Weststar Financial Services (WFSC) 10-Q 2010 Q3 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 September 30, 2010

£ 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 £ 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).   £ Yes £ 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   £ Accelerated filer £ Non-accelerated filer   £   (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). £ 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 – 2,167,489 shares outstanding as of October 23, 2010.

INDEX		Page
Part I – FINANCIAL INFORMATION
Financial Statements:
	Consolidated Balance Sheets
	September 30, 2010 and December 31, 2009	2
	Consolidated Statements of Operations
	Three and Nine Months Ended September 30, 2010 and 2009	3
	Consolidated Statements of Comprehensive Income (Loss)
	Three and Nine Months Ended September 30, 2010 and 2009	4
	Consolidated Statements of Changes in Shareholders’ Equity (Deficit)
	Nine Months Ended September 30, 2010 and 2009	5
	Consolidated Statements of Cash Flows
	Nine Months Ended September 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 4 – Controls and Procedures		31
Part II – OTHER INFORMATION
Item 1. – Legal Proceedings		33
Item 5 – Other Information		33
Item 6 –Exhibits		33
Signatures		34

Part I.     FINANCIAL INFORMATION

Item I.     Financial Statements

Weststar Financial Services Corporation & Subsidiary

Consolidated Balance Sheets

	(unaudited)
	September 30,			December 31,
	2010			2009*
ASSETS:
Cash and cash equivalents:
Cash and due from banks	$	5,608,789		$	6,785,293
Interest-bearing deposits		11,219,539			1,550,240
Total cash and cash equivalents		16,828,328			8,335,533
Investment securities – available for sale, at fair value
(amortized cost of $11,262,979 and $24,613,580, at
September 30, 2010 and December 31, 2009, respectively)		11,631,139			25,046,500
Loans		165,309,503			185,474,873
Allowance for loan losses		(8,449,832	)		(3,512,263	)
Net loans		156,859,671			181,962,610
Premises and equipment, net		2,709,219			2,415,933
Accrued interest receivable		928,115			886,471
Federal Home Loan Bank stock, at cost		549,700			592,300
Deferred income taxes		-			985,802
Foreclosed properties		2,974,725			511,112
Other assets		2,824,953			3,019,479
TOTAL	$	195,305,850		$	223,755,740
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT):
Liabilities:
Deposits:
Demand	$	24,239,656		$	23,569,001
NOW accounts		37,741,044			43,591,452
Money market accounts		24,546,986			26,442,360
Savings		2,944,728			2,890,582
Time deposits of $100,000 or more		19,948,731			27,166,487
Other time deposits		78,417,876			73,462,859
Total deposits		187,839,021			197,122,741
Short-term borrowings		15,234			4,374,673
Accrued interest payable		289,268			372,356
Other liabilities		890,650			917,762
Long-term debt		8,124,000			4,124,000
Total liabilities		197,158,173			206,911,532
COMMITMENTS AND CONTINGENCIES (Note 3)
SHAREHOLDERS' EQUITY (DEFICIT):
Preferred stock; authorized 1,000,000 shares;
no shares issued and outstanding		-			-
Common stock, $1 par value, authorized – 9,000,000 shares;
outstanding shares– 2,167,489 and 2,167,517 at September 30, 2010
and December 31, 2009, respectively		2,167,489			2,167,517
Additional paid-in capital		6,269,432			6,269,404
Retained earnings (accumulated deficit)		(10,515,478	)		8,141,258
Accumulated other comprehensive income		226,234			266,029
Total shareholders' equity (deficit) (Note 7)		(1,852,323	)		16,844,208
TOTAL	$	195,305,850		$	223,755,740

*Derived from audited consolidated financial statements.

See notes to consolidated financial statements.

2

Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Operations (unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2010			2009			2010			2009
INTEREST INCOME:
Interest and fees on loans	$	2,237,320		$	2,941,802		$	6,993,200		$	8,701,003
Federal funds sold		-			53			-			1,185
Interest-bearing deposits		7,193			6,790			15,558			10,795
Investments:
Taxable interest income		130,238			162,448			438,240			511,521
Nontaxable interest income		109,490			95,373			323,013			282,230
Corporate dividends		649			1,242			1,432			1,242
Total interest income		2,484,890			3,207,708			7,771,443			9,507,976
INTEREST EXPENSE:
Time deposits of $100,000 or more		78,524			170,615			323,160			619,427
Other time and savings deposits		531,878			781,818			1,792,329			2,483,581
Short-term borrowings		269			51,074			45,737			111,188
Long-term debt		57,013			39,065			147,913			174,703
Total interest expense		667,684			1,042,572			2,309,139			3,388,899
NET INTEREST INCOME		1,817,206			2,165,136			5,462,304			6,119,077
PROVISION FOR LOAN LOSSES		4,497,030			869,015			19,004,420			1,344,905
NET INTEREST INCOME (EXPENSE) AFTER PROVISION
FOR LOAN LOSSES		(2,679,824	)		1,296,121			(13,542,116	)		4,774,172
OTHER INCOME:
Services charges on deposit accounts		212,677			306,610			718,523			858,945
Other service fees and commissions		158,967			146,009			454,448			446,621
Gain on sale of available for sale securities		504,200			-			504,200			-
Other		14,802			10,847			31,355			30,698
Total other income		890,646			463,466			1,708,526			1,336,264
OTHER EXPENSES:
Salaries and wages		708,746			703,476			2,070,355			2,094,747
Employee benefits		42,596			84,483			357,504			298,618
Occupancy expense, net		118,225			124,016			330,100			431,145
Equipment rentals, depreciation and
maintenance		86,057			86,420			288,574			287,795
Supplies		63,877			64,901			203,197			196,759
Professional fees		162,400			84,704			330,722			220,691
Data processing fees		182,924			168,761			552,399			479,709
FDIC insurance premiums		247,712			76,968			419,022			323,180
Audit, tax and accounting		40,561			24,219			159,496			103,841
Consultant fees		27,612			18,085			144,781			33,491
Marketing		74,908			65,431			226,514			238,553
Credit and collection expenses		195,226			(23,973	)		470,959			(48,337	)
Expenses from foreclosed properties		249,527			20,343			292,244			20,413
Other		529,250			118,444			756,104			320,437
Total other expenses		2,729,621			1,616,278			6,601,971			5,001,042
INCOME (LOSS) BEFORE INCOME TAXES		(4,518,799	)		143,309			(18,435,561	)		1,109,394
INCOME TAX PROVISION		138,415			11,686			221,175			319,959
NET INCOME (LOSS)	$	(4,657,214	)	$	131,623		$	(18,656,736	)	$	789,435
EARNINGS / (LOSS) PER SHARE:
Basic	$	(2.15	)	$	.06		$	(8.61	)	$	.37
Diluted	$	(2.15	)	$	.06		$	(8.61	)	$	.35

See notes to consolidated financial statements.

3

Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Comprehensive Income (Loss) (unaudited)

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2010			2009			2010			2009
NET INCOME (LOSS)	$	(4,657,214	)	$	131,623		$	(18,656,736	)	$	789,435
OTHER COMPREHENSIVE INCOME
Unrealized holding gains (losses) on securities
available for sale		145,145			502,156			439,440			745,833
Tax effect		(55,954	)		(193,581	)		(169,404	)		(287,518	)
Unrealized holding gains (losses) on securities
available for sale, net of tax		89,191			308,575			270,036			458,315
Reclassification adjustment for realized losses		(504,200	)		-			(504,200	)		-
Tax effect		194,369			-			194,369			-
Reclassification adjustment for realized losses,
net of tax		(309,831	)		-			(309,831	)		-
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX		(220,640	)		308,575			(39,795	)		458,315
COMPREHENSIVE INCOME (LOSS)	$	(4,877,854	)	$	440,198		$	(18,696,531	)	$	1,247,750

See notes to consolidated financial statements.

4

Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Changes in Shareholders’ Equity (Deficit) (unaudited)

For the Nine Months Ended September 30, 2010 and 2009

									Retained			Accumulated
							Additional		Earnings			Other			Total
	Common Stock						Paid-In		(Accumulated			Comprehensive			Shareholders’
	Shares			Amount			Capital		Deficit)			Income (Loss)			Equity (Deficit)
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													458,315			458,315
Issuance of common stock pursuant
to the exercise of stock options		21,385			21,385			48,330								69,715
Tax benefit on exercise of non-
qualified stock options								17,421								17,421
Net Income										789,435						789,435
Balance September 30, 2009		2,147,132		$	2,147,132		$	6,218,619	$	9,003,915		$	475,791		$	17,845,457
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													(39,795	)		(39,795	)
Stock conversion		(28	)		(28	)		28
Net Income										(18,656,736	)					(18,656,736	)
Balance September 30, 2010		2,167,489		$	2,167,489		$	6,269,432	$	(10,515,478	)	$	226,234		$	(1,852,323	)

See notes to consolidated financial statements.

5

Weststar Financial Services Corporation & Subsidiary

Consolidated Statements of Cash Flows (unaudited)

For the Nine Months Ended September 30,

	2010			2009
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income (loss)	$	(18,656,736	)	$	789,435
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation		233,074			248,978
Provision for loan losses		19,004,420			1,344,905
Premium amortization and discount accretion, net		15,158			(24,641	)
Deferred income tax provision (benefit)		1,010,767			(507,651	)
Provision and net gain/loss on sale of other real estate		81,082			17,809
Gain on sale of securities		(504,200	)
Increase in accrued interest receivable		(41,644	)		(131,089	)
(Increase) decrease in other assets		211,760			(57,312	)
Decrease in accrued interest payable		(83,088	)		(175,467	)
Increase (decrease) in other liabilities		(27,112	)		117,119
Net cash provided by operating activities		1,243,481			1,622,086
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of securities available for sale		(1,132,875	)		(1,597,260	)
Maturities of securities available for sale		2,934,995			3,731,472
Net (increase) decrease in loans		2,023,332			(15,026,358	)
Proceeds from sale of securities		12,037,523			-
Proceeds from sale of repossessions		46,465			-
Proceeds from sales of foreclosed properties		1,466,793			20,191
FHLB stock purchase		-			(54,200	)
FHLB stock redemption		42,600			47,500
Additions to premises and equipment		(526,360	)		(86,095	)
Net cash provided by (used in) investing activities		16,892,473			(12,964,750	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in demand deposits, NOW Accounts,
MMDA and savings accounts		(7,020,981	)		21,360,598
Net increase (decrease) in time deposits		(2,262,739	)		3,581,353
Issuance of common stock		-			69,715
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		-			17,421
Net decrease in short-term borrowing		(359,439	)		(4,489,999	)
Net cash provided by (used in) financing activities		(9,643,159	)		19,539,088
NET INCREASE IN CASH AND CASH EQUIVALENTS		8,492,795			8,196,424
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		8,335,533			4,419,778
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	16,828,328		$	12,616,202

See notes to consolidated financial statements.

6

WESTSTAR FINANCIAL SERVICES CORPORATION & 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 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.

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 September 30, 2010 and December 31, 2009, and the consolidated results of their operations for the three and nine-month periods ended September 30, 2010 and 2009 and their cash flows for the nine-month periods ended September 30, 2010 and 2009.  Operating results for the three and nine-month periods ended September 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

7

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.

“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 perio ds 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. Commitments and Contingencies

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 $15,934,553 and $26,179,686 at September 30, 2010 and December 31, 2009, respectively.

The Bank has entered into a settlement agreement to resolve all claims alleged against it in the lawsuit styled Queens Gap Holding Company, LLC and D. F. McCarthy Investments XVIII, LLC v. Bank of Asheville, filed in the United States District Court for the Western District of North Carolina on June 18, 2010, Case No. 1:10-CV-00122.

Pursuant to the settlement agreement, the parties have agreed to dismiss the lawsuit with prejudice and to release each other from any claims and damages arising out of or related to the facts alleged in the lawsuit. The parties will be responsible for their own costs and expenses, including attorneys’ fees, incurred in connection with the lawsuit and the settlement.  These costs and other related expenses have been included in the other expense line on the income statement. The settlement agreement concludes the lawsuit.

4. Earnings per Share

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 206,390 options excluded during the three and nine month periods ended September 30, 2010 due to antidilution.  During the periods ended September 30, 2009, no options were excluded due to antidilution.

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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:

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
	2010		2009		2010		2009
Weighted average number of
common shares used in
computing basic net income
per share		2,167,517		2,146,817		2,167,517		2,142,534
Effect of dilutive stock options		-		97,212		-		99,464
Weighted average number of
common shares and dilutive
potential common shares
used in computing diluted net
income per common share		2,167,517		2,244,029		2,167,517		2,241,998

5. Fair Value

The fair value estimates presented herein are based on pertinent information available to management as of September 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.

	September 30, 2010					December 31, 2009
	Carrying		Estimated			Carrying		Estimated
	amount		fair value			amount		fair value
	(In thousands)
Assets:
Cash and cash equivalents	$	16,828	$	16,828		$	8,336	$	8,336
Investment securities		11,631		11,631			25,047		25,047
Federal Home Loan Bank stock		550		550			592		592
Loans, net		156,860		157,787			181,963		183,328
Interest receivable		928		928			886		886
Bank owned life insurance		329		329			361		361
Liabilities:
Demand deposits, NOW accounts,
money market accounts, savings		89,472		89,472			96,493		96,493
Time deposits		98,367		98,773			100,629		100,799
Short-term borrowings		15		15			4,375		4,417
Interest payable		289		289			372		372
Long-term debt		8,124		8,124	*		4,124		4,039

*Book cost, see discussion below

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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.

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 value of short-term borrowings approximates cost due to the short-term nature of these instruments. The fair value of long-term debt approximates cost due to the interest rate of the long-term debt being at a variable rate.  Due to the debt not being publicly traded and the Company not having a credit rating, a credit risk component is not included and is not practicable to include in the fair value of long-term debt.

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 securities 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

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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 September 30, 2010 and December 31, 2009, substantially all of the total im paired loans were evaluated based on the fair 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:

	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
	Identical		Observable		Unobservable		Assets/
	Assets		Inputs		Inputs		Liabilities
Fair Value at:	(Level 1)		(Level 2)		(Level 3)		at Fair Value
September 30, 2010:
Mortgage-backed Securities		-	$	1,743,430		-	$	1,743,430
Municipal bonds		-	$	9,887,709		-	$	9,887,709
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:

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	Quoted Prices
	in Active		Significant
	Markets for		Other		Significant
Fair Value at:	Identical		Observable		Unobservable		Assets/
	Assets		Inputs		Inputs		Liabilities
September 30, 2010	(Level 1)		(Level 2)		(Level 3)		at Fair Value
Impaired Loans		-	$	17,185,593	$	2,179,469	$	19,365,062
Foreclosed properties		-		2,974,725		-		2,974,725
December 31, 2009
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 September 30, 2010 and December 31, 2009 are summarized as follows:

September 30, 2010

Available-for-sale securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Due within 1 year:
Municipal bonds	$	555,134	$	7,687		-		$	562,821
Residential mortgage-backed securities		71,025		673		-			71,698
		626,159		8,360		-			634,519
Due within 5 to 10 years:
Municipal bonds		1,428,725		50,817		-			1,479,542
Due after 10 years:
Municipal bonds		7,644,238		223,524		(22,417	)		7,845,345
Residential mortgage-backed securities		1,563,857		107,876		-			1,671,733
		9,208,095		331,400		(22,417	)		9,517,078
Total available-for-sale securities	$	11,262,979	$	390,577	$	(22,417	)	$	11,631,139

December 31, 2009

Available-for-sale securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Due within 1 year:
Residential mortgage-backed securities	$	501,935		-	$	(176	)	$	501,759
Due within 1 to 5 years:
U.S. Government agencies		1,019,655		63,885		-			1,083,540
Residential mortgage-backed securities		999,939		20,929		-			1,020,868
Municipal bonds		1,549,329		60,297		-			1,609,626

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December 31, 2009

Available-for-sale securities	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
		3,568,923		145,111		-			3,714,034
Due within 5 to 10 years:
U.S. Government agencies		1,265,259		101,087		-			1,366,346
Residential mortgage-backed securities		722,932		32,432		-			755,364
Municipal bonds		1,642,396		5,684		(9,887	)		1,638,193
		3,630,587		139,203		(9,887	)		3,759,903
Due after 10 years:
U.S. Government agencies		9,227,386		308,305		(48,795	)		9,486,896
Municipal bonds		7,684,749		50,973		(151,814	)		7,583,908
		16,912,135		359,278		(200,609	)		17,070,804
Total available-for-sale securities	$	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 September 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 September 30, 2010 are a result of volatility in the market during 2010 and relate to three municipal bonds.  All unrealized losses on investment securities resulted from changes in interest rates and are considered by management to be 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. Furthermore, in the event of a future sale of any of the remaining unpledged investments for liquidity, the securities with the unrealized gains would be disposed of first.

September 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	$	275,663	$	12,084	$	997,728	$	10,333	$	1,273,391	$	22,417
Total temporarily impaired
securities	$	275,663	$	12,084	$	997,728	$	10,333	$	1,273,391	$	22,417

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	)

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The aggregate cost of the Company’s cost method investment, Federal Home Loan Bank stock, totaled $549,700 at September 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.

During the third quarter, securities with a cost basis of $ 11,533,323 were sold for $12,037,523 at a gain of $504,200. There were none sold at a loss. The fair value of the investments pledged at September 30, 2010 was $ 6,016,050.

7. Capital and Regulatory Matters

Effective September 23, 2010, The Bank of Asheville (the “Bank”), the wholly owned subsidiary of Weststar Financial Services Corporation (the “Company”), entered into a Stipulation to the Issuance of a Consent Order (the “Stipulation”) with the North Carolina Office of the Commissioner of Banks (the “Commissioner”) whereby the Bank consented to the issuance of a Consent Order (the “Order”) by the Commissioner without admitting or denying the alleged charges.The Order requires that the Bank:

· Retain qualified management, including a chief executive officer, chief credit officer or senior lending officer, and a chief financial officer, with experience and expertise appropriate and necessary for the performance of their duties.

· Must engage an independent third party to prepare a report analyzing and assessing the Bank’s management, staffing performance, and needs. Within 60 days of the receipt of the third-party report, the board must develop a written management plan and submit it to the Commissioner for review.

· Maintain Tier 1 capital of at least 8% of the Bank’s total assets.

· Must develop a written plan to reduce the Bank’s amount of assets that were classified “substandard” or “doubtful.”

· Must eliminate from its books, by charge-off or collection, any assets classified “loss” and 50% of those assets classified “doubtful” and prevents the Bank from extending any additional credit to, or for the benefit of, any borrower who has a loan or other extension of credit that has been charged off or classified as “loss” or “doubtful.”

· May not accept, renew, or roll over any brokered deposit unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits.

· Refrains from declaring or paying dividends or any distributions of interest, principal, or other sums on subordinated debentures without the prior written approval of the Commissioner.

· Limit asset growth to no more than 10% per year.

· Adopt an effective internal loan review and grading system to provide for the periodic review of the Bank’s loan portfolio

In addition, under the terms of the Order, the Bank is required to prepare and submit written plans or reports to the Commissioner that address the following items:

· Improving the Bank’s liquidity position and funds management practices

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· Reducing concentrations of credit

· Implementing lending and collection practices to provide effective guidance and control over the Bank’s lending functions

· Establishing a comprehensive policy for determining the adequacy of the Bank’s allowance for loan and lease losses

· Develop a comprehensive budget for all categories of income and expense for the 2011 calendar year

· Develop a strategic plan consisting of long-term goals designed to improve the condition of the Bank and its viability and strategy for achieving those goals

· Develop written plans regarding management, capital, liquidity and funds management, reducing concentrations of credit and managing other real estate

Under the Order, the Bank’s board of directors has agreed to increase its participation in the affairs of the Bank, including assuming full responsibility for the approval of policies and objectives for the supervision of all of the Bank’s activities.  These matters potentially raise substantial doubt about the Bank’s ability to continue as a going concern

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

REGULATORY CAPITAL

												To Be Well
							For Capital					Capitalized Under
	Actual						Adequacy					Prompt Corrective
							Purposes					Action Provisions
	Amount			Ratio			Amount		Ratio			Amount		Ratio
(Dollars in Thousands)
As of September 30, 2010
Total Capital /(Deficit) (to Risk
Weighted Assets)
Consolidated	$	-			0	%	$	13,224		8.00	%	$	16,530		10.00	%
Bank	$	2,712			1.63	%	$	13,205		8.00	%	$	16,506		10.00	%
Tier 1 Capital/(Deficit) (to Risk
Weighted Assets)
Consolidated	$	(2,091	)		(1.26	%)	$	6,612		4.00	%	$	13,224		8.00	%
Bank	$	1,356			0.82	%	$	6,602		4.00	%	$	13,205		8.00	%
Tier 1 Capital/(Deficit) (to Average
Assets)
Consolidated	$	(2,091	)		(0.98	%)	$	8,495		4.00	%	$	16,990		8.00	%
Bank	$	1,356			0.65	%	$	8,495		4.00	%	$	16,990		8.00	%

The Bank is considered critically undercapitalized under the prompt corrective action provisions of the FDIC and while the Order is in effect required to maintain Tier 1 capital at or above 8% of total assets.

8. Reclassifications

Certain expenses have been reclassified to conform to the 2010 presentation.  The reclassifications had no effect on net income or stockholders’ equity, as previously reported.

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Item 2. Management’s Discussion and Analysis

Financial Condition and Results of Operations

Weststar Financial Services Corporation & Subsidiary

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 Financi al 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 nine month periods ended September 30, 2010 totaled $232,621 and $14,066,852, respectively, compared to $196,639 and $355,002 during the three and nine month periods ended September 30, 2009, respectively.  Third 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. Year-to-date net charge-offs resulted in a significant reduction to the Company’s capital. Refer to the discussion under “Capital R esources” for further discussion.

Non-performing assets totaled $33,377,051 and $25,973,097 at September 30, 2010 and December 31, 2009, respectively.  Loans outstanding decreased 10.87% to $165,309,503, when compared to December 31, 2009 primarily as a result of loan charge-offs and write-downs. The investment portfolio decreased to $11,631,139, when compared to $25,046,500 at December 31, 2009 as a result of sales of investments to provide liquidity for operations.

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 second 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 16.07% 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 and impaired loan reserves, the Company added $4,497,030 to the allowance for loan losses compared to $869,015 during the comparable period in 2009.  Other non-interest income for the September 30, 2010 and 2009 quarters totaled $890,646 and $463,466 respectively.  The increase in other income is a result of the gain on sale of securities of $504,200 offset by a decrease in net NSF fees which declined $89,325. The non-interest expenses increased from $1,616,278 to $2,729,621 or 68.88%.  The increase was primarily attributable to credit and

16

foreclosure-related expenses such as appraisals and legal services. In addition, increased FDIC insurance premiums, and other expenses related to a previously disclosed lawsuit increased the non-interest expenses.

Net income (loss) totaled $(4,657,214) and $131,623 for the quarters ended September 30, 2010 and 2009, respectively.

A decrease in the yield on earning assets caused a decrease in the net interest income of 10.73% during the nine months ending September 30, 2010.  Primarily as a result of net charge-offs, the Company added $19,004,420 to the loan loss reserve compared to $1,344,905 during the comparable period in 2009.  Other non-interest income for the September 30, 2010 and 2009 periods totaled $1,708,526 and $1,336,264 respectively.  The increase in other income primarily reflects the increase in interchange fees and the gain from sale of securities which was offset by the decrease in mortgage origination fees and NSF overdraft fees.  Non-interest expenses increased from $5,001,042 to $6,601,971 or 32.01%.  The increase was primarily attributable to credit related expenses such as appraisals and co llections, and foreclosure-related expenses. Also higher FDIC insurance premiums and expenses related to a previously disclosed lawsuit increased the non-interest expenses.

Net income (loss) totaled $(18,656,736) and $789,435 for the nine-month periods ended September 30, 2010 and 2009, respectively.

CHANGES IN FINANCIAL CONDITION

SEPTEMBER 30, 2010 COMPARED TO DECEMBER 31, 2009

During the period from December 31, 2009 to September 30, 2010, total assets decreased $28,449,890 or 12.72%.  The decrease in assets were a result of net charge-offs and/or write-downs of loans and the reduction in liquidity to fund deposit withdrawals. The net charge-offs and/or write-downs of the loans 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 September 30, 2010 totaled $22,850,678 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 $549,700.

At September 30, 2010, the loan portfolio constituted 84.64% of the Company’s total assets.  Loans decreased $20,165,370 or 10.87%, from December 31, 2009 to September 30, 2010 primarily as a result of net charge-offs and/or write-downs .

The recorded investment in impaired loans was $35,277,649, $7,664,640 and $33,329,137, which includes nonperforming and restructured loans, at September 30, 2010 and 2009 and December 31, 2009, respectively.  Impaired loans of $27,772,424, $4,213,251 and $33,329,137 had no related allowances for loan losses, primarily due to the charge-off of the collateral shortfall.  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 nine months ended September 30, 2010 and 2009 totaled $32,584,955 and $3,141,102, respectively and $7,356,699 for the year ended December 31, 2009.  For the nine-mo nth periods ended September 30, 2010 and 2009, the Company recognized interest income from impaired loans of approximately $256,646 and $40,224, 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

17

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:

	September 30, 2010		December 31, 2009
Commercial real estate:
Residential ADC	$	27,562	$	5,527,742
Other commercial real estate		-		464,270
Total non-owner occupied
commercial real estate		27,562		5,992,012
Commercial owner occupied
real estate		2,126,998		1,172,095
Commercial and industrial		138,658		167,341
Residential mortgage:
First lien, closed end		105,804		274,151
Home equity lines of credit		80,080		198,602
Consumer		12,246		8,987
Total	$	2,491,348	$	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 September 30, 2010, the Company identified ten potential problem loans totaling $7,925,813 as compared to one potential problem loan totaling $2,756 at December 31, 2009.

Deposits decreased $9,283,720 during the nine months ended September 30, 2010.  The decrease in deposits was primarily attributable to declines in money market and NOW accounts.  The Company experienced a $2,588,252 decrease in money market accounts and a $5,850,409 decrease in NOW accounts during the nine months ended September 30, 2010. The decrease in these deposit accounts appears to have coincided with the announcement regarding the issuance of the Consent Order (refer to Note 7). During the third quarter, the Company reduced the rate paid on eZchecking, a NOW account product, from 3.65% to 3.00% and reduced the maximum base upon which the rate could be paid from $25,000 to $15,000 during the second quarter.  Changes in the product reflect trends in the market area and adjustments needed to increase p roduct 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 September 30, 2010, the Company had 2,161 eZchecking accounts totaling $27,376,985 compared to 1,818 accounts totaling $29,777,082 at December 31, 2009.  Savings accounts increased from $2,890,582 to $2,944,728 or 1.87%.  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 $2,262,739 from December 31, 2009 to September 30, 2010.  The decrease i n these deposit accounts appears to have occurred shortly after an announcement of the issuance of the Consent Order (refer to Note 7). Demand deposits have increased by $549,710 since December 31, 2009.  Demand deposit account growth primarily reflects increased deposits in commercial accounts rather than retail consumer accounts. Wholesale deposits provided additional funding, increasing deposits by $24.8 million with $16.7 million in brokered deposits.

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Short-term borrowings consisted of securities sold under agreements to repurchase in the amount of $15,234.  Securities sold under agreements to repurchase bear a variable rate of interest and mature daily.  At September 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 (3.68% at September 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.  None of the trust preferred securities were eligible for inclusion as Tier I capital or 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.  Third quarter dividend payments on the trust preferred securities were paid as scheduled; however, the Company has deferred pay out of its fourth quarter dividend  as allowed in the agreement.

The Company’s total capital to risk weighted assets was zero at September 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 September 30, 2010, the Company’s capital was considered to be critically 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, rollove r, 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 additional discussion under “Capital Resources” and “Liquidity”

RESULTS OF OPERATIONS

FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 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 September 30, 2010 totaled $1,817,206 compared to $2,165,136 in 2009.  The decrease was attributable to decreases in net earning assets and net interest margin.  The Company’s net interest margin was approximately 3.52% and 3.91% for the quarters ended September 30, 2010 and 2009, respectively.

Primarily as a result of changes in nonperforming loans, and charge-offs, and increases in reserves on impaired loans, partially offset by some stabilization in the national and local economies, the Company recorded a provision for loan losses of $4,497,030 for the three months ended September 30, 2010 compared to $869,015 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 or specific reserves 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 $232,621 for the three months ended September 30, 2010 compared to $1,186,542 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

19

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 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 a nd 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 third 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 September 30, 2010 and 2009 quarters totaled $890,646 and $463,466, respectively.  The increase in other income primarily reflects the gain from the sale of securities of $504,200 offset by a decrease in NSF of $95,236.  Fees earned on overdrafts decreased from $249,072 to $159,747.  Fees from this service are activity based.  Mortgage fee income dropped by $7,786 as mortgage lending activity as whole decrease compared to last year.  Interchange revenue increased from $90,475 to $111,203 for the periods ended September 30, 2009 and 2010, respectively.  The Company earns interchange revenue from customer ATM, debit and credit card activities.  Other income increased by 36.47% to $10,847 primarily due to rental income collected on othe r real estate.

Other non-interest expense totaled $2,729,621 compared to $1,616,278 in 2009.  The increase was primarily attributable to increased FDIC insurance premiums, credit and foreclosure expenses, other expenses relating to the lawsuit. The Bank incurred loan collection expenses, which are included in the credit and collection expenses, of $174,483 compared to $3,268 during 2009. The majority of the loan collection expenses were attributable to legal fees.

Salaries and benefits decreased 4.65% to $751,342.  The decrease was largely due to the reduction in the 401(k) expense and in the cash surrender value of an insurance contract.  Occupancy expense decreased from $124,016 to $118,225.  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. A slight increase in depreciation expense and decrease in rental income offset the decrease in Bank’s rental expense. Equipment expenses remained relatively unchanged at $86,057.  Professional fees increased from $84,704 to $162,400 primarily due to various legal fees.  Data processing fees increased by 8.39% to $182,924 as a result of growth in the number of demand deposit accounts and increased internet banking and remote deposit capture activities.  FDIC insurance premiums increased from $76,968 to $247,712 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 $65,431 to $74,908, which reflects increased marketing efforts for products and services.  Expenses relating to the foreclosures of properties increased from $20,343 during 2009 to $249,527 during 2010, which is included in other expense.  The increase reflects the levels of foreclosure related activities.  Other expenses totaled $529,250 in 2010 compared to $94,471 in 2009 due primarily to expenses related to the previously disclosed lawsuit.  Income (loss) be fore income tax provision totaled $(4,518,799) and $143,309 for the quarters ended September 30, 2010 and 2009, respectively.  Income tax provision totaled $138,415 and $11,686 for the quarters ended September 30, 2010 and 2009, respectively, which equated to an effective tax rate of (2.76%) and 8.15%, 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

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such valuation existed during the comparable 2009 period.  Net income (loss) totaled $(4,657,214) and $131,623 for the quarters ended September 30, 2010 and 2009, respectively.

Other comprehensive income (loss) totaled $(220,640) and $308,575 for the three months ended September 30, 2010 and 2009, respectively.  Comprehensive income (loss), which is the change in shareholders’ equity excluding transactions with shareholders, totaled $(4,877,854) and $440,198 for the quarters ended September 30, 2010 and 2009, respectively.

COMPARATIVE NINE MONTHS

Net interest income for the nine-month period ended September 30, 2010 totaled $5,462,304 compared to $6,119,077 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 3.40% and 3.87% for the nine months ended September 30, 2010 and 2009, respectively.

The Company recorded a provision for loan losses of $19,004,420 and $1,344,905 for the nine months ended September 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.”

Other non-interest income for the nine months ended September 30, 2010 and 2009 totaled $1,708,526 and $1,336,264, respectively.  The increase in other income primarily reflects an increase in the interchange revenue and the gain on sale of securities offset by a decrease in fees from overdraft activities and fees from the origination of mortgage loans. Fees earned on overdrafts decreased from $685,805 to $553,004.  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. & #160;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 $63,054 as mortgage activity decreased compared to prior year.  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 $251,103 to $318,825 for the periods ended September 30, 2009 and 2010, respectively.  The Company earns interchange revenue from customer ATM, debit and credit card activities.  Other income increased slightly from $30,698 to $31,355.

Other non-interest expense totaled $6,601,971 compared to $5,001,042 in 2009.  The increase was primarily attributable to credit and foreclosure expenses, increased FDIC insurance premiums, consultant fees and other expenses associated with the lawsuit.  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 higher loan collection expenses, which are included in credit expense, as the number of delinquent loans increased; raising expenses attributable to collections to $380,297 in 2010 from $16,163 during 2009.  The majority of these expenses were attrib utable to legal fees.  The Bank further employed consultants to review lending activities and processes for quality control purposes.  Consultant fees totaled $144,781 during 2010 compared to $33,491 during 2009.

Salaries and benefits increased 19.72% to $2,427,859. The increase was largely due to the changes in cash surrender value of an insurance contract.  Occupancy expense decreased from $431,145 to $330,100.  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 $288,574.  Professional fees increased from

21

$220,691 to $330,722 primarily due to various legal fees.  Data processing fees increased by 15.15% to $552,399 as a result of growth in the number of deposits and increased internet banking and remote deposit capture activities.  FDIC insurance premiums increased from $323,180 to $419,022 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 $238,553 to $226,514, which reflects a realignment of marketing efforts for products and services during the third quarter of 2010.  Expenses relating to the foreclosures of properties increased from $20,413 during 2009 t o $292,244 during 2010. This increase reflects the increased level of foreclosure related activities.  Other expenses totaled $756,104 in 2010 compared to $272,100 for the same period in 2009 due to expenses associated with the previously disclosed lawsuit.  Income (loss) before income tax provision totaled $(18,435,561) and $1,109,394 for the periods ended September 30, 2010 and 2009, respectively.  Income tax provision totaled $221,175 and $319,959 for the periods ended September 30, 2010 and 2009, respectively, which equated to an effective tax rate of (1.20%) and 28.84%, 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 $(18,656,736) and $789,435 for the periods ended September 30, 2010 and 2009, respectively.

Other comprehensive income (loss) totaled $(39,795) and $458,315 for the nine months ended September 30, 2010 and 2009, respectively.  Comprehensive income (loss), which is the change in shareholders’ equity excluding transactions with shareholders, totaled $(18,696,531) and $1,247,750 for the nine months ended September 30, 2010 and 2009, respectively.

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 ins titution 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

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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 th e 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, 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 September 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.

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TERMS TO REPRICING AT SEPTEMBER 30, 2010

	1-90 Days			91-180 Days			181-365 Days			Total One			Non-		Total
										Year			Sensitive
Interest-earning assets:
Interest bearing deposits	$	11,219,539			-			-		$	11,219,539			-	$	11,219,539
Investment securities		91,334		$	370,347		$	246,456			708,137		$	10,554,842		11,262,979
Federal Home Loan Bank
stock		549,700			-			-			549,700			-		549,700
Loans		94,713,372			4,226,088			7,876,253			106,815,713			58,493,790		165,309,503
Total Interest-earning assets	$	106,573,945		$	4,596,435		$	8,122,709		$	119,293,089		$	69,048,632	$	188,341,721
Interest-bearing liabilities:
Time deposits		21,724,971			29,048,228			34,772,801			85,546,000			12,820,607		98,366,607
All other deposits		65,232,758			-			-			65,232,758			-		65,232,758
Short-term debt		15,234			-			-			15,234			-		15,234
Long-term debt		4,124,000			-			-			4,124,000			4,000,000		8,124,000
Total interest-bearing liabilities		91,096,963			29,048,228			34,772,801			154,917,992			16,820,607		171,738,599
Interest sensitivity gap	$	15,476,982		$	(24,451,793	)	$	(26,650,092	)	$	(35,624,903	)	$	52,228,025
Cumulative interest sensitivity
Gap				$	(8,974,811	)	$	(35,624,903	)
Interest-earning assets as
Percent of interest sensitive
liabilities*		117.0	%		15.8	%		23.4	%		77.0	%

*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.

ASSET QUALITY

Total loans outstanding at September 30, 2010 and December 31, 2009 were $165,309,503 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.

	September 30, 2010			December 31, 2009
Real Estate -
Construction	$	60,986,613		$	68,712,886
Mortgage		82,803,433			88,843,525
Commercial, financial and agricultural		19,678,784			25,833,920
Consumer		1,962,481			2,254,665
Subtotal		165,431,311			185,644,996
Deferred origination fees, net		(121,808	)		(170,123	)
Total	$	165,309,503		$	185,474,873

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Real estate loans represented 87% and 85% of the portfolio at September 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 September 30, 2010 and December 31, 2009, respectively.  Commercial loans of $19,678,784 and $25,833,920, consumer loans of $1,962,481 and $2,254,665 and real estate mortgage loans of $82,803,433 and $88,843,525 at September 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 $60,986,613 and $68,712,886 are loans for which the principal source of repayment c omes from the sale of real estate or from obtaining permanent financing.

Total non-owner occupied loans decreased from $93,004,204 to $82,926,523.  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 $54,707,146 and $66,364,620 and commercial real estate, which totaled $28,144,763 and $26,560,538 at September 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 $33,166,386.  Commercial and industrial loans decreased from $25,833,920 to $19,678,784.  The majority of the decrease was attributable to charge-offs and write-downs.  Residential mortgage loans decreased $2,624,790 to $15,599,163 resulting mainly from a decrease in housing starts and sales of completed units.  Home equity lines of credit increased slightly from $11,329,544 to $12,097,975 primarily as a result of increased draws on available lines of credit, while consumer loans dropped slightly to $1,962,481.

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 September 30, 2010 these loans had been charged-off and/or written-down to approximately $7,126,000. Write downs were attributed to the receipt of updated appraisals during the period which reflect lower values due to th e 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 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 or less 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.  0;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.

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At September 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			Restructured		Loans to Loans
	Outstanding			Loans		Outstanding
Commercial real estate:
Residential ADC	$	54,707,146		$	3,230,259		5.90	%
Other Commercial		28,144,763			134,002		.48	%
Agricultural		74,613			-		-
Total non-owner occupied		82,926,522			3,364,261		4.06	%
Commercial real estate
owner-occupied		33,166,386			3,237,209		9.76	%
Commercial:
Construction and industrial		19,678,784			231,029		1.17	%
Residential mortgage:
1st lien; closed end		13,638,739			1,007,433		7.39	%
Junior lien; closed end		1,960,424			-		-
Total residential mortgage		15,599,163			1,007,433		6.46	%
Home equity lines		12,097,975			342,489		2.83	%
Consumer - other		1,962,482			22,499		1.15	%
Deferred fees/costs		(121,809	)		-		-
Total	$	165,309,503		$	8,204,920		4.96	%

Restructured owner-occupied commercial real estate included four commercial customers with combined balances of approximately $3.2 million.  All of the six loans totaling approximately $3.2 million were in compliance with modified terms.  Restructured non-owner occupied commercial real estate of approximately $3.4 million includes 9 customers with a total of 12 notes.

NONPERFORMING ASSETS

	September 30, 2010		December 31, 2009
Nonaccrual	$	24,688,754	$	22,870,696
Restructured loans		5,713,572		2,591,289
Nonperforming loans		30,402,326		25,461,985
Other real estate owned		2,974,725		511,112
Repossessions		-		-
Total	$	33,377,051	$	25,973,097
Restructured loans not included in
categories above	$	2,491,348	$	7,748,562

Approximately $1.6 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 September 30, 2010, $2.5 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.

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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 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 September 30, 2010 and 2009, and December 31, 2009 was $8,449,832, $3,519,884 and $3,512,263 or 5.11%, 1.90% and 1.89%, respectively, of gross loans outstanding. During the third quarter, the allowance for loan loss included specific reserves of $3.1 million.  Management, while historically charging off these loans, determined that the conditions were not met for charging off. However, management felt it would be prudent at this time to establish the specific reserve. The ratio of annualized net charge-offs to average loans outstanding was 5.15 %, .27% and 1.24% at September 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 nine-months ended September 30, 2010 and 2009, and for the year ended December 31, 2009.

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Summary of Allowance for Loan Losses

	For the nine months						For the year ended
	ended September 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	)		(236,392	)		(994,756	)
Real estate:
Construction		(9,030,117	)		(9,211	)		(693,002	)
Mortgage		(708,922	)		(78,877	)		(493,467	)
Consumer		(389,431	)		(55,914	)		(85,257	)
Total charge-offs		(14,155,455	)		(380,394	)		(2,266,482	)
Recoveries
Commercial, financial and agricultural		1,982			28			28
Real estate:
Construction		-			-			-
Mortgage		-			-			-
Consumer		86,622			25,364			30,336
Total recoveries		88,604			25,392			30,364
Net charge-offs		(14,066,852	)		(355,002	)		(2,236,118	)
Provision charged to operations		19,004,420			1,344,905			3,218,400
Balance, end of period	$	8,449,832		$	3,519,884		$	3,512,263
Percentage of annualized net charge-offs to
average loans		5.15	%		.27	%		1.24	%
Percentage of allowance to
period-end loans		5.11	%		1.90	%		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 receivable that was deemed worthless in the second 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 or $300,000 or less 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 29% 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 whi ch provide debt service capacity.  Additionally, in the normal owner-occupied loan situation, personal guarantees for the loan are present.

Nonaccrual and non-performing restructured loans increased from $25,461,985 at December 31, 2009 to $30,402,326 at September 30, 2010 due primarily to significant charge-offs previously discussed offset by

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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 the third quarter, the loss horizon time frame in the migration analysis was consistent with the methodology used during the second quarter to 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.

	September 30, 2010					December 31, 2009
			Percent of					Percent of
	Amount of		Loans			Amount of		Loans
TYPE OF LOAN:	Allowance		Outstanding			Allowance		Outstanding
Real Estate	$	7,581,174		5	%	$	2,481,578		2	%
Commercial and industrial
loans		744,271		4	%		878,086		3	%
Consumer		124,387		6	%		152,599		7	%
Unallocated		-		-			-		-
Total Allowance	$	8,449,832		5	%	$	3,512,263		2	%

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 critically undercapitalized under the prompt corrective action provisions.
60; 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 an investment banking firm to assist management in the sale of additional shares of stock which would increase the required Tier 1 levels to a level that would be in compliance with the Consent Order.  The Consent Order increases the Tier 1 Levels for the Bank and the Company from 6% for Tier 1 Capital to Risk Weighted Assets to 8% and from 5% Tier 1 Capital to Average Assets to 8%. The Company has 90 days from the date of the Consent Order, or until December 22, 2010 to meet these capital requirements.

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REGULATORY CAPITAL

												To Be Well
							For Capital					Capitalized Under
	Actual						Adequacy					Prompt Corrective
							Purposes					Action Provisions
	Amount			Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in Thousands)
As of September 30, 2010
Total Capital/(Deficit)
(to Risk Weighted Assets)
Consolidated	$	-			0	%	$	13,224		8.00	%	$	16,530		10.00	%
Bank	$	2,712			1.63	%	$	13,205		8.00	%	$	16,506		10.00	%
Tier 1 Capital/(Deficit) (to Risk
Weighted Assets)
Consolidated	$	(2,091	)		(1.25	%)	$	6,612		4.00	%	$	13,224		8.00	%*
Bank	$	1,356			0.82	%	$	6,602		4.00	%	$	13,205		8.00	%*
Tier 1 Capital/(Deficit) (to Average
Assets)
Consolidated	$	(2,091	)		(0.99	%)	$	8,495		4.00	%	$	16,990		8.00	%*
Bank	$	1,356			0.65	%	$	8,495		4.00	%	$	16,990		8.00	%*

*As stipulated in the Consent Order issued by the NC Commissioner of Banks.

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 September 30, 2010 liquid assets (cash and due from banks and interest-earning bank deposits) were approximately $16.8 million, which represents 8.62% of total assets and 8.96% of total deposits. Of this amount, $250,000 is pledged to a correspondent bank. In addition, Weststar has unpledged investment securities of $5.7 million. At September 30, 2010, outstanding commitments to extend credit and available lines of credit were $15.9 million. Due to the Company currently being undercapitalized, it has no remaining available line of credit with the FHLB or any of its correspondent banks.

Certificates of deposit represented approximately 41.85% of the Company’s total deposits at September 30, 2010. Certificates of deposit of $100,000 or more represented 10.62% of the Company’s total deposits at September 30, 2010.  These deposits are generally considered rate sensitive, but management believes most of them are relationship-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 consent order from our primary regulators and the current level of capital will 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 consent order also restricts our ability to offer interest rates on deposit products that exceed the prevailing effective yields by more than 75 basis points in the Bank’s normal market area.

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The Company has deferred pay out of its fourth quarter trust preferred dividend payment as allowed in the agreement.

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 4. 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.

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· 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.

· 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 developing enhanced lending policies and credit administration procedures in order to improve the effectiveness of 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, alleged 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 were based on alleged oral and email representations and promises from the Bank to them.  The Plaintiffs sought $4,250,000 in compensatory damages plus treble damages and attorney's fees.  During October 2010, the Bank entered into a settle ment agreement to resolve all claims alleged against it in the lawsuit. Pursuant to the settlement agreement, the parties have agreed to dismiss the lawsuit with prejudice and to release each other from any claims and damages arising out of or related to the facts alleged in the lawsuit. The parties will be responsible for their own costs and expenses, including attorneys’ fees, incurred in connection with the lawsuit and the settlement. The settlement agreement concludes the lawsuit.

On November 8, 2010, the Registrant and its wholly-owned subsidiary, the Bank of Asheville, filed suit against G. Gordon Greenwood in Buncombe County Superior Court.  Mr. Greenwood is the former President and Chief Executive Officer of the Registrant and of the Bank and is also a former member of the Boards of Directors of the Registrant and the Bank.

The lawsuit alleges claims based on breach of contract, breach of fiduciary duty and violation of Section 53-89 of the North Carolina General Statutes, which is a banking law that governs account overdrafts.

In view of the inherent difficulty of predicting the outcome of litigation, the Registrant cannot predict the eventual outcome, resolution or timing of pending litigation.

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: November 12, 2010		By:	/s/    Randall C. Hall
			Randall C. Hall
			President and Chief Executive Officer
			Chief Financial and Principal Accounting Officer

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