North State Bancorp (NSBC) 10-Q 2008 Q2 Quarterly report

U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2008

or

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period ended            

Commission File Number - 000-49898

NORTH STATE BANCORP

(Exact name of small business issuer as specified in its charter)

NORTH CAROLINA	65-1177289
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification Number)

4270 THE CIRCLE AT NORTH HILLS, RALEIGH, NORTH CAROLINA 27609

(Address of principal executive office)

(919) 787-9696

(Issuer’s telephone number)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x (Do not check if a smaller reporting company)

Smaller reporting company  ¨

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

As of August 12, 2008, 7,163,816 shares of the registrant’s common stock, no par value per share, were outstanding. The registrant has no other classes of securities outstanding.

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
	Consolidated Balance Sheets June 30, 2008 and December 31, 2007	3
	Consolidated Statements of Operations Three and Six Months Ended June 30, 2008 and 2007	4
	Consolidated Statements of Comprehensive Income Three and Six Months Ended June 30, 2008 and 2007	5
	Consolidated Statement of Shareholders’ Equity Six Months Ended June 30, 2008	6
	Consolidated Statements of Cash Flows Six Months Ended June 30, 2008 and 2007	7
	Notes to Consolidated Financial Statements	8
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4T -	Controls and Procedures	25
Part II.	OTHER INFORMATION
Item 4 -	Submission of Matters to a Vote of Security Holders	26
Item 6 -	Exhibits	27

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Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

NORTH STATE BANCORP

CONSOLIDATED BALANCE SHEETS

	June 30, 2008 (Unaudited)		December 31, 2007*
	(Dollars in thousands, except per share data)
ASSETS
Cash and due from banks	$	14,503	$	11,425
Interest-earning deposits with banks		914		1,139
Federal funds sold		41,749		18,202
Investment securities available for sale, at fair value		26,996		34,843
Loans		534,595		469,228
Less allowance for loan losses		5,321		5,020
NET LOANS		529,274		464,208
Accrued interest receivable		2,022		2,090
Stock in the Federal Home Loan Bank of Atlanta, at cost		2,192		1,621
Premises and equipment		10,851		10,463
Other assets		3,672		3,529
TOTAL ASSETS	$	632,173	$	547,520
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Demand	$	71,674	$	94,788
Savings, money market and NOW		246,129		199,503
Time deposits		212,552		163,019
TOTAL DEPOSITS		530,355		457,310
Accrued interest payable		2,825		2,511
Short-term borrowings		31,988		37,886
Long-term debt		26,072		16,332
Accrued expenses and other liabilities		7,200		1,924
TOTAL LIABILITIES		598,440		515,963
Commitments (Note C)
Shareholders’ equity:
Preferred stock, no par value, 1,000,000 shares authorized, none issued		—		—
Common stock, no par value; 10,000,000 shares authorized 7,163,816 and 6,974,604 shares issued and outstanding at June 30, 2008 and December 31, 2007, respectively		20,192		19,609
Retained earnings		12,711		11,439
Accumulated other comprehensive income		830		509
TOTAL SHAREHOLDERS’ EQUITY		33,733		31,557
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	632,173	$	547,520

* Derived from audited consolidated financial statements.

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

	Three Months Ended June 30,				Six Months Ended June 30,
	2008		2007		2008		2007
	(Amounts in thousands, except share and per share data)
INTEREST INCOME
Loans	$	8,422	$	7,055	$	16,922	$	13,817
Investments		362		423		756		869
Federal funds sold and interest-earning deposits		59		439		153		779
TOTAL INTEREST INCOME		8,843		7,917		17,831		15,465
INTEREST EXPENSE
Money market, NOW and savings deposits		1,167		1,670		2,723		3,197
Time deposits		2,014		1,744		4,130		3,506
Short-term borrowings		140		46		286		98
Long-term debt		331		203		658		405
TOTAL INTEREST EXPENSE		3,652		3,663		7,797		7,206
								��
NET INTEREST INCOME		5,191		4,254		10,034		8,259
PROVISION FOR LOAN LOSSES		671		211		1,097		422
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		4,520		4,043		8,937		7,837
NON-INTEREST INCOME
Fees from mortgage operations		31		67		72		109
Service charges and fees on deposit accounts		243		183		434		354
Other		53		53		124		90
TOTAL NON-INTEREST INCOME		327		303		630		553
NON-INTEREST EXPENSE
Salaries and employee benefits		2,070		1,582		4,174		3,094
Occupancy and equipment		637		475		1,218		936
Professional fees		97		65		192		120
Postage, printing and office supplies		49		36		100		87
Data processing and other outsourced services		202		149		414		307
Advertising		71		52		139		103
Other		696		578		1,308		1,194
TOTAL NON-INTEREST EXPENSE		3,822		2,937		7,545		5,841
INCOME BEFORE INCOME TAXES		1,025		1,409		2,022		2,549
INCOME TAXES		382		563		750		995
NET INCOME	$	643	$	846	$	1,272	$	1,554
NET INCOME PER COMMON SHARE
Basic	$	.09	$	.12	$	.18	$	.23
Diluted	$	.09	$	.12	$	.17	$	.21
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
Basic		7,162,062		6,889,775		7,150,374		6,867,118
Diluted		7,366,688		7,338,636		7,354,996		7,335,313

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2008			2007			2008			2007
	(In thousands)						(In thousands)
Net income	$	643		$	846		$	1,272		$	1,554
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding losses on available for sale securities		(548	)		(378	)		(98	)		(218	)
Tax effect		212			146			38			84
Reclassification of loss recognized in net income		6			—			6			—
Tax effect		(2	)		—			(2	)		—
Net of tax amount		(332	)		(232	)		(56	)		(134	)
Cash flow hedging activities:
Unrealized holding gains (losses) on on hedging activities		—			(233	)		900			(184	)
Net of tax amount		—			90			(370	)		78
Reclassification of (gains) losses recognized in net income		(217	)		5			(249	)		6
Tax effect		84			(2	)		96			(2	)
Net of tax amount		(133	)		(140	)		377			(102	)
Total other comprehensive income (loss)		(465	)		(372	)		321			(236	)
Comprehensive income	$	178		$	474		$	1,593		$	1,318

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (Unaudited)

	Common stock			Retained earnings		Accumulated other comprehensive income		Total shareholders’ equity
	Shares	Amount
	(Dollars in thousands)
Balance at December 31, 2007	6,974,604	$	19,609	$	11,439	$	509	$	31,557
Net income	—		—		1,272		—		1,272
Other comprehensive income, net of tax	—		—		—		321		321
Stock based compensation	—		78		—		—		78
Stock options exercised	189,212		505		—		—		505
Balance at June 30, 2008	7,163,816	$	20,192	$	12,711	$	830	$	33,733

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Six Months Ended June 30,
	2008			2007
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,272		$	1,554
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		402			336
Net (accretion) amortization of premiums and discounts on investment securities		10			(10	)
Provision for loan losses		1,097			422
Loss on sale of securities		6			—
Stock based compensation		78			43
Change in assets and liabilities:
(Increase) decrease in accrued interest receivable		68			(73	)
Increase in other assets		(1,634	)		(22	)
Increase in accrued interest payable		314			286
Increase in accrued expenses and other liabilities		5,276			84
NET CASH PROVIDED BY OPERATING ACTIVITIES		6,889			2,620
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from termination of derivative		1,905			—
Purchase of investment securities available for sale		—			(5,192	)
Proceeds from maturities and repayments of investment securities available for sale		7,738			6,573
Purchases of premises and equipment		(790	)		(2,410	)
Net increase in loans		(66,163	)		(41,512	)
Purchase of Federal Home Loan Bank Stock		(571	)		(54	)
NET CASH USED BY INVESTING ACTIVITIES		(57,881	)		(42,595	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		73,045			50,365
Net decrease in short-term borrowings		(5,898	)		(3,156	)
Proceeds from long-term debt		9,750			—
Repayments on long-term debt		(10	)		(9	)
Exercise of stock options		505			236
Excess tax benefits from exercise of stock options		—			67
NET CASH PROVIDED BY FINANCING ACTIVITIES		77,392			47,503
NET INCREASE IN CASH AND CASH EQUIVALENTS		26,400			7,528
CASH AND CASH EQUIVALENTS, BEGINNING		30,766			57,497
CASH AND CASH EQUIVALENTS, ENDING	$	57,166		$	65,025

See accompanying notes.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE A – BASIS OF PRESENTATION

In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of June 30, 2008 and for the three and six-month periods ended June 30, 2008 and 2007, in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements include the accounts of North State Bancorp (the “Company”) and its wholly-owned subsidiary, North State Bank (the “Bank”). All significant intercompany transactions and balances have been eliminated in consolidation.

The preparation of consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements, as well as the amounts of income and expense during the reporting period. Actual results could differ from those estimates. Operating results for the three and six-month periods ended June 30, 2008 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2008.

The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the consolidated financial statements filed as part of the Company’s 2007 Annual Report on Form 10-K for the year ended December 31, 2007. This quarterly report should be read in conjunction with the Annual Report.

NOTE B – RECENT ACCOUNTING PRONOUNCEMENTS

On January 1, 2008, the Corporation adopted Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value under accounting principles generally accepted in the United States, and enhances disclosures about fair value measurements. The Company elected not to delay the application of SFAS No.157 to nonfinancial assets and nonfinancial liabilities, as allowed by Financial Accounting Standards Board (“FASB”) Staff Position SFAS 157-2. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value and, therefore, does not expand the use of fair value in any new circumstances. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 clarifies that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. SFAS 157 requires fair value measurements to be separately disclosed by level within the fair value hierarchy. Under SFAS 157, the Company bases fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in SFAS 157.

Where there is limited or no observable market data for assets or liabilities, the fair value measurements for such assets or liabilities are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the results cannot be determined with precision and may not be realized in an actual sale or immediate

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NOTE B – RECENT ACCOUNTING PRONOUNCEMENTS (Continued)

settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. The adoption of SFAS No. 157 did not have a material effect on the Company’s consolidated financial statements.

Beginning January 1, 2008, the Company can prospectively elect to apply SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – including an amendment of FASB Statement No. 115,”(“SFAS 159”) and measure selected financial assets and liabilities at fair value on a contract-by-contract basis. The Company evaluated the guidance contained in SFAS 159 and decided not to elect the fair value option for any financial assets or liabilities at this time.

On March 19, 2008, FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities”. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company had not adopted the standard as of June 30, 2008.

From time to time the FASB issues exposure drafts for proposed statements of financial accounting standards. Such exposure drafts are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as statements of financial accounting standards. Management considers the effect of the proposed statements on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of exposure drafts.

NOTE C – COMMITMENTS

At June 30, 2008, loan commitments were as follows (in thousands):

Commitments to extend credit	$	79,942
Undisbursed lines of credit		23,708
Letters of credit		3,488

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NOTE D – NONPERFORMING ASSETS

Nonperforming assets at June 30, 2008 and December 31, 2007 consisted of the following:

	June 30, 2008			December 31, 2007
	(Dollars in thousands)
Nonaccrual loans	$	2,205		$	3,103
Restructured loans		—			—
Total nonperforming loans		2,205			3,103
Other real estate owned		—			—
Total nonperforming assets	$	2,205		$	3,103
Accruing loans past due 90 days or more (1)	$	65		$	492
Other impaired loans (2)	$	307		$	327
Allowance for loan losses	$	5,321		$	5,020
Nonperforming loans to period end loans		0.41	%		0.66	%
Allowance for loan losses to period end loans		1.00	%		1.07	%
Nonperforming assets to loans and other real estate owned		0.41	%		0.66	%
Nonperforming assets to total assets		0.35	%		0.57	%
Ratio of allowance for loan losses to nonperforming loans		2.41	x		1.62	x

(1) $17,000 and $492,000, respectively, at June 30, 2008 and December 31, 2007 considered as impaired in management's evaluation.

(2) Other impaired loans as of June 30, 2008 consists of two loans, both of which were performing and not past due.

Other impaired loans as of December 31, 2007 consists of one loan which was performing and not past due and two loans which were past due 30- 89 days.

NOTE E – ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses follows:

	Six Months Ended June 30, 2008
	2008		2007
	(Dollars in thousands)
Allowance for loan losses beginning of period	$	5,020	$	3,982
Provision for loan losses		1,097		422
Loans charged off		796		302
Recoveries		—		—
Net charge-offs		796		302
Allowance for loan losses end of period	$	5,321	$	4,102

NOTE F – NET INCOME PER SHARE

Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had

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NOTE F – NET INCOME PER SHARE (CONTINUED)

been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate to outstanding stock options. Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below.

The Company effected a 3-for-2 stock split in the second quarter of 2007. All references in these financial statements to per share results and weighted average common and potential common shares outstanding have been adjusted for the effects of the stock split.

The weighted average number of shares outstanding or assumed to be outstanding are summarized below:

	Three Months Ended June 30,		Six Months Ended June 30,
	2008	2007	2008	2007
Weighted average number of common shares used in computing basic net income per share	7,162,062	6,889,775	7,150,374	6,867,118
Effect of dilutive stock options	204,626	448,861	217,261	468,195
Weighted average number of common shares and dilutive potential common shares used in computing diluted net income per share	7,366,688	7,338,636	7,367,635	7,335,313

For the three and six-month periods ended June 30, 2008 there were 70,800 and 70,613 anti-dilutive shares, respectively, excluded from the calculation of total dilutive weighted average shares due to the exercise price exceeding the average market price for the three and six-month periods. There were no anti-dilutive stock options for the three and six-month periods ended June 30, 2007.

NOTE G – STOCK OPTION PLANS

During 2000, the Bank adopted, with shareholder approval, an Employee Stock Option Plan and a Non-Employee Director Stock Option Plan. The Company assumed these plans in July 2002 as part of the Bank’s holding company reorganization. In 2003, the Company adopted, with shareholder approval, the 2003 Stock Plan. The 2003 Stock Plan replaced the two prior plans. All shares available for issuance under the prior plans, plus any shares covered by outstanding options that are forfeited under the prior plans, were transferred to the 2003 Plan. An aggregate of 1,239,827 shares of the Company’s common stock was initially reserved for options under the stock option plans. Certain of the options granted to directors in 2000 vested immediately at the time of grant. All other options granted vest 20% annually. All unexercised options expire ten years after the date of grant.

The fair market value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. In valuing options under Black-Scholes, the risk-free interest rate is based upon a U.S. Treasury instrument with a life that is similar to the expected life of the option grant. Expected volatility is based on the Company’s stock price. The expected term of the options is based upon the maximum life of the issued stock options. The expected dividend yield is based upon current yield on date of grant. No post-vesting restrictions exist for these options.

Estimated per share fair value of options granted during the six-month period ended June 30, 2008 $12.25

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NOTE G – STOCK OPTION PLANS (Continued)

Assumptions in estimating option values:
Risk-free interest rate	3.66	%
Dividend yield	0.00	%
Volatility	40.38	%
Expected life	10.0 years

A summary of option activity under the stock option plans as of June 30, 2008 and changes during the six-month period ended June 30, 2008 is presented below:

	Shares	Weighted Average			Aggregate Intrinsic Value
		Exercise Price		Remaining Contractual Term
					(In thousands)
Outstanding at December 31, 2007	597,780	$	4.36	3.75 years	$	5,015
Granted	2,000		12.25
Exercised	189,212		2.67
Forfeited	—		—
Expired	—		—
Outstanding at June 30, 2008	410,568	$	5.17	3.89 years	$	1,572
Exercisable at June 30, 2008	328,409	$	3.25		$	1,888

For the six-month period ended June 30, 2008 the intrinsic value of options exercised was approximately $1.5 million. During the three-month period ended March 31, 2008, 2,000 shares were granted, no shares were granted during the three months ended June 30, 2008 or for the first six months of 2007. The fair value of options vested during the six-month period ended June 30, 2008 was approximately $76,000. As of June 30, 2008, approximately $474,000 of share-based compensation expense remained to be recognized over a weighted average period of 3.0 years.

Cash received from option exercises under share-based payment arrangements for the six-month period ended June 30, 2008 was approximately $505,000.

NOTE H – DERIVATIVE FINANCIAL INSTRUMENTS

To mitigate exposure to variability in expected future cash flows resulting from changes in interest rates, the Company purchased on October 12, 2006 a prime-based interest rate floor agreement with an aggregate notional amount of $50.0 million with a strike rate of 7.50%. The purchase price of $366,000 was to be amortized on an allocated fair value basis over the three-year term of the agreement. In the first quarter of 2008, the Company decided to terminate the interest rate floor agreement only after considering the impact of the transaction on its risk management objectives and concluded the termination provided protection against the impact of expected interest rates on its net interest margin. On March 17, 2008, the Company received $1.9 million in connection with the termination of the interest rate floor agreement. The contractual maturity of the floor was November 1, 2009. During the life of the floor, pre-tax gains of approximately $1.5 million were deferred in accumulated other comprehensive income (“AOCI”) in accordance with cash flow hedge accounting rules established by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities (as amended)”. The amounts deferred in AOCI will be reclassified out of equity into earnings over the remaining 19 months of the original contract. SFAS 133 requires that amounts deferred in AOCI be reclassified into earnings in the same periods during which the originally hedged cash flows (prime-based interest payments on loan assets) affects earnings, as long as the originally hedged cash flows remain probable of occurring (i.e. the principal amount of designated prime-based loans match or exceed the notional amount of the terminated floor through November 1, 2009). If the principal amount of the originally hedged loans falls below the notional amount of the terminated floor, then amounts in AOCI could be accelerated. At June 30, 2008, the remaining pre-tax gains are approximately $1.3 million.

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NOTE I – FAIR VALUES OF ASSETS AND LIABILITIES

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans. The nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. In accordance with FAS 157, the Company groups its financial assets and financial liabilities measured 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 value. These levels are:

• Level 1 – Valuations for assets and liabilities traded in active exchange markets, such as the New York Stock Exchange. Level 1 also includes U.S. Treasury, other U.S. government and agency mortgage-backed securities that are traded by dealers or brokers in active markets. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

• Level 2 – Valuations for assets and liabilities traded in less active dealer or broker markets. Valuations are obtained from third party services for identical or comparable assets or liabilities.

• Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or brokered traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The following is a description of valuation methodologies used by the Company 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 the 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 include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include 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 an allowance for loan losses 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. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” (“SFAS 114”). 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 flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2008, a portion of our impaired loans was evaluated based on the fair value of the collateral. In accordance with SFAS 157,

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NOTE I – FAIR VALUES OF ASSETS AND LIABILITIES (Continued)

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.

The table below presents the balances of assets and liabilities measured at fair value on a recurring basis.

	As of June 30, 2008
	Total		Level 1		Level 2		Level 3
	(Amounts in thousands)
Securities available for sale	$	26,996	$	—	$	26,996	$	—

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.

The table below presents the balances of assets and liabilities measured at fair value on a nonrecurring basis.

	As of June 30, 2008
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Impaired loans	$	2,264	$	—	$	2,264	$	—

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This report contains forward-looking statements intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such because the context of the statement will include words such as we “believe,” “anticipate,” “expect” or words of similar meaning. Similarly, statements that describe our future plans, objectives or goals are also forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those currently anticipated, including: our ability to manage growth; changes in interest rates, deposit flows, loan demand, real estate values and competition; general and local economic conditions; changes in accounting principles, policies or guidelines; changes in legislation or regulation; and other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services.

Management’s discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. You should read this discussion in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002. Effective June 28, 2002, North State Bank became our wholly owned subsidiary. In March 2004, we formed North State Statutory Trust I, in December 2005 we formed North State Statutory Trust II and in November 2007 we established a third subsidiary trust, North State Statutory Trust III, all of which issued trust preferred securities to provide additional capital for general corporate purposes, including current and future expansion of North State Bank. In October 2007, we acquired approximately 5.6% of Beacon Title Agency, LLC, a title insurance agency. Our only business is the ownership and operation of North State Bank, the three subsidiary trusts and our investment in Beacon Title Agency.

North State Bank is a commercial bank that was incorporated under the laws of the State of North Carolina on May 25, 2000 and began operations on June 1, 2000. The Bank is a full service community bank providing banking services through eight locations: its main office in the North Hills section of Raleigh, North Carolina; one office in North Raleigh; one office in West Raleigh; one office in downtown Raleigh; one office in Garner, North Carolina; one office serving the Wake Forest area of North Carolina; one office in Wilmington, North Carolina; and a loan production office in Morehead City, North Carolina. Construction of a new multi-story full-service banking office for our North Raleigh office began in May 2008.

Comparison of Financial Condition at June 30, 2008 and December 31, 2007

Total assets at June 30, 2008 were $632.2 million compared to $547.5 million at December 31, 2007, an increase of $84.7 million or 15.5%. Loan production continued to lead our asset growth, up a total of $65.4 million or 13.9% over December 31, 2007. The loan growth was funded principally through core deposit growth of $35.5 million or 9.9% and additional brokered deposits of $40.2 million, respectively, over December 31, 2007. We exclude time deposits over $100,000 and wholesale brokered time deposits in our calculation of core deposits. Also, in May 2008, the Bank issued $9.8 million in long-term subordinated notes. The additional funding contributed to the reduction of our short-term borrowings by $5.9 million from December 31, 2007.

Investments decreased $7.8 million or 22.5% from $34.8 million at December 31, 2007 as principal re-payments and maturing investments were redeployed into the loan portfolio. The investment portfolio decreased in fair value $98,000 with a $4,000 loss reclassification recognized in income net of tax during

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the six-month period ended June 30, 2008. Federal funds sold increased $23.5 million to $41.7 million and cash and due from banks increased $3.1 million to $14.5 million at June 30, 2008 from December 31, 2007.

Loans increased $65.4 million to $534.6 million at June 30, 2008 from $469.2 million at December 31, 2007. The loan growth was primarily in commercial real estate and construction loans throughout all our markets in Wake and New Hanover counties during the six-month period ended June 30, 2008. We continue to have no direct exposure to sub-prime mortgages. Our loan portfolio grew significantly during the first six months of the year during a period where the prime interest rate fell 225 basis points from 7.25% at year-end 2007 to 5.00% at June 30, 2008. Also, as market rates have dropped, approximately 40.0% of our loans with variable interest rates have re-priced with market conditions.

The allowance for loan losses was $5.3 million at June 30, 2008 or 1.00% of total loans outstanding compared to $5.0 million or 1.07% of loans outstanding at December 31, 2007. The level of the allowance relative to gross loans was decreased due to a decrease in specific reserves for impaired loans. Our reserve for impaired loans decreased to $145,000 at June 30, 2008 from $472,000 at December 31, 2007, representing six basis points of the total seven basis point decline in the allowance as a percent of loans outstanding. Approximately $205,000 of the decrease in impaired reserve was due to charge-offs. Management considers the level of the allowance for loan losses adequate to provide for probable loan losses based on our assessment of our loan portfolio at June 30, 2008.

Our premises and equipment grew slightly to $10.9 million at June 30, 2008 from $10.5 million at December 31, 2007. The $388,000 increase reflects additions for the completion of our new full service office in Wilmington which opened in January 2008, initial costs on construction of our new multi-story building for our North Raleigh office which began in the second quarter of 2008 and the opening in June 2008 of our loan production office in Morehead City. Overall, other assets and accrued interest receivable increased slightly, $75,000, at June 30, 2008 over December 31, 2007. During March 2008, we terminated our interest rate floor at $1.9 million, see “Quantitative and Qualitative Disclosures about Market Risk” discussed in Item 3 for additional information.

Our loan growth was funded primarily with increased deposit funds, up $73.0 million or 16.0% from December 31, 2007. Since December 31, 2007, noninterest-bearing deposits have declined $23.1 million or 24.4% to $71.7 million, while interest-bearing savings, money market and interest checking deposits grew $46.6 million or 23.4%. The decline in noninterest-bearing demand deposits is in part a result of the North Carolina State Bar requiring deposit accounts of our attorney trust customers to be moved from noninterest-bearing demand deposit accounts and held in interest-bearing deposit accounts by the end of June 30, 2008. Total time deposits grew $49.5 million or 30.4%, primarily in brokered time deposits which increased $40.2 million from December 31, 2007 to June 30, 2008. Time deposits greater than $100,000 decreased $2.6 million or 2.9% to $87.8 million at June 30, 2008. Our core deposits grew by $35.5 million or 9.9% from December 31, 2007 to June 30, 2008, as the result of our continuous efforts to expand and develop full banking relationships with our customers. Additional funds, however, were necessary from brokered time deposits to support our high level of loan growth.

We also use borrowings to support balance sheet management and growth. Total borrowings were up $3.8 million to $58.1 million at June 30, 2008 from $54.2 million at December 31, 2007. Short-term funds decreased due to additional funds available from brokered time deposits and the new long-term debt issuance. Long-term borrowings increased due to the issuance of $9.8 million of subordinated notes by the Bank in May 2008 that mature in June 2018. Additional subordinated notes of $1.2 million were issued on July 1, 2008. The subordinated notes issued in May 2008 are included in our calculation of Tier II capital.

Accrued expenses were up $5.4 million due to principal and interest collections on participated loans which were submitted subsequent to quarter end.

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Total shareholders’ equity increased $2.2 million or 6.9% from $31.6 million at December 31, 2007 to $33.7 million at June 30, 2008. The increase was provided by net income of $1.27 million and the conversion of 189,212 stock options held by directors and employees into common stock. The exercise of these options contributed $505,000 to our total shareholders’ equity while stock based compensation added $78,000. Other comprehensive income components increased shareholders’ equity at June 30, 2008 by $321,000.

Comparison of Results of Operations for the Three-Month Periods Ended June 30, 2008 and 2007

Net Income. For the three-month period ended June 30, 2008, net income was $643,000 compared to $846,000 for the corresponding three-month period of 2007, representing a 24.0% decrease. On a diluted share basis, earnings were $.09 and $.12 per share, respectively, for the three-month periods ended June 30, 2008 and 2007.

The decrease in earnings is primarily attributable to the additional operating expenses related to the opening of two new banking offices, a loan production office, increased loan loss provision and the impact of a 325 basis point drop in the prime interest rate since June 30, 2007. Approximately 40.0% of our loan portfolio re-prices with each reduction in interest rate and new loans funded during the 2008 period were priced at comparably lower interest rates than the prior year period. Overall, net interest income grew $937,000 in the three-month period ended June 30, 2008 compared to the prior year period, driven by higher average loan volumes. The increase in net interest income was offset by increases in loan loss provision of $460,000 (discussed below) and other noninterest expense of $885,000, primarily in personnel costs related to staffing the new banking and loan production offices.

Net Interest Income. Interest income for the three-month period ended June 30, 2008 increased $926,000 or 11.7% over the prior year period. The increase in interest income was provided substantially by growth in average earning assets, specifically loans. For the three-month period ended June 30, 2008 compared to the prior year period, average loan volumes increased $144.0 million, providing additional interest income of approximately $2.5 million. An average decrease in volume for Federal funds sold and investment securities decreased interest income by approximately $332,000. Declines in yield among average interest-earning assets decreased interest income approximately $1.3 million.

Deposit interest expense decreased $233,000 overall for the three-month period ended June 30, 2008 compared to the prior year period. Lower rates paid on average interest-bearing deposits decreased interest expense approximately $986,000. The lower rates were the result of repricing of our interest-bearing deposit funds to reflect market conditions. Growth in average interest-bearing deposits occurred in money market and time deposits, which increased $40.8 million and $39.2 million, respectively, which increased interest expense approximately $753,000. Interest expense on average short-term and long-term borrowings increased $222,000 over the prior year period as growth in these funds increased $34.9 million. Average noninterest-bearing demand deposits were down $8.8 million to $84.3 million.

Overall, net interest income for the three-month period ended June 30, 2008 increased $937,000 or 22.0%, with approximately $1.1 million attributable to earning asset growth offset by approximately $193,000 due to lower rates. The net interest margin for the three-month period was 3.79% compared to 3.88% for the prior year period.

The following table contains information relating to our average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented.

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	Three Months Ended June 30, 2008						Three Months Ended June 30, 2007
	Average Balance		Interest		Average Rate		Average Balance		Interest		Average Rate
	(Dollars in thousands)						(Dollars in thousands)
Interest-earning assets:
Loans	$	515,113	$	8,422	6.58	%	$	371,078	$	7,055	7.63	%
Investments available for sale		28,494		362	5.11	%		38,162		423	4.45	%
Fed funds sold		4,220		19	1.81	%		28,322		383	5.42	%
Other Interest-earning assets		3,051		40	5.27	%		2,291		56	9.80	%
Total interest-earning assets		550,878		8,843	6.46	%		439,853		7,917	7.22	%
Other assets		19,719						17,582
Total assets	$	570,597					$	457,435
Interest-bearing liabilities:
Deposits:
NOW & Money Market	$	214,516		1,165	2.18	%	$	173,736		1,669	3.85	%
Savings		1,007		2	0.80	%		1,165		1	0.34	%
Time deposits over $100,000		91,022		1,083	4.79	%		74,555		975	5.25	%
Other time deposits		85,365		931	4.39	%		62,657		769	4.92	%
Short-term borrowings		26,885		140	2.09	%		8,332		46	2.21	%
Long-term debt		27,507		331	4.84	%		11,189		203	7.28	%
Total interest-bearing liabilities		446,302		3,652	3.29	%		331,634		3,663	4.43	%
Demand deposits		84,251						93,082
Other liabilities		5,752						4,245
Shareholders’ equity		34,292						28,474
Total liabilities and shareholders’ equity	$	570,597					$	457,435
Net interest income and interest rate spread			$	5,191	3.17	%			$	4,254	2.79	%
Net yield on average interest-earning assets					3.79	%					3.88	%
Ratio of average interest-earning assets to average interest-bearing liabilities					123.43	%					132.63	%

Provision for Loan Losses. The provision for loan losses was $671,000 during the three-month period ended June 30, 2008 compared with $211,000 for the same period in 2007. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for the three-month period ended June 30, 2008 is principally in response to loan growth and funding our reserve for impaired loans. Net charge-offs were $794,000 and $3,000, respectively, for the three-month periods ended June 30, 2008 and 2007. A significant portion of the charge-offs for the three-month period ended June 30, 2008 was the result of a $542,000 loan charged off for a single-practice physician who died unexpectedly. Nonaccrual loans were $2.2 million and $3.1 million, respectively, representing .41% and .66% of period-end loans as of June 30, 2008 and December 31, 2007. There were $98,000 in loans on nonaccrual status as of June 30, 2007. We had no restructured loans or other real estate owned at June 30, 2008, December 31, 2007 or June 30, 2007. The allowance for loan losses was $5.3 million at June 30, 2008, $5.0 million at December 31, 2007, and $4.1 million at June 30, 2007 representing 1.00%, 1.07% and 1.06%, respectively, of loans outstanding at each date. The decrease in the level of the allowance relative to gross loans resulted from the decrease in the actual impairment reserve allocated to specific loans of which approximately $205,000 is attributable to impaired loans charged off during the period and approximately $120,000 due to a reduction in impaired evaluation. Total loans considered impaired in accordance with SFAS No. 114 decreased from $3.9 million at December 31, 2007 to $2.5 million at June 30, 2008, with the corresponding allowance for the impaired loans declining to $145,600 at June 30, 2008 from $472,000 at December 31, 2007. The allowance for loan losses is maintained at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio at June 30, 2008.

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Management evaluates the adequacy of our allowance for loan losses on a monthly basis and our directors review management’s evaluation of the allowance for loan losses on a quarterly basis. In evaluating the allowance for loan losses, we prepare on a monthly basis an analysis of our current loan portfolio using historical loss rates, peer statistics and data from our portfolio. We utilize a system of nine possible risk ratings. The risk ratings are established based on perceived probability of loss. All loans risk rated “doubtful” and “loss” are removed from their homogeneous group and individually analyzed for impairment as detailed in FAS 114. Other groups of loans based on loan size may be selected for impairment review. For loans determined to be impaired, the specific allowance is based on the present value of expected cash flows or the fair value of the collateral or the loan’s observable market price. We have identified seven qualitative factors that are considered indicators of changes in the level of risk of loss inherent in our loan portfolio. These factors include and consider the risk of payment performance, overall portfolio quality (utilizing weighted average risk rating), general economic factors such as unemployment, inflation, delinquency and charge-off rates, regulatory examination results, interest rate environment, levels of highly leveraged transactions (as defined in Section 365.2 of the FDIC regulations) and levels of construction, development and non-owner occupied commercial real estate lending. These factors are examined for trends and the risk that they represent to our loan portfolio. Each of these factors is assigned a level of risk and this risk factor is applied to only the SFAS No. 5 “Accounting for Contingencies” (“SFAS 5”) pool of loans to calculate the appropriate allowance. Using the data gathered during this monthly evaluation process, the model calculates an estimated reserve amount.

While we believe that our management uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Because these factors and management’s assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Also, as an important component of their periodic examination process, regulatory agencies review our allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management. Additional information regarding our allowance for loan losses and loan loss experience is presented in our 2007 Annual Report on Form 10-K for the year ended December 31, 2007.

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The following is a summary of nonperforming assets at the dates presented:

	June 30, 2008			December 31, 2007			June 30, 2007
	(Dollars in thousands)
Nonaccrual loans	$	2,205		$	3,103		$	98
Restructured loans		—			—			—
Total nonperforming loans		2,205			3,103			98
Other real estate owned		—			—			—
Total nonperforming assets	$	2,205		$	3,103		$	98
Accruing loans past due 90 days or more (1)	$	65		$	492		$	569
Other impaired loans (2)	$	307		$	327		$	241
Allowance for loan losses	$	5,321		$	5,020		$	4,103
Nonperforming loans to period end loans		0.41	%		0.66	%		0.03	%
Allowance for loan losses to period end loans		1.00	%		1.07	%		1.06	%
Nonperforming assets to loans and other real estate owned		0.41	%		0.66	%		0.03	%
Nonperforming assets to total assets		0.35	%		0.57	%		0.02	%
Ratio of allowance for loan losses to nonperforming loans		2.41	x		1.62	x		41.87x

(1) $17,000 and $492,000, and $569,000 respectively, at June 30, 2008, December 31, 2007 and June 30, 2007 considered impaired in management’s evaluation.

(2) Other impaired loans as of June 30, 2008 consists of two loans, both of which were performing and not past due. Other impaired loans as of December 31, 2007 consists of one loan which was performing and not past due and two loans which were past due 30- 89 days. Other impaired loans as of June 30, 2007 consisted of one loan which was performing and not past due.

Noninterest Income. For the three-month period ended June 30, 2008, non-interest income increased $24,000 to $327,000 from $303,000 for the corresponding period in the prior year. We began efforts at the beginning of 2008 to dissolve our mortgage operations by the end of June 2008, resulting in the decrease of mortgage operation fees of $36,000 from the prior year three-month period. The mortgage operations were terminated in the three-month period ended June 30, 2008. Deposit fees, service charges and other fees increased $60,000 for the three-month period ended June 30, 2008 compared to the prior year period primarily due to efforts to reduce the number of waived fees and increase loan modification fees. Fees from annuity sales and other fees generated from wealth management services were down slightly.

Noninterest Expense. Total non-interest expense for the three-month period ended June 30, 2008 was $3.8 million, with salaries and benefits representing the largest expense category at $2.1 million. This compares to total non-interest expense for the three-month period ended June 30, 2007 of $2.9 million with salaries and benefits of $1.6 million. The $488,000 increase in salaries and benefits for the three-month period ended June 30, 2008 is attributable to an overall increase of 19 full time equivalent employees from the prior year period. We hired additional staff late in 2007 for our new full service office in Wilmington which opened in January 2008 and our full service office in downtown Raleigh which opened in December 2007 as well as other management and support staff throughout the Bank.

Occupancy and equipment costs increased $162,000 to $637,000 for the three-month period ended June 30, 2008 compared to the same period last year. These costs include the additional lease expense for our new full-service office in Wilmington which opened in January 2008 and additional lease expense for expansion in our current operations area. Overall, lease expense increased approximately $98,000 over the prior year three-month period. Other non-interest expenses increased $235,000 during the three-month period ended June 30, 2008 over the prior year period in 2007. Outsourced data processing fees were up $53,000 due to an increase in the volume of accounts, professional fees were up $32,000, telephone expense was up $26,000 and donations were up $28,000.

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Comparison of Results of Operations for the Six-Month Period Ended June 30, 2008 and 2007

Net Income. For the six-month period ended June 30, 2008, net income was $1.27 million compared to $1.6 million for the corresponding six-month period of 2007, representing an 18.1% decrease. On a diluted share basis, earnings were $.17 and $.21 per share, respectively, for the six-month period ended June 30, 2008 and 2007.

The decrease in earnings is primarily attributable to the additional operating expenses related to the opening of two new banking offices, a loan production office, increased loan loss provision and the impact of a 325 basis point drop in the prime interest rate since June 30, 2007. Overall, net interest income grew $1.8 million in the six-month period ended June 30, 2008 compared to the prior year period, driven by higher average loan volumes. The increase in net interest income was offset by increases in loan loss provision of $675,000 and other noninterest expense of $1.7 million, primarily in personnel costs related to staffing the new banking and loan production offices.

Net Interest Income. Interest income for the six-month period ended June 30, 2008 increased $2.4 million or 15.3% over the prior year period with a corresponding increase in interest expense of $591,000 over the prior year period. The increase in interest income was provided substantially by growth in average loans of $133.8 million, which generated additional interest income of approximately $4.8 million for the six-month period ended June 30, 2008 compared to the prior year period. An average decrease in volume for Federal funds sold and investment securities reduced interest income by approximately $578,000. Lower yields on our average interest-earning assets reduced overall interest income approximately $1.9 million.

Lower rates resulting from the repricing of our interest-bearing deposits to reflect market conditions reduced interest expense approximately $1.4 million while growth in these average interest-bearing deposits of $76.8 million resulted in an increase in interest expense of approximately $1.5 million, resulting in a net increase in interest expense of $150,000 for the six-month period ended June 30, 2008 compared to the prior year period. Average noninterest-bearing demand deposits decreased $3.4 million. Interest expense on average short-term and long-term borrowings increased $441,000 over the prior year period as these funds increased on average $28.8 million.

Overall, net interest income for the six-month period ended June 30, 2008 increased $1.8 million or 21.5%, with approximately $2.1 million attributable to earning asset growth offset by approximately $295,000 due to lower rates. The net interest margin for the six-month period was 3.75% compared to 3.86% for the prior year period.

The following table contains information relating to our average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented.

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	Six Months Ended June 30, 2008						Six Months Ended June 30, 2007
	Average Balance		Interest		Average Rate		Average Balance		Interest		Average Rate
	(Dollars in thousands)						(Dollars in thousands)
Interest-earning assets:
Loans	$	498,713	$	16,922	6.82	%	$	364,921	$	13,817	7.64	%
Investments available for sale		30,930		756	4.92	%		39,355		869	4.45	%
Fed funds sold		5,012		67	2.69	%		24,966		670	5.41	%
Other interest-earning assets		2,877		86	6.01	%		2,370		109	9.27	%
Total interest-earning assets		537,532		17,831	6.67	%		431,612		15,465	7.23	%
Other assets		19,782						17,303
Total assets	$	557,314					$	448,915
Interest-bearing liabilities:
Deposits:
NOW & Money Market	$	209,439		2,720	2.61	%	$	166,548		3,194	3.87	%
Savings		910		3	0.66	%		1,164		3	0.52	%
Time deposits over $100,000		92,211		2,270	4.95	%		75,085		1,945	5.22	%
Other time deposits		81,242		1,860	4.60	%		64,176		1,561	4.91	%
Short-term borrowings		22,225		286	2.59	%		8,750		98	2.26	%
Long-term debt		26,533		658	4.99	%		11,191		405	7.30	%
Total interest-bearing liabilities		432,560		7,797	3.62	%		326,914		7,206	4.45	%
Demand deposits		85,961						89,378
Other liabilities		4,960						4,656
Shareholders’ equity		33,833						27,967
Total liabilities and shareholders’ equity	$	557,314					$	448,915
Net interest income and interest rate spread			$	10,034	3.05	%			$	8,259	2.78	%
Net yield on average interest-earning assets					3.75	%					3.86	%
Ratio of average interest-earning assets to average interest-bearing liabilities					124.27	%					132.03	%

Provision for Loan Losses. The provision for loan losses increased $675,000 to $1.1 million for the six-month period ended June 30, 2008 as compared with $422,000 for the same period in 2007. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for the six-month period ended June 30, 2008 is principally in response to loan growth. Net charge-offs were $796,000 or .32% of average loans and $302,000 or .17% of average loans, respectively, for the six-month periods ended June 30, 2008 and 2007. See additional discussion regarding provision for loan losses and allowance for loan loss under “Provision for Loan Losses” included above under “Comparison of Results of Operations for the Three-Month Periods Ended June 30, 2008 and 2007”.

Noninterest Income. For the six-month period ended June 30, 2008, non-interest income increased $77,000 over the corresponding period in the prior year. We began efforts at the beginning of the year to dissolve our mortgage operations by the end of June 2008, resulting in a decrease in mortgage operation fees of $37,000 from the prior year six-month period. Deposit fees, service charges and other fees increased $114,000 for the six-month period ended June 30, 2008 compared to the prior year period primarily due to efforts to reduce the number of waived fees and increase loan modification fees. Deposit related fees were up $35,000, loan modification fees were up $70,000 and fees from annuity sales and other fees generated from wealth management services were up $23,000 for the six-month period ended June 30, 2008 compared to the prior year period.

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Noninterest Expense. Total non-interest expense for the six-month period ended June 30, 2008 was $7.5 million, with salaries and benefits representing the largest expense category at $4.2 million. This compares to total non-interest expense for the six-month period ended June 30, 2007 of $5.8 million with salaries and benefits of $3.1 million. The $1.1 million increase in salaries and benefits for the six-month period ended June 30, 2008 is attributable to an overall increase of 19 full time equivalent employees from the prior year period. We hired additional staff late in 2007 for our new full service office in Wilmington which opened in January 2008 and our full service office in downtown Raleigh which opened in December 2007 as well as other management and support staff throughout the Bank.

Occupancy and equipment costs increased $282,000 to $1.2 million for the six-month period ended June 30, 2008 compared to the same period last year. These costs include the additional lease expense for our new full-service office in Wilmington which opened in January 2008 and additional lease expense for expansion in our current operations area. Overall, lease expense increased approximately $131,000 over the prior year six-month period. Other non-interest expense increased $342,000 during the six-month period ended June 30, 2008 over the prior year period in 2007. The new offices also contributed to additional costs in other non-interest expense. Outsourced data processing fees were up $107,000 due to an increase in the volume of accounts, professional fees were up $72,000, telephone expense was up $48,000 and donations were up $40,000. Director fees for the first six months of 2008 were $158,000, down $123,000 from the prior year period. Directors fees for the first six months of 2007 included fees for an equity compensation plan. During September 2007, the board of directors waived the equity compensation portion of the 2007 deferred compensation plan for fiscal 2007 and in December 2007, terminated the equity compensation portion in its entirety. The remaining non-interest expenses were up overall in various categories due to increases in general operating expense.

Liquidity and Capital Resources

Our liquidity is a measure of our ability to fund loans, withdrawals and maturities of deposits, and other cash outflows in a cost effective manner. Our principal sources of liquidity are deposits, scheduled payments and prepayments of loan principal, maturities of investment securities, access to liquid assets, and funds provided by operations. While scheduled loan payments and maturing investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Liquid assets (consisting of cash and due from banks, interest-earning deposits with other banks, Federal funds sold and investment securities classified as available for sale) comprised $84.2 million or 13.3% and $65.6 million or 12.0% of our total assets at June 30, 2008 and December 31, 2007, respectively.

We have historically been a net seller of Federal funds, as our liquidity has exceeded our need to fund new loan demand. However, beginning in the fourth quarter of 2007, strong loan demand necessitated our borrowing short-term funds rather than selling federal funds and this trend continued during the first six months of 2008. For the first three months of 2008 our short-term borrowings averaged $17.5 million compared to $5.8 million of average Federal funds sold. During the second quarter of 2008, short-term borrowings averaged $26.9 million compared to $4.2 million of average Federal funds sold. During June of 2008 we also acquired additional funding of $40.0 million through brokered certificates of deposits included in time deposits. We have established credit lines with other financial institutions to purchase up to $26.3 million in Federal funds. As a member of the Federal Home Loan Bank of Atlanta, or FHLB, we may obtain advances up to 10% of our Bank’s assets. As another source of short-term borrowings, we also utilize securities sold under agreements to repurchase. At June 30, 2008, our short-term borrowings consisted of securities sold under agreements to repurchase of $9.0 million and short-term FHLB advances of $23.0 million. Federal funds sold at June 30, 2008 were $41.7 million.

Total deposits were $530.4 million and $457.3 million at June 30, 2008 and December 31, 2007, respectively. Time deposits, which are the only deposit accounts that have stated maturity dates, are generally considered to be rate sensitive. Time deposits represented 40.1% and 35.6%, respectively, of

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total deposits at June 30, 2008 and December 31, 2007. Time deposits of $100,000 or more represented 16.5% and 19.8%, respectively, of our total deposits at June 30, 2008 and December 31, 2007. Time deposits at June 30, 2008 and December 31, 2007 included $50.2 million and $10.0 million, respectively, of wholesale brokered certificates of deposit that mature in various terms less than a year. We began acquiring these brokered deposits in the fourth quarter of 2007 to partially fund the significant rise in loan demand which has out-paced our growth in core deposits. Other than these brokered deposits, we believe that most of the time deposits are relationship-oriented. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention and we will continue to focus on developing full banking relationships with our customers. Based upon prior experience, we anticipate that a substantial portion of outstanding certificates of deposit will renew upon maturity.

Also, on May 13, 2008, the Bank sold $9.75 million in principal of 3-month LIBOR plus 3.50% floating rate subordinated notes due June 30, 2018. Additional subordinated notes of $1.25 million were issued on July 1, 2008. The subordinated notes issued in May 2008 are included in our calculation of Tier II capital.

Short and long-term borrowings as of June 30, 2008 and December 31, 2007

	June 30, 2008		December 31, 2007
	($ in thousands)
Short-term borrowings
Federal funds purchased	$	—	$	—
Repurchase agreements		8,988		23,886
FHLB advances		23,000		14,000
	$	31,988	$	37,886
Long-term borrowings
FHLB advances	$	857	$	867
Subordinated notes		9,750		—
Junior subordinated debentures		15,465		15,465
	$	26,072	$	16,332

A description of the trust preferred securities and related junior subordinated debentures outstanding at June 30, 2008 and December 31, 2007 are as follows:

	6/30/2008		12/31/2007		Maturity Date	Interest rate
North State Statutory Trust I	$	5,155	$	5,155	4/17/2034	3-mo LIBOR plus 2.79%, resets quarterly
North State Statutory Trust II		5,155		5,155	4/15/2035	3-mo LIBOR plus 1.65%, resets quarterly
North State Statutory Trust III		5,155	$	5,155	12/15/2037	3-mo LIBOR plus 2.75%, resets quarterly
	$	15,465	$	15,465

A description of the subordinated notes outstanding at June 30, 2008 and December 31, 2007 are as follows:

	6/30/2008		12/31/2007		Maturity Date	Interest rate
Floating rate subordinated notes	$	9,750	$	—	6/30/2018	3-mo LIBOR plus 3.50%, resets quarterly

We closely monitor and evaluate our overall liquidity position on an ongoing basis and adjust our position as management deems appropriate. We believe our liquidity position at June 30, 2008 is adequate to meet our operating needs.

At June 30, 2008, our equity to assets ratio was 5.3%. The Bank’s leverage and risk based capital ratios and its total risk based capital ratio were 8.30%, 8.71% and 11.49%, respectively. At June 30, 2008, the Bank exceeded the minimum requirements of a “well capitalized” institution as defined by federal banking regulations.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

The largest component of our earnings is net interest income which can fluctuate widely, directly impacting our overall earnings. Significant interest rate movements occur due to differing maturities or repricing intervals of our interest-earning assets and interest-bearing liabilities and the fact that rates on these financial instruments do not change uniformly. Management is responsible for minimizing our exposure to interest rate risk. This is accomplished by developing objectives, goals and strategies designed to enhance profitability and performance while minimizing our overall interest rate risk.

We use several modeling techniques to measure interest rate risk. Our primary method is the simulation of net interest income under varying interest rate scenarios. We believe this methodology is preferable in that it takes into account the pricing strategies we would undertake in response to rate changes, whereas other methods such as interest rate shock or balance sheet gap analysis do not take these into consideration. Our balance sheet remains asset-sensitive, which means that more assets than liabilities are subject to immediate repricing as market rates change. During periods of rising rates, this should result in increased interest income. The opposite would be expected during periods of declining rates. Our market risk has not changed significantly since December 31, 2007.

Our hedging strategy is generally intended to take advantage of opportunities to reduce, to the extent possible, unpredictable cash flows. We may use a variety of commonly used derivative products that are instruments used by financial institutions to manage interest rate risk. The products that may be used as part of a hedging strategy include swaps, caps, floors and collars. We have used a stand-alone derivative financial instrument, in the form of an interest rate floor, in our asset/liability management program. The transaction involved both credit and market risk. The instrument was designated as a cash flow hedge of the risk of overall changes in cash flows below the strike rate of 7.50% on the floor. Although the cash flow hedge was consistent with our risk management objective, we decided in March 2008 to terminate the interest rate floor agreement after considering the impact of the transaction on our risk management objectives and after alternative strategies were in place to mitigate the adverse impact of falling interest rates on our net interest margin. On March 17, 2008, we received $1.9 million in connection with the termination of the interest rate floor and are amortizing the remaining pre-tax gain of $1.5 million over the remaining 19 months of the original contract period. At December 31, 2007, the outstanding notional value of the interest rate floor was $50.0 million with a fair value of $1.0 million and an unrealized gain of $681,000 and a maturity date of November 1, 2009. Additional discussion of derivatives is presented in Note L in our Annual Report on Form 10-K for the year ended December 31, 2007.

Item 4T. Controls and Procedures

(a) As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective.

(b) No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II. OTHER INFORMATION

Item 4. Submission of Matters to a Vote of Security Holders

Our Annual Meeting of Shareholders was held on May 29, 2008. The following matters were voted on at the meeting:

Proposal 1: To elect five Class II Directors for three-year terms until the Annual Meeting of Shareholders in 2011. Votes for each nominee were as follows:

Name	For	Withheld
Larry D. Barbour	5,154,027	50,839
Charles T. Francis	5,191,220	13,646
Ambassador Jeannette W. Hyde	5,195,356	9,510
Brig. Gen. Gary H. Pendleton (Retired)	5,201,296	3,570
Fred J. Smith Jr.	5,201,296	3,570

The following directors continued in office after the meeting: James C. Branch, Glenn E. Futrell, J. Keith Keener, M.D., W. Harold (Hal) Perry and Jack M. Stancil, Forrest H. Ball, C. Thomas Hendrickson, Honorable Burley B. Mitchell, Jr., Barry W. Partlo, and Nutan T. Shah.

Proposal 2: To ratify the appointment of Dixon Hughes PLLC, Raleigh, North Carolina, as our independent registered public accounting firm for the fiscal year ending December 31, 2008.

For	Against	Abstain
5,164,396	27,458	13,011

Proposal 3: To act upon such other matters as may properly come before the meeting or any adjournment thereof.

For	Against	Abstain
5,082,945	74,064	47,855

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Item 6. Exhibits

Exhibit #	Description
10.18	Fiscal and Paying Agent Agreement, dated May 13, 2008, between North State Bank and Wilmington Trust Company (including form of Floating Rate Subordinated Note due June 30, 2018)
31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)
31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)
32.1	Certification by the Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification by the 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

In accordance with 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.

	NORTH STATE BANCORP
Date: August 14, 2008	By:	/s/ Larry D. Barbour
		Larry D. Barbour
		President and Chief Executive Officer
Date: August 14, 2008	By:	/s/ Kirk A. Whorf
		Kirk A. Whorf
		Executive Vice President and Chief Financial Officer