3 million at December 31, 2006. Average FHLB borrowings for 2008 were $79.2 million, compared to average balances of $80.1 million for 2007 and $74.1 million for 2006. The maximum amount of outstanding FHLB borrowings was $97.6 million in 2008, and $95.0 in 2007 and $99.5 in 2006. The FHLB borrowings outstanding at December 31, 2008 had both fixed and adjustable interest rates ranging from 3.71% to 6.49%. At December 31, 2008, all of the Bank’s FHLB borrowings had maturities exceeding one year. The FHLB has the option to convert $72.0 million of the total borrowings to a floating rate and, if converted, the Bank may repay borrowings without a prepayment fee. The Company also has an additional $5.0 million in variable rate convertible borrowings, which may be repaid without a prepayment fee if converted by the FHLB. Additional information regarding FHLB borrowings is provided in Note 6 to the Consolidated Financial Statements.

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $48,085,617 based on the closing price of such common stock on June 30, 2008, which was $10.89 per share.

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 5,539,056 shares of common stock, outstanding at February 28, 2009.

SELECTED FINANCIAL DATA

Dollars in Thousands Except Per Share Amounts

	2008		2007	2006	2005	2004
Summary of Operations
Interest income	$	56,323	61,732	55,393	41,913	35,095
Interest expense		23,527	27,585	23,110	15,429	12,335

Net interest income		32,796	34,147	32,283	26,484	22,760
Provision for loan losses		4,794	2,038	2,513	3,110	3,256

Net interest income after provision for loan losses		28,002	32,109	29,770	23,374	19,504
Non-interest income		10,495	8,816	7,554	6,668	6,000
Non-interest expense		28,893	25,993	22,983	20,330	18,840

Income before taxes		9,604	14,932	14,341	9,712	6,664
Income taxes		3,213	5,340	5,170	3,381	2,233
Net income	$	6,391	9,592	9,171	6,331	4,431

Selected Year-End Balances
Assets	$	968,762	907,262	818,948	730,280	686,348
Available for sale securities		124,916	120,968	117,581	115,158	105,598
Loans, net		770,163	713,174	643,078	559,239	527,419
Mortgage loans held for sale		-	-	-	2,248	3,783
Interest-earning assets		921,101	853,878	780,082	692,835	653,111
Deposits		721,062	693,639	633,820	582,854	556,522
Interest-bearing liabilities		758,334	718,870	650,364	576,681	553,135
Shareholders' equity	$	101,128	70,102	62,835	54,353	50,938
Shares outstanding*		5,539,056	5,624,234	5,745,951	5,677,328	5,689,763

Selected Average Balances
Assets	$	929,799	846,836	772,585	706,843	684,385
Available for sale securities		115,853	120,296	118,137	108,690	93,770
Loans		747,203	665,379	604,427	550,545	547,753
Interest-earning assets		876,425	801,094	732,244	668,614	650,528
Deposits		720,918	659,174	605,407	570,997	558,142
Interest-bearing liabilities		740,478	665,727	613,686	563,210	553,880
Shareholders' equity	$	76,241	70,586	62,465	55,989	51,978
Shares outstanding*		5,588,314	5,700,860	5,701,829	5,692,290	5,707,975

Profitability Ratios
Return on average total assets		0.69%	1.13%	1.19%	0.90%	0.65%
Return on average shareholders' equity		8.38%	13.59%	14.68%	11.31%	8.52%
Dividend payout ratio		41.93%	24.30%	20.78%	22.34%	28.37%

Liquidity and Capital Ratios (averages)
Loan to deposit		103.65%	100.94%	99.84%	96.42%	98.14%
Shareholders' equity to total assets		8.20%	8.34%	8.09%	7.92%	7.59%

Per share of common stock*
Basic net income	$	1.14	1.68	1.61	1.11	0.77
Diluted net income	$	1.13	1.65	1.58	1.09	0.77
Cash dividends	$	0.48	0.41	0.33	0.25	0.22
Book value	$	13.73	12.46	10.94	9.57	8.95

*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividend during first quarter 2005, a 10% stock dividend during second quarter 2006 and a 3-for-2 stock split during second quarter 2007.

Table 16 - Contractual Obligations and Other Commitments

(Dollars in thousands)	Within One Year		One to Three Years	Three to Five Years	Five Years or More	Total
Contractual Cash Obligations
Long-term borrowings	$	-	12,000	-	65,000	77,000
Junior subordinated debentures		-	-	-	20,619	20,619
Operating lease obligations		769	1,191	701	1,893	4,554

Total	$	769	13,191	701	87,512	102,173

Other Commitments
Commitments to extend credit	$	54,767	14,566	2,336	87,270	158,939
Standby letters of credit
and financial guarantees written		4,294	22	-	-	4,316

Total	$	59,061	14,588	2,336	87,270	163,255

Table 17 - Equity Ratios

	2008	2007	2006
Return on average assets	0.69%	1.13%	1.19%
Return on average equity	8.38%	13.59%	14.68%
Dividend payout ratio	41.93%	24.30%	20.78%
Average equity to average assets	8.20%	8.34%	8.09%

Table 18 - Quarterly Financial Data

	2008						2007
Dollars in thousands, except
per share amounts)	First		Second	Third	Fourth		First		Second	Third	Fourth

Total interest income	$	14,553	14,072	14,122	13,576		$	15,200	15,446	15,625	15,461
Total interest expense		6,680	5,700	5,627	5,520			6,607	6,735	7,038	7,205

Net interest income		7,873	8,372	8,495	8,056			8,593	8,711	8,587	8,256

Provision for loan losses		391	681	1,035	2,687			323	634	296	785
Other income		2,607	2,802	2,506	2,580			2,122	2,139	2,007	2,548
Other expense		6,930	7,113	7,278	7,572			6,021	6,180	6,214	7,578

Income before income taxes		3,159	3,380	2,688	377			4,371	4,036	4,084	2,441
Income taxes		1,103	1,188	942	(20	)		1,584	1,446	1,471	839

Net earnings	$	2,056	2,192	1,746	397		$	2,787	2,590	2,613	1,602

Basic earnings per share	$	0.37	0.39	0.31	0.07		$	0.49	0.45	0.46	0.28
Diluted earnings per share	$	0.36	0.39	0.31	0.07		$	0.48	0.44	0.45	0.28

PEOPLES BANCORP OF NORTH CAROLINA, INC.
FORM 10-K CROSS REFERENCE INDEX

			Notice of 2009
			Annual Meeting,
		2008 Form	Proxy Statement
		10-K	and Annual Report
		Page	Page
PART I
Item 1 - Business		4 - 11	N/A
Item 1A - Risk Factors		11 - 15	N/A
Item 1B - Unresolved Staff Comments		15	N/A
Item 2 - Properties		16	N/A
Item 3 - Legal Proceedings		16	N/A
Item 4 - Submission of Matters to a Vote of Security Holders		16	N/A

PART II
Item 5 - Market for the Common Equity, Related Shareholder Matters and
	Issuer Purchases of Equity Securities	17 - 18	A-28
Item 6 - Selected Financial Data		18	A-3
Item 7 - Management's Discussion and Analysis of Financial Condition and
	Results of Operations	18	A-4 - A-29
Item 7A - Quantitative and Qualitative Disclosures About Market Risk		18	A-26
Item 8 - Financial Statements and Supplementary Data		18	A-30 - A-61
Item 9 - Changes in and Disagreements with Accountants on Accounting
	and Financial Disclosure	18	N/A
Item 9A - Controls and Procedures		19	N/A
Item 9B - Other Information		19	N/A

PART III
Item 10 - Directors and Executive Officers of the Registrant		20	A-62
Item 11 - Executive Compensation		20	11 - 27
Item 12 - Security Ownership of Certain Beneficial Owners and Management		20	4 - 7
Item 13 - Certain Relationships and Related Transactions		20	28
Item 14 - Principal Accountant Fees and Services		20	35

PART IV
Item 15 - Exhibits and Financial Statement Schedules		21 - 24	N/A

Signatures		25	N/A

Table 19 - Market Risk Table

(Dollars In thousands)	Principal/Notional Amount Maturing in Year Ended December 31,
Loans Receivable	2009			2010		2011		2012 & 2013		Thereafter		Total	Fair Value
Fixed rate	$	33,980		32,285		20,804		80,068		40,692		207,829	210,922
Average interest rate		7.25	%	7.00	%	6.97	%	6.86	%	7.34	%
Variable rate	$	241,262		84,819		31,616		50,428		165,234		573,359	573,359
Average interest rate		4.09	%	3.98	%	4.39	%	4.33	%	5.99	%
												781,188	784,281
Investment Securities		.
Interest bearing cash	$	-		-		-		-		1,453		1,453	1,453
Average interest rate		-		-		-		-		0.03	%
Federal funds sold	$	6,733		-		-		-		-		6,733	6,733
Average interest rate		0.10	%	-		-		-		-
Securities available for sale	$	22,806		21,907		34,228		14,346		31,629		124,916	126,539
Average interest rate		4.95	%	4.80	%	4.38	%	4.77	%	4.66	%
Nonmarketable equity securities	$	-		-		-		-		6,303		6,303	6,303
Average interest rate		-		-		-		-		3.52	%

Debt Obligations
Deposits	$	368,469		23,198		12,805		2,249		314,341		721,062	716,678
Average interest rate		3.17	%	3.02	%	2.50	%	3.09	%	4.08	%
Advances from FHLB	$	-		7,000		5,000		15,000		50,000		77,000	83,038
Average interest rate		-		6.05	%	4.21	%	4.19	%	4.27	%
Federal Reserve Borrowings	$	5,000		-		-		-		-		5,000	4,999
Average interest rate		0.28	%	-		-		-		-
Demand notes payable to U.S. Treasury	$	1,600		-		-		-		-		1,600	1,600
Average interest rate		0.12	%	-		-		-		-
Securities sold under agreement to repurchase	$	37,501										37,501	37,501
Average interest rate		1.34	%
Junior subordinated debentures	$	-		-		-		-		20,619		20,619	20,619
Average interest rate		-		-		-		-		3.63	%

Derivative Instruments (notional amount)
Interest rate floor contracts	$	115,000		-		-		-		-		115,000	2,254
Average interest rate		7.58	%	-		-		-		-
Interest rate swap contracts	$	-		-		50,000		-		-		50,000	2,727
Average interest rate		-		-		6.25	%	-		-

Table 20 - Interest Rate Risk

(Dollars in thousands)
		Estimated Resulting Theoretical Net Interest Income
Hypothetical rate change (ramp over 12 months)		Amount		% Change
	+2%	$	32,175		3.95%
	+1%	$	31,476		1.70%
	0%	$	30,951		0.00%
	-1%	$	30,455		-1.60%
	-2%	$	29,832		-3.62%



		Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)		Amount		% Change
	+2%	$	92,797		-10.94%
	+1%	$	98,019		-5.92%
	0%	$	104,192		0.00%
	-1%	$	106,142		1.87%
	-2%	$	108,667		4.30%

Table 21 - Market and Dividend Data

				Cash Dividend
2008	Low Bid		High Bid	Per Share
First Quarter	$	12.20	15.50	0.12

Second Quarter	$	9.56	14.19	0.12

Third Quarter	$	7.36	13.14	0.12

Fourth Quarter	$	8.51	12.00	0.12


				Cash Dividend
2007	Low Bid		High Bid	Per Share
First Quarter	$	17.37	19.26	0.08

Second Quarter	$	17.89	21.15	0.09

Third Quarter	$	17.13	20.03	0.12

Fourth Quarter	$	14.75	18.00	0.12

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Financial Statements
December 31, 2008, 2007 and 2006


INDEX

	PAGE(S)

Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements	A-31

Financial Statements
Consolidated Balance Sheets at December 31, 2008 and December 31, 2007	A-32

Consolidated Statements of Earnings for the years ended December 31, 2008, 2007 and 2006	A-33

Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2008, 2007 and 2006	A-34

Consolidated Statements of Comprehensive Income for the years ended December 31, 2008, 2007 and 2006	A-35

Consolidated Statements of Cash Flows for the years ended December 31, 2008, 2007 and 2006	A-36 - A-37

Notes to Consolidated Financial Statements	A-38 - A-61

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2008 and 2007

Assets	2008			2007


Cash and due from banks, including reserve requirements	$	19,743,047			26,108,437
of $7,257,000 and $7,439,000
Interest bearing deposits		1,452,825			1,539,190
Federal funds sold		6,733,000			2,152,000
Cash and cash equivalents		27,928,872			29,799,627

Investment securities available for sale		124,916,349			120,968,358
Other investments		6,302,809			6,433,947
Total securities		131,219,158			127,402,305

Loans		781,188,082			722,276,948
Less allowance for loan losses		(11,025,516	)		(9,103,058	)
Net loans		770,162,566			713,173,890

Premises and equipment, net		18,296,895			18,234,393
Cash surrender value of life insurance		7,019,478			6,776,379
Accrued interest receivable and other assets		14,135,328			11,875,202
Total assets	$	968,762,297			907,261,796

Liabilities and Shareholders' Equity

Deposits:
Non-interest bearing demand	$	104,448,128			112,071,090
NOW, MMDA & savings		210,057,612			196,959,895
Time, $100,000 or more		220,374,302			203,499,504
Other time		186,182,341			181,108,214
Total deposits		721,062,383			693,638,703

Demand notes payable to U.S. Treasury		1,600,000			1,600,000
Securities sold under agreement to repurchase		37,500,738			27,583,263
Short-term Federal Reserve Bank borrowings		5,000,000			-
FHLB borrowings		77,000,000			87,500,000
Junior subordinated debentures		20,619,000			20,619,000
Accrued interest payable and other liabilities		4,851,750			6,219,248
Total liabilities		867,633,871			837,160,214

Shareholders' equity:

Series A preferred stock, $1,000 stated value; authorized
5,000,000 shares; issued and outstanding
25,054 shares in 2008 and no shares
outstanding in 2007		24,350,219			-
Common stock, no par value; authorized
20,000,000 shares; issued and
outstanding 5,539,056 shares in 2008
and 5,624,234 shares in 2007		48,268,525			48,651,895
Retained earnings		22,985,694			19,741,876
Accumulated other comprehensive income		5,523,988			1,707,811
Total shareholders' equity		101,128,426			70,101,582

Total liabilities and shareholders' equity	$	968,762,297			907,261,796

See accompanying notes to consolidated financial statements.

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

For the Years Ended December 31, 2008, 2007 and 2006

	2008			2007			2006


Interest income:
Interest and fees on loans	$	50,603,885			55,400,514			49,667,700
Interest on federal funds sold		54,765			383,492			85,307
Interest on investment securities:
U.S. Government sponsored enterprises		4,392,356			4,571,571			4,321,346
States and political subdivisions		904,432			887,584			798,185
Other		367,423			488,465			521,077
Total interest income		56,322,861			61,731,626			55,393,615

Interest expense:
NOW, MMDA & savings deposits		3,248,844			4,098,892			3,060,201
Time deposits		15,008,193			17,430,012			14,188,623
FHLB borrowings		3,616,018			3,758,996			3,588,169
Junior subordinated debentures		1,016,361			1,475,701			1,962,692
Other		637,201			821,331			310,188
Total interest expense		23,526,617			27,584,932			23,109,873

Net interest income		32,796,244			34,146,694			32,283,742

Provision for loan losses		4,794,000			2,038,000			2,513,282

Net interest income after provision for loan losses		28,002,244			32,108,694			29,770,460

Other income:
Service charges		5,202,972			4,278,238			3,929,956
Other service charges and fees		2,399,051			1,938,137			1,539,367
Loss on sale and write-down of securities		(167,048	)		(561,832	)		(591,856	)
Mortgage banking income		660,288			560,291			289,293
Insurance and brokerage commissions		425,653			521,095			388,559
Loss on sale and write-down of
other real estate and repossessed assets		(287,431	)		(117,880	)		(107,712	)
Miscellaneous		2,261,104			2,197,645			2,106,188
Total other income		10,494,589			8,815,694			7,553,795

Other expense:
Salaries and employee benefits		15,194,393			13,887,841			11,785,094
Occupancy		5,029,096			4,750,634			4,180,058
Other		8,669,465			7,354,401			7,017,986
Total other expenses		28,892,954			25,992,876			22,983,138

Earnings before income taxes		9,603,879			14,931,512			14,341,117

Income taxes		3,213,316			5,339,541			5,170,300

Net earnings	$	6,390,563			9,591,971			9,170,817

Basic earnings per common share	$	1.14			1.68			1.61
Diluted earnings per common share	$	1.13			1.65			1.58
Cash dividends declared per common share	$	0.48			0.41			0.33


See accompanying notes to consolidated financial statements.

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2008, 2007 and 2006

	2008			2007			2006
Cash flows from operating activities:
Net earnings	$	6,390,563			9,591,971			9,170,817
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion		1,678,913			1,553,251			1,616,558
Provision for loan losses		4,794,000			2,038,000			2,513,282
Deferred income taxes		(485,137	)		(479,806	)		(615,626	)
Loss on sale and write-down of investment securities		167,048			561,832			591,856
Recognition of gain on sale of
derivative instruments		-			-			386,285
Loss (gain) on sale of premises and equipment		1,404			(10,337	)		(20,896	)
Loss (gain) on sale of repossessed assets		46,801			83,294			(2,288	)
Write-down of other real estate and repossessions		240,630			34,586			110,000
Amortization of deferred issuance costs on
junior subordinated debentures		-			-			461,298
Stock option compensation expense		12,434			9,658			5,690
Change in:
Mortgage loans held for sale		-			-			2,247,900
Cash surrender value of life insurance		(243,099	)		(243,973	)		(220,649	)
Other assets		(19,918	)		(1,013,866	)		(1,206,937	)
Other liabilities		(1,851,672	)		2,403,990			(230,144	)

Net cash provided by operating activities		10,731,967			14,528,600			14,807,146

Cash flows from investing activities:
Purchases of investment securities available for sale		(41,658,966	)		(15,858,155	)		(30,579,262	)
Proceeds from calls and maturities of investment securities
available for sale		16,488,469			7,470,991			8,562,058
Proceeds from sales of investment securities available
for sale		23,448,161			8,362,525			19,871,979
Purchases of other investments		(4,179,862	)		(8,356,900	)		(12,748,200	)
Proceeds from sale of other investments		4,311,000			8,424,000			11,263,500
Net change in loans		(65,188,183	)		(72,815,928	)		(86,825,349	)
Purchases of premises and equipment		(1,857,429	)		(7,672,018	)		(1,624,299	)
Proceeds from sale of premises and equipment		33,545			55,630			-
Proceeds from sale of repossessed assets		2,867,543			425,158			825,115
Purchases of derivative financial instruments		-			(634,000	)		(961,500	)

Net cash used by investing activities		(65,735,722	)		(80,598,697	)		(92,215,958	)

Cash flows from financing activities:
Net change in deposits		27,423,680			59,818,414			50,966,628
Net change in demand notes payable to U.S. Treasury		-			-			126,307
Net change in securities sold under agreement to repurchase		9,917,475			21,165,460			5,436,753
Proceeds from FHLB borrowings		97,100,000			275,300,000			700,800,000
Repayments of FHLB borrowings		(107,600,000	)		(277,100,000	)		(683,100,000	)
Proceeds from FRB borrowings		5,000,000			-			-
Proceeds from issuance of junior subordinated debentures		-			-			20,619,000
Repayments of junior subordinated debentures		-			-			(14,433,000	)
Proceeds from issuance of Series A preferred stock		25,054,000			-			-
Proceeds from exercise of stock options		43,948			330,997			1,014,425
Common stock repurchased		(1,126,275	)		(2,810,907	)		(425,000	)
Cash paid in lieu of fractional shares		-			(3,355	)		(6,426	)
Cash dividends paid		(2,679,828	)		(2,331,203	)		(1,905,556	)

Net cash provided by financing activities		53,133,000			74,369,406			79,093,131

Net change in cash and cash equivalent		(1,870,755	)		8,299,309			1,684,319

Cash and cash equivalents at beginning of period		29,799,627			21,500,318			19,815,999

Cash and cash equivalents at end of period	$	27,928,872			29,799,627			21,500,318

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows, continued

For the Years ended December 31, 2008, 2007 and 2006


	2008		2007		2006


Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	23,799,196		27,420,245		23,171,572
Income taxes	$	4,165,800		5,689,500		6,398,100

Noncash investing and financing activities:
Change in unrealized gain on investment securities
available for sale, net	$	1,411,256		1,542,546		481,944
Change in unrealized gain on derivative financial
instruments, net	$	2,404,921		936,502		146,485
Transfer of loans to other real estate and repossessions	$	4,538,987		681,735		746,004
Financed portion of sale of other real estate	$	1,133,480		-		273,000
Reclassification of an investment from other assets
to securities available for sale	$	-		499,995		-
Reclassification of a security from other investments
to securities available for sale	$	-		600,000		-
Transfer of retained earnings to common stock for
issuance of stock dividend	$	-		-		9,430,532
Deferred gain rolled into cost basis of
acquired building	$	-		539,815		-
Cumulative effect of adoption of EITF 06-4	$	466,917		-		-


See accompanying notes to consolidated financial statements.

Buildings and improvements		10 - 50 years
Furniture and equipment		3 - 10 years

Stock Option Activity
For the years ended December 31, 2008, 2007 and 2006

	Shares			Weighted Average Option Price Per Share		Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding, December 31, 2005		319,692		$	8.13

Granted during the period		-		$	-
Forfeited during the period		(164	)	$	7.38
Exercised during the period		(97,854	)	$	7.87

Outstanding, December 31, 2006		221,674		$	8.24

Granted during the period		-		$	-
Forfeited during the period		-		$	-
Exercised during the period		(28,949	)	$	8.26

Outstanding, December 31, 2007		192,725		$	8.24

Granted during the period		-		$	-
Forfeited during the period		(2,458	)	$	8.02
Exercised during the period		(5,322	)	$	8.26

Outstanding, December 31, 2008		184,945		$	8.24	3.08	$ 174,002

Exercisable, December 31, 2008		184,945		$	8.24	3.08	$ 174,002

For the year ended December 31, 2008:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	6,390,563	5,588,314	$	1.14
Effect of dilutive securities:
Stock options		-	58,980
Diluted earnings per common share	$	6,390,563	5,647,294	$	1.13

For the year ended December 31, 2007:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	9,591,971	5,700,860	$	1.68
Effect of dilutive securities:
Stock options		-	109,455
Diluted earnings per common share	$	9,591,971	5,810,315	$	1.65

For the year ended December 31, 2006:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per common share	$	9,170,817	5,701,829	$	1.61
Effect of dilutive securities:
Stock options		-	100,495
Diluted earnings per common share	$	9,170,817	5,802,324	$	1.58

	December 31, 2008
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value

Mortgage-backed securities	$	36,556,684		854,237		139,840		37,271,081
U.S. government sponsored enterprises		55,222,788		3,266,198		2,324		58,486,662
State and political subdivisions		26,648,553		459,546		134,525		26,973,574
Trust preferred securities		1,250,000		-		-		1,250,000
Equity securities		1,382,184		-		447,152		935,032

Total	$	121,060,209		4,579,981		723,841		124,916,349

	December 31, 2007
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value

Mortgage-backed securities	$	16,469,053		6,423		204,509		16,270,967
U.S. government sponsored enterprises		75,155,693		1,839,143		3,035		76,991,801
State and political subdivisions		25,856,311		250,483		201,406		25,905,388
Trust preferred securities		250,000		-		-		250,000
Equity securities		1,692,799		246,000		388,597		1,550,202

Total	$	119,423,856		2,342,049		797,547		120,968,358

	December 31, 2008
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

Mortgage-backed securities	$	10,017,250		139,840		-		-		10,017,250		139,840
U.S. government sponsored enterprises		-		-		614,289		2,324		614,289		2,324
State and political subdivisions		2,748,094		75,172		2,373,145		59,353		5,121,239		134,525
Equity securities		528,000		72,000		407,032		375,152		935,032		447,152

Total	$	13,293,344		287,012		3,394,466		436,829		16,687,810		723,841

	December 31, 2007
	Less than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses

Mortgage-backed securities	$	24,591		104		14,320,043		204,405		14,344,634		204,509
U.S. government sponsored enterprises		-		-		689,775		3,035		689,775		3,035
State and political subdivisions		2,059,746		33,781		11,188,720		167,625		13,248,466		201,406
Equity securities		425,620		88,134		278,581		300,463		704,201		388,597

Total	$	2,509,957		122,019		26,477,119		675,528		28,987,076		797,547

	Amortized Cost		Estimated Fair Value

Due within one year	$	5,904,880		6,015,036
Due from one to five years		44,167,067		46,804,084
Due from five to ten years		20,019,656		20,602,860
Due after ten years		13,029,738		13,288,256
Mortgage-backed securities		36,556,684		37,271,081
Equity securities		1,382,184		935,032

Total	$	121,060,209		124,916,349

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916,349	935,032	122,731,317	1,250,000
Market value of derivatives (in other assets)	$	4,980,701	-	4,980,701	-

	2008		2007

Land	$	3,572,799	3,572,241
Buildings and improvements		14,709,218	14,700,078
Furniture and equipment		17,156,190	15,496,630

Total premises and equipment		35,438,207	33,768,949

Less accumulated depreciation		17,141,312	15,534,556

Total net premises and equipment	$	18,296,895	18,234,393

2009	$	368,499,249
2010		23,010,748
2011		12,797,281
2012		1,156,885
2013 and thereafter		1,092,480

Total	$	406,556,643

Maturity Date	Call Date	Rate	Rate Type	Amount

March 30, 2010	September 30, 2000 and every
	three months thereafter	5.880%	Convertible		5,000,000

May 24, 2010	May 24, 2001 and every three
	months thereafter	6.490%	Convertible		2,000,000

June 24, 2015	June 24, 2010	3.710%	Convertible		5,000,000

March 25, 2019	March 25, 2009	4.360%	Convertible		5,000,000

March 31, 2016	March 31, 2009 and every three
	months thereafter	4.620%	Convertible		5,000,000

October 5, 2016	October 5, 2009	4.450%	Convertible		5,000,000

December 12, 2011	December 12, 2007 and every	4.210%	Convertible		5,000,000
	three months thereafter

January 30, 2017	October 30, 2008 and every	4.500%	Convertible		5,000,000
	three months thereafter

June 8, 2017	December 8, 2008 and every	4.713%	Convertible		15,000,000
	three months thereafter

June 9, 2014	February 11, 2008 and every	4.685%	Convertible		15,000,000
	month thereafter


July 11, 2017	January 11, 2008 and every	4.440%	Convertible		5,000,000
	three months thereafter

July 24, 2017	April 24, 2008 and every	4.420%	Convertible		5,000,000
	month thereafter

				$	77,000,000

	2008		2007
Deferred tax assets:
Allowance for loan losses	$	4,280,854	3,531,076
Amortizable intangible assets		43,703	76,398
Accrued retirement expense		1,184,373	819,246
Income from non-accrual loans		36,973	50,219
Unrealized loss on cash flow hedges		-	20,525
Premises and equipment		-	9,757
Total gross deferred tax assets		5,545,903	4,507,221

Deferred tax liabilities:
Deferred loan fees		1,654,311	1,346,322
Premises and equipment		194,463	-
Unrealized gain on available for sale securities		1,501,966	601,583
Unrealized gain on cash flow hedges		1,318,536	-
Other		84,100	12,482
Total gross deferred tax liabilities		4,753,376	1,960,387
Net deferred tax asset	$	792,527	2,546,834

Beginning balance	$	5,615,899
New loans		3,734,377
Repayments		3,692,009

Ending balance	$	5,658,267

Year ending December 31,
2009	$	769,569
2010		626,965
2011		563,901
2012		444,834
2013		255,909
Thereafter		1,893,313

Total minimum obligation	$	4,554,491

	Contractual Amount
	2008		2007
Financial instruments whose contract amount represent credit risk:

Commitments to extend credit	$	158,939,113	190,653,583

Standby letters of credit and financial guarantees written	$	4,316,012	3,894,259

	Asset Derivatives				Liability Derivatives
	As of December 31, 2008		As of December 31, 2007		As of December 31, 2008		As of December 31, 2007
	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value
Interest rate
derivative
contracts	Other assets	$ 4,981,000	Other assets	$ 1,907,000	N/A	$ -	N/A	$ -

	2008

Benefit obligation at beginning of period	$	1,528,488
Service cost		180,162
Interest cost		99,569
Benefits paid		(28,931	)
Benefit obligation at end of period	$	1,779,288

	2008

Benefit obligation	$	1,779,288
Fair value of plan assets		-

	2008

Funded status	$	(1,779,288	)
Unrecognized prior service cost/benefit		-
Unrecognized net actuarial loss		-
Net amount recognized	$	(1,779,288	)

Unfunded accrued liability	$	(1,779,288	)
Intangible assets		-
Net amount recognized	$	(1,779,288	)

Weighted average discount rate assumption used to
determine benefit obligation		6.68%

Year ending December 31,
2009	$	58,713
2010	$	62,690
2011	$	86,858
2012	$	199,328
2013	$	204,735
Thereafter	$	9,459,971

	Actual			For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions

	Amount		Ratio	Amount	Ratio	Amount	Ratio
	(dollars in thousands)

As of December 31, 2008:

Total Capital (to Risk-Weighted Assets)
Consolidated	$	125,871	14.90%	67,589	8.00%	N/A	N/A
Bank	$	93,530	11.10%	67,411	8.00%	84,264	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	115,332	13.65%	33,794	4.00%	N/A	N/A
Bank	$	82,991	9.85%	33,705	4.00%	50,558	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$	115,332	12.40%	37,192	4.00%	N/A	N/A
Bank	$	82,991	8.94%	37,137	4.00%	46,421	5.00%

As of December 31, 2007:

Total Capital (to Risk-Weighted Assets)
Consolidated	$	97,410	12.16%	64,071	8.00%	N/A	N/A
Bank	$	87,393	10.93%	63,940	8.00%	79,926	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	88,307	11.03%	32,035	4.00%	N/A	N/A
Bank	$	78,290	9.80%	31,970	4.00%	47,955	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$	88,307	10.43%	33,873	4.00%	N/A	N/A
Bank	$	78,290	9.26%	33,827	4.00%	42,284	5.00%

	2008			2007
	Carrying Amount		Estimated Fair Value	Carrying Amount	Estimated Fair Value
	(dollars in thousands)

Assets:
Cash and cash equivalents	$	27,929	27,929	29,800	29,800
Investment securities available for sale	$	124,916	126,539	120,968	120,968
Other investments	$	6,303	6,303	6,434	6,434
Loans, net	$	770,163	773,256	713,174	713,689
Cash surrender value of life insurance	$	7,019	7,019	6,776	6,776
Derivative instruments	$	4,981	4,981	1,907	1,907

Liabilities:
Deposits and demand notes payable	$	722,662	718,278	695,239	695,659
Securities sold under agreements
to repurchase	$	37,501	37,501	27,583	27,583
Short-term FRB borrowings	$	5,000	4,999	-	-
FHLB borrowings	$	77,000	83,038	87,500	90,223
Junior subordinated debentures	$	20,619	20,619	20,619	20,619