PEOPLES BANCORP OF NORTH CAROLINA INC (Form: 10-K, Received: 03/25/2010 09:57:14)

	UNITED STATES
	SECURITIES AND EXCHANGE COMMISSION
	Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2009

Peoples Bancorp of North Carolina, Inc.
( Exact Name of Registrant as Specified in Its Charter)

North Carolina
(State or Other Jurisdiction of Incorporation)

000-27205	56-2132396
(Commission File No.)	(IRS Employer Identification No.)

518 West C Street, Newton, North Carolina	28658
(Address of Principal Executive Offices)	(Zip Code)

(828) 464-5620
(Registrant’s Telephone Number, Including Area Code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, no par value
(title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.

Large Accelerated Filer

Accelerated Filer

Non-Accelerated Filer

Smaller Reporting Company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

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. $27,086,476 based on the closing price of such common stock on June 30, 2009, which was $6.15 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, 2010.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Annual Report of Peoples Bancorp of North Carolina, Inc. for the year ended December 31, 2009 (the “Annual Report”), which will be included as Appendix A to the Proxy Statement for the 2010 Annual Meeting of Shareholders, are incorporated by reference into Part I and Part II and included as Exhibit 13 to the Form 10-K.

Portions of the Proxy Statement for the 2010 Annual Meeting of Shareholders of Peoples Bancorp of North Carolina, Inc. to be held on May 6, 2010 (the “Proxy Statement”), are incorporated by reference into Part III.

This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of Peoples Bancorp of North Carolina, Inc. (the “Company”). These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by Peoples Bank (the “Bank”), (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission. The Company undertakes no obligation to update any forward-looking statements.

		Notice of 2010
		Annual Meeting,
	2009 Form	Proxy Statement
	10-K	and Annual Report
	Page	Page
PART I
Item 1 - Business	4 - 11	N/A
Item 1A - Risk Factors	11 - 16	N/A
Item 1B - Unresolved Staff Comments	16	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	17	N/A

PART II
Item 4 - Market for the Common Equity, Related Shareholder Matters and
Issuer Purchases of Equity Securities	18 - 20	N/A
Item 5 - Selected Financial Data	20	A-3
Item 6 - Management's Discussion and Analysis of Financial Condition and
Results of Operations	20	A-4 - A-31
Item 6A - Quantitative and Qualitative Disclosures About Market Risk	20	A-30
Item 7 - Financial Statements and Supplementary Data	20	A-32 - A-66
Item 8 - Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure	21	N/A
Item 8A - Controls and Procedures	21	N/A
Item 8B - Other Information	21	N/A

PART III
Item 9 - Directors and Executive Officers of the Registrant	22	A-67
Item 10 - Executive Compensation	22	18 - 28
Item 11 - Security Ownership of Certain Beneficial Owners and Management	22 - 23	5 - 8
Item 12 - Certain Relationships and Related Transactions	23	28 - 29
Item 13 - Principal Accountant Fees and Services	23	30

PART IV
Item 14 - Exhibits and Financial Statement Schedules	24 - 27	N/A

Signatures	28	N/A

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 22 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, 2009, the Company had total assets of $1.0 billion, net loans of $762.6 million, deposits of $809.3 million, total securities of $201.5 million, and shareholders’ equity of $99.2 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-31 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, 2009, the Bank employed 267 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.

The Company established a new subsidiary, Community Bank Real Estate Solutions, LLC (“CBRES”), during second quarter 2009. CBRES serves as a “clearing-house” for appraisal services for community banks. Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property is located. This type of service ensures that the appraisal process remains independent from the financing process within the bank.

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), Catawba Valley Medical Center, Catawba County, CV Industries (furniture manufacturer), Ethan Allen (furniture manufacturer) and Hickory Public Schools.

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, 2009 comparative data, the Bank had 21.96% of the deposits in Catawba County, placing it second in deposit size among a total of 14 banks with branch offices in Catawba County; 15.01% of the deposits in Lincoln County, placing it third in deposit size among a total of ten banks with branch offices in Lincoln County and 12.77 % 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, 2009. At December 31, 2009, the Company’s Tier I risk-based capital and total risk-based capital were 13.74% and 15.00%, 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 December 23, 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 Bank’s deposits, therefore, are subject to FDIC deposit insurance assessment.

On February 27, 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009, at 12 to 45 basis points; and due to extraordinary circumstances, extended the time within which the reserve ratio must be returned to 1.15 percent from five to seven years. The Bank‘s base assessment averaged 12.94 basis points in 2009. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution's assets minus Tier 1 capital as of June 30, 2009. The Bank incurred an expense of $453,000 in 2009 as a result of the special assessment.

On November 12, 2009, the FDIC amended its regulations requiring certain insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012. The prepaid assessment for these periods was collected on December 30, 2009, along with each institution's regular quarterly risk-based deposit insurance assessment for the third quarter of 2009. The prepayment has been treated as a prepaid expense on the books of the Company, and will be recognized as expense in the period for which the assessments are effective.

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 provided 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 are 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. The $250,000 deposit insurance coverage limit was scheduled to return to $100,000 on January 1, 2010, but was extended by congressional action until December 31, 2013. The TLGP has been extended to cover debt of FDIC-insured institutions issued through April 30, 2010, and the TAGP has been extended through June 30, 2010. The Company has participated in the TAGP since its beginning, and has elected to continue its participation during the extension period.

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 Company is eligible to participate in the DGP although the it 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, 2009, 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.

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. The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000.

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 took 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 2009, 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 requirements of the TARP at any time. Future changes in the TARP requirements 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 CPP requirements 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.

Increases in FDIC insurance premiums may adversely affect our earnings

During 2008 and 2009, higher levels of bank failures have dramatically increased resolution costs of the FDIC and depleted the Deposit Insurance Fund. In addition, the FDIC instituted two temporary programs to further insure customer deposits at FDIC insured banks: deposit accounts are currently insured up to $250,000 per customer (up from $100,000) and non-interest bearing transactional accounts at institutions participating in the Transaction Account Guarantee Program are currently fully insured (unlimited coverage). These programs have placed additional stress on the Deposit Insurance Fund.

In order to maintain a strong funding position and restore reserve ratios of the Deposit Insurance Fund, the FDIC has increased assessment rates of insured institutions. In addition, on November 12, 2009, the FDIC adopted a rule requiring banks to prepay three years’ worth of premiums to replenish the depleted fund.

The Company is generally unable to control the amount of premiums that it is required to pay for FDIC insurance. If there are additional bank or financial institution failures the Company may be required to pay even higher FDIC premiums than the recently increased levels. Further, on January 12, 2010, the FDIC requested comments on a proposed rule tying assessment rates of FDIC-insured institutions to the institution’s employee compensation programs. The exact requirements of such a rule are not yet known, but such a rule could increase the amount of premiums the

Company must pay for FDIC insurance. These announced increases and any future increases or required prepayments of FDIC insurance premiums may adversely impact our earnings.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

At December 31, 2009, the Bank conducted its business from the headquarters office in Newton, North Carolina, its Banco de la Gente administrative office and its 22 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, 2009.

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

125-E Trade Court

Mooresville, NC 28117

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.

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

Peoples Bancorp common stock is traded on the over-the-counter (OTC) market and quoted on the Nasdaq Global Market, under the symbol “PEBK.” Market makers for the Company’s shares include Scott and Stringfellow, Inc. and Sterne Agee & Leach.

Although the payment of dividends by the Company is subject to certain requirements and limitations of North Carolina corporate law, 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 and repurchase shares may be dependent upon the Company’s receipt of dividends from the Bank. The Bank’s ability to pay dividends is limited. 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). Based on its current financial condition, the Bank does not expect that this provision will have any impact on the Bank’s ability to pay dividends. Due to the Company’s participation in the CPP, the full dividend for the latest completed CPP dividend period must be declared and paid in full before dividends may be paid to common shareholders and UST approval is required for any increase in common dividends per share.

As of March 17, 2010, the Company had 712 shareholders of record, not including the number of persons or entities whose stock is held in nominee or street name through various brokerage firms or banks. The market price for the Company’s common stock was $5.47 on March 17, 2010.

The following table presents certain market and dividend information for the last two fiscal years. Over-the-counter quotations reflect inter-dealer prices, without retail mark-up, mark down or commission and may not necessarily represent actual transactions.

Market and Dividend Data

				Cash Dividend
2009	Low Bid		High Bid	Per Common Share
First Quarter	$	4.81	10.00	0.10

Second Quarter	$	5.00	7.46	0.07

Third Quarter	$	5.93	7.00	0.07

Fourth Quarter	$	3.95	6.84	0.02


				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

STOCK PERFORMANCE GRAPH

The following graph compares the Company’s cumulative shareholder return on its Common Stock with a NASDAQ index and with a southeastern bank index. The graph was prepared by SNL Securities, L.C., Charlottesville, Virginia, using data as of December 31, 2009.

COMPARISON OF SIX-YEAR CUMULATIVE TOTAL RETURNS

Performance Report for

Peoples Bancorp of North Carolina, Inc.

The information required by Item 201(d) concerning securities authorized for issuance under equity compensation plans is set forth in Item 11 hereof .

ISSUER PURCHASES OF EQUITY SECURITIES

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

January 1 - 31, 2009	-		$	-	-	-

February 1 - 28, 2009	1,900			7.37	-	-

March 1 - 31, 2009	1,100			5.18	-	-

April 1 - 30, 2009	-			-	-	-

May 1 - 31, 2009	2,530			6.51	-	-

June 1 - 30, 2009	2,497			6.39	-	-

July 1 - 31, 2009	2,260			6.12	-	-

August 1 - 31, 2009	1,080			6.32	-	-

September 1 - 30, 2009	1,140			6.53	-	-

October 1 - 31, 2009	-			-	-	-

November 1 - 30, 2009	2,450			5.72	-	-

December 1 - 31, 2009	1,350			4.18	-	-

Total	16,307	(1)	$	6.13	-

(1) The Company purchased 16,307 shares on the open market in 2009 for its deferred compensation plan. All purchases were funded by participant contributions to the plan. The agreements with UST under the CPP program allow the Company to purchase its common stock pursuant to benefit plans.

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, as amended in reliance on the exemption set forth in Section 4(2) thereof.

ITEM 5.

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 6.

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-31 of the Annual Report, which section is included in this Form 10-K as Exhibit (13).

ITEM 6A.

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-30 of the Annual Report, which section is included in this Form 10-K as Exhibit (13).

ITEM 7.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of the Company and supplementary data set forth on pages A-32 through A-66 of the Annual Report are included in this Form 10-K as Exhibit (13).

ITEM 8.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ONACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 8A.

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, 2009 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, 2009. 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, 2009.

/s/ Tony W. Wolfe		/s/ A. Joseph Lampron
Tony W. Wolfe		A. Joseph Lampron
Chief Executive Officer		Chief Financial Officer
February 25, 2010		February 25, 2010

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 SEC that permit the Company to provide only management’s report in this annual report.

ITEM 8B.

OTHER INFORMATION

None

PART III

ITEM 9.

DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by this Item regarding directors and executive officers of the Company is set forth under the sections captioned “Nominees”, “Directors Continuing in Office”, “Our Board of Directors and Its Committees”; “Executive Committee”, “Governance Committee”, “Audit Committee”, “Compensation Committee”, “Board Leadership and Structure and Risk Oversight” 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 “Audit Committee” 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. These documents are available on the Bank’s website (www.peoplesbanknc.com) under “Investor Relations.”

ITEM 10.

EXECUTIVE COMPENSATION

The information required by this Item is set forth under the sections captioned “Executive Compensation and Benefits ” contained in the Proxy Statement, which sections are incorporated herein by reference.

ITEM 11.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table presents the number of shares of Company common stock to be issued upon the exercise of outstanding options, warrants and rights; the weighted-average price of the outstanding options, warrants and rights and the number of options, warrants and rights remaining that may be issued under the Company’s Omnibus Plan described under the section captioned “Omnibus Stock Option and Long Term Incentive Plan” contained in the Proxy Statement .

Plan Category	Number of securities to be issued upon exercise of outstanding option, warrants and rights (1), (2)	Weighted-average exercise price of outstanding options, warrants and rights (3)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (4)
	(a)	(b)		(c)
Equity compensation plans approved by security holders	176,212	$	8.04	360,000
Equity compensation plans not approved by security holders	-		-	-
Total	176,212	$	8.04	360,000

(1) Includes 176,212 stock options issued under the 1999 Omnibus Plan, which are fully vested as of December 31, 2009. Of the outstanding stock options, options to purchase a total of 19,391 options were granted on September 25, 2000; 63,544 options were granted on October 30, 2001; 7,510 options were granted on December 18, 2001; 72,966 options were granted on December 17, 2002; 3,630 options were granted on May 6, 2004; and 2,421 options were granted on December 16, 2004.

(2) Includes 3,000 shares of restricted stock granted on September 20, 2007, 1,750 shares granted on March 20, 2008 and 2,000 shares granted on November 20, 2008 under the 1999 Omnibus Plan. These restricted stock grants cliff vest three years after issuance.

(3) The exercise prices for the grants of stock options under the 1999 Omnibus Plan on September 25, 2000; October 30, 2001; December 18, 2001; December 17, 2002; May 6, 2004 and December 16, 2004 are: $6.99; $8.78; $8.10; $7.77; $10.31; and $10.57, respectively. All prices and shares have been adjusted for the 10% stock dividends paid March 16, 2005 and June 16, 2006 and the three-for-two stock split paid June 15, 2007. The exercise price used for the grants of restricted stock is $4.95, the closing price for the Company’s stock on December 31, 2009.

(4) Reflects shares authorized under the February 19, 2009 Omnibus Stock Ownership and Long Term Incentive Plan. No shares have been issued under this plan as of December 31, 2009.

ITEM 12.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE

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

ITEM 13.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

See the section captioned “Proposal 3 - Ratification of Selection of Independent Auditor” contained in the Proxy Statement, which section is incorporated herein by reference.

ITEM 14.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

14(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, 2009 and 2008

	(c)	Consolidated Statements of Earnings for the Years Ended December 31, 2009, 2008 and
		2007

	(d)	Consolidated Statements of Changes in Shareholders' Equity for the Years Ended
		December 31, 2009, 2008 and 2007

	(e)	Consolidated Statements of Comprehensive Income for the Years Ended December 31,
		2009, 2008 and 2007

	(f)	Consolidated Statements of Cash Flows for the Years Ended December 31, 2009, 2008
		and 2007

	(g)	Notes to Consolidated Financial Statements

14(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.

14(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 Commission on December 29, 2008

		Exhibit (3)(2)	Articles of Amendment dated February 26, 2010 filed herewith

		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., filed herewith

		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 Exhibit
			(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 March 18, 2010 filed herewith

		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 incorporated by reference to Exhibit (10)(o) to the Form 10-K
			filed with the Securities and Exchange Commission on March 20, 2009

		Exhibit (11)	Statement regarding computation of per share earnings

		Exhibit (12)	Statement regarding computation of ratios

		Exhibit (13)	2009 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

		Exhibit (99)(a)	Certification of the Principal Executive Officer Pursuant to Section 111 of the Emergency
			Economic Stabilization Act of 2008

		Exhibit (99)(b)	Certification of the Principal Financial Officer Pursuant to Section 111 of the Emergency
			Economic Stabilization Act of 2008

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)


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

		Date: March 24, 2010

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 24, 2010
Tony W. Wolfe	(Principal Executive Officer)

/s/ James S. Abernethy	Director	March 24, 2010
James S. Abernethy

/s/ Robert C. Abernethy	Chairman of the Board and Director	March 24, 2010
Robert C. Abernethy

/s/ Douglas S. Howard	Director	March 24, 2010
Douglas S. Howard

/s/ A. Joseph Lampron	Executive Vice President and Chief	March 24, 2010
A. Joseph Lampron	Financial Officer (Principal Financial
	and Principal Accounting Officer)

/s/ John W. Lineberger, Jr.	Director	March 24, 2010
John W. Lineberger, Jr.

/s/ Gary E. Matthews	Director	March 24, 2010
Gary E. Matthews

/s/ Billy L. Price, Jr., M.D.	Director	March 24, 2010
Billy L. Price, Jr., M.D.

/s/ Larry E. Robinson	Director	March 24, 2010
Larry E. Robinson

/s/ William Gregory Terry	Director	March 24, 2010
William Gregory Terry

/s/ Dan Ray Timmerman, Sr.	Director	March 24, 2010
Dan Ray Timmerman, Sr.

/s/ Benjamin I. Zachary	Director	March 24, 2010
Benjamin I. Zachary

AMENDED AND RESTATED BYLAWS

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Section 1. Principal Office . The principal office of the Corporation shall be located at such place as the Board of Directors may fix from time to time.

Section 2. Registered Office . The registered office of the Corporation required by law to be maintained in the State of North Carolina may be, but need not be, identical with the principal office.

Section 3. Other Offices . The Corporation may have offices at such other places, either within or without the State of North Carolina, as the Board of Directors may designate or as the affairs of the Corporation may require from time to time.

MEETINGS OF SHAREHOLDERS

Section 1. Place of Meetings . All meetings of shareholders shall be held at the principal office of the Corporation, or at such other place, either within or without the State of North Carolina, as shall in each case be (i) fixed by the President and Chief Executive Officer, the Chairman of the Board, or the Board of Directors and designated in the notice of the meeting or (ii) agreed upon by a majority of the shareholders entitled to vote at the meeting.

Section 2. Annual Meetings . The annual meeting of shareholders shall be held during the first five (5) calendar months following the end of the Corporation's fiscal year, on any day (except Saturday, Sunday, or a legal holiday) during that period as shall be determined by the Board of Directors, for the purpose of electing directors of the Corporation and for the transaction of such other business as may be properly brought before the meeting.

Section 3. Substitute Annual Meeting . If the annual meeting shall not be held within the time designated by these Bylaws, a substitute annual meeting may be called in accordance with the provisions of Section 4 of this Article II. A meeting so called shall be designated and treated for all purposes as the annual meeting.

Section 4. Special Meetings . Special meetings of the shareholders may be called at any time by the President and Chief Executive Officer, the Chairman of the Board of Directors or the Board of Directors.

Section 5. Notice of Meetings . Written notice stating the date, time, and place of the meeting shall be given not less than ten (10) nor more than sixty (60) days before the date of any shareholders' meeting, either by personal delivery, or by mail by or at the direction of the President and Chief Executive Officer, the Chairman of the Board of Directors or the Board of Directors, to each shareholder entitled to vote at such meeting; provided, however, that such notice must be given to all shareholders with respect to any meeting at which a merger or share exchange is to be considered and in such other instances as required by law. If mailed, such notice shall be deemed to be effective when deposited in the United States mail, correctly addressed to the shareholder at the shareholder's address as it appears on the current record of shareholders of the Corporation, with postage thereon prepaid.

In the case of a special meeting, the notice of meeting shall include a description of the purpose or purposes for which the meeting is called; but, in the case of an annual or substitute annual meeting, the notice of meeting need not include a description of the purpose or purposes for which the meeting is called unless such a description is required by the provisions of the North Carolina Business Corporation Act.

When a meeting is adjourned to a different date, time or place, notice need not be given of the new date, time or place if the new date, time or place is announced at the meeting before adjournment and if a new record date is not fixed for the adjourned meeting. If a new record date is fixed for the adjourned meeting (which must be done if the new date is more than 120 days after the date of the original meeting), notice of the adjourned meeting must be given as provided in this Section 5 to persons who are shareholders as of the new record date.

Section 6. Waiver of Notice . Any shareholder may waive notice of any meeting before or after the meeting. The waiver must be in writing, signed by the shareholder, and delivered to the Corporation for inclusion in the minutes or for filing with the corporate records. A shareholder's attendance, in person or by proxy, at a meeting (i) waives objection to lack of notice or defective notice of the meeting, unless the shareholder or his or her proxy at the beginning of the meeting objects to holding the meeting or transacting business at the meeting, and (ii) waives objection to consideration of a particular matter at the meeting that is not within the purpose or purposes described in the meeting notice, unless the shareholder or his or her proxy objects to considering the matter before it is voted upon.

Section 7. Shareholders' List . Before each meeting of shareholders, the Corporate Secretary shall prepare an alphabetical list of the shareholders entitled to notice of such meeting. The list shall be arranged by voting group (and within each voting group by class or series of shares) and show the address of and number of shares held by each shareholder. The list shall be kept on file at the principal office of the Corporation, or at a place identified in the meeting notice in the city where the meeting will be held, for the period beginning two (2) business days after notice of the meeting is given and continuing through the meeting, and shall be available for inspection by any shareholder, or by any shareholder’s agent or attorney, at any time during regular business hours. The list shall also be available at the meeting and shall be subject to inspection by any shareholder, his or her agent or attorney, at any time during the meeting or any adjournment thereof.

Section 8. Fixing Record Date . The Board of Directors may fix a future date as the record date for one (1) or more voting groups in order to determine the shareholders entitled to notice of a shareholders' meeting, to demand a special meeting, to vote, or to take any other action. Such record date may not be more than seventy (70) days before the meeting or action requiring a determination of shareholders. A determination of shareholders entitled to notice of or to vote at a shareholders' meeting is effective for any adjournment of the meeting unless the Board of Directors fixes a new record date for the adjourned meeting, which it must do if the meeting is adjourned to a date more than 120 days after the date fixed for the original meeting.

If no record date is fixed by the Board of Directors for the determination of shareholders entitled to notice of or to vote at a meeting of shareholders, the close of business on the day before the first notice of the meeting is delivered to shareholders shall be the record date for such determination of shareholders.

Section 9. Voting Groups . All shares of one (1) or more classes or series that, under the Articles of Incorporation or the North Carolina Business Corporation Act, are entitled to vote and be counted together collectively on a matter at a meeting of shareholders constitute a voting group. All shares entitled by the Articles of Incorporation or the North Carolina Business Corporation Act to vote generally on a matter are for that purpose a single voting group. Classes or series of shares shall not be entitled to vote separately by voting group unless expressly authorized by the Articles of Incorporation or specifically required by law.

Section 10. Quorum . Shares entitled to vote as a separate voting group may take action on a matter at the meeting only if a quorum of those shares exists. A majority of the votes entitled to be cast on the matter by the voting group constitutes a quorum of that voting group for action on that matter.

Once a share is represented for any purpose at a meeting, it is deemed present for quorum purposes for the remainder of the meeting and for any adjournment of that meeting unless a new record date is or must be set for that adjourned meeting.

In the absence of a quorum at the opening of any meeting of shareholders, such meeting may be adjourned from time to time by the vote of a majority of the votes cast on the motion to adjourn; and, subject to the provisions of Section 5 of this Article II, at any adjourned meeting any business may be transacted that might have been transacted at the original meeting if a quorum exists with respect to the matter proposed.

Section 11. Proxies . Shares may be voted either in person or by proxy. A shareholder may appoint one (1) or more proxies to vote or otherwise act for him or her by signing an appointment form, either personally or by his or her attorney-in-fact. A photocopy, telegram, cablegram, facsimile transmission, or equivalent reproduction of a writing appointing one or more proxies, shall be deemed a valid appointment form within the meaning of this section. In addition, a shareholder may appoint one or more proxies (i) by an electronic mail message or other form of electronic, wire, or wireless communication that provides a written statement appearing to have been sent by the shareholder, or (ii) by any kind of electronic or telephonic transmission, even if not accompanied by written communication, under circumstances or together with information from which the Corporation can reasonably assume that the appointment was made or authorized by the shareholder. An appointment of proxy is valid for eleven (11) months from the date of its execution, unless a different period is expressly provided in the appointment form.

Section 12. Voting of Shares . Subject to the provisions of the Articles of Incorporation, each outstanding share shall be entitled to one (1) vote on each matter voted on at a meeting of shareholders.

Except in the election of directors as governed by the provisions of Section 4 of Article III, if a quorum exists, action on a matter by a voting group is approved if the votes cast within the voting group favoring the action exceed the votes cast opposing the action, unless a greater vote is required by law or the Articles of Incorporation or these Bylaws.

Absent special circumstances, shares of the Corporation are not entitled to vote if they are owned, directly or indirectly, by a second corporation in which the Corporation owns, directly or indirectly, a majority of the shares entitled to vote for directors of the second corporation; provided that this provision does not limit the power of the Corporation or such second corporation to vote shares held by it in a fiduciary capacity.

Section 1. General Powers . All corporate powers shall be exercised by or under the authority of, and the business and affairs of the Corporation shall be managed under the direction of, the Board of Directors.

Section 2. Number and Qualification . The number of directors of the Corporation shall not be less than five (5) nor more than fifteen (15), with the exact number to be fixed from time to time by the Board of Directors.

No person shall be elected, re-elected, or appointed as a director after attaining seventy (70) years of age, unless that person is an employee of the Corporation. In the event a non-employee director attains the age of seventy (70) years during his or her term, such director shall serve until his or her current term has expired, at which time his or her successor shall be elected by the shareholders.

Section 3. Nominations . At any meeting of shareholders at which directors are to be elected, nominations for election to the Board of Directors may be made by the Board of Directors or, subject to the conditions described below, by any holder of shares entitled to be voted at that meeting in the election of directors. To be eligible for consideration at the meeting of shareholders, all nominations, other than those made by the Board of Directors, shall be in writing and must be delivered to Corporate Secretary not less than fifty (50) days nor more than ninety (90) days prior to the meeting at which such nominations will be made; provided, however, that if less than sixty (60) days' notice of the meeting is given to shareholders, such nominations must be delivered to the Corporate Secretary not later than the close of business on the tenth (10 th ) day following the day on which the notice of meeting was mailed.

Section 4. Election . Except as provided in Section 6 and Section 7 of this Article III, the directors shall be elected at the annual meeting of shareholders. Those persons who receive the highest number of votes at a meeting at which a quorum is present shall be deemed to have been elected.

Section 5. Terms of Directors . Except as otherwise provided below to transition the Board of Directors from the staggered classes existing prior to the 2008 annual meeting of shareholders, the Board of Directors shall be composed of one (1) class. Each director shall serve for a term ending on the date of the annual meeting of shareholders following the annual meeting at which such director was elected or the director’s earlier death, resignation, disqualification or removal or until his successor is elected and qualified. In the event of any increase or decrease in the authorized number of directors, each director then serving as such shall nevertheless continue as a director until the expiration of the director’s current term or the director’s earlier death, resignation, disqualification or removal. In the event of the death, resignation, removal or disqualification of a director during the director’s elected term of office, the Board of Directors or, subject to the provisions of these bylaws and applicable law, the shareholders, may appoint the director’s successor, who shall serve until the next annual shareholders’ meeting at which directors are elected. Notwithstanding the foregoing, in the event that preferred stock of the corporation is issued and if the articles of incorporation so provide, the holders of the preferred stock or the corporation may increase the Board of Directors within the range set forth by these bylaws by additional directors to serve as provided in the articles of incorporation. Should a vacancy occur among such directors elected by the preferred shareholders, such vacancy shall be filled, until the next election of directors, by such shareholders or by the affirmative vote of the majority of the remaining directors elected by such shareholders.

At the 2009 annual meeting of shareholders, each director whose term expires at that meeting shall be elected for a term expiring at the 2011 annual meeting of shareholders or until his or her earlier death, resignation, disqualification or removal or a successor shall be shall be elected and shall qualify; any director whose term expires at the 2009 annual meeting of shareholders shall be elected for a term expiring at the 2011 annual meeting or until his or her earlier death, resignation, disqualification or removal or a successor shall be shall be elected and shall qualify; at the 2010 annual meeting of shareholders, each director whose term expires at that meeting shall be elected for a term expiring at the 2011 annual meeting of shareholders or until his or her earlier death, resignation, disqualification or removal or a successor shall be shall be elected and shall qualify; and at each annual meeting of shareholders thereafter, the directors shall be elected for terms expiring at the next annual meeting of shareholders.

Section 6. Removal . Any director may be removed from office at any time, with or without cause, by a vote of the shareholders if the number of votes cast to remove such director exceeds the number of votes cast not to remove him or her. If a director is elected by a voting group of shareholders, only the shareholders of that voting group may participate in the vote to remove him or her. A director may not be removed by the shareholders at a meeting unless the notice of that meeting states that the purpose, or one (1) of the purposes, of the meeting is removal of the director. If any directors are so removed, new directors may be elected at the same meeting.

Section 7. Vacancies . Any vacancy occurring in the Board of Directors, including without limitation a vacancy resulting from an increase in the number of directors or from the failure by the shareholders to elect the full authorized number of directors, may be filled by the shareholders or by the Board of Directors, whichever group shall act first. If the directors remaining in office do not constitute a quorum, the directors may fill the vacancy by the affirmative vote of a majority of the remaining directors or by the sole remaining director. If the vacant office was held by a director elected by voting group, only the remaining director or directors elected by that voting group or the holders of shares of that voting group are entitled to fill the vacancy. The term of a director elected to fill a vacancy expires at the next meeting of shareholders at which directors are elected.

Section 8. Chairman of the Board of Directors . There may be a Chairman of the Board of Directors elected by the directors from their number at any meeting of the Board of Directors. The Chairman shall serve in such position at the pleasure of the Board of Directors and shall preside at all meetings of the Board of Directors and shareholders, serve as a member of the Executive Committee, and perform such other duties as may be directed by the Board of Directors.

In the absence of the Chairman, the President and Chief Executive Officer shall preside at meetings of directors or shareholders.

Section 9. Compensation . The Board of Directors may provide for the compensation of directors for their services as such and for the payment or reimbursement of any or all expenses incurred by them in connection with such services.

MEETINGS AND COMMITTEES OF DIRECTORS

Section 1. Regular Meetings . A regular meeting of the Board of Directors shall be held immediately after, and at the same place as, the annual meeting of shareholders. In addition, the Board of Directors may provide, by resolution, the time and place, either within or without the State of North Carolina, for the holding of additional regular meetings.

Section 2. Special Meetings . Special meetings of the Board of Directors may be called by or at the request of the Chairman of the Board or the President and Chief Executive Officer if such officer is also a director, or by any three (3) or more directors. Such a meeting may be held either within or without the State of North Carolina, as fixed by the person or persons calling the meeting.

Section 3. Notice of Meetings . Regular meetings of the Board of Directors may be held without notice. The person or persons calling a special meeting of the Board of Directors shall, at least two (2) days before the meeting, give or cause to be given notice thereof by any usual means of communication. Such notice need not specify the purpose for which the meeting is called. Any duly convened regular or special meeting may be adjourned by the directors to a later time without further notice.

Section 4. Waiver of Notice . Any director may waive notice of any meeting before or after the meeting. The waiver must be in writing, signed by the director entitled to the notice, and be delivered to the Corporation for inclusion in the minutes or for filing with the corporate records. A director's attendance at or participation in a meeting waives any required notice of such meeting unless the director at the beginning of the meeting, or promptly upon arrival, objects to holding the meeting or to transacting business at the meeting and does not thereafter vote for or assent to action taken at the meeting.

Section 5. Quorum . Unless the Articles of Incorporation or these Bylaws provide otherwise, a majority of the number of directors fixed by or pursuant to these Bylaws shall constitute a quorum for the transaction of business at any meeting of the Board of Directors, or if no number is so fixed, a majority of the number of directors in office immediately before the meeting begins shall constitute a quorum.

Section 6. Manner of Acting . Except as otherwise provided in the Articles of Incorporation or these Bylaws, including Section 9 of this Article IV, the affirmative vote of a majority of the directors present at a meeting at which a quorum is present shall be the act of the Board of Directors. A director may not vote at the directors’ meeting by proxy or otherwise act by proxy at a meeting of the Board of Directors.

Section 7. Presumption of Assent . A director who is present at a meeting of the Board of Directors or a committee of the Board of Directors when corporate action is taken is deemed to have assented to the action taken unless (i) he or she objects at the beginning of the meeting, or promptly upon his or her arrival, to holding it or to transacting business at the meeting, or (ii) his or her dissent or abstention from the action taken is entered in the minutes of the meeting, or (iii) he or she files written notice of his or her dissent or abstention with the presiding officer of the meeting before its adjournment or with the Corporation immediately after the adjournment of the meeting. Such right of dissent or abstention is not available to a director who votes in favor of the action taken.

Section 8. Action Without Meeting . Action required or permitted to be taken at a meeting of the Board of Directors may be taken without a meeting if the action is taken by all members of the Board of Directors. The action must be evidenced by one (1) or more written consents signed by each director before or after such action, describing the action taken, and included in the minutes or filed with the corporate records.

Section 9. Independent Directors Meetings. A meeting of the independent directors shall be held periodically to provide opportunities for continuing education, and the discussion of the business and operations of the Corporation without management present. Meetings of the independent directors shall not constitute acting in an official capacity of the Corporation.

Section 10. Committees of the Board of Directors . The Board of Directors may create such committees of the Board of Directors as it shall consider appropriate, including without limitation those committees specifically provided for in these Bylaws . The Governance Committee shall have the authority to appoint members of the Board to the Corporation’s committees in accordance with the Corporation’s Governance Policy.

Section 11. Executive Committee . The members of the Executive Committee shall be appointed by the Governance Committee and shall include the Chairman of the Board, the Vice Chairman of the Board, the President/Chief Executive Officer and a minimum of two independent directors. The Executive Committee performs duties as assigned by the full Board of Directors and is empowered to act for and on behalf of the Board of Directors in any and all matters when such authority has been voted and assigned to the Executive Committee by the Board of Directors. The Executive Committee shall not take any actions or perform any duties that are the responsibility of the Audit Committee. All actions taken by the Executive Committee must be brought before the Board of Directors for review. The Executive Committee shall meet on an as needed basis.

Section 12. Audit Committee . Members of the Audit Committee shall be appointed by the Governance Committee and shall consist of a minimum of three independent directors who are financially literate with competency in reviewing financial statements and an understanding of the banking industry and financial practices. Members of the Audit Committee may receive, directly or indirectly, any type of compensation fees from the Corporation only for their service on the Board of Directors and committee(s). The Audit Committee Chairman shall be a designated “Audit Committee Financial Expert” under criteria established by the Securities Exchange Commission and the National Association of Securities Dealers. The Audit Committee shall supervise examination of the assets and liabilities and the internal audit program of the Corporation and its subsidiaries, shall be responsible for the hiring of external and internal auditors in compliance with all applicable Securities Exchange Commission, National Association of Securities Dealers and bank regulatory agency rules and regulations. The Audit Committee shall meet at least quarterly and shall make periodic reports to the Board of Directors.

Section 13. Governance Committee . The Governance Committee shall consist of a minimum of three independent directors. The Chairman of the Board serves as the Chairman of the Governance Committee and shall recommend members to serve on the Governance Committee, which recommendation shall be subject to the approval of the Board of Directors. The Governance Committee is responsible for developing and maintaining the Corporation’s governance policy. The Governance Committee is responsible for (1) establishing criteria for membership on the Board of Directors, (2) establishing performance criteria and coordinating annual review of members of the Board of Directors, (3) establishing and maintaining Board policies regarding attendance, continuing education, meeting procedures, (4) assigning committee appointments and (5) establishing a management succession plan. The Governance Committee shall perform the duties of the nominating committee by recommending candidates for board membership in accordance with the Governance Policy. The Governance Committee shall perform the duties of the compensation committee in accordance with the Governance Policy, including conducting the evaluation of the President/Chief Executive Officer, recommending for Board approval compensation for the President/Chief Executive Officer and recommending for Board approval compensation for service on the Board of Directors and the committees.

Section 1. Officers of the Corporation . The officers of the Corporation shall consist of: a President and Chief Executive Officer; an Executive Vice President and Corporate Secretary; an Executive Vice President and Assistant Corporate Secretary; an Executive Vice President, Chief Financial Officer, and Corporate Treasurer; an Executive Vice President and Assistant Corporate Treasurer; and such other officers (including assistant officers) as may from time to time be appointed by or under the authority of the Board of Directors. Any two (2) or more offices may be held by the same person, but no officer may act in more than one (1) capacity where action of two (2) or more officers is required.

Section 2. Appointment and Term . The officers of the Corporation shall be appointed by the Board of Directors or by a duly appointed officer authorized by the Board of Directors to appoint one (1) or more officers. Each officer shall hold office until his or her death, resignation, retirement, removal, disqualification, or his or her successor shall have been appointed.

Section 3. Compensation of Officers . The compensation of all officers of the Corporation shall be fixed by or under the authority of the Board of Directors, and no officer shall serve the Corporation in any other capacity and receive compensation therefor unless such additional compensation shall be duly authorized. The appointment of an officer does not itself create contract rights.

Section 4. Removal . Any officer may be removed by the Board of Directors at any time with or without cause; but such removal shall not itself affect the officer's contract rights, if any, with the Corporation except to the extent, if any, specified in any such contract.

Section 5. Resignation . An officer may resign at any time by communicating his or her resignation to the Corporation, orally or in writing. A resignation is effective when communicated unless it specifies in writing a later effective date. If a resignation is made effective at a later date that is accepted by the Corporation, the Board of Directors may fill the pending vacancy before the effective date if the Board of Directors provides that the successor does not take office until the effective date. An officer's resignation does not affect the Corporation's contract rights, if any, with the officer except to the extent, if any, specified in any such contract.

Section 6. Bonds . The Board of Directors may by resolution require any officer, agent, or employee of the Corporation to give bond to the Corporation, with sufficient sureties, conditioned on the faithful performance of the duties of his or her respective office or position, and to comply with such other conditions as may from time to time be required by the Board of Directors.

Section 7. President and Chief Executive Officer . The President and Chief Executive Officer shall be the principal executive officer of the Corporation and, subject to the control of the Board of Directors, shall in general supervise and control all of the business and affairs of the Corporation. He or she shall sign, with the Corporate Secretary, an Assistant Corporate Secretary, or any other proper officer of the Corporation thereunto authorized by the Board of Directors, certificates for shares of the Corporation, any deeds, mortgages, bonds, contracts, or other instruments which the Board of Directors has authorized to be executed, except in cases where the signing and execution thereof shall be expressly delegated by the Board of Directors or by these Bylaws to some other officer or agent of the Corporation, or shall be required by law to be otherwise signed or executed, and in general he or she shall perform all duties incident to the office of the President and Chief Executive Officer and such other duties as may be prescribed by the Board of Directors from time to time. The President and Chief Executive Officer shall be entitled to attend all regular and special meetings and meetings of committees of the Board of Directors. If The President and Chief Executive Officer of the Corporation shall serve as a member of the Executive Committee.

Section 8. Executive Vice Presidents . In the absence of the President and Chief Executive Officer or in the event of his or her death, inability or refusal to act, the Executive Vice Presidents, unless otherwise determined by the Board of Directors, shall perform the duties of the President and Chief Executive Officer, and when so acting shall have all the powers of and be subject to all the restrictions upon the President and Chief Executive Officer. Any Executive Vice President (or Assistant Executive Vice President) may sign, with the Corporate Secretary, an Assistant Corporate Secretary, or any other proper officer of the Corporation thereunto authorized by the Board of Directors, certificates for shares of the Corporation and any other instruments which may be signed by the President and Chief Executive Officer, and shall perform such other duties as from time to time may be prescribed by the President and Chief Executive Officer or the Board of Directors.

Section 9. Corporate Secretary . The Corporate Secretary shall: (i) keep the minutes of the meetings of shareholders, of the Board of Directors, and of all committees of the Board of Directors, in one or more books provided for that purpose; (ii) see that all notices are duly given in accordance with the provisions of these Bylaws or as required by law; (iii) maintain and authenticate the records of the Corporation and be custodian of the seal of the Corporation and see that the seal of the Corporation is affixed to all documents the execution of which on behalf of the Corporation under its seal is duly authorized; (iv) sign with the President and Chief Executive Officer or an Executive Vice President, certificates for shares of the Corporation, the issuance of which shall have been authorized by resolution of the Board of Directors; (v) maintain or cause to be maintained, and have general charge of, the stock transfer books of the Corporation; (vi) prepare or cause to be prepared shareholder lists prior to each meeting of shareholders as required by law; (vii) attest the signature or certify the incumbency or signature of any officer of the Corporation; and (viii) in general perform all duties incident to the office of corporate secretary and such other duties as from time to time may be prescribed by the President and Chief Executive Officer or by the Board of Directors.

Section 10. Corporate Treasurer . The Corporate Treasurer shall be, and may be designated as such as, the Corporation's Chief Financial Officer, and shall: (i) have charge and custody of and be responsible for all funds and securities of the Corporation; receive and give receipts for moneys due and payable to the Corporation from any source whatsoever, and deposit all such moneys in the name of the Corporation in such depositories as shall be selected in accordance with the provisions of Section 4 of Article VI of these Bylaws; (ii) maintain, or cause to be maintained, appropriate accounting records as required by law; (iii) prepare, or cause to be prepared, annual financial statements of the Corporation that include a balance sheet as of the end of the fiscal year and income and cash flow statement for that year, which statements, or a written notice of their availability, shall be mailed to each shareholder within 120 days after the end of such fiscal year; and (iv) in general perform all of the duties incident to the office of corporate treasurer and such other duties as from time to time may be prescribed by the President and Chief Executive Officer or by the Board of Directors.

Section 11. Assistant Officers . In the absence of a duly appointed officer of the Corporation, or in the event of his or her death, inability or refusal to act, any person appointed by the Board of Directors and designated by title as an assistant to that officer, unless otherwise determined by the Board of Directors, may perform the duties of, and when so acting shall have all the powers of and be subject to all the restrictions upon, that officer. Such assistant officers shall perform such other duties as from time to time may be prescribed by the President and Chief Executive Officer or by the Board of Directors.

CONTRACTS, LOANS, CHECKS, AND DEPOSITS

Section 1. Contracts . The Board of Directors may authorize any officer or officers, agent or agents, to enter into any contract or execute and deliver any instrument in the name of and on behalf of the Corporation, and such authorization may be general or confined to specific instances. Also, the Board of Directors may limit, condition, restrict or deny such authority to any officer or officers, or any agent or agents.

Section 2. Loans . No loans shall be contracted on behalf of the Corporation and no evidence of indebtedness shall be issued in its name unless authorized by the Board of Directors. Such authority may be general or confined to specific instances.

Section 3. Checks and Drafts . All checks, drafts, or other orders for the payment of money, issued in the name of the Corporation, shall be signed by such officer or officers, agent or agents of the Corporation and in such manner as shall from time to time be determined by the Board of Directors.

Section 4. Deposits . All funds of the Corporation not otherwise employed shall be deposited from time to time to the credit of the Corporation in such depositories as may be selected by or under the authority of the Board of Directors.

SHARES AND THEIR TRANSFER

Section 1. Certificate For Shares . The Board of Directors may authorize the issuance of some or all of the shares of the Corporation's classes or series without issuing certificates to represent such shares. If shares are represented by certificates, the certificates shall be in such form as required by law and as determined by the Board of Directors. Certificates shall be signed, either manually or in facsimile, by the President and Chief Executive Officer or an Executive Vice President, and by the Corporate Secretary or Corporate Treasurer or an Assistant Corporate Secretary or an Assistant Corporate Treasurer. All certificates for shares shall be consecutively numbered or otherwise identified and entered into the stock transfer books of the Corporation. When shares are represented by certificates, the Corporation shall issue and deliver, to each shareholder to whom such shares have been issued or transferred, certificates representing the shares owned by him or her. When shares are not represented by certificates, then within a reasonable time after the issuance or transfer of such shares, the Corporation shall send the shareholder to whom such shares have been issued or transferred a written statement of the information required by law to be on certificates.

Section 2. Stock Transfer Books . The Corporation shall keep or cause to be kept a book or set of books, to be known as the stock transfer books of the Corporation, containing the name of each shareholder of record, together with such shareholder's address and the number and class or series of shares held by him or her. Transfers of shares of the Corporation shall be made only on the stock transfer books of the Corporation (i) by the holder of record thereof or by his or her legal representative, who shall provide proper evidence of authority to transfer; (ii) by his or her attorney authorized to effect such transfer by power of attorney duly executed and filed with the Corporate Secretary; and (iii) on surrender for cancellation of the certificate for such shares (if the shares are represented by certificates).

Section 3. Lost Certificates . The Board of Directors may direct a new certificate to be issued in place of any certificate theretofore issued by the Corporation claimed to have been lost or destroyed, upon receipt of an affidavit of such fact from the person claiming the certificate to have been lost or destroyed. When authorizing such issue of a new certificate, the Board of Directors shall require that the owner of such lost or destroyed certificate, or his or her legal representative, give the Corporation a bond in such sum and with such surety or other security as the Board of Directors may direct as indemnity against any claims that may be made against the Corporation with respect to the certificate claimed to have been lost or destroyed, except where the Board of Directors by resolution finds that in the judgment of the Board of Directors the circumstances justify omission of a bond.

Section 4. Distribution or Share Dividend Record Date . The Board of Directors may fix a date as the record date for determining shareholders entitled to a distribution or share dividend. If no record date is fixed by the Board of Directors for such determination, it is the date the Board of Directors authorizes the distribution or share dividend.

Section 5. Holder of Record . Except as otherwise required by law, the Corporation may treat the person in whose name the shares stand of record on its books as the absolute owner of the shares and the person exclusively entitled to receive notification and distributions, to vote, and to otherwise exercise the rights, powers, and privileges of ownership of such shares.

Section 6. Shares Held by Nominees . The Corporation shall recognize the beneficial owner of shares registered in the name of the nominee as the owner and shareholder of such shares for certain purposes if the nominee in whose name such shares are registered files with the Corporate Secretary a written certificate in a form prescribed by the Corporation, signed by the nominee, indicating the following: (i) the name, address, and taxpayer identification number of the nominee; (ii) the name, address, and taxpayer identification number of the beneficial owner; (iii) the number and class or series of shares registered in the name of the nominee as to which the beneficial owner shall be recognized as the shareholder; and (iv) the purposes for which the beneficial owner shall be recognized as the shareholder.

The purposes for which the Corporation shall recognize the beneficial owner as the shareholder may include the following: (i) receiving notice of, voting at, and otherwise participating in shareholders' meetings; (ii) executing consents with respect to the shares; (iii) exercising dissenters' rights under the North Carolina Business Corporation Act; (iv) receiving distributions and share dividends with respect to the shares; (v) exercising inspection rights; (vi) receiving reports, financial statements, proxy statements, and other communications from the Corporation; (vii) making any demand upon the Corporation required or permitted by law; and (viii) exercising any other rights or receiving any other benefits of a shareholder with respect to the shares.

The certificate shall be effective ten (10) business days after its receipt by the Corporation and until it is changed by the nominee, unless the certificate specifies a later effective time or an earlier termination date.

If the certificate affects less than all of the shares registered in the name of the nominee, the Corporation may require the shares affected by the certificate to be registered separately on the books of the Corporation and be represented by a share certificate that bears a conspicuous legend stating that there is a nominee certificate in effect with respect to the shares represented by that share certificate.

Section 1. Distributions . The Board of Directors may from time to time authorize, and the Corporation may grant, distributions and share dividends to its shareholders pursuant to law and subject to the provisions of its Articles of Incorporation.

Section 2. Seal . The corporate seal of the Corporation shall consist of two concentric circles between which is the name of the Corporation and in the center of which is inscribed SEAL; and such seal, as impressed or affixed on the margin hereof, is hereby adopted as the corporate seal of the Corporation.

Section 3. Fiscal Year . The fiscal year of the Corporation shall be fixed by the Board of Directors.

Section 4. Amendments . Except as otherwise provided in the Articles of Incorporation or by law, these Bylaws may be amended or repealed and new Bylaws may be adopted by the Board of Directors.

No Bylaw adopted, amended, or repealed by the shareholders shall be readopted, amended, or repealed by the Board of Directors, unless the Articles of Incorporation or a Bylaw adopted by the shareholders authorizes the Board of Directors to adopt, amend, or repeal that particular Bylaw or the Bylaws generally.

Section 5. Definitions . Unless the context otherwise requires, terms used in these Bylaws shall have the meanings assigned to them in the North Carolina Business Corporation Act to the extent defined therein.

Section 1. Indemnification . In addition to any indemnification required or permitted by law, and except as otherwise provided in these Bylaws, any person who at any time serves or has served as a director, officer, employee or agent of the Corporation and any such person who serves or has served at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, or as a trustee or administrator under an employee benefit plan, shall have a right to be indemnified by the Corporation to the full extent allowed by applicable law against liability and litigation expense arising out of such status or activities in such capacity. "Liability and litigation expense" shall include costs and expenses of litigation (including reasonable attorneys' fees), judgments, fines and amounts paid in settlement which are actually and reasonably incurred in connection with or as a consequence of any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative, including appeals.

Litigation expense incurred by a person described in this Article IX in connection with a matter described in this Article IX may be paid by the Corporation in advance of the final disposition or termination of such matter, if the Corporation receives an undertaking, dated, in writing and signed by the person to be indemnified, to repay all such sums unless such person is ultimately determined to be entitled to be indemnified by the Corporation as provided in this Article IX. Requests for payments in advance of final disposition or termination shall be submitted in writing unless this requirement is waived by the Corporation.

A person described in this Article IX may apply to the Corporation in writing for indemnification or advance expenses. Such applications shall be addressed to the Corporate Secretary or, in the absence of the Corporate Secretary, to any executive officer of the Corporation. The Corporation shall respond in writing to such applications as follows: to a request for indemnity under this Article IX, within ninety (90) days after receipt of the application; to a request for advance expenses under this Article IX, within fifteen (15) days after receipt of the application.

Notwithstanding the foregoing, no advance payment shall be made as to any payment or portion of a payment for which the determination is made that the person requesting payment will not be entitled to indemnification. Such determination may be made only by a majority vote of disinterested directors or by independent legal counsel as provided in Section 2 of this Article IX. If there are not at least two (2) disinterested directors, the notice of all requests for advance payment shall be delivered for review to independent legal counsel for the Corporation. Such counsel shall have the authority to disapprove any advance payment or portion of a payment for which it appears that the person requesting payment will not be entitled to indemnification.

If any action is necessary or appropriate to authorize the Corporation to pay the indemnification required by these Bylaws, the Board of Directors shall take such action, including (i) making a good faith evaluation of the indemnification request, (ii) giving notice to, and obtaining approval by, the shareholders of the Corporation, and (iii) taking any other action.

The right to indemnification or advance expenses provided herein shall be enforceable in any court of competent jurisdiction. A legal action may be commenced if a claim for indemnity or advance expenses is denied in whole or in part, or upon the expiration of the time periods provided above. In any such action, if the claimant establishes the right to indemnification, he or she shall also have the right to be indemnified against the litigation expense (including, without limitation, reasonable attorneys' fees) of such action.

If this Article or any portion hereof shall be invalidated on any ground by any court or agency of competent jurisdiction, then the Corporation shall nevertheless indemnify each person described in this Article IX to the full extent permitted by the portion of this Article that is not invalidated and also to the full extent (not exceeding the benefits described herein) permitted or required by other applicable law.

Section 2. Determination . Promptly after the final disposition or termination of any matter which involves liability or litigation expense as described above or at such earlier time as it sees fit, the Corporation shall determine whether any person described in this Article IX is entitled to indemnification thereunder. Such determination shall be limited to the following issues: (i) whether the persons to be indemnified are persons described in this Article IX, (ii) whether the liability or litigation expense incurred arose out of the status or activities of such persons as described in this Article IX, (iii) whether liability was actually incurred and/or litigation expense was actually and reasonably incurred, and (iv) whether the indemnification requested is permitted by applicable law. Such determination shall be made by a majority vote of directors who were not parties to the action, suit or proceeding (or, in connection with "threatened" actions, suits or proceedings, who were not "threatened parties"). If at least two such disinterested directors are not obtainable, or, even if obtainable, if at least half of the number of disinterested directors so direct, such determination shall be made by independent legal counsel in written opinion.

Section 3. Settlement . The Corporation shall not be obligated to indemnify persons described in this Article IX for any amounts paid in settlement unless the Corporation consents in writing to the settlement. The Corporation shall not unreasonably withhold its consent to proposed settlements. The Corporation's consent to a proposed settlement shall not constitute an agreement by the Corporation that any person is entitled to indemnification hereunder. The Corporation may waive the requirement of this section for its written consent as fairness and equity may require.

Section 4. Insurance . As provided by N.C. Gen. Stat. §55-8-57, the Corporation shall have the power to purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the Corporation, or who is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, or as a trustee or administrator under an employee benefit plan, against any liability asserted against him or her and incurred by him or her in any such capacity or arising out of his or her status as such, whether or not the Corporation has the power to indemnify him or her against such liability.

Section 5. Non-Exclusive . The right to indemnification provided herein shall not be deemed exclusive of any other rights to which any persons seeking indemnity may be entitled apart from the provisions of this bylaw, except there shall be no right to indemnification as to any liability or litigation expense for which such person is entitled to receive payment under any insurance policy other than a directors' and officers' liability insurance policy maintained by the Corporation. Such right inures to the benefit of the heirs and legal representatives of any persons entitled to such right.

Any person who at any time after the adoption of this bylaw serves or has served in any status or capacity described in this Article IX, shall be deemed to be doing or to have done so in reliance upon, and as consideration for, the right of indemnification provided herein. Any repeal or modification hereof shall not affect any rights or obligations then existing. The right provided herein shall not apply as to persons serving institutions which are hereafter merged into or combined with the Corporation, except after the effective date of such merger or combination and only as to status and activities after such date.

STATEMENT REGARDING COMPUTATION OF PER SHARE EARNINGS

The computation of earnings per share is contained in Note 1 of the Notes to Consolidated Financial Statements and is incorporated by reference.

STATEMENT REGARDING COMPUTATION OF RATIOS

The averages used in computing the performance ratios provided in Item 6 represent average daily balances.

Appendix A to the Proxy Statement for the 2010 Annual Meeting of Shareholders

PEOPLES BANCORP OF NORTH CAROLINA, INC.

General Description of Business

At December 31, 2009, the Bank employed 267 full-time equivalent employees.

Subsidiaries

A-1

A-2

SELECTED FINANCIAL DATA
Dollars in Thousands Except Per Share Amounts

	2009		2008	2007	2006	2005
Summary of Operations
Interest income	$	50,037	56,322	61,732	55,393	41,913
Interest expense		17,187	23,526	27,585	23,110	15,429
Net interest earnings		32,850	32,796	34,147	32,283	26,484
Provision for loan losses		10,535	4,794	2,038	2,513	3,110
Net interest earnings after provision
for loan losses		22,315	28,002	32,109	29,770	23,374
Non-interest income		11,823	10,495	8,816	7,554	6,668
Non-interest expense		29,883	28,893	25,993	22,983	20,330
Earnings before taxes		4,255	9,604	14,932	14,341	9,712
Income taxes		1,339	3,213	5,340	5,170	3,381
Net earnings		2,916	6,391	9,592	9,171	6,331
Dividends and accretion of preferred stock		1,246	-	-	-	-
Net earnings available to common
shareholders	$	1,670	6,391	9,592	9,171	6,331

Selected Year-End Balances
Assets	$	1,048,494	968,762	907,262	818,948	730,280
Available for sale securities		195,115	124,916	120,968	117,581	115,158
Loans, net		762,643	770,163	713,174	643,078	559,239
Mortgage loans held for sale		2,840	-	-	-	2,248
Interest-earning assets		988,017	921,101	853,878	780,082	692,835
Deposits		809,343	721,062	693,639	633,820	582,854
Interest-bearing liabilities		826,838	758,334	718,870	650,364	576,681
Shareholders' equity	$	99,223	101,128	70,102	62,835	54,353
Shares outstanding*		5,539,056	5,539,056	5,624,234	5,745,951	5,677,328

Selected Average Balances
Assets	$	1,016,257	929,799	846,836	772,585	706,843
Available for sale securities		161,135	115,853	120,296	118,137	108,690
Loans		782,464	747,203	665,379	604,427	550,545
Interest-earning assets		956,680	876,425	801,094	732,244	668,614
Deposits		772,075	720,918	659,174	605,407	570,997
Interest-bearing liabilities		796,260	740,478	665,727	613,686	563,210
Shareholders' equity	$	101,162	76,241	70,586	62,465	55,989
Shares outstanding*		5,539,056	5,588,314	5,700,860	5,701,829	5,692,290

Profitability Ratios
Return on average total assets		0.29%	0.69%	1.13%	1.19%	0.90%
Return on average shareholders' equity		2.88%	8.38%	13.59%	14.68%	11.31%
Dividend payout ratio**		86.22%	41.93%	24.30%	20.78%	22.34%

Liquidity and Capital Ratios (averages)
Loan to deposit		101.35%	103.65%	100.94%	99.84%	96.42%
Shareholders' equity to total assets		9.95%	8.20%	8.34%	8.09%	7.92%

Per share of Common Stock*
Basic net income	$	0.30	1.14	1.68	1.61	1.11
Diluted net income	$	0.30	1.13	1.65	1.58	1.09
Cash dividends	$	0.26	0.48	0.41	0.33	0.25
Book value	$	13.37	13.73	12.46	10.94	9.57

*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.
**As a percentage of net earnings available to common shareholders.

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-32 through A-66.

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, 2009, 2008 and 2007. 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.

Economic conditions in 2009 continued to deteriorate and had a negative impact on our financial condition and results of operations. Unfavorable trends, such as increased unemployment, falling real estate prices, increased loan default and increased bankruptcy rates, demonstrate the difficult business conditions that are affecting the general economy and therefore our operating results. The unemployment rates in our primary market area have been higher than state and national averages throughout 2009.

Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.

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 0.25% as of December 31, 2009. These decreases had a negative impact on 2009 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

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Federal Funds Rate has been partially offset by the increase in earnings realized on interest rate contracts, including both an interest rate swap 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 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. As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock. The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000. 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 be 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 above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; 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 provide capital to support making 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 Company 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 Company continues to face challenges resulting from the impact of the current economy on the housing and real estate markets. The Bank continues to monitor and evaluate all significant loans in its portfolio, and will continue to manage its credit risk exposure with the expectation that stabilization of the real estate market will not occur until late 2010 or 2011. The CPP funds have enhanced our capital position as the Company infused the Bank with $8.0 million additional regulatory capital. The Company has $19.0 million available that can be infused into the Bank as additional capital if needed to maintain its position as a well capitalized bank. We anticipate increased loan losses in the short run and have prepared for that expectation. We have quality individuals managing our past due loans and foreclosed properties to minimize our potential losses. As the economy recovers, we are positioned to take advantage of all opportunities that present themselves. Over the remainder of the year we anticipate net interest margin improvement as repricing of deposits should exceed repricing of loans. The amount and timing of any future Federal Reserve rate adjustment remains uncertain, and may further impact the Bank if those adjustments are significant.

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The Company established a new subsidiary, Community Bank Real Estate Solutions, LLC (“CBRES”), during second quarter 2009. CBRES will serve as a “clearing-house” for appraisal services for community banks. Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property is located. This type of service ensures that the appraisal process remains independent from the financing process within the bank.

The Bank opened a new office in Iredell County, in Mooresville, North Carolina in September 2009. Management continues to look for branching opportunities in nearby markets although there are no additional offices planned in 2010.

Summary of Significant Accounting Policies

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiaries, Peoples Bank and Real Estate Solutions, along with the Bank’s 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 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 2009 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 6, 2010 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 Generally Accepted Accounting Principles ("GAAP"). For a more complete discussion of policies, see the notes to consolidated financial statements.

The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

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The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of December 31, 2009 and December 31, 2008.

(Dollars in thousands)
	Asset Derivatives
	As of December 31, 2009		As of December 31, 2008
	Balance Sheet Location	Fair Value	Balance Sheet Location	Fair Value
Interest rate derivative contracts	Other assets	$ 1,762	Other assets	$ 4,981

The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy. For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount. For hedges of the Company’s variable-rate loan assets, the interest rate floor designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium. As of December 31, 2009, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company recognized a hedge ineffectiveness gain of $1,000 in earnings during the year ended December 31, 2009.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest income or expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next twelve months, the Company estimates that $1.4 million will be reclassified as an increase to interest income.

The tables below present the effect of the Company’s derivative financial instruments on the Income Statement for the years ended December 31, 2009 and 2008.

(Dollars in thousands)

	Amount of Gain (Loss) Recognized in OCI on Derivatives			Location of Gain (Loss) Reclassified from Accumulated OCI into Income	Amount of Gain (Loss) Reclassified from Accumulated OCI into Income
	Years ended December 31,				Years ended December 31,
	2009		2008		2009	2008
Interest rate derivative contracts	$ 434	$	7,147	Interest income	$ 3,114	$ 3,403
				Non-interest income	$ 46	$ -

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guidance of the pronouncement to record the portion of this benefit earned by participants prior to adoption of the pronouncement. In 2009 the Company made a $358,000 addition to retained earnings to reflect an adjustment of the cumulative effect due to amendments to the individual split-dollar plans implemented during 2009.

GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is 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 table below presents the balance of securities available for sale and derivatives, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of December 31, 2009 and 2008.

(Dollars in thousands)
	Fair Value Measurements December 31, 2009		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	195,115	861	193,004	1,250
Mortgage loans held for sale	$	2,840	-	2,840	-
Market value of derivatives (in other assets)	$	1,762	-	1,762	-



	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916	935	122,731	1,250
Market value of derivatives (in other assets)	$	4,981	-	4,981	-

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.

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, 2009:

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

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

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The Company’s December 31, 2009 and 2008 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:

(Dollars in thousands)
	Fair Value Measurements December 31, 2009		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation	Total Gains/(Losses) for the Year Ended December 31, 2009
Impaired loans	$	15,958	-	14,174	1,784	(1,924)
Other real estate	$	3,997	-	3,997	-	(100)



	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	-	5,903	1,170	(345)
Other real estate	$	1,867	-	1,867	-	(166)

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 expected cash flow or appraised value of any underlying collateral. At December 31, 2009 and 2008, the recorded investment in loans that were considered to be impaired was approximately $16.6 million and $7.5 million, respectively. In addition, the Company had approximately $2.0 million and $514,000 in loans past due more than ninety days and still accruing interest at December 31, 2009 and 2008, respectively. The Company had specific reserves on impaired loans of $673,000 and $462,000 at December 31, 2009 and 2008, respectively. The average recorded investment in impaired loans for the twelve months ended December 31, 2009 and 2008 was approximately $15.0 million and $8.8 million, respectively. For the years ended December 31, 2009, 2008 and 2007, the Company recognized approximately $53,000, $57,000 and $29,000, respectively, of interest income on impaired loans.

At each reporting period, the Company determines which loans are impaired. Accordingly, the Company’s impaired loans are reported at their estimated fair value on a non-recurring basis. An allowance for each impaired loan, which are generally collateral-dependent, is calculated based on the fair value of its collateral. The fair value of the collateral is based on appraisals performed by third-party valuation specialists. Factors including the assumptions and techniques utilized by the appraiser are considered by Management. If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses.

In April 2009, the Financial Accounting Standards Board (“FASB”) issued new authoritative guidance under the following two ASC's intended to provide additional guidance and enhance disclosures regarding fair value measurements and impairment of securities:

ASC Topic 820 (formerly FASB Staff Position (FSP) FAS 157-4), “Fair Value Measurements and Disclosures,” provides additional guidance for estimating fair value in accordance with ASC Topic 820 when the volume and level of activity for the asset or liability have decreased significantly. ASC Topic 820 also provides guidance on identifying circumstances that indicate a transaction is not orderly. The provisions of ASC Topic 820 were effective for the period ended March 31, 2009 and did not have a significant effect on the Company's condensed consolidated financial statements.

ASC Topic 320 (formerly FSP FAS 115-2 and FAS 124-2), “Investments – Debt and Equity Securities,” amends current other-than-temporary impairment guidance in GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This ASC Topic 320 does not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. The Company adopted the provisions of ASC Topic 320 as of June 30, 2009 and it did not have a significant effect on the Company's condensed consolidated financial statements.

In June 2009, the FASB issued new authoritative guidance under ASC Topic 860 (formerly Statement No. 166) “Transfers and Servicing,” to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. ASC Topic 860 eliminates the concept of a "qualifying special-purpose entity" and changes the requirements for derecognizing financial assets. ASC Topic 860 also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative guidance

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under ASC Topic 860 will be effective January 1, 2010 and is not expected to have a significant impact on the Company's consolidated financial statements.

In June 2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” (SFAS 167) to amend certain requirements of FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” to improve financial reporting by enterprises involved with variable interest entities and to provide more relevant and reliable information to users of financial statements. SFAS 167 will remain authoritative until integrated into FASB Codification. SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. SFAS 167 has not had any effect on the Company's financial position, results of operations or disclosures.

In June 2009, the FASB issued Accounting Standards Update No. 2009-01 (“ASU 2009-01”), “Topic 105 – Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards No. 168 – The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.” ASU 2009-01 amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 168 (“SFAS 168”), “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.” ASU 2009-1 includes SFAS 168 in its entirety, including the accounting standards update instructions contained in Appendix B of the Statement. The FASB Accounting Standards Codification TM (“Codification”) became the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement was effective for the Company’s financial statements beginning in the interim period ended September 30, 2009.

Following this Statement, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates. The FASB does not consider Accounting Standards Updates as authoritative in their own right. Accounting Standards Updates serve only to update the Codification, provide background information about the guidance, and provide the basis for conclusions on the change(s) in the Codification. FASB Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles”, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with GAAP. Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly. Upon becoming effective, all of the content of the Codification carries the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy has been modified to include only two levels of GAAP: authoritative and non-authoritative. As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy. The adoption of the Codification and ASU 2009-01 did not have any effect on the Company’s results of operations or financial position. All references to accounting literature included in the notes to the financial statements have been changed to reference the appropriate sections of the Codification.

In June 2009, the FASB issued Accounting Standards Update No. 2009-02 (“ASU 2009-02”), “Omnibus Update – Amendments to Various Topics for Technical Corrections.” The adoption of ASU 2009-02 did not have a material effect on the Company’s results of operations, financial position or disclosures.

In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (“ASU 2009-05”), “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value.” ASU 2009-05 applies to all entities that measure liabilities at fair value within the scope of ASC Topic 820. ASU 2009-05 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following techniques:

1) A valuation technique that uses:

a. The quoted price of the identical liability when traded as an asset

b. Quoted prices for similar liabilities or similar liabilities when traded as assets.

2) Another valuation technique that is consistent with the principles of ASC Topic 820. Two examples would be an income approach, such as a technique

that is based on the amount at the measurement date that the reporting entity would pay to transfer the identical liability or would receive to enter into the

identical liability.

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at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. The guidance provided in ASU 2009-5 became effective for the Company in the fourth quarter of 2009. Because the Company does not currently have any liabilities that are recorded at fair value, the adoption of this guidance did not have any impact on results of operations, financial position or disclosures.

ASU 2009-12, “Fair Value Measurements and Disclosures (Topic 820) - Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent),” issued in September, 2009, allows a company to measure the fair value of an investment that has no readily determinable fair market value on the basis of the investee's net asset value per share as provided by the investee. This allowance assumes that the investee has calculated net asset value in accordance with the GAAP measurement principles of Topic 946 as of the reporting entity's measurement date. Examples of such investments include investments in hedge funds, private equity funds, real estate funds and venture capital funds. The update also provides guidance on how the investment should be classified within the fair value hierarchy based on the value for which the investment can be redeemed. The amendment is effective for interim and annual periods ending after December 15, 2009 with early adoption permitted. The Company does not have investments in such entities and, therefore, there is no impact to our financial statements.

ASU 2009-13, “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force” was issued in October, 2009 and provides guidance on accounting for products or services (deliverables) separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable. The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price. The amendments in the Update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The Company does not expect the update to have an impact on its financial statements.

Issued October, 2009, ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity's own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs. The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company has no plans to issue convertible debt and, therefore, the update had no impact on its financial statements as of December 31, 2009.

In December 2009, the FASB issued Accounting Standards Update No. 2009-16 (“ASU 2009-16”), “Accounting for Transfers of Financial Assets”. ASU No. 2009-16 formally incorporates into the FASB Codification amendments to SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”, made by SFAS No. 166 “Accounting for Transfers of Financial Assets”, an amendment of FASB Statement No. 140, primarily to 1.) eliminate the concept of a qualifying special-purpose entity, 2.) limit the circumstances under which a financial asset should be derecognized when the entire financial asset has not been transferred to a non-consolidated entity, 3.) requires additional disclosures concerning a transferor’s continuing involvement with transferred financial assets and 4.) requires that all servicing assets and liabilities be measured at fair value. This guidance is effective as of the start of the first annual and interim reporting periods. ASU No. 2009-19 is not expected to have a material impact on the Company’s results of operations, financial position or disclosures; however the Company will need to review future loan participation agreements and other transfers of financial assets for compliance with the new standard.

In December 2009, the FASB issued Accounting Standards Update No. 2009-17 (“ASU 2009-17”), “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”. ASU No. 2009-17 formally incorporates into the FASB Codification amendments to FASB Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities”, made by SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” to require that a comprehensive qualitative analysis be performed to determine whether a holder of variable interests in a variable interest entity also has a controlling financial interest in the entity. In addition, the amendments require that the same type of analysis be applied to entities that were previously designated as qualified special-purpose entities. This ASU is effective as of the start of the first annual reporting period beginning after November 15, 2009, for interim periods within the first annual reporting period and for all subsequent annual and interim reporting periods. ASU No. 2009-17 is not expected to have a material impact on the Company’s financial position, results of operations or disclosures.

A-11

In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASU 2010-06”), “Improving Disclosures about Fair Value Measurements”. ASU No. 2010-06 amends FASB Accounting Standards Codification topic 820-10-50, “Fair Value Measurements and Disclosures”, to require additional information to be disclosed principally regarding Level 3 measurements and transfers to Level 1 and 2. In addition, enhanced disclosure is required concerning inputs and valuation techniques used to determine Level 2 and Level 3 measurements. This guidance is generally effective for interim and annual reporting periods beginning with December 15, 2009; however requirements to disclose separately purchases, sales, issuances and settlements in the Level 3 reconciliation are effective for fiscal years beginning after December 15, 2010 (and for interim periods within such years). ASU No. 2010-06 is not expected to have a material impact on the Company’s financial position or results of operations and will have a minimal impact on its disclosures.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company's financial position, results of operations or cash flows.

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- 32 through A- 66 .

Results of Operations

Summary. The Company reported earnings of $2.9 million in 2009, or $0.53 basic and diluted net earnings per common share before adjustment for preferred stock dividends and accretion as compared to $6.4 million, or $1.14 basic net earnings per common share and $1.13 diluted net earnings per common share for 2008. After adjusting for $1.2 million in dividends and accretion on preferred stock, net earnings available to common shareholders for the year ended December 31, 2009 were $1.7 million or $0.30 basic and diluted net earnings per common share. Net earnings from recurring operations for the year ended December 31, 2009 were $2.5 million, or $0.46 basic and diluted net earnings per share, before adjustment for preferred stock dividends and accretion, as compared to net earnings from recurring operations of $6.7 million, or $1.20 basic net earnings per share and $1.19 diluted net earnings per share, for the same period one year ago. The Company’s decrease in net earnings for 2009 is primarily attributable to an increase in provision for loan losses and an increase in non-interest expense, which were partially offset by an increase in non-interest income.

Net earnings for 2008 represented a decrease of 33% as compared to 2007 net earnings of $9.6 million or $1.68 basic net earnings per common share and $1.65 diluted net earnings per common share. The decrease in 2008 net earnings was primarily attributable to a decrease in net interest income, an increase in the provision for loan losses and an increase in non-interest expense, which was partially offset by an increase in non-interest income.

The return on average assets in 2009 was 0.29%, compared to 0.69% in 2008 and 1.13% in 2007. The return on average shareholders’ equity was 2.88% in 2009 compared to 8.38% in 2008 and 13.59% in 2007.

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 for 2009 increased to $32.9 million compared to $32.8 million in 2008. This increase is primarily attributable to a reduction in interest expense due to a decrease in the cost of funds for time deposits. Net interest income decreased 4% in 2008 from $34.1 million in 2007. The decrease in 2008 was primarily related 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.

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, 2009, 2008 and 2007. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on average total interest-earning assets for the same

A-12

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 of 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, 2009						December 31, 2008				December 31, 2007
(Dollars in thousands)	Average Balance				Interest	Yield / Rate	Average Balance		Interest	Yield / Rate	Average Balance		Interest		Yield / Rate
Interest-earning assets:

Loans	$	782,464			40,058	5.12%	747,203		46,808	6.26%	665,379		55,109		8.28%
Interest rate derivative contracts		-			3,114	0.40%	-		3,403	0.45%	-		(406	)	-0.06%
Loan fees		-			39	0.00%	-		393	0.05%	-		698		0.10%
Total loans		782,464			43,211	5.52%	747,203		50,604	6.77%	665,379		55,401		8.33%

Investments - taxable		81,642			3,477	4.26%	26,591		1,253	4.71%	20,305		868		4.27%
Investments - nontaxable*		79,493			4,226	5.32%	89,262		4,924	5.52%	99,991		5,470		5.47%
Federal funds sold		704			1	0.14%	3,050		55	1.80%	7,378		383		5.19%
Other		12,377			53	0.43%	10,319		293	2.84%	8,041		444		5.52%

Total interest-earning assets		956,680			50,968	5.33%	876,425		57,129	6.52%	801,094		62,566		7.81%

Cash and due from banks		31,225					21,331				20,081
Other assets		41,866					41,626				34,287
Allowance for loan losses		(13,514	)				(9,583	)			(8,626	)

Total assets	$	1,016,257					929,799				846,836


Interest-bearing liabilities:

NOW accounts	$	112,452			1,373	1.22%	92,612		1,269	1.37%	79,550		1,127		1.42%
Regular savings accounts		35,762			368	1.03%	17,423		50	0.29%	18,685		54		0.29%
Money market accounts		94,537			1,224	1.29%	93,564		1,930	2.06%	87,916		2,918		3.32%
Time deposits		412,127			9,687	2.35%	406,127		15,008	3.70%	361,859		17,430		4.82%
FHLB / FRB borrowings		84,547			3,596	4.25%	79,417		3,616	4.55%	80,058		3,759		4.70%
Demand notes payable to U.S. Treasury		805			-	0.00%	859		14	1.63%	814		39		4.79%
Trust preferred securities		20,619			546	2.65%	20,619		1,016	4.93%	20,619		1,476		7.16%
Other		35,411			393	1.11%	29,857		624	2.09%	16,226		782		4.82%

Total interest-bearing liabilities		796,260			17,187	2.16%	740,478		23,527	3.18%	665,727		27,585		4.14%

Demand deposits		117,197					111,192				111,164
Other liabilities		2,428					4,021				3,022
Shareholders' equity		101,162					76,241				70,586

Total liabilities and shareholders' equity	$	1,017,047					931,932				850,499

Net interest spread				$	33,781	3.17%			33,602	3.34%			34,981		3.67%

Net yield on interest-earning assets						3.53%				3.83%					4.37%

Taxable equivalent adjustment
Investment securities				$	931				806				834

Net interest income				$	32,850				32,796				34,147

*Includes U.S. government agency securities that are non-taxable for state income tax purposes of $45.5 million in 2009, $63.6 million in 2008 and $74.9 million in 2007. 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.

A-13

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


	December 31, 2009							December 31, 2008
(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	$	2,168		(9,561	)	(7,393	)	6,177		(10,974	)	(4,797	)

Investments - taxable		2,470		(246	)	2,224		282		102		384
Investments - nontaxable		(529	)	(169	)	(698	)	(589	)	43		(546	)
Federal funds sold		(23	)	(31	)	(54	)	(151	)	(177	)	(328	)
Other		33		(273	)	(240	)	95		(246	)	(151	)

Total interest income		4,119		(10,280	)	(6,161	)	5,814		(11,252	)	(5,438	)

Interest expense:

NOW accounts		257		(153	)	104		182		(40	)	142
Regular savings accounts		121		197		318		(4	)	-		(4	)
Money market accounts		16		(722	)	(706	)	152		(1,140	)	(988	)
Time deposits		181		(5,502	)	(5,321	)	1,884		(4,306	)	(2,422	)
FHLB / FRB Borrowings		226		(246	)	(20	)	(30	)	(113	)	(143	)
Demand notes payable to
U.S. Treasury		-		(14	)	(14	)	1		(27	)	(26	)
Trust Preferred Securities		-		(470	)	(470	)	-		(459	)	(459	)
Other		89		(320	)	(231	)	471		(630	)	(159	)

Total interest expense		890		(7,230	)	(6,340	)	2,656		(6,716	)	(4,059	)

Net interest income	$	3,229		(3,050	)	179		3,158		(4,536	)	(1,379	)

Net interest income on a tax equivalent basis totaled $33.8 million in 2009 as compared to $33.6 million in 2008. The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.17% in 2009, a decrease from the 2008 net interest spread of 3.34%. The net yield on interest-earning assets in 2009 decreased to 3.53% from the 2008 net interest margin of 3.83%.

Tax equivalent interest income decreased $6.2 million or 11% in 2009 primarily due to a reduction in the Bank’s prime commercial lending rate. The yield on interest-earning assets decreased to 5.33% in 2009 from 6.52% in 2008 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 $80.3 million primarily as the result of a $35.3 million increase in average loans and a $45.3 million increase in average investment securities over 2008. All other interest-earning assets including federal funds sold were $13.1 million in 2009 and $13.4 million in 2008.

Interest expense decreased $6.3 million or 27% in 2009 due to a decrease in the average rate paid on interest-bearing liabilities. The cost of funds decreased to 2.16% in 2009 from 3.18% in 2008. 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 $55.8 million growth in average interest-bearing liabilities was primarily attributable to an increase in interest-bearing checking and savings accounts of $39.2 million to $242.8 million in 2009 from $203.6 million in 2008.

In 2008 net interest income on a tax equivalent basis decreased $1.4 million or 4% to $33.6 million in 2008 from $35.0 million in 2007. The interest rate spread was 3.34% 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%.

A-14

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, 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 $10.5 million, $4.8 million, and $2.0 million for the years ended December 31, 2009, 2008 and 2007, respectively. The increase in the provision for loan losses for 2009 is primarily attributable to an increase in non-performing assets and a $3.3 million increase in net charge-offs. 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 2009 totaled $11.8 million, an increase of $1.3 million or 13% from non-interest income of $10.5 million for 2008. This increase in non-interest income is attributable to an increase in gains on sale of securities which were partially offset by an increase in write-downs of securities and a decrease in miscellaneous income and other service charges and fees when compared to the same period last year. Recurring non-interest income increased 2% to $11.2 million for the year ended December 31, 2009, as compared to $11.0 million for the same period one year ago. The increase in recurring non-interest income is primarily due to a $167,000 increase in mortgage banking income resulting from increased mortgage loan demand. Net non-recurring gains of $574,000 for the year ended December 31, 2009 included a $1.8 million gain on sale of securities, which was partially offset by write-downs of three securities totaling $723,000. This $1.1 million net gain on the sale and write-down of securities for the year ended December 31, 2009 was partially offset by a $498,000 net loss on the disposition of assets. Net non-recurring losses of $456,000 for the year ended December 31, 2008 were due to a $167,000 loss on the sale of securities and a $289,000 net loss on the disposition of assets.

Non-interest income for 2008 increased $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 when compared to the same period in 2007. 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 2008 when compared to 2007.

Service charges on deposit accounts totaled $5.6 million during 2009, an increase of $370,000, or 7% over 2008. Service charge income increased $925,000, or 22% in 2008 compared to 2007. 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 decreased to $2.1 million for the year ended December 31, 2009 as compared to $2.4 million for the same period one year ago. This decrease is primarily attributable to a decrease in check cashing fees.

The Company reported net gains on sale and write-downs of securities of $1.1 million in 2009 and net losses on sale and write-downs of securities of $167,000 and $562,000 in 2008 and 2007, respectively. The Company periodically evaluates its investments for any impairment which would be deemed other than temporary. As part of its evaluation in 2009, the Company determined that the fair values of three investments were less than the original cost of the investments and that the decline in fair value was not temporary in nature. As a result, the Company wrote down its original investments by $723,000. The remaining fair value of the investments at December 31, 2009 was $11,000. Similarly, as part of its evaluation in 2008, the Company wrote down one investment by $300,000. The remaining fair value of the investments at December 31, 2008 was $22,000.

During the year ended 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 $827,000 in 2009 from $660,000 in 2008 primarily due to an increase in mortgage loan demand. During 2008 mortgage banking income increased $100,000 from the $560,000 reported in 2007. The increase in mortgage banking income for 2008 was primarily attributable to an increase in brokered loan activity.

Net losses on other real estate and repossessed assets were $501,000, $287,000 and $118,000 for 2009, 2008 and 2007, respectively. The increase in net losses on other real estate and repossessed assets during 2009 was primarily attributable to increased write-downs on foreclosed property for the year ended December 31, 2009 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 2009.

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Miscellaneous income for 2009 totaled $2.4 million, an increase of 5% from $2.3 million for 2008. During 2008, miscellaneous income increased 3% from $2.2 million for 2007.

Table 3 presents a summary of non-interest income for the years ended December 31, 2009, 2008 and 2007.

Table 3 - Non-Interest Income

(Dollars in thousands)	2009			2008		2007
Service charges	$	5,573		5,203		4,279
Other service charges and fees		2,058		2,399		1,938
Gain (loss) on sale of securities		1,072		(167	)	(562	)
Mortgage banking income		827		660		560
Insurance and brokerage commissions		414		426		521
Loss on foreclosed and repossessed assets		(501	)	(287	)	(118	)
Miscellaneous		2,380		2,261		2,198
Total non-interest income	$	11,823		10,495		8,816

Non-Interest Expense. Total non-interest expense amounted to $29.9 million for 2009, an increase of 3% from 2008. Non-interest expense for 2008 increased 11% to $28.9 million from non-interest expense of $26.0 million for 2007.

Salary and employee benefit expense was $14.8 million in 2009, compared to $15.2 million during 2008, a decrease of $436,000 or 3%, following a $1.3 million or 9% increase in salary and employee benefit expense in 2008 over 2007. The decrease in salary and employee benefits in 2009 is primarily due to a reduction in incentive expense. The increase in salary and employee benefits in 2008 was primarily related to normal salary increases and expense associated with additional staff for new branches.

The Company recorded occupancy expenses of $5.4 million in 2009, compared to $5.0 million during 2008, an increase of $380,000 or 8%, following an increase of $278,000 or 6% in occupancy expenses in 2008 over 2007. The increases in 2009, 2008 and 2007 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 $1.0 million or 12% to $9.7 million during 2009. The increase in other expense for 2009 is primarily attributable to a $1.2 million increase in FDIC insurance expense due to an increase in 2009 FDIC insurance assessment rates combined with a $453,000 FDIC insurance special assessment paid in September 2009. Other operating expense increased $1.3 million or 18% in 2008 over 2007. The increase in other expense for 2008 is primarily attributable an increase 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

Table 4 presents a summary of non-interest expense for the years ended December 31, 2009, 2008 and 2007.

Table 4 - Non-Interest Expense

(Dollars in thousands)	2009		2008	2007
Salaries and wages	$	11,530	11,591	10,276
Employee benefits		3,228	3,603	3,612
Total personnel expense		14,758	15,194	13,888
Occupancy expense		5,409	5,029	4,751
Office supplies		426	564	554
FDIC deposit insurance		1,766	547	140
Professional services		358	422	400
Postage		342	360	320
Telephone		616	476	405
Director fees and expense		350	450	499
Advertising		860	1,076	988
Consulting fees		198	385	460
Taxes and licenses		248	193	272
Other operating expense		4,552	4,197	3,316
Total non-interest expense	$	29,883	28,893	25,993

A-16

Income Taxes. Total income tax expense was $1.3 million in 2009 compared with $3.2 million in 2008 and $5.3 million in 2007. The primary reason for the decrease in taxes for 2009 as compared to 2008 and 2007 was the decrease in pretax income. The Company’s effective tax rates were 31.47%, 33.46% and 35.76% in 2009, 2008 and 2007, respectively.

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, 2009 such unfunded commitments to extend credit were $140.2 million, while commitments in the form of standby letters of credit totaled $3.3 million.

The Company uses several sources to meet its liquidity requirements. The primary source is core deposits, which includes demand deposits, savings accounts and non-brokered 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, 2009, the Company’s core deposits totaled $569.0 million, or 70% 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. In third quarter 2008, the Bank significantly improved its funding capacity by pledging loans to the Federal Reserve Bank ("FRB"). The Bank’s policies include the ability to access wholesale funding up to 40% of total assets. The Bank’s wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits, internet certificates of deposit and certificates of deposit issued to the State of North Carolina. The Company’s ratio of wholesale funding to total assets was 15.75% as of December 31, 2009.

At December 31, 2009, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $84.0 million, which have an average maturity of 14 months. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits. Access to the brokered deposit market could be restricted if the Bank were to fall below the well capitalized level. 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, 2009. At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $147.0 million. As additional collateral, the Bank has pledged securities to FHLB. At December 31, 2009, the market value of securities pledged to FHLB totaled $7.5 million. The remaining availability at FHLB was $3.5 million at December 31, 2009. The Bank had no borrowings from the FRB at December 31, 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, 2009, the carrying value of loans pledged as collateral to the FRB totaled approximately $428.2 million. During 2009, the Bank increased its overall borrowing capacity by pledging commercial real estate loans to the FRB that were previously pledged to the FHLB.

The Bank also had the ability to borrow up to $40.5 million for the purchase of overnight federal funds from four correspondent financial institutions as of December 31, 2009.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 19.10% at December 31, 2009, 11.71% at December 31, 2008 and 13.93% at December 31, 2007. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy for on balance sheet liquidity is 10%.

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $4.6 million during 2009. Net cash used in investing activities of $80.3 million consisted primarily of purchases of available-for-sale investments totaling $141.8 million which were partially offset by maturities, calls and sales of available-for-sale investments which totaled $71.4 million. Net cash provided by financing activities amounted to $79.1 million, primarily from a $88.3 million net increase in deposits which was partially offset by a reduction in FRB borrowings of $5.0 million.

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

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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, 2009.

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	$	506,108	7,751		27,801		541,660		236,396	778,056
Mortgage loans held for sale		2,840	-		-		2,840		-	2,840
Investment securities		-	1,798		2,646		4,444		190,671	195,115
Interest-bearing deposit accounts		1,458	249		-		1,707		-	1,707
Certificates of deposit		-	-		3,345		3,345		-	3,345
Other interest-earning assets		-	-		-		-		6,954	6,954

Total interest-earning assets		510,406	9,798		33,792		553,996		434,021	988,017

Interest-bearing liabilities:
NOW, savings, and money market deposits		290,273	-		-		290,273		-	290,273
Time deposits		42,465	107,827		142,271		292,563		108,871	401,434
Other short term borrowings		636	-		-		636		-	636
FHLB borrowings		-	5,000		2,000		7,000		70,000	77,000
Securities sold under
agreement to repurchase		36,876	-		-		36,876		-	36,876
Trust preferred securities		-	20,619		-		20,619		-	20,619

Total interest-bearing liabilities		370,250	133,446		144,271		647,967		178,871	826,838

Interest-sensitive gap	$	140,156	(123,648	)	(110,479	)	(93,971	)	255,150	161,179

Cumulative interest-sensitive gap	$	140,156	16,508		(93,971	)	(93,971	)	161,179

Interest-earning assets as a percentage of
interest-bearing liabilities		137.85%	7.34%		23.42%		85.50%		242.64%

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, 2009 totaled $956.7 million, exceeding rate sensitive liabilities of $796.3 million by $160.4 million.

Included in the rate sensitive assets are $490.4 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,

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2009, the Bank had $317.8 million in loans with interest rate floors. The floors were in effect on $315.5 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 1.19% higher than the indexed rate on the promissory notes without interest rate floors.

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, 2009, the Company had a cash flow hedge with a notional amount of $50.0 million. This derivative instrument consists of one interest rate swap contract. 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, 2009) on the notional amount of $50.0 million. The swap agreement matures in June 2011. The Company recognized $3.1 million in interest income, net of premium amortization, from interest rate derivative contracts during the year ended December 31, 2009. Based on the current interest rate environment, it is expected the Company will continue to receive income on this interest rate contract throughout 2010. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company recognized a hedge ineffectiveness gain of $1,000 in earnings during the year ended December 31, 2009.

Table 6 presents additional information on the Company’s derivative financial instruments as of December 31, 2009.

Table 6 - Derivative Instruments
(Dollars in thousands)
Type of Derivative	Notional A mount		Contract Rate	Year-to-date Income (Net of Premium Amortization)
Interest rate floor contact*		-	-		106
Interest rate floor contact*		-	-		623
Interest rate floor contact*		-	-		912
Interest rate swap contact expiring 06/01/11		50,000	6.245%		1,472
	$	50,000		$	3,114

* Interest rate floor contracts expired during 2009

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, 2009 the market value of AFS securities totaled $195.1 million, compared to $124.9 million and $121.0 million at December 31, 2008 and 2007, respectively. The increase in 2009 investment securities is primarily due to $87.9 million in securities purchased to offset the cost of the Company’s CPP dividend. Table 7 presents the market value of the AFS securities held at December 31, 2009, 2008 and 2007.

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Table 7 - Summary of Investment Portfolio

(Dollars in thousands)	2009		2008	2007
Obligations of United States government
sponsored enterprises	$	41,142	58,487	76,992

Obligations of states and political subdivisions		44,336	26,973	25,905

Mortgage-backed securities		107,526	37,271	16,271

Trust preferred securities		1,250	1,250	250

Equity securities		861	935	1,550

Total securities	$	195,115	124,916	120,968

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 $161.1 million in 2009, $115.9 million in 2008 and $120.3 million in 2007. Table 8 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2009. 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 8 - 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
sponsored enterprises	$	-	-	11,998	5.25%	23,358	5.37%	4,903	5.81%	40,259	5.39%

States and political subdivisions		2,566	2.83%	10,727	3.48%	10,303	4.29%	19,864	4.23%	43,460	3.97%

Mortgage backed securities		-	-	1,924	4.55%	19,220	5.21%	84,771	5.48%	105,915	5.41%

Trust preferred securities		-	-	-	-	500	5.09%	750	5.76%	1,250	5.49%

Equity securities		-	-	-	-	-	-	1,233	0.00%	1,233	0.00%

Total securities	$	2,566	2.83%	24,649	4.43%	53,381	5.10	111,521	5.21%	192,117	5.05%

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.

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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. Real estate mortgage loans include both commercial and residential mortgage loans. At December 31, 2009, the Company had $116.1 million in residential mortgage loans, $99.1 million in home equity loans and $297.8 million in commercial mortgage loans, which include $231.2 million using commercial property as collateral and $66.6 million using residential property as collateral. At December 31, 2009, real estate construction loans included $101.9 million in speculative construction and development loans.

Residential mortgage loans include $55.4 million made to customers in the Company’s traditional banking offices and $60.7 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.

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, 2009 there were 21 loans with an outstanding balance of $2.1million that were 30 days or more past due and two loans more than 90 days past due totaling $369,000.

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, 2009, 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 experienced a decline in values within the residential real estate market. At December 31, 2009 there were 113 loans with an outstanding balance of $12.6 million 30 days or more past due and 12 loans more than 90 days past due totaling $1.3 million. Total losses on this portfolio, since the first loans were originated in 2004, have amounted to approximately $706,000 through December 31, 2009.

As a recipient of CPP funds, the Bank will continue 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 9.

Table 9 - Loan Portfolio

	2009				2008			2007			2006			2005
(Dollars in thousands)	Amount		% of Loans		Amount	% of Loans		Amount	% of Loans		Amount	% of Loans		Amount	% of Loans
Breakdown of loan receivables:
Commercial	$	67,487	8.67	%	76,945	9.85	%	82,190	11.38	%	85,064	13.06	%	79,902	14.10	%
Real estate - mortgage		512,963	65.93	%	474,732	60.77	%	417,709	57.83	%	364,595	55.97	%	330,227	58.28	%
Real estate - construction		169,680	21.81	%	216,188	27.67	%	209,644	29.03	%	187,960	28.86	%	141,420	24.96	%
Consumer		27,926	3.59	%	13,323	1.71	%	12,734	1.76	%	13,762	2.11	%	15,115	2.66	%

Total loans	$	778,056	100.00	%	781,188	100.00	%	722,277	100.00	%	651,381	100.00	%	566,664	100.00	%

Less: Allowance for loan losses		15,413			11,025			9,103			8,303			7,425

Net loans	$	762,643			770,163			713,174			643,078			559,239

As of December 31, 2009, gross loans outstanding were $778.1 million, a decrease of $3.1 million from the December 31, 2008 balance of $781.2 million. Commercial loans decreased $9.5 million in 2009. Real estate mortgage loans grew $38.2 million when compared to 2008 due to an increase in non-conforming mortgage loans and commercial real estate loans. Real estate construction loans decreased $46.5 million in 2009 as a result of a decrease in real estate development loans. Consumer loans increased $14.6 million in 2009. Loans originated or renewed during the year ended December 31, 2009 amounting to approximately $135.2 million were offset by paydowns and payoffs of existing loans. The Bank has modified terms on mortgage loans totaling $19.5 million during the year ended December 31, 2009. Average loans represented 82% and 85% of total earning assets for the years ended December 31, 2009 and 2008, respectively. The Company had $2.8 million in mortgage loans held for sale as of December 31, 2009 and no mortgage loans held for sale as of December 31, 2008.

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Table 10 identifies the maturities of all loans as of December 31, 2009 and addresses the sensitivity of these loans to changes in interest rates.

Table 10 - 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	$	57,181	9,563	743	67,487
Real estate - mortgage		307,750	147,484	57,729	512,963
Real estate - construction		159,823	8,730	1,127	169,680
Consumer		16,906	10,723	297	27,926

Total loans	$	541,660	176,500	59,896	778,056

Total fixed rate loans	$	30,329	135,847	59,896	226,072
Total floating rate loans		511,331	40,653	-	551,984

Total loans	$	541,660	176,500	59,896	778,056

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, 2009, outstanding loan commitments totaled $140.2 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.

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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. 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, 2009 and 2008, the recorded investment in loans that were considered to be impaired was approximately $16.6 million and $7.5 million, respectively, with related allowance for loan losses of approximately $673,000 and $462,000 for December 31, 2009 and 2008, respectively.

The general allowance reflects reserves established under GAAP 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 GAAP 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, 2009 as compared to the year ended December 31, 2008. 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. Also, a loan review process further assists with evaluating credit quality and assessing potential performance issues.

Net charge-offs for 2009 were $6.1 million. The ratio of net charge-offs to average total loans was 0.79% in 2009, 0.38% in 2008 and 0.19% in 2007. Management expects the ratio of net charge-offs to average total loans to increase again in 2010 due to the recessionary economic conditions and the decline in real estate values and new home sales. The allowance for loan losses increased to $15.4 million or 1.98% of total loans outstanding at December 31, 2009. For December 31, 2008 and 2007, the allowance for loan losses amounted to $11.0 million or 1.41% of total loans outstanding and $9.1 million, or 1.26% of total loans outstanding, respectively. Management would expect the percentage of the allowance for loan losses to total loans to increase in 2010 if non-performing loans continue to increase as a result of the current recessionary economic conditions.

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Table 11 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, 2009 and 2008.

Table 11 - Loan Risk Grade Analysis
	Percentage of Loans
	By Risk Grade*
Risk Grade	2009	2008
Risk Grade 1 (Excellent Quality)	3.52%	4.08%
Risk Grade 2 (High Quality)	16.34%	17.95%
Risk Grade 3 (Good Quality)	51.12%	63.08%
Risk Grade 4 (Management Attention)	17.16%	10.42%
Risk Grade 5 (Watch)	7.43%	2.14%
Risk Grade 6 (Substandard)	1.45%	0.80%
Risk Grade 7 (Low Substandard)	0.04%	0.00%
Risk Grade 8 (Doubtful)	0.00%	0.00%
Risk Grade 9 (Loss)	0.00%	0.00%

* Excludes non-accrual loans

Table 12 presents an analysis of the allowance for loan losses, including charge-off activity.

Table 12 - Analysis of Allowance for Loan Losses

(Dollars in thousands)	2009		2008	2007	2006	2005
Reserve for loan losses at beginning	$	11,025	9,103	8,303	7,425	8,049

Loans charged off:
Commercial		697	249	414	505	293
Real estate - mortgage		3,384	1,506	471	568	2,141
Real estate - construction		1,754	644	252	250	1,250
Consumer		835	748	489	636	516

Total loans charged off		6,670	3,147	1,626	1,959	4,200

Recoveries of losses previously charged off:
Commercial		111	87	86	64	144
Real estate - mortgage		161	8	21	108	162
Real estate - construction		36	30	102	2	-
Consumer		215	150	179	150	160

Total recoveries		523	275	388	324	466

Net loans charged off		6,147	2,872	1,238	1,635	3,734

Provision for loan losses		10,535	4,794	2,038	2,513	3,110

Reserve for loan losses at end of year	$	15,413	11,025	9,103	8,303	7,425

Loans charged off net of recoveries, as
a percent of average loans outstanding		0.79%	0.38%	0.19%	0.27%	0.68%

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 $28.8 million at December 31, 2009 compared to $14.2 million at December 31, 2008. Non-accrual loans were $22.8 million at December 31, 2009, an increase of $11.0 million from non-accruals of $11.8 million at December 31, 2008. As a percentage of loans outstanding, non-accrual loans were 2.93% and 1.51% at December 31, 2009 and 2008, respectively. The Bank had $2.0 million and $514,000 in loans 90 days past due and still accruing at December 31, 2009 and 2008, respectively. Other real estate owned totaled $4.0 million and $1.9 million as of December 31, 2009 and 2008, respectively. The Bank had no repossessed assets as of December 31, 2009 and 2008.

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At December 31, 2009, the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $24.8 million or 3.18% of total loans. Non-performing loans for 2008 were $12.3 million, or 1.58% of total loans and $8.0 million, or 1.11% of total loans for 2007. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2009, 2008 and 2007, had they performed in accordance with their original terms, amounted to approximately $1.6 million, $850,000 and $693,000, respectively. Interest income on impaired loans included in the results of operations for 2009, 2008, and 2007 amounted to approximately $53,000, $57,000 and $29,000, 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 2010.

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 13.

Table 13 - Non-performing Assets

(Dollars in thousands)	2009		2008	2007	2006	2005
Non-accrual loans	$	22,789	11,815	7,987	7,560	3,492
Loans 90 days or more past due and still accruing		1,977	514	-	78	946
Total non-performing loans		24,766	12,329	7,987	7,638	4,438
All other real estate owned		3,997	1,867	483	344	531
Total non-performing assets	$	28,763	14,196	8,470	7,982	4,969

As a percent of total loans at year end
Non-accrual loans		2.93%	1.51%	1.11%	1.16%	0.62%
Loans 90 days or more past due and still accruing		0.25%	0.07%	0.00%	0.01%	0.17%
Total non-performing assets		3.70%	1.82%	1.17%	1.23%	0.88%

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, 2009, total deposits were $809.3 million, an increase of $88.3 million or 12% increase over the December 31, 2008 balance of $721.1 million. Core deposits, which include demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $100,000, increased to $569.0 million at December 31, 2009 from $497.2 million at December 31, 2008.

Time deposits in amounts of $100,000 or more totaled $233.1 million, $220.4 million and $203.5 million at December 31, 2009, 2008 and 2007, respectively. At December 31, 2009, brokered deposits amounted to $84.0 million as compared to $61.0 million at December 31, 2008. This increase is primarily due to a $10.8 million increase in certificates of deposit issued through the Certificate of Deposit Account Registry Service (CDARS) as of December 31, 2009 compared to December 31, 2008. 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, 2009 have a weighted average rate of 1.90% with a weighted average original term of 14 months.

A-25

Table 14 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2009.

Table 14 - Maturities of Time Deposits over $100,000

(Dollars in thousands)	2009
Three months or less	$	89,013
Over three months through six months		57,696
Over six months through twelve months		24,080
Over twelve months		62,353
Total	$	233,142

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, 2009 and 2008, FHLB borrowings totaled $77.0 million compared to $87.5 million at December 31, 2007. Average FHLB borrowings for 2009 were $77.3 million, compared to average balances of $79.2 million for 2008 and $80.1 million for 2007. The maximum amount of outstanding FHLB borrowings was $87.9 million in 2009, and $97.6 in 2008 and $95.0 in 2007. The FHLB borrowings outstanding at December 31, 2009 had fixed interest rates ranging from 3.71% to 6.49%. At December 31, 2009, $70.0 million 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 an advance that has been converted to a fixed rate by the FHLB, which may be repaid with a prepayment fee. Additional information regarding FHLB borrowings is provided in Note 6 to the Consolidated Financial Statements.

The Bank had no borrowings from the FRB at December 31, 2009. At December 31, 2008, FRB borrowings totaled $5.0 million. This borrowing was a 28-day Term Auction Facility loan at an interest rate of 0.28% which matured in January 2009.

Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from customers, amounted to approximately $636,000 and $1.6 million at December 31, 2009 and 2008, respectively.

Securities sold under agreements to repurchase amounted to $36.9 million and $37.5 million as of December 31, 2009 and 2008, respectively.

Junior Subordinated Debentures (related to Trust Preferred Securities). 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 to repay in December 2007 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 has 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.

A-26

Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations and other commitments as of December 31, 2009 are summarized in Table 15 below. The Company’s contractual obligations include the repayment of principal and interest related to FHLB advances and junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.

Table 15 - 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	$	7,000	5,000	15,000	50,000	77,000
Junior subordinated debentures		-	-	-	20,619	20,619
Operating lease obligations		653	1,056	498	1,652	3,859

Total	$	7,653	6,056	15,498	72,271	101,478

Other Commitments
Commitments to extend credit	$	45,629	4,405	2,876	87,297	140,207
Standby letters of credit
and financial guarantees written		3,302	-	-	-	3,302

Total	$	48,931	4,405	2,876	87,297	143,509

The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-19 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.

Capital Resources. Shareholders’ equity at December 31, 2009 was $99.2 million compared to $101.1 million at December 31, 2008 and $70.1 million at December 31, 2007. Unrealized gains and losses, net of taxes, at December 31, 2009, 2008 and 2007 amounted to gains of $2.9 million, $5.5 million and $1.7 million, respectively. Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength. Average shareholders’ equity as a percentage of total average assets was 9.95%, 8.20% and 8.34% for 2009, 2008 and 2007. The return on average shareholders’ equity was 2.88% at December 31, 2009 as compared to 8.38% and 13.59% as of December 31, 2008 and December 31, 2007, respectively. Total cash dividends paid on common stock during 2009 amounted to $1.4 million. Cash dividends totaling $2.7 million and $2.3 million were paid during 2008 and 2007, respectively. The Company paid dividends totaling $1.1 million on preferred stock during 2009. There were no dividends paid on preferred stock during the years ended December 31, 2008 and 2007.

In August 2007, the Company’s Board of Directors authorized the repurchase of up to 75,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of August 2008. The Company repurchased 50,497 shares, or $873,000, of its common stock under this plan during 2007. The Company repurchased 25,000 shares, or $350,000, of its common stock under this plan during 2008. The Board of Directors ratified the purchase of 497 additional shares in March 2008.

In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009. The Company repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008. Because of the Company’s participation in the U.S. Treasury Department’s CPP, discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without UST approval.

A-27

The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.

On December 23, 2008, the Company entered into a Securities Purchase Agreement (“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. As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock. The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000. 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 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 above the last quarterly dividend of $0.12 per share paid prior to December 23, 2008; 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.

Under regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital at December 31, 2009, 2008 and 2007 includes $20.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 13.74%, 13.65% and 11.03% at December 31, 2009, 2008 and 2007, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 15.00%, 14.90% and 12.16% at December 31, 2009, 2008 and 2007, respectively. In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 11.42%, 12.40% and 10.43% at December 31, 2009, 2008 and 2007, respectively.

The Bank’s Tier 1 risk-based capital ratio was 11.22%, 9.85% and 9.80% at December 31, 2009, 2008 and 2007, respectively. The total risk-based capital ratio for the Bank was 12.48%, 11.10% and 10.93% at December 31, 2009, 2008 and 2007, respectively. The Bank’s Tier 1 leverage capital ratio was 9.33%, 8.94% and 9.26% at December 31, 2009, 2008 and 2007 respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at December 31, 2009, 2008 and 2007.

A-28

The Company’s key equity ratios as of December 31, 2009, 2008 and 2007 are presented in Table 16.

Table 16 - Equity Ratios

	2009	2008	2007
Return on average assets	0.29%	0.69%	1.13%
Return on average equity	2.88%	8.38%	13.59%
Dividend payout ratio *	86.22%	41.93%	24.30%
Average equity to average assets	9.95%	8.20%	8.34%
* As a percentage of net earnings available to common shareholders.

Quarterly Financial Data. The Company’s consolidated quarterly operating results for the years ended December 31, 2009 and 2008 are presented in Table 17.

Table 17 - Quarterly Financial Data

	2009						2008
(Dollars in thousands, except per share amounts)	First		Second	Third		Fourth	First		Second	Third	Fourth

Total interest income	$	12,581	12,523	12,403		12,530	$	14,553	14,072	14,122	13,576
Total interest expense		4,702	4,324	4,132		4,029		6,680	5,700	5,627	5,520

Net interest income		7,879	8,199	8,271		8,501		7,873	8,372	8,495	8,056

Provision for loan losses		1,766	2,251	3,139		3,379		391	681	1,035	2,687
Other income		2,186	4,251	2,503		2,883		2,607	2,802	2,506	2,580
Other expense		7,342	7,956	7,344		7,241		6,930	7,113	7,278	7,572

Income before income taxes		957	2,243	291		764		3,159	3,380	2,688	377
Income taxes		332	883	(9	)	133		1,103	1,188	942	(20	)

Net earnings		625	1,360	300		631		2,056	2,192	1,746	397

Dividends and accretion of preferred
stock		201	349	348		348		-	-	-	-

Net earnings (loss) available
to common shareholders	$	424	1,011	(48	)	283	$	2,056	2,192	1,746	397

Basic earnings per common share	$	0.08	0.18	(0.01	)	0.05	$	0.37	0.39	0.31	0.07
Diluted earnings per common share	$	0.08	0.18	(0.01	)	0.05	$	0.36	0.39	0.31	0.07

A-29

QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates. This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.

The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely (positively) impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off-balance sheet derivative instruments. During the years ended December 31, 2009, 2008 and 2007, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management.”

Table 18 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments and the notional amount and estimated fair value of the Company’s off-balance sheet derivative instruments at their expected maturity dates for the period ended December 31, 2009. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2009. All convertible FHLB advances are callable at the option of FHLB. For core deposits without contractual maturity (i.e. interest bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.

Table 18 - Interest Rate Risk

(Dollars in thousands)
		Estimated Resulting Theoretical Net Interest Income
Hypothetical rate change (ramp over 12 months)		Amount		% Change
	+2%	$	34,296	2.84%
	+1%	$	33,679	0.99%
	0%	$	33,348	0.00%
	-1%	$	33,119	-0.69%
	-2%	$	32,837	-1.53%



		Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)		Amount		% Change
	+2%	$	84,719	-9.97%
	+1%	$	90,621	-3.70%
	0%	$	94,098	0.00%
	-1%	$	99,547	5.79%
	-2%	$	105,540	12.16%

A-30

Table 19 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps.” The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1% and 2% as compared to the estimated theoretical impact of rates remaining unchanged. The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the theoretical impact of rates remaining unchanged. The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates. This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes. Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.

Table 19 - Market Risk Table

(Dollars In Thousands)	Principal/Notional Amount Maturing in Year Ended December 31,
Loans Receivable	2010		2011	2012	2013 & 2014	Thereafter	Total	Fair Value
Fixed rate	$	40,661	21,164	36,311	81,016	46,920	226,072	227,368
Average interest rate		6.71%	7.04%	7.07%	6.27%	7.19%
Variable rate	$	248,988	49,482	35,462	61,846	156,206	551,984	551,984
Average interest rate		4.53%	4.41%	4.49%	4.53%	5.40%
							778,056	779,352
Investment Securities
Interest bearing cash	$	249	-	-	-	1,458	1,707	1,707
Average interest rate		0.50%	-	-	-	-
Securities available for sale	$	28,561	25,923	32,397	36,623	71,611	195,115	195,115
Average interest rate		5.12%	5.31%	5.40%	5.00%	4.78%
Nonmarketable equity securities	$	-	-	-	-	6,345	6,345	6,345
Average interest rate		-	-	-	-	0.34%
Certificates of Deposit	$	3,345	-	-	-	-	3,345	3,345
Average interest rate		1.32%	-	-	-	-

Debt Obligations
Deposits	$	292,247	39,069	66,784	3,322	407,921	809,343	809,081
Average interest rate		1.76%	2.02%	2.28%	2.46%	0.89%
Advances from FHLB	$	7,000	5,000	10,000	40,000	15,000	77,000	86,680
Average interest rate		6.05%	4.21%	4.43%	4.66%	4.14%
Demand notes payable to U.S. Treasury	$	636	-	-	-	-	636	636
Average interest rate		-	-	-	-	-
Securities sold under agreement to repurchase	$	36,876					36,876	36,876
Average interest rate		1.09%
Junior subordinated debentures	$	-	-	-	-	20,619	20,619	20,619
Average interest rate		-	-	-	-	1.90%

Derivative Instruments (notional amount)
Interest rate swap contracts	$	-	50,000	-	-	-	50,000	1,762
Average interest rate		-	6.25%	-	-	-

A-31

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES
Consolidated Financial Statements
December 31, 2009, 2008 and 2007


INDEX

	PAGE(S)

Report of Independent Registered Public Accounting Firm on the Consolidated Financial Statements	A-33

Financial Statements
Consolidated Balance Sheets at December 31, 2009 and December 31, 2008	A-34

Consolidated Statements of Earnings for the years ended December 31, 2009, 2008 and 2007	A-35

Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2009, 2008 and 2007	A-36

Consolidated Statements of Comprehensive Income for the years ended December 31, 2009, 2008 and 2007	A-37

Consolidated Statements of Cash Flows for the years ended December 31, 2009, 2008 and 2007	A-38 - A-39

Notes to Consolidated Financial Statements	A-40 - A-66

A-32

Porter Keadle Moore, LLP

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Peoples Bancorp of North Carolina, Inc.

Newton, North Carolina

We have audited the accompanying consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Bancorp of North Carolina and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.

We were not engaged to examine management's assessment of the effectiveness of Peoples Bancorp of North Carolina, Inc’s. internal control over financial reporting as of December 31, 2009, included in the accompanying Management’s Report of Internal Controls Over Financial Reporting and, accordingly, we do not express an opinion thereon.

/s/ Porter Keadle Moore, LLP

Atlanta, Georgia

February 25, 2010

Certified Public Accountants
Suite 1800	●	235 Peachtree Street NE	●	Atlanta, Georgia 30303	●	Phone 404-588-4200	●	Fax 404-588-4222	●	www.pkm.com

A-33

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2009 and 2008

(Dollars in thousands)
Assets	2009			2008


Cash and due from banks, including reserve requirements	$	29,633		19,743
of $5,017,000 and $7,257,000
Interest bearing deposits		1,707		1,453
Federal funds sold		-		6,733
Cash and cash equivalents		31,340		27,929

Certificates of deposit		3,345		-

Investment securities available for sale		195,115		124,916
Other investments		6,346		6,303
Total securities		201,461		131,219

Mortgage loans held for sale		2,840		-

Loans		778,056		781,188
Less allowance for loan losses		(15,413	)	(11,025	)
Net loans		762,643		770,163

Premises and equipment, net		17,947		18,297
Cash surrender value of life insurance		7,282		7,019
Accrued interest receivable and other assets		21,636		14,135
Total assets	$	1,048,494		968,762

Liabilities and Shareholders' Equity

Deposits:
Non-interest bearing demand	$	117,636		104,448
NOW, MMDA & savings		290,273		210,058
Time, $100,000 or more		233,142		220,374
Other time		168,292		186,182
Total deposits		809,343		721,062

Demand notes payable to U.S. Treasury		636		1,600
Securities sold under agreement to repurchase		36,876		37,501
Short-term Federal Reserve Bank borrowings		-		5,000
FHLB borrowings		77,000		77,000
Junior subordinated debentures		20,619		20,619
Accrued interest payable and other liabilities		4,797		4,852
Total liabilities		949,271		867,634

Shareholders' equity:

Series A preferred stock, $1,000 stated value; authorized
5,000,000 shares; issued and outstanding
25,054 shares in 2009 and 2008		24,476		24,350
Common stock, no par value; authorized
20,000,000 shares; issued and outstanding
5,539,056 shares in 2009 and 2008		48,269		48,269
Retained earnings		23,573		22,985
Accumulated other comprehensive income		2,905		5,524
Total shareholders' equity		99,223		101,128

Total liabilities and shareholders' equity	$	1,048,494		968,762

See accompanying notes to consolidated financial statements.

A-34

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

For the Years Ended December 31, 2009, 2008 and 2007

(Dollars in thousands)

	2009			2008		2007


Interest income:
Interest and fees on loans	$	43,211		50,604		55,401
Interest on federal funds sold		1		55		383
Interest on investment securities:
U.S. Government sponsored enterprises		5,461		4,392		4,572
States and political subdivisions		1,242		904		888
Other		122		367		488
Total interest income		50,037		56,322		61,732

Interest expense:
NOW, MMDA & savings deposits		2,965		3,249		4,099
Time deposits		9,687		15,008		17,430
FHLB borrowings		3,577		3,616		3,759
Junior subordinated debentures		546		1,016		1,476
Other		412		637		821
Total interest expense		17,187		23,526		27,585

Net interest income		32,850		32,796		34,147

Provision for loan losses		10,535		4,794		2,038

Net interest income after provision for loan losses		22,315		28,002		32,109

Other income:
Service charges		5,573		5,203		4,278
Other service charges and fees		2,058		2,399		1,938
Gain (loss) on sale and write-down of securities		1,072		(167	)	(562	)
Mortgage banking income		827		660		561
Insurance and brokerage commissions		414		426		521
Loss on sale and write-down of
other real estate and repossessed assets		(501	)	(287	)	(118	)
Miscellaneous		2,380		2,261		2,198
Total other income		11,823		10,495		8,816

Other expense:
Salaries and employee benefits		14,758		15,194		13,888
Occupancy		5,409		5,029		4,751
Other		9,716		8,670		7,354
Total other expenses		29,883		28,893		25,993

Earnings before income taxes		4,255		9,604		14,932

Income taxes		1,339		3,213		5,340

Net earnings		2,916		6,391		9,592

Dividends and accretion of preferred stock		1,246		-		-

Net earnings available to common shareholders	$	1,670		6,391		9,592

Basic earnings per common share	$	0.30		1.14		1.68
Diluted earnings per common share	$	0.30		1.13		1.65
Cash dividends declared per common share	$	0.26		0.48		0.41


See accompanying notes to consolidated financial statements.

A-35

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Changes in Shareholders' Equity

For the Years Ended December 31, 2009, 2008 and 2007

(Dollars in thousands)

										Accumulated
										Other
	Stock Shares			Stock Amount				Retained		Comprehensive
	Preferred	Common		Preferred		Common		Earnings		Income (Loss)		Total
Balance, December 31, 2006	-	3,830,634		$	-	51,122		12,484		(771	)	62,835

3 for 2 stock split	-	1,915,147			-	-		-		-		-
Cash paid in lieu of
fractional shares	-	-			-	-		(3	)	-		(3	)
Cash dividends declared	-	-			-	-		(2,331	)	-		(2,331	)
Repurchase and retirement of
common stock	-	(150,497	)		-	(2,811	)	-		-		(2,811	)
Exercise of stock options	-	28,950			-	239		-		-		239
Stock option tax benefit	-	-			-	92		-		-		92
Restricted stock/stock option
compensation expense	-	-			-	10		-		-		10
Net earnings	-	-			-	-		9,592		-		9,592
Change in accumulated other
comprehensive income
(loss), net of tax	-	-			-	-		-		2,479		2,479
Balance, December 31, 2007	-	5,624,234			-	48,652		19,742		1,708		70,102

Cumulative effect of
adoption of EITF 06-4	-	-			-	-		(467	)	-		(467	)
Issuance of Series A
preferred stock	25,054	-			24,350	704		-		-		25,054
Cash dividends declared on
common stock	-	-			-	-		(2,681	)	-		(2,681	)
Repurchase and retirement of
common stock	-	(90,500	)		-	(1,126	)	-		-		(1,126	)
Exercise of stock options	-	5,322			-	44		-		-		44
Restricted stock/stock option
compensation expense	-	-			-	(5	)	-		-		(5	)
Net earnings	-	-			-	-		6,391		-		6,391
Change in accumulated other
comprehensive income
(loss), net of tax	-	-			-	-		-		3,816		3,816
Balance, December 31, 2008	25,054	5,539,056			24,350	48,269		22,985		5,524		101,128

Adjustment to the
cumulative effect of
adoption of EITF 06-4	-	-			-	-		358		-		358
Accretion of Series A
preferred stock	-	-			126	-		(126	)	-		-
Cash dividends declared on
Series A preferred stock	-	-			-	-		(1,120	)	-		(1,120	)
Cash dividends declared on
common stock	-	-			-	-		(1,440	)	-		(1,440	)
Net earnings	-	-			-	-		2,916		-		2,916
Change in accumulated other
comprehensive income
(loss), net of tax	-	-			-	-		-		(2,619	)	(2,619	)
Balance, December 31, 2009	25,054	5,539,056		$	24,476	48,269		23,573		2,905		99,223

See accompanying notes to consolidated financial statements.

A-36

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

For the Years Ended December 31, 2009, 2008 and 2007

(Dollars in thousands)

	2009			2008	2007


Net earnings	$	2,916		6,391	9,592

Other comprehensive income:
Unrealized holding gains on securities
available for sale		214		2,145	1,965
Reclassification adjustment for losses (gains) on sales
and write-downs of securities available for sale
included in net earnings		(1,072	)	167	562
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		(2,726	)	3,744	1,245
Reclassification adjustment for gains on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		(1	)	-	-

Total other comprehensive income (loss),
before income taxes		(3,585	)	6,056	3,772

Income tax expense (benefit) related to other
comprehensive income:

Unrealized holding gains on securities
available for sale		83		836	765
Reclassification adjustment for losses (gains) on sales
and write-downs of securities available for sale
included in net earnings		(417	)	65	219
Unrealized holding gains (losses) on derivative
financial instruments qualifying as cash flow
hedges		(632	)	1,339	309

Total income tax expense (benefit) related to
other comprehensive income		(966	)	2,240	1,293

Total other comprehensive income (loss),
net of tax		(2,619	)	3,816	2,479

Total comprehensive income	$	297		10,207	12,071

See accompanying notes to consolidated financial statements.

A-37

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2009, 2008 and 2007

(Dollars in thousands)

	2009			2008		2007
Cash flows from operating activities:
Net earnings	$	2,916		6,391		9,592
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion		2,931		1,679		1,553
Provision for loan losses		10,535		4,794		2,038
Deferred income taxes		(1,720	)	(485	)	(480	)
Loss (gain) on sale of investment securities		(1,795	)	(133	)	132
Write-down of investment securities		723		300		430
Gain on ineffective portion of derivative financial
instruments		(1	)	-		-
Loss (gain) on sale of premises and equipment		(3	)	1		(10	)
Loss on sale of repossessed assets		24		47		83
Write-down of other real estate and repossessions		477		240		35
Restricted stock/stock option compensation expense		4		12		10
Origination of mortgage loans held for sale		(2,840	)	-		-
Change in:
Cash surrender value of life insurance		(263	)	(243	)	(244	)
Other assets		(6,578	)	(20	)	(1,014	)
Other liabilities		300		(1,851	)	2,404

Net cash provided by operating activities		4,710		10,732		14,529

Cash flows from investing activities:
Purchases of certificates of deposit		(3,345	)	-		-
Purchases of investment securities available for sale		(141,770	)	(41,659	)	(15,858	)
Proceeds from calls and maturities of investment securities
available for sale		40,629		16,488		7,471
Proceeds from sales of investment securities available
for sale		30,743		23,448		8,363
Purchases of other investments		(1,426	)	(4,180	)	(8,357	)
Proceeds from sale of other investments		809		4,311		8,424
Net change in loans		(7,916	)	(65,188	)	(72,816	)
Purchases of premises and equipment		(1,614	)	(1,857	)	(7,672	)
Proceeds from sale of premises and equipment		24		34		56
Proceeds from sale of repossessed assets		3,435		2,868		425
Purchases of derivative financial instruments		-		-		(634	)

Net cash used by investing activities		(80,431	)	(65,735	)	(80,598	)

Cash flows from financing activities:
Net change in deposits		88,281		27,424		59,818
Net change in demand notes payable to U.S. Treasury		(964	)	-		-
Net change in securities sold under agreement to repurchase		(625	)	9,917		21,165
Proceeds from FHLB borrowings		24,100		97,100		275,300
Repayments of FHLB borrowings		(24,100	)	(107,600	)	(277,100	)
Proceeds from FRB borrowings		45,000		5,000		-
Repayments of FRB borrowings		(50,000	)	-		-
Proceeds from issuance of Series A preferred stock		-		25,054		-
Proceeds from exercise of stock options		-		44		331
Common stock repurchased		-		(1,126	)	(2,811	)
Cash paid in lieu of fractional shares		-		-		(3	)
Cash dividends paid on Series A preferred stock		(1,120	)	-		-
Cash dividends paid on common stock		(1,440	)	(2,681	)	(2,331	)

Net cash provided by financing activities		79,132		53,132		74,369

Net change in cash and cash equivalent		3,411		(1,871	)	8,300

Cash and cash equivalents at beginning of period		27,929		29,800		21,500

Cash and cash equivalents at end of period	$	31,340		27,929		29,800

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PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows, continued

For the Years ended December 31, 2009, 2008 and 2007

(Dollars in thousands)


	2009			2008	2007


Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	17,541		23,799	27,420
Income taxes	$	2,230		4,166	5,690

Noncash investing and financing activities:
Change in unrealized gain on investment securities
available for sale, net	$	(524	)	1,411	1,543
Change in unrealized gain on derivative financial
instruments, net	$	(2,095	)	2,405	936
Transfer of loans to other real estate and repossessions	$	6,067		4,539	682
Financed portion of sale of other real estate	$	1,166		1,133	-
Reclassification of an investment from other assets
to securities available for sale	$	-		-	500
Reclassification of a security from other investments
to securities available for sale	$	-		-	600
Accretion of Series A preferred stock	$	126		-	-
Deferred gain rolled into cost basis of
acquired building	$	-		-	540
Cumulative effect and resulting adjustment of
adoption of EITF 06-4	$	(358	)	467	-


See accompanying notes to consolidated financial statements.

A-39

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Notes to Consolidated Financial Statements

(1)	Summary of Significant Accounting Policies

Organization

Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999. Bancorp is primarily regulated by the Board of Governors of the Federal Reserve System, and serves as the one-bank holding company for Peoples Bank (the “Bank"). Bancorp established a new subsidiary, Community Bank Real Estate Solutions, LLC (“Real Estate Solutions”), in 2009.

The Bank commenced business in 1912 upon receipt of its banking charter from the North Carolina State Banking Commission (the “SBC”). The Bank is primarily regulated by the SBC and the Federal Deposit Insurance Corporation and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg, Iredell, Union and Wake counties in North Carolina.

Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.

Real Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.

Real Estate Solutions is a wholly owned subsidiary of Bancorp and will serve as a “clearing house” for appraisal services for community banks. Other banks are able to contract with Real Estate Solutions to find and engage appropriate appraisal companies in the area where property is located.

Principles of Consolidation

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiaries, the Bank and Real Estate Solutions, along with the Bank’s 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.

Basis of Presentation

The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.

Cash and Cash Equivalents

Cash and due from banks, interest bearing deposits and federal funds sold are considered cash and cash equivalents for cash flow reporting purposes. Generally, federal funds are sold for one-day periods.

Investment Securities

The Company classifies its securities in one of three categories: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2009 and 2008, the Company classified all of its investment securities as available for sale.

Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.

Management evaluates investment securities for other-than-temporary impairment on an annual basis. A decline in the market value of any investment below cost that is deemed other-than-temporary is charged to earnings for

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the decline in value deemed to be credit related. The decline in value attributed to non-credit related factors is recognized in comprehensive income and or new cost basis in the security is established.

Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to the yield. Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.

Other Investments

Other investments include equity securities with no readily determinable fair value. These investments are carried at cost.

Mortgage Loans Held for Sale

Mortgage loans held for sale are carried at lower of aggregate cost or market value. At December 31, 2009, the cost of mortgage loans held for sale approximates the market value. The Company did not have any mortgage loans held for sale at December 31, 2008.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. The recognition of certain loan origination fee income and certain loan origination costs is deferred when such loans are originated and amortized over the life of the loan.

Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected.

Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings and interest is recognized on a cash basis when such loans are placed on non-accrual status.

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.

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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 GAAP 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, thus adversely affecting the operating results of the Company.

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. Also, a loan review process further assists with evaluation credit quality and assessing potential performance issues.

Mortgage Banking Activities

Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Company’s origination of single-family residential mortgage loans.

Mortgage servicing rights (“MSR's”) represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee. MSRs are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans. The Company recognized no servicing assets during 2009, 2008 and 2007.

Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $6.6 million, $9.3 million and $12.1 million at December 31, 2009, 2008 and 2007, respectively.

The Company originates certain fixed rate mortgage loans and commits these loans for sale. The commitments to originate fixed rate mortgage loans and the commitments to sell these loans to a third party are both derivative contracts. The fair value of these derivative contracts is immaterial and has no effect on the recorded amounts in the financial statements.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for the period. The cost of maintenance and repairs that do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:

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

Foreclosed Assets

Foreclosed assets include all assets received in full or partial satisfaction of a loan and include real and personal property. Foreclosed assets are reported at the lower of carrying amount or net realizable value, and are included in other assets on the balance sheet. The balance of other real estate owned was $4.0 million and $1.9 million at December 31, 2009 and 2008, respectively.

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Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that the realization of such benefits is more likely than not. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.

In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in deferred tax assets, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies.

Derivative Financial Instruments and Hedging Activities

In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All derivative financial instruments are recorded at fair value in the financial statements.

On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.

If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.

The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.

Advertising Costs

Advertising costs are expensed as incurred.

Accumulated Other Comprehensive Income

At December 31, 2009, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $1.8 million and net unrealized gains on derivatives of $1.1 million. At December 31, 2008, accumulated other comprehensive income consisted of net unrealized gains on securities available for sale of $2.3 million and net unrealized gains on derivatives of $3.2 million.

Stock-Based Compensation

The Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “1999 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. The 1999 Plan expired on May 13, 2009.

Under the Plan, the Company granted incentive stock options to certain eligible employees in order that they may purchase Company stock at a price equal to the fair market value on the date of the grant. The options granted in 1999 vested over a five-year period. Options granted subsequent to 1999 vest over a three-year period.

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All options expire after ten years. A summary of the activity in the Plan is presented below:

Stock Option Activity
For the years ended December 31, 2009, 2008 and 2007

	Shares		Weighted Average Option Price Per Share		Weighted Average Remaining Contractual Term (in years)
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

Granted during the period	-		$	-
Expired during the period	(15,483	)	$	9.02
Exercised during the period	-		$	-

Outstanding, December 31, 2009	169,462		$	8.17	2.30

Exercisable, December 31, 2009	169,462		$	8.17	2.30

Options outstanding at December 31, 2009 are exercisable at option prices ranging from $6.99 to $10.57. As of December 31, 2009, the exercise price on options outstanding is more than the current market value; therefore, options outstanding as of December 31, 2009 have no intrinsic value. Such options have a weighted average remaining contractual life of approximately two years.

The Company recognized compensation expense for employee stock options and restricted stock awards of $4,000, $12,000 and $10,000 for the years ended December 31, 2009, 2008 and 2007, respectively. As of December 31, 2009 and 2008, there was no unrecognized compensation cost related to nonvested employee stock options.

No options were granted during the years ended December 31, 2009 and 2008. There were no options exercised during the year ended December 31, 2009. The total intrinsic value (amount by which the fair market value of the underlying stock exceeds the exercise price of an option on exercise date) of options exercised during the year ended December 31, 2008 was $26,000. Cash received from option exercises for the year ended December 31, 2008 was $44,000. There were no tax deductions from options exercised for the years ended December 31, 2009 and 2008.

The Company granted 3,000 shares of restricted stock in 2007 at a grant date fair value of $17.40 per share. The Company granted 1,750 shares of restricted stock at a grant date fair value of $12.80 per share during third quarter 2008 and 2,000 shares of restricted stock at a fair value of $11.37 per share during fourth quarter 2008. The Company recognizes compensation expense on the restricted stock over the period of time the restrictions are in place (three years from the grant date for the grants to date). The amount of expense recorded each period reflects the changes in the Company’s stock price during the period. As of December 31, 2009 and 2008, there was $14,000 and $47,000 of total unrecognized compensation cost related to restricted stock grants, respectively, which is expected to be recognized over a period of three years.

The Company has a new Omnibus Stock Ownership and Long Term Incentive Plan, which was approved by shareholders’ on May 7, 2009 (the “2009 Plan”) whereby certain stock-based rights, such as stock options, restricted stock, performance units, stock appreciation rights, or book value shares, may be granted to eligible directors and employees. A total of 360,000 shares are currently reserved for possible issuance under the 2009 Plan. All rights must be granted or awarded within ten years from the May 7, 2009 effective date of the 2009 Plan. The Company has not granted any rights under this plan.

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Net Earnings Per Share

Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share. The average market price during the year is used to compute equivalent shares.

The reconciliations of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the years ended December 31, 2009, 2008 and 2007 are as follows:

For the year ended December 31, 2009:	Net Earnings Available to Common Shareholders (Dollars in thousands)		Common Shares	Per Share Amount
Basic earnings per common share	$	1,670	5,539,056	$	0.30
Effect of dilutive securities:
Stock options		-	3,681
Diluted earnings per common share	$	1,670	5,542,737	$	0.30

For the year ended December 31, 2008:	Net Earnings Available to Common Shareholders (Dollars in thousands)		Common Shares	Per Share Amount
Basic earnings per common share	$	6,391	5,588,314	$	1.14
Effect of dilutive securities:
Stock options		-	58,980
Diluted earnings per common share	$	6,391	5,647,294	$	1.13

For the year ended December 31, 2007:	Net Earnings Available to Common Shareholders (Dollars in thousands)		Common S hares	Per Share Amount
Basic earnings per common share	$	9,592	5,700,860	$	1.68
Effect of dilutive securities:
Stock options		-	109,455
Diluted earnings per common share	$	9,592	5,810,315	$	1.65

Recent Accounting Pronouncements

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In June 2009, the FASB issued Accounting Standards Update No. 2009-01 (“ASU 2009-01”), “Topic 105 – Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards No. 168 – The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.” ASU 2009-01 amends the FASB Accounting Standards Codification for the issuance of FASB Statement No. 168 (“SFAS 168”), “The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles.” ASU 2009-1 includes SFAS 168 in its entirety, including the accounting standards update instructions contained in Appendix B of the Statement. The FASB Accounting Standards Codification TM (“Codification”) became the source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement was effective for the Company’s financial statements beginning in the interim period ended September 30, 2009.

1) A valuation technique that uses:

a. The quoted price of the identical liability when traded as an asset

b. Quoted prices for similar liabilities or similar liabilities when traded as assets.

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2) Another valuation technique that is consistent with the principles of ASC Topic 820. Two examples would be an income approach, such as a technique

that is based on the amount at the measurement date that the reporting entity would pay to transfer the identical liability or would receive to enter into the

identical liability.

The amendments in ASU 2009-5 also clarify that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. It also clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. The guidance provided in ASU 2009-5 became effective for the Company in the fourth quarter of 2009. Because the Company does not currently have any liabilities that are recorded at fair value, the adoption of this guidance did not have any impact on results of operations, financial position or disclosures.

Issued October, 2009, ASU 2009-15, “Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing” amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity's own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs. The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company has no plans to issue convertible debt and, therefore, the update to had no impact on its financial statements at December 31, 2009.

A-47

17 formally incorporates into the FASB Codification amendments to FASB Interpretation (“FIN”) No. 46(R), “Consolidation of Variable Interest Entities”, made by SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)” to require that a comprehensive qualitative analysis be performed to determine whether a holder of variable interests in a variable interest entity also has a controlling financial interest in the entity. In addition, the amendments require that the same type of analysis be applied to entities that were previously designated as qualified special-purpose entities. This ASU is effective as of the start of the first annual reporting period beginning after November 15, 2009, for interim periods within the first annual reporting period and for all subsequent annual and interim reporting periods. ASU No. 2009-17 is not expected to have a material impact on the Company’s financial position, results of operations or disclosures.

In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASU 2010-06”), “Improving Disclosures about Fair Value Measurements”. ASU No. 2010-06 amends FASB Accounting Standards Codification topic 820-10-50, “Fair Value Measurements and Disclosures”, to require additional information to be disclosed principally regarding Level 3 measurements and transfers to Level 1 and 2. In addition, enhanced disclosure is required concerning inputs and valuation techniques used to determine Level 2 and Level 3 measurements. This guidance is generally effective for interim and annual reporting periods beginning with December 15, 2009; however requirements to disclose separately purchases, sales, issuances and settlements in the Level 3 reconciliation are effective for fiscal years beginning after December 15, 2010 (and for interim periods within such years). ASU No. 2010-06 is not expected to have a material impact on the Company’s financial position or results of operations, and will have a minimal impact on its disclosures.

(2)	Investment Securities

Investment securities available for sale at December 31, 2009 and 2008 are as follows:

(Dollars in thousands)
	December 31, 2009
	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses	Estimated Fair Value

Mortgage-backed securities	$	105,915	1,830	219	107,526
U.S. government
sponsored enterprises		40,259	934	51	41,142
State and political subdivisions		43,460	1,065	189	44,336
Trust preferred securities		1,250	-	-	1,250
Equity securities		1,233	-	372	861

Total	$	192,117	3,829	831	195,115

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

Mortgage-backed securities	$	36,557	854	140	37,271
U.S. government
sponsored enterprises		55,223	3,266	2	58,487
State and political subdivisions		26,648	460	135	26,973
Trust preferred securities		1,250	-	-	1,250
Equity securities		1,382	-	447	935

Total	$	121,060	4,580	724	124,916

The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2009 and 2008 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.

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(Dollars in thousands)
	December 31, 2009
	Less than 12 Months			12 Months or More		Total
	Fair Value		Unrealized Losses	Fair Value	Unrealized Losses	Fair Value	Unrealized Losses

Mortgage-backed securities	$	16,970	219	-	-	16,970	219
U.S. government
sponsored enterprises		8,683	51	-	-	8,683	51
State and political subdivisions		9,249	182	153	7	9,402	189
Equity securities		-	-	861	372	861	372

Total	$	34,902	452	1,014	379	35,916	831

	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	140	-	-	10,017	140
U.S. government
sponsored enterprises		-	-	614	2	614	2
State and political subdivisions		2,748	75	2,373	60	5,121	135
Equity securities		528	72	407	375	935	447

Total	$	13,293	287	3,394	437	16,687	724

At December 31, 2009, unrealized losses in the investment securities portfolio relating to debt securities totaled $459,000. The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary. From the December 31, 2009 tables above, 17 out of 99 securities issued by state and political subdivisions contained unrealized losses and 13 out of 92 securities issued by U.S. government sponsored enterprises, including mortgage-backed securities, contained unrealized losses. These unrealized losses are considered temporary because of acceptable investment grades on each security and the repayment sources of principal and interest are government backed.

The Company periodically evaluates its investments for any impairment which would be deemed other than temporary. As part of its evaluation in 2009, the Company determined that the fair values of three investments were less than the original cost of the investments and that the decline in fair value was not temporary in nature. As a result, the Company wrote down its original investments by $723,000. The remaining fair value of the investments at December 31, 2009 was $11,000. Similarly, as part of its evaluation in 2008, the Company wrote down one investment by $300,000. The remaining fair value of the investments at December 31, 2008 was $22,000.

The amortized cost and estimated fair value of investment securities available for sale at December 31, 2009, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

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(Dollars in thousands)
	Amortized Cost		Estimated Fair Value

Due within one year	$	2,566	2,584
Due from one to five years		22,725	23,396
Due from five to ten years		34,161	34,824
Due after ten years		25,517	25,924
Mortgage-backed securities		105,915	107,526
Equity securities		1,233	861

Total	$	192,117	195,115

Proceeds from sales of securities available for sale during 2009 were $30.7 million and resulted in a gross gain of $1.8 million. During 2008 and 2007, the proceeds from sales of securities available for sale were $23.4 million and $8.4 million, respectively. Gross gains of $160,000 for 2008 and gross losses of $132,000 for 2007 were realized on those sales.

Securities with a fair value of approximately $69.6 million and $65.2 million at December 31, 2009 and 2008, respectively, were pledged to secure public deposits and for other purposes as required by law.

(Dollars in thousands)
	Fair Value Measurements December 31, 2009		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	195,115	861	193,004	1,250
Mortgage loans held for sale	$	2,840	-	2,840	-
Market value of derivatives (in other assets)	$	1,762	-	1,762	-

	Fair Value Measurements December 31, 2008		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation
Investment securities available for sale	$	124,916	935	122,731	1,250
Market value of derivatives (in other assets)	$	4,981	-	4,981	-

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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, 2009:

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

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

(3)

Loans

Major classifications of loans at December 31, 2009 and 2008 are summarized as follows:

(Dollars in thousands)
	2009		2008

Commercial	$	67,487	76,945
Real estate - mortgage		512,963	474,732
Real estate - construction		169,680	216,188
Consumer		27,926	13,323

Total loans		778,056	781,188

Less allowance for loan losses		15,413	11,025

Total net loans	$	762,643	770,163

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 of North Carolina. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market.

The Company’s December 31, 2009 and 2008 fair value measurement for impaired loans and other real estate on a non-recurring basis is presented below:

(Dollars in thousands)
	Fair Value Measurements December 31, 2009		Level 1 Valuation	Level 2 Valuation	Level 3 Valuation	Total Gains/(Losses) for the Year Ended December 31, 2009
Impaired loans	$	15,958	-	14,174	1,784	(1,924)
Other real estate	$	3,997	-	3,997	-	(100)

	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	-	5,903	1,170	(345)
Other real estate	$	1,867	-	1,867	-	(166)

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Changes in the allowance for loan losses were as follows:

(Dollars in thousands)
	2009			2008		2007

Balance at beginning of year	$	11,025		9,103		8,303
Amounts charged off		(6,670	)	(3,147	)	(1,626	)
Recoveries on amounts previously charged off		523		275		388
Provision for loan losses		10,535		4,794		2,038

Balance at end of year	$	15,413		11,025		9,103

(4)	Premises and Equipment

Major classifications of premises and equipment are summarized as follows:

(Dollars in thousands)
	2009		2008

Land	$	3,581	3,573
Buildings and improvements		14,737	14,709
Furniture and equipment		18,624	17,156

Total premises and equipment		36,942	35,438

Less accumulated depreciation		18,995	17,141

Total net premises and equipment	$	17,947	18,297

Depreciation expense was approximately $1.9 million for the year ended December 31, 2009. The Company recognized approximately $1.8 and $1.7 million in depreciation expense for the years ended December 31, 2008 and 2007.

(5)	Time Deposits

At December 31, 2009, the scheduled maturities of time deposits are as follows:

(Dollars in thousands)

2010	$	292,563
2011		38,849
2012		66,700
2013		1,050
2014 and thereafter		2,272

Total	$	401,434

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At December 31, 2009 and 2008, the Company has approximately $84.0 million and $61.0 million, respectively, in time deposits purchased through third party brokers. The weighted average rate of brokered deposits as of December 31, 2009 and 2008 was 1.90% and 3.25%, respectively.

(6)	Federal Home Loan Bank and Federal Reserve Bank Borrowings

The Bank has borrowings from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly or quarterly interest payments at December 31, 2009. The FHLB borrowings are collateralized by a blanket assignment on all residential first mortgage loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns. At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $147.0 million. As additional collateral, the Bank has pledged securities to FHLB. At December 31, 2009, the market value of securities pledged to FHLB totaled $7.5 million.

Borrowings from the FHLB outstanding at December 31, 2009 consist of the following:

(Dollars in thousands)

Maturity Date	Call Date	Rate	Rate Type	Amount

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

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

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

March 25, 2019	N/A	4.260%	Fixed		5,000

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

October 5, 2016	N/A	4.450%	Convertible		5,000

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

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

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

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


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

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

				$	77,000

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 payment of a prepayment fee. The Company also has an additional $5.0 million in an advance that has been converted to a fixed rate by the FHLB, which may be repaid with a prepayment fee.

The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. At December 31, 2009 and 2008, the Bank owned FHLB stock amounting to $5.5 million and $5.1 million, respectively.

As of December 31, 2009, the Bank had no borrowings from the Federal Reserve Bank (“FRB”). The Bank had $5.0 million in borrowings from the 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

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by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2009, the carrying value of loans pledged as collateral totaled approximately $428.2 million.

(7)	Junior Subordinated Debentures

In June 2006, the Company formed a second 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 to repay in December 2006 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 has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

(8)	Income Taxes

The provision for income taxes in summarized as follows:

(Dollars in thousands)
	2009			2008		2007
Current	$	3,059		3,698		5,820
Deferred		(1,720	)	(485	)	(480	)
Total	$	1,339		3,213		5,340

The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:

(Dollars in thousands)
	2009			2008		2007
Pre-tax income at statutory rates (34%)	$	1,447		3,265		5,077
Differences:
Tax exempt interest income		(429	)	(313	)	(307	)
Nondeductible interest and other expense		38		60		56
Cash surrender value of life insurance		(89	)	(83	)	(83	)
State taxes, net of federal benefits		100		257		560
Nondeductible capital losses		234		-		-
Other, net		38		27		37
Total	$	1,339		3,213		5,340

The following summarized the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities. The net deferred tax asset is included as a component of other assets at December 31, 2009 and 2008.

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(Dollars in thousands)
	2009		2008
Deferred tax assets:
Allowance for loan losses	$	5,942	4,281
Amortizable intangible assets		11	44
Accrued retirement expense		987	1,184
Income from non-accrual loans		14	37
Other		112	-
Total gross deferred tax assets		7,066	5,546

Deferred tax liabilities:
Deferred loan fees		1,404	1,654
Premises and equipment		328	194
Unrealized gain on available for sale securities		1,168	1,502
Unrealized gain on cash flow hedges		686	1,319
Other		-	84
Total gross deferred tax liabilities		3,586	4,753
Net deferred tax asset	$	3,480	793

(9)	Related Party Transactions

The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers are made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2009:

(Dollars in thousands)

Beginning balance	$	5,658
New loans		5,217
Repayments		4,935

Ending balance	$	5,940

At December 31, 2009 and 2008, the Company had deposit relationships with related parties of approximately $17.2 million and $20.0 million, respectively.

(10)	Commitments and Contingencies

The Company leases various office spaces for banking and operational facilities and equipment under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2009 are as follows:

(Dollars in thousands)

Year ending December 31,
2010	$	653
2011		590
2012		466
2013		256
2014		242
Thereafter		1,652

Total minimum obligation	$	3,859

Total rent expense was approximately $922,000, $1.0 million and $1.1 million for 2009, 2008 and 2007, respectively.

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The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

In most cases, the Company requires collateral or other security to support financial instruments with credit risk.

(Dollars in thousands)
	Contractual Amount
	2009		2008
Financial instruments whose contract amount represent credit risk:

Commitments to extend credit	$	140,207	158,939

Standby letters of credit and financial guarantees written	$	3,302	4,316

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 and because they may expire without being drawn upon, the total commitment amount of $143.5 million does not necessarily represent future cash requirements.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Company’s delineated market area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.

In the normal course of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Bank or the Company.

The Company has employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive stock option, and change in control provisions.

The Company has $40.5 million available for the purchase of overnight federal funds from four correspondent financial institutions.

(11)	Derivative Financial Instruments and Hedging Transactions

Accounting Policy for Derivative Instruments and Hedging Activities

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hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

Risk Management Objective of Using Derivatives

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the Balance Sheet as of December 31, 2009 and 2008.

(Dollars in thousands)
	Asset Derivatives
	As of December 31, 2009			As of December 31, 2008
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
Interest rate derivative contracts	Other assets	$	1,762	Other assets	$	4,981

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest income and expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps and floors as part of its interest rate risk management strategy. For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount. For hedges of the Company’s variable-rate loan assets, the interest rate floors designated as a cash flow hedge involves the receipt of variable-rate amounts from a counterparty if interest rates fall below the strike rate on the contract in exchange for an up front premium. As of December 31, 2009, the Company had one interest rate swap with a notional amount of $50.0 million that was designated as a cash flow hedge of interest rate risk.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2009, such derivatives were used to hedge the variable cash inflows associated with existing pools of prime-based loan assets. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company recognized hedge ineffectiveness gains of $1,000 in earnings during the year ended December 31, 2009.

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Effect of Derivative Instruments on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments on the Income Statement for the years ended December 31, 2009 and 2008.

(Dollars in thousands)

	Amount of Gain (Loss) Recognized in OCI on Derivatives				Location of Gain (Loss) Reclassified from Accumulated OCI into Income	Amount of Gain (Loss) Reclassified from Accumulated OCI into Income
	Years ended December 31,					Years ended December 31,
	2009		2008			2009		2008
Interest rate derivative contracts	$	434	$	7,147	Interest income	$	3,114	$	3,403
					Non-interest income	$	46	$	-

(12)	Employee and Director Benefit Programs

The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under this plan, the Company matches employee contributions to a maximum of five percent of annual compensation. The Company’s contribution pursuant to this formula was approximately $482,000, $483,000 and $424,000 for the years 2009, 2008 and 2007, respectively. Investments of the plan are determined by the compensation committee consisting of selected outside directors and senior executive officers. No investments in Company stock have been made by the plan. The vesting schedule for the plan begins at 20 percent after two years of employment and graduates 20 percent each year until reaching 100 percent after six years of employment.

In December 2001, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries. Under the plan, the Company purchased life insurance contracts on the lives of the key officers and each director. The increase in cash surrender value of the contracts constitutes the Company’s contribution to the plan each year. Plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to this plan were approximately $609,000, $365,000 and $258,000 during 2009, 2008 and 2007, respectively.

The Company is currently paying medical benefits for certain retired employees. Postretirement benefits expense, including amortization of the transition obligation, as applicable, was approximately $23,000 for the years ended December 31, 2009, 2008 and 2007.

The following table sets forth the change in the accumulated benefit obligation for the Company’s two postretirement benefit plans described above:

(Dollars in thousands)
	2009

Benefit obligation at beginning of period	$	1,779
Service cost		500
Interest cost		105
Benefits paid		(29	)

Benefit obligation at end of period	$	2,355

The amounts recognized in the Company’s consolidated balance sheet as of December 31, 2009 are shown in the following two tables:

(Dollars in thousands)
	2009

Benefit obligation	$	2,355
Fair value of plan assets		-

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(Dollars in thousands)
	2009

Funded status	$	(2,355	)
Unrecognized prior service cost/benefit		-
Unrecognized net actuarial loss		-

Net amount recognized	$	(2,355	)

Unfunded accrued liability	$	(2,355	)
Intangible assets		-

Net amount recognized	$	(2,355	)

Net periodic benefit cost of the Company’s two post retirement benefit plans for the year ended December 31, 2009 consisted of the following:

(Dollars in thousands)
	2009

Service cost	$	500
Interest cost		105

Net periodic cost	$	605

Weighted average discount rate assumption used to
determine benefit obligation		6.66%

During the year ended December 31, 2009, the Company paid benefits totaling $46,000. Information about the expected benefit payments for the Company’s two postretirement benefit plans is as follows:

(Dollars in thousands)

Year ending December 31,
2010	$	49
2011	$	82
2012	$	197
2013	$	202
2014	$	226
Thereafter	$	9,284

Members of the Board of Directors are eligible to participate in the Company’s Omnibus Stock Ownership and Long Term Incentive Plan (the “Stock Benefits Plan”). Each director has been awarded 9,737 book value shares (adjusted for stock dividends and stock splits) under the Stock Benefits Plan. The book value of the shares awarded range from $6.31 to $8.64. All book value shares were fully vested on May 6, 2009 and were exercised subsequently. The Company recorded expenses of approximately $59,000, $136,000 and $159,000 associated with the benefits of this plan in the years ended December 31, 2009, 2008 and 2007, respectively.

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A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2009, 2008 and 2007 is presented below.

	2009				2008			2007
	Shares		Weighted Average Price of Book Value Shares		Shares	Weighted Average Price of Book Value S hares		Shares	Weighted Average Price of Book Value Shares
Outstanding, beginning of period	97,377		$	7.38	97,377	$	7.38	97,377	$	7.38
Exercised during the period	(97,377	)	$	7.38	-	$	-	-	$	-

Outstanding, end of period	-		$	-	97,377	$	7.38	97,377	$	7.38

Number of shares exercisable	-		$	-	89,580	$	7.27	81,791	$	7.89

Relating to the post retirement benefit plan, the Company is required 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. The Company made a $467,000 reduction to retained earnings in 2008 pursuant to the guidance of the pronouncement to record the portion of this benefit earned by participants prior to adoption of this pronouncement. In 2009 the Company made a $358,000 addition to retained earnings to reflect an adjustment of the cumulative effect due to policy amendments to the individual split-dollar plans implemented during 2009.

(13)	Regulatory Matters

The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 Capital consists of the allowance for loan losses up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2009, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2009, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.

A-60

The Company’s and the Bank’s actual capital amounts and ratios are presented below:

(Dollars in thousands)
	Actual			For Capital Adequacy Purposes		To Be Well Capitalized Under Prompt Corrective Action Provisions

	Amount		Ratio	Amount	Ratio	Amount	Ratio

As of December 31, 2009:

Total Capital (to Risk-Weighted Assets)
Consolidated	$	126,689	15.00%	67,586	8.00%	N/A	N/A
Bank	$	105,217	12.48%	67,444	8.00%	84,305	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$	116,091	13.74%	33,793	4.00%	N/A	N/A
Bank	$	94,619	11.22%	33,722	4.00%	50,583	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$	116,091	11.42%	40,650	4.00%	N/A	N/A
Bank	$	94,619	9.33%	40,581	4.00%	50,726	5.00%

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%

(14)	Shareholders' Equity

In March 2008, the Company’s Board of Directors authorized the repurchase of up to 100,000 common shares of the Company’s outstanding common stock through its existing Stock Repurchase Plan effective through the end of March 2009. The Company repurchased 65,500 shares, or $776,000, of its common stock under this plan as of December 31, 2008. Because of the Company’s participation in the U.S. Treasury Department’s Capital Purchase Program (“CPP”), discussed below, the Company can no longer repurchase shares of its common stock under the Stock Repurchase Plan without United States Department of the Treasury (“UST”) approval.

A-61

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. As of December 31, 2009, the Company has accreted a total of $126,000 of the discount related to the Series A preferred stock. The Company paid dividends of $1.1 million on the Series A preferred stock during 2009 and cumulative undeclared dividends at December 31, 2009 were $157,000. 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 exercise price of the warrant is $10.52 per common share and it is exercisable at anytime on or before December 18, 2018.

The Board of Directors of the Bank may declare a dividend of all of its retained earnings as it may deem appropriate, subject to the requirements of the General Statutes of North Carolina, without prior approval from the requisite regulatory authorities. As of December 31, 2009, this amount was approximately $41.4 million.

(15)	Other Operating Expense

Other operating expense for the years ended December 31 included the following items that exceeded one percent of total revenues:

(Dollars in thousands)
	2009		2008	2007

Advertising	$	860	1,076	988
FDIC insurance	$	1,766	547	140
Visa debit card expense	$	1,064	761	666
Telephone	$	616	476	405

(16)	Fair Value of Financial Instruments

The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in value of financial instruments held by the Company since purchase, origination, or issuance.

A-62

Cash and Cash Equivalents

For cash, due from banks, interest bearing deposits and federal funds sold, the carrying amount is a reasonable estimate of fair value.

Certificates of Deposit

The carrying amount of certificates of deposits is a reasonable estimate of fair value.

Investment Securities Available for Sale

Fair values for investment securities are based on quoted market prices.

Other Investments

For other investments, the carrying value is a reasonable estimate of fair value.

Mortgage Loans Held for Sale

Mortgage loans held for sale are carried at lower of aggregate cost or market value. The cost of mortgage loans held for sale approximates the market value.

Loans

The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. For variable rate loans, the carrying amount is a reasonable estimate of fair value.

Cash Surrender Value of Life Insurance

For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Derivative Instruments

For derivative instruments, fair value is estimated as the amount that the Company would receive or pay to terminate the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts.

Deposits and Demand Notes Payable

The fair value of demand deposits, interest-bearing demand deposits, savings, and demand notes payable to U.S. Treasury is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Securities Sold Under Agreements to Repurchase

For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value.

FHLB and Short-term FRB Borrowings

The fair value of FHLB and FRB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings.

Junior Subordinated Debentures

Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value.

Commitments to Extend Credit and Standby Letters of Credit

Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.

Limitations

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

A-63

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include the deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2009 and 2008 are as follows:

	December 31, 2009			December 31, 2008
	Carrying Amount		Estimated Fair Value	Carrying Amount	Estimated Fair Value
	(dollars in thousands)

Assets:
Cash and cash equivalents	$	31,340	31,340	27,929	27,929
Certificates of deposit	$	3,345	3,345	-	-
Investment securities available for sale	$	195,115	195,115	124,916	124,916
Other investments	$	6,346	6,346	6,303	6,303
Mortgage loans held for sale	$	2,840	2,840	-	-
Loans, net	$	762,643	763,939	770,163	773,256
Cash surrender value of life insurance	$	7,282	7,282	7,019	7,019
Derivative instruments	$	1,762	1,762	4,981	4,981

Liabilities:
Deposits and demand notes payable	$	809,979	809,717	722,662	718,278
Securities sold under agreements
to repurchase	$	36,876	36,876	37,501	37,501
Short-term FRB borrowings	$	-	-	5,000	4,999
FHLB borrowings	$	77,000	86,680	77,000	83,038
Junior subordinated debentures	$	20,619	20,619	20,619	20,619

A-64

(17)	Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements

Balance Sheets

December 31, 2009 and 2008
(Dollars in thousands)

Assets	2009		2008

Cash	$	300	25,600
Interest-bearing time deposit		19,000	5,000
Investment in subsidiaries		98,455	89,407
Investment securities available for sale		1,668	1,811
Other assets		437	415

Total assets	$	119,860	122,233

Liabilities and Shareholders' Equity

Accrued expenses	$	18	486
Junior subordinated debentures		20,619	20,619
Shareholders' equity		99,223	101,128

Total liabilities and shareholders' equity	$	119,860	122,233

Statements of Earnings

For the Years Ended December 31, 2009, 2008 and 2007
(Dollars in thousands)

Revenues:	2009			2008		2007

Dividends from subsidiaries	$	-		1,929		4,811
Interest and dividend income		454		443		464
Loss on sale of securities		(149	)	(327	)	(236	)

Total revenues		305		2,045		5,039

Expenses:

Interest		546		1,016		1,476
Other operating expenses		230		244		266

Total expenses		776		1,260		1,742

Earnings (loss) before income tax benefit and equity in
undistributed earnings of subsidiaries		(471	)	785		3,297

Income tax benefit		84		389		515

Earnings (loss) before equity in undistributed
earnings of subsidiaries		(387	)	1,174		3,812

Equity in undistributed earnings of subsidiaries		3,303		5,217		5,780

Net earnings	$	2,916		6,391		9,592

A-65

Statements of Cash Flows

For the Years Ended December 31, 2009, 2008 and 2007
(Dollars in thousands)

	2009			2008		2007
Cash flows from operating activities:

Net earnings	$	2,916		6,391		9,592
Adjustments to reconcile net earnings to net
cash provided (used) by operating activities:
Book value shares accrual		(720	)	136		159
Equity in undistributed earnings of subsidiaries		(3,303	)	(5,217	)	(5,780	)
Deferred income tax benefit		278		(53	)	(62	)
Loss on sale of investment securities		149		327		236
Change in:
Other assets		(319	)	(3	)	-
Accrued income		17		(17	)	2
Accrued expense		252		15		(254	)

Net cash provided by operating activities		(730	)	1,579		3,893

Cash flows from investing activities:

Purchases of investment securities available for sale		(15,000	)	(1,000	)	-
Proceeds from maturities of investment securities available for sale		15,000		-		-
Proceeds from sales of investment securities available for sale		-		3		-
Net change in interest-bearing time deposit		(14,000	)	3,000		-
Payments for investments in subsidiaries		(8,010	)	-		-

Net cash provided (used) by investing activities		(22,010	)	2,003		-

Cash flows from financing activities:

Proceeds from issuance of Series A preferred stock		-		25,054		-
Cash dividends paid on Series A preferred stock		(1,120	)	-		-
Cash dividends paid on common stock		(1,440	)	(2,680	)	(2,331	)
Cash paid in lieu of fractional shares		-		-		(3	)
Common stock repurchased		-		(1,126	)	(2,811	)
Proceeds from exercise of stock options		-		44		331

Net cash provided (used) by financing activities		(2,560	)	21,292		(4,814	)

Net change in cash		(25,300	)	24,874		(921	)

Cash at beginning of year		25,600		726		1,647

Cash at end of year	$	300		25,600		726

A-66

DIRECTORS AND OFFICERS OF THE COMPANY

DIRECTORS

Robert C. Abernethy – Chairman

Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;

President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)

James S. Abernethy

Vice President, Carolina Glove Company, Inc. (glove manufacturer)

President and Assistant Secretary, Midstate Contractors, Inc. (paving company)

Douglas S. Howard

Vice President, Howard Ventures, Inc. (private equity firm)

Secretary and Treasurer, Denver Equipment of Charlotte, Inc.

John W. Lineberger, Jr.

President, Lincoln Bonded Warehouse Company (commercial warehousing facility)

Gary E. Matthews

President and Director, Matthews Construction Company, Inc. (general contractor)

Billy L. Price, Jr. MD

Managing Partner and Practitioner of Internal Medicine, Catawba Valley Internal Medicine, PA

Larry E. Robinson

President and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and wine distributor)

Partner and Chief Operating Officer, United Beverages of North Carolina, LLC (beer distributor)

William Gregory (Greg) Terry

Executive Vice President, Drum & Willis-Reynolds Funeral Homes and Crematory

Dan Ray Timmerman, Sr.

President and Chief Executive Officer, Timmerman Manufacturing, Inc. (wrought iron furniture, railings and gates manufacturer)

Benjamin I. Zachary

President, Treasurer, General Manager and Director, Alexander Railroad Company

OFFICERS

Tony W. Wolfe

President and Chief Executive Officer

A. Joseph Lampron

Executive Vice President, Chief Financial Officer and Corporate Treasurer

Joseph F. Beaman, Jr.

Executive Vice President and Corporate Secretary

Lance A. Sellers

Executive Vice President and Assistant Corporate Secretary

William D. Cable, Sr.

Executive Vice President and Assistant Corporate Treasurer

A-67

SUBSIDIARIES OF THE REGISTRANT

A list of subsidiaries is contained in Part I, Item 1 Business, Subsidiaries and is incorporated by reference.

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We have issued our report, dated February 25 , 2010 , accompanying the consolidated financial statements incorporated by reference in the Annual Report of Peoples Bancorp of North Carolina, Inc. on Form 10-K for the year ended December 31, 2009. We hereby consent to the incorporation by reference of said report in the Registration Statement of Peoples Bancorp of North Carolina, Inc. on Form S-3 (File No. 333-43426, effective August 10, 2000), and on Form S-8 (File No. 333-46860, effective September 28, 2000).

/s/ PORTER KEADLE MOORE, LLP

I, Tony W. Wolfe, certify that:

1.	I have reviewed this annual report on Form 10-K of Peoples Bancorp of North Carolina, Inc.;

2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.	Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5.	The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

March 24, 2010		/s/ Tony W. Wolfe
Date		Tony W. Wolfe
		President and Chief Executive Officer
		(Principal Executive Officer)

I, A. Joseph Lampron, certify that:

i.	I have reviewed this annual report on Form 10-K of Peoples Bancorp of North Carolina, Inc.;

ii.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

iii.	Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

iv.

c)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation ; and

5.	The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.


March 24, 2010		/s/ A. Joseph Lampron
Date		A. Joseph Lampron
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Principal Accounting Officer)

CERTIFICATION PURSUANT TO

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Peoples Bancorp of North Carolina, Inc. (the “Company”) on Form 10-K for the period ending December 31, 2009, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), each of the undersigned certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best knowledge of the undersigned:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities

Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial

condition and results of operations of the Company.

Dated: March 24, 2010		/s/ Tony W. Wolfe
		Tony W. Wolfe
		Chief Executive Officer


Dated: March 24, 2010		/s/ A. Joseph Lampron
		A. Joseph Lampron
		Chief Financial Officer

I, Tony W. Wolfe, Peoples Bancorp of North Carolina, Inc., certify that:

The compensation committee of the Company has discussed, reviewed, and evaluated with senior risk officers at least every six months during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date, senior executive officer (“SEO”) compensation plans and employee compensation plans and the risks these plans pose to the Company;

ii.

The compensation committee of the Company has identified and limited during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date, the features in the SEO compensation plans that could lead SEOs to take unnecessary and excessive risks that could threaten the value of the Company and identified any features in the employee compensation plans that pose risks to the Company and limited those features to ensure that the Company is not unnecessarily exposed to risks

iii.

The compensation committee has reviewed at least every six months during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date, the terms of each employee compensation plan and identified the features in the plan that could encourage the manipulation of reported earnings of the Company to enhance the compensation of an employee and has limited those features;

iv.	The compensation committee of the Company will certify to the reviews of the SEO compensation plans and employee compensation plans required under (i) and (iii) above;

v.	The compensation committee of the Company will provide a narrative description of how it limited during any part of the most recently completed fiscal year that included a TARP period the features in:

a)	SEO compensation plans that could lead SEOs to take unnecessary and excessive risks that could threaten the value of the Company;

b)	Employee compensation plans that unnecessarily expose the Company to risks; and

c)	Employee compensation plans that could encourage the manipulation of reported earnings of the Company to enhance the compensation of an employee;

vi.

The Company has required that bonus payments, as defined in the regulations and guidance established under section 111 of EESA (“bonus payments”), of the SEOs and 20 next most highly compensated employees be subject to a recovery or “clawback” provision during any part of the most recently completed fiscal year that was a TARP period if the bonus payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria;

vii.

The Company has prohibited any golden parachute payment, as defined in the regulations and guidance established under section 111 of EESA, to an SEO or any of the next five most highly compensated employees during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date;

viii.

The Company has limited bonus payments to its applicable employees in accordance with section 111 of EESA and the regulations and guidance established thereunder during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date;

ix.

The board of directors of the Company has established an excessive or luxury expenditures policy, as defined in the regulations and guidance established under section 111 of EESA, has provided this policy to Treasury and its primary regulatory agency, and the Company and its employees have complied with this policy during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date, and that any expenses requiring approval of the board of directors, a committee of the board of directors, an SEO, or an executive officer with a similar level of responsibility, were properly approved;

The Company will permit a non-binding shareholder resolution in compliance with any applicable federal securities rules and regulations on the disclosures provided under the federal securities laws related to SEO compensation paid or accrued during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date;

xi.

The Company will disclose the amount, nature, and justification for the offering during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date of any perquisites, as defined in the regulations and guidance established under section 111 of EESA, whose total value exceeds $25,000 for each employee subject to the bonus payment limitations identified in paragraph (vii);

xii.

The Company will disclose whether the Company, the board of directors of the Company, or the compensation committee of the Company has engaged during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date, a compensation consultant; and the services the compensation consultant or any affiliate of the compensation consultant provided during this period;

xiii.

The Company has prohibited the payment of any gross-ups, as defined in the regulations and guidance established under section 111 of EESA, to the SEOs and the next 20 most highly compensated employees during the period beginning on the later of the closing date of the agreement between the Company and Treasury or June 15, 2009, and ending with the last day of the Company’s fiscal year containing that date;

xiv.	The Company has substantially complied with all other requirements related to employee compensation that are provided in the agreement between the Company and Treasury, including any amendments;

xv.

The Company has submitted to Treasury a complete and accurate list of the SEOs and the twenty next most highly compensated employees for the current fiscal year and the most recently completed fiscal year, with the non-SEOs ranked in order of level of annual compensation starting with the greatest amount:

xvi.	I understand that a knowing and willful false or fraudulent statement made in connection with this certification may be punished by fine, imprisonment, or both.

March 24, 2010		/s/ Tony W. Wolfe
Date		Tony W. Wolfe
		President and Chief Executive Officer
		(Principal Executive Officer)

I, A. Joseph Lampron, Peoples Bancorp of North Carolina, Inc., certify that:

ii.

iii.

iv.	The compensation committee of the Company will certify to the reviews of the SEO compensation plans and employee compensation plans required under (i) and (iii) above;

v.	The compensation committee of the Company will provide a narrative description of how it limited during any part of the most recently completed fiscal year that included a TARP period the features in:

a)	SEO compensation plans that could lead SEOs to take unnecessary and excessive risks that could threaten the value of the Company;

b)	Employee compensation plans that unnecessarily expose the Company to risks; and

c)	Employee compensation plans that could encourage the manipulation of reported earnings of the Company to enhance the compensation of an employee;

vi.

vii.

viii.

ix.

xi.

xii.

xiii.

xiv.	The Company has substantially complied with all other requirements related to employee compensation that are provided in the agreement between the Company and Treasury, including any amendments;

xv.

xvi.	I understand that a knowing and willful false or fraudulent statement made in connection with this certification may be punished by fine, imprisonment, or both.