North State Bancorp (NSBC) 10-Q 2011 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, 2011

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	(IRS Employer
incorporation or organization)	Identification Number)

6204 FALLS OF THE NEUSE ROAD, 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 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 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 [ ] (Do not check if a smaller reporting company) Smaller reporting company [X]

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, 2011, 7,427,976shares 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, 2011 and December 31, 2010	3
	Consolidated Statements of Operations
	Three and Six Months Ended June 30, 2011 and 2010	4
	Consolidated Statements of Comprehensive Income
	Three and Six Months Ended June 30, 2011 and 2010	5
	Consolidated Statement of Shareholders’ Equity
	Six Months Ended June 30, 2011 and 2010	6
	Consolidated Statements of Cash Flows
	Six Months Ended June 30, 2011 and 2010	7
	Notes to Consolidated Financial Statements	8
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4 -	Controls and Procedures	47
Part II.	OTHER INFORMATION
Item 6 -	Exhibits	48

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Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

NORTH STATE BANCORP

CONSOLIDATED BALANCE SHEETS

		June 30, 2011		December 31, 2010
		(unaudited)			*
ASSETS		(Dollars in thousands)
Cash and due from banks		$	8,731	$	5,974
Interest-earning deposits with banks			61,684		43,859
Certificates of deposit with banks			735		198
Investment securities available for sale, at fair value	��		17,011		9,234
Investment securities held to maturity, at amortized cost			250		250
Loans held for sale			47,182		51,472
Loans			482,721		499,523
Less allowance for loan losses			9,944		9,935
Net loans			472,777		489,588
Accrued interest receivable			1,424		1,654
Stock in the Federal Home Loan Bank of Atlanta, at cost			1,227		1,273
Premises and equipment, net			14,487		14,801
Foreclosed assets			3,121		5,296
Prepaid FDIC insurance			2,991		3,646
Other assets			6,717		6,620
TOTAL ASSETS		$	638,337	$	633,865
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Demand		$	130,549	$	117,840
Savings, money market and NOW			264,107		250,469
Time			172,218		194,439
Total deposits			566,874		562,748
Accrued interest payable			1,308		1,181
Short-term borrowings			3,461		3,615
Long-term borrowings			27,258		27,269
Accrued expenses and other liabilities			1,304		1,550
TOTAL LIABILITIES			600,205		596,363
Commitments
Shareholders' equity:
Preferred stock, no par value, 1,000,000 shares authorized, none issued			-		-
Common stock, no par value; 10,000,000 shares authorized; 7,427,976 shares issued and outstanding June 30, 2011 and December 31, 2010			21,686		21,636
Retained earnings			16,240		15,926
Accumulated other comprehensive loss			206		(60	)
TOTAL SHAREHOLDERS' EQUITY			38,132		37,502
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY		$	638,337	$	633,865

*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,
	2011		2010		2011		2010
	(Dollars in thousands, except per share data)
INTEREST INCOME
Loans	$	6,156	$	7,108	$	12,816	$	14,209
Loans held for sale		272		298		546		358
Investments		244		181		347		391
Dividends and interest-earning deposits		62		202		105		431
Total interest income		6,734		7,789		13,814		15,389
INTEREST EXPENSE
Savings, money market and NOW		401		521		881		1,066
Time deposits		717		1,215		1,487		2,601
Short-term borrowings		1		7		2		13
Long-term borrowings		230		228		461		448
Total interest expense		1,349		1,971		2,831		4,128
NET INTEREST INCOME		5,385		5,818		10,983		11,261
PROVISION FOR LOAN LOSSES		1,418		1,612		2,433		2,862
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		3,967		4,206		8,550		8,399
NON-INTEREST INCOME
Merchant and other loan fees		27		33		53		63
Service charges and fees on deposits		98		98		196		196
Gain on sale of investment securities		329		-		329		232
Fees from mortgage operations		536		484		1,033		653
Other		175		110		297		167
Total non-interest income		1,165		725		1,908		1,311
NON-INTEREST EXPENSE
Salaries and employee benefits		2,266		1,956		4,569		3,593
Occupancy and equipment		702		654		1,405		1,365
Professional fees		86		161		168		256
Advertising and promotion		33		24		62		74
Data processing and other outsourced services		443		344		913		697
FDIC insurance		358		353		690		717
Net cost of foreclosed assets		561		464		1,052		791
Other		501		421		1,093		787
Total non-interest expense		4,950		4,377		9,952		8,280
INCOME BEFORE INCOME TAXES		182		554		506		1,430
INCOME TAXES		71		244		192		606
NET INCOME	$	111	$	310	$	314	$	824
NET INCOME PER COMMMON SHARE:
Basic	$	0.01	$	0.04	$	0.04	$	0.11
Diluted	$	0.01	$	0.04	$	0.04	$	0.11
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		7,427,976		7,337,980		7,427,976		7,298,201
Diluted		7,431,682		7,371,396		7,432,884		7,345,693

See accompanying notes

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NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
	(Dollars in thousands)
Net income	$	111		$	310		$	314		$	824
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding gains on available for sale securities		792			171			762			207
Tax effect		(305	)		(66	)		(294	)		(79	)
Reclassification of net gain recognized in net income		(329	)		-			(329	)		(232	)
Tax effect		127			-			127			89
Total other comprehensive income (loss)		285			105			266			(15	)
Comprehensive income	$	396		$	415		$	580		$	809

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (Unaudited)

							Accumulated
							other			Total
	Common Stock				Retained		comprehensive			shareholders'
	Shares		Amount		earnings		income (loss)			equity
	(Dollars in thousands)
Balance as of December 31, 2009		7,198,513	$	20,865	$	14,902	$	399		$	36,166
Net income		-		-		824		-			824
Other comprehensive loss, net of tax		-		-		-		(15	)		(15	)
Stock based compensation		-		50		-		-			50
Stock options exercised including income tax benefit of $61		229,463		672		-		-			672
Balance as of June  30, 2010		7,427,976	$	21,587	$	15,726	$	384		$	37,697
Balance as of December 31, 2010		7,427,976	$	21,636	$	15,926	$	(60	)	$	37,502
Net income		-		-		314		-			314
Other comprehensive income, net of tax		-		-		-		266			266
Stock based compensation		-		50		-		-			50
Balance as of June  30, 2011		7,427,976	$	21,686	$	16,240	$	206		$	38,132

See accompanying notes.

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NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Six months ended June 30,
	2011			2010
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	314		$	824
Adjustments to reconcile net income to net cash provided (used) by operating activities:
Provision for loan losses		2,433			2,862
Depreciation and amortization		453			465
Net amortization (accretion) of premiums and discounts on investment securities		1			(12	)
Amortization of investment accounted for under the cost method		40			19
Originations of loans held for sale		(157,799	)		(84,863	)
Proceeds from sales of loans held for sale		161,757			53,651
Net realized gain on sale of investment securities available for sale		(329	)		(232	)
Loss on sale of foreclosed assets		67			24
Provision for foreclosed assets		957			649
Stock based compensation		50			50
Changes in assets and liabilities:
Decrease in other assets		683			2,266
Decrease in accrued interest receivable		230			166
Decrease in accrued expenses and other liabilities		(246	)		(240	)
Increase in accrued interest payable		127			207
Net cash provided (used) by operating activities		8,738			(24,164	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in certificates of deposit with banks		(537	)		14,741
Proceeds from sales of investment securities available for sale		17,785			4,885
Proceeds from maturities and repayments of investment securities available for sale		7,876			2,223
Purchases of investment securities available for sale		(32,677	)		(4,990	)
Sale of FHLB stock		46			-
Net decrease in loans		13,510			6,901
Purchases of premises and equipment		(139	)		(350	)
Proceeds from sales of foreclosed assets		2,090			3,203
Capital expenditures on foreclosed assets		(71	)		(114	)
Net cash provided by investing activities		7,883			26,499
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in short term borrowed funds		(154	)		(720	)
Repayments on long-term borrowings		(11	)		(10	)
Net increase (decrease) in deposit accounts		4,126			(28,888	)
Excess tax benefits from exercise of stock options		-			61
Exercise of stock options		-			611
Net cash provided (used) by financing activities		3,961			(28,946	)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		20,582			(26,611	)
CASH AND CASH EQUIVALENTS, BEGINNING		49,833			59,083
CASH AND CASH EQUIVALENTS, ENDING	$	70,415		$	32,472

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, 2011 and December 31, 2010 and for the three and six-month periods ended June 30, 2011 and 2010, 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”).  North State Bank Mortgage (“NSB Mortgage”), a division of the Bank, began operations during February 2010 for the purpose of originating and selling single family, residential first mortgage loans.

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, 2011 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2011.

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 2010 Annual Report on Form 10-K for the year ended December 31, 2010.  This quarterly report should be read in conjunction with the Annual Report.

NOTE B – RECENT ACCOUNTING PRONOUNCEMENTS

In April 2011, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The new standard provides additional guidance on a creditor’s evaluation of when a concession on a loan has been granted and whether a debtor is experiencing financial difficulties. A creditor must conclude that both of these conditions exist for the loan to be considered a troubled debt restructuring. This guidance is effective for interim and annual reporting periods beginning after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The Company expects to adopt the update of this standard during the quarter ending September 30, 2011. The adoption is not expected to have a material impact on the consolidated financial statements.

In April 2011, the FASB issued Accounting Standards Update No. 2011-03, Transfers and Servicing (Topic 860), Reconsideration of Effective Control for Repurchase Agreements. The amendments in this standard remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this Update. The guidance in this Update is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company does not anticipate that the adoption of this statement will have a material impact on the consolidated financial statements.

In May 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement. The purpose of the standard is to clarify and combine fair value measurements and disclosure requirements for

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE B – RECENT ACCOUNTING PRONOUNCEMENTS (Continued)

U.S. generally accepted accounting principles, or GAAP, and international financial reporting standards, or IFRS. The new standard provides amendments and wording changes used to describe certain requirements for measuring fair value and for disclosing information about fair value measurements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied prospectively to the beginning of the annual period of adoption. The Company does not anticipate that the adoption of this statement will have a material impact on the consolidated financial statements.

In June 2011, the FASB issued Accounting Standards Update No. 2011-05, Comprehensive Income. The new standard provides guidance and new formats for reporting components of total net income and comprehensive income. The guidance allows the presentation of net income and comprehensive income to be in a single continuous statement or two separate but consecutive statements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. The Companydoes not anticipatethat the adoption of this statement will have a material impact on the consolidated financial statements.

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

NOTE C - INVESTMENT SECURITIES

Available for sale securities are reported at fair value and consist of debt instruments not classified as trading securities or as held to maturity securities. Unrealized holding gains and losses on available for sale securities are reported, net of related tax effect, in other comprehensive income. Gains and losses on the sale of available for sale securities are determined using the specific-identification method. Bonds and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using a method that approximates the interest method over the period to maturity. Declines in the fair value of available for sale and held to maturity securities below their cost that are other than temporary would result in write-downs of the individual securities to their fair value. If the Company does not intend to sell the security prior to recovery and it is more likely than not the Company will not be required to sell the impaired security prior to recovery, the credit loss portion of the impairment is recognized in earnings and the remaining impairment is recognized in other comprehensive income. Otherwise, the full impairment loss is recognized in earnings. The classification of securities is determined at the date of purchase.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE C - INVESTMENT SECURITIES (Continued)

The amortized cost and fair value of securities available for sale and securities held to maturity, with gross unrealized gains and losses, follows:

	As of June 30, 2011
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	16,672	$	377	$	38	$	17,011
Total securities available for sale	$	16,672	$	377	$	38	$	17,011
Securities held to maturity:
Corporate securities	$	250	$	-	$	46		204
Total securities held to maturity	$	250	$	-	$	46	$	204
	As of December 31, 2010
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		value
			(Dollars in thousands)
Securities available for sale:
U. S. government securities and obligations of U.S. government agencies	$	5,500	$	-	$	-	$	5,500
Government-sponsored residential mortgage-backed securities		3,829		28		123		3,734
Total securities available for sale	$	9,329	$	28	$	123	$	9,234
Securities held to maturity:
Corporate securities	$	250	$	-	$	39		211
Total securities held to maturity	$	250	$	-	$	39	$	211

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE C - INVESTMENT SECURITIES (Continued)

The following table shows as of June 30, 2011 and December 31, 2010 gross unrealized losses on and fair values of the Company’s investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position. All unrealized losses on investment securities are considered by management to be temporary given the credit ratings on these investment securities and the Company’s intent and ability to hold its securities to maturity. The unrealized losses as of June 30, 2011 and December 31, 2010 relate to one government-sponsored residential mortgage-backed security. The unrealized losses on held to maturity corporate securities as of June 30, 2011 and December 31, 2010 relate to one corporate security.  The unrealized losses are not likely to reverse unless and until market interest rates and/or spreads decline to the levels that existed when the securities were purchased. Since the Company does not intend to sell the securities prior to recovery and it is more likely than not the Company will not be required to sell the impaired securities prior to recovery, none of the securities are deemed to be other than temporarily impaired.

	As of June 30, 2011
	Less than 12 months				12 months of more				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	2,964	$	38	$	-	$	-	$	2,964	$	38
Total temporarily impaired securities	$	2,964	$	38	$	-	$	-	$	2,964	$	38
Securities held to maturity:
Corporate securities	$	-	$	-	$	204	$	46	$	204	$	46
Total securities held to maturity	$	-	$	-	$	204	$	46	$	204	$	46
	As of December 31, 2010
	Less than 12 months				12 months of more				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	2,879	$	123	$	-	$	-	$	2,879	$	123
Total temporarily impaired securities	$	2,879	$	123	$	-	$	-	$	2,879	$	123
Securities held to maturity:
Corporate securities	$	-	$	-	$	211	$	39	$	211	$	39
Total securities held to maturity	$	-	$	-	$	211	$	39	$	211	$	39

The amortized cost and fair values of securities available for sale and securities held to maturity as of June 30, 2011 by contractual maturity are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	As of June 30, 2011
	Amortized		Fair
	Cost		Value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities
Due within one year	$	288	$	292
Due after one but within five years		193		202
Due after five but within ten years		4,760		4,818
Due after ten years		11,431		11,699
	$	16,672	$	17,011
Securities held to maturity:
Corporate Securities
Due after five but within ten years	$	250	$	204
	$	250	$	204

Securities with a carrying value of $6.3 million and $8.8 million as of June 30, 2011 and December 31, 2010, respectively, were pledged to secure securities sold under agreements to repurchase and public deposits.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE C - INVESTMENT SECURITIES (Continued)

For the three and six months ended June 30, 2011 proceeds from sales of investment securities of $17.8 million resulted in gross gains of $329,000. There were no sales of investment securities for the three months ended June 30, 2010. For the six months ended June 30, 2010 proceeds from sales of investment securities of $4.9 million resulted in gross gains of $232,000.

NOTE D - COMMITMENTS

As of June 30, 2011, loan commitments were as follows:

	June 30, 2011
	(Dollars in thousands)
Commitments to extend credit	$	27,246
Undisbursed lines of credit		14,416
Letters of credit		1,955
Commitments to originate mortgage loans, fixed and variable		102,491
	$	146,108

NOTE E – LOANS

Following is a summary of loans segregated by category:

	June 30, 2011					December 31, 2010
			% of					% of
			Total					Total
	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Real estate loans:
Residential - construction	$	37,036		7.6	%	$	51,058		10.2	%
Commercial - construction		76,627		15.9	%		82,010		16.4	%
Residential - other		121,485		25.2	%		98,324		19.7	%
Commercial - other		207,159		42.9	%		221,603		44.4	%
		442,307		91.6	%		452,995		90.7	%
Non-real estate loans:
Commercial and industrial		37,127		7.7	%		42,884		8.6	%
Consumer and other		3,287		0.7	%		3,644		0.7	%
		40,414		8.4	%		46,528		9.3	%
Total loans	$	482,721		100.0	%	$	499,523		100.0	%

Loans are primarily funded in Wake County and New Hanover County in North Carolina. Real estate loans can be affected by the condition of the local real estate market. Commercial and installment loans can be affected by local, regional and national economic conditions.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

The following describe the risk characteristics relevant to each of the portfolio segments.

Real estate construction

Commercial and residential construction loans are underwritten utilizing independent appraisal reviews, sensitivity analysis of absorption and financial analysis of the developers and property owners.  Construction loans are generally based upon estimates of costs and value associated with the project as completed. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with the repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, general economic conditions, availability of long-term financing and government regulation of real property. As of June 30, 2011 and December 31, 2010, residential construction and commercial construction loans represented 7.6% and 15.9% and 10.2% and 16.4%, respectively, of the Company’s loans outstanding.

Commercial and residential real estate

Commercial and residential real estate secured loans are subject to underwriting similar to real estate construction loans. These loans are either cash flow loans or development loans paid from the real estate sale and secondarily as loans secured by real estate.  Commercial real estate lending typically involves higher risk and higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in real estate markets or the general economy. The properties securing the Company’s commercial real estate portfolio are principally secured by owner-occupied buildings including professional practices, office and church properties and single family rental properties. Management monitors and evaluates commercial real estate loans based on collateral, market area and risk grade criteria. As a general rule, the Company avoids non-owner occupied commercial single-purpose projects unless other underwriting factors are present to help mitigate risk. The Company also utilizes third-party experts to provide insight and guidance about economic conditions and trends within its market areas. Residential real estate properties are typically secured by the primary residence of the borrower and the combined loan-to-value ratio is usually 90% or less. As of June 30, 2011 and December 31, 2010, commercial and residential real estate represented 42.9% and 25.2% and 44.4% and 19.7%, respectively, of our loans outstanding.

Commercial and industrial

Non-real estate secured commercial and industrial loans are underwritten after evaluating and understanding the borrowers’ ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Management examines current and projected cash flows of the borrower to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the indentified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower and tertiary, as applicable, the guarantors. The cash flows of borrowers, however, may not materialize as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or equipment and usually incorporate a personal guaranty. In the case of loans secured by accounts receivable, the availability of the funds for repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. As of June 30, 2011 and December 31, 2010, commercial and industrial loans represented 7.7% and 8.6%, respectively, of the Company’s loans outstanding.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

The Company maintains an independent loan review function that reviews and validates our portfolio credit risk on a periodic basis. Results of these reviews are presented to management and the board of directors. The loan review process complements and reinforces the risk identification and assessment decisions made by bankers and credit personnel, as well as the Company’s policies and procedures.

The Company also originates single-family, residential mortgage loans that have been approved by secondary investors which are included on the consolidated balance sheet under the caption “loans held for sale.” The Company recognizes certain origination and service release fees from sale, which are included in non-interest income on the consolidated statements of operations. As of June 30, 2011 and December 31, 2010 mortgage loans held for sale were $47.2 million and $51.5 million, respectively.

Nonperforming assets and potential problem loans

A summary of total nonperforming assets and detail of nonaccrual loans, troubled debt restructured (“TDR”) loans, foreclosed assets and potential problem loans by loan category as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011				December 31, 2010
	(Dollars in thousands)
Nonaccrual loans	$	21,978			$	10,972
TDR nonaccrual loans		4,776				520
Total nonaccrual loans		26,754				11,492
Foreclosed assets		3,122				5,296
Total nonperforming assets	$	29,876			$	16,788
Accruing loans past due 90 days or more	$	133			$	131
TDR accruing loans	$	7,113			$	11,741
Potential problem loans	$	-			$	1,184
Allowance for loan losses	$	9,944			$	9,935
Nonaccrual loans to period end loans		5.54	%			2.30	%
Allowance for loan losses to period end loans		2.06	%			1.99	%
Nonperforming assets to total assets		4.68	%			2.65	%
Ratio of allowance for loan losses to nonaccrual loans		0.37		x		0.86	x

-14-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

	As of June 30, 2011
	Nonaccrual		Nonaccrual TDR		Total Nonaccrual		Foreclosed Assets		Total Nonperforming Assets		Potential Problem Loans		Accruing TDR
	(Dollars in thousands)
Commercial and industrial	$	423	$	461	$	884	$	-	$	884	$	-	$	64
Commercial real estate loans:
Construction		7,288		2,888		10,176		1,218		11,394		-		568
Other		2,642		914		3,556		846		4,402		-		3,272
		9,930		3,802		13,732		2,064		15,796		-		3,840
Residential real estate loans:
Construction		8,614		-		8,614		816		9,430		-		2,021
Other		2,997		468		3,465		242		3,707		-		1,171
		11,611		468		12,079		1,058		13,137		-		3,192
Consumer		14		45		59		-		59		-		17
	$	21,978	$	4,776	$	26,754	$	3,122	$	29,876	$	-	$	7,113
	As of December 31, 2010
	Nonaccrual		Nonaccrual TDR			Total Nonaccrual		Foreclosed Assets		Total Nonperforming Assets		Potential Problem Loans	Accruing TDR
	(Dollars in thousands)
Commercial and industrial	$	1,544	$	54	$	1,598	$	-	$	1,598	$	461	$	1,078
Commercial real estate loans:
Construction		2,875		-		2,875		1,484		4,359		523		4,752
Other		255		-		255		1,868		2,123		-		3,870
		3,130		-		3,130		3,352		6,482		523		8,622
Residential real estate loans:
Construction		4,056		-		4,056		813		4,869		-		2,021
Other		2,231		466		2,697		1,131		3,828		200		-
		6,287		466		6,753		1,944		8,697		200		2,021
Consumer		11		-		11		-		11		-		20
	$	10,972	$	520	$	11,492	$	5,296	$	16,788	$	1,184	$	11,741

All classes of loans are classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. Loans that are current or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt (as determined by the contractual terms of the note). Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms.

Past due loans

An aged analysis of past due loans segregated by loan category as of June 30, 2011 and December 31, 2010 are as follows:

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

	As of June 30, 2011
											Accruing
											Loans 90 or
	30 - 89 Days		Over 90		Total Past				Total		More Days
	Past Due (1)		Days (2)		Due		Current (3)		Loans		Past Due (2)
	(Dollars in thousands)
Commercial and industrial	$	155	$	1,485	$	1,640	$	35,487	$	37,127	$	-
Commercial real estate loans:
Construction		2,267		8,126		10,393		66,234		76,627		-
Other		908		3,138		4,046		203,113		207,159		-
		3,175		11,264		14,439		269,347		283,786		-
Residential real estate loans:
Construction		-		9,169		9,169		27,867		37,036		-
Other		345		2,505		2,850		118,635		121,485		133
		345		11,674		12,019		146,502		158,521		133
Consumer		-		45		45		2,860		2,905		-
Other		-		-		-		382		382		-
Total	$	3,675	$	24,468	$	28,143	$	454,578	$	482,721	$	133

(1) Total loans past due 30 – 89 days includes approximately $1.7 million of loans in nonaccrual status.

(2) All loans past due 90 days or more are in nonaccrual status with the exception of one accruing loan past due more than 90 days for $133,000.

(3) Includes approximately $420,000 of loans that are in nonaccrual status and not past due 30 days or more.

	As of December 31, 2010
											Accruing
											Loans 90 or
	30 - 89 Days		Over 90		Total Past				Total		More Days
	Past Due (1)		Days (2)		Due		Current (3)		Loans		Past Due (2)
	(Dollars in thousands)
Commercial and industrial	$	1,797	$	602	$	2,399	$	40,485	$	42,884	$	-
Commercial real estate loans:
Construction		4,801		2,462		7,263		74,747		82,010		-
Other		1,554		438		1,992		219,611		221,603		-
		6,355		2,900		9,255		294,358		303,613		-
Residential real estate loans:
Construction		1,274		3,079		4,353		46,705		51,058		-
Other		2,510		1,863		4,373		93,951		98,324		131
		3,784		4,942		8,726		140,656		149,382		131
Consumer		11		-		11		3,165		3,176		-
Other		-		-		-		468		468		-
Total	$	11,947	$	8,444	$	20,391	$	479,132	$	499,523	$	131

(1) Total loans past due 30 – 89 days includes approximately $2.5 million of loans in nonaccrual status.

(2) All loans past due 90 days or more are in nonaccrual status with the exception of one accruing loan past due more than 90    days for $131,000.

(3) Includes approximately $690,000 of loans that are in nonaccrual status and not past due 30 days or more.

Impaired loans

For all classes of impaired loans, interest payments are applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis.  Accrual of interest is continued for restructured loans when the borrower is performing prior to the loan restructuring and there is reasonable assurance of repayment and continued performance under the modified terms. Accrual of interest on restructured loans in nonaccrual status is resumed when the

-16-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

borrower has established a sustained period of performance under the restructured terms of at least six months. Information regarding impaired loans segregated by loan category as of and for the three and six months ended June 30, 2011 and year ended December 31, 2010 are as follows.

							For the three months ended				For the six months ended
	As of June 30, 2011						June 30, 2011				June 30, 2011
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Commercial and industrial	$	100	$	384	$	-	$	163	$	-	$	206	$	-
Commercial real estate loans:
Construction		5,818		6,167		-		5,212		-		3,855		-
Other		1,325		1,520		-		1,122		-		929		-
		7,143		7,687		-		6,334		-		4,784		-
Residential real estate loans:
Construction		4,930		5,171		-		5,105		-		4,461		-
Other		2,103		3,444		-		2,222		-		2,254		-
		7,033		8,615		-		7,327		-		6,715		-
Consumer		14		28		-		17		-		13		-
Total	$	14,290	$	16,714	$	-	$	13,841	$	-	$	11,718	$	-
Impaired performing restructured loans with no related allowance recorded:
Commercial and industrial	$	64	$	64	$	-	$	112	$	2	$	200	$	3
Commercial real estate loans:
Construction		571		568		-		1,177		3		1,812		33
Other		3,282		3,272		-		3,391		32		3,608		73
		3,853		3,840		-		4,568		35		5,420		106
Residential real estate loans:
Construction		2,028		2,021		-		2,021		14		2,021		41
Other		1,172		1,171		-		1,174		6		929		31
		3,200		3,192		-		3,195		20		2,950		72
Consumer		17		17		-		18		1		19		1
Total	$	7,134	$	7,113	$	-	$	7,893	$	58	$	8,589	$	182
Impaired with a related allowance recorded:
Commercial and industrial	$	784	$	784	$	300	$	784	$	-	$	707	$	-
Commercial real estate loans:
Construction		4,358		4,393		740		4,081		-		4,016		-
Other		2,231		3,035		861		2,218		-		2,006		-
		6,589		7,428		1,601		6,299		-		6,022		-
Residential real estate loans:
Construction		3,684		3,684		92		3,684		-		2,756		-
Other		1,362		1,362		341		1,181		-		868		-
		5,046		5,046		433		4,865		-		3,624		-
Consumer		45		45		45		45		-		37		-
Total	$	12,464	$	13,303	$	2,379	$	11,993	$	-	$	10,390	$	-
Total impaired
Commercial	$	18,533	$	20,187	$	1,901	$	18,260	$	37	$	17,339	$	109
Residential		15,279		16,853		433		15,387		20		13,289		72
Consumer		76		90		45		80		1		69		1
Total	$	33,888	$	37,130	$	2,379	$	33,727	$	58	$	30,697	$	182

-17-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

	As of and for the year ended December 31, 2010
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Commercial and industrial	$	54	$	204	$	-	$	130	$	-
Commercial real estate loans:
Construction		2,554		2,589		-		1,980		-
Other		54		54		-		48		-
		2,608		2,643		-		2,028		-
Residential real estate loans:
Construction		1,350		1,433		-		1,013		-
Other		989		989		-		873		-
		2,339		2,422		-		1,886		-
Consumer		11		25		-		17		-
Total	$	5,012	$	5,294	$	-	$	4,061	$	-
Impaired accruing restructured loans with no related allowance recorded:
Commercial and industrial	$	1,089	$	1,078	$	-	$	1,081	$	56
Commercial real estate loans:
Construction		4,787		4,752		-		4,760		204
Other		3,879		3,870		-		4,451		217
		8,666		8,622		-		9,211		421
Residential real estate loans:
Construction		2,025		2,021		-		2,020		96
Other		-		-		-		-		-
		2,025		2,021		-		2,020		96
Consumer		20		20		-		22		2
Total	$	11,800	$	11,741	$	-	$	12,334	$	575
Impaired with a related allowance recorded:
Commercial and industrial	$	1,544	$	1,934	$	697	$	845	$	-
Commercial real estate loans:
Construction		321		321		96		350		-
Other		201		201		111		98		-
		522		522		207		448		-
Residential real estate loans:
Construction		2,706		2,763		188		2,283		-
Other		1,708		1,708		1,009		875		-
		4,414		4,471		1,197		3,158		-
Consumer		-		-		-		-		-
Total	$	6,480	$	6,927	$	2,101	$	4,451	$	-
Total impaired
Commercial	$	14,483	$	15,003	$	904	$	13,743	$	477
Residential		8,778		8,914		1,197		7,064		96
Consumer		31		45		-		39		2
Total	$	23,292	$	23,962	$	2,101	$	20,846	$	575

-18-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

All loans risk rated “substandard”, “doubtful” and “loss” are reviewed to determine if they are impaired loans.  If a loan is determined to be impaired it is removed from its homogeneous group and individually analyzed for impairment. Other groups of loans based on facts and circumstances may also be selected for impairment review. If a loan is impaired, a specific reserve allowance is established if necessary. Interest payments on impaired loans are typically applied to principal. Impaired loans are charged off in full or in part when losses are confirmed.

As of June 30, 2011, the recorded investment in loans considered impaired totaled $33.9 million. Additions to impaired loans since December 31, 2010 include approximately $6.4 million and $2.6 million, respectively, of residential and commercial construction loans. As of June 30, 2011, the Company provided specific reserves of $2.4 million for probable losses on impaired loan balances of $12.5 million.  Management analyzed $14.3 million of impaired loans and determined the collateral to be adequate and no additional specific reserve allowance necessary after recording approximately $424,000 in partial charge-offs related to loan balances of approximately $1.7 million. Also included in the impaired loans as of June 30, 2011 are $7.1 million of restructured but still accruing loans and 12 restructured nonaccrual loans for $4.8 million, for a TDR balance amounting to $11.9 million. The loans were primarily restructured to forgive accrued interest due to financial difficulties of the borrower. There were no potential problem loans outstanding as of June 30, 2011 because potential problem loans at year-end have been charged off or are currently nonaccrual. The determination that there were no potential problem loans as of June 30, 2011 is further supported by the $8.3 million decline in 30 - 89 day past due loans.

As of December 31, 2010, the recorded investment in loans that management considered impaired totaled $23.3 million including $11.8 million of restructured but still accruing loans and six restructured nonaccrual loans for $520,000, for a TDR balance of $12.3 million. The Company provided for probable losses through specific reserve allowances of $2.1 million with corresponding outstanding loan balances of $6.5 million.  There was no corresponding allowance with the remaining $740,000 of loan balances analyzed for impairment after recording approximately $366,000 in related charge-offs.  In addition, the Company identified $1.2 million of potential problem loans with $290,000 in allocated reserves included in the allowance for loan losses.

Credit Quality Indicators

As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management examines certain credit quality indicators which consider the risk of payment performance, overall portfolio quality utilizing weighted-average risk ratings, general economic factors,  net charge-offs, non-performing loans and the level of classified loans.  All loans risk rated “substandard”, “doubtful” and “loss” are reviewed on an individual basis for probable losses.

A description of our credit quality indicators follows:

Pass – loans with acceptable credit quality and moderate risk.

Special mention – This grade is intended to be temporary and includes loans (1) with potential weaknesses which if left uncorrected could result in deterioration or (2)  classified as substandard accruing or substandard nonaccruing where the borrowers made improvements to their financial profile but do not yet meet the definition of a pass grade.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE E – LOANS (Continued)

Substandard, accruing – These loans have a well defined weakness where the accrual of interest has not been stopped. The defined weakness may make default or principal exposure likely but not certain. These loans are likely to be dependent on collateral liquidation or a secondary source of repayment.

Substandard, nonaccruing – These assets have well defined weaknesses that jeopardize the liquidation of the debt and are past due over 90 days. The institution may sustain loss if the weaknesses are not corrected. These loans are inadequately protected by the paying capacity of the borrower and/or any guarantors or by the pledged collateral.  These loans are individually analyzed for impairment.

Doubtful – These loans have all the weaknesses of substandard, nonaccruing loans plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values highly questionable and improbable.

Loss – These loans are considered uncollectable and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off these loans even though partial recovery may be affected in the future.

Information regarding the Company’s credit risk by internally assigned risk grades as of June 30, 2011 and December 31, 2010 follows:

	As of June 30, 2011
	Real Estate Loans								Non-Real Estate Loans
	Construction								Commercial &
	Residential		Commercial		Residential		Commercial		Industrial		Consumer		Other		Total
	(Dollars in thousands)
Pass	$	18,844	$	51,737	$	103,619	$	192,995	$	33,779	$	2,819	$	382	$	404,175
Special mention		2,564		11,162		8,677		3,754		2,255		27		-		28,439
Substandard accruing		7,014		3,854		5,724		6,854		209		-		-		23,655
Substandard nonaccruing		8,614		9,634		3,443		3,556		884		59		-		26,190
Doubtful		-		240		22		-		-		-		-		262
Loss		-		-		-		-		-		-		-		-
Total by exposure	$	37,036	$	76,627	$	121,485	$	207,159	$	37,127	$	2,905	$	382	$	482,721

		As of December 31, 2010
		Real Estate Loans								Non-Real Estate Loans
		Construction								Commercial &
	��	Residential		Commercial		Residential		Commercial		Industrial		Consumer		Other		Total
		(Dollars in thousands)
Pass		$	28,520	$	59,122	$	86,364	$	210,371	$	38,616	$	3,066	$	468	$	426,527
Special mention			4,424		8,171		6,532		3,013		1,366		28		-		23,534
Substandard accruing			14,058		11,842		2,240		7,817		1,075		71		-		37,103
Substandard nonaccruing			4,056		2,875		2,697		255		1,598		11		-		11,492
Doubtful			-		-		491		147		180		-		-		818
Loss			-		-		-		-		49		-		-		49
Total by exposure		$	51,058	$	82,010	$	98,324	$	221,603	$	42,884	$	3,176	$	468	$	499,523

-20-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE F – ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense for estimated loan losses inherent in the loan portfolio.  The allowance is maintained at a level which management considers adequate to provide for probable loan losses based on our assessment of various factors affecting the loan portfolio. Additional information regarding the Company’s policies and methodology used to estimate the allowance for possible loan losses is presented in Note B- Summary of Significant Accounting Policies of the Company’s 2010 Annual Report on Form 10-K.

The tables below detail activity in the allowance for loan losses by segregated loan category for the three and six months ended June 30, 2011 and year ended December 31, 2010.  Allocation of a portion of the allowance to one class of loan does not preclude its availability to absorb losses in other categories.

	For the Three Months Ended June 30, 2011
	Real Estate Loans											Non-Real Estate Loans
	Construction											Commercial &
	Residential			Commercial		Residential			Commercial			Industrial			Consumer			Other		Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,224		$	2,152	$	2,016		$	2,610		$	1,269		$	72		$	3	$	9,346
Charge-offs		(46	)		-		(469	)		(141	)		(190	)		-			-		(846	)
Recoveries		18			-		-			5			2			1			-		26
Provision		(225	)		836		470			479			(137	)		(5	)		-		1,418
Ending balance	$	971		$	2,988	$	2,017		$	2,953		$	944		$	68		$	3	$	9,944
Ending balance, individually evaluated for impairment	$	92		$	740	$	341		$	861		$	300		$	45		$	-	$	2,379
Ending balance, collectively evaluated for impairment	$	879		$	2,248	$	1,676		$	2,092		$	644		$	23		$	3	$	7,565
Loans:
Ending balance	$	37,036		$	76,627	$	121,485		$	207,159		$	37,127		$	2,905		$	382	$	482,721
Ending balance, individually evaluated for impairment	$	10,642		$	10,747	$	4,637		$	6,838		$	948		$	76		$	-	$	33,888
Ending balance, collectively evaluated for impairment	$	26,394		$	65,880	$	116,848		$	200,321		$	36,179		$	2,829		$	382	$	448,833

	For the Six Months Ended June 30, 2011
	Real Estate Loans												Non-Real Estate Loans
	Construction												Commercial &
	Residential			Commercial			Residential			Commercial			Industrial			Consumer			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,475		$	2,269		$	2,339		$	2,464		$	1,354		$	30		$	4		$	9,935
Charge-offs		(164	)		(149	)		(1,342	)		(609	)		(314	)		(11	)		-			(2,589	)
Recoveries		30			-			1			16			90			28			-			165
Provision		(370	)		868			1,019			1,082			(186	)		21			(1	)		2,433
Ending balance	$	971		$	2,988		$	2,017		$	2,953		$	944		$	68		$	3		$	9,944
Ending balance, individually evaluated for impairment	$	92		$	740		$	341		$	861		$	300		$	45		$	-		$	2,379
Ending balance, collectively evaluated for impairment	$	879		$	2,248		$	1,676		$	2,092		$	644		$	23		$	3		$	7,565
Loans:
Ending balance	$	37,036		$	76,627		$	121,485		$	207,159		$	37,127		$	2,905		$	382	��	$	482,721
Ending balance, individually evaluated for impairment	$	10,642		$	10,747		$	4,637		$	6,838		$	948		$	76		$	-		$	33,888
Ending balance, collectively evaluated for impairment	$	26,394		$	65,880		$	116,848		$	200,321		$	36,179		$	2,829		$	382		$	448,833

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE F – ALLOWANCE FOR LOAN LOSSES (Continued)

	For the Year Ended December 31, 2010
	Real Estate Loans												Non-Real Estate Loans
	Construction												Commercial &
	Residential			Commercial			Residential			Commercial			Industrial			Consumer			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,753		$	2,604		$	1,276		$	2,023		$	870		$	42		$	13		$	8,581
Charge-offs		(3,152	)		(1,293	)		(765	)		(364	)		(1,224	)		(34	)		-			(6,832	)
Recoveries		34			34			7			10			6			-			-			91
Provision		2,840			924			1,821			795			1,702			22			(9	)		8,095
Ending balance	$	1,475		$	2,269		$	2,339		$	2,464		$	1,354		$	30		$	4		$	9,935
Ending balance, individually evaluated for impairment	$	188		$	96		$	1,009		$	111		$	697		$	-		$	-		$	2,101
Ending balance, collectively evaluated for impairment	$	1,287		$	2,173		$	1,330		$	2,353		$	657		$	30		$	4		$	7,834
Loans:
Ending balance	$	51,058		$	82,010		$	98,324		$	221,603		$	42,884		$	3,176		$	468		$	499,523
Ending balance, individually evaluated for impairment	$	6,081		$	7,662		$	2,697		$	4,134		$	2,687		$	31		$	-		$	23,292
Ending balance, collectively evaluated for impairment	$	44,977		$	74,348		$	95,627		$	217,469		$	40,197		$	3,145		$	468		$	476,231

 NOTE G - 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

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

	Three Months Ended June 30,				Six Months Ended June 30,
	2011		2010		2011		2010
Weighted average number of common shares used in computing basic net income per share		7,427,976		7,337,980		7,427,976		7,298,201
Effect of dilutive stock options		3,706		33,416		4,908		47,492
Weighted average number of common shares and dilutive potential shares used in computing diluted net income per share		7,431,682		7,371,396		7,432,884		7,345,693

Due to the exercise price exceeding the average market price, the following anti-dilutive shares were excluded from the calculation of total dilutive weighted average shares. Anti-dilutive shares for the three and six months ended June 30, 2011 were 115,787. For the corresponding prior year periods there were 105,787 anti-dilutive shares.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE H - 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 historical 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.

The following table illustrates the assumptions for the Black-Scholes model used in determining the fair value of options granted to employees for the six-month periods ended June 30, 2011 and 2010.

	Six Months Ended June 30,
	2011			2010
Estimated fair value of options granted	$	2.83		$	1.97
Assumptions in estimating option values:
Risk-free interest rate		3.12	%		2.39	%
Dividend yield		0	%		0	%
Expected volatility		59.8	%		39.6% - 41.0	%
Expected life	10 years			6.5 - 7 years

A summary of option activity under the stock option plans as of June 30, 2011 and changes during the six-month period ended June 30, 2011 is presented below:

			Weighted Average
					Remaining		Aggregate
			Exercise		Contractual		Intrinsic
	Shares		Price		Term		Value
							(in thousands)
Outstanding as of December 31, 2010		140,508	$	8.51	5.19 years		$	9
Granted		10,000		4.00		-		-
Exercised		-		-		-		-
Forfeited		-		-		-		-
Expired		-		-		-		-
Outstanding as of June 30, 2011		150,508	$	8.21	5.04 years		$	16
Exercisable as of June 30, 2011		106,976	$	7.97	3.92 years		$	16

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE H - STOCK OPTION PLANS (Continued)

	Range of Exercise Prices
	Number of options outstanding	Number of exercisable options
$3.22 - $5.15	75,308		53,286
$6.37 - $12.25	48,700		37,790
$17.00 - $18.50	26,500		15,900
	150,508		106,976

	Nonvested Shares
				Weighted
				Average Grant
	Shares			Date Fair Value
Nonvested, December 31, 2010		38,532		$	9.64
Granted		10,000		$	2.83
Vested		(5,000	)	$	5.79
Forfeited		-			-
Nonvested, June 30, 2011		43,532		$	8.78

There were 10,000 options granted during the three and six-month period ended June 30, 2011. No options were exercised during this period. For the six month period in 2010, the intrinsic value of options exercised was approximately $400,000 and 15,000 shares were granted. Cash received from option exercises under share-based payment arrangements for the six-month period ended June 30, 2010 was approximately $611,000.  The fair value of options vested during the three and six-month periods ended June 30, 2011 was approximately $26,000 and $50,000, respectively.  For the same periods in 2010, the fair value of options vested was $25,000 and $50,000. As of June 30, 2011 and 2010, approximately $130,000 and $201,000, respectively, of share-based compensation expense remained to be recognized over a period of 4.8 and 5 years, respectively, for the current and prior year periods stated.

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. 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.

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NORTH STATE BANCORP

Notes to Consolidated Financial Statements

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

 ● 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 broker 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.

Mortgage Banking Activity

The Company enters into written loan commitments and commitments to sell mortgages. Changes in the written loan commitments subjected to recurring fair value adjustments are affected by the changes in the balances of locked mortgage loan commitments, changes in the fall out rates and changes in the prevailing secondary market prices for like-kind mortgage loans. The fall out rate measures the likelihood that an interest rate lock commitment will ultimately not become a closed loan held for sale.  Fall out rates as of June 30, 2011 averaged 29.75%. The fair value adjustment associated with these written commitments was $504,000, which was included in other assets. As of December 31, 2010, fall out rates averaged 21.6% and the amount of fair value associated with written loan commitments was $411,000. Commitments to sell mortgages are generally equal and offsetting to the interest rate lock commitment. These fair values were deemed to be immaterial as of June 30, 2011 and December 31, 2010.

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 accounting standards. 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. As of June 30, 2011, a portion of the Company’s impaired loans were evaluated based on the fair value of the collateral. 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

-25-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

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

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 Assets

Foreclosed assets are adjusted to fair value, less cost to sell, upon transfer of the loans to other real estate owned. Subsequently, other real estate owned assets are carried at fair value less costs to sell. Fair value is based upon independent market prices, appraised values 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.

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

	As of June 30, 2011
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	17,011	$	-	$	17,011	$	-
Written loan commitments		504		-		-		504
	$	17,515	$	-	$	17,011	$	504
	As of December 31, 2010
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Securities available for sale:
U. S. government securities and obligations of U.S. governmental agencies	$	5,500	$	-	$	5,500	$	-
Government-sponsored residential mortgage-backed securities		3,734		-		3,734		-
Written loan commitments		411		-		-		411
	$	9,645	$	-	$	9,234	$	411

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the first six months of 2011.

	Interest Rate
	Lock Commitments
	(Dollars in thousands)
Balance, December 31, 2010	$	411
Included in earnings		93
Balance, June 30, 2011	$	504

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.

-26-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

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

	As of June 30, 2011
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Impaired loans	$	11,771	$	-	$	230	$	11,541
Foreclosed assets		3,121		-		801		2,320
	$	14,892	$	-	$	1,031	$	13,861
	As of December 31, 2010
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Impaired loans	$	5,119	$	-	$	727	$	4,392
Foreclosed assets		5,296		-		-		5,296
	$	10,415	$	-	$	727	$	9,688

There were no further market driven discounts applied to the year-end 2010 impaired loans that required transfers between Level 2 and Level 3 as of June 30, 2011.

NOTE J - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS

Financial instruments include cash and due from banks, interest-earning deposits with banks, certificates of deposit with banks, federal funds sold, investments, accrued interest, loans, written loan commitments, deposit accounts and borrowings. Accounting standards require the disclosure of the estimated fair value of financial instruments.  The Company has recorded certain assets at fair value. Fair value estimates are made at a specific moment in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no active market readily exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Due from Banks, Interest-Earning Deposits with Banks, and Federal Funds Sold

The carrying amounts are a reasonable estimate of fair value for cash and due from banks, interest-earning deposits with banks, and federal funds sold because of the short maturities of those instruments.

Certificates of Deposit with Banks

The fair values are based on discounting expected cash flows at the interest rate for certificates of deposit with the same or similar remaining maturity.

Investment Securities

Fair value for investment securities available for sale equals quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Fair value for investment securities held to maturity is determined using discounted cash flow analysis.

-27-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE J - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

Loans and Loans Held for Sale

The fair value of loans is based on estimated cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, less a credit component. The carrying amount of loans held for sale is a reasonable estimate of fair value since they will be sold in a short period. This does not include consideration of liquidity discounts that market participants would use to value such loans.

Stock in Federal Home Loan Bank of Atlanta

The fair value for FHLB stock approximates carrying value, based on the redemption provisions of the Federal Home Loan Bank.

Deposits

The fair value of demand, savings, money market and NOW deposits is the amount payable on demand at the reporting date. The fair value of time deposits and borrowings is estimated by discounting expected cash flows using the rates currently offered for instruments of similar remaining maturities.

Borrowings

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

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Written Loan Commitments

The Company enters into written loan commitments and commitments to sell mortgages. The amount of fair value associated with these written loan commitments is included in other assets. Commitments to sell mortgages are generally equal and offsetting to interest rate lock commitments. 

Financial Instruments with Off-Balance Sheet Risk

With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.

-28-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE J - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

The following table presents the carrying values and estimated fair values of the Company's financial instruments as of June 30, 2011 and December 31, 2010.

	June 30, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	8,731	$	8,731	$	5,974	$	5,974
Interest-earning deposits with banks		61,684		61,684		43,859		43,859
Certificates of deposit with banks		735		735		198		198
Investment securities available for sale		17,011		17,011		9,234		9,234
Investment securities held to maturity		250		204		250		211
Loans held for sale		47,182		47,182		51,472		51,472
Loans, net		472,777		470,813		489,588		490,131
Accrued interest receivable		1,424		1,424		1,654		1,654
Stock in the Federal Home Loan Bank		1,227		1,227		1,273		1,273
Written loan commitments		504		504		411		411
Financial liabilities:
Deposits	$	566,874	$	568,049	$	562,748	$	562,640
Short-term borrowings		3,461		3,461		3,615		3,615
Long-term borrowings		27,258		27,247		27,269		27,253
Accrued interest payable		1,308		1,308		1,181		1,181

NOTE K – BUSINESS SEGMENT INFORMATION

The Company has three reportable business segments, the Bank, NSB Mortgage and the parent Company.  The Bank is engaged in general commercial and retail banking in central and coastal North Carolina.  The Bank operates six full-service banking offices located in Wake County and one full-service office in Wilmington, New Hanover County, North Carolina.  NSB Mortgage, a division of the Bank, originates and sells and, beginning in the second quarter of 2011, to a limited extent retains single-family, residential first mortgage loans. The remaining segment consists of activities of the parent Company. Eliminations necessary to accurately report the operations of the Company are also included. The tables below present segment reporting disclosure as of and for the three and six-months periods ended June 30, 2011 and for the three and six months ended June 30, 2010 and as of December 31, 2010.  The mortgage division was not established until February 2010.

-29-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE K – BUSINESS SEGMENT INFORMATION (Continued)

	As of June 30, 2011
	Bank		NSB Mortgage		Parent Company		Eliminations			Total Company
	(Dollars in thousands)
Total assets	$	570,475	$	66,191	$	53,621	$	(51,950	)	$	638,337
Net loans		456,084		16,693		-		-			472,777
Loans held for sale		-		47,182		-		-			47,182
Goodwill		-		141		-		-			141
	As of December 31, 2010
	Bank		NSB Mortgage		Parent Company		Eliminations			Total Company
	(Dollars in thousands)
Total assets	$	579,400	$	53,505	$	52,985	$	(52,025	)	$	633,865
Net loans		489,588		-		-		-			489,588
Loans held for sale		-		51,472		-		-			51,472
Goodwill		-		141		-		-			141

	For the Three Months Ended June 30, 2011
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	6,353	$	377	$	8		$	(4	)	$	6,734
Total interest expense		1,246		-		107			(4	)		1,349
Net interest income		5,107		377		(99	)		-			5,385
Provision for loan losses		1,418		-		-			-			1,418
Net interest income after provision for loan losses		3,689		377		(99	)		-			3,967
Noninterest income		625		540		250			(250	)		1,165
Noninterest expense		4,249		590		111			-			4,950
Income before income taxes		65		327		40			(250	)		182
Income taxes		25		117		(71	)		-			71
Net income	$	40	$	210	$	111		$	(250	)	$	111
	For the Six Months Ended June 30, 2011
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	13,065	$	742	$	15		$	(8	)	$	13,814
Total interest expense		2,621		-		218			(8	)		2,831
Net interest income		10,444		742		(203	)		-			10,983
Provision for loan losses		2,433		-		-			-			2,433
Net interest income after provision for  loan losses		8,011		742		(203	)		-			8,550
Noninterest income		865		1,043		550			(550	)		1,908
Noninterest expense		8,450		1,349		153			-			9,952
Income before income taxes		426		436		194			(550	)		506
Income taxes		155		157		(120	)		-			192
Net income	$	271	$	279	$	314		$	(550	)	$	314

-30-

NORTH STATE BANCORP

Notes to Consolidated Financial Statements

NOTE K – BUSINESS SEGMENT INFORMATION (Continued)

	For the Three Months Ended June 30, 2010
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	7,488	$	298	$	11		$	(8	)	$	7,789
Total interest expense		1,872		-		107			(8	)		1,971
Net interest income		5,616		298		(96	)		-			5,818
Provision for loan losses		1,612		-		-			-			1,612
Net interest income after provision for loan losses		4,004		298		(96	)		-			4,206
Noninterest income		237		488		450			(450	)		725
Noninterest expense		3,787		474		116			-			4,377
Income before income taxes		454		312		238			(450	)		554
Income taxes		187		129		(72	)		-			244
Net income	$	267	$	183	$	310		$	(450	)	$	310
	As of or for the Six Months Ended June 30, 2010
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	15,025	$	358	$	19		$	(13	)	$	15,389
Total interest expense		3,934		-		207			(13	)		4,128
Net interest income		11,091		358		(188	)		-			11,261
Provision for loan losses		2,862		-		-			-			2,862
Net interest income after provision for loan losses		8,229		358		(188	)		-			8,399
Noninterest income		654		657		1,071			(1,071	)		1,311
Noninterest expense		7,546		548		186			-			8,280
Income before income taxes		1,337		467		697			(1,071	)		1,430
Income taxes		543		190		(127	)		-			606
Net income	$	794	$	277	$	824		$	(1,071	)	$	824

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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: general and local economic conditions; changes in real estate values; changes in interest rates, deposit flows, and loan demand; changes in legislation or regulation including regulatory assessments;  our ability to manage growth; changes in accounting principles, policies or guidelines; competition;  other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services; and factors set out in our Annual Report on Form 10-K for the year ended December 31, 2010 and our other filings with the Securities and Exchange Commission.

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, 2010.

Recent Market Developments in the Banking Industry

The economy and business activity within our markets generally continued to be sluggish during the first six months of 2011. The effects of the prolonged recession continues to financially stress our customers as unemployment rates remain high, real estate prices on homes and commercial real estate, in some areas,  have declined further while foreclosures continue to rise.

Our financial performance is directly tied to the ability of our borrowing customers to pay interest on and repay principal of outstanding loans, which ability, and the value of collateral securing those loans, is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover Counties, in North Carolina. Due to the state of the economy in our market areas and the resultant potential impact on our loan portfolio, we continue to closely monitor our loan portfolio, nonperforming assets and allowance for loan losses. See the discussions on “Provision for Loan Losses” and “Allowance for Loan Losses and Asset Quality.” The business environment in North Carolina and the markets in which we operate may continue to see some deterioration for the foreseeable future which could continue to adversely impact our earnings in the future. Further, newly enacted and potential further imposition of new laws and regulations and regulatory assessments from the U.S. government could significantly impact our operations in the future.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002.  We have one subsidiary, North State Bank, which we acquired on June 28, 2002 as part of the formation and reorganization of our bank holding company.  In March 2004, we established a subsidiary trust, North State Statutory Trust I, which we refer to as Trust I, to issue trust preferred securities.  In December 2005, we established a second subsidiary trust, North State Statutory Trust II, which we refer to as Trust II and in November 2007 we established a third subsidiary trust, North State Statutory Trust III, which we refer to as Trust III.  Our only business is the ownership and operation of North State Bank and its three subsidiary trusts.

North State Bank is a North Carolina chartered banking corporation. The Bank, which offers a full array of commercial and retail banking services, opened for business on June 1, 2000. Through the Bank, we currently operate six full-service banking offices located in Raleigh, Garner, and Wake Forest, North Carolina and one full-service banking office located in Wilmington, North Carolina. Our principal customers consist of professional firms, professionals, churches, property management companies, non-profits and individuals who value a mutually beneficial banking relationship. The Bank has a subsidiary, North State Financial Services, Inc., which offers brokerage services and wealth management. In February 2010, we acquired the operations of a Raleigh-based mortgage company, Affiliated Mortgage, LLC, creating North State Bank Mortgage, or NSB Mortgage, as a division of the Bank for the purpose of originating and selling single-family residential first mortgages.

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Comparison of Financial Condition as of June 30, 2011 and December 31, 2010

Total assets as of June 30, 2011 remained substantially unchanged at $638.3 million, an increase of $4.5 million over $633.9 million as of December 31, 2010.  Our portfolio loans, representing 78.8% of our total assets at year-end, declined to 75.6% of total assets as of June 30, 2011 as loan charge-offs and  transfers to foreclosed assets more than offset new loan production net of payoffs.  Portfolio loans were $482.7 million as of June 30, 2011, down $16.8 million from December 31, 2010. Mortgage loans held for sale were down $4.3 million from year-end to $47.8 million as of June 30, 2011.  Funds from declines in these earning assets were redeployed into interest-earning deposits in banks and purchases of investment securities in our available for sale securities portfolio.  Our assets are primarily funded through deposits, which were up slightly by $4.1 million to $566.9 million as of June 30, 2011 compared to total deposits of $562.7 million as of December 31, 2010. Although overall deposit volume has not changed significantly, we have experienced continuing improvement in our deposit mix by focusing on core deposits resulting in growth in noninterest-bearing demand and lower costing interest-bearing transaction deposits while reducing higher costing time deposits.

Excess funds due to lower loan demand have funded investment security purchases as well as higher levels of interest-earning deposits with banks. As of June 30, 2011, our interest-earning deposits with banks included $59.1 million in excess overnight funds in our Federal Reserve account and $2.6 million held at correspondent banks compared to $42.4 million and $1.5 million, respectively, as of December 31, 2010.  Our available for sale investment portfolio as of June 30, 2011 consisted of $17.0 million of government-sponsored residential mortgage-backed securities compared to $3.7 million as of December 31, 2010 in addition to $5.5 million of U.S. treasury notes as of December 31, 2010. We purchased $1.0 million in U.S. treasury notes and $31.7 million in government-sponsored residential mortgage-backed securities during the first six months of 2011. Also during this period, $6.5 million of U.S. treasury notes matured along with $1.4 million in cash flows received from government-sponsored residential mortgage-backed securities.  During the month of June 2011, $17.5 million in government-sponsored residential mortgage-backed securities were sold realizing gains of approximately $329,000.  All of our investments are accounted for as available for sale and are presented at their fair market value with the exception of $250,000 in corporate bonds that are accounted for as held to maturity and are carried at book value.

Our portfolio loans decreased $16.8 million or 3.4% to $482.7 million as of June 30, 2011 compared to $499.5 million as of December 31, 2010. The decline in the loan portfolio reflects a continued cycle of higher levels of loan payoffs over new loan volume, $2.4 million of net charge-offs as well as $868,000 of transfers to foreclosed assets.  New commercial loan demand remains slow due to the continued effects of the sluggish economy, however, we are focused on building and maintaining mutually beneficial relationships with our targeted customers which we believe will provide us opportunities to respond to their borrowing needs in the future. To offset the slowdown in new commercial loan volume, in the second quarter of 2011, we began retaining a small portion of our mortgage loan division originations.  As of June 30, 2011, our loan portfolio includes approximately $16.7 million of mortgage loans originated through our mortgage loan division, NSB Mortgage.

While there have been slight changes in our loan composition since year-end 2010, the portfolio remains primarily secured by real estate with $442.3 million or 91.6% of loans outstanding as of June 30, 2011 so secured. Real estate values are generally affected by changes in economic conditions, fluctuations in interest rates, the availability of loans to potential purchasers as well as changes in tax and other laws. A further downturn in the real estate markets in which we operate, specifically New Hanover and Wake Counties, could have an adverse effect on our business, financial condition and results of operations because loans in these markets are secured by real estate. Borrowers may not be able to make current payments on or repay real estate loans and the value of the collateral securing these loans may decline, which would reduce the security for these loans.

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As part of our long-term plan to minimize construction and land development lending, real-estate-secured construction and land development loans decreased $19.4 million to 23.7% of loans outstanding from 26.7% as of year-end 2010 as construction projects were paid off or completed and moved to longer-term financing. Our concentration in commercial real estate, including commercial construction and land development, remains high at $283.8 million or 58.8% of the loan portfolio, compared to $303.6 million or 60.8% of the loan portfolio at year-end.  A concentration in commercial real estate exposes us to more credit and regulatory risk than other types of loans because of the ongoing sluggish economy and real estate market. In addition, our concentration in these loans has and could possibly subject us to adverse comment or action by our federal and state banking regulators, including the FDIC, the Federal Reserve and the North Carolina Commissioner of Banks. Of the properties securing these commercial real estate loans, 14.7% are located within our New Hanover County market and 85.3% are located within our Wake County market.

Residential real-estate loans including construction loans grew to $158.5 million, including $16.7 million originated through NSB Mortgage, and represented approximately 32.8% of the loan portfolio as of June 30, 2011 compared to 29.9% of the loan portfolio as of year-end 2010.  We retain select mortgages originated through NSB Mortgage to partially offset slow loan demand from our traditional commercial customers.  The 1 – 4 family residential mortgage loans originated through NSB Mortgage and selected for retention are subject to strict underwriting standards which are at a minimum per the Federal Home Loan Mortgage Corporation, or FREDDIE MAC, guidelines and typically have terms less than 15 years with a loan to value ratio less than 70%. Non-real estate commercial and industrial loans declined to $37.1 million or 7.7% of loans from 8.6% as of year-end 2010.

Loan originations from within our NSB Mortgage division are held for sale, with the exception of select loans discussed above that are retained within our loan portfolio.  Mortgage loan originations represent single-family, residential first mortgage loans, generally on a pre-sold basis.  Mortgage originations are subject to volatility due to interest rates and home sales.  During the first three months of 2011, loan originations declined sharply as refinancing and loans from home sales were slow during this period.  During the second three months of 2011, mortgage loan originations have increased in both refinancing activity as well as loans for home purchases. As of June 30, 2011, mortgage loans held for sale were $47.2 million compared to $51.5 million as of year-end 2010.

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The following table is a summary of our loans outstanding by major category for the total Bank, New Hanover County and Wake County.

	As of June 30, 2011
						New Hanover County					Wake County
			% of					% of					% of
			Total					Total Bank					Total
	Amount		Loans			Amount		Loans			Amount		Loans
	(Dollars in thousands)
Real estate loans:
Residential - construction	$	37,036		7.6	%	$	3,191		0.7	%	$	33,845		7.0	%
Commercial - construction		76,627		15.9	%		19,502		4.0	%		57,125		11.8	%
Residential - other		121,485		25.2	%		13,803		2.9	%		107,682		22.3	%
Commercial - other		207,159		42.9	%		22,238		4.6	%		184,921		38.3	%
		442,307		91.6	%		58,734		12.2	%		383,573		79.4	%
Non-real estate loans:
Commercial and industrial		37,127		7.7	%		5,826		1.2	%		31,301		6.5	%
Consumer and other		3,287		0.7	%		561		0.1	%		2,726		0.6	%
		40,414		8.4	%		6,387		1.3	%		34,027		7.1	%
Total loans	$	482,721		100.0	%	$	65,121		13.5	%	$	417,600		86.5	%

The allowance for loan losses was $9.9 million as of June 30, 2011 and December 31, 2010, representing 2.06% and 1.99%, respectively, of loans outstanding at each date. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The level of the loan loss allowance relative to gross loans increased primarily due to a higher charge-off rate applied to the general reserve and additional reserves for new loan impairments. The increase in the provision for loan losses includes an overall $278,000 increase to impairment reserves. Approximately $1.0 million of the impairment reserve as of June 30, 2011 is attributable to new additions to impaired loans since December 31, 2010 resulting from impairment analysis of the collateral securing these impaired loans. Management also considered the $8.3 million decline in 30 – 89 day past due loans since year-end 2010 in its evaluation of the allowance for loan losses. We established the allowance for loan losses at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio as of June 30, 2011. We monitor the allowance monthly. See “Allowance for Loan Losses and Asset Quality” for additional detail.

Our premises and equipment remained substantially unchanged from year-end 2010 at $14.5 million. Foreclosed assets declined to $3.1 million as of June 30, 2011 from $5.3 million as of December 31, 2010 reflecting $868,000 of additional properties, sales of $2.1 million, capital expenditures on foreclosed properties of $71,000 and valuation adjustments on foreclosed properties of $957,000 during the six months ended June 30, 2011.  Additional discussion regarding foreclosed assets is included in the section “Allowance for Loan Losses and Asset Quality.”

As of June 30, 2011 our deposits were $566.9 million, an increase of $4.1 million from $562.7 million as of December 31, 2010 due to significant growth in core deposits primarily funded through our property management division “CommunityPLUS”. Traditional core deposits grew $25.5 million while we reduced non-relationship deposits such as time deposits greater than $100,000 by $13.3 million and eliminating entirely non-core internet deposits which were $5.2 million as of year-end 2010. As was the same for year-end 2010, our time deposits as of June 30, 2011 also do not include any wholesale brokered certificates of deposit.

Our deposit mix continues to improve as we emphasize relationship deposits with individuals and entities within our market areas and from our “CommunityPLUS” customers within North Carolina, Texas, Maryland, South Carolina, Illinois, Colorado and New Mexico. Noninterest-bearing demand deposits and low-cost interest-bearing transaction accounts increased to 23.0% and 46.6%, respectively, of total deposits as of June 30, 2011 compared to 20.9% and 44.5%, respectively, as of year-end 2010.  Simultaneously for the same periods, higher costing time deposits declined to 30.4% of total deposits compared to 34.6%. In total, our core deposits increased to $463.3 million representing 81.7% compared to 78.0%, respectively, of our total deposits as of June 30, 2011 and year-end 2010. A key factor to our success in core deposit growth is through our “CommunityPLUS” division, dedicated to growing deposits specifically in the property management industry. This division experienced deposit growth of approximately $37.4 million, growing to approximately $237.8 million as of June 30, 2011 compared to $200.4 million as of year-end 2010. As of June 30, 2011, deposits within this division represented approximately 42.0% of our total deposits, up from 36.0% of total deposits as of year-end 2010.

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Non-interest bearing deposits increased $12.7 million or 10.8% to $130.5 million as of June 30, 2011 compared to $117.8 million as of year-end 2010 while interest-bearing transaction deposits grew to $264.1 million, an increase of $13.6 million or 5.4%. Our “CommunityPLUS” division contributed approximately $13.3 million and $17.7 million, respectively, of the increases in these deposit fund categories. Conversely, time deposits decreased $22.2 million to $172.2 million as of June 30, 2011 down from $194.4 million as of year-end 2010.  The decline in these deposits was, for the most part, intentional as strategic decisions regarding profitability and/or non-relationship accounts led to the intentional reduction in generally more volatile time deposits over $100,000, which declined $13.3 million from year-end 2010 in addition to the purposeful elimination of $5.2 million of non-relationship internet deposits. Time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program decreased $2.9 million to $23.3 million as of June 30, 2011. The CDARS program provides full FDIC insurance on deposit balances greater than posted FDIC limits by exchanging larger depository relationships with other CDARS members. The balance of generally more relationship generated time deposits less than $100,000 remained substantially unchanged from year-end 2010 at $68.6 million as of June 30, 2011.

Our focus for the future will be to continue to grow traditional core deposits with our customers with whom we seek to obtain the customers’ primary borrowing and deposit relationship as well as from “CommunityPLUS”. Continued success in these efforts are expected to continue to eliminate or reduce any future reliance on wholesale brokered time deposits and other non-traditional funding sources such as internet deposits.

Strong core deposit growth continues to minimize our need for short-term borrowings. Short-term borrowings as of June 30, 2011, consisting solely of securities sold under repurchase agreements, were $3.5 million, compared to $3.6 million as of year-end 2010. Long-term borrowings remained unchanged from year-end 2010 at $27.3 million consisting primarily of $11.0 million of subordinated notes and $15.5 million in junior subordinated debentures.

Total shareholders’ equity increased $630,000 to $38.1 million as of June 30, 2011.  The increase was primarily provided by net income of $314,000 and other comprehensive income of $266,000.

Comparison of Results of Operations for the Three-Month Periods Ended June 30, 2011 and 2010

Net Income.  For the three-month period ended June 30, 2011, net income was $111,000 compared to $310,000 for the corresponding three-month period of 2010, representing a decrease of $199,000 or 64.2%.  On a diluted share basis, earnings were $.01 and $.04 per share, respectively, for the three-month periods ended June 30, 2011 and 2010. The length and depth of the recession and the sluggish recovery continues to affect real estate and business activity in the markets we serve and continues to restrain our overall results of operations compared to pre-recession results. Lower earnings are driven by a decline in loan volume resulting in lower interest income, high levels of nonperforming assets, continued foreclosed asset valuation adjustments and losses on sales of such properties. Favorable changes in deposit mix helped to minimize the decrease in net interest income and $17.5 million of securities sales generated gains of approximately $329,000. For the three months ended June 30, 2011 return on average assets was .07% compared to .19% for the prior year period while for the same periods return on average equity was 1.17% compared to 3.29%.

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Net Interest Income. Interest income for the three months ended June 30, 2011 decreased $1.1 million or 13.5% over the prior year period while for the same period interest expense decreased $622,000 or 31.6% resulting in a net decrease of $433,000 in net interest income over the prior year three-month period. Net interest income was $5.4 million for the three-month period ended June 30, 2011 compared to $5.8 million for the prior year period, down 7.4%.

Interest income is affected by changes in the mix and volume of average earning assets, interest rates and also by the level of loans on nonaccrual status. Interest income for the three months ended June 30, 2011 was $6.7 million compared to $7.8 million for the prior year period, a decrease of $1.1 million.  The reduction in interest income is primarily due to a $46.4 million decrease in volume of average performing loans, our highest yielding earning asset. This decline in average loan volume effectively reduced interest income by approximately $649,000 while a net volume increase in all other average interest-earning assets of $4.4 million provided approximately $50,000 in additional interest income. In summary, the overall net decline of $42.0 million in average interest-earning assets decreased interest income approximately $599,000 while lower yields on interest-earning assets reduced interest income approximately $456,000.  In addition, no interest income is recognized when loans are on nonaccrual status. Accrued interest is reversed and future interest accruals are suspended at the time loans are placed on nonaccrual status. During the three-month period ended June 30, 2011, loans on nonaccrual status averaged approximately $25.8 million, representing an estimated quarterly loss of interest income of $352,000.  During the prior year period, nonaccrual loans averaged $17.2 million, representing an estimated quarterly loss of interest income of $246,000.

Our efforts in improving our deposit mix and repricing deposits at lower rates were the primary factors for the overall decrease in interest expense. Interest expense for the three months ended June 30, 2011 was $1.3 million compared to $2.0 million for the prior year three-month period, a decrease of $622,000. Average time deposits decreased $65.0 million from the previous year period primarily in non-core internet and single-service certificates of deposit. These higher-costing and generally more volatile deposits were replaced with lower costing interest checking, money market and non-interest-bearing transaction deposits which grew in total an average of $31.8 million, of which $19.8 million were in non-interest-bearing demand deposits. Average short-term borrowings declined $1.8 million. In summary, the overall decrease in interest-bearing liabilities of $54.9 million decreased interest expense by approximately $428,000 while lower interest rates paid on these funds decreased interest expense approximately $194,000.

The yield on our earning assets averaged 4.62% during three months ended June 30, 2011 compared to 4.99% during for the three months ended June 30, 2010.  During the same periods, the cost of our interest-bearing liabilities averaged 1.18% compared to 1.54%.  Overall our net interest margin, excluding average nonaccrual loans, decreased three basis points to 3.70% compared to 3.73%.

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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.

	Three Months Ended							Three Months Ended
	June 30, 2011							June 30, 2010
	Average				Average			Average				Average
	Balance		Interest		Rate			Balance		Interest		Rate
	(Dollars in thousands)
Interest-earning assets:
Loans (1)	$	450,266	$	6,156		5.48	%	$	496,644	$	7,108		5.74	%
Loans held for sale		25,706		272		4.24	%		22,246		298		5.37	%
Investments available for sale		30,774		242		3.15	%		21,883		180		3.30	%
Investments held to maturity		250		2		3.21	%		438		1		0.92	%
Other interest-earning assets		77,051		62		3.21	%		84,857		202		0.92	%
Total interest-earning assets		584,047		6,734		4.62	%		626,068		7,789		4.99	%
Other assets		52,271							45,624
Total assets	$	636,318						$	671,692
Interest-bearing liabilities:
Deposits:
Savings, NOW & Money Market	$	253,906		401		0.63	%	$	241,993		521		0.85	%
Time deposits over $100,000		82,451		379		1.84	%		113,616		645		2.28	%
Other time deposits		91,619		338		1.48	%		125,422		570		1.82	%
Short-term borrowings		4,494		1		0.09	%		6,333		7		0.44	%
Long-term borrowings		27,261		230		3.38	%		27,281		228		3.35	%
Total interest-bearing liabilities		459,731		1,349		1.18	%		514,645		1,971		1.54	%
Demand deposits		136,170							116,329
Other liabilities		2,333							2,976
Shareholders' equity		38,084							37,742
Total liabilities and shareholders' equity	$	636,318						$	671,692
Net interest income and interest rate spread			$	5,385		3.44	%			$	5,818		3.45	%
Net yield on average interest-earning assets						3.70	%						3.73	%
Ratio of average interest-earning assets to average interest-bearing liabilities						127.04	%						121.65	%
Net yield on average interest-earning assets including nonaccrual loans						3.54	%						3.63	%

(1) Nonaccrual loans are excluded in loan amounts.

Provision for Loan Losses.  The provision for loan losses was $1.4 million for the three months ended June 30, 2011, $194,000 lower than in the prior year three-month period.  Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by management. The decline in the provision for the three-month period ended June 30, 2011 is principally due to fewer charge-offs compared to the prior year period as well as a decline in our performing loan volume. The allowance for loan losses was $9.9 million as of June 30, 2011 or 2.06% of loans outstanding compared to $9.9 million or 1.99% of loans outstanding as of year-end 2010. See “Allowance for Loan Losses and Asset Quality” for additional detail.

Non-interest Income. Non-interest income, including security gains of $329,000, increased $440,000 or 60.7% to $1.1 million for the three months ended June 30, 2011 compared to the prior year period.  Excluding security gains, non-interest income grew $111,000 over the prior year period. Fees from mortgage operations were up $52,000 to $536,000 for the three months ended June 30, 2011. Fees from annuity sales and other fees generated from our wealth management services division provided $135,000 in non-interest income, up $69,000 over the prior year period. Our restructure of our wealth management services division and the appointment of a new director for this division during the second quarter of 2010 continues to generate higher levels of income over periods prior to the division restructure.  We expect fees from this division as well as fees from our mortgage division to be key sources of noninterest income in the future. As a percentage of average assets, non-interest income increased to .73% for the three months ended June 30, 2011 compared to .43% for the prior period.

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Non-interest Expense. Non-interest expense for the three months ended June 30, 2011 increased $573,000 or 13.1% to $5.0 million from $4.4 million for the prior year period. The increase is primarily attributable to additional personnel expense, up $310,000.

Salaries and other personnel expense represent our largest expense category at $2.3 million for the three months ended June 30, 2011, up over $310,000 or 15.9% from $2.0 million for the prior year period.  Approximately $100,000 of the increase is attributable to our mortgage division by means of commissions paid to mortgage loan originators as well as additional costs for support personnel within this division. Personnel expense within our wealth management services division is also primarily fee driven.  Higher fee income resulted in higher commission expense in addition to additional personnel expense for support personnel, up approximately $78,000 over the prior year period. The remaining increase in personnel cost is attributable to organizational changes within management as well as fewer deferred loan origination costs as a result of the slowdown in new commercial loan demand. Overall, full time equivalent employees increased by four over the prior year. We continued to temporarily suspend 401k matching benefits, incentive bonuses as well as merit increases as part of the cost saving initiatives we began in 2009.  As a percentage of average assets, personnel expense increased to 1.43% for the three months ended June 30, 2011 compared to 1.17% for the prior year period.

Occupancy and equipment costs increased $48,000 to $702,000 for the three months ended June 30, 2011 primarily as a result of increased building lease expense attributable to the relocation of our downtown office. Other non-interest expenses increased $215,000 or 12.2% over the prior year period primarily due to increased expenses related to foreclosed assets and data processing fees. Subsequent to foreclosure, valuations are periodically performed on the properties. Due to continued downturn in the markets we serve, specifically New Hanover and Wake County, revaluations of foreclosed properties resulted in valuation losses of $487,000 for the three months ended June 30, 2011 compared to $416,000 for the prior year period, up $71,000. Additional losses from sales of foreclosed properties and general costs to maintain foreclosed properties net of rental income received were up approximately $26,000 over the prior year period. As a percent of average assets, net foreclosed asset costs were .35% for the three months ended June 30, 2011 compared to .28% for the prior year period. Our outsourced services expense is related to data processing and other services for our customers’ accounts.  These services are primarily volume driven and increase as we add new offices and products with corresponding increases in loan, deposit and other customer-based accounts. In total, outsourced data processing fees were up $99,000 over the prior year period, substantially in response to outsourced software services due to increased volume from customers of our “CommunityPLUS” division. Director fees increased $32,000 due to the re-instatement of corporate board fees after a two year suspension of these fees. There were no other significant changes in other noninterest expenses. Including additional net costs related to foreclosed assets, our non-interest expense as a percentage of average assets was 3.12% for the three months ended June 30, 2011 compared to 2.61% for the prior year period.

We recorded $71,000 and $244,000, respectively, in income tax expense for the three months ended June 30, 2011 and 2010.  Income tax expense as a percentage of pretax income for the same periods was 39.0% and 44.0%, respectively.  Changes in permanent tax differences and tax exempt income resulted in a higher effective rate for the prior year period.

Comparison of Results of Operations for the Six-Month Periods Ended June 30, 2011 and 2010

Net Income.  Net income for the six-month period ended June 30, 2011 was $314,000, down $510,000 or 61.9% from $824,000 for the corresponding six-month period of 2010. On a diluted share basis, earnings for the periods were $.04 and $.11 per share, respectively. Earnings continue to be below pre-recession levels driven by several factors including a decline in loan volume resulting in lower interest income, high levels of nonperforming assets, continued foreclosed asset valuation adjustments and losses on sales of such properties. Favorable changes in deposit mix helped to minimize the decrease in net interest income. For the six months ended June 30, 2011, return on average assets was .10% compared to .25% for the prior year period while for the same periods return on average equity was 1.67% compared to 4.43%.

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Net Interest Income. Net interest income for the six months ended June 30, 2011 decreased $278,000 or 2.5% from the prior year period. The decline in income is primarily a result of decreased loan volume, our highest yielding earning asset, resulting from decreased activity within our markets due to the prolonged effects of the recession.

Interest income is affected by changes in the mix and volume of average earning assets, interest rates and also by the level of loans on nonaccrual status. Interest income for the six months ended June 30, 2011 was $13.8 million compared to $15.4 million for the prior year period, a decrease of $1.6 million.  The reduction in interest income is primarily due to a $36.9 million decrease in volume of average performing loans, our highest yielding earning asset. This decline in average loan volume effectively reduced interest income by approximately $1.0 million while the average $13.6 million increased volume of held for sale mortgage loans provided additional interest income of approximately $315,000.  All other interest-earning assets declined an average of $16.4 million, reducing interest income approximately $146,000. In summary, the overall net decline of $39.7 million in average interest-earning assets decreased interest income approximately $865,000 while lower yields on interest-earning assets reduced interest income approximately $710,000. In addition, interest income not recognized due to loans on nonaccrual status during the six-month periods ended June 30, 2011 and 2010 was approximately $612,000 and $497,000, respectively, as loans on nonaccrual status averaged approximately $22.1 million and $17.5 million, respectively, for these periods.

Improvement in our deposit mix resulting from the successful building of our core deposits and repricing deposits at lower rates were the primary factors for the overall decrease in interest expense. Interest expense for the six months ended June 30, 2011 was $2.8 million compared to $4.1 million for the prior year period, a decrease of $1.3 million. Average time deposits decreased $68.0 million from the previous year period primarily in non-core wholesale brokered, internet and single-service certificates of deposit. These higher-costing and generally more volatile deposits were replaced with lower costing interest checking, money market and non-interest-bearing transaction deposits which grew in total an average of $33.1 million, of which $21.1 million were in non-interest-bearing demand deposits. Average short-term borrowings declined $1.7 million from the prior year period.  In summary, the overall decrease in average interest-bearing liabilities of $57.7 million decreased interest expense approximately $679,000 while lower interest rates paid on these funds decreased total interest expense by approximately $618,000.

The yield on our earning assets averaged 4.70% during six months ended June 30, 2011 compared to 4.91% during for the six months ended June 30, 2010.  During the same periods, the cost of our interest-bearing liabilities averaged 1.23% compared to 1.59%.  Overall our net interest margin, excluding average nonaccrual loans, decreased 15 basis points to 3.74% compared to 3.59%.

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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.

	Six Months Ended							Six Months Ended
	June 30, 2011							June 30, 2010
	Average				Average			Average				Average
	Balance		Interest		Rate			Balance		Interest		Rate
	(Dollars in thousands)
Interest-earning assets:
Loans (1)	$	463,254	$	12,816		5.58	%	$	500,129	$	14,209		5.73	%
Loans held for sale		27,182		546		4.05	%		13,597		358		5.31	%
Investments available for sale		23,181		342		2.98	%		22,696		381		3.39	%
Investments held to maturity		250		5		4.03	%		593		10		3.40	%
Other interest-earning assets		78,720		105		0.27	%		95,233		431		0.91	%
Total interest-earning assets		592,587		13,814		4.70	%		632,248		15,389		4.91	%
Other assets		48,550							45,705
Total assets	$	641,137						$	677,953
Interest-bearing liabilities:
Deposits:
Savings, NOW & money market	$	252,261	$	881		0.70	%	$	240,212	$	1,066		0.89	%
Time deposits over $100,000		86,990		803		1.86	%		121,061		1,395		2.32	%
Other time deposits		93,358		684		1.48	%		127,297		1,206		1.91	%
Short-term borrowings		4,467		2		0.09	%		6,197		13		0.42	%
Long-term debt		27,263		461		3.41	%		27,284		448		3.31	%
Total interest-bearing liabilities		464,339		2,831		1.23	%		522,051		4,128		1.59	%
Demand deposits		136,551							115,480
Other liabilities		2,227							2,930
Shareholders' equity		38,020							37,492
Total liabilities and shareholders' equity	$	641,137						$	677,953
Net interest income and interest rate spread			$	10,983		3.47	%			$	11,261		3.32	%
Net yield on average interest-earning assets						3.74	%						3.59	%
Ratio of average interest-earning assets to average interest-bearing liabilities						127.62	%						121.11	%
Net yield on average interest-earning assets including nonaccrual loans						3.60	%						3.50	%

(1) Nonaccrual loans are excluded in loan amounts.

Provision for Loan Losses.  The provision for loan losses was $2.4 million for the six months ended June 30, 2011, $429,000 lower than in the prior year period.  Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The decline in the provision is principally due to fewer charge-offs compared to the prior year period as well as a decline in our performing loan volume. The allowance for loan losses was $9.9 million as of June 30, 2011 or 2.06% of loans outstanding compared to $9.9 million or 1.99% of loans outstanding as of year-end 2010. See “Allowance for Loan Losses and Asset Quality” for additional detail.

Non-interest Income. Non-interest income was $1.9 million for the six months ended June 30, 2011 compared to $1.3 million for the prior year period, an increase of $597,000.  Included in noninterest income were security gains of $329,000 and $232,000, respectively, for the six months ended June 30, 2011 and 2010.  Excluding security gains, non-interest income grew $500,000 or 46.3% over the prior year period. Fees from mortgage operations were up $380,000 to $1.0 million for the six months ended June 30, 2011. Our acquisition and operations of NSB Mortgage did not begin until mid-February 2010 resulting in less fee income generated n the prior year period. Fees from annuity sales and other fees generated from our wealth management services division provided $221,000 in non-interest income, up $135,000 over the prior year period. Our restructure of our wealth management services division and the appointment of a new director for this division during the second quarter of 2010 continues to generate higher levels of income over periods prior to the division restructure.  We expect fees from this division as well as fees from our mortgage division to be key sources of noninterest income in the future. As a percentage of average assets, non-interest income increased to .60% for the six months ended June 30, 2011 compared to .39% for the prior period.

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Non-interest Expense. Non-interest expense for the six months ended June 30, 2011 was $10.0 million, an increase of $1.7 million or 20.2% over the prior year period. The increase is primarily attributable to additional personnel expense, up $976,000.

Salaries and other personnel expense represent over 45.0% of our total noninterest expense and increased to $4.6 million for the six months ended June 30, 2011.  The increase of $976,000 or 27.2% over the prior year period was primarily attributable to our mortgage and wealth management divisions.  Commissions paid to mortgage loan originators as well as additional costs for support personnel represented approximately $566,000 of the increase in total personnel expense.  As with the increase in mortgage fee income over the prior year, personnel expense for this division includes six months of expense during 2011 compared to less than four months in the prior year period due to the timing of the acquisition.  Higher fee income produced from our wealth management division resulted in higher commission expense in addition to additional personnel expense for support personnel.  Personnel expense for this division contributed approximately $146,000 to the increase in personnel expense over the prior year period. The remaining increase in personnel cost is attributable to fewer deferred loan origination costs as a result of the slow down in new commercial loan demand and organizational changes within management. Overall, full time equivalent employees increased by four over the prior year. We continued to temporarily suspend 401k matching benefits, incentive bonuses as well as merit increases as part of the cost saving initiatives we began in 2009.  As a percentage of average assets, personnel expense increased to 2.86% for the six months ended June 30, 2011 compared to 2.13% for the prior year period.

Occupancy and equipment costs increased $40,000 to $1.4 million for the six months ended June 30, 2011 primarily as a result of increased building lease expense attributable to the relocation of our downtown office. Other non-interest expenses increased $656,000 or 19.7% over the prior year period primarily due to increased expenses related to foreclosed assets and data processing fees. Subsequent to foreclosure, valuations are periodically performed on the properties. Revaluations of foreclosed properties during the first six months of 2011 resulted in valuation losses of $957,000 compared to $649,000 for the prior year period, up $308,000. Additional losses from sales of foreclosed properties were $67,000 for the 2011 six-month period compared to losses of $24,000 for the prior year period. General costs to maintain foreclosed properties net of rental income received were down $90,000 from the prior year period. As a percent of average assets, net foreclosed asset costs were .33% for the six months ended June 30, 2011 compared to .24% for the prior year period. Our outsourced services expense is related to data processing and other services for our customers’ accounts.  These services are primarily volume driven and increase as we add new offices and products with corresponding increases in loan, deposit and other customer-based accounts. In total, outsourced data processing fees were up $216,000 over the prior year period, substantially in response to outsourced software services due to increased volume from customers of our “CommunityPLUS” division. Director fees were up $77,000 due to the re-instatement of corporate board fees after a two year suspension of these fees. There were no other significant changes in other noninterest expenses. Including additional net costs related to foreclosed assets, non-interest expense as a percentage of average assets was 3.13% for the six months ended June 30, 2011 compared to 2.46% for the prior year period.

We recorded $192,000 and $606,000, respectively, in income tax expense for the six months ended June 30, 2011 and 2010.  Income tax expense as a percentage of pretax income for the same periods was 39.0% and 44.0%, respectively.  Changes in permanent tax differences and tax exempt income resulted in a higher effective rate for the prior year period.

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Allowance for Loan Losses and Asset Quality

Nonperforming assets as of June 30, 2011 were comprised of $26.8 million nonaccrual loans, and foreclosed assets of $3.1 million. Included in nonaccrual loans were $4.8 million of restructured loans considered troubled debt restructurings, or TDRs. Not included in nonperforming assets were accruing TDRs of $7.1 million, and $133,000 of accruing loans past due 90 days or more. Concessions we have granted to customers experiencing cash flow difficulties resulting in a TDR include reduction in interest rate, forgiveness of interest or modification of payment terms.

Our level of 30 to 89 day past due loans was $3.7 million as of June 30, 2011, down from $4.8 million as of March 31, 2011 and $11.9 million as of year-end 2010. Total nonaccrual loans increased to $26.8 million or 5.5% of period-end loans as of June 30, 2011, up from $22.5 million or 4.7% as of March 31, 2011 and $11.5 million or 2.3% of period-end loans as of December 31, 2010.  Our borrowers tied to the residential and commercial real estate industry continued to experience slow business activity resulting from the recession. The business activity of our customers in the markets we serve, particularly those involved in residential real estate, have experienced continuing restrictions on cash-flows during the first six  months of 2011 resulting from low real estate sales. Consequently, loans that may have been past due at year-end have been moved to nonaccrual status as of June 30, 2011.

The table below presents for the dates indicated summary information regarding our non-performing assets, TDRs, potential problem loans and loans 90 days or more past due.  For further detail by loan category, see Note E to our consolidated financial statements.

	June 30, 2011				December 31, 2010
	(Dollars in thousands)
Nonaccrual loans	$	21,978			$	10,972
TDR nonaccrual loans		4,776				520
Total nonaccrual loans		26,754				11,492
Foreclosed assets		3,122				5,296
Total nonperforming assets	$	29,876			$	16,788
Accruing loans past due 90 days or more	$	133			$	131
TDR accruing loans	$	7,113			$	11,741
Potential problem loans	$	-			$	1,184
Allowance for loan losses	$	9,944			$	9,935
Nonaccrual loans to period end loans		5.54	%			2.30	%
Allowance for loan losses to period end loans		2.06	%			1.99	%
Nonperforming assets to total assets		4.68	%			2.65	%
Ratio of allowance for loan losses to nonaccrual loans		0.37		x		0.86		x

As of June 30, 2011, 96.5% of our nonaccrual loans were real-estate secured, with 36.8% represented within our New Hanover County market. Real-estate secured construction and land development loans comprised 70.2% of nonaccrual loans. All nonaccrual residential construction loans were located in our Wake County market, while 12.1% of commercial construction loans were located in Wake County and 25.9% in New Hanover County. In total, $9.9 million or 36.8% of the $26.8 million nonaccrual loans as of June 30, 2011 were located in our New Hanover County market area with the remaining $16.9 million represented throughout our locations in Wake County.

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The following table is a summary of our nonaccrual loans by major category for the total Bank, New Hanover County and Wake County as of June 30, 2011.

	Nonaccrual Loan Composition as of June 30, 2011
	Total Bank					New Hanover County					Wake County
			% of Total					% of Total					% of Total
			Nonaccrual					Nonaccrual					Nonaccrual
	Amount		Loans			Amount		Loans			Amount		Loans
						(Dollars in thousands)
Real estate loans:
Residential - construction	$	8,614		32.2	%	$	-		0.0	%	$	8,614		32.2	%
Commercial - construction		10,176		38.0	%		6,939		25.9	%		3,237		12.1	%
Residential - other		3,465		13.0	%		421		1.6	%		3,044		11.4	%
Commercial - other		3,556		13.3	%		2,482		9.3	%		1,074		4.0	%
		25,811		96.5	%		9,842		36.8	%		15,969		59.7	%
Non-real estate loans:
Commercial and industrial		884		3.3	%		-		0.0	%		884		3.3	%
Consumer and other		59		0.2	%		14		0.0	%		45		0.2	%
		943		3.5	%		14		0.0	%		929		3.5	%
Total nonaccrual loans	$	26,754		100.0	%	$	9,856		36.8	%	$	16,898		63.2	%

An aggregate of $9.8 million of the nonaccrual loans as of June 30, 2011 is attributable to five borrowers primarily consisting of real estate construction loans.  Approximately $3.1 million or 31.8% are loans to borrowers located in our New Hanover County market area. The average loan exposure for these borrowers is approximately $2.0 million with the largest exposure to any one borrower included in our nonaccrual loans at $4.5 million for residential construction. Each specific loan in these customer relationships was analyzed for impairment and our management concluded specific impairment reserves aggregating $1.0 million on these loans were necessary in addition to $1.1 million of partial charge-offs. Our impairment analysis on the remaining $17.0 million of nonaccrual loans resulted in additional impairment reserves of $1.4 million in addition to life to date partial charge-offs of $2.2 million.  Included in the above nonaccrual loans are 12 residential and commercial real estate loans totaling $4.8 million which were restructured to forgive all accrued interest due to financial difficulties of the borrower. See Note E to our consolidated financial statements for additional detail regarding loans, nonaccrual loans and credit quality.

Our loan loss allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries.  Net charge-offs were $2.4 million or .50% of average loans for the six-month period ended June 30, 2011 compared to net charge-offs of $3.0 million or .57% of average loans for the prior year period. Approximately $2.2 million or 89.3% of the loans charged off for the six months ended June 30, 2011 were real estate secured loans, with 57.9% representing properties located in our Wake County market. Overall, residential real estate property represented 60.9% and commercial real estate property represented 28.5% of the charge-offs for the first six months of 2011. For the three months ended June 30, 2011 net charge-offs were $820,000 or .17% of average loans, down from $1.0 million or .20% of average loans for the prior year three-month period.  Our loan loss allowance as a percentage of loans was 2.06% as of June 30, 2011 and 1.99% as of December 31, 2010. The level of the loan loss allowance relative to gross loans increased primarily due to a higher charge-off rate applied to the general reserve and additional reserves for new loan impairments.

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The following table is a summary of our net charge-offs by major category for the total Bank, New Hanover County and Wake County as of June 30, 2011.

	Net Charge-off Composition for the Six-Month Period Ended June 30 , 2011
	Total Bank						New Hanover County						Wake County
				% of Net						% of Total Bank Net						% of Total Bank Net
	Amount			Charge-offs			Amount			Charge-offs			Amount			Charge-offs
	(Dollars in thousands)
Real estate loans:
Residential - construction	$	135			5.6	%	$	(12	)		-0.5	%	$	147			6.1	%
Commercial - construction		149			6.1	%		-			0.0	%		149			6.1	%
Residential - other		1,340			55.3	%		583			24.1	%		757			31.2	%
Commercial - other		593			24.5	%		190			7.8	%		403			16.6	%
		2,217			91.5	%		761			31.4	%		1,456			60.0	%
Non-real estate loans:
Commercial and industrial		224			9.2	%		140			5.8	%		84			3.5	%
Consumer and other		(17	)		-0.7	%		-			0.0	%		(17	)		-0.7	%
		207			8.5	%		140			5.8	%		67			2.8	%
Total loans	$	2,424			100.0	%	$	901			37.2	%	$	1,523			62.8	%

	Net Charge-off Composition for the Three-Month Period Ended June 30 , 2011
	Total Bank					New Hanover County					Wake County
			% of Net					% of Total Bank Net					% of Total Bank Net
	Amount		Charge-offs			Amount		Charge-offs			Amount		Charge-offs
						(Dollars in thousands)
Real estate loans:
Residential - construction	$	29		3.5	%	$	-		-		$	29		3.5	%
Residential - other		469		57.1	%		381		46.4	%		88		10.7	%
Commercial - other		137		16.7	%		137		16.7	%		-		-
		635		77.3	%		518		63.0	%		117		14.2	%
Non-real estate loans:
Commercial and industrial		187		22.7	%		178		21.7	%		9		1.1	%
		187		22.7	%		178		21.7	%		9		1.1	%
Total loans	$	822		100.0	%	$	696		84.7	%	$	126		15.3	%

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, certificates of deposit with banks, investment securities and loans classified as held for sale) comprised $135.3 million or 21.2% and $110.7 million or 17.5%, respectively, of our total assets as of June 30, 2011 and December 31, 2010.

As a member of the FHLB, we may obtain advances of up to 10% of our Bank’s assets.  We are also authorized to borrow from the Federal Reserve Bank’s “discount window.”  As of June 30, 2011, we had pledged specific collateral for potential borrowing of up to $144.8 million from the “discount window.” As another source of short-term borrowings, we also utilize securities sold under agreements to repurchase.  As of June 30, 2011, our short-term borrowings consisted of securities sold under agreements to repurchase of $3.5 million. As of June 30, 2011, overnight excess funds of $59.1 million were invested in our account at the Federal Reserve.

Total deposits were $566.9 million and $562.7 million, respectively, as of June 30, 2011 and December 31, 2010.  Time deposits, which are the only deposit accounts that have stated maturity dates, are generally considered to be rate sensitive.  Time deposits represented 30.4% and 34.6%, respectively, of total deposits as of June 30, 2011 and December 31, 2010. Time deposits of $100,000 or more represented 14.2% and 16.7%, respectively, of our total deposits as of June 30, 2011 and December 31, 2010.  As of June 30, 2011 and year-end 2010, we had no wholesale brokered certificates of deposit.  Under FDIC regulations governing brokered deposits, well capitalized institutions are not subject to brokered deposit limitations. Deposits generated through an internet subscription service of $5.2 million as of year-end 2010, were intentionally eliminated as of June 30, 2011. We believe that most of our time deposits are relationship-oriented. While we will need to pay competitive rates to retain deposits at their maturities, there are other subjective factors that we believe 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. 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 as of June 30, 2011 is adequate to meet our operating needs.

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Short and long-term borrowings as of June 30, 2011 and December 31, 2010 are as follows:

	June 30, 2011		December 31, 2010
	(Dollars in thousands)
Short-term borrowings:
Repurchase agreements	$	3,461	$	3,615
	$	3,461	$	3,615
Long-term borrowings:
FHLB advances	$	793	$	804
Subordinated debentures		11,000		11,000
Junior subordinated debentures		15,465		15,465
	$	27,258	$	27,269

A description of the trust preferred securities and related junior subordinated debentures outstanding as of June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011		December 31, 2010		Maturity	Interest
	(Dollars in thousands)				Date	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 as of June 30, 2011 and December 31, 2010 is as follows:

	June 30, 2011		December 31, 2010		Maturity	Interest
	(Dollars in thousands)				Date	rate
Floating rate subordinated notes	$	11,000	$	11,000	6/30/2018	3 mo LIBOR plus 3.50%, resets quarterly

As of June 30, 2011, our equity to assets ratio was 5.97%. The Bank's tier 1 leverage and tier 1 risk based capital ratios and its total risk based capital ratios were 8.09%, 10.33% and 13.80%, respectively, as of June 30, 2011 compared to 8.04%, 9.64% and 12.99% as of December 31, 2010.  As of June 30, 2011, the Bank exceeded the minimum requirements of a "well capitalized" institution as defined by federal banking regulations.  Based on the current economic and regulatory environment, the Bank’s board of directors has decided to maintain a Tier I leverage ratio of 8% or more and a total risk based capital ratio of 12% or more.

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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 reliable 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.

In addition to simulation of net interest income, we utilize a discounted net present value of cash flow analysis called Economic Value of Equity or “EVE”.  This methodology aids management in identifying long-term interest rate risk. Additional discussion of EVE is presented in Item 7, under “Asset/Liability Management” of our Annual Report on Form 10-K for the year ended December 31, 2010.

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 previously have used a stand-alone derivative financial instrument, in the form of an interest rate floor, in our asset/liability management program. Additional discussion of derivatives is presented in Note L to our consolidated financial statements included under Item 8 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2010.

Item 4.  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 were effective as of June 30, 2011.

(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 6.   Exhibits

Exhibit #                           Description

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

    101                      Financials provided in XBRL format

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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 15, 2011	By:	/s/ Larry D. Barbour
		Larry D. Barbour
		President and Chief Executive Officer

Date: August 15, 2011	By:	/s/ Kirk A. Whorf
		Kirk A. Whorf
		Executive Vice President and Chief Financial Officer