Weststar Financial Services (WFSC) 10-Q 2010 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2010

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

For the transition period from _____________________ to __________________________

Commission File Number: 000-30515

Weststar Financial Services Corporation

(Exact name of registrant as specified in its charter)

North Carolina	56-2181423
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

79 Woodfin Place, Asheville NC 28801

(Address of principal executive offices)

828.252.1735

(Registrant’s telephone number)

______________________________________________________________________________

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the of the Exchange Act 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.  T Yes  o No

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).   o Yes  o No

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act: (Check one): Large accelerated filer   o Accelerated filer  o Non-accelerated filer   o   (Do not check if a smaller company) Smaller reporting company   T

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

APPLICABLE ONLY TO CORPORATE ISSUERS:

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: Common stock, $1.00 par value – 2,167,517 shares outstanding as of August 23, 2010.

INDEX	Page
Part I – FINANCIAL INFORMATION
Financial Statements:
Consolidated Balance Sheets
June 30, 2010 and December 31, 2009	2
Consolidated Statements of Operations
Three and Six Months Ended June 30, 2010 and 2009	3
Consolidated Statements of Comprehensive Income (Loss)
Three and Six Months Ended June 30, 2010 and 2009	4
Consolidated Statements of Changes in Shareholders’ Equity
Six Months Ended June 30, 2010 and 2009	5
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2010 and 2009	6
Notes to Consolidated Financial Statements	7
Item 2 - Management’s Discussion and Analysis
Financial Condition and Results of Operations	16
Item 4T – Controls and Procedures	31
Part II – OTHER INFORMATION
Item 1. – Legal Proceedings	33
Item 4 – {Reserved}	33
Item 5 – Other Information	33
Item 6 –Exhibits	33
Signatures	33

Part I.          FINANCIAL INFORMATION

Item I.         Financial Statements

Weststar Financial Services Corporation & Subsidiary
Consolidated Balance Sheets	(unaudited)
	June 30,			December 31,
	2010			2009*
ASSETS:
Cash and cash equivalents:
Cash and due from banks	$	4,253,292		$	6,785,293
Interest-bearing deposits		8,994,928			1,550,240
Total cash and cash equivalents		13,248,220			8,335,533
Investment securities – available for sale, at fair value
(amortized cost of $23,729,664 and $24,613,580, at
June 30, 2010 and December 31, 2009, respectively)		24,456,879			25,046,500
Loans		170,438,295			185,474,873
Allowance for loan losses		(4,185,422	)		(3,512,263	)
Net loans		166,252,873			181,962,610
Premises and equipment, net		2,765,853			2,415,933
Accrued interest receivable		937,046			886,471
Federal Home Loan Bank stock, at cost		592,300			592,300
Deferred income taxes		-			985,802
Foreclosed properties		2,910,381			511,112
Other assets		3,074,451			3,019,479
TOTAL	$	214,238,003		$	223,755,740
LIABILITIES AND SHAREHOLDERS' EQUITY:
Liabilities:
Deposits:
Demand	$	25,235,372		$	23,569,001
NOW accounts		42,115,842			43,591,452
Money market accounts		29,746,632			26,442,360
Savings		3,727,603			2,890,582
Time deposits of $100,000 or more		23,824,480			27,166,487
Other time deposits		76,246,680			73,462,859
Total deposits		200,896,609			197,122,741
Short-term borrowings		840,310			4,374,673
Accrued interest payable		366,550			372,356
Other liabilities		985,004			917,762
Long-term debt		8,124,000			4,124,000
Total liabilities		211,212,473			206,911,532
COMMITMENTS AND CONTIGENCIES (Note 3)
SHAREHOLDERS' EQUITY:
Preferred stock; authorized 1,000,000 shares;
no shares issued and outstanding		-			-
Common stock, $1 par value, authorized – 9,000,000 shares;
outstanding shares– 2,167,517 and 2,167,517 at June 30, 2010
and December 31, 2009, respectively		2,167,517			2,167,517
Additional paid-in capital		6,269,404			6,269,404
Retained earnings(accumulated deficit)		(5,858,264	)		8,141,258
Accumulated other comprehensive income		446,873			266,029
Total shareholders' equity (Note 7)		3,025,530			16,844,208
TOTAL	$	214,238,003		$	223,755,740

*Derived from audited consolidated financial statements.

See notes to consolidated financial statements.

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Weststar Financial Services Corporation & Subsidiary
Consolidated Statements of Operations (unaudited)	Three Months Ended June 30,						Six Months Ended June 30,
	2010			2009			2010			2009
INTEREST INCOME:
Interest and fees on loans	$	2,262,780		$	2,968,095		$	4,755,880		$	5,759,201
Federal funds sold		-			160			-			1,132
Interest-bearing deposits		5,887			3,939			8,365			4,005
Investments:
Taxable interest income		149,669			169,191			308,002			349,073
Nontaxable interest income		107,914			95,221			213,523			186,857
Corporate dividends		380			-			783			-
Total interest income		2,526,630			3,236,606			5,286,553			6,300,268
INTEREST EXPENSE:
Time deposits of $100,000 or more		116,155			220,283			244,636			448,812
Other time and savings deposits		629,858			837,982			1,260,451			1,701,763
Short-term borrowings		475			50,388			45,468			60,114
Long-term debt		54,202			44,601			90,900			135,638
Total interest expense		800,690			1,153,254			1,641,455			2,346,327
NET INTEREST INCOME		1,725,940			2,083,352			3,645,098			3,953,941
PROVISION FOR LOAN LOSSES		14,069,355			221,310			14,507,390			475,890
NET INTEREST INCOME (EXPENSE) AFTER PROVISION
FOR LOAN LOSSES		(12,343,415	)		1,862,042			(10,862,292	)		3,478,051
OTHER INCOME:
Services charges on deposit accounts		261,621			287,680			505,846			552,335
Other service fees and commissions		154,181			166,932			295,481			300,612
Other		9,106			9,979			16,553			19,851
Total other income		424,908			464,591			817,880			872,798
OTHER EXPENSES:
Salaries and wages		668,706			709,874			1,361,609			1,391,271
Employee benefits		192,444			82,860			314,908			214,135
Occupancy expense, net		110,234			122,076			211,875			307,129
Equipment rentals, depreciation and
maintenance		106,848			102,653			202,517			201,375
Supplies		72,648			67,585			139,320			131,858
Professional fees		90,001			65,551			168,322			135,988
Data processing fees		186,728			156,960			369,475			310,948
FDIC insurance premiums		86,516			173,808			171,310			246,212
Audit, tax and accounting		32,551			24,458			118,935			79,622
Consultant fees		63,383			8,584			117,169			15,405
Marketing		87,932			80,435			151,606			173,122
Credit expenses, net of deferred fees/costs		209,038			(15,401	)		275,733			(24,365	)
Expenses from foreclosed properties		27,129			70			42,717			70
Other		131,754			109,363			226,854			201,994
Total other expenses		2,065,912			1,688,876			3,872,350			3,384,764
INCOME (LOSS) BEFORE INCOME TAXES		(13,984,419	)		637,757			(13,916,762	)		966,085
INCOME TAX PROVISION		96,351			203,888			82,760			308,273
NET INCOME (LOSS)	$	(14,080,770	)	$	433,869			(13,999,522	)		657,812
EARNINGS / (LOSS) PER SHARE:
Basic	$	(6.50	)	$	.20		$	(6.46	)	$	.31
Diluted	$	(6.50	)	$	.19		$	(6.46	)	$	.29

See notes to consolidated financial statements.

3

Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Comprehensive Income (Loss) (unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2010			2009			2010			2009
NET INCOME (LOSS)	$	(14,080,770	)	$	433,869		$	(13,999,522	)	$	657,812
OTHER COMPREHENSIVE INCOME
Unrealized holding income (losses) on securities
available for sale		272,308			(6,986	)		294,295			243,677
Tax effect		(104,975	)		2,693			(113,451	)		(93,937	)
Unrealized holding gains (losses) on securities
available for sale, net of tax		167,333			(4,293	)		180,844			149,740
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX		167,333			(4,293	)		180,844			149,740
COMPREHENSIVE INCOME (LOSS)	$	(13,913,437	)	$	429,576		$	(13,818,678	)	$	807,552

See notes to consolidated financial statements.

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Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Changes in Shareholders’ Equity (unaudited)

For the Six Months Ended June 30, 2010 and 2009

	Common Stock				Additional Paid-In		Retained Earnings (Accumulated			Accumulated Other Comprehensive		Total Shareholders’
	Shares		Amount		Capital		Deficit)			Income (Loss)		Equity
Balance December 31, 2008		2,125,747	$	2,125,747	$	6,152,868	$	8,214,480		$	17,476	$	16,510,571
Net change in unrealized
gains on securities held for sale											149,740		149,740
Issuance of common stock pursuant
to the exercise of stock options		20,385		20,385		46,070							66,455
Tax benefit on exercise of non-
qualified stock options						16,581							16,581
Net Income								657,812					657,812
Balance June 30, 2009		2,146,132	$	2,146,132	$	6,215,519	$	8,872,292		$	167,216	$	17,401,159
Balance December 31, 2009		2,167,517	$	2,167,517	$	6,269,404	$	8,141,258		$	266,029	$	16,844,208
Net change in unrealized
gains on securities held for sale											180,844		180,844
Net Income								(13,999,522	)				(13,999,522	)
Balance June 30, 2010		2,167,517	$	2,167,517	$	6,269,404	$	(5,858,264	)	$	446,873	$	3,025,530

See notes to consolidated financial statements.

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Weststar Financial Services Corporation & Subsidiary
Consolidated Statements of Cash Flows (unaudited)
For the Six Months Ended June 30,	2010			2009
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income (loss)	$	(13,999,522	)	$	657,812
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		163,794			175,464
Provision for loan losses		14,507,390			475,890
Premium amortization and discount accretion, net		6,474			(15,834	)
Deferred income tax provision		872,351			(202,424	)
Net (gains) losses from foreclosed properties		15,534			-
Increase in accrued interest receivable		(50,575	)		(6,643	)
Increase in other assets		(41,647	)		(50,910	)
Decrease in accrued interest payable		(5,806	)		(652	)
Increase in other liabilities		67,242			243,024
Net cash provided by operating activities		1,535,235			1,275,727
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of securities available for sale		(1,132,875	)		(1,499,005	)
Maturities of securities available for sale		2,010,317			2,538,623
Net increase in loans		(2,406,804	)		(9,570,746	)
Proceeds from sales of foreclosed properties		1,181,023			-
FHLB stock purchase		-			(54,200	)
FHLB stock redemption		-			47,500
Additions to premises and equipment		(513,714	)		(61,973	)
Net cash used in investing activities		(862,053	)		(8,599,801	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in demand deposits, NOW Accounts, MMDA
and savings accounts		4,332,054			16,975,858
Net increase (decrease) in time deposits		(558,186	)		7,659,382
Issuance of common stock		-			66,455
Proceeds of FHLB advances		4,000,000			1,110,000
Repayment of FHLB advances		(4,000,000	)		(2,110,000	)
Tax benefit from exercise of non-qualified stock options		-			16,581
Net increase (decrease) in short-term borrowing		465,637			(4,103,053	)
Net cash provided by financing activities		4,239,505			19,615,223
NET INCREASE IN CASH AND CASH EQUIVALENTS		4,912,687			12,291,149
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		8,335,533			4,419,778
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	13,248,220		$	16,710,927

See notes to consolidated financial statements.

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WESTSTAR FINANCIAL SERVICES CORPORTION & SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Weststar Financial Services Corporation (the “Company”) is the holding company for The Bank of Asheville (the “Bank”).  The Bank is a state chartered commercial bank, which was incorporated in North Carolina on October 29, 1997.  The Bank provides consumer and commercial banking services in Buncombe County and surrounding areas.  Common shares of The Bank of Asheville were exchanged for common shares of Weststar Financial Services Corporation on April 29, 2000.  Weststar Financial Services Corporation formed Weststar Financial Services Corporation I (the “Trust”) during October 2003 in order to facilitate the issuance of trust preferred securities.  The Trust is a statutory business trust formed under the laws of the state of Delaware, of which all common securities are owned by Weststar Financial Services Corporation.

In the opinion of management, the accompanying consolidated financial statements contain all adjustments necessary to present fairly the consolidated financial position of the Company as of June 30, 2010 and December 31, 2009, and the consolidated results of their operations for the three and six-month periods ended June 30, 2010 and 2009 and their cash flows for the six-month periods ended June 30, 2010 and 2009.  Operating results for the three and six-month periods ended June 30, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2010.

The accounting policies followed are set forth in Note 1 to the 2009 Annual Report to Shareholders (Form 10-K) on file with the Securities and Exchange Commission.

2. “Accounting for Transfers of Financial Assets”.  The Company adopted the new accounting standard governing the recognition and presentation of transfers of financial assets. This standard eliminates the concept of a qualifying special purpose entity (QSPE), changes the requirements for de-recognizing financial assets, and requires additional disclosures, including information about continuing exposure to risks related to transferred financial assets.  The effective date is for financial asset transfers occurring after the beginning of fiscal years beginning after November 15, 2009.  The disclosure requirements must be applied to transfers that occurred before and after the effective date. The adoption of this standard did not have a material effect on the Company’s financial position and results of operations.

”Consolidation of Variable Interest Entities”.  The Company adopted the new accounting standard governing the recognition and presentation of consolidation of variable interest entities (VIE), which amended the VIE guidance in U.S. GAAP to include new criteria for determining the primary beneficiary, eliminates the exception to consolidating QSPEs, requires continual reconsideration of conclusions reached in determining the primary beneficiary, and requires additional disclosures.  This requirement is effective as of the beginning of fiscal years beginning after November 15, 2009 and is applied using a cumulative effect adjustment to retained earnings for any carrying amount adjustments (e.g., for newly-consolidated VIEs). The adoption of this standard did not have an effect on the Company.

“Fair Value Measurements and Disclosures”.  The Company adopted the new accounting standard governing the recognition and presentation of fair value measurements and disclosures. This standard requires additional fair value measurement disclosures including the amount of and reasons for transfers in and out of Level 1 and Level 2 fair value measurements and changes the requirement to disclose purchases, sales, issuances and settlements in the reconciliation of Level 3 fair value measurements to a gross basis rather than a net basis. In addition, the standard clarifies that the level of disaggregation required for existing fair value disclosures should be provided for each class of assets and liabilities. Disclosures about inputs and valuation techniques should be disclosed for Level 2 and Level 3 fair value measurements. The requirements of this standard are effective for interim and annual periods beginning after December 15, 2009, except for the disclosures about measurements, which are effective for fiscal years beginning after December 15, 2010 and interim periods within those fiscal years. The adoption of this standard did not have a material impact on our financial statements.

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“Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses”.  In July the Bank adopted the new standard governing the disclosures associated with credit quality and the allowance for loan losses.  This standard requires additional disclosures related to the allowance for loan loss with the objective of providing financial statement users with greater transparency about an entity’s loan loss reserves and overall credit quality.  Additional disclosures include showing on a disaggregated basis the aging of receivables, credit quality indicators, and troubled debt restructures with its effect on the allowance for loan loss.  The provisions of this standard are effective for interim and annual periods ending on or after December 15, 2010.  The adoption of this standard will not have a material impact on the Bank’s financial position and results of operations however it will increase the amount of disclosures in the notes to the financial statements.

3. In the normal course of business there are various commitments and contingent liabilities such as commitments to extend credit, which are not reflected on the financial statements.  The unused portions of commitments to extend credit were $19,776,975 and $26,179,686 at June 30, 2010 and December 31, 2009, respectively.

On June 18, 2010, Queens Gap Holding Company, LLC and D.F. McCarthy Investments XVIII, LLC filed suit against the Bank in the United States District Court for the Western District of North Carolina.  In summary, the Plaintiffs, who were the sellers in a real estate development transaction, allege that the Bank improperly allowed the buyer to divert, for personal use, funds from an account set up at the Bank to fund infrastructure improvements in the development.  The Plaintiffs' claims are based on alleged oral and email representations and promises from the Bank to them.  The Plaintiffs seek $4,250,000 in compensatory damages plus treble damages and attorney's fees.  The Bank intends to defend this case vigorously. Bank’s management and its counsel are still in the early phase of discovery and have concluded as of June 30, 2010 that it is not probable that the Bank will incur a loss as a result of this suit.  As more information becomes available and as the suit progresses, the conclusion may change.

4. Basic and diluted net income per share have been computed by dividing net income for each period by the weighted average number of shares of common stock outstanding during each period.

Basic earnings per common share represents income available to common stockholders divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per common share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustments to income that would result from the assumed issuance.  Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.  There were 211,615 options excluded during the three and six month periods ended June 30, 2010 due to antidilution.  During the periods ended June 30, 2009, no options were excluded due to antidilution.

Basic and diluted net income per share have been computed based upon net income (loss) as presented in the accompanying statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:

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	Three Months Ended June 30,				Six Months Ended June 30,
	2010		2009		2010		2009
Weighted average number of
common shares used in
computing basic net income
per share		2,167,517		2,146,132		2,167,517		2,140,937
Effect of dilutive stock options		-		111,231		-		100,807
Weighted average number of
common shares and dilutive
potential common shares
used in computing diluted net
income per common share		2,167,517		2,257,363		2,167,517		2,241,744

5. The fair value estimates presented herein are based on pertinent information available to management as of June 30, 2010 and December 31, 2009.  These fair value estimates are based on relevant market information and information about the financial instruments.  Fair value estimates are intended to represent the price an asset could be sold at or the price for which a liability could be settled.  However, given that there is no active market or observable market transaction for many of the Company’s financial instruments, the Company has made estimates of many of these fair values, which are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the estimated values.

	June 30, 2010				December 31, 2009
	Carrying amount		Estimated fair value		Carrying amount		Estimated fair value
	(In thousands)
Assets:
Cash and cash equivalents	$	13,248	$	13,248	$	8,336	$	8,336
Investment securities		24,457		24,457		25,047		25,047
Federal Home Loan Bank stock		592		592		592		592
Loans, net		166,253		167,112		181,963		183,328
Interest receivable		937		937		886		886
Bank owned life insurance		329		329		361		361
Liabilities:
Demand deposits, NOW accounts,
money market accounts, savings		100,825		100,825		96,493		96,493
Time deposits		100,071		100,437		100,629		100,799
Short-term borrowings		840		840		4,375		4,417
Interest payable		335		335		372		372
Long-term debt		8,124		8,085		4,124		4,039

Cash and Cash Equivalents and Accrued Interest - The carrying amounts approximate their fair value because of the short maturity of these financial instruments.

Investment Securities - The fair value of securities, excluding the Federal Home Loan Bank stock, is based on quoted market prices. The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank.

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Loans - Fair value of loans are estimated based on discounted expected cash flows.  These cash flows include assumptions for prepayment estimates over the loan’s remaining life, considerations for the current interest rate environment compared to the weighted average rate of each portfolio credit, a credit risk component based on historical and expected performance of each portfolio.  The fair value calculation did not include a liquidity adjustment, which in the current environment could possibly reflect a significant discount.

Deposits - - The fair value of deposits with no stated maturity, such as non-interest-bearing demand deposits, savings, NOW, and money market accounts, is equal to the amount payable on demand as of the valuation date. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-term borrowings and long-term debt – The fair values are based on discounting expected cash flows at the interest rate for debt with same or similar remaining maturities and collateral requirements.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair values.  These levels are:

Level 1  Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2  Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3  Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market.  These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability.  Valuation techniques included use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available-for-Sale

Investment securities available-for-sale are recorded at fair value on a recurring basis.  Fair value measurement is based upon quoted prices, if available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  Level 1 securities included those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds.  Level 2 securities included mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities.  Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

The Company does not record loans at fair value on a recurring basis.  However, from time to time a loan is considered impaired and a specific reserve is established.  Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flow.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investment in such loans.  At June 30, 2010 and December 31, 2009, substantially all of the total impaired loans were evaluated based on the fair

10

value of the collateral.  In accordance with FASB ASC 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

Foreclosed Properties

Foreclosed assets are adjusted to fair value less estimated selling costs upon transfer of the loans to foreclosed assets.  Subsequently, foreclosed assets are carried at the lower of carrying value or fair value.  Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2.  When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets measured at fair value on a recurring basis are summarized below:

	Fair Value Measurements at June 30, 2010
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Assets/Liabilities
Description	(Level 1)		(Level 2)		(Level 3)		at Fair Value
U.S. Government
agencies		-	$	2,218,212		-	$	2,218,212
Mortgage-backed
Securities		-	$	10,697,788		-	$	10,697,788
Municipal bonds		-	$	11,540,879		-	$	11,540,879
	Fair Value Measurements at December 31, 2009
U.S. Government
agencies		-	$	2,449,886		-	$	2,449,886
Mortgage-backed
Securities		-	$	11,764,887		-	$	11,764,887
Municipal bonds		-	$	10,831,727		-	$	10,831,727

Assets measured at fair value on a non-recurring basis are summarized below:

	Fair Value Measurements at June 30, 2010
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Assets/Liabilities
Description	(Level 1)		(Level 2)		(Level 3)		at Fair Value
Impaired Loans		-	$	13,046,972	$	1,970,457	$	15,017,429
Foreclosed properties		-		1,426,649		1,483,732		2,910,381

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	Fair Value Measurements at December 31, 2009
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Assets/Liabilities
Description	(Level 1)		(Level 2)		(Level 3)		at Fair Value
Impaired Loans		-	$	5,820,701	$	313,776	$	6,134,477
Foreclosed properties		-		-		511,112		511,112

6. INVESTMENT PORTFOLIO

The amortized cost, gross unrealized gains and losses and fair values of available-for-sale securities at June 30, 2010 are as follows:

Available-for-sale securities consist of the following at June 30, 2010:

			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		value
Type and Maturity Group
Mortgage-backed securities due -
Within 1 year		142,375		1,594		-		143,969
Municipal bonds due –
Within 1 year		555,296		11,242		-		566,538
Total due within 1 year		697,671		12,836		-		710,507
U.S. Government agencies due -
Within 1 to 5 years		2,038,323		179,889		-		2,218,212
Residential mortgage-backed
securities due -
Within 1 to 5 years		781,453		27,484		-		808,937
Municipal bonds due –
Within 1 to 5 years		988,831		39,041		-		1,027,872
Total due within 1 to 5 years		3,808,607		246,414		-		4,055,021
Residential mortgage-backed
securities due -
Within 5 to 10 years		1,014,122		72,082		-		1,086,204
Municipal bonds due –
Within 5 to 10 years		1,635,180		22,062		-		1,657,242
Total due within 5 to 10 years		2,649,302		94,144		-		2,743,446
Residential mortgage-backed
securities due -
After 10 years		8,262,959		395,719		-		8,658,678

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Municipal bonds due –
after 10 years		8,311,125		104,844		(126,742	)		8,289,227
Total due after years		16,574,084		500,563		(126,742	)		16,947,905
Total at June 30, 2010	$	23,729,664	$	853,957	$	(126,742	)	$	24,456,879

Available-for-sale securities consist of the following at December 31, 2009:

	Amortized cost		Gross unrealized gains		Gross unrealized losses			Fair value
Type and Maturity Group
Residential mortgage-backed securities -
Within 1 year	$	501,935	$	-	$	(176	)	$	501,759
U.S. Government agencies due –
Within 1 to 5 years		1,019,655		63,885		-			1,083,540
Residential mortgage-backed U.S.
Government agencies securities due -
Within 1 to 5 years		999,939		20,929		-			1,020,868
Municipal bonds due –
Within 1 to 5 years		1,549,329		60,297		-			1,609,626
Total due within 1 to 5 years		3,568,923		145,111		-			3,714,034
U.S. Government agencies due -
Within 5 to 10 years		1,265,259		101,087		-			1,366,346
Residential mortgage-backed U.S.
Government agencies securities due -
Within 5 to 10 years		722,932		32,432		-			755,364
Municipal bonds due –
Within 5 to 10 years		1,642,396		5,684		(9,887	)		1,638,193
Total due within 5 to 10 years		3,630,587		139,203		(9,887	)		3,759,903
Residential mortgage-backed U.S.
Government agencies securities due -
after 10 years		9,227,386		308,305		(48,795	)		9,486,896
Municipal bonds due –
after 10 years		7,684,749		50,973		(151,814	)		7,583,908
Total due after years		16,912,135		359,278		(200,609	)		17,070,804
Total at December 31, 2009	$	24,613,580	$	643,592	$	(210,672	)	$	25,046,500

The following tables show investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2010.  These investments represent securities that the Company has the positive intent and ability to hold to maturity.  The unrealized losses on investment securities as of June 30, 2010 are a result of volatility in the market during 2010 and relate to eight municipal bonds.  All unrealized losses on investment securities resulted from changes in interest rates and are considered by management to be

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temporary given the credit ratings on these investment securities, the duration of the unrealized loss, and our intent and ability to retain our investment in a security for a period of time sufficient to allow for any anticipated recovery in market value.  Since the Company intends to hold all of its investment securities until maturity, and it is more likely than not that the Company will not have to sell any of its investment securities before unrealized losses have been recovered, and because the Company expects to recover the entire amount of the amortized cost basis of all its securities, none of the securities are deemed other than temporarily impaired.

June 30, 2010
	Less Than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	value		losses			value		losses			value		losses
Securities available for sale:
Municipal bonds	$	1,934,421	$	41,908		$	1,399,073	$	84,834		$	3,333,494	$	126,742
Total temporarily impaired
securities	$	1,934,421	$	41,908		$	1,399,073	$	84,834		$	3,333,494	$	126,742
December 31, 2009:
	Less Than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	value		losses			value		losses			value		losses
Securities available for sale:
Residential mortgage-
backed U.S. Government
agencies securities	$	2,912,885	$	(48,971	)	$	-	$	-		$	2,912,885	$	(48,971	)
Municipal bonds		3,998,244		(53,226	)		1,377,766		(108,475	)		5,376,010		(161,701	)
Total temporarily impaired
securities	$	6,911,129	$	(102,197	)	$	1,377,766	$	(108,475	)	$	8,288,895	$	(210,672	)

The aggregate cost of the Company’s cost method investment, Federal Home Loan Bank stock, totaled $592,300 at June 30, 2010.  The Company estimated that the fair value equaled the cost of the investment (that is, the investment was not impaired).  The investment in Federal Home Loan Bank stock is not reflected in investment securities; the investment is carried as a separate line item in the financial statements.

7. Capital and Regulatory Matters

Due to the signifcant decline in capital, it is anticipated that the Bank will be required to enter into a formal consent order with the North Carolina Commissioner of Banks and the FDIC.  An enforcement action of this nature would most likely require higher regulatory capital requirements than would otherwise be required. A consent order could also result in requiring the Bank to raise additional capital within a specified timeframe, limit access to the brokered CD market, restrict rates it can offer on customer deposits and necessitate a corrective plan for the reduction of non-performing assets, among other matters. Furthermore, because such consent orders are public, there could be an adverse customer or market reaction to such announcement. These matters potentially raise substantial doubt about the Bank’s ability to continue as a going concern.  If the Bank is unable to comply with the terms of any such consent order, further regulatory actions could be taken.

As a result of the loan losses, our capital accounts have changed significantly since year and are as follows as of June 30, 2010:

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REGULATORY CAPITAL

	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
(Dollars in Thousands)
As of June 30, 2010
Total Capital (to Risk Weighted
Assets)
Consolidated	$	6,878		3.85	%	$	14,278		8.00	%	$	17,847		10.00	%
Bank	$	8,249		4.63	%	$	14,258		8.00	%	$	17,823		10.00	%
Tier 1 Capital (to Risk Weighted
Assets)
Consolidated	$	3,439		1.93	%	$	7,139		4.00	%	$	10,708		6.00	%
Bank	$	5,997		3.36	%	$	7,129		4.00	%	$	10,694		6.00	%
Tier 1 Capital (to Average Assets)
Consolidated	$	3,439		1.51	%	$	9,122		4.00	%	$	11,403		5.00	%
Bank	$	5,997		2.63	%	$	9,113		4.00	%	$	11,392		5.00	%

The Bank is considered significantly undercapitalized under the prompt corrective action provisions of the FDIC.

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Item 2.    Management’s Discussion and Analysis

Financial Condition and Results of Operations

Weststar Financial Services Corporation & Subsidiaries

Management’s Discussion and Analysis

Management’s Discussion and Analysis is provided to assist in understanding and evaluating the Company’s results of operations and financial condition. The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this report. Weststar Financial Services Corporation is the holding company for The Bank of Asheville (the “Bank”).  The Bank is a state-chartered commercial bank which was incorporated in North Carolina on October 29, 1997. The Bank provides consumer and commercial banking services in Buncombe County and surrounding areas. Common shares of The Bank of Asheville were exchanged for common shares of Weststar Financial Services Corporation on April 28, 2000. Weststar Financial Services Corporation formed Weststar Financial Services Corporation I (the “Trust”) during October 2003 in order to facilitate the issuance of trust preferred securities.  The Trust is a statutory business trust formed under the laws of the state of Delaware, of which all common securities are owned by Weststar Financial Services Corporation.  Because Weststar Financial Services Corporation has no material operations and conducts no business on its own other than owning the Bank, the discussion contained in Management’s Discussion and Analysis concerns primarily the business of the Bank.  However, for ease of reading and because the financial statements are presented on a consolidated basis, Weststar Financial Services Corporation and the Bank are collectively referred to herein as the Company.

EXECUTIVE OVERVIEW

Net charge-offs during the three and six month periods ended June 30, 2010 totaled $13,398,016 and $13,834,231, respectively, compared to $51,667 and $158,363 during the three and six month periods ended June 30, 2009, respectively.  Second quarter 2010 charge-offs were primarily related to declines in real estate values of impaired collateral dependent loans and changes in the types of appraisals obtained to support valuations on properties that are expected to be resolved via foreclosure.  The sluggish real estate market continues to significantly affect real estate collateral values which directly impacts the level of specific reserves required on impaired loans.

Non-performing assets totaled $27,780,216 and $25,973,097 at June 30, 2010 and December 31, 2009, respectively.  Loans outstanding decreased 8.11% to $170,438,295, when compared to December 31, 2009 primarily as a result of loan charge-offs and write-downs. The investment portfolio remained relatively flat at $24,456,879, when compared to $25,046,500 at December 31, 2009.

As a reaction to the continued trends in nonperforming loans, the Bank has brought in third party loan review assistance to review significant portions of the portfolio for potential problem loans.  During the quarter, this function has identified additional classified or impaired loans.  The Bank will continue to have the portfolio reviewed by the outside consultant for additional problem loans.

Net interest income decreased by 17.16% during the three-month period due to a decrease in net earning assets and net interest margin.  Primarily as a result of net charge-offs, the Company added $14,069,355 to the allowance for loan losses compared to $221,310 during the comparable period in 2009.  Other non-interest income for the June 30, 2010 and 2009 quarters totaled $424,908 and $464,591, respectively.  The decrease in other income primarily reflects decreased fees from the origination of mortgage loans and decreased overdraft fees.  Non-interest expenses increased from $1,688,876 to $2,065,912 or 22.32%.  The increase was primarily attributable to credit related expenses such as appraisals and collections, and expenses incurred to support loan and deposit servicing.

Net income (loss) totaled $(14,080,770) and $433,869 for the quarters ended June 30, 2010 and 2009, respectively.

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The Company’s net interest income decreased by 7.81% during the six-month period due to a decrease in earning assets.  Primarily as a result of net charge-offs, the Company added $14,507,390 to the loan loss reserve compared to $475,890 during the comparable period in 2009.  Other non-interest income for the June 30, 2010 and 2009 periods totaled $817,880 and $872,798 respectively.  The decrease in other income primarily reflects decreased fees from the origination of mortgage loans and decreased overdraft fees.  Non-interest expenses increased from $3,384,764 to $3,872,350 or 14.41%.  The increase was primarily attributable to credit related expenses such as appraisals and collections, and expenses incurred to support loan and deposit servicing.

Net income (loss) totaled $(13,999,522) and $657,812 for the six month periods ended June 30, 2010 and 2009, respectively.

CHANGES IN FINANCIAL CONDITION

JUNE 30, 2010 COMPARED TO DECEMBER 31, 2009

During the period from December 31, 2009 to June 30, 2010, total assets decreased $9,517,737 or 4.25%.  This decrease, reflected primarily in loans, resulted from net charge-offs and/or write-downs. This trend was driven by the sluggish real estate market’s affect on real estate collateral which had a significant impact on the level of specific reserves required on impaired loans.

Securities and interest-bearing balances with other financial institutions at June 30, 2010 totaled $33,451,807 compared to $26,596,740 at December 31, 2009.  Through an investment in the Federal Home Loan Bank, the Company gained access to the Federal Home Loan Bank system.  This access grants the Company sources of funds for lending and liquidity.  Investments in Federal Home Loan Bank stock to date total $592,300.

At June 30, 2010, the loan portfolio constituted 79.56% of the Company’s total assets.  Loans decreased $15,036,578, or 8.11%, from December 31, 2009 to June 30, 2010 as a result of net charge-offs and/or write-downs ..

The recorded investment in impaired loans was $28,461,384, $3,007,369 and $33,329,137, which includes nonperforming and restructured loans, at June 30, 2010 and 2009 and December 31, 2009, respectively.  Impaired loans of $28,461,384, $2.193,220 and $33,329,137 had no related allowances for loan losses.  The Company compares the net realizable value of impaired loans against the recorded investment in such loans and generally charges-off any deficit to the allowance for loan losses in accordance with FDIC guidance.  The average recorded balance of impaired loans for the six months ended June 30, 2010 and 2009 totaled $33,731,623 and $1,861,357, respectively and $7,356,699 for the year ended December 31, 2009.  For the six-month periods ended June 30, 2010 and 2009, the Company recognized interest income from impaired loans of approximately $191,530 and $20,115, respectively.  See “Asset Quality” for discussion and analysis of loan loss reserves.

During 2010, the Company focused significant attention on working with loan customers, who were experiencing financial difficulties.  The economic downturn impacted many businesses in our market ranging from real estate development to retail sales, which in turn negatively impacted land sales in the region and retail sales of our commercial customers.  The Company attempted to take proactive measures to restructure notes for businesses and individuals, where restructuring indicated an improvement in loan collectibility.

The following table presents the recorded investments in troubled debt restructure loans by category that are performing:

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	June 30,		December 31,
	2010		2009
Commercial real estate:
Residential ADC	$	56,723	$	5,527,742
Other commercial real estate		-		464,270

Total non-owner occupied
commercial  real estate		56,723		5,992,012
Commercial owner occupied
real estate		3,015,186		1,172,095
Commercial and industrial		150,224		167,341
Residential mortgage:
First lien, closed end		267,588		274,151
Home equity lines of credit		80,804		198,602
Consumer		13,202		8,987
Total	$	3,583,727	$	7,813,188

The reduction in troubled debt restructured loans was primarily due to loan charge-offs.  Potential problem loans consist of loans that are performing in accordance with contractual terms, but for which management has concerns about the ability of an obligor to continue to comply with repayment terms, because of the obligor’s potential operating or financial difficulties.  Management monitors these loans closely and reviews their performance on a regular basis.  These loans do not meet the standards for, and are therefore not included in, nonperforming assets.  At June 30, 2010, the Company identified nine potential problem loans totaling $3,058,281 as compared to one potential problem loan totaling $2,756 at December 31, 2009.

Deposits increased $3,773,868 during the six months ended June 30, 2010.  The increase in deposits was primarily attributable to growth in demand, money market and savings accounts.  The Company experienced a $1,475,610 decrease in NOW accounts during the quarter.  The decrease primarily resulted from fluctuations in Interest On Lawyers Trust Accounts, commonly called IOLTAs, which is an escrow account primarily used for real estate transactions.  These accounts are subject to wide fluctuations representing real estate closing activities.  During the second quarter, the Company reduced the rate paid on eZchecking, a NOW account product, from 4.01% to 3.65% and reduced the maximum base upon which the rate could be paid from $25,000 to $15,000.  Changes in the product reflect trends in the market area and adjustments needed to increase product profitability.  eZchecking remains one of the Company’s most popular accounts.  Qualifiers for the account included a minimum of 10 debit card transactions, one direct deposit and receipt of an electronic statement each month.  The Company earns interchange revenue from debit card usage and can deliver electronic statements more efficiently than through standard U.S. mail; these two factors effectively minimize the cost of funds on the product.  At June 30, 2010, the Company had 2,151 eZchecking accounts totaling $31,287,410 compared to 1,818 accounts totaling $29,777,082 at December 31, 2009.  Savings accounts increased from $2,890,582 to $3,727,603 or 28.96%.  The increase in savings most likely reflects the national trends of increased savings and reduced spending as consumers remain pessimistic about the economy.  Time deposits decreased $558,186 from December 31, 2009 to June 30, 2010.  The decrease appears to have stemmed from a shift in funds from certificates of deposit to the equities sector as the stock market demonstrated gains during the majority of the period.  Demand deposit account growth primarily reflects increased deposits in commercial accounts rather than retail consumer accounts.

Short-term borrowings consisted of securities sold under agreements to repurchase in the amount of $840,310.  Securities sold under agreements to repurchase bear a variable rate of interest and mature daily.  At June 30, 2010, the rate on these borrowings was .25%.

Long-term borrowings consisted of trust preferred securities totaling $4,124,000 and one advance from the Federal Home Loan Bank of Atlanta.  The trust preferred securities bear a rate of LIBOR plus 315 basis points (3.45% at June 30, 2010) and pay dividends quarterly.  The rate is subject to quarterly resets.  The trust preferred securities mature October 7, 2033, and became callable on or after October 7, 2008.  $860,000 of the trust preferred securities were eligible for inclusion as Tier I capital and $1,184,000 as Tier 2 capital.  Trust preferred securities are limited 25% of Tier 1 capital.  Amounts in excess of this limit generally may be included in Tier 2 capital.  Advances from the FHLB are secured by a blanket lien on 1-4 family real estate loans and certain commercial real estate loans.  The interest rate on the advance was 1.83% and matures on March 15, 2013.

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The Company’s total capital to risk weighted assets totaled 3.85% at June 30, 2010.  Current regulations require a minimum ratio of total capital to risk weighted assets of 8%, with at least 4% being in the form of Tier 1 capital, as defined in the regulation.  As of June 30, 2010, the Company’s capital was considered to be significantly undercapitalized under the prompt corrective action provisions.   If the Company does not improve its capital, regulators may issue a warning to the Company and may also be required to take certain actions with respect to the Bank under federal bank regulatory “prompt corrective action” standards, including changing management and forcing the Bank to take other corrective actions. In addition, the Bank would lose the ability to renew, rollover or originate brokered deposits and to offer certain deposit products priced at above market rates.  Additionally, the Company’s access to borrowing from the Federal Home Loan Bank – Atlanta and Federal Reserve Bank may also be subject to reduced levels and terms.  See discussions under “Capital Resources” and “Liquidity”

RESULTS OF OPERATIONS

FOR THE THREE-MONTH AND SIX-MONTH PERIODS ENDED JUNE 30, 2010 AND 2009

Net interest income, the principal source of the Company’s earnings, is the amount of income generated by earning assets (primarily loans and investment securities) less the total interest cost of the funds obtained to carry them (primarily deposits and other borrowings).  The volume, rate and mix of both earning assets and related funding sources determine net interest income.

COMPARATIVE THREE MONTHS

Net interest income for the quarter ended June 30, 2010 totaled $1,725,940 compared to $2,083,352 in 2009.  The decrease was attributable to decreases in net earning assets and net interest margin.  The Company’s net interest margin was approximately 3.13% and 3.93% for the quarters ended June 30, 2010 and 2009, respectively.

Primarily as a result of changes in nonperforming loans and charge-offs, partially offset by some stabilization in the national and local economies, the Company recorded a provision for loan losses of $14,069,355 for the three months ended June 30, 2010 compared to $221,310 for the same period in 2009.  The increased provision was necessary in order to bring the allowance for loan losses to a level deemed appropriate in light of the risk inherent in the Bank’s loan portfolio indicated by recent loss experience, management’s analysis of applicable credit quality metrics and updated appraisals that resulted in charge-offs based upon their analysis of loan repayment probabilities of projected borrower cash flows or underlying collateral values, as applicable.Charge-offs, net of recoveries, totaled $13,398,016 for the three months ended June 30, 2010 compared to $51,667 for the same period in 2009.  Impaired loans, which include both nonaccrual and nonperforming restructured loans, are measured at net realizable value (the value of supporting collateral less costs to sell) or present value of cash flows, if not collateral- dependent.   If the net realizable value or present value of cash flows is less than the carrying value of the loan, the deficit is charged against the loan loss reserve.  During 2009, real estate values and real estate sales continued to decline on the heels of the depressed national, regional and local economies.  Real estate loans that formerly reflected low loan-to-value levels now reflect higher loan-to-value levels.  Management has taken these factors among others such as a a short time horizon of historic charge-off rates,  concentrations of credit, delinquency trend, economic and business conditions, external factors, lending management/staff, lending policies/procedures, loss and recovery trends, nature and volume of portfolio, nonaccrual trends, and other adjustments, problem loan trend and quality of loan review system by loan sector, into account when estimating the allowance for loans losses for both performing and nonperforming loans, which resulted in an increased provision for loan losses.  Loan charge-offs during second quarter resulted primarily from the decline in real estate values of impaired collateral dependent loans and changes in the types of appraisals obtained to support valuations on collateral of impaired loans.  Management continues to be concerned about the economy and related job growth.  Sustained growth in unemployment may necessitate additional increases to the provision for loan losses.  See “ASSET QUALITY” for more discussion.

Other non-interest income for the June 30, 2010 and 2009 quarters totaled $424,908 and $464,591, respectively.  The decrease in other income primarily reflects decreased fees from overdraft activities and fees from the origination of mortgage loans; decreases were partially offset by an increase in interchange revenue.  Fees earned

19

on overdrafts decreased from $228,301 to $205,014.  Fees from this service are activity based.  Mortgage fee income dropped by $39,074 as fewer customers qualified for mortgage loans.  Qualifications are primarily based upon customer credit scores and cash flows to meet borrowing obligations.  The Company continues to explore alternate financing options in an effort to provide a wide array of products to meet borrower needs.  Interchange revenue increased from $87,152 to $111,723 for the periods ended June 30, 2009 and 2010, respectively.  The Company earns interchange revenue from customer ATM, debit and credit card activities.  Other income remained relatively flat at $9,106.

Other non-interest expense totaled $2,065,912 compared to $1,688,876 in 2009.  The increase was primarily attributable to credit expenses and consultant fees.  During the period, the Bank ordered numerous appraisals on problem loans secured by real estate in order to determine the underlying value of the collateral.  Depending on the size and complexity of the collateral, appraisal costs ranged from $500 to $6,000.  Additionally, the Bank incurred loan collection and repossession expenses of $135,972 compared to $5,765 during 2009.  The majority of the loan collection expenses were attributable to legal fees.  The Bank further employed consultants to review lending activities and processes for quality control purposes.  Consultant fees totaled $63,383 during 2010 compared to $8,584 during 2009.

Salaries and benefits increased 8.63% to $861,150.  The increase was largely due to the changes in cash surrender value of an insurance contract and the increased participation in the Company’s 401(k) retirement plan.  Occupancy expense decreased from $122,076 to $110,234.  The decrease in expense reflects the change from lease to purchase of one of the Bank’s properties.  In January, the Bank purchased the building that houses the Reynolds office, which had originally been established as a leased property.  Equipment expenses remained relatively flat at $106,848.  Professional fees increased from $65,551 to $90,001 primarily due to various legal fees.  Data processing fees increased by 18.96% to $186,728 as a result of growth in the number of loans and deposits and increased internet banking and remote deposit capture activities.  FDIC insurance premiums decreased from $173,808 to $86,516 in 2010.  During the second quarter of 2009, the FDIC imposed a 5 basis point special assessment, which totaled approximately $101,000, to help replenish the FDIC’s deposit insurance fund.  No such assessment was imposed during 2010.  Marketing expenses increased from $80,435 to $87,932, which reflects increased marketing efforts for products and services.  Expenses from the foreclosures of properties increased from $70 during 2009 to $27,129 during 2010.  The increase reflects the levels of foreclosure related activities.  Other expenses totaled $131,754 in 2010 compared to $109,363 in 2009.  Income (loss) before income tax provision totaled $(13,984,419) and $637,757 for the quarters ended June 30, 2010 and 2009, respectively.  Income tax provision totaled $96,351 and $203,888 for the quarters ended June 30, 2010 and 2009, respectively, which equated to an effective tax rate of (.69)% and 31.97%, respectively.  The decrease in 2010’s tax rate reflects the creation of a deferred tax valuation allowance account, which offset the Company’s deferred tax assets.   No such valuation existed during the comparable 2009 period.  Net income (loss) totaled $(14,080,770) and $433,869 for the quarters ended June 30, 2010 and 2009, respectively.

Other comprehensive income (loss) totaled $167,333 and $(4,293) for the three months ended June 30, 2010 and 2009, respectively.  Comprehensive income (loss), which is the change in shareholders’ equity excluding transactions with shareholders, totaled $(13,913,437) and $429,576 for the quarters ended June 30, 2010 and 2009, respectively.

COMPARATIVE SIX MONTHS

Net interest income for the six-month period ended June 30, 2010 totaled $3,645,098 compared to $3,953,941 for the same period in 2009.  The decrease was attributable to a decrease in net earning assets and net interest margin.  The Company’s net interest margin was approximately 3.35% and 3.85% for the six months ended June 30, 2010 and 2009, respectively.

The Company recorded a provision for loan losses of $14,507,390 and $475,890 for the six months ended June 30, 2010 and 2009, respectively.  The provision for loan losses is charged to operations to bring the allowance to a level deemed appropriate by management based on the factors discussed under “Asset Quality.”

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Other non-interest income for the six months ended June 30, 2010 and 2009 totaled $817,880 and $872,798, respectively.  The decrease in other income primarily reflects decreased fees from overdraft activities and fees from the origination of mortgage loans; decreases were partially offset by an increase in interchange revenue.  Fees earned on overdrafts decreased from $436,734 to $393,256.  Fees from this service are activity based.  Effective July 1, 2010, changes in federal regulations that govern the Company’s ability to charge overdraft fees will likely further reduce the Company’s revenue from this service.  The Company will be prohibited from charging overdraft fees for ATM and one-time debit card transactions under the new Federal Reserve rules.  The new rules require the Company to ask consumers whether they want to opt in for overdraft protection. Additionally, the Company’s customers will be allowed only one overdraft fee per month, or six annually.  Mortgage fee income dropped by $55,269 as fewer customers qualified for mortgage loans.  Qualifications are primarily based upon customer credit scores and cash flows to meet borrowing obligations.  The Company continues to explore alternate financing options in an effort to provide a wide array of products to meet borrower needs.  Interchange revenue increased from $160,628 to $207,622 for the periods ended June 30, 2009 and 2010, respectively.  The Company earns interchange revenue from customer ATM, debit and credit card activities.  Other income remained relatively flat at $16,553.

Other non-interest expense totaled $3,872,350 compared to $3,384,764 in 2009.  The increase was primarily attributable to credit expenses and consultant fees.  During the period, the Bank ordered numerous appraisals on problem loans secured by real estate in order to determine the underlying value of the collateral.  Depending on the size and complexity of the collateral, appraisal costs ranged from $500 to $6,000.  Additionally, the Bank incurred loan collection and repossession expenses of $205,814 compared to $12,895 during 2009.  The majority of the loan collection expenses were attributable to legal fees.  The Bank further employed consultants to review lending activities and processes for quality control purposes.  Consultant fees totaled $117,169 during 2010 compared to $15,405 during 2009.

Salaries and benefits increased 4.43% to $1,676,517.  The increase was largely due to the changes in cash surrender value of an insurance contract and the increased participation in the Company’s 401(k) retirement plan.  Occupancy expense decreased from $307,129 to $211,875.  The decrease in expense reflects the change from lease to purchase of one of the Bank’s properties.  In January, the Bank purchased the building that houses the Reynolds office, which had originally been established as a leased property.  Equipment expenses remained relatively flat at $202,517.  Professional fees increased from $135,988 to $168,322 primarily due to various legal fees.  Data processing fees increased by 18.82% to $369,475 as a result of growth in the number of loans and deposits and increased internet banking and remote deposit capture activities.  FDIC insurance premiums decreased from $246,212 to $171,310 in 2010.  During the second quarter of 2009, the FDIC imposed a 5 basis point special assessment, which totaled approximately $101,000, to help replenish the FDIC’s deposit insurance fund.  No such assessment was imposed during 2010.  Marketing expenses decreased from $173,122 to $151,606, which reflects decreased marketing efforts for products and services during the first quarter of 2010.  Expenses from the foreclosures of properties increased from $70 during 2009 to $42,717 during 2010.  The increase reflects the levels of foreclosure related activities.  Other expenses totaled $226,854 in 2010 compared to $201,994 in 2009.  Income (loss) before income tax provision totaled $(13,916,762) and $966,085 for the periods ended June 30, 2010 and 2009, respectively.  Income tax provision totaled $82,760 and $308,273 for the periods ended June 30, 2010 and 2009, respectively, which equated to an effective tax rate of (.59)% and 31.91%, respectively.  The decrease in 2010’s tax rate reflects the creation of a deferred tax valuation allowance account, which offset the Company’s deferred tax assets.   No such valuation existed during the comparable 2009 period.  Net income (loss) totaled $(13,999,522) and $657,812 for the periods ended June 30, 2010 and 2009, respectively.

Other comprehensive income totaled $180,844 and $149,740 for the six months ended June 30, 2010 and 2009, respectively.  Comprehensive income (loss), which is the change in shareholders’ equity excluding transactions with shareholders, totaled $(13,818,678) and $807,552 for the six months ended June 30, 2010 and 2009, respectively.

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ASSET/LIABILITY MANAGEMENT

The Company’s asset/liability management, or interest rate risk management, program is focused primarily on evaluating and managing the composition of its assets and liabilities in view of various interest rate scenarios. Factors beyond the Company’s control, such as market interest rates and competition, may also have an impact on the Company’s interest income and interest expense.

Interest Rate Gap Analysis. As a part of its interest rate risk management policy, the Company calculates an interest rate “gap.” Interest rate “gap” analysis is a common, though imperfect, measure of interest rate risk, which measures the relative dollar amounts of interest-earning assets and interest-bearing liabilities which reprice within a specific time period, either through maturity or rate adjustment. The “gap” is the difference between the amounts of such assets and liabilities that are subject to repricing. A “positive” gap for a given period means that the amount of interest-earning assets maturing or otherwise repricing within that period exceeds the amount of interest-bearing liabilities maturing or otherwise repricing within the same period. Accordingly, in a declining interest rate environment, an institution with a positive gap would generally be expected, absent the effects of other factors, to experience a decrease in the yield on its assets greater than the decrease in the cost of its liabilities and its income should be negatively affected. Conversely, the cost of funds for an institution with a positive gap would generally be expected to increase more slowly than the yield on its assets in a rising interest rate environment, and such institution’s net interest income generally would be expected to be positively affected by rising interest rates. Changes in interest rates generally have the opposite effect on an institution with a “negative gap.”

The majority of the Company’s deposits are rate-sensitive instruments with rates that tend to fluctuate with market rates. These deposits, coupled with the Company’s short-term certificates of deposit, have increased the opportunities for deposit repricing. The Company places great significance on monitoring and managing the Company’s asset/liability position. The Company’s policy of managing its interest margin (or net yield on interest-earning assets) is to maximize net interest income while maintaining a stable deposit base. The Company’s deposit base is not generally subject to the level of volatility experienced in national financial markets in recent years; however, the Company does realize the importance of minimizing such volatility while at the same time maintaining and improving earnings. Therefore, management prepares on a regular basis earnings projections based on a range of interest rate scenarios of rising, flat and declining rates in order to more accurately measure interest rate risk.

Interest-bearing liabilities and variable rate loans are generally repriced to current market rates. Based on its analysis, the Company believes that its balance sheet is liability-sensitive; meaning that in a given period there will be more liabilities than assets subject to immediate repricing as the market rates change. Because a significant portion of the Company’s deposits are either variable rate or have short-term maturities, they reprice more rapidly than rate sensitive interest-earnings assets. During periods of rising rates, this results in decreased net interest income, assuming similar growth rates and stable product mixes in loans and deposits. The opposite occurs during periods of declining rates.

The Company uses interest sensitivity analysis to measure the sensitivity of projected earnings to changes in interest rates. The sensitivity analysis takes into account the current contractual agreements that the Company has on deposits, borrowings, loans, investments and any commitments to enter into those transactions. The Company monitors interest sensitivity by means of computer models that incorporate the current volumes, average rates, scheduled maturities and payments and repricing opportunities of asset and liability portfolios. Using this information, the model estimates earnings based on projected portfolio balances under multiple interest rate scenarios. In an effort to estimate the effects of pure interest-rate risk, the Company assumes no growth in its balance sheet, because to do so could have the effect of distorting the balance sheet’s sensitivity to changing interest rates. The Company simulates the effects of interest rate changes on its earnings by assuming no change in interest rates as its base case scenario and either (1) gradually increasing or decreasing interest rates by over a twelve-month period or (2) immediately increasing or decreasing interest rates by .25%, .50%, 1% and 2%. Although these methods are subject to the accuracy of the assumptions that underlie the process and do not take into account the pricing strategies that management would undertake in response to sudden interest rate changes,

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the Company believes that these methods provide a better indication of the sensitivity of earnings to changes in interest rates than other analyses.

Income simulation through modeling is one tool that the Company uses in the asset/liability management process. The Company also considers a number of other factors in determining its asset/liability and interest rate sensitivity management strategies. Management strives to determine the most likely outlook for the economy and interest rates by analyzing external factors, including published economic projections and data, the effects of likely monetary and fiscal policies as well as any enacted or prospective regulatory changes. The Company’s current and prospective liquidity position, current balance sheet volumes and projected growth, accessibility of funds for short-term needs and capital maintenance are also considered. This data is combined with various interest rate scenarios to provide management with information necessary to analyze interest sensitivity and to aid in the development of strategies to manage the Company’s balance sheet.

The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at June 30, 2010, which are projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period.  The interest rate sensitivity of the Company’s assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions.

	TERMS TO REPRICING AT JUNE 30, 2010
	1-90 Days			91-180 Days			181-365 Days			Total One			Non-		Total
										Year			Sensitive
Interest-earning assets:
Interest bearing deposits	$	8,994,928		$	8,994,928		$	8,994,928
Investment securities		263,646		$	236,087		$	919,075			1,418,808		$	22,310,856		23,729,664
Federal Home Loan Bank
stock		592,300			-			-			592,300			-		592,300
Loans		96,370,259			7,150,267			7,825,507			111,346,033			59,092,262		170,438,295
Total Interest-earning assets		106,221,133			7,386,354			8,744,582			122,352,069			81,403,118		203,755,187
Interest-bearing liabilities:
Time deposits		37,801,847			19,184,488			31,827,771			88,814,106			11,257,055		100,071,161
All other deposits		75,590,076			-			-			75,590,076			-		75,590,076
Short-term debt		840,310			-			-			840,310			-		840,310
Long-term debt		4,124,000			-			-			4,124,000			4,000,000		8,124,000
Total interest-bearing liabilities		118,356,233			19,184,488			31,827,771			169,368,492			15,257,055		184,625,547
Interest sensitivity gap	$	(12,135,100	)	$	(11,798,134	)	$	(23,083,189	)	$	(47,016,423	)	$	66,146,063
Cumulative interest sensitivity
Gap	$	(12,135,100	)	$	23,933,234		$	(47,016,423	)
Interest-earning assets as
Percent of interest sensitive
liabilities*		89.7	%		38.5	%		27.5	%		72.2	%

*Percentages shown are not cumulative.

The Company has established an acceptable range of 80% to 120% for interest-earning assets as a percent of interest sensitive liabilities for the total one year horizon.  The increase in nonaccrual loans and the popularity of eZchecking caused the Company’s static gap to fall outside of policy.  Efforts are being undertaken to decrease nonaccrual loans.  As mentioned elsewhere, the Company has augmented selected components of its eZchecking product, which should minimize the gap between actual ratios and policy.

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ASSET QUALITY

Total loans outstanding at June 30, 2010 and December 31, 2009 were $170,438,295 and $185,474,873, respectively.  Historically, the Bank has made loans within its primary market area.  The Bank generally considers its primary market to be Buncombe County in North Carolina.  Emphasis is placed on commercial loans to small- and medium-sized business and consumers.  The amounts and types of loans outstanding are shown the following table.

	June 30,			December 31,
	2010			2009
LOANS:
Real Estate -
Construction	$	62,993,477		$	68,712,886
Mortgage		85,363,394			88,843,525
Commercial, financial and agricultural		20,323,689			25,833,920
Consumer		1,892,894			2,254,665
Subtotal		170,573,454			185,644,996
Deferred origination fees, net		(135,159	)		(170,123	)
Total	$	170,438,295		$	185,474,873

Real estate loans represented 87% and 85% of the portfolio at June 30, 2010 and December 31, 2009, respectively.  Commercial loans represented 12% of the portfolio in 2010 compared to 14% at December 31, 2009, while consumer loans represented 1% of the portfolio at June 30, 2010 and December 31, 2009, respectively.  Commercial loans of $20,323,689 and $25,833,920, consumer loans of $1,892,894 and $2,254,665 and real estate mortgage loans of $85,363,394 and $88,843,525 at June 30, 2010 and December 31, 2009, respectively, are loans for which the principal source of repayment is derived from the ongoing cash flow of the business and other generally recurring sources of income.  Real estate construction loans of $62,993,477 and $68,712,886 are loans for which the principal source of repayment comes from the sale of real estate or from obtaining permanent financing.

Total non-owner occupied loans decreased from $93,004,204 to $85,230,079.  The decrease was primarily attributable to loan charge-offs and write-downs as a result of decreased asset values.  These loans primarily represent residential acquisition and development (“ADC”) real estate loans, which totaled $56,764,647 and $66,364,620 and commercial real estate, which totaled $28,388,363 and $26,560,538 at June 30, 2010 and December 31, 2009, respectively.  Residential ADC loans consist of short-term construction facilities with the majority having takeouts for permanent financing.  Commercial real estate owner-occupied loans decreased modestly from $34,988,710 to $33,992,112.  Commercial and industrial loans decreased from $25,833,920 to $20,323,689.  The majority of the decrease was attributable to charge-offs and write-downs.  Residential mortgage loans remained relatively flat at $17,470,989.  Home equity lines of credit increased slightly from $11,329,544 to $11,663,690 primarily as a result of increased draws on available lines of credit, while consumer loans dropped slightly to $1,892,894.

The Bank has a diversified loan portfolio with two notable concentrations.  While management believes there is no concentration to any one borrower, a concentration does exist among a group of interrelated parties.  The Bank had funded a total of 14 commercial notes totaling in excess of $13,000,000 to individuals, who appear to have interrelated business connections; a portion of which is secured by residential lots in a real estate development project that has filed for protection under Chapter 11 bankruptcy.  The individual borrowers, however, have not filed bankruptcy.  As of June 30, 2010 these loans had been charged-off and/or written-down to approximately $6,600,000. Write downs were attributed to the receipt of updated appraisals during the period which reflect lower values due to the continued slow real estate sales environment.  All notes to this group of related parties continue to be classified as nonaccrual, and are carried at the lower of cost or net

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realizable values.  Management monitors these loans closely, meets with the borrowers on a frequent basis and is pursuing collection efforts against debtors and guarantors.

The Bank’s loan portfolio also reflects a concentration in real estate lending; however, that lending while geographically concentrated, is spread across a diverse group of businesses and industries.  The Bank further attempts to mitigate its exposure to real estate construction lending by limiting the number of unsold houses to four per developer.  Currently, home developer loans have an average balance of approximately $300,000 per unit.  The Bank uses third party building inspectors to evaluate construction progress.  Based upon reports provided by the inspectors, the Bank believes it is better equipped to monitor and distribute loan draws according to percent of project completed.  Approximately 20% of commercial real estate mortgage loans are owner-occupied.  In general, owner-occupied loans pose lower risks than non-owner-occupied loans as there is lower risk of the borrower-tenant leaving the building for a better lease.  Additionally, in the normal owner-occupied loan situation, personal guarantees for the loan are present. Lastly, the Bank also contracts with a third party loan reviewer to evaluate a selection of loans on a quarterly basis.  The reviewer provides feedback on quality of loan underwriting, timeliness of customer financial statements, independent global cash flow analysis, concentrations of credit risk and loan risk grading, among others.  Management believes this third party review to be an integral part of its internal controls and risk monitoring systems.

At June 30, 2010, restructured loans, including both nonaccrual and performing, were largely concentrated in the residential ADC sector of commercial real estate notes followed by owner-occupied commercial real estate notes as shown below.

Loan Type

	Restructured Loans Outstanding			Restructured Loans		Loans to Loans Outstanding
Commercial real estate:
Residential ADC	$	56,764,647		$	3,136,228		5.52	%
Other Commercial		28,388,363			436,502		1.54	%
Agricultural		77,069			-		-
Total non-owner occupied		85,230,079			3,572,730		4.19	%
Commercial real estate
owner-occupied		33,992,112			3,249,705		9.56	%
Commercial:
Construction and industrial		20,323,689			227,806		1.12	%
Residential mortgage:
1st lien; closed end		15,334,436			628,325		4.10	%
Junior lien; closed end		2,136,554			-		-	%
Total residential mortgage		17,470,990			628,325		3.60	%
Home equity lines		11,663,690			343,403		2.94	%
Consumer - other		1,892,894			13,041		.69	%
Deferred fees/costs		(135,159	)		-		-	%
Total	$	170,438,295		$	8,035,010		4.71	%

Restructured owner-occupied commercial real estate included four commercial customers with combined balances of approximately $3.2 million.  Four of the five loans totaling approximately $3.0 million were in compliance with modified terms.  Restructured non-owner occupied commercial real estate of approximately $3.6 million includes of 10 customers with a total of 13 notes.

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NONPERFORMING ASSETS

	June 30,		December 31,
	2010		2009
NONPERFORMING ASSETS
Nonaccrual	$	20,386,235	$	22,870,696
Restructured loans		4,470,275		2,591,289
Nonperforming loans		24,856,510		25,461,985
Other real estate owned		2,910,381		511,112
Repossessions		13,325		-
Total	$	27,780,216	$	25,973,097
Restructured loans not included in
categories above	$	3,564,735	$	7,748,562

Approximately $3.7 million of loans classified as nonperforming loans receive regular payments from the borrowers.  The Company, however, requires the borrowers to continue payments for a minimum of six months and provide financial projections that indicate an ability to continue to make payments before the loan is returned to performing status.  As of June 30, 2010, $3.6 million of loans categorized as restructured loans not included in categories above continue to make regular payments in accordance with their restructured terms.

We maintain an allowance for loan losses to absorb probable losses inherent in the loan portfolio. The loan portfolio is analyzed monthly in an effort to identify potential problems before they actually occur.  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. The provision for loan losses is based upon management’s best estimate of the amount needed to maintain the allowance for loan losses at an adequate level. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of the current status of the portfolio, historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. Management segments the loan portfolio by loan type in considering each of the aforementioned factors and their impact upon the level of the allowance for loan losses.

This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. Therefore, while management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require the Company to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the

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shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.  Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

The provision for loan losses represents a charge against income in an amount necessary to maintain the allowance at an appropriate level.  The quarterly provision for loan losses may fluctuate based on the results of this analysis.  The allowance for loan losses at June 30, 2010 and 2009, and December 31, 2009 was $4,185,422, $2,847,508 and $3,512,263 or 2.46%, 1.58% and 1.89%, respectively, of gross loans outstanding.   The ratio of annualized net charge-offs to average loans outstanding was 15.09%, .18% and 1.24% at June 30, 2010 and 2009, and December 2009, respectively.

The following table contains an analysis for the allowance for loan losses, including the amount of charge-offs and recoveries by loan type, for the six-months ended June 30, 2010 and 2009, and for the year ended December 31, 2009.

Summary of Allowance for Loan Losses

	For the six months						For the year ended
	ended June 30,						December 31,
	2010			2009			2009
Balance, beginning of period	$	3,512,263		$	2,529,981		$	2,529,981
Charge-offs:
Commercial, financial and agricultural		(4,026,985	)		(117,754	)		(994,756	)
Real estate:
Construction		(8,899,115	)		-			(693,002	)
Mortgage		(634,925	)		(30,000	)		(493,467	)
Consumer		(344,747	)		(31,242	)		(85,257	)
Total charge-offs		(13,905,772	)		(178,996	)		(2,266,482	)
Recoveries
Commercial, financial and agricultural		-			-			28
Real estate:
Construction		-			-			-
Mortgage		-			-			-
Consumer		71,541			20,633			30,336
Total recoveries		71,541			20,633			30,364
Net charge-offs		(13,834,231	)		(158,363	)		(2,236,118	)
Provision charged to operations		14,507,390			475,890			3,218,400
Balance, end of period	$	4,185,422		$	2,847,508		$	3,512,263
Percentage of annualized net charge-offs to
average loans		15.09	%		.18	%		1.24	%
Percentage of allowance to
period-end loans		2.46	%		1.58	%		1.89	%

The Bank operates in a well diversified market.  Major economic drivers include tourism, medical industry and light manufacturing in addition to state and federal government agencies.  The majority of the commercial loan chargeoffs were related to a loan whose proceeds were used for an ADC project that was collateralized by a note

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receivable that was deemed worthless in the current quarter.  This is considered a nonrecurring type of charge-off and not reflective of our commercial portfolio as a whole.  The Bank’s primary market area has experienced increased unemployment levels, but they are lower than the North Carolina average.  However, the ADC market has experienced significant disruption in volumes and market value due to the reduced level of purchasers providing liquidity to this market segment.  Continued low volumes of sales could have a negative impact on the Bank in the form of increased nonperforming loans and real estate owned.

The Bank attempts to mitigate its exposure to real estate construction lending by limiting the number of unsold houses to four per developer.  Currently, home developer loans have an average balance of approximately $300,000 per unit.  The Bank uses third party building inspectors to evaluate construction progress.  Based upon reports provided by the inspectors the Bank believes it is better equipped to monitor and distribute loan draws according to percent of project completed.  Approximately 20% of commercial real estate mortgage loans are owner-occupied.  In general, owner-occupied loans pose lower risks than non-owner-occupied loans as there is lower risk of the borrower-tenant leaving the building for a better lease and generally there are business-related cash flows which provide debt service capacity.  Additionally, in the normal owner-occupied loan situation, personal guarantees for the loan are present.

Nonaccrual and restructured loans decreased slightly from $25,461,985 at December 31, 2009 to $24,856,510 at June 30, 2010 due primarily to significant charge-offs previously discussed offset by impaired loans migrating to nonaccrual status.  Although some of the customers have resumed payments, management has continued to classify the relationships until such time as the borrowers demonstrate a consistent and consecutive payment history.  Management has reviewed each non-performing loan, supporting collateral, financial stability of each borrower and the relevant loan loss allowance.  During the first quarter of 2010, management reorganized its credit administration department to improve its underwriting analysis, training and loan monitoring.  Management continued its engagement of third party loan review services to supplement and validate overall loan review analytics and portfolio risk assessments.  Based upon this analysis, management believes the allowance is appropriate in light of the risk associated with current loans outstanding.

The Bank utilizes a loan migration model to assist in its determination of the proper level of reserves for loan losses. During second quarter, the loss horizon time frame in the migration analysis was reduced for the construction and commercial secured loan pool groupings as a result of a significant short-term increase in substandard loans and losses on those loans related to a group of loans totaling approximately $13, million related through interrelated business connections.  Management believes that the losses of these loans are isolated and not indicative of the risks currently in the remaining construction and commercial loan portfolio.  Therefore, the changes made to the loss horizon better represent the management’s current judgment about the credit quality of the loan portfolio as a whole.

The following table allocates the allowance for loan losses by loan category at the dates indicated.  The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any category.

	June 30, 2010					December 31, 2009
	Amount of Allowance		Percent of Total Loans			Amount of Allowance		Percent of Total Loans
TYPE OF LOAN:
Real Estate	$	3,340,312		87	%	$	2,481,578		85	%
Commercial and industrial
loans		751,127		12	%		878,086		14	%
Consumer		93,983		1	%		152,599		1	%
Unallocated		-		-			-		-
Total Allowance	$	4,185,422		100	%	$	3,512,263		100	%

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CAPITAL RESOURCES

Banks and bank holding companies, as regulated institutions, must meet required levels of capital. The Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve, the primary federal regulators of The Bank of Asheville and Weststar, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to its assets in accordance with these guidelines. As shown in the following table, Weststar and the Bank of Asheville both are no longer considered adequately capitalized in accordance with these guidelines.  The Bank is considered significantly undercapitalized under the prompt corrective action provisions.  Currently, the Company is actively pursuing strategic plans to enhance its capital ratios.  As part of these efforts, the Company has retained the services of investment bankers to review all strategic opportunities available to the Company and Bank.

REGULATORY CAPITAL

	Actual					For Capital Adequacy Purposes					To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in Thousands)
As of June 30, 2010
Total Capital (to Risk Weighted
Assets)
Consolidated	$	6,878		3.85	%	$	14,278		8.00	%	$	17,847		10.00	%
Bank	$	8,249		4.63	%	$	14,258		8.00	%	$	17,823		10.00	%
Tier 1 Capital (to Risk Weighted
Assets)
Consolidated	$	3,439		1.93	%	$	7,139		4.00	%	$	10,708		6.00	%
Bank	$	5,997		3.36	%	$	7,129		4.00	%	$	10,694		6.00	%
Tier 1 Capital (to Average Assets)
Consolidated	$	3,439		1.51	%	$	9,122		4.00	%	$	11,403		5.00	%
Bank	$	5,997		2.63	%	$	9,113		4.00	%	$	11,392		5.00	%

LIQUIDITY

Maintaining adequate liquidity while managing interest rate risk is the primary goal of our asset and liability management strategy. Liquidity is the ability to fund the needs of the Company’s borrowers and depositors, pay operating expenses, and meet regulatory liquidity requirements. Loan repayments, deposit growth, federal funds purchased and borrowings from the Federal Home Loan Bank are presently the main sources of the Company’s liquidity. The Company’s primary uses of liquidity are to fund loans, deposit maturities and to make investments.

As of June 30, 2010 liquid assets (cash and due from banks and interest-earning bank deposits) were approximately $13.2 million, which represents 6.18% of total assets and 6.59% of total deposits. Supplementing this liquidity, Weststar has available lines of credit from correspondent banks of approximately $18.9 million; and unpledged investment securities of $18.3 million. At June 30, 2010, outstanding commitments to extend credit and available lines of credit were $19.8 million.

Certificates of deposit represented approximately 49.81% of Weststar’s total deposits at June 30, 2010. Certificates of deposit of $100,000 or more represented 11.86% of the Company’s total deposits at June 30, 2010.  These deposits are generally considered rate sensitive, but management believes most of them are relationship-

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oriented. While the Company will need to pay competitive rates to retain these deposits at maturity, there are other subjective factors that will determine the Company’s continued retention of these deposits.

The anticipated order from our primary regulators and the current level of capital may restrict the Bank’s ability to use brokered CD’s as a source of liquidity and may also reduce access to other lines of credit that were previously mentioned without posting additional collateral.  The anticipated order may also restrict our ability to offer interest rates on deposit products above the market rates.

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IMPACT OF INFLATION AND CHANGING PRICES

A financial institution has assets and liabilities that are distinctly different from those of a company with substantial investments in plant and inventory because the major portion of its assets is monetary in nature. As a result, a bank’s performance may be significantly influenced by changes in interest rates. Although the banking industry is more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor, which may influence interest rates. However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses, cost of supplies and outside services tend to increase more during periods of high inflation.

Item 4T.    Controls and Procedures

At the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Securities Exchange Act Rule 13a-14.

Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective (1) to provide reasonable assurance that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act was recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) to provide reasonable assurance that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosure.

As discussed in Item 2 of this report, we experienced substantial deterioration in the quality of our loan portfolio. We have identified material weaknesses in our disclosure controls and procedures and internal controls relating to segregation of duties, underwriting practices, overdraft policy overrides and problem asset management.  We have engaged an independent third party to assist us with an in-depth loan portfolio review and review our loan policies, internal controls and governance practices.  This third party reviewer’s recommendations included improving loan polices, practices and procedures; utilizing appropriate measures to identify current credit losses; and enhancing our monitoring and workout strategies for problem assets.

Remediation Plan

In response to the material weaknesses stated above, we have developed the following remediation plan to address these weaknesses and are diligently proceeding with the following measures to enhance our disclosure controls and procedures and internal controls.

· We have revised loan officer lending authority and reassigned portfolio responsibilities.

· We have restructured the Chief Credit Officer role to be independent of lending and to report to the Loan Committee of the Board of Directors.

· We have provided additional resources to our Credit Administrative staff with the addition an interim Chief Credit Officer and Credit Analyst. We have also implemented additional monitoring procedures that have helped improve underwriting practices.

· We have increased the frequency of loan committee meetings from monthly to weekly or as needed.

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· We are in the process of developing a disciplined approach for problem assets.  We have strengthened our appraisal policies and obtaining updated appraisals on all troubled loans.

· We are assessing current lending policies and credit administration procedures in order to determine what changes are necessary to strengthen our internal controls.

Our Board of Directors is actively monitoring our remediation accomplishments and will oversee additional measures if deemed necessary.  We cannot be certain of the length of time for implementation of this remediation plan, whether it will be effective to maintain adequate controls over our financial processes and reporting in the future, or whether the remediation plan will be sufficient to address and eliminate the material weaknesses that have been identified.

Changes in Internal Control Over Financial Reporting

Except for the matters discussed above, there were no changes in the Company’s internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The Company reviews its disclosure controls and procedures, which may include its internal control over financial reporting, on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that the Company’s systems evolve with its business.

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Part II.    OTHER INFORMATION

Item 1.    Legal Proceedings

In the Matter of Queens Gap Holding Company, LLC, et al.:  On June 18, 2010, Queens Gap Holding Company, LLC and D.F. McCarthy Investments XVIII, LLC filed suit against the Bank in the United States District Court for the Western District of North Carolina..   In summary, the Plaintiffs, who were the sellers in a real estate development transaction, allege that the Bank improperly allowed the buyer to divert, for personal use, funds from an account set up at the Bank to fund infrastructure improvements in the development.  The Plaintiffs' claims are based on alleged oral and email representations and promises from the Bank to them.  The Plaintiffs seek $4,250,000 in compensatory damages plus treble damages and attorney's fees.  The Bank intends to defend this case vigorously. Bank’s management and its counsel sre still in the early phase of discovery and has concluded as of June 30, 2010 that it is not probable that the Bank will incur a loss as a result of this suit.  As more information becomes available and as the suit progresses, the conclusion may change.

Item 5.    Other Information

(a) None.

(b) None.

Item 6.    Exhibits

(a) Exhibits.

31.1 – Certification of the Chief Executive Officer  and Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 – Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

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

	WESTSTAR FINANCIAL SERVICES CORPORATION
Date: August 23, 2010		By:	/s/   Randall C. Hall
			Randall C. Hall
			Interim President and Chief Executive Officer
			Chief Financial and Principal Accounting Officer

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