North State Bancorp (NSBC) 10-K 2011 FY Annual report

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-K

Annual Report under Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the Fiscal Year ended December 31, 2011

OR

Transition Report under Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the Transition Period from ___________ to ___________

Commission File Number: 000-49898

North State Bancorp

(Exact name of registrant as specified in its charter)

North Carolina	65-1177289
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

6204 Falls of the Neuse Road

Raleigh, North Carolina 27609

(Address of principal executive offices, including zip code)

(919) 787-9696

(Issuer’s telephone number)

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

Securities Registered under Section 12(g) of the Act:

Title of Each Class	Name of Each Exchange On Which Registered
Common Stock, No Par Value	None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes [   ] No [X]

Indicate by check mark if the registrant is not required to file reports to Section 13 or Section 15(d) of the Act.    Yes [   ] No [X]

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 during the past 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes [X]   No  

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

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

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

The aggregate market value of the common stock held by non-affiliates was approximately $15.9 million as of June 30, 2011, based on the closing price of the common stock as quoted on the over-the-counter Bulletin Board on that day.

As of March 29, 2012, the registrant had outstanding 7,427,976 shares of Common Stock, no par value.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be filed for its 2012 Annual Meeting of Shareholders to be held on May 31, 2012 to be filed with the Securities and Exchange Commission within 120 days of December 31, 2011 are incorporated by reference into Part III of this report.

NORTH STATE BANCORP

ANNUAL REPORT ON FORM 10-K

Table of Contents

Page

PART I
Item 1.	Business	1
Item 1A.	Risk Factors	8
Item 1B.	Unresolved Staff Comments	15
Item 2.	Properties	16
Item 3.	Legal Proceedings	16
Item 4.	Mine Safety Disclosures	16
PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	16
Item 6.	Selected Financial Data	18
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	47
Item 8.	Financial Statements and Supplementary Data	48
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	48
Item 9A.	Controls and Procedures	48
Item 9B.	Other Information	48
PART III
Item 10.	Directors, Executive Officers and Corporate Governance	48
Item 11.	Executive Compensation	49
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	49
Item 13.	Certain Relationships and Related Transactions, and Director Independence	49
Item 14.	Principal Accountant Fees and Services	49
PART IV
Item 15.	Exhibits and Financial Statement Schedules	50

NOTE REGARDING FORWARD-LOOKING STATEMENTS

Statements contained in this report, which are not historical facts, are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Amounts herein could vary as a result of market and other factors. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents we file with the U.S. Securities and Exchange Commission from time to time. Such forward-looking statements may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “might,” “planned,” “estimated,” and “potential.” Examples of forward-looking statements include, but are not limited to, estimates with respect to our financial condition, expected or anticipated revenue, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to: local, regional and national economies; changes in real estate values and real estate markets; substantial changes in financial markets; changes in interest rates; changes in legislation or regulation;  loss of deposits and loan demand to other savings and financial institutions; our ability to manage growth; changes in accounting principles, policies, or guidelines; and other economic competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services.

PART I

Item 1.    Business.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002.  We have one corporate subsidiary, North State Bank, which we acquired on June 28, 2002 as part of the Bank’s holding company reorganization.  Our primary business is the ownership and operation of North State Bank.  We also have three trust subsidiaries that we established to issue trust preferred securities.

North State Bank was incorporated under the laws of the State of North Carolina in May 2000 and opened for business on June 1, 2000.  The Bank is not a member of the Federal Reserve System.  Our main office and that of the Bank is located at 6204 Falls of the Neuse Road in north Raleigh, North Carolina.  The Bank also operates full service offices at 4270 The Circle at North Hills, Raleigh, 2413 Blue Ridge Road in west Raleigh, 14091 New Falls of Neuse Road in the Wakefield area of north Raleigh, 835 Highway 70 West in Garner, North Carolina, 230 Fayetteville Street in downtown Raleigh, and 1411 Commonwealth Drive, Wilmington, North Carolina and a mortgage loan office at 1340 Environ Way, Chapel Hill, North Carolina. The term “we” in this report refers interchangeably to North State Bancorp and North State Bank.

We focus on serving the total banking needs of professional firms, professionals, property management companies, churches, non-profits and individuals who highly value a mutually beneficial banking relationship in the cities of Raleigh, Garner and Wilmington and the greater Wake County and New Hanover County market areas, by providing banking services including checking, savings and investment accounts; commercial, installment, mortgage, and personal loans; safe deposit boxes; wire transfer; and other associated services.  Our “CommunityPLUS” property management division is dedicated to serving community association management companies by offering services specific to this industry. In June 2011, the Bank established North State Title, LLC, a wholly owned subsidiary, which owns 67% of Title Group, LLC, a title insurance agency. Through the Bank’s subsidiary, we offer wealth management and brokerage services.  North State Bank Mortgage, a division of the Bank, began operations during February 2010 for the purpose of originating and selling single family, residential first mortgage loans.

Supervision and Regulation

Regulation of North State Bank

North State Bank is a North Carolina banking corporation whose deposits are insured by the Federal Deposit Insurance Corporation, or FDIC.   As a commercial bank, we are subject to extensive regulation by the FDIC and the North Carolina Commissioner of Banks. The North Carolina Commissioner of Banks and the FDIC periodically examine our operations and require us to submit periodic reports regarding our financial condition and operations.

We are subject to various state and federal laws and regulations that restrict or otherwise apply to our lending, deposit-taking and other business activities. Additionally, federal law generally prohibits us from engaging as principal in activities that are not permitted for national banks unless the FDIC determines that the activity would pose no significant risk to the deposit insurance fund, and we are, and continue to be, in compliance with all applicable capital standards.  In addition, we generally are not able to acquire or retain equity investments of a type, or in an amount, that is not permissible for a national bank.

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A bank must obtain the prior approval of the North Carolina Commissioner of Banks for any of the following events:

· the merger with or purchase of substantially all the assets or assumption of liabilities of another financial institution;

· the establishment of a branch office; and

· the establishment or acquisition of a subsidiary corporation.

The North Carolina Commissioner of Banks or the FDIC may sanction any insured bank not operated in accordance with or not conforming to applicable regulations, policies, and directives. Proceedings may be instituted against an insured bank or any director, officer or employee of a bank that engages in unsafe and unsound practices, including the violation of applicable laws and regulations. The FDIC can terminate insurance of accounts of any insured bank not operated in accordance with or not conforming to its regulations, policies, and directives.

All FDIC-insured banks must maintain average daily reserves against their transaction accounts. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the Bank’s interest-earning assets.

The Bank is subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of certain transactions with affiliate entities. The total amount of the transactions by the Bank with a single affiliate is limited to 10% of the Bank’s capital and surplus and, for all affiliates, to 20% of the Bank’s capital and surplus. Each of the transactions among affiliates must also meet specified collateral requirements and must comply with other provisions of Section 23A designed to avoid transfers of low-quality assets between affiliates.  The Bank also is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits transactions with affiliates that are subject to Section 23A unless the transactions are on terms substantially the same, or at least as favorable to the Bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

The USA Patriot Act of 2001 is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The Patriot Act contains sweeping anti-money laundering and financial transparency laws which require various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act requires financial institutions to adopt policies and procedures to combat money laundering, and it grants the Secretary of the Treasury broad authority to establish regulations and impose requirements and restrictions on financial institutions’ operations.

Community Reinvestment Act

We are subject to the provisions of the Community Reinvestment Act of 1977, which requires financial institutions to meet the credit needs of their local communities, including low and moderate income communities. In accordance with the Community Reinvestment Act, the FDIC periodically assesses our record of meeting the credit needs of our local communities by assigning one of the following ratings to our performance in that regard:

· outstanding;

· satisfactory;

· needs to improve; or

· substantial noncompliance.

In addition, the FDIC will strongly consider our performance under the Community Reinvestment Act as a factor upon any application by us for any of the following:

· the establishment of a branch;

· the relocation of a main office or branch; and

· the merger or consolidation with or the acquisition of assets or assumption of liabilities of an insured depository institution.

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Capital Requirements

We must comply with the capital requirements imposed by the FDIC. Under the FDIC’s regulations, state-chartered, nonmember banks that receive the highest rating during the examination process have the following characteristics:

· no anticipated or significant current growth;

· well-diversified risk (including no undue interest rate risk exposure), excellent asset quality, high liquidity and good earnings; and

· in general, are considered strong banking organizations.

The FDIC requires banks to maintain a minimum leverage ratio of 3% of Tier 1 capital, which is common stockholders’ equity less intangible assets, identified losses and other adjustments, to average total consolidated assets. The FDIC can require banks to maintain a ratio of 100 to 200 basis points above the stated minimum, and has generally set a minimum leverage ratio of not less than 4% for most banks.

To provide measurement of capital adequacy that is more sensitive to the individual risk profiles of financial institutions, the FDIC’s risk-based capital regulations provide that, in addition to maintaining their required leverage ratio, banks are expected to maintain a level of capital commensurate with risk profiles assigned to their assets. The regulations generally require a minimum ratio of Tier 1 capital to risk-weighted assets of 4%, and a minimum ratio of total capital to risk-weighted assets of 8%, of which at least one-half must be in the form of Tier 1 capital.

Dividends

The payment of any cash dividend is subject to the Bank’s board of directors’ evaluation of its operating results, financial condition, future growth plans, general business conditions, and to tax and other relevant considerations and regulatory limitations, including our minimum capital requirements.  The Bank might not declare and pay any cash dividends, and if it were to do so, it might not continue to declare them or maintain them at the same level.  As North State Bancorp owns all of the stock of North State Bank, any dividend declared would be paid to it.

In addition, statutory and regulatory restrictions apply to the payment of cash dividends on our common stock. Under North Carolina law applicable to banks, our directors may declare a cash dividend in an amount equal to our undivided profits, as they deem appropriate, subject to the limitation that the Bank’s capital surplus is at least 50% of its paid-in capital.  Cash dividends may only be paid out of retained earnings.  We cannot pay a cash dividend at any time that we are “undercapitalized” or insolvent, or when payment of the dividend would render us insolvent. Also, a FDIC-insured bank cannot pay a cash dividend while it is in default on any assessment due the FDIC.

Insurance Assessments

The FDIC insures our customers’ deposits. Under the Federal Deposit Insurance Reform Act of 2005, as amended (the “Reform Act”), the FDIC uses a risk-based assessment system to determine the amount of a bank’s deposit insurance assessment based on an evaluation of the probability that the deposit insurance fund will incur a loss with respect to that bank. The evaluation considers risks attributable to different categories and concentrations of the bank’s assets and liabilities and other factors the FDIC considers to be relevant, including information obtained from the bank’s federal and state banking regulators.  The FDIC is responsible for maintaining the adequacy of the deposit insurance fund, and the amount paid by a bank for deposit insurance is influenced not only by the assessment of the risk it poses to the deposit insurance fund, but also by the adequacy of the insurance fund to cover the risk posed by all insured institutions.

The FDIC amended its risk-based assessment system for 2007 to implement authority granted by the Reform Act. Under the revised system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors. An institution’s assessment rate depends upon the category to which it is assigned. Risk Category I is the lowest risk category while Risk Category IV is the highest risk category.  For 2011, the Bank qualified for Risk Category II.  The actual assessment is dependent upon certain risk measures as defined in the final rule.

In an effort to restore capitalization levels and to ensure the Deposit Insurance Fund will adequately cover projected losses from future bank failures, the FDIC, in late 2008, adopted a rule that alters the way in which it differentiates for risk in the risk-based assessment system and to revise deposit insurance assessment rates, including base assessment rates.  For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by seven basis points.  These new rates ranged from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions.  Under the FDIC’s restoration plan, the FDIC established new initial base assessment rates that are subject to adjustment as described below.  Beginning April 1, 2009, the base assessment rates range from 12 to 14 basis points for Risk Category I institutions to 45 basis points for Category IV institutions.  Changes in the risk-based assessment system include increasing premiums for institutions that rely on excessive amounts of brokered deposits, including CDARS, increasing premiums for excessive use of secured liabilities, including Federal Home Loan Bank advances, and lowering premiums for smaller institutions with very high capital levels.

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In May 2009, the FDIC passed amendments to the restoration plan for the Deposit Insurance Fund.  The amendment imposed a 20 basis point emergency special assessment on insured depository institutions as of June 30, 2009.  The assessment was collected on September 30, 2009.   On March 17, 2009, the FDIC adopted changes to the Temporary Liquidity Guarantee Program or TLGP which may provide for reduction of the emergency special assessment by up to four basis points. An interim rule proposed on February 27, 2009 would also permit the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance.

In late 2009, the Board of Directors of the FDIC adopted a rule to require insured institutions to prepay their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The entire assessment is accounted for as a prepaid expense as of December 30, 2009.  For each quarter in 2011 and 2010, we have expensed the portion of the prepaid expense applicable for each quarter and will continue to charge as an expense to our earnings the portion of the applicable prepaid expense for each quarter of 2012.  The results of the special assessment and increased regular assessments will continue to have a significant impact on our results of operations for 2012 and in the future.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was signed into law. The Dodd-Frank Act imposes additional assessments and costs with respect to deposits, requiring the FDIC to impose deposit insurance assessments based on total assets rather than total deposits.  Based on rules passed pursuant to the Dodd-Frank Act, which rules became effective in April 2011, the FDIC revised the deposit insurance assessment system to base assessments on the average total consolidated assets of the institution, rather than upon deposits payable in the U.S. as was previously the case. The FDIC also adopted a comprehensive, long-range “restoration” plan for the deposit insurance fund to ensure that the ratio of the fund’s reserves to insured deposits reaches 1.35 percent by 2020, as required by the Dodd-Frank Act. Based upon updated projections for the fund, the new restoration plan would forgo the uniform 3 basis point assessment rate increase previously scheduled to go into effect on January 1, 2011, and would keep the current rate schedule in effect. The FDIC’s rule also envisions eventually building the fund’s reserve ratio to 2.0 percent. Base assessment rates would adjust downward over time as the fund reached specified reserve levels. At this time, the ultimate effect of these legislative and regulatory developments, including the new assessment rules, cannot be predicted with any certainty. FDIC insurance assessments could be further increased in the future if the FDIC finds it necessary to adequately maintain the Deposit Insurance Fund. Currently, the Banks’ assessment rate under Risk Category II is 12.98 basis points.

Insurance of an institution’s deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management of the Bank does not know of any practice, condition or violation that might lead to termination of the Bank’s deposit insurance.

The Dodd-Frank Act implements far-reaching regulatory reform. Some of the more significant implications of the Dodd-Frank Act are summarized below:

· Established centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws;

· Established the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies;

· Required financial holding companies to be well-capitalized and well managed as of July 21, 2011; bank holding companies and banks must also be both well-capitalized and well managed in order to acquire banks located outside their home state;

· Disallowed the ability of holding companies with more than $15 billion in assets to include trust preferred securities as Tier 1 capital; this provision will be applied over a three-year period beginning January 1, 2013;

· Changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;

· Eliminated the ceiling on the size of the Deposit Insurance Fund and increased the floor on the size of the Deposit Insurance Fund;

· Required implementation of corporate governance revisions, affecting areas such as executive compensation and proxy access by shareholders;

· Repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

· Amended the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer; and

· Increased the authority of the Federal Reserve to examine financial institutions including non-bank subsidiaries.

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Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact to financial institutions and consumers. Provisions in the legislation that affect the payment of interest on demand deposits are likely to increase the costs associated with deposits.

The Dodd-Frank Act instituted significant changes to the overall regulatory framework for financial institutions including our company and the Bank. Many of the specific provisions of the Act have yet to be fully implemented, and the impact on us cannot be accurately predicted until regulations are enacted. The Dodd-Frank Act will likely cause a decline in certain revenues from consumer and mortgage products that are significant to our overall financial performance, and create additional compliance costs that we will incur.

Interstate Banking and Branching

Subject to state law, federal law permits adequately capitalized and managed bank holding companies to acquire control of a bank in any state. In addition, federal law permits banks to merge with banks located in other states and allows states to adopt legislation permitting out-of-state banks to open branch offices within that state’s borders. The North Carolina Reciprocal Interstate Banking Act permits banking organizations in any state with similar reciprocal legislation to acquire North Carolina banking organizations. In addition, subject to another state having similar laws, the North Carolina Interstate Branch Banking Act:

· permits North Carolina banks and out-of-state banks to merge;

· authorizes North Carolina banks to establish or acquire branch offices in any other state; and

· permits out-of-state banks to establish or acquire branch offices in North Carolina.

Prompt Corrective Action

The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, the federal banking regulators must rate supervised institutions on a basis of five capital categories. The federal banking regulators also must take certain mandatory supervisory actions and are authorized to take all other discretionary actions with respect to institutions in the three undercapitalized categories, the severity of which will depend upon the capital category in which the institution is placed. Generally, subject to narrow exception, the Federal Deposit Insurance Corporation Improvement Act requires the primary or appropriate banking regulator to appoint a receiver or conservator for an institution that is critically undercapitalized. The federal banking agencies have specified by regulation the relevant capital level for each category.

Under the Federal Deposit Insurance Corporation Improvement Act, the FDIC adopted regulations setting forth a five-tier scheme for measuring the capital adequacy of FDIC-insured commercial banks. Under the regulations, a bank is placed in one of the following capital categories:

• Well Capitalized – a bank which has a total risk-based capital ratio of at least 10%, a Tier 1 capital ratio of at least 6%, and a Tier 1 leverage ratio of at least 5%;

• Adequately Capitalized – a bank which has a total risk-based capital ratio of at least 8%, a Tier 1 capital ratio of at least 4%, and a Tier 1 leverage ratio of at least 4%;

• Undercapitalized – a bank that has a total risk-based capital ratio of under 8%, a Tier 1 capital ratio of under 4%, or a Tier 1 leverage ratio of under 4%;

• Significantly Undercapitalized – a bank that has a total risk-based capital ratio of under 6%, a Tier 1 capital ratio of under 3%, or a Tier 1 leverage ratio of under 3%; and

• Critically Undercapitalized – a bank whose tangible equity is not greater than 2% of total tangible assets.

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The regulations permit the FDIC to downgrade a bank to the next lower category if the FDIC determines after notice and opportunity for hearing or response that the bank is in an unsafe or unsound condition or that the bank has received and not corrected a less-than-satisfactory rating for any of the categories of asset quality, management, earnings, or liquidity in its most recent examination. Supervisory actions by the appropriate federal banking regulator depend upon an institution’s classification within the five categories.

The Federal Deposit Insurance Corporation Improvement Act generally prohibits a depository institution from making any capital distribution including payment of a cash dividend if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized.

Significantly undercapitalized depository institutions might be subject to a number of requirements and restrictions including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator.

Safety and Soundness Standards

The Federal Deposit Insurance Act requires the federal bank regulatory agencies to prescribe standards relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation, and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. The federal bank regulatory agencies have adopted a set of guidelines prescribing safety and soundness standards under the Federal Deposit Insurance Corporation Improvement Act. In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by the executive officer, employee, director or principal shareholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the prompt correction action provisions of the Federal Deposit Insurance Corporation Improvement Act. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

Financial Modernization Legislation

The Gramm-Leach-Bliley Act of 1999 permits bank holding companies meeting management, capital and Community Reinvestment Act standards, and that register as a “financial holding company,” to engage in a broad range of non-banking activities, including insurance underwriting and investment banking. The Act allows insurance companies and other financial services companies to acquire banks and allows bank holding companies to acquire securities firms and mutual fund advisory companies. The Act requires appropriate safeguards if a bank holding company wishes to engage in any of these activities. The Act also contains extensive customer privacy protection provisions which require banks to adopt and implement policies and procedures for the protection of the financial privacy of their customers, including procedures that allow customers to elect that certain financial information not be disclosed to certain persons.

A bank holding company may become a financial holding company under the Gramm-Leach-Bliley Act if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve Board that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. We registered as a financial holding company in September 2007 in order to invest in Beacon Title Agency, LLC, a title insurance agency, as a means to generate non-interest income. In November 2009, we sold our interest in Beacon Title Agency, LLC and terminated our financial holding company registration.

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Regulation of North State Bancorp

As a bank holding company, we are subject to the supervision of, and to regular inspection by, the Board of Governors of the Federal Reserve System.

The Federal Reserve is authorized to adopt regulations affecting various aspects of bank holding companies.  As a bank holding company, our activities, and those of companies which we control or in which we hold more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for our subsidiaries, or any other activity which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  In making such determinations, the Federal Reserve is required to consider whether the performance of such activities by a bank holding company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition or gains in efficiency that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.

Generally, bank holding companies are required to obtain prior approval of the Federal Reserve to engage in any new activity not previously approved by the Federal Reserve or acquire more than 5% of any class of voting stock of any company.  Bank holding companies also must obtain the prior approval of the Federal Reserve before acquiring more than 5% of any class of voting stock of any bank that is not already majority-owned by the bank holding company.  Similarly, an entity seeking to acquire more than 5% of the voting securities of a bank holding company such as our company must first receive Federal Reserve approval.

Bank holding companies are required to give the Federal Reserve Board prior written notice of any purchase or redemption of outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the holding company’s consolidated net worth. The Federal Reserve Board may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, Federal Reserve Board order or directive, or any condition imposed by, or written agreement with, the Federal Reserve Board. Such notice and approval is not required for a bank holding company that would be treated as “well capitalized” under applicable regulations of the Federal Reserve Board, that has received a composite “1” or “2” rating at its most recent bank holding company inspection by the Federal Reserve Board, and that is not the subject of any unresolved supervisory issues.

Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

Bank holding companies must meet minimum capital requirements imposed by the Federal Reserve.  These capital requirements are the same as those for banks imposed by the FDIC.

Dividends

As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary, North State Bank. At present, our only sources of income are cash dividends paid by the Bank. We must pay all of our operating expenses from funds we receive from the Bank. Therefore, shareholders may receive cash dividends from us only to the extent that funds are available after payment of our operating expenses and only in the event that the board decides to declare a dividend. In addition, the Federal Reserve Board generally prohibits bank holding companies from paying cash dividends except out of operating earnings where the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition.   To date, we have retained our earnings for use in the development of our business. As a relatively young bank holding company that expects to continue to expand its operations in Wake County, and other markets in North Carolina, we might or might not pay cash dividends on our common stock in the foreseeable future.  We might not declare and pay any cash dividends, and if we were to do so, we might not continue to declare them or maintain them at the same level.  We expect that, for the foreseeable future, any cash dividends paid by the Bank to us will likely be limited to amounts needed to pay any separate expenses or to make required payments on our debt obligations, including the interest payments on our junior subordinated debt.

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Competition

The banking laws of North Carolina allow banks located in North Carolina to develop branches throughout the state.  In addition, out-of-state institutions may open branches in North Carolina as well as acquire or merge with institutions located in North Carolina.  As a result of such laws, banking in North Carolina is highly competitive.

We have six full-service banking offices located in Wake County and one full-service banking office in Wilmington, New Hanover County. These counties have numerous branches and corporate headquarters of money-center, super-regional, regional and statewide institutions, some of which have a major presence in Raleigh and Wilmington.  In our market areas, we face competition from other banks, savings and loan associations, savings banks, credit unions, finance companies and major retail stores that offer competing financial services.  Many of these competitors have greater resources, broader geographic coverage and higher lending limits than we do. We focus our efforts on selective customer groups including professional firms, professionals, churches, property management companies, non-profits and individuals who value a mutually beneficial banking relationship.  We believe our efforts in attracting and keeping relationships with our chosen customers help to provide us with a competitive advantage. As of June 30, 2011, we held 2.61% and 1.44%, respectively, of deposits at bank offices in Wake and New Hanover County.

Employees

As of December 31, 2011, we had 119 full-time equivalent employees. We believe that our future success will depend in part on our continued ability to attract, hire, and retain qualified personnel. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.

Available Information

Our web site address is www.northstatebank.com. Information on our web site is not incorporated by reference herein. We make available free of charge through our web site our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission, or SEC.

Item 1A. Risk Factors

Ownership of shares of our securities involves certain risks.  Holders of our securities and prospective investors in our securities should carefully consider the following risk factors and uncertainties described below together with all of the other information included and incorporated by reference in this report in evaluating an investment in our securities.  If any of the risks and uncertainties discussed below actually occurs, our business, financial condition and results of operations could be materially adversely affected.  In addition, other risks and uncertainties of which we are not currently aware, including those relating to the banking and financial services industries in general, or which we do not now believe are material, may cause earnings to be lower, or impair our future financial condition or results of operations.  The value or market price of our common stock or any of our other securities could decline due to any of these identified or other risks, and you could lose all or part of your investment.

Risks Related to Our Business

Our Business May Be Adversely Affected by Conditions in the Financial Markets and Economic Conditions Generally.

            Currently the United States is in a period of slow economic recovery after suffering from the effects of the prolonged recession that began in 2007 and officially declared over in June 2009. Business activity across a wide range of industries and regions remains greatly reduced compared to pre-2007 recession standards. Although there have been recent indications of increased consumer activity, local governments and many businesses are continuing to experience serious financial difficulty due to lower levels of consumer spending and the continued pressures for available liquidity in the credit markets. Unemployment has declined slightly, however, remaining significantly higher than pre-recession levels with indications of continued high levels over the next several years. Since mid-2007 the financial services industry and the securities markets generally have been, and continue to be materially and adversely affected by significant declines in the values of nearly all asset classes and by concerns of inadequate liquidity and a lack of financing for many investors.

Market conditions have also led to the failure or merger of a number of prominent financial institutions and many small banks and savings institutions. In addition, declining asset values, defaults on mortgages and consumer loans, and the lack of market and investor confidence, as well as other factors, have all combined to cause rating agencies to lower credit ratings, and to otherwise increase the cost and decrease the availability of liquidity, despite very significant declines in Federal Reserve borrowing rates and other government actions.

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 Some banks and other lenders have suffered significant losses and have become reluctant to lend, even on a secured basis, due to the increased risk of default and the impact of reduced or declining asset values on the value of collateral. The foregoing has significantly weakened the strength and liquidity of some financial institutions.  Since September 2008, the U.S. government, the Federal Reserve and other regulators have taken numerous steps to increase liquidity and to restore investor confidence, including significant investment in the equity of other banking organizations, but asset values generally have either continued to decline or remain low and access to liquidity continues to be limited.

Our financial performance generally, and in particular the ability of our borrowers to pay interest on and repay principal of outstanding loans 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 and in the United States as a whole.

Overall, during 2011, the business environment has continued to be adverse for many households and businesses in the United States. The business environment in North Carolina and the markets in which we operate has been less adverse than in the United States generally but remains weak and could deteriorate further. It is expected that the business environment in North Carolina and the United States will slowly improve as the economy recovers from the recession. However, there can be no assurance that these conditions will greatly improve in the near term. Such conditions could further adversely affect the credit quality of our loans, the value of our investment securities, and our overall results of operations and financial condition.

The FDIC Deposit Insurance assessments that we are required to pay will increase, possibly materially, in the future, which would have an adverse effect on our earnings.

As a member institution of the FDIC, we are required to pay quarterly deposit insurance premium assessments to the FDIC.  During the year ended December 31, 2011, we expensed $919,000 in deposit insurance assessments and we paid $1.3 million in 2010.  Due to the turmoil in 2008, 2009 and to a lesser extent in 2010 and 2011 in the financial system, including the failure of several unaffiliated FDIC-insured depository institutions, the deposit insurance premium assessments paid by all banks have increased.  Prior to 2009, banks paid anywhere from five basis points to 43 basis points for deposit insurance. The FDIC increased the assessment rate schedule by seven basis points (annualized) beginning on January 1, 2009. In May 2009, the FDIC passed amendments to the restoration plan for the Deposit Insurance Fund.  This amendment imposed a five basis point emergency special assessment on insured depository institutions as of June 30, 2009.  The assessment was collected on September 30, 2009.  On March 17, 2009, the FDIC adopted changes to the Temporary Liquidity Guarantee Program, or TLGP, which may provide the possibility for reduction in the emergency special assessment by up to four basis points. An interim rule proposed on February 27, 2009 would also permit the FDIC to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. The FDIC also required insured institutions to prepay on December 30, 2009 their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The entire assessment is accounted for as a prepaid expense on our balance sheet, as of December 30, 2009. For each quarter in 2011 and 2010, we have expensed the portion of the prepaid expense applicable for each quarter and will continue to charge as an expense to our earnings the portion of the applicable prepaid expense for each quarter of 2012.  The results of the special assessment and increased regular assessments will continue to have a significant impact on our results of operations for 2012 and in the future. For the quarter beginning April 1, 2011, the FDIC implemented revisions made by Dodd-Frank, including, among other changes, to redefine the FDIC assessment base used for calculating deposit insurance assessments to equal average consolidated total assets minus average tangible equity. Additional or increased assessments in the future would impact our results of operations, perhaps significantly depending on the assessment.

Our profitability depends significantly on economic conditions in our market areas.

Our success depends to a large degree on the general economic conditions in Wake and New Hanover counties and adjoining markets. As of December 31, 2011, approximately 91.4% of our total loan portfolio was secured by real estate located in Wake and New Hanover counties. The local economic conditions in these areas have a significant impact on the amount of loans that we make to our borrowers, the ability of our borrowers to repay these loans and the value of the collateral securing these loans. The recession affecting the nation as a whole began to affect North Carolina in the latter half of 2008, with decreased property values and increased loan defaults, which impacted our loan portfolio and those of other financial institutions in the state. As an example, our provision for loan losses in 2011was $6.7 million, significantly higher than the pre-recession provision of $1.3 million expensed in 2007.  In addition, we charged off, net of recoveries, an aggregate of $6.8 million in loans in 2011, approximately the same amount as in 2010, significantly higher than net charge-offs of $302,000 recorded during 2007.  If the value of real estate in our market areas were to further decline materially, a significant portion of our loan portfolio could become under collateralized despite our underwriting efforts to minimize risk, which could have a material adverse effect on us. A significant decline in general economic conditions caused by the recession, unemployment and other factors beyond our control could impact our market areas, perhaps significantly, and could negatively affect our financial condition and performance.

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Our loan loss reserves may be insufficient.

We attempt to maintain an appropriate allowance for loan losses to provide for possible losses in our loan portfolio. We periodically determine the amount of the allowance based on consideration of several factors, including:

· Historical loss rates through internal historical data;

· Evaluation of general economic factors such as unemployment, inflation and  interest rate environment;

· Regulatory examination results and asset quality rating;

· Regular reviews of loan delinquencies and overall loan portfolio quality; and

· The levels of construction, development and non-owner occupied commercial real estate lending, the amount and quality of collateral, including guarantees, securing those loans and the levels of highly leveraged transactions.

There is no precise method of predicting credit losses, however, since any estimate of loan losses is necessarily subjective and the accuracy depends on the outcome of future events. If the economy continues to deteriorate, our borrowers could be negatively impacted which could result in higher levels of charge-offs which could require us to increase our allowance for loan losses.

We make and hold in our loan portfolio a significant number of commercial real estate loans, including construction and development loans, which pose more credit and regulatory risk than other types of loans typically made by financial institutions.

As of December 31, 2011, commercial real estate loans, including construction and development loans, comprised approximately 56.2% of our loan portfolio. The amount of commercial construction and development loans in our portfolio approximately doubled between 2007 and 2009, however, by the end of 2011 these loans were below 2007 levels as we returned to our historic niche lending to our chosen customer groups while minimizing builder/developer lending activities.  Real estate values are generally affected by changes in economic conditions, fluctuations in interest rates, the availability of loans to potential purchasers, changes in tax and other laws and acts of nature.  Our concentration in commercial real estate exposes us to risk should the economy in our market areas continue to stagnate or further decline. Borrowers may not be able to make current payments on or repay commercial real estate loans and the value of the properties securing these loans may decline, which would reduce the security for these loans.  A continuation of the stagnation or a further downturn in the real estate markets where we have loans could have a material adverse effect on our business, financial condition and results of operations. Further, banks’ concentration in commercial real estate loans have become a focal point of the federal banking regulators; our concentration in these loans subjects us to adverse comment or action by our federal banking regulators, including the FDIC and the Federal Reserve.

If we experience greater loan losses than anticipated, it would have an adverse effect on our net income.

While the risk of nonpayment of loans is inherent in banking, if we experience greater nonpayment levels than we anticipate, our earnings would be adversely impacted, which could adversely affect our overall financial condition. We cannot assure you that our monitoring procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses. In addition, as a result of the rapid growth in our loan portfolio between 2007 and 2008, loan losses may be greater than management’s estimates of the appropriate level for the allowance. Our net loan charge-offs in 2011 were $6.8 million and our provision for loan losses was $6.7 million. Loan losses can cause insolvency and failure of a financial institution. In addition, future provisions for loan losses could materially and adversely affect our profitability. Any loan losses will reduce our loan loss allowance. A reduction in our loan loss allowance may require an increase in our provision for loan losses, which would reduce our earnings.

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Liquidity is essential to our business and we rely, in part, on external sources to finance a significant portion of our operations.

Liquidity is essential to our business. Our liquidity could be substantially negatively affected by our inability to attract sufficient deposits, access secured lending markets, brokered deposit markets or raise funding in the long-term or short-term capital markets. Factors that we cannot control, such as disruption of the financial markets or negative views about the financial services industry generally, could impair our ability to raise funding. In addition, our ability to raise funding could be impaired if the Federal Home Loan Bank or deposit brokers develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could develop if we suffer a decline in the level of our business activity, regulatory authorities take significant action against us, or we discover employee misconduct or illegal activity, among other things. If we were unable to raise funds using the methods described above, we would likely need to liquidate unencumbered assets, such as our investment and loan portfolios, to meet maturing liabilities. We may be unable to sell some of our assets, or we may have to sell assets at a discount from market value, either of which could adversely affect our operations.

We may not be able to maintain and manage our growth, which may adversely affect our results of operations and financial condition and the value of our common stock.

Our strategy has been to increase the size of our company by opening new offices and pursuing business relationship opportunities within our chosen niches. We grew rapidly since we began operations in 2000 through 2007. We can provide no assurance that we will continue to be successful in increasing the volume of loans and deposits at acceptable risk levels and upon acceptable terms while managing the costs and implementation risks associated with our growth strategy. As anticipated, slower loan growth during 2011 coupled with high loan charge-offs decreased loans overall by $9.1 million. Excluding $39.8 million in single-family residential mortgages originated through North State Bank Mortgage and held for investment, total loans decreased $48.9 million. We further anticipate continued slow growth in loan volume in 2012 as compared to our growth prior to 2008 due to continued sluggish economic conditions and our focus on our historic customer groups. There can be no assurance that any further expansion will be profitable or that we will continue to be able to sustain our historic rate of growth, either through internal growth or through expansion in our existing markets or into new markets, or that we will be able to maintain capital sufficient to support our continued growth. If we grow too quickly, however, and are not able to control costs and maintain asset quality, rapid growth also could adversely affect our financial performance. There are considerable costs involved in opening new banking offices.  New banking offices generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more.  Also, we have no assurance these new or any future banking offices will be successful even after they are established.

Interest rate volatility could significantly harm our business.

Our results of operations may be significantly affected by the monetary and fiscal policies of the federal government and the regulatory policies of government authorities. A significant component of our earnings is our net interest income. Net interest income is the difference between income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits and our borrowings. We may not be able to effectively manage changes in what we charge as interest on our earning assets and the expense we must pay on interest-bearing liabilities, which may significantly reduce our earnings.  The Federal Reserve has made significant changes in interest rates during the last few years, and especially during 2008.  The decline in market interest rates that occurred throughout 2008 and in particular in the fourth quarter of 2008 and the continued low rates in the years since have negatively impacted our net interest income, net interest spread, net interest margin, and overall results of operations. Since rates charged on loans often tend to react to market conditions faster than do rates paid on deposit accounts, these rate changes, especially decreasing rates, are expected to have a negative impact on our earnings until we can make appropriate adjustments in our deposit rates.  Fluctuations in interest rates are not predicable or controllable and therefore there can be no assurances of our ability to continue to maintain a consistent positive spread between the interest earned on our earning assets and the interest paid on our interest-bearing liabilities.  In addition, increases in interest rates could increase the interest we owe on our long-term debt which would have a negative effect on our results of operations.

We rely heavily on the services of key personnel.

Larry D. Barbour, our president and chief executive officer, has substantial experience with our operations and has contributed significantly to our growth since our founding. The loss of the services of Mr. Barbour or of one or more members of our executive management team may have a material adverse effect on our operations. If Mr. Barbour or other members of our executive management team were no longer employed by us, our operations and our ability to implement our growth strategy could be impaired.

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Our ability to retain and attract qualified employees is critical to the success of our business and the failure to do so may materially adversely affect our performance.

Our people are our most important resource. Retention of our employees is important to our successful operation and competition for qualified employees is intense. We may expand our banking network over the next several years, not just in our existing core market areas, but also in other community markets throughout central and eastern North Carolina and other contiguous markets. To expand into new markets successfully, we must identify and retain experienced key management members with local expertise and relationships in these markets. In order to retain and attract qualified employees, we must compensate such employees at market levels. Those levels have caused employee compensation to be our greatest noninterest expense as compensation is highly variable and moves with performance. If we are unable to continue to retain and attract qualified employees, or if compensation costs required to retain and attract employees become more expensive, our performance, including our competitive position, could be materially adversely affected.

We are subject to operational risk and an operational failure could materially adversely affect our businesses.

Operational risk refers to the risk of loss arising from inadequate or failed internal processes, people and/or systems. Operational risk also refers to the risk that external events, such as external changes (e.g., natural disasters, terrorist attacks and/or health epidemics), failures or frauds, will result in losses to our businesses.

Our business is highly dependent on our ability to process, on a daily basis, a large number of transactions and the transactions we process have become increasingly complex. We perform the functions required to operate our business either by ourselves or through agreements with third parties. We rely on the ability of our employees, our internal systems and systems at technology centers operated by third parties to process high numbers of transactions. In the event of a breakdown or improper operation of our own or our third-party’s systems or improper action by third parties or employees, we could suffer financial loss, impairment to our liquidity, a disruption of our businesses, regulatory sanctions and damage to our reputation.

In order to be profitable, we must compete successfully with other financial institutions which have greater resources and capabilities than we do.

The banking business in North Carolina in general and in Wake and New Hanover Counties in particular, in which we operate, is extremely competitive. Most of our competitors are larger and have greater resources than we do and have been in existence a longer period of time. We will have to overcome historical bank-customer relationships to attract customers away from our competition. We compete with other commercial banks, savings banks, thrifts, credit unions and securities brokerage firms.

Some of our competitors are not regulated as extensively as we are and, therefore, may have greater flexibility in competing for business. Some of these competitors are subject to similar regulation but have the advantages of larger established customer bases, higher lending limits, extensive branch networks, numerous automated teller machines, greater advertising-marketing budgets or other factors.

Our legal lending limit is determined by law and is based on our capital levels. The size of the loans that we offer to our customers may be less than the size of the loans that larger competitors are able to offer. This limit may affect our success in establishing relationships with the larger businesses in our markets.

We are subject to extensive regulation that could limit or restrict our activities.

We operate in a highly regulated industry and are subject to examination, supervision, and comprehensive regulation by the North Carolina Office of the Commissioner of Banks, the FDIC, the Federal Reserve Board and Consumer Financial Protection Bureau, or CFPB. Our compliance with these regulations is costly and restricts certain of our current and possible future activities, including, investments, loans and interest rates charged, interest rates paid on deposits, locations of offices, payment of cash dividends, and mergers and acquisitions. We must also meet regulatory capital requirements. If we fail to meet these capital and other regulatory requirements, our financial condition, liquidity, and results of operations would be materially and adversely affected. Our failure to remain “well capitalized” and “well managed” for regulatory purposes could affect customer confidence, our ability to grow, the cost of our funds and FDIC insurance, our ability, should we decide to pay cash dividends on our common stock, and our ability to make acquisitions.  Further, a “critically undercapitalized” institution (even if it has a positive net worth) may not, beginning 60 days after becoming “critically undercapitalized,” make any payment of principal or interest on subordinated debt (subject to certain limited exceptions). Accordingly, if we were to become “critically undercapitalized,” we would generally be prohibited from making payments on the subordinated notes we issued in May and July 2008.  In addition, “critically undercapitalized” institutions are subject to the appointment of a receiver or conservator with specified time frames.  The regulators have discretion to impose additional restrictions on undercapitalized, significantly undercapitalized and critically undercapitalized institutions which could restrict our operations and our ability to make payments on our subordinated notes were we to fall under any undercapitalized category.

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The Dodd-Frank Act will add to our compliance obligations and increase our cost of compliance, as well as likely adversely impact our revenues from consumer and mortgage products and could possibly adversely impact other parts of our business, financial condition and results of operations.  Many provisions of the Act are subject to rulemaking and will take effect over several years, making it difficult for us to anticipate the overall financial impact on our business. The Dodd-Frank Act of 2010 established the consumer bureau CFPB for the purpose of implementing and where applicable, enforcing Federal consumer financial law consistently for the purpose of ensuring that all consumers have access to markets for consumer financial products and services and that markets for consumer financial products and services are fair, transparent and competitive. The CFPB has no direct supervision of banks with less than $10 billion in assets; however the bureau can include examiners as part of other primary bank regulator’s examinations of financial institutions.

The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to obtain financing, attract deposits, and make loans. Many of these regulations are intended to protect depositors, the public, and the FDIC, not shareholders. In addition, the burden imposed by these regulations may place us at a competitive disadvantage compared to competitors who are larger or who are less regulated. The laws, regulations, interpretations, and enforcement policies that apply to us have been subject to significant change in recent years, sometimes retroactively applied, and may change significantly in the future.  Any future legislation or regulation enacted into law could significantly alter the current regulatory scheme. Our cost of compliance with new legislation or regulation could adversely affect our ability to operate profitably.

Any future losses or growth may require us to raise additional capital that may not be available when it is needed, or at all.

We are required by regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our capital resources will satisfy our capital requirements for the foreseeable future. We may at some point, however, need to raise additional capital to offset operating losses, if any, to support our growth, , or in response to regulatory changes. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed our ability to meet our regulatory capital requirements, absorb losses or further expand our operations through internal growth and acquisitions could be materially impaired. In addition, if we issue additional equity capital, the interests of existing shareholders would be diluted.

Declines in value in investment securities held by us could require write-downs, which would reduce our earnings.

The securities in our investment portfolio primarily consist of U.S. Government securities and obligations of U.S. Government agencies as well as government-sponsored residential mortgage-backed securities, or MBSs, where mortgages are the underlying collateral. As a result of the national downturn in real estate markets and the rising mortgage delinquency and foreclosure rates, investors are increasingly concerned about these types of securities, which have negatively impacted the prices of such securities in the marketplace.  The MBSs included in our investment portfolio are all agency-guaranteed with fixed rate mortgage securities underwritten and guaranteed by Freddie Mac (FHLMC) and Fannie Mae (FNMA) with Treasury funding commitment under the Treasury Senior Preferred Stock Purchase Agreement. We monitor the value of our investment portfolio regularly, including the ratings of securities in the portfolio and the dealer price quotes.  Based upon these and other factors, the investment portfolio may experience impairment, which could harm our earnings and financial condition. If we were to conclude there were unrealized losses which were other than temporary, we would be required under U.S. generally accepted accounting principles, or  GAAP, to reduce the carrying amount of the security to fair value and record a corresponding charge to earnings, which would also reduce our regulatory capital and negatively impact our capital ratios.  These negative impacts could significantly impair our ability to borrow funds under credit arrangements, as well as various material depository arrangements and relationships. Temporary impairments on available for sale securities also reduce our book value per share as the changes in the value reduce shareholders’ equity.  Currently, all of our available for sale securities in our investment portfolio are rated AAA by the three major rating agencies.

We are subject to security and operational risks relating to the use of our technology that could damage our reputation and business.

Security breaches in our internet banking activities could expose us to possible liability and damage our reputation.  Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information.  We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data and access to bank informational systems.  These precautions may not protect our systems from compromises or breaches of our security measures that could result in damage to our reputation and business.  Additionally, we outsource our data processing to a third party.  If our third party provider encounters difficulties or if we have difficulty in communicating with such a third party, it will significantly affect our ability to adequately process and account for customer transactions, which would significantly affect our business operations.

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Volatile and illiquid financial markets resulting from a significant event in the market may hinder our ability to increase or maintain our current liquidity position.

Financial concerns in broad based financial sectors such as mortgage banking or home building may result in a volatile and illiquid bond market and may reduce or eliminate our ability to pledge certain types of assets to increase or maintain our liquidity position.  A decline in our liquidity position may hinder our ability to grow the balance sheet through internally generated loan growth or otherwise.

Changes in the federal or state tax laws may negatively impact our financial performance.

We are subject to changes in tax law that could increase the effective tax rate payable to the state or federal government.  These changes may be retroactive to previous periods and, as a result, could negatively affect our current and future financial performance.

Changes in accounting standards or interpretation of new or existing standards could materially affect our financial results.

From time to time the Financial Accounting Standards Board, or FASB, and the SEC change accounting regulations and reporting standards that govern the preparation of our consolidated financial statements.  In addition, the FASB, the Securities and Exchange Commission, or SEC, bank regulators and our outside independent auditors may revise their previous interpretations regarding existing accounting regulations and the application of these accounting standards.  Revisions to these interpretations are beyond our control and may have a material impact on our results of operations.

Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions.

Geopolitical conditions might affect our earnings. Acts or threats of terrorism and political or military actions taken by the United States or other governments in response to terrorism, or similar activity, could adversely affect general economic or industry conditions.

Unpredictable catastrophic events could have a material adverse effect on our operations.

The occurrence of catastrophic events such as hurricanes, earthquakes, pandemic disease, floods, other severe weather, fires or other catastrophes could adversely affect our financial condition or results of operations. Unpredictable natural and other disasters could have an adverse effect on us in that such events could materially disrupt our operations or the ability or willingness of our customers to access the financial services offered by us. The incidence and severity of catastrophes are inherently unpredictable. Although we carry insurance to mitigate our exposure to certain catastrophic events, such insurance may not adequately cover our losses. These events could reduce our earnings and cause volatility in our financial results for any fiscal quarter or year and have a material adverse effect on our financial condition and results of operations.

Risks Related to Owning Our Common Stock

We have implemented anti-takeover devices that could make it more difficult for another company to acquire us, even though such an acquisition may increase shareholder value.

If we were to be acquired by another company, our shareholders may receive a premium for their shares. However, provisions in our articles of incorporation and bylaws could make it difficult for anyone to acquire us. Our articles of incorporation require a supermajority vote of two-thirds of our outstanding common stock in order to affect a sale or merger of our company that has not been approved by our board of directors. Our articles of incorporation also provide for “blank check” preferred stock, which allows our board of directors, without shareholder approval, to issue preferred shares with rights and preferences superior to those of our common stock, including superior rights on voting and to cash dividends and liquidation proceeds.  In addition, our articles of incorporation permit our board to consider constituents other than our shareholders in deciding on a merger or sale of the company.  These constituents are our employees, depositors, customers, creditors and the communities in which we conduct business.  This provision also allows the board to consider the competence, experience and integrity of any proposed acquirer as well as the prospects of success of any merger or sale proposal.  All of these provisions may make a merger or sale of our company more difficult or prevent a merger or sale altogether even if the merger or sale is supported by our shareholders and would provide them a premium for their shares.

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 Our bylaws divide the board of directors into three classes of directors serving staggered three-year terms with approximately one-third of the board of directors elected at each annual meeting of shareholders. The classification of directors makes it more difficult for shareholders to change the composition of the board of directors. As a result, at least two annual meetings of shareholders would be required for the shareholders to change a majority of the directors, whether or not a change in the board of directors would be beneficial and whether or not a majority of shareholders believe that such a change would be desirable. Consequently, a takeover attempt may prove difficult, and shareholders may not realize the highest possible price for their shares.

Our common stock is quoted on the Over-the-Counter Bulletin Board and is not quoted on a stock exchange, the trading volume is low and the sale of a substantial amount of our common stock in the public market could depress the price of our common stock.

Our common stock is not traded on a national stock exchange, such as the NASDAQ.  It is only quoted on the Over-the-Counter Bulletin Board.  Consequently, our common stock is not as liquid as most stocks traded on an exchange.  In addition, the average daily trading volume of our shares as quoted on the Over-the-Counter Bulletin Board for all trading days in 2011 on which there were trades in our stock, was approximately 561 shares, which means our stock is thinly traded. Thinly traded stock can be more volatile than stock trading on an exchange. We cannot predict the extent to which an active public market for our common stock will develop or be sustained. Since mid-2008, the stock market has experienced an unprecedented level of price and volume volatility, and market prices for the stock of many companies, including financial services companies, have experienced wide price fluctuations that have not necessarily been related to their operating performance. Therefore, our shareholders may not be able to sell their shares at the volumes, prices, or times that they desire. We cannot predict the effect, if any, that future sales of our common stock in the market, or availability of shares of our common stock for sale in the market, will have on the market price of our common stock. We therefore can give no assurance that sales of substantial amounts of our common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our ability to raise capital through sales of our common stock.

We have never paid cash dividends and may not ever pay cash dividends.

We have never paid cash dividends on our common stock and may never do so.  Consequently, any returns on an investment in our common stock in the foreseeable future will have to come from an increase in the value of the stock itself.  As noted above, the lack of an active trading market for our common stock could make it difficult to sell shares of our common stock.  The payment of cash dividends would be dependent on our operations, capital levels and needs, regulatory approval and other factors.

Our securities are not FDIC insured.

None of our securities, including our common stock, is a savings or deposit account or other obligation of North State Bank, and none is insured by the FDIC or any other governmental agency and our securities are subject to investment risk, including the possible loss of principal.

The holders of our junior subordinated debentures have rights that are senior to those of our common shareholders.

We have supported our past growth in part through the issuance of trust preferred securities from three special purpose trusts and an accompanying sale of an aggregate of $15.5 million junior subordinated debentures to these trusts. Payments of the principal and interest on the preferred securities of the trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures that we issued to the trusts are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any cash dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holder of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on the junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no cash dividends may be paid on our common stock.

Item 1B. Unresolved Staff Comments

None.

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Item 2.    Properties.

Our headquarters and our main office are located in north Raleigh, North Carolina, where we occupy approximately 22,635 square feet of office space in a stand-alone building which we own.  We have an operations center in north Raleigh that consists of approximately 9,773 square feet of office space under a lease extending through April 2017. Beginning in May 2008, we added another 1,756 square feet under lease in the same building.  We have an office in the North Hills area of Raleigh where we occupy approximately 12,000 square feet of office space under a lease extending through March 2015. We own an office in west Raleigh that consists of approximately 10,000 square feet, approximately 5,200 square feet of which we occupy and the remainder of which is under tenant lease.  We have an office in Garner, North Carolina, where we own a building that has approximately 5,000 square feet of office space.  We own an office in the Wakefield area of Raleigh, which has approximately 10,000 square feet of office space.   We have an office in Wilmington where we occupy the entire first floor, approximately 9,440 square feet of office space, in a stand-alone building under lease. This lease runs through December 31, 2022.  We moved our downtown Raleigh office in August 2010 where we lease 4,300 square feet of office space on the first floor.  This lease runs through June 2020. We continue to lease approximately 3,700 square feet of office space in downtown Raleigh which is currently unoccupied. The rent expense on the unoccupied space was reimbursed monthly by our new landlord until the lease expired in October 2011. We also lease a small office in Chapel Hill, North Carolina.

Item 3.    Legal Proceedings.

From time to time, we are party to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Although the ultimate outcome of these matters cannot be determined until final resolution of the matter, we do not believe that the resolution of any of these matters will have a material effect upon our financial condition or results of operations in any interim or annual period.

Item 4.    Mine Safety Disclosures

Not applicable.

PART II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Stock Information

Our common stock is not traded on any exchange.  Our stock is listed on the Over-the-Counter Bulletin Board under the symbol “NSBC.OB.”  Set forth below for each quarter in 2011 and 2010 is information on the high and low bid and asked prices of our common stock as reported on the Over-the-Counter Bulletin Board.

	High		Low
Fiscal Year Ended December 31, 2011
January 1 through March 31, 2011	$	4.25	$	3.70
April 1 through June 30, 2011		4.01		3.00
July 1 through September 30, 2011		3.75		3.00
October 1 through December 31, 2011		3.60		1.85
Fiscal Year Ended December 31, 2010
January 1 through March 31, 2010	$	5.00	$	3.90
April 1 through June 30, 2010		4.50		3.50
July 1 through September 30, 2010		4.40		3.58
October 1 through December 31, 2010		4.25		2.75

As of March 17, 2012, there were approximately 532 shareholders of record.   We estimate that there were approximately 950 beneficial owners on March 17, 2012.

Dividends

To date, we have not paid any cash dividends.  Our ability to pay cash dividends is dependent on the earnings of our subsidiary, North State Bank.  Pursuant to the order of the North Carolina Commissioner of Banks approving the organization of North State Bank in 2000, North State Bank could not pay cash dividends for its first three years of operation.  In the future, we expect that any earnings will be used for the development of our business as we seek to expand our operations in North Carolina.  Subject to these restrictions, the Board of Directors will consider the payment of cash dividends when it is deemed prudent to do so.  Further, our ability to declare and pay cash dividends depends upon, among other things, restrictions imposed by the reserve and capital requirements of North Carolina and federal law, our income and fiscal condition, tax considerations, and general business conditions.  Therefore, we might or might not pay cash dividends on our common stock in the foreseeable future, and it is possible we might never pay cash dividends.

16

On March 17, 2004, our trust subsidiary issued preferred securities in a private placement. On December 15, 2005 and on November 28, 2007, our second and third trust subsidiaries, respectively, issued preferred securities in a private placement.  In each instance, we, in turn, issued $5.0 million unsecured subordinated debentures to each trust to serve as the income source for the trust’s payment of interest on its preferred securities.  Pursuant to the terms of the indentures that govern our debentures, we are prohibited from paying cash dividends on our stock in the event we are in default on the terms of the debentures or the indentures.

Equity Compensation Plans

Set forth below is information on our equity compensation plans as of December 31, 2011.

Plan Category	Number of securities to be issued upon exercise of outstanding options, warrants and rights		Weighted average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans
Equity compensation plans approved by our shareholders		125,503	$	7.43		512,498
Equity compensation plans not approved by our shareholders		-		-		-
Total		125,503	$	7.43		512,498

Our equity compensation plans consist of the 2000 Stock Option Plan for Employees, the 2000 Stock Option Plan for Non-Employee Directors and the 2003 Stock Plan, all of which were approved by our shareholders.  The 2003 Stock Plan replaced the two prior plans. We do not have any equity compensation plans or arrangements that have not been approved by our shareholders.

Comparison of Cumulative Total Return

The following graph compares the cumulative total shareholder return on our common stock over the five-year period ended December 31, 2011, with the cumulative total return for the same period on the Russell 2000 Index, the SNL $500M - $1B and SNL Bank Pink Sheets Index.  The graph assumes that at the beginning of the period indicated $100 was invested in our common stock and the stock of the companies comprising the Russell 2000 Index, the SNL $500M - $1B and SNL Bank Pink Sheets Index,and that all dividends, if any, were reinvested. Prices are based on quotations for our common stock on the Over-the-Counter Bulletin Board.

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Item 6.    Selected Financial Data.

The following table sets forth selected consolidated financial information for our company as of and for the years ended December 31, 2011, 2010, 2009, 2008 and 2007.  The data has been derived from our audited consolidated financial statements.  The consolidated financial statements as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009 and the independent registered public accounting firm’s report thereon are included elsewhere in this report. The following should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Item 7 of this report.

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	As of or for the Year Ended December 31,
	2011				2010				2009				2008				2007
	(Dollars in thousands, except per share data)
Operating Data:
Total interest income	$	27,790			$	30,962			$	33,440			$	36,075			$	32,738
Total interest expense		5,323				7,488				11,846				15,817				15,439
Net interest income		22,467				23,474				21,594				20,258				17,299
Provision for loan losses		6,749				8,095				5,710				2,755				1,339
Net interest income after provision for loan losses		15,718				15,379				15,884				17,503				15,960
Noninterest income		5,089				4,476				1,168				1,226				1,121
Noninterest expense		19,069				18,036				15,137				14,809				12,033
Income before income taxes		1,738				1,819				1,915				3,920				5,048
Provision for income taxes		601				795				817				1,555				1,953
Net income	$	1,137			$	1,024			$	1,098			$	2,365			$	3,095
Per Share Data: (1)
Earnings per share - basic	$	0.15			$	0.14			$	0.15			$	0.33			$	0.45
Earnings per share - diluted		0.15				0.14				0.15				0.32				0.42
Market price:
High		4.25				5.00				8.00				14.35				21.75
Low		1.85				2.75				2.76				5.25				12.00
Close		2.70				3.51				4.25				7.00				12.75
Tangible book value		5.23				5.03				5.02				4.96				4.52
Weighted average shares outstanding:
Basic		7,427,976				7,363,618				7,179,744				7,158,545				6,917,365
Diluted		7,431,544				7,389,397				7,316,292				7,356,364				7,301,377
Selected Year-End Balance Sheet Data:
Total assets	$	632,890			$	633,865			$	679,429			$	687,581			$	547,520
Loans - held for sale		49,728				51,472				-				-				-
Loans		490,455				499,523				521,809				546,357				469,228
Allowance for loan losses		9,906				9,935				8,581				6,376				5,020
Deposits		564,439				562,748				606,888				612,678				457,310
Short-term borrowings		73				3,615				6,103				7,782				37,886
Long-term borrowings		27,246				27,269				27,290				27,311				16,332
Shareholders' equity		38,989				37,502				36,166				35,546				31,557
Selected Average Balances:
Total assets	$	635,804			$	656,006			$	695,908			$	594,532			$	472,827
Loans - held for sale		39,369				30,726				-				-				-
Loans		484,904				510,000				541,576				520,075				393,927
Total interest-earning assets		583,682				613,103				658,549				571,615				454,005
Deposits		565,373				582,154				618,242				512,855				412,125
Short-term borrowings		2,541				5,804				9,236				16,130				14,681
Long-term borrowings		27,257				27,271				27,291				26,927				11,666
Total interest-bearing liabilities		458,231				500,302				563,999				476,414				349,144
Shareholders' equity		38,193				37,896				36,974				34,526				29,219
Selected Performance Ratios:
Return on average assets		0.18	%			0.16	%			0.16	%			0.40	%			0.65	%
Return on average equity		2.98	%			2.70	%			2.97	%			6.85	%			10.59	%
Net interest spread (4)		3.60	%			3.55	%			2.98	%			2.99	%			2.79	%
Net interest margin (4)		3.85	%			3.83	%			3.28	%			3.54	%			3.81	%
Noninterest income to total revenue		18.47	%			16.01	%			5.13	%			5.71	%			6.09	%
Noninterest income to average assets		0.80	%			0.68	%			0.17	%			0.21	%			0.24	%
Noninterest expense to average assets		3.00	%			2.75	%			2.18	%			2.49	%			2.54	%
Efficiency ratio		69.20	%			64.53	%			66.50	%			66.83	%			65.33	%
Asset Quality Ratios:
Nonaccrual loans to period-end loans		4.90	%			2.30	%			3.61	%			0.93	%			0.66	%
Allowance for loan losses to period-end loans		2.02	%			1.99	%			1.64	%			1.17	%			1.07	%
Ratio of allowance for loan losses to nonaccrual loans		0.41		x		0.86		x		0.46		x		1.26		x		1.62		x
Nonperforming assets to total assets		4.25	%			2.65	%			3.26	%			1.07	%			0.57	%
Net charge-offs to average loans		1.40	%			1.32	%			0.65	%			0.27	%			0.08	%

 

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	As of or for the Year Ended December 31,
	2011			2010			2009			2008			2007
Capital Ratios (2):
Total risk-based capital		13.87	%		12.99	%		12.64	%		11.99	%		10.32	%
Tier 1 risk-based capital		10.43	%		9.64	%		9.34	%		8.85	%		9.25	%
Leverage ratio		8.37	%		8.04	%		7.31	%		7.39	%		8.50	%
Equity to assets ratio		6.16	%		5.92	%		5.32	%		5.17	%		5.76	%
Average equity to average assets		6.01	%		5.78	%		5.31	%		5.81	%		6.18	%
Other Data (3):
Number of banking offices		7			7			8			8			7
Number of full time equivalent employees		119			118			96			100			99

(1)	Adjusted for the 3-for-2 stock splits in  2007.
(2)	Capital ratios are for bank only.
(3)	Includes one loan production office for the years 2009, 2008, and 2007.
(4)	Excludes average nonaccrual loans in the calculation for the years 2011, 2010 and 2009.

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Management’s Discussion and Analysis

The following discussion and analysis is presented to assist in understanding our consolidated financial condition and results of operations for the years ended December 31, 2011 and 2010.  You should read this discussion and the related financial data in conjunction with the information set forth under Item 1A “Risk Factors,” and our audited consolidated financial statements and the related footnotes, which are included elsewhere in Item 8 in this report. Because we have no operations and our only significant business is the ownership of North State Bank, the following discussion concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, this discussion makes no distinction between our company and the Bank unless otherwise noted.

Recent Market Developments in the Banking Industry

Although recent news indicates the economy is showing signs of improvement, the effects of the prolonged recession continue to financially stress many of our customers as unemployment rates, while down, remain high compared to pre-recession levels and real estate prices on homes and commercial real estate, in some areas, have declined further while foreclosures continue to rise.

Our financial performance generally, and in particular the ability of our borrowing customers to pay interest on and repay principal of outstanding loans 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 “Asset Quality and the Allowance for Loan Losses.”

The resulting effects of the deep and prolonged recession on the real estate market and economy have negatively impacted in the past and could adversely affect in the future the credit quality of our loans and our overall results of operations and financial condition. Further, the U.S. government’s response to the recession and the financial crisis could significantly impact our operations, including the recent and potential imposition of new laws and regulations and regulatory assessments.

The FDIC required insured institutions to prepay on December 30, 2009 their estimated quarterly risk-based insurance deposit premiums for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  The assessment rate was based on the third quarter of 2009 and assumed a 5% annual growth rate in deposits each year with a three-basis point increase in assessment rates effective on January 1, 2011. The $4.9 million assessment we paid was accounted for as a prepaid expense on our balance sheet, as of December 30, 2009.  Our earnings for the year ended December 31, 2011 include the applicable portion of the prepaid expense for the period. We generally are unable to control the amount of premiums that we are required to pay for FDIC insurance.  Additional bank or financial institution failures may require payment of even higher FDIC premiums than the recently increased levels.

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In response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the U.S. Government adopted in the fourth quarter of 2008 the Emergency Economic Stabilization Act, or EESA, and authorized the Department of the Treasury to establish the Troubled Asset Relief Program, or TARP, to purchase equity stakes in a wide variety of banks and thrifts through TARP’s Capital Purchase Program, or CPP.  After careful and complete evaluation, our Board of Directors chose not to participate in the CPP. Also, the FDIC adopted the Temporary Liquidity Guarantee Program, or TLGP, as an initiative to counter the system-wide crisis in the nation’s financial sector.  We elected to participate in the TLGP, in part, through full FDIC insurance coverage of all non-interest bearing deposit transaction accounts regardless of dollar amount.   The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in August 2010, permanently sets the deposit insurance limit for banks at $250,000 which was scheduled to expire December 31, 2013. We also elected to participate in the Transaction Account Guarantee, or TAG, program which was extended through December 31, 2010.  Under TAG, customers of participating insured depository institutions were provided full coverage on qualifying transaction accounts. The rule required that interest rates on qualifying NOW accounts be reduced to .25%.   On November 9, 2010 the FDIC issued a final rule implementing Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Section 343 provides unlimited deposit insurance for noninterest-bearing transaction accounts from December 31, 2010 through December 31, 2012.  This rule is similar to the FDIC’s TAG program and replaced the TAG program when it expired at the end of 2010.  Initially, Section 343 excluded low interest bearing Negotiable Order of Withdrawal, or NOW, accounts, and Interest on Lawyers Trust Account, or IOLTA. These accounts under Section 343 would be insured under the general insurance rules up to the standard maximum insurance amount of $250,000.  During February 2011, Section 343 was modified to provide unlimited FDIC coverage to IOLTA accounts through December 31, 2012. Beginning April 1, 2011, the FDIC implemented revisions made by Dodd-Frank, including among other changes to redefine the FDIC assessment base used for calculating deposit insurance assessments to equal average consolidated total assets minus average tangible equity. We will continue to monitor and evaluate the Dodd-Frank Act and its effect on our Bank and the banking industry in general.

Description of Business

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 our bank holding company reorganization.  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 and Garner, North Carolina, one full-service banking office located in Wilmington, North Carolina and a mortgage loan office located in Chapel Hill, 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 Wealth Advisors, Inc., which offers brokerage services and wealth management. In February 2010, we acquired the operations of a Raleigh-based mortgage lender, 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. In June 2011, the Bank established North State Title, LLC which owns 67% of Title Group, LLC, a title insurance agency.

Financial Condition at December 31, 2011 and 2010

Overview

Total assets as of December 31, 2011 were $632.9 million, down slightly, $975,000, from $633.9 million as of December 31, 2010.  Overall assets remained essentially the same as the prior year-end with modest changes in the loan portfolio, investments and other assets. Our loan portfolio overall decreased $9.1 million to $490.5 million from $499.5 million as of December 31, 2010.  Our traditional commercial loan portfolio continues to decline from 2008 levels primarily due to minimal new loan demand coupled with increased market competition, higher levels of loan charge-offs and transfers to foreclosed assets.  In 2011, we added to the loan portfolio $39.8 million of single-family residential mortgage loans originated through NSB Mortgage. Excess funds of $3.7 million were invested in additional investment securities available for sale and the purchase of $10.1 million of bank owned life insurance. Overall, deposits remained essentially the same, increasing $1.7 million to $564.4 million over the prior year-end; however there was significant improvement in deposit mix. Emphasis on building core deposits provided the opportunity to reduce non-traditional funding sources and jumbo certificates of deposit throughout the year.

We continue to utilize our Federal Reserve account for our overnight excess funds. Our interest-earning deposits with banks as of December 31, 2011 included $36.0 million in excess overnight funds in our Federal Reserve account and $3.5 million held at correspondent banks compared to $42.4 million and $1.5 million, respectively, as of December 31, 2010.  Throughout the year, excess funds from our Federal Reserve account were primarily re-deployed into our held for sale mortgage loan pipeline.

Substantially all of our investments are accounted for as available for sale and are presented at their fair market value. Our available for sale investment portfolio increased $3.7 million to $12.9 million as of December 31, 2011 as proceeds from sales and maturities were re-deployed into additional securities purchases throughout the year.  As part of our investment portfolio management, we strategically sold $19.7 million of our Government-sponsored residential mortgage-backed securities for gains of $374,000 during 2011. Maturities of available for sale securities were $10.1 million during the year. Proceeds from these sales and maturities were re-deployed into $32.7 million of new Government-sponsored residential mortgage-backed security purchases. We own $250,000 in corporate bonds that are accounted for as held to maturity and are carried at book value.

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Our portfolio loans declined $9.1 million to $490.5 million as of December 31, 2011 compared to $499.5 million as of December 31, 2010.  For the same year-end periods, loans held for sale in our mortgage loan pipeline were down slightly to $49.7 million from $51.5 million.

					Increase (decrease)
	December 31, 2011		December 31, 2010		$			%
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	27,323	$	51,058	$	(23,735	)		-46.5	%
Commercial construction, all land development and other land loans		47,524		82,136		(34,612	)		-42.1	%
Residential properties		105,226		98,451		6,775			6.9	%
Residential mortgage (1)		39,829		-		39,829			-
Commercial real estate - other		228,256		221,350		6,906			3.1	%
Total real estate secured loans		448,158		452,995		(4,837	)		-1.1	%
Other non-real estate loans:
Commercial and industrial		38,435		42,884		(4,449	)		-10.4	%
Consumer and other		3,862		3,644		218			6.0	%
Total loans held for investment	$	490,455	$	499,523	$	(9,068	)		-1.8	%
Mortgage loans held for sale	$	49,728	$	51,472	$	(1,744	)		-3.4	%

(1) Single-family residential mortgages originated through NSB Mortgage held for investment.

The decline in the loan portfolio reflects a higher level of loan payoffs over new loan volume, $6.8 million of net loan charge-offs and transfers to foreclosed assets of $2.7 million.  New commercial loan demand remains slow due to the combined effects of the prolonged recession and consequential increased competition for lending opportunities among our targeted customer groups. Our loan portfolio continues to represent our largest earning asset component at 77.5% of total assets. Although new loan volume has been down since the onset of the recession, we remain committed to building and maintaining mutually beneficial relationships with our targeted customers. Ongoing communication with our target customers and obtaining a better understanding of their businesses should provide us opportunities to respond to their borrowing needs in the future as the economy recovers. To offset the slowdown in our traditional commercial loan portfolio caused by economic conditions, we began retaining a portion of our mortgage loan division originations.  As of year-end, our loan portfolio includes approximately $39.8 million of single-family residential mortgages originated through NSB Mortgage. NSB Mortgage originates single-family, residential first mortgage loans that have been approved for purchase by secondary investors and generally are sold in the secondary market.  As of December 31, 2011, mortgage loans held for sale were $49.7 million.

The allowance for loan losses was $9.9 million as of December 31, 2011 and 2010, representing 2.02% and 1.99% of loans outstanding, respectively, at each balance sheet date. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries.  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 December 31, 2011. We monitor the allowance monthly.

Our premises and equipment declined slightly to $14.2 million as of December 31, 2011 from $14.8 million as of December 31, 2010. Foreclosed assets decreased to $2.9 million from $5.3 million for the same period, reflecting $2.7 million of additional properties, sales of foreclosed properties of $3.8 million, capital expenditures on foreclosed properties of $70,000 and valuation adjustments on foreclosed properties of $1.4 million during the year ended December 31, 2011.  Additional discussion regarding foreclosed assets is included in the section “Asset Quality and the Allowance for Loan Losses.”

As of December 31, 2011, total deposits were substantially unchanged, up overall $1.7 million to $564.4 million over $562.7 million as of December 31, 2010 with marked improvement in our deposit mix as relationship driven deposits grew while non-relationship deposits were reduced.

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					Increase (decrease)
	December 31, 2011		December 31, 2010		$			%
	(Dollars in thousands)
Demand deposits	$	145,185	$	117,840	$	27,345			23.2	%
Savings, money market and NOW		264,304		250,469		13,835			5.5	%
Time less than $100,000		63,318		69,491		(6,173	)		-8.9	%
Total traditional core deposits (1)		472,807		437,800		35,007			8.0	%
Time $100,000 or greater		69,711		93,656		(23,945	)		-25.6	%
Wholesale brokered time deposits		-		-		-			-
CDARS deposits (2)		21,921		26,115		(4,194	)		-16.1	%
Internet time deposits (3)		-		5,177		(5,177	)		-100.0	%
Total deposits	$	564,439	$	562,748	$	1,691			0.3	%
Deposits funded through CommunityPLUS division:
Demand deposits	$	74,049	$	58,188	$	15,861			27.3	%
Savings, money market and NOW		114,136		89,331		24,805			27.8	%
Time deposits		62,017		52,905		9,112			17.2	%
Total CommunityPLUS deposits	$	250,202	$	200,424	$	49,778			24.8	%

(1) Excludes internet subscription service, CDARS, wholesale brokered time deposits and time deposits $100,000 or greater.

(2) CDARS - Certificate of Deposit Account Registry Service

(3) Non-brokered time deposits issued by means of an internet subscription service.

Growth in traditional core deposits provided the opportunity to eliminate $5.2 million of internet time deposits, as well as substantially reduce generally non-relationship time deposits of $100,000 or greater by $23.9 million as of year-end 2011. In addition we have continued to not utilize wholesale brokered certificates of deposit as a funding source for the past two years. Our core deposit growth is a result of our continued efforts to develop banking relationships with our targeted customer groups throughout all our markets in general and through the success of our property management division “CommunityPLUS.” As of December 31, 2011, deposits in this division represented approximately 44.3% of our total deposits, up from 35.6% as of December 31, 2010, 24.7% as of December 31, 2009 and 18.4% as of December 31, 2008.

Our “CommunityPLUS” deposit customers are within North Carolina, Texas, Maryland, South Carolina, Illinois, Colorado and New Mexico.  Deposits from this division grew $49.8 million or 24.8% to $250.2 million over the prior year-end with $15.9 million of the increase attributable to noninterest-bearing demand deposits and $24.8 million of the increase attributable to lower costing interest-bearing transaction accounts. Our ability to attract and provide specialized services required of companies within this industry has been instrumental to our improvement in deposit mix over the prior year.

As shown in the above table, traditional core deposits grew $35.0 million to $472.8 million over the prior year-end while simultaneously non-traditional and generally non-relationship funding sources decreased $33.3 million from the prior year-end. Noninterest-bearing demand deposits and low-cost interest-bearing transaction accounts increased $27.3 million and $13.8 million, respectively, to 25.7% and 46.8%, respectively, of total deposits as of December 31, 2011 compared to 20.9% and 44.5%, respectively, as of December 31, 2010.  Simultaneously, higher costing time deposits declined to 27.5% of total deposits compared to 34.6% for the prior year period. In total, our traditional core deposits, including time deposits less than $100,000, increased to $472.8 million as of year-end 2011 from $437.8 million as of year-end 2010, representing 83.8% compared to 77.8%, respectively, of our total deposits as of December 31, 2011 and December 31, 2010. As noted above, the $250.2 million of deposits provided through our “CommunityPLUS” division, dedicated to growing deposits specifically in the property management industry, was a key factor to our core deposit growth and improvement in deposit mix.

Strong core deposit growth continues to minimize our level of short-term borrowings, down to $73,000 as of December 31, 2011 from $3.6 million as of December 31, 2010.  We utilize short-term borrowings to support our balance sheet management when  short-term funds are needed. Long-term borrowings were essentially unchanged from December 31, 2010 at $27.2 million, consisting primarily of $11.0 million of subordinated notes and $15.5 million in junior subordinated debentures.

Total shareholders’ equity increased $1.5 million to $39.0 million as of December 31, 2011.  The increase was primarily provided by net income of $1.1 million.  Other comprehensive income increased shareholders’ equity by $278,000.

23

Investments

Our investment portfolio as of year-end consists of U.S. Government agency securities, including residential mortgage-backed securities, or MBSs. The MBSs consist of fixed-rate mortgage securities underwritten and guaranteed by Freddie Mac (FHLMC) and Fannie Mae (FNMA) with Treasury funding commitment under the EESA. Currently, all of our available for sale securities in our investment portfolio are rated AAA by the three major rating agencies.  We continue to have no holdings in non-agency mortgage-backed securities.   Most all of the securities held in our investment portfolio are available for sale.  In addition to economic and market conditions, our overall management strategy for our investment portfolio is determined by, among other factors, loan demand, deposit mix, liquidity and collateral needs, our interest rate risk position and the overall structure of our balance sheet.

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. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. As of December 31, 2011 our available for sale investment portfolio consisted entirely of $12.9 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. During 2011, we strategically sold $19.7 million of Government-sponsored residential mortgage-backed securities for gains of $374,000.  Also during 2011, $6.5 million of U.S. treasury notes matured along with $3.6 million in cash flows received from government-sponsored residential mortgage-backed securities. Proceeds from these sales and maturities were re-deployed throughout the year into $32.7 million in new security purchases for our available for sale portfolio. As of December 31, 2011, we own $250,000 in corporate bonds that are accounted for as held to maturity and are carried at book value.  During June 2010, $500,000 of $750,000 of the corporate bonds was transferred for collateral on a community reinvestment loan. Declines in the fair value of individual held to maturity and available for sale securities below their cost that are other than temporary would result in permanent write-downs of the individual securities to their fair value. If we do not intend to sell the security prior to recovery and it is more likely than not we 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 generally determined at the date of purchase.

The tables below present information on our investment portfolio at the dates indicated.

	As of December 31, 2011
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	12,559	$	358	$	-	$	12,917
Total securities available for sale	$	12,559	$	358	$	-	$	12,917
Securities held to maturity:
Corporate securities	$	250	$	-	$	49		201
Total securities held to maturity	$	250	$	-	$	49	$	201

	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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The amortized cost, fair value and weighted average yield of securities available for sale at December 31, 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 December 31, 2011
					Weighted
	Amortized		Fair		Average
	Cost		Value		Yield
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities
Due within one year	$	86	$	87		2.5	%
Due after one but within five years		153		164		4.6	%
Due after five but within ten years		3,860		3,930		1.8	%
Due after ten years		8,460		8,736		3.2	%
	$	12,559	$	12,917		2.8	%
Securities held to maturity:
Corporate securities
Due after five but within ten years	$	250	$	201		4.3	%
	$	250	$	201		4.3	%

Loan Portfolio

Our loan policies and procedures establish the basic guidelines governing lending operations. Generally, the guidelines address the type of loans that we seek, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. The policies are reviewed and approved at least annually by the board of directors. Responsibility for loan review, underwriting, compliance and document monitoring resides with the chief credit officer and his staff, who also, are responsible for loan processing and approval. All loans and credit lines are subject to approval procedures and amount limitations. Depending upon the loan requested, approval may be granted by the individual commercial banker, our credit administration officers or, for the largest relationships, the loan committee of our Board of Directors.  Any loan exposure in the aggregate greater than $3 million requires the approval of the loan committee.  All individual loan authorities are reviewed and approved annually by the chief credit officer, chief executive officer and the loan committee.

Our current loan portfolio consists of commercial and residential real estate loans including construction and land development, business loans and loans to individuals. Although at a lower level than recent years, our current loan portfolio includes loans provided to customers outside our established groups such as builders and developers in the residential and commercial real-estate industry. We transitioned our lending strategy beginning in late 2008 back to our original objective to lend to specific customer groups that we originally defined and set out to provide unique and competitive service choosing customers such as professional firms, professionals, property management companies, non-profits, churches and individuals seeking a mutually beneficial banking relationship. During 2011, construction and land development loans were reduced by $58.3 million as we continued our transition out of loans to builders and developers as loans were paid off, charged off or completed and moved to longer-term financing. As we continue to minimize construction and land development lending in the future, our long-term strategy is to focus on future lending opportunities by developing new and strengthening current relationships with our targeted customer groups.  To offset the slow-down in loan demand from our traditional customer groups, we began retaining a select portion of our mortgage loan division originations during 2011.

Our loan portfolio as of December 31, 2011 was $490.5 million, a decrease of $9.1 million from $499.5 million as of December 31, 2010. Excluding $39.8 million of single-family residential mortgage originations retained from NSB Mortgage, our traditional commercial loan portfolio decreased $48.9 million from the prior year-end, substantially in residential and commercial construction real estate loans. During the year 2011, our variable rate loan portfolio averaged approximately 34.3% of our total average loans, up slightly from 33.6% during 2010.  The prime interest rate remained at 3.25% throughout 2011. Although we experienced a change in our real estate loan composition during 2011, which declined overall $4.8 million from the prior year-end, the overall loan portfolio remains primarily secured by real estate at 91.4% of total loans. 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. Although indications are the economy is currently in a slow recovery, 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 of the high level of loans in these markets secured by real estate. Our New Hanover County market experienced a reduction of $5.1 million in loans from December 31, 2010, of which $2.3 million was due to loans charged off. Loans in this market area represent approximately 12.3% of total loans outstanding as of December 31, 2011.  Although recent indications are beginning to show some signs of economic improvement in both New Hanover and Wake Counties, these counties experienced significant deterioration in real estate market conditions and reduced business activity as a whole during and after the recession and may continue to struggle in the near future.

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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.

	Total Bank					New Hanover County					Wake County
	December 31, 2011					December 31, 2011					December 31, 2011
			% of					% of					% of
			Total					Total Bank					Total
	Amount		Loans			Amount		Loans			Amount		Loans
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	27,323		5.6	%	$	2,107		0.4	%	$	25,216		5.1	%
Commercial construction, all land development and land loans		47,524		9.7	%		13,727		2.8	%		33,797		6.9	%
Residential properties		105,226		21.5	%		14,135		2.9	%		91,091		18.6	%
Residential mortgage (1)		39,829		8.1	%		-		-			39,829		8.1	%
Commercial real estate - other		228,256		46.5	%		26,208		5.3	%		202,048		41.3	%
Total real estate secured loans		448,158		91.4	%		56,177		11.4	%		391,981		80.0	%
Other non-real estate loans:
Commercial and industrial		38,435		7.8	%		4,164		0.8	%		34,271		7.0	%
Consumer and other		3,862		0.8	%		520		0.1	%		3,342		0.7	%
Total loans held for investment	$	490,455		100.0	%	$	60,861		12.3	%	$	429,594		87.7	%
Single-family residential mortgages held for sale	$	49,728

(1) Single-family residential mortgages originated through NSB Mortgage held for investment.

Commercial real-estate construction and land development loans decreased approximately $34.6 million during 2011 after decreasing $33.1 million during 2010. As construction projects were paid off, charged off or completed and moved to longer-term commercial real-estate-secured loans, we essentially withdrew from new builder/developer lending to minimize our exposure in this loan segment. Other commercial real-estate secured loans increased $6.9 million over December 31, 2010. Although our concentration in commercial real estate, including commercial construction and land development, remains high at $275.8 million or 56.2% of the loan portfolio, this segment has declined $28.0 million from $303.5 million or 60.8% of the loan portfolio as of year-end 2010. Commercial loans secured by real estate are principally secured by owner-occupied buildings including professional practices, office, and church properties; and single family rental properties, residential building lots, commercially-zoned land and residential homes.  Properties securing these loans are located primarily within our markets of Wake and New Hanover County, North Carolina. As of December 31, 2011, 14.5% of our commercial real estate secured loans were located within our New Hanover County market and 85.5% located throughout our Wake County market.

 As of December 31, 2011, real-estate-secured one-to-four family construction, residential loans and home equity lines of credit, combined, represented 35.1% of the loan portfolio at $172.4 million, up $22.9 million from $149.5 million or 29.9% of the loan portfolio as of December 31, 2010.  These loans are typically secured by the primary residence of the borrower and the combined loan-to-value ratio is usually less than 90%. The 2011 increase was attributable to our decision to retain select mortgages originated through NSB Mortgage which grew to $39.8 million as of year-end 2011. These one-to-four 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 within 10 to 15 years with low to moderate loan-to-value ratios, typically less than 70% and higher credit scores. Prior to our February 2010 establishment of NSB Mortgage, we on occasion originated and retained a small number of mortgage loans in our loan portfolio.

 Non-real estate secured commercial and industrial loans declined $4.4 million to $38.4 million, representing 7.8% of the loan portfolio, from $42.9 million and 8.6% of the portfolio as of December 31, 2011 and December 31, 2010, respectively. Consumer installment and other loans were $3.9 million as of year-end 2011, up $218,000 from the prior year-end, representing less than one percent of the loan portfolio outstanding. We do not service loans for other financial institutions.  We have no foreign loans and we do not engage in lease financing or loan financing in highly leveraged transactions used for buyouts, acquisitions and recapitalizations.

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Through NSB Mortgage we originate single-family, residential first mortgage loans on a presold basis that have been approved for purchase by secondary investors and are generally sold in the secondary market.  Mortgage originations are subject to volatility due to interest rates and home sales. During the first three months of 2011, mortgage loan originations declined sharply as refinancing and loans from home sales were slow. Activity increased after the first quarter of 2011 in both refinancing activity as well as loans for home purchases.  As of December 31, 2011, mortgage loans held for sale were $49.7 million. We continue to have no exposure to subprime loans in our loan portfolio including NSB Mortgage which offers traditional single-family residential first mortgage loans underwritten at a minimum per FREDDIE MAC guidelines and are typically sold to investors within two to three weeks after closing.

The table below presents information on our loan portfolio by major category at the dates indicated.

	As of December 31,
	2011				2010				2009				2008				2007
			% of Total				% of Total				% of Total				% of Total				% of Total
	Amount		Loans		Amount		Loans		Amount		Loans		Amount		Loans		Amount		Loans
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	27,323	5.6	%	$	51,058	10.2	%	$	59,531	11.4	%	$	77,635	14.2	%	$	69,385	14.8	%
Commercial construction, all land development and other land loans		47,524	9.7	%		82,136	16.5	%		115,233	22.1	%		100,344	18.4	%	$	62,869	13.4	%
Residential properties		105,226	21.5	%		98,451	19.7	%		108,229	20.7	%		105,869	19.4	%		86,262	18.4	%
Residential mortgage (1)		39,829	8.1	%		-	-			-	-			-	-			-	-
Commercial real estate - other		228,256	46.5	%		221,350	44.3	%		188,117	36.0	%		199,037	36.4	%		190,957	40.7	%
Total real estate secured loans		448,158	91.4	%		452,995	90.7	%		471,110	90.2	%		482,885	88.4	%		409,473	87.3	%
Other non-real estate loans:
Commercial and industrial		38,435	7.8	%		42,884	8.6	%		45,713	8.8	%		57,306	10.5	%		53,052	11.3	%
Consumer and other		3,862	0.8	%		3,644	0.7	%		4,986	1.0	%		6,166	1.1	%		6,703	1.4	%
Total loans held for investment	$	490,455	100.0	%	$	499,523	100.0	%	$	521,809	100.0	%	$	546,357	100.0	%	$	469,228	100.0	%

 

The table below presents as of December 31, 2011 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of such loans, by variable and fixed rates.

	As of December 31, 2011
	Due within					Due after one					Due after
	one year					year but within 5					five years					Total
	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
	(Dollars in thousands)
Variable rate loans:
Real estate - construction	$	5,301		5.3	%	$	15,450		5.0	%	$	6,702		4.3	%	$	27,453		5.0	%
Real estate - commercial		44,779		4.1	%		25,236		4.0	%		5,530		4.1	%		75,545		4.0	%
Commercial and industrial loans		9,905		4.4	%		3,655		4.0	%		90		4.0	%		13,650		4.3	%
Installment loans		103		4.1	%		227		3.8	%		76		3.8	%		406		3.8	%
Equity lines		6,885		3.2	%		21,268		3.7	%		306		3.3	%		28,459		3.6	%
Total at variable rates		66,973		4.1	%		65,836		4.1	%		12,704		4.1	%		145,513		4.1	%
Fixed rate loans:
Real estate - construction		2,209		5.6	%		31,225		6.0	%		11,537		6.1	%		44,971		6.1	%
Real estate - residential		12,913		4.6	%		44,412		4.4	%		13,412		5.5	%		70,737		4.4	%
Real estate - commercial		45,624		6.0	%		111,725		6.2	%		13,959		6.2	%		171,308		6.1	%
Commercial and industrial loans		13,132		6.2	%		15,925		6.2	%		2,692		5.6	%		31,749		6.1	%
Installment loans		899		5.2	%		571		5.7	%		687		5.7	%		2,157		5.4	%
Total at fixed rates		74,777		5.8	%		203,858		5.8	%		42,287		5.9	%		320,922		5.7	%
Subtotal		141,750		5.0	%		269,694		5.4	%		54,991		5.5	%		466,435		5.2	%
Nonaccrual loans		24,020					-					-					24,020
Loans, gross	$	165,770				$	269,694				$	54,991				$	490,455

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The above table is based on contractual scheduled maturities.  Early repayment of loans or renewals at maturity is not considered in this table. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

Asset Quality and the Allowance for Loan Losses

We prepare our consolidated financial statements on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on a non-accrual basis.  We generally place loans on a non-accrual basis when a loan becomes 90 days past due and/or in management’s opinion the borrower may be unable to meet payments as they become due.  Amounts received on non-accrual loans generally are applied first to principal and then to interest only after all principal has been collected.  Restructured loans considered troubled debt restructurings, or TDRs, occur when for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that would not otherwise be considered, including the reduction of interest rates below a rate otherwise available to that borrower or the forgiveness of interest or principal due to the borrower’s weakened financial condition.  Interest on TDRs is accrued at the restructured rate when it is anticipated that no loss of original principal will occur.  Potential problem loans are loans that are currently performing in accordance with the original terms of the loan and are not a component of nonperforming assets but are closely monitored as a result of information regarding possible credit problems of the related borrowers. We have increased our level of review and monitoring of our real estate secured loans due to the weakened real estate market and the substantial portion of our loan portfolio consisting of real-estate secured loans.

 Our nonperforming assets as of December 31, 2011 were comprised of $13.4 million in nonaccrual loans, $10.6 million nonaccrual TDRs and foreclosed assets of $2.9 million. In addition to the nonperforming assets, there were accruing potential problem loans of $1.9 million as of December 31, 2011 and accruing TDRs of $10.7 million. As of December 31, 2010, total nonperforming assets were $16.8 million and potential problem loans were $1.2 million, accruing TDRs were $11.7 million and accruing loans past due ninety days or more were $131,000.  Concessions we have granted to customers experiencing cash flow difficulties resulting in a TDR include reduction in interest rate, extended payment terms, or forgiveness of interest. In total, nonaccrual loans were $24.0 million or 4.9% of loans as of year-end 2011, up $12.5 million from $11.5 million or 2.3% of loans as of year-end 2010.  Markets in which we operate have continued to experience reduction in business activity and slow real estate sales during 2011, which directly impacted our level of nonaccrual loans which increased throughout the year.  Our borrowers tied to the residential and commercial real estate industry have particularly been impacted as residential and commercial construction and land development loans comprise over 80% of our nonaccrual loans as of year-end 2011. Although as of December 31, 2011 our level of past due loans have declined indicating recent improvement in business activity resulting in increases in cash flow, this trend could reverse if the recovery is sluggish for an extended period or the economy experiences an additional downturn. Our level of accruing 30 to 89 days past due loans has declined throughout 2011 from $9.4 million as of year-end 2010 to $1.2 million as of year-end 2011.

The tables below presents for the dates indicated information regarding our non-performing assets.

	As of December 31,
	2011				2010				2009				2008				2007
	(Dollars in thousands)
Nonaccrual loans	$	13,436			$	10,972			$	17,009			$	5,057			$	3,103
Troubled debt restructured nonaccrual loans		10,584				520				1,839				-				-
Total nonaccrual loans		24,020				11,492				18,848				5,057				3,103
Foreclosed assets		2,851				5,296				3,271				2,276				-
Total nonperforming assets	$	26,871			$	16,788			$	22,119			$	7,333			$	3,103
Accruing loans past due 90 days or more	$	-			$	131			$	200			$	-			$	492
Troubled debt restructured accruing loans	$	10,703			$	11,741				-				-				-
Potential problem loans	$	1,912			$	1,184			$	1,433			$	3,494			$	327
Allowance for loan losses	$	9,906			$	9,935			$	8,581			$	6,376			$	5,020
Nonaccrual loans to period end loans		4.90	%			2.30	%			3.61	%			0.93	%			0.66	%
Allowance for loan losses to period end loans		2.02	%			1.99	%			1.64	%			1.17	%			1.07	%
Nonperforming assets to total assets		4.25	%			2.65	%			3.26	%			1.07	%			0.57	%
Ratio of allowance for loan losses to nonaccrual loans (x)		0.41		x		0.86		x		0.46		x		1.26		x		1.62		x

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	As of December 31,
	2011		2010		2009		2008		2007
	(Dollars in thousands)
Nonaccrual loans by major category:
Real estate secured loans:
Residential construction	$	9,007	$	4,056	$	7,696	$	3,910	$	133
Commercial construction, all land development and land loans		10,252		2,875		6,788		313		-
Residential properties		2,447		2,697		1,738		16		-
Residential mortgage (1)		-		-		-		-		-
Commercial real estate - other		1,850		255		2,152		480		1,958
Total real estate secured loans		23,556		9,883		18,374		4,719		2,091
Other non-real estate loans:
Commercial and industrial		464		1,598		438		288		1,012
Consumer and other		-		11		36		50		-
Total nonaccrual loans	$	24,020	$	11,492	$	18,848	$	5,057	$	3,103
Foreclosed assets by major category:
Residential construction	$	-	$	813	$	1,303	$	-	$	-
Commercial construction, all land development and land loans		711		1,484		344		210		-
Residential properties		841		1,131		-		-		-
Commercial real estate - other		1,299		1,868		1,624		2,066		-
Total foreclosed assets	$	2,851	$	5,296	$	3,271	$	2,276	$	-

(1) Single-family residential mortgages originated through NSB Mortgage held for investment.

As of December 31, 2011, 98.1% of our nonaccrual loans were real-estate secured with 44.6% represented within our New Hanover County market. Real-estate secured residential and commercial construction and land development loans comprised 80.2% of nonaccrual loans with 38.2% represented in New Hanover County and 42.0% represented in our Wake County market. Non-real estate commercial and industrial and consumer loans comprised less than 2% of nonaccrual loans. In total, $10.7 million or 44.6% of the $24.0 million nonaccrual loans as of December 31, 2011 were in our New Hanover County market area with the remaining $13.3 million or 55.4% represented throughout our offices in Wake County.

An aggregate of $14.8 million of the nonaccrual loans as of December 31, 2011 is attributable to seven borrowers for various residential and commercial construction and land development loans, of which $8.4 million are located in our New Hanover County market area. The average loan exposure for these borrowers is approximately $2.1 million with the largest exposure to any one borrower included in our nonaccrual loans at $4.5 million. Each specific loan in these customer relationships was analyzed for impairment and our management concluded specific impairment reserves aggregating $1.5 million on these loans were necessary in addition to $1.1 million of partial charge-offs. Our impairment analysis of the remaining $9.2 million of nonaccrual loans resulted in additional impairment reserves of $582,000 in addition to life to date charge-offs of $7.4 million. Due to financial difficulties of the borrowers, included in the above nonaccrual loans are 14 various residential and commercial real estate TDR loans totaling $10.6 million where concessionary modifications were granted to the borrowers that otherwise would not have been granted.  See Note D to our consolidated financial statements for additional detail regarding loans, nonaccrual loans, TDRs and credit quality.

29

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 December 31, 2011.

	Nonaccrual Loan Composition as of December 31, 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 secured loans:
Residential construction	$	9,007		37.5	%	$	2,021		8.4	%	$	6,986		29.1	%
Commercial construction, all land development and land loans		10,252		42.7	%		7,150		29.8	%		3,102		12.9	%
Residential properties		2,447		10.2	%		314		1.3	%		2,133		8.9	%
Commercial real estate - other		1,850		7.7	%		1,224		5.1	%		626		2.6	%
Total real estate secured loans		23,556		98.1	%		10,709		44.6	%		12,847		53.5	%
Other non-real estate loans:
Commercial and industrial		464		1.9	%		-		-			464		1.9	%
Consumer and other		-		-			-		-			-		-
		464		1.9	%		-		-			464		1.9	%
Total loans held for investment	$	24,020		100.0	%	$	10,709		44.6	%	$	13,311		55.4	%

As of December 31, 2011, we also identified and evaluated $1.9 million of potential problem loans, primarily as a result of information regarding possible, although not probable, credit problems of the related borrowers.  These loans were performing in accordance with the original terms of the loans as of December 31, 2011.  Management considered these loans in assessing the adequacy of our allowance for loan losses. These loans were represented by five individual loans and borrowers with an average loan balance under $400,000 and substantially secured by real estate. The $1.2 million potential problem loans as of year-end 2010 have been charged off or are included in our nonaccrual loans as of year-end 2011 with the exception of one loan for $24,000 which we continue to monitor as a potential problem loan.

Foreclosed assets declined $2.4 million from year-end 2010 to $2.9 million as of December 31, 2011. The properties acquired through foreclosure represented as of year-end 2011 approximately $711,000 commercial construction and land development properties, approximately $841,000 one-to-four family residential properties and approximately $1.3 million represented commercial real estate properties. The largest of these properties in terms of dollar value is approximately $518,000 in commercial real estate located in our New Hanover County market area.

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, the initial recorded value may be reduced by additional valuation allowances which are charged to earnings if the estimated fair value of the property less estimated costs to sell declines below the initial recorded value.  Approximately 65.3% of the foreclosed real estate properties as of December 31, 2011 were in the New Hanover market area. Due to the continued declines in real estate in this and our Wake County market as well, the foreclosed properties underwent periodic revaluations throughout 2011, resulting in additional valuation losses on various foreclosed properties of $1.4 million.  These write-downs are in our consolidated statements of operations included in this report. During the year 2011, sales of 26 foreclosed properties with a carrying value of approximately $3.8 million were sold resulting in additional net losses of approximately $60,000. Fair value of foreclosed assets is based on recent appraisals or discounted collateral values for properties for which recent appraisals were not available. After review of these foreclosed assets, we believe the fair values, less estimated costs to sell, equal their current carrying value as of December 31, 2011. Foreclosed assets as of December 31, 2010 totaled $5.3 million with the largest dollar value approximately $623,000 in commercial real estate located in our New Hanover County market.

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The following table presents for the dates indicated, information about foreclosed assets.

	For the years ended December 31,
	2011			2010			2009			2008		2007
	(Dollars in thousands)
Foreclosed assets beginning of  year	$	5,296		$	3,271		$	2,276		$	-	$	-
Loans transferred to foreclosed assets		2,713			9,183			2,376			2,276		-
Expenditures on foreclosed assets		70			169			135			-		-
Proceeds from sales, net of selling expenses		(3,784	)		(5,996	)		(781	)		-		-
Net loss on sale of foreclosed assets		(60	)		(183	)		(38	)		-		-
		4,235			6,444			3,968			2,276		-
Valuation allowance for foreclosed assets		(1,384	)		(1,148	)		(697	)		-		-
Foreclosed assets end of year	$	2,851		$	5,296		$	3,271		$	2,276	$	-

Our allowance for loan losses is maintained at a level that our management considers adequate to provide for probable loan losses based on our assessment of various factors affecting our loan portfolio, including a review of problem loans, business conditions and loss experience and an overall evaluation of the quality of the underlying collateral.

Management evaluates the adequacy of our allowance for loan losses on a monthly basis.  The evaluation of the allowance for loan losses is divided into two components. A general reserve allowance is calculated on the current loan portfolio for the homogeneous or general pool of loans and a separate reserve is determined for loans that are individually analyzed for impairment. In evaluating the allowance for loan losses, we prepare on a monthly basis an analysis of our current homogeneous group of loans using historical loss rates, other identified factors, and data from our loan portfolio.  We also utilize a factor methodology to apply a charge-off rate to our performing loan portfolio. This methodology utilizes three components to determine factors to apply to this section of our loan loss model which is subdivided by seven classes of loans. The factors applied to the seven loan classes include charge-off history, current impairments and management’s judgment.  The charge-off history review results in a determination by loan category of where our charge-offs have historically occurred which allows us to determine a risk factor for the historical charge-off risk of each given loan category. We also review the current impairments by loan category as we consider these as a predictor of future charge-offs to determine a risk factor for each given loan category.  Management’s determination of the charge-off history and current impairments determines a range of factors for each loan category.  The range of factors correspond to the inherit risk of the loan type. For example, construction and land development loans typically have significantly higher risk factors than other loan types with less risk exposure. The general reserve was reduced as of December 31, 2011 compared to the prior year-end due to the $58.3 million decline in such loans from the prior year-end. The individual ranges from charge-off history and current impairments are added together to arrive at a final factor range. Management then uses its judgment based on internal and external items to determine the final factor. An estimated reserve allowance for the performing portfolio is then calculated from the final risk factors for each category of loan applied to the five-year weighted average annual charge-off rate.  In addition, management applies a specific risk factor to our portfolio of originated single-family mortgage loans based on the high quality of the borrowers and the conservative structure of these loans as compared to other one-to-four family loans in the portfolio.

We also have identified seven qualitative factors that are considered indicators of changes in the level of risk of loss inherent in our loan portfolio. These factors  consider the risk of payment performance, overall portfolio quality (utilizing weighted average risk rating), general economic factors such as unemployment,  delinquency and charge-off rates, regulatory examination results, interest rate environment, levels of highly leveraged transactions (as defined in Section 365.2 of the FDIC regulations) and levels of construction, development and non-owner occupied commercial real estate lending.  These factors are examined for trends and the risk that they represent to our loan portfolio.  Each of these factors is assigned a level of risk and this risk factor is applied to only the general pool of loans to calculate the appropriate allowance.

In addition to the general reserve, all loans risk rated “substandard”, “doubtful” and “loss” are reviewed for probable losses and if management determines a loan to be impaired it is removed from its homogeneous group and individually analyzed for impairment.  A loan is considered impaired when it is considered probable that all amounts due under the contractual terms of the loan will not be collected when due. We have established policies and procedures for identifying loans that should be considered for impairment such as credit risk reviews, a watch list, delinquency monitoring and specific market, product and concentration reviews. Other groups of loans may be selected for impairment review. For loans determined to be impaired, the specific allowance is based on the present value of expected cash flows or the fair value of the collateral or the loan’s observable market price.  Using the combined data gathered during this monthly evaluation process, the model calculates an estimated reserve amount.

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

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The table below provides information on our allocation of our allowance for loan losses among various loan categories for the dates presented.

	As of December 31,
	2011				2010				2009				2008				2007
			% of Total				% of Total				% of Total				% of Total				% of Total
	Amount		Loans (1)		Amount		Loans (1)		Amount		Loans (1)		Amount		Loans (1)		Amount (2)		Loans (1)
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	1,497	5.6	%	$	1,475	10.2	%	$	1,753	11.4	%	$	852	14.2	%	$	742	14.8	%
Commercial construction, all land development and other land loans		2,783	9.7	%		2,269	16.5	%		2,604	22.1	%		1,101	18.4	%		672	13.4	%
Residential properties		1,608	21.5	%		2,339	19.7	%		1,276	20.7	%		1,019	19.4	%		922	18.4	%
Residential mortgage (3)		40	8.1	%		-	-			-	-			-	-			-	-
Commercial real estate - other		3,179	46.5	%		2,464	44.3	%		2,023	36.1	%		1,320	36.4	%		2,045	40.7	%
Total real estate secured loans		9,107	91.4	%		8,547	90.7	%		7,656	90.3	%		4,292	88.4	%		4,381	87.3	%
Commercial and industrial		763	7.8	%		1,354	8.6	%		870	8.7	%		2,005	10.5	%		567	11.3	%
Consumer and other		36	0.8	%		34	0.7	%		55	1.0	%		79	1.1	%		72	1.4	%
Total loans held for investment	$	9,906	100.0	%	$	9,935	100.0	%	$	8,581	100.0	%	$	6,376	100.0	%	$	5,020	100.0	%

(1) Represents the percent of total loans outstanding by loan type.  This allowance for loan and lease losses is calculated on an approximate basis and is not necessarily indicative of future losses.

(2) Represents an estimated allocation of the allowance for loan losses based on loans outstanding in each category as a percent of total loans outstanding.

(3) Single-family residential mortgages originated through NSB Mortgage held for investment.

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The table below presents information regarding the changes in our allowance for loan losses as of or for the years indicated.

	As of or for the Year Ended December 31,
	2011			2010			2009			2008			2007
	(Dollars in thousands)
Loan outstanding at the end of the year	$	490,455		$	499,523		$	521,809		$	546,357		$	469,228
Average loans outstanding during the year	$	484,904		$	510,000		$	541,576		$	520,075		$	393,927
Allowance for loan losses at beginning of year	$	9,935		$	8,581		$	6,376		$	5,020		$	3,983
Provision for loan losses		6,749			8,095			5,710			2,755			1,339
		16,684			16,676			12,086			7,775			5,322
Loans charged off:
Real estate secured loans:
Residential construction		1,015			3,152			852			75			-
Commercial construction, all land development and land loans		1,875			1,293			842			48			-
Residential properties		2,316			765			896			148			-
Commercial real estate - other		1,755			364			178			45			-
Total real estate secured loans		6,961			5,574			2,768			316			-
Non-real estate loans:
Commercial and industrial		531			1,224			636			805			299
Consumer and other		56			34			106			284			3
Total charge-offs		7,548			6,832			3,510			1,405			302
Recoveries of loans previously charged off:
Real estate secured loans:
Residential construction		30			34			-			-			-
Commercial construction, all land development and land loans		55			34			-			-			-
Residential properties		538			7			1			-			-
Commercial real estate - other		16			10			-			-			-
Total real estate secured loans		639			85			1			-			-
Non-real estate loans:
Commercial and industrial		97			6			4			6			-
Consumer and other		34			-			-			-			-
Total recoveries		770			91			5			6			-
Net charge-offs		6,778			6,741			3,505			1,399			302
Allowance for loan losses at end of year	$	9,906		$	9,935		$	8,581		$	6,376		$	5,020
Ratios:
Nonaccrual loans to period end loans		4.90	%		2.30	%		3.61	%		0.93	%		0.66	%
Allowance for loan losses to period end loans		2.02	%		1.99	%		1.64	%		1.17	%		1.07	%
Net charge-offs as a percent of average loans		1.40	%		1.32	%		0.65	%		0.27	%		0.08	%

As of December 31, 2011, the allowance for loan losses remained at $9.9 million, the same as the prior year-end although there are changes in the reserve composition.  The charge-off factor applied to the general reserve was significantly higher than the previous year-end, however the general reserve as of December 31, 2011 decreased overall by approximately $633,000 due a combination of factors including the $58.3 million decline in higher risk construction and land development loans, the $9.1 million decline in overall loans outstanding as well as improvements in other risk factors, such as improved past due loans.  Risk factors are examined for trends and the risk that they represent to our loan portfolio and are modified with changes in general economic trends such as payment performance, loan delinquency and charge-off rates, unemployment and changes in risk ratings. Including reserves for potential problem loans, the specific reserve allocated to impaired loans was up approximately $599,000 over the prior year-end due to a higher level of impaired loans. We provided for probable losses through specific impairment reserve allowances of $2.1 million on $12.3 million of impaired loans as of year-end 2011 and additional reserves of $451,000 on impaired performing TDRs. The level of the allowance relative to gross loans increased to 2.02% from 1.99% primarily due to the $9.1 million decline in loans outstanding from the prior year-end.

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Our loan loss allowance is increased throughout the year by provisions charged to operations and reduced by loans charged off, net of recoveries.  Net charge-offs were $6.8 million for the year-ended December 31, 2011, slightly above the prior year $6.7 million of net charge-offs. Approximately $6.3 million or 93.3% of the loans charged off during 2011 were for real estate secured loans of which residential and commercial construction and land development loans represented $2.8 million or 41.4%. Approximately 30% of net charge-offs for real estate secured loans were within our New Hanover County market and the remaining 63.3% within our Wake County market areas. Loans securing one-to-four family residential properties comprised 26.2% and commercial real estate loans comprised 25.7% of the 2011 net charge-offs.  Additional information regarding our allowance for loan losses and loan loss experience is presented in Notes D and E to our consolidated financial statements included in this report. If the economy continues to languish or deteriorate, our borrowers could be negatively impacted which could result in continued increased charge-offs and non-performing loans, which could require us to increase our allowance for loan losses.

The following table is a summary of our net charge-offs as of December 31, 2011 by major category for the total Bank, New Hanover County and Wake County.

	Net Charge-off Composition for the Year Ended December 31 , 2011
	Total Bank					New Hanover County						Wake County
			% of						% of					% of
			Net			Total Bank Net								Total Bank Net
	Amount		Charge-offs			Amount			Charge-offs			Amount		Charge-offs
						(Dollars in thousands)
Real estate secured loans:
Residential construction	$	985		14.5	%	$	(13	)		-0.2	%	$	998		14.7	%
Commercial construction, all land development and land loans		1,820		26.9	%		1,042			15.4	%		778		11.5	%
Residential properties		1,778		26.2	%		110			1.6	%		1,668		24.6	%
Commercial real estate - other		1,739		25.7	%		892			13.2	%		847		12.5	%
Total real estate secured loans		6,322		93.3	%		2,031			30.0	%		4,291		63.3	%
Other non-real estate loans:
Commercial and industrial		434		6.4	%		245			3.6	%		189		2.8	%
Consumer and other		22		0.3	%		(3	)		0.0	%		25		0.4	%
Total loans held for investment	$	6,778		100.0	%	$	2,273			33.5	%	$	4,505		66.5	%

Deposits

Our deposits are the primary source of our funds for our portfolio loans, mortgage pipeline and investments. Our deposit strategy is to obtain deposit funds from within our market areas through relationship banking wherein we do not lend to a customer without a deposit relationship. We believe that the great majority of our deposits are from individuals and entities located in our market areas with an increasing concentration of deposits from our “CommunityPLUS” division where we have deposit relationships with property management customers located within our market areas as well as a number of states outside our North Carolina markets.  As of December 31, 2011, deposits from our “CommunityPLUS” division were approximately $250.2 million representing 44.3% of our total deposits, up $138.2 million from approximately $112 million or 18.4% of total deposits when we created this division in early February 2009.  Our continued success in building and retaining deposit relationships has provided the opportunity to eliminate non-traditional funding sources such as internet deposits, wholesale brokered time deposits as well as significantly reduce generally non-relationship and more volatile time deposits over $100,000.

In total, our deposits at year-end were up $1.7 million over $562.7 million as of December 31, 2010, however we continued to experience notable improvement in deposit composition throughout the year.  Traditional core deposits generally include noninterest-bearing demand deposits, interest-bearing transaction accounts, which are savings, money market and interest checking accounts as well as relationship-oriented certificates of deposit less than $100,000. These relationship-oriented core deposits increased $35.0 million to $472.8 million from $437.8 million as of December 31, 2010, representing 83.8% compared to 77.8%, respectively, of our total deposits as of December 31, 2011 and 2010.

A key factor to our success in core deposit growth is attributable to “CommunityPLUS”. Non-interest bearing deposits increased $27.3 million, or 23.2%, to $145.2 million as of December 31, 2011 with $15.9 million of the increase provided by “CommunityPLUS”.  Interest-bearing transaction deposits grew to $264.3 million as of December 31, 2011, an increase of $13.8 million or 5.5% over the prior year-end. “CommunityPLUS” interest-bearing transaction deposits grew $24.8 million during this period. “CommunityPLUS” demand and interest-bearing transactions accounts contributed $40.7 million of the $41.2 million increase in these lower costing deposit funds. Overall, noninterest-bearing demand deposits have increased to 25.7% of total deposits as of December 31, 2011 compared to 20.9% and 17.3% as of December 31, 2010 and 2009.  Similarly, interest-bearing transaction deposits increased to 46.8% of total deposits compared to 44.5% and 38.3% for the same corresponding periods.

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As we achieved success from our efforts to grow lower-costing transaction deposits, we intentionally, for the most part, reduced time deposits, particularly generally higher costing time deposits over $100,000. Overall time deposits decreased $39.5 million to $155.0 million and 27.5% of total deposits as of December 31, 2011 compared to $194.4 million or 34.6% of total deposits as of December 31, 2010 and 44.4% of total deposits as of year-end 2009.  We strategically began reducing or eliminating non-relationship time deposits in 2010 for profitability and/or non-relationship, single-service customer accounts.  Generally more volatile time deposits over $100,000 decreased $23.9 million or 25.6% to $69.7 million as of December 31, 2011. Time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program decreased $4.2 million to $21.9 million as of December 3, 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. Traditional core time deposits less than $100,000 declined $6.2 million to $63.3 million. Although overall time deposits were substantially reduced, we did experience growth in core time deposits through our “CommunityPLUS” division which grew to approximately $62.0 million, an increase of $9.1 million over the prior year-end. Our strong core deposit growth continues to provide support for our balance sheet management without utilizing non-core deposit funding sources such as wholesale brokered certificates of deposit and internet time deposits from our deposit funds.

The table below presents information on our average deposits for the years presented.

	For the Year Ended December 31,
	2011					2010					2009
	Average		Average			Average		Average			Average		Average
	Amount		Rate			Amount		Rate			Amount		Rate
	(Dollars in thousands)
Savings, money market and NOW	$	257,032		0.63	%	$	242,359		0.85	%	$	229,016		0.90	%
Time deposits over $100,000		80,592		1.82	%		110,325		2.20	%		141,852		2.98	%
Other time deposits		90,809		1.43	%		114,543		1.79	%		156,604		2.83	%
Total interest-bearing deposits		428,433		1.03	%		467,227		1.40	%		527,472		2.04	%
Noninterest-bearing deposits		136,940					114,927					90,770
Total deposits	$	565,373		0.78	%	$	582,154		1.12	%	$	618,242		1.74	%

 

The following table presents the amounts and maturities of deposits with balances of $100,000 or more:

As of December 31, 2011
(Dollars in thousands)
Remaining maturity:
Less than three months	$	21,898
Three to six months		13,375
Six to twelve months		23,193
Over twelve months		33,166
Total	$	91,632

Borrowings

Securities sold under agreements to repurchase generally mature within one to four days from the transaction date and are collateralized by U.S. Government Agency obligations.  These repurchase agreements are classified as short-term borrowings in the accompanying balance sheets.  As of December, 31, 2011, we had available lines of credit totaling approximately $169.8 million with various financial institutions and the Federal Reserve for borrowing on a short-term basis.  These lines are subject to annual renewals with varying interest rates.  We had no outstanding borrowings on these lines of credit as of December 31, 2011 except a long-term FHLB advance for approximately $781,000 maturing in 2025.

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The following table sets forth certain information regarding our short-term borrowings for the periods indicated.

	For the Year Ended December 31,
	2011			2010			2009
	(Dollars in thousands)
Short-term borrowings:
Repurchase agreements and federal funds purchased:
Balance outstanding at end of period	$	73		$	3,615		$	6,103
Maximum amount outstanding at any month end during the period		5,097			7,444			16,754
Average balance outstanding		2,541			5,804			9,236
Weighted-average interest rate during the period		0.08	%		0.33	%		0.36	%
Weighted-average interest rate at end of period		0.09	%		0.11	%		0.36	%

Long-term trust preferred securities and related junior subordinated debentures outstanding as well as subordinated notes are included in long-term borrowings in the accompanying balance sheets.  Long-term borrowings as of December 31, 2010 are as follows:

	As of December 31,
	2011		2010
	(Dollars in thousands)
Long-term borrowings:
FHLB advances	$	781	$	804
Subordinated debentures		11,000		11,000
Junior subordinated debentures		15,465		15,465
	$	27,246	$	27,269

Results of Operations For the Years Ended December 31, 2011 and 2010

Overview. Net income for the year ended December 31, 2011 continues to be lower than pre-recession levels due to the longevity of the recession, slow recovery and the resultant effects on real estate and business activity in the markets we serve. Net income was $1.1 million compared to $1.0 million for the year ended December 31, 2010, an increase of $113,000 or 11.0%. Diluted net income per share of common stock was $0.15 in 2011 compared to $0.14 in 2010. Compared to pre-recession levels, earnings are down due to higher provision for loan losses, costs related to foreclosed assets and lower interest income resulting from slow new loan volume, loan charge-offs and nonaccrual loans.  Improvements in earnings for the year 2011 over 2010 are primarily attributable to a decrease in loan loss provision and additional fee income from our mortgage division. Mortgage income generated from our mortgage division increased over the prior year due to a higher volume of originations as well as a full year of operations compared to approximately 10 months in the prior year. We have also continued several cost savings initiatives such as the temporary suspension of the company’s 401(k) match, the elimination of incentive bonuses and merit increases for the year and other cost savings in general. We anticipate we will re-instate 401k matching contributions and other compensation benefits for employees during 2012. For the year ended 2011, return on average assets increased to 0.18% from 0.16% while return on average equity was 2.98% compared to 2.70% for 2010.

Net Interest Income. Interest income for the year ended December 31, 2011 was down $3.2 million or 10.2% over the prior year while interest expense was down $2.2 million or 28.9% resulting in an overall net decrease in net interest income of $1.0 million. The decline in net interest income is primarily a result of lower loan volume, our highest yielding asset.  Beneficial changes to our deposit mix with a corresponding decrease in interest expense helped to partially offset the decline in interest income.

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 year ended December 31, 2011 was $27.8 million compared to $31.0 million for the prior year, a decrease of $3.2 million. The reduction in interest income is primarily due to a $32.9 million decrease in average performing loan volume, our highest yielding asset. The decline in average loan volume effectively reduced interest income by approximately $1.8 million while the $8.6 million increase in average mortgage loans held for sale provided additional interest income of approximately $388,000.  All other interest-earning assets declined overall by an average of $5.2 million, reducing interest income approximately $260,000. In summary, the overall net decrease of $29.4 million in average interest-earning assets decreased interest income approximately $1.7 million while lower yields on these assets reduced interest income approximately $1.5 million.  In addition, interest income not recognized due to loans on nonaccrual status during the year was approximately $1.3 million compared to $875,000 for the prior year as loans on nonaccrual status averaged approximately $23.1 million and $15.3 million, respectively for the years 2011 and 2010.

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Our strategic improvement in deposit mix resulting from the successful building of our core deposits and subsequent repricing to lower costing products were the key factors for the overall decrease in deposit interest expense. Deposit interest expense decreased to $4.4 million for the year ended December 31, 2011 compared to $6.5 million for the prior year. Average time deposits decreased $53.5 million over the prior year. These higher-costing deposits were replaced with lower costing interest checking, money market and noninterest-bearing demand deposits which grew an average of $36.7 million, of which $22.0 million were noninterest-bearing demand deposits. Overall the $38.8 million decrease in interest bearing deposits reduced interest expense by approximately $872,000 while repricing to lower rates, reduced deposit interest expense by approximately  $1.3 million. Changes to short-term and long-term borrowings were insignificant.

The yield on our earning assets averaged 4.76% during 2011 compared to 5.05% during 2010.  During the same period, the cost of our interest-bearing liabilities averaged 1.16% compared to 1.50%.  Overall our net interest margin, excluding average nonaccrual loans, increased two basis points to 3.85% during 2011 compared to 3.83% during 2010.

Provision for Loan Losses. The provision for loan losses decreased $1.3 million or 16.6% to $6.7 million for the year ended December 31, 2011.  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 loan loss provision corresponded to net overall positive changes to our general reserve which more than offset higher reserves for impaired loans.  The general reserve was reduced due to improvements in loan composition, specifically, a significant reduction in higher risk construction and land development loans,  an overall decline in loan volume, and improvements in certain risk factors such as a lower level of past due loans.. The general reserve was increased due to an increase in historical charge-off factor applied to the general loan portfolio. Overall positive changes to the general reserve more than offset the increase in impaired reserves resulting in an overall decrease in loan loss provision compared to the prior year.  Net charge-offs were up slightly over the prior year at $6.8 million or 1.40% of average loans for the year ended December 31, 2011 compared to $6.7 million or 1.32% of average loans for the prior year. The allowance for loan losses remained at $9.9 million for year-end 2011 and 2010, representing 2.02% and 1.99%, respectively, of loans outstanding.  See “Asset Quality and the Allowance For Loan Losses” above for additional discussion.

Non-interest Income.For the year ended December 31, 2011, non-interest income increased $613,000 or 13.7% over the prior year. Included in non-interest income for 2011 and 2010 are security gains from our available for sale portfolio of $374,000 and $741,000, respectively.  Excluding securities gains, noninterest income grew $980,000 primarily due to additional fee income generated from our mortgage division. Fees generated from mortgage operations were $3.5 million, up $872,000 resulting from a higher volume of mortgage loan originations over the prior year for refinances due to lower interest rates as well as home purchases.  Another key factor was that our mortgage division began operations in February 2010 whereas fees for 2011were earned over the entire year. We anticipate fees from our mortgage division will continue to be a key source of income in the future. Fees from annuity sales and other fees generated from our wealth management services division provided $406,000 in non-interest income, just under the $439,000 generated in the prior year period. We restructured, and hired a new wealth management director for our wealth management services division during the second quarter of 2010.  Although these fees are down slightly over the prior year, the income produced is at higher levels than prior to the restructure of the division and we expect income to improve as the economy recovers. Our purchase of $10.0 million of bank owned life insurance in August 2011 provided additional noninterest income of $146,000 for the year. As a percentage of average assets, non-interest income increased to 0.80% for the year 2011 compared to 0.68% for the year 2010.

Non-interest Expense.Non-interest expense includes salaries and benefits paid to employees, occupancy and equipment expenses and all other operating costs. Total non-interest expense for the year ended December 31, 2011 increased $1.0 million or 5.7% to $19.1 million from $18.0 million for the prior year period. The increase is primarily attributable to additional personnel costs attributable to our mortgage division. We continued expense reducing initiatives during 2011 which began in early 2009 in an effort to partially offset unexpected asset quality and related costs due to the economic environment. As planned, we re-instated fees paid to our corporate board early in 2011 which had been suspended for the past two years and anticipate re-instating 401k matching contributions,  and  compensation initiatives in the coming year as asset quality levels begin to improve.

Salaries and other personnel expense, our largest expense category, grew $1.0 million to $9.4 million for the year ended December 31, 2011, an increase of 12.5% over the prior year.  Over half or approximately $583,000 of the increase was attributable to our mortgage division due to the high level of mortgage loan activity and corresponding higher personnel costs through commissions paid, additional costs for support personnel within the division as well as 12 months of personnel expense compared to approximately 10 months in 2010. Lower new commercial loan demand also contributed indirectly to an increase in personnel expense due to fewer deferred origination costs, contributing approximately $162,000 to the increase in personnel cost. Other changes contributing to the increase in personnel costs include the addition of a regional market executive position early in 2011 as well as other compensation and personnel costs throughout the organization. We continued to temporarily suspend 401k matching benefits, incentive bonuses as well as merit increases as part of the cost savings initiatives we began in 2009. As a percentage of average assets, personnel expense increased to 1.49% for the year 2011 compared to 1.28% for the year 2010.

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Occupancy and equipment costs as well as other noninterest expense remained substantially unchanged over the prior year at $2.7 million and $6.9 million, respectively. Key operating costs and changes from the prior year include foreclosed asset costs, FDIC insurance, data processing costs, director fees and professional fees. Subsequent to foreclosure, valuations are periodically performed on the properties. Revaluations of foreclosed properties during 2011 resulted in additional valuation losses of $1.4 million compared to $1.1 million for the prior year, an increase of $236,000.  Additional losses on sales of such properties were $60,000 compared to losses of $183,000 for the prior year and general costs to maintain foreclosed properties net of rental income received were down $82,000 over the prior year due to sales of properties during the year. As a percent of average assets, net foreclosed asset costs were 0.25% for the year ended December 31, 2011 compared to 0.24% for the prior year period. FDIC insurance premiums were $919,000, down $427,000 from the prior year due to changes in the calculation of the insurance assessment from deposit based to asset based. 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 such as generated by our “CommunityPLUS” division. In total, outsourced data processing fees were unchanged at $1.5 million over the prior year, however the 2011 outsourced services costs are net of a $326,000 refund received during 2011 from our outsourced software service provider related to services for our “CommunityPLUS” division. Professional fees were down $106,000 over the prior year primarily due to professional fees related to our mortgage acquisition in the prior year and employment contracts. Director fees were up $149,000 over the prior year due to the reinstatement of corporate board fees after a two year suspension. There were no other significant changes in other noninterest expenses. Including net costs related to foreclosed assets, our non-interest expense as a percent of average assets was 3.00% for the year ended December 31, 2011 compared to 2.75% for the prior year.

Income Taxes. We recorded $601,000 in income tax expense for the year ended December 31, 2011 and $795,000 for the year ended December 31, 2010.  Income tax expense as a percentage of pretax income was 34.6% for 2011 and 43.7% for 2010. The effective tax rate was lower in 2011 due to additional permanent tax differences, primarily income from bank owned life insurance, than the previous year. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

Results of Operations For the Years Ended December 31, 2010 and 2009

Overview. Net income for the year ended December 31, 2010 was $1.0 million compared to $1.1 million for the year ended December 31, 2009, a decrease of $74,000 or 6.7%. Diluted net income per share of common stock was $0.14 in 2010 compared to $0.15 in 2009. The decrease in earnings can be directly attributed to a higher provision for loan losses and increases in expenses related to foreclosed assets.  The increase in loan loss provision was a result of increased loan charge-offs, additional reserves on impaired loans and increases in risk factors to the loan portfolio in general.  Additional foreclosed properties and continued deterioration in real-estate prices resulted in higher operating expenses related to foreclosed properties as well as additional write-downs on re-valuations and losses on sales of foreclosed properties during the year. The overall decrease in earnings was minimized through favorable changes in deposit mix, mortgage income generated from our new mortgage division and the continuation of several cost savings initiatives such as the temporary suspension to our company’s 401(k) match, fees to our corporate board members, the elimination of incentive bonuses and merit increases for the year and other cost savings in general. For the year ended 2010, return on average assets remained at 0.16% while return on average equity declined to 2.70% from 2.97% for 2009.

Net Interest Income. Interest income for the year ended December 31, 2010 decreased $2.5 million or 7.4% over the prior year period while for the same period interest expense decreased $4.4 million or 36.8% resulting in an increase of $1.9 million in net interest income for the year.  Net interest income was $23.5 million for the year ended December 31, 2010 compared to $21.6 million for the year ended December 31, 2009, up 8.7%. Our focus on developing and maintaining our core deposit relationships while simultaneously reducing non-core deposits brought beneficial changes to our deposit mix with a corresponding decrease in interest expense. The favorable change in deposit mix was the primary factor for the increase in net interest income coupled with the redeployment of lower yielding interest-earning deposits into higher yielding mortgage loans held for sale.

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 year ended December 31, 2010 was $31.0 million compared to $33.4 million for the prior year, a decrease of $2.5 million. The overall decrease in interest income over the prior year was attributable to a decrease in volume of our average-earning assets, primarily loans, lower yields as well as the effect of a higher level of average nonaccrual loans over the prior year.  Our loan portfolio, our highest yielding asset, declined $33.8 million on average from 2009, effectively reducing interest income by approximately $2.0 million.  Lower loan yields effectively decreased interest income by approximately $1.0 million.  In addition a higher average of nonaccrual loans resulted in additional lost interest income of approximately $171,000 over the prior year.  Mortgage loans held for sale averaged $30.7 million for the year 2010 providing additional income of $1.5 million, offsetting declines in other lower-yielding interest-earning assets including investments and certificates of deposits with banks. The yield on mortgage loans held for sale averaged 4.79% compared to 2.94%,  and 0.89%, respectively, for available for sale investments and other interest-earning deposits and certificates of deposit.

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Our intentional change in deposit mix and repricing of time deposits at lower rates were the primary factors for the overall decrease in interest expense. Interest expense for the year ended December 31, 2010 was $7.5 million compared to $11.8 million for the prior year, a $4.4 million decrease. Average time deposits decreased $73.6 million from the previous year 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 $37.5 million, of which $24.2 million were in non-interest-bearing demand deposits. The decrease in average time deposits decreased interest expense by approximately $1.8 million while lower interest rates as a result of repricing reduced total interest expense by approximately $2.4 million. Interest expense on average short-term and long-term borrowings decreased $14,000 and $157,000, respectively, over the prior year due substantially to lower interest rates on these borrowings.

The yield on our earning assets averaged 5.05% during 2010 compared to 5.08% during 2009.  During the same period, the cost of our interest-bearing liabilities averaged 1.50% compared to 2.10%.  Overall our net interest margin, excluding average nonaccrual loans, increased 55 basis points to 3.83% during 2010 compared to 3.28% during 2009.

Provision for Loan Losses. The provision for loan losses increased $2.4 million or 41.8% to $8.1 million for the year ended December 31, 2010, compared with $5.7 million for the prior year.  Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for year 2010 is principally in response to higher charge-offs, additional reserves for impaired loans and overall increases to risk factors to the general reserve. Net charge-offs increased to $6.7 million or 1.32% of average loans for the year ended December 31, 2010 compared to $3.5 million or .65% of average loans the year ended December 31, 2009. The allowance for loan losses was $9.9 million as of December 31, 2010 and $8.6 million as of December 31, 2009, representing 1.99% and 1.64%, respectively, of loans outstanding as of December 31, 2010 and 2009.  See “Asset Quality and the Allowance For Loan Losses” above for more detail.

Non-interest Income.For the year ended December 31, 2010, non-interest income increased $3.3 million or over 283% over the prior year primarily due to fee income from our new mortgage division. Fees from mortgage operations were $2.6 million for the year ended 2010 resulting from a high volume of mortgage loan refinances due to lower interest rates.  Included in non-interest income for 2010 and 2009 are security gains from our available for sale portfolio of $741,000 and $464,000, respectively.  During 2009, non-interest income includes the loss from the write-off of our stock investment in our lead correspondent bank of $134,000. Fees from annuity sales and other fees generated from our wealth management services division provided $439,000 in non-interest income, up $323,000 or 277.0% over the prior year period. We restructured, and hired a new wealth management director for our wealth management services division during the second quarter of 2010 and expect fees generated from this division as well as fees from our new mortgage division to be key sources of noninterest income in the future. Service charges and fees on deposit accounts and merchant and other loan fees were $402,000 and $114,000, respectively, for 2010 compared to $432,000 and $136,000, respectively for 2009. As a percentage of average assets, non-interest income increased to0.68% for the year 2010 compared to 0.17% for the year 2009.

Non-interest Expense.Non-interest expense includes salaries and benefits paid to employees, occupancy and equipment expenses and all other operating costs. Total non-interest expense for the year ended December 31, 2010 increased $2.9 million or 19.2% to $18.0 million from $15.1 million for the prior year period. The increase is primarily attributable to substantially higher net costs related to foreclosed assets, up $780,000, over the prior year period as well as additional personnel costs attributable to our new mortgage division. We continued expense reducing initiatives during 2010 which began in early 2009 in an effort to partially offset unexpected expenses, particularly higher asset quality related costs due to the current and anticipated economic environment. We plan to re-instate fees paid to our corporate board early in 2011 which had been suspended for the past two years. Presently, other than corporate board fees, we do not anticipate re-instatement of other  cost saving initiatives such as incentive bonuses and merit increases or 401k matching contributions in the near future until our asset quality related expenses return to historically low levels.

Salaries and other personnel expense represent our largest expense category at $8.4 million for the year ended December 31, 2010, up $2.0 million or 30.6% from $6.4 million for the year ended December 31, 2009.  Approximately $1.9 million of the increase was attributable to our new mortgage division. A high level of mortgage loan refinancing activity throughout the year generated increased personnel costs through 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.  Significantly higher fee income resulted in higher commission expense, up approximately $230,000 over the prior year. We continued to temporarily suspend 401k matching benefits, incentive bonuses as well as merit increases as part of the cost savings initiatives we began in 2009.  Expense for 401k matching contributions decreased $108,000 from the prior year as these benefits were not suspended until May 2009. As a percentage of average assets, personnel expense increased to 1.28% for the year 2010 compared to 0.92% for the year 2009.

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Occupancy and equipment costs remained substantially unchanged increasing $16,000 to $2.8 million for the year ended December 31, 2010 from the same period last year. Other non-interest expenses increased $913,000 or 15.3% over the prior year period primarily due to increased expenses related to foreclosed assets. Subsequent to foreclosure, valuations are periodically performed on the properties. Due to continued downturn in the New Hanover County and increasingly in the Wake County real estate markets, revaluations of foreclosed properties resulted in valuation losses of $1.1 million for the year ended December 31, 2010, up $451,000 or 64.7% over the prior year.  In addition to the valuation write-downs, net losses on sales of foreclosed assets for the period were $183,000 compared to $38,000 for the prior year. General costs on foreclosed properties net of rental income received were $256,000, up $184,000 or 255.6% over 2009 due to a higher number of foreclosed properties maintained during the year.  As a percent of average assets, net foreclosed asset costs were 0.24% for the year ended December 31, 2010 compared to 0.12% for the prior year period. FDIC insurance premiums were down $420,000 for 2010 from the prior year.  The decrease is due to a lower deposit base as well as the inclusion in the prior year period of an emergency special assessment levied against all banks in June 2009 in addition to a higher base assessment. Additional discussion regarding increased insurance assessments is presented in Item 1. Business “Supervision and Regulation-Insurance Assessments.” 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 $266,000 over the prior year, primarily due to outsourced software services to our customers of our “CommunityPLUS” division. Professional fees were up $59,000 over the prior year for legal, audit and tax services and shareholder communications due primarily to higher annual meeting expense, the acquisition of our new mortgage loan division and employment contracts. There were no other significant changes in other noninterest expenses. Including additional net costs related to foreclosed assets and additional personnel expense as a result of our new mortgage division, our non-interest expense as a percent of average assets was 2.75% for the year ended December 31, 2010 compared to 2.18% for the prior year.

Income Taxes. We recorded $795,000 in income tax expense for the year ended December 31, 2010 and $817,000 for the year ended December 31, 2009.  Income tax expense as a percentage of pretax income was 43.7% for 2010 and 42.7% for 2009. The effective tax rate was higher in 2010 primarily due to fewer permanent tax differences compared to the prior year. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

Net Interest Income

Like most financial institutions, the primary component of our earnings is net interest income.  Net interest income is the difference between interest income, principally from loan and investment securities portfolios, and interest expense, principally on customer deposits and borrowings.  Changes in net interest income result from changes in volume, spread and margin.  For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of non-interest-bearing liabilities.  The following table sets forth, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Non-accrual loans are excluded in determining average loans outstanding.  Accretion of net deferred loan fees is included in interest income in the table below.

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Average Balances and Net Interest Income Analysis

	Year Ended December 31, 2011							Year Ended December 31, 2010							Year Ended December 31, 2009
	Average				Average			Average				Average			Average				Average
	Balance		Interest		Rate			Balance		Interest		Rate			Balance		Interest		Rate
	(Dollars in thoursands)
Interest-earning assets:
Loans (1)	$	461,849	$	25,429		5.51	%	$	494,706	$	28,288		5.72	%	$	528,476	$	31,257		5.91	%
Loans held for sale		39,369		1,647		4.18	%		30,726		1,472		4.79	%		-		-		-
Investment securities available for sale		18,844		530		2.81	%		19,970		587		2.94	%		25,725		1,113		4.33	%
Investment securities held to maturity		250		11		4.40	%		420		16		3.81	%		750		38		5.07	%
Other interest-earning assets		63,370		173		0.27	%		67,281		599		0.89	%		103,598		1,032		1.00	%
Total interest-earning assets		583,682		27,790		4.76	%		613,103		30,962		5.05	%		658,549		33,440		5.08	%
Other assets		52,122							42,903							37,359
Total assets	$	635,804						$	656,006						$	695,908
Interest-bearing liabilities:
Deposits:
Savings, money market and NOW	$	257,032		1,630		0.63	%	$	242,359		2,066		0.85	%	$	229,016		2,062		0.90	%
Time deposits over $100,000		80,592		1,469		1.82	%		110,325		2,431		2.20	%		141,852		4,234		2.98	%
Other time deposits		90,809		1,300		1.43	%		114,543		2,051		1.79	%		156,604		4,439		2.83	%
Borrowings:
Short-term borrowings		2,541		2		0.08	%		5,804		19		0.33	%		9,236		33		0.36	%
Long-term borrowings		27,257		922		3.38	%		27,271		921		3.38	%		27,291		1,078		3.95	%
Total interest-bearing liabilities		458,231		5,323		1.16	%		500,302		7,488		1.50	%		563,999		11,846		2.10	%
Noninterest-bearing deposits		136,940							114,927							90,770
Other liabilities		2,440							2,881							4,165
Shareholders' equity		38,193							37,896							36,974
Total liabilities and shareholders' equity	$	635,804						$	656,006						$	695,908
Net interest income and interest rate spread			$	22,467		3.60	%			$	23,474		3.55	%			$	21,594		2.98	%
Net interest margin						3.85	%						3.83	%						3.28	%
Ratio of average interest-earning assets to average interest-bearing liabilities						127.38	%						122.55	%						116.76	%
Net interest margin including nonaccrual loans						3.70	%						3.74	%						3.22	%

(1) Nonaccrual loans are excluded from loan amounts.

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Rate/Volume Analysis

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities.  The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns).  The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

	Year Ended December 31, 2011 vs. 2010									Year Ended December 31, 2010 vs. 2009
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
	(Dollars in thousands)
Interest income:
Loans	$	(1,844	)	$	(1,015	)	$	(2,859	)	$	(1,964	)	$	(1,005	)	$	(2,969	)
Loans held for sale		388			(213	)		175			1,472			-			1,472
Investment securities available for sale		(32	)		(25	)		(57	)		(209	)		(317	)		(526	)
Investment securities held to maturity		(7	)		2			(5	)		(15	)		(7	)		(22	)
Other interest-earning assets		(221	)		(205	)		(426	)		(393	)		(40	)		(433	)
Total interest income		(1,716	)		(1,456	)		(3,172	)		(1,109	)		(1,369	)		(2,478	)
Interest expense:
Deposits:
Savings, money market and NOW		109			(545	)		(436	)		114			(110	)		4
Time deposits over $100,000		(599	)		(363	)		(962	)		(818	)		(985	)		(1,803	)
Other time deposits		(382	)		(369	)		(751	)		(973	)		(1,415	)		(2,388	)
Borrowings:
Short-term borrowings		(7	)		(10	)		(17	)		(12	)		(2	)		(14	)
Long-term borrowings		(1	)		2			1			(1	)		(156	)		(157	)
Total interest expense		(880	)		(1,285	)		(2,165	)		(1,690	)		(2,668	)		(4,358	)
Net interest income increase (decrease)	$	(836	)	$	(171	)	$	(1,007	)	$	581		$	1,299		$	1,880

Liquidity

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, Federal funds sold, investment securities and loans classified as held for sale) comprised $112.3 million or 17.7% and $110.7 million or 17.5%, respectively, of our total assets as of December 31, 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 December 31, 2011, we had pledged specific collateral for potential borrowing of up to $146.0 million from the “discount window.” As another source of short-term borrowings, we also utilize securities sold under agreements to repurchase.  As of December 31, 2011, our short-term borrowings consisted of securities sold under agreements to repurchase of $73,000. As of December 31, 2011, overnight excess funds of $36.0 million were invested in our account at the Federal Reserve.

Total deposits were $564.4 million and $562.7 million, respectively, as of December 31, 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 27.5% and 34.6%, respectively, of total deposits as of December 31, 2011 and December 31, 2010. Time deposits of $100,000 or more represented 16.2% and 17.6%, respectively, of our total deposits as of December 31, 2011 and December 31, 2010.  As of December 31, 2011, our funds did not include any wholesale brokered certificates of deposit or internet deposits.  Under FDIC regulations governing brokered deposits, well capitalized institutions are not subject to brokered deposit limitations. To be categorized as well capitalized, the Bank must maintain a minimum ratio of total risk-based capital of 10.0% among other ratios. As of December 31, 2011, the Bank was “well capitalized” with a total risk-based capital ratio of 13.87%. Deposits generated through an internet subscription service of $5.2 million as of year-end 2010 were intentionally eliminated by the end of the first quarter of 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 December 31, 2011 is adequate to meet our operating needs.

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Asset/Liability Management

Our results of operations depend substantially on our net interest income.  Like most financial institutions, our interest income and cost of funds are affected by general economic conditions and by competition in the marketplace.

The purpose of asset/liability management is to provide stable net interest income growth by protecting our earnings from undue interest rate risk, which arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk, and capital adequacy.  We maintain, and have complied with, our Board approved asset/liability management policy that provides guidelines for controlling exposure to interest rate risk by utilizing the following ratios and trend analysis:  liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities.  Our policy is to control the exposure of our earnings to changing interest rates by generally endeavoring to maintain a position within a narrow range around an “earnings neutral position,” which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest rate changes.

When suitable lending opportunities are not sufficient to utilize available funds, we have generally invested such funds in securities, primarily securities issued by governmental agencies and mortgage-backed securities.  The securities portfolio contributes to our earnings and plays an important part in our overall interest rate management.  However, management of the securities portfolio alone cannot balance overall interest rate risk.  The securities portfolio must be used in combination with other asset/liability techniques to actively manage the balance sheet.  The primary objectives in our overall management of our securities portfolio are safety, liquidity, yield, asset/liability management, which is also known as interest rate risk, and investing in securities that can be pledged for public deposits.

In reviewing our needs with regard to proper management of our asset/liability program, we estimate our future needs, taking into consideration historical periods of high loan demand and low deposit balances, estimated loan and deposit increases (due to increased demand through marketing), and forecasted interest rate changes.

The analysis of an institution’s interest rate gap, which is the difference between the repricing of interest-earning assets and interest-bearing liabilities during a given period of time, is a standard tool for the measurement of exposure to interest rate risk. We currently utilize a process of net interest income simulation where we project future balance sheet levels, interest rates, and noninterest income and noninterest expenses.   These projections are then shocked with changes in interest rates to capture any interest rate risk within the base case projections. Beginning in 2009, we began to incorporate Economic Value of Equity, or EVE, as a component of asset/liability management.  EVE analysis provides insight into the trends of our Bank’s earning capacity and utilizes a process of determining the present net value of our cash flows. The following table sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding at December 31, 2011, which is projected to reprice or mature in each of the future time periods shown. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. Money market deposit accounts and negotiable order of withdrawal or other transaction accounts are assumed to be subject to immediate repricing and depositor availability and have been placed in the shortest period. In making the gap computations, none of the assumptions made regarding prepayment rates and deposit drop off rates have been used for any interest-earning assets or interest-bearing liabilities. In addition, the table does not reflect scheduled principal payments that will be received throughout the lives of the loans. The interest rate sensitivity of our assets and liabilities illustrated in the following table would vary substantially if different assumptions were used or if actual experience differs from that indicated by such assumptions.

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	Terms to Repricing as of December 31, 2011
	3 Months			Over 3 Months			Total Within			Over 12
	or Less			to 12 Months			12 Months			Months			Total
	(Dollars in thousands)
Interest-earning assets:
Loans available for sale	$	49,728		$	-		$	49,728		$	-		$	49,728
Loans		181,994			57,300			239,294			251,161			490,455
Investment securities available for sale		1,314			4,712			6,026			6,891			12,917
Investment securities held to maturity		250			-			250			-			250
Other earning assets		39,547			-			39,547			1,073			40,620
Total interest-earning assets	$	272,833		$	62,012		$	334,845		$	259,125		$	593,970
Percent of total interest-earning assets		45.93	%		10.44	%		56.37	%		43.63	%		100.00	%
Cumulative percent of total interest-earning assets		45.93	%		56.37	%		56.37	%		100.00	%		100.00	%
Interest-bearing liabilities:
Deposits:
Savings, money market, and NOW	$	264,304		$	-		$	264,304		$	-		$	264,304
Time deposits		36,721			69,170			105,891			49,059			154,950
Borrowings:
Short-term borrowings		73			-			73			-			73
Long-term borrowings		26,464			-			26,464			782			27,246
Total interest-bearing liabilities	$	327,562		$	69,170		$	396,732		$	49,841		$	446,573
Percent of total interest-bearing liabilities		73.35	%		15.49	%		88.84	%		11.16	%		100.00	%
Cumulative percent of total interest-bearing liabilities		73.35	%		88.84	%		88.84	%		100.00	%		100.00	%
Interest sensitivity gap	$	(54,729	)	$	(7,158	)	$	(61,887	)	$	209,284		$	147,397
Cumulative interest sensitivity gap		(54,729	)		(61,887	)		(61,887	)		147,397			147,397
Cumulative interest sensitivity gap as a percent of total interest-earning assets		-9.21	%		-10.42	%		-10.42	%		24.82	%		24.82	%
Cumulative ratio of interest-sensitive assets to interest-sensitive liabilities		83.29	%		84.40	%		84.40	%		133.01	%		133.01	%

Capital

A significant measure of the strength of a financial institution is its capital base.  Federal bank regulators have classified capital into the following components:  (1) Tier I capital, which includes common shareholders’ equity (excluding accumulated other comprehensive income) and qualifying preferred equity, and (2) Tier II capital, which includes a portion of the allowance for loan losses, certain qualifying long-term debt and preferred stock that does not qualify as Tier I capital.  Minimum capital levels are regulated by risk-based capital adequacy guidelines, which require a financial institution to maintain capital as a percentage of its risk-adjusted assets, which are the institution’s assets and certain off-balance sheet items adjusted for predefined credit risk factors.  A financial institution is required to maintain, at a minimum, Tier I capital as a percentage of risk-adjusted assets of 4.0% and combined Tier I and Tier II capital as a percentage of risk-adjusted assets of 8.0%.  In addition to the risk-based guidelines, federal regulations require a financial institution to maintain a minimum leverage ratio (Tier I capital as a percentage of tangible assets) of 4.0%. Our equity to assets ratio was 6.16% and 5.92%, respectively, as of December 31, 2011 and December 31, 2010. 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 for the Bank. As the following table indicates, as of December 31, 2011, we exceeded our regulatory capital requirements for both the Company and Bank.

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	North State Bancorp									North State Bank
	As of December 31, 2011									As of December 31, 2011
				Minimum			Well-Capitalized						Minimum			Well-Capitalized
	Actual			Requirement			Requirement			Actual			Requirement			Requirement
	Ratio			Ratio			Ratio			Ratio			Ratio			Ratio
Total risk-based capital ratio		14.08	%		8.00	%		10.00	%		13.87	%		8.00	%		10.00	%
Tier I risk-based capital ratio		10.12	%		4.00	%		6.00	%		10.43	%		4.00	%		6.00	%
Tier I leverage ratio		8.12	%		4.00	%		5.00	%		8.37	%		4.00	%		5.00	%

In March 2004, we established a trust, North State Statutory Trust I, which sold $5.2 million of its preferred and common securities in a pooled private placement and in turn used these funds to purchase $5.2 million of junior subordinated debentures issued by us.  In December 2005, we established a second trust, North State Statutory Trust II, which sold $5.2 million of its preferred and common securities in a pooled private placement and in turn used these funds to purchase $5.2 million of junior subordinated debentures issued by us. In November 2007, we established a third trust, North State Statutory Trust III, which sold $5.2 million of its preferred and common securities in a pooled private placement and in turn used these funds to purchase $5.2 million of junior subordinated debentures issued by us.

Our trust preferred securities presently qualify as Tier 1 regulatory capital subject to a limit of 25% of total core capital elements and are reported in Federal Reserve regulatory reports as a minority interest in a consolidated subsidiary.  Accounting pronouncements require the Trusts to be deconsolidated from our financial statements.  In March 2005, the Board of Governors of the Federal Reserve adopted a rule affecting the inclusion of trust preferred securities in Tier 1 capital.  Effective March 31, 2011, the Federal Reserve rule limits the aggregate amount of restricted core capital elements, including trust preferred securities that can be included in Tier 1 capital to not more than 25% of total core capital elements, net of goodwill, less any associated tax liability.  The new rule also limits the aggregate amount of restricted core capital elements (including trust preferred securities), term subordinated debt and limited life preferred stock that can be included in Tier II capital to 50% of Tier 1 capital.  The new rules, effective March 31, 2011, had a minimal effect on our calculation of Tier I capital and we expect the effect to remain minimal.  There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier 1 capital for regulatory capital purposes in these same amounts or at all.  In the event of a disallowance, there would be a reduction in our consolidated Tier 1 and leverage capital ratios.

On May 13, 2008, the Bank issued $9.8 million and on July 1, 2008 an additional $1.2 million of floating-rate subordinated notes due June 30, 2018.  The Bank may redeem some or all of the notes at any time beginning on June 30, 2013 at a price equal to 100% of the principal amount of the notes redeemed plus accrued but unpaid interest to the redemption date. The subordinated notes are included in long-term borrowings and currently qualify 100% as Tier II capital. To qualify for Tier II capital, the subordinated notes must have an original weighted average maturity of at least five years. The subordinated notes are discounted 20% each year after the remaining maturity is five years or less until maturity. The portion of qualifying subordinated notes that remains after discounting, if any, is limited to 50% of Tier I capital. The subordinated notes are scheduled for discounting 20% per year beginning July1, 2013 when the notes will have a remaining maturity of less than five years.

We intend that our company and our bank remain “well-capitalized” for regulatory purposes.  To do so, we might need additional capital in the future due to any impact on our operations or financial condition caused by the recent prolonged recession and continuing economic stagnation and any governmental and regulatory responses to the recession, greater than expected future growth, or other reasons.  If necessary, we will consider all viable alternatives for raising capital including additional issuances of trust preferred securities. After careful and complete evaluation, in November 2008 we chose not to participate in the Capital Purchase Plan of the U.S. Government’s Troubled Asset Relief Program.

Contractual Obligations and Commitments

              In the normal course of business, we have various outstanding contractual obligations that will require future cash outflows, as well as commitments and contingent liabilities, such as commitments to extend credit that may or may not require future cash outflows. To meet the financing needs of our customers, we issue various financial instruments, such as lines of credit, loan commitments and standby letters of credit. These instruments either are not recorded on our balance sheet or are recorded on our balance sheet in amounts that differ from the full contract or notional amounts. These instruments involve varying elements of market, credit and liquidity risk.

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The following table reflects our expected contractual obligations and future operating lease commitments as of December 31, 2011.

	Payments Due by Period
Contractual Obligations	Total		On Demand or Within 1 Year		2 - 3 Years		4 - 5 Years		5 Years
	(Dollars in thousands)
Short-term borrowings	$	73	$	73	$	-	$	-	$	-
Long-term borrowings		27,246		-		-		-		27,246
Operating lease payments		7,531		1,052		2,152		1,509		2,818
Commitments to fund affordable housing investment		200		165		35		-		-
Time deposits		154,950		105,891		41,398		7,553		108
Total contractual cash obligations	$	190,000	$	107,181	$	43,585	$	9,062	$	30,172

The following table reflects our other commitments outstanding as of December 31, 2011.

	Amount of Commitment Expiration Per Period
	Total
	Amounts		Within						After
Commercial Commitments	Committed		1 Year		2 - 3 Years		4 - 5 Years		5 Years
	(Dollars in thousands)
Undisbursed portion of home equity credit lines secured by 1-4 family residential properties	$	16,567	$	2,280	$	7,323	$	6,267	$	697
Undisbursed portion of commercial real estate, construction and land development loans		11,819		10,015		1,233		29		542
Other commitments and lines of credit		9,890		8,641		426		473		350
Commitments to originate mortgage loans, fixed and variable		124,872		124,872		-		-		-
Letters of credit		1,385		1,371		14		-		-
Total commercial commitments	$	164,533	$	147,179	$	8,996	$	6,769	$	1,589

Off-Balance Sheet Arrangements

Information about our off-balance sheet risk exposure is presented in Note L to the consolidated financial statements included in this report. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities, or SPEs, which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  As of December 31, 2011, our sole SPE activity is with North State Statutory Trust I, North State Statutory Trust II and North State Statutory Trust III.  We issued $5.2 million of junior subordinated debentures, included in long-term debt on the balance sheet, to each of these trusts on March 17, 2004, December 15, 2005 and November 28, 2007, respectively, in exchange for the proceeds of trust preferred securities issued by these trusts.

Recent Accounting Pronouncements

See Note B to our consolidated financial statements for a discussion of recent accounting pronouncements and management’s assessment of the potential impact on our consolidated financial statements.

Critical Accounting Policies

Our most significant critical accounting policies are the determination of our allowance for loan losses and periodic valuation of foreclosed assets. A critical accounting policy is one that is both very important to the portrayal of our financial condition and results, and requires our most difficult, subjective or complex judgments. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain. If the mix and amount of future write-offs differ significantly from those assumptions we use in making our determination, the allowance for loan losses, valuation allowance on foreclosed assets and the provisions for loan losses and foreclosed assets on our income statement could be materially affected. For further discussion of the allowance for loan losses and a detailed description of the methodology we use in determining the adequacy of the allowance, see the section of this discussion titled “Asset Quality and the Allowance for Loan Losses” and Notes B and E to our consolidated financial statements contained in this report.

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QUARTERLY FINANCIAL DATA (UNAUDITED)

The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period.

	Selected Quarterly Financial Data (Unaudited)
	2011								2010
	Fourth Quarter		Third Quarter		Second Quarter		First Quarter		Fourth Quarter			Third Quarter		Second Quarter			First Quarter
	(Dollars in thousands, except per share data)
Operating Data:
Total interest income	$	6,874	$	7,102	$	6,734	$	7,080	$	7,720		$	7,853	$	7,789		$	7,600
Total interest expense		1,203		1,289		1,349		1,482		1,590			1,770		1,971			2,157
Net interest income		5,671		5,813		5,385		5,598		6,130			6,083		5,818			5,443
Provision for loan losses		2,179		2,137		1,418		1,015		3,067			2,166		1,612			1,250
Net interest income after provision		3,492		3,676		3,967		4,583		3,063			3,917		4,206			4,193
Noninterest income		1,822		1,359		1,165		743		1,593			1,572		725			586
Noninterest expense		4,421		4,696		4,950		5,002		4,861			4,895		4,377			3,903
Income (loss) before income taxes		893		339		182		324		(205	)		594		554			876
Provision for income taxes		304		106		71		120		(66	)		255		244			362
Net income (loss)	$	589	$	233	$	111	$	204	$	(139	)	$	339	$	310		$	514
Per Share Data:
Net income (loss):
Basic	$	0.08	$	0.03	$	0.01	$	0.03	$	(0.02	)	$	0.05	$	0.04		$	0.07
Diluted	$	0.08	$	0.03	$	0.01	$	0.03	$	(0.02	)	$	0.05	$	0.04		$	0.07
Common stock price:																��
High	$	3.60	$	3.75	$	4.01	$	4.25	$	4.25		$	4.40	$	4.50		$	5.00
Low	$	1.85	$	3.00	$	3.00	$	3.70	$	2.75		$	3.58	$	3.50		$	3.90
Close	$	2.70	$	3.50	$	3.75	$	4.00	$	3.51		$	4.25	$	3.50		$	4.40
Tangible book value	$	5.23	$	5.16	$	5.11	$	5.06	$	5.03		$	5.09	$	5.06		$	5.04

Item 7A. 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”.

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 in this Form 10-K.

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Item 8.    Financial Statements and Supplemental Data.

The information required by this Item is found beginning at page F-1 of this report.

Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

Not applicable.

Item 9A. Controls and Procedures.

Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, carried out an evaluation of our disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2011.

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Exchange Act. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

Under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control — Integrated Framework” promulgated by the Committee of Sponsoring Organizations of the Treadway Commission, commonly referred to as the “COSO” criteria. Based on this evaluation under the COSO criteria, management concluded that our internal control over financial reporting was effective as of December 31, 2011.

Because of its inherent limitations, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives.  Internal control over financial reporting is a process that involves human adherence to and compliance with policies and procedures.  It is subject to lapses in judgment and breakdowns resulting from human failures.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.

This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting.  Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the SEC that permit us to provide only management’s report in this annual report.

There was no change in our internal control over financial reporting that occurred during the fourth quarter of 2011 that has materially affected or is likely to materially affect our internal control over financial reporting.

Item 9B. Other Information.

Not applicable.

PART III

Item 10.  Directors, Executive Officers, and Corporate Governance.

The information required by this Item concerning our directors and executive officers is incorporated by reference from the sections captioned “Proposal No. 1 - Election of Directors”, “Other Information – Other Directors” and “Other Information - Executive Officers” contained in our proxy statement related to the 2012 Annual Meeting of Shareholders scheduled to be held on May 31, 2012.  The information required by this Item concerning compliance with Section 16(a) of the United States Securities Exchange Act is incorporated by reference from the section of our proxy statement captioned “Section 16(a) Beneficial Ownership Reporting Compliance.”

The information required by this Item concerning our “audit committee financial expert” is contained under the section captioned “Other Information-Report of the Audit Committee” contained in our proxy statement for the 2012 Annual Meeting of Shareholders.

48

Our Board of Directors has adopted a code of ethics for our Chief Executive Officer, Chief Financial Officer and any other senior accounting officer or other persons performing similar functions.  We will provide copies of our code of ethics without charge upon request.  To obtain a copy of our code of ethics, please send your written request to North State Bancorp, 6204 Falls of the Neuse Road, Raleigh, North Carolina 27609, Attention: Stacey Koble.

Since the date of our proxy statement for our 2011 Annual Meeting of Shareholders, we have not made any material change to the procedures by which our shareholders may recommend nominees to our Board of Directors.  Those procedures are discussed under the section captioned “Director Nominations” in our proxy statement for the 2012 Annual Meeting of Shareholders.

Item 11.  Executive Compensation.

The information required by this Item is incorporated by reference to the information under the sections captioned “Executive Compensation”, “Other Information – Compensation Discussion and Analysis”, “Employment and Change in Control Agreements” , “Other Information – Compensation Committee Report”, “Other Information – Compensation Committee Interlocks and Insider Participation”, and “Other Information - Director Compensation” contained in our proxy statement for the 2012 Annual Meeting of Shareholders .

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

The information required by this Item is incorporated by reference to the information under the section captioned “Security Ownership of Management and Certain Beneficial Owners” contained in our proxy statement for the 2012 Annual Meeting of Shareholders and in Part II, Item 5 of this report.

Item 13.  Certain Relationships and Related Transactions, and Director Independence.

The information required by this Item is incorporated by reference to the information under the section captioned “Certain Transactions” contained in our proxy statement for the 2012 Annual Meeting of Shareholders.

Item 14.  Principal Accountant Fees and Services.

The information required by this Item is incorporated by reference to the information under the section captioned “Report of the Audit Committee” contained in our proxy statementfor the 2012 Annual Meeting of Shareholders.

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Item 15.  Exhibits and Financial Statement Schedules.

(A)           Exhibits

Exhibit No.	Exhibit Title
3.1 (a)	Articles of Incorporation, amended as of May 9, 2007
3.2 (l)	Bylaws adopted June 7, 2002, amended as of March 24, 2010
4.1 (a)	Form of North State Bancorp stock certificate
4.2 (f)	Amended and Restated Declaration of Trust by and among U.S. Bank National Association, as Institutional Trustee, North State Bancorp, as Sponsor, and Larry D. Barbour and Kirk A. Whorf as administrators, dated as of March 17, 2004
4.3 (f)	Indenture dated as of March 17, 2004, between North State Bancorp, as Issuer and U.S. Bank National Association, as Trustee
4.4 (b)	Amended and Restated Declaration of Trust by and among Wilmington Trust Company, as Delaware Trustee, Wilmington Trust Company, as Institutional Trustee, North State Bancorp, as Sponsor, and Larry D. Barbour and Kirk A. Whorf as administrators, dated as of December 15, 2005
4.5 (b)	Indenture dated as of December 15, 2005, between North State Bancorp, as Issuer and Wilmington Trust Company, as Trustee
4.6 (h)	Amended and Restated Declaration of Trust by and among Wells Fargo Delaware Trust Company, as Delaware Trustee, Wells Fargo Bank, N.A., as Property Trustee, North State Bancorp, as Depositor, and Kirk A. Whorf, Sandra A. Temple and David M. Shipp as administrators, dated as of November 28, 2007
4.7 (h)	Junior Subordinated Indenture dated as of November 28, 2007, between North State Bancorp, as Issuer and Wells Fargo Bank, N.A., as Trustee
10.1 (c)	Stock Option Plan for Non-Employee Directors, assumed as of June 28, 2002
10.2 (c)	Stock Option Plan for Employees, assumed as of June 28, 2002
10.3 (l)	Employment Agreement between North State Bank and Larry D. Barbour, dated as of June 1, 2000, as amended on December 30, 2009
10.4 (l)	Change in Control Agreement between North State Bank and Kirk A. Whorf, dated as of  December 30, 2009
10.6 (l)	Change in Control Agreement between North State Bank and Sandra A. Temple, dated as of  December 30, 2009
10.7 (e)	2003 Stock Plan
10.8 (f)	Guarantee Agreement dated as of March 17, 2004, by and between North State Bancorp and U.S. Bank National Association
10.9 (b)	Guarantee Agreement dated as of December 15, 2005, by and between North State Bancorp and Wilmington Trust Company

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10.11(f)	Lease dated May 1, 2003 between North State Bancorp and NHM00, LLC.
10.12(g)	Assignment and Assumption of Lease effective January 14, 2000 among North State Bank, Oberlin Investors Two, LLC and Branch Banking & Trust Company.
10.13(g)	Office Lease dated April 10, 2000 between North State Bank and Oberlin Investors Two, LLC (including Amendment No. One dated March 29, 2001).
10.14(i)	Lease agreement dated as of December 29, 2006 by and between North State Bank and Atrium Investments, LLC
10.15(i)	Lease agreement dated as of November 1, 2006 between North State Bancorp and Capital Club Properties, LLC
10.16(h)	Guarantee Agreement dated as of November 28, 2007, by and between North State Bancorp and Wells Fargo Bank, N.A.
10.17	Change in Control Agreement between North State Bank and Brian S. Hedges, datedMay 24, 2011
10.18(k)	Fiscal and Paying Agent Agreement, dated May 13, 2008, between North State Bank and Wilmington Trust Company (including form of Floating Rate Subordinated Note due June 30, 2018)
10.19(l)	Employment Agreement between North State Bank and J. Kenneth Sykes, dated February 12, 2010
21.1	List of Subsidiaries
23	Consent of Dixon Hughes Goodman LLP
31.1	Certification pursuant to Rule 13a-14(a)
31.2	Certification pursuant to Rule 13a-14(a)
32	Certifications pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101	Financials provided in XBRL format

_____________

(a) Incorporated by reference to exhibits filed with our Quarterly Report of Form 10-Q filed on May 15, 2007.

(b) Incorporated by reference to exhibits filed with our Current Report on Form 8-K filed on December 20, 2005.

(c) Incorporated by reference to exhibits filed with our Registration Statement on Form S-8 filed on July 31, 2002 (Registration Statement No. 333-97419).

(d) Incorporated by reference to exhibits filed with our Annual Report on Form 10-KSB for the year ended December 31, 2002.

(e) Incorporated by reference to Appendix A to our definitive Proxy Statement filed on April 7, 2003.

(f) Incorporated by reference to exhibits filed with our Annual Report on Form 10-KSB for the year ended December 31, 2005.

(g)  Incorporated by reference to exhibits filed with our Quarterly Report on Form 10-QSB for the quarter ended March 31, 2005.

(h) Incorporated by reference to exhibits filed with our Current Report on Form 8-K filed on November 30, 2007.

(i) Incorporated by reference to exhibits filed with our Annual Report on Form 10-KSB for the year ended December 31, 2006.

(j) Incorporated by reference to exhibits filed with our Annual Report on Form 10-K for the year ended December 31, 2007.

(k) Incorporated by reference to exhibits filed with our Quarterly Report on Form 10-Q for the quarter ended June 30, 2008.

(l) Incorporated by reference to exhibits filed with our Annual Report on Form 10-K for the year ended December 31, 2010.

51

ITEM 8 – FINANCIAL STATEMENTS

NORTH STATE BANCORP

INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS

	Page No.
Report of Independent Registered Public Accounting Firm	F-2
Consolidated Balance Sheets as of December 31, 2011 and 2010	F-3
Consolidated Statements of Operations for the years ended December 31, 2011, 2010 and 2009	F-4
Consolidated Statements of Comprehensive Income for the years ended December 31, 2011, 2010 and 2009	F-5
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2011, 2010 and 2009	F-6
Consolidated Statements of Cash Flows for the years ended December 31, 2011, 2010 and 2009	F-7
Notes to Consolidated Financial Statements	F-9

F-1

 

Report of Independent Registered Public Accounting Firm

To the Shareholders and the Board of Directors

North State Bancorp

Raleigh, North Carolina

We have audited the accompanying consolidated balance sheets of North State Bancorp (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2011.  These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of North State Bancorp at December 31, 2011 and 2010 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2011 in conformity with accounting principles generally accepted in the United States of America.

/s/ Dixon Hughes Goodman LLP

Greenville, North Carolina

March 30, 2012

F-2

NORTH STATE BANCORP

CONSOLIDATED BALANCE SHEETS

December 31, 2011 and 2010

	2011		2010
	(Dollars in thousands)
ASSETS
Cash and due from banks	$	9,826	$	5,974
Interest-earning deposits with banks		39,547		43,859
Certificates of deposit with banks		-		198
Investment securities available for sale, at fair value		12,917		9,234
Investment securities held to maturity, at amortized cost		250		250
Loans held for sale		49,728		51,472
Loans		490,455		499,523
Less allowance for loan losses		9,906		9,935
Net loans		480,549		489,588
Accrued interest receivable		1,441		1,654
Stock in the Federal Home Loan Bank of Atlanta, at cost		1,073		1,273
Premises and equipment, net		14,159		14,801
Foreclosed assets		2,851		5,296
Prepaid FDIC insurance		2,777		3,646
Bank owned life insurance		10,146		-
Other assets		7,626		6,620
TOTAL ASSETS	$	632,890	$	633,865
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Demand	$	145,185	$	117,840
Savings, money market and NOW		264,304		250,469
Time		154,950		194,439
Total deposits		564,439		562,748
Accrued interest payable		897		1,181
Short-term borrowings		73		3,615
Long-term borrowings		27,246		27,269
Accrued expenses and other liabilities		1,246		1,550
TOTAL LIABILITIES		593,901		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 December 31, 2011 and December 31, 2010		21,708		21,636
Retained earnings		17,063		15,926
Accumulated other comprehensive income (loss)		218		(60	)
TOTAL SHAREHOLDERS' EQUITY		38,989		37,502
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	632,890	$	633,865

See accompanying notes.

F-3

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31, 2011, 2010 and 2009

	2011		2010		2009
	(Dollars in thousands, except per share data)
INTEREST INCOME
Loans	$	25,429	$	28,288	$	31,257
Loans held for sale		1,647		1,472		-
Investments		541		603		1,151
Dividends and interest-earning deposits		173		599		1,032
Total interest income		27,790		30,962		33,440
INTEREST EXPENSE
Savings, money market and NOW		1,630		2,066		2,062
Time deposits		2,769		4,482		8,673
Short-term borrowings		2		19		33
Long-term borrowings		922		921		1,078
Total interest expense		5,323		7,488		11,846
NET INTEREST INCOME		22,467		23,474		21,594
PROVISION FOR LOAN  LOSSES		6,749		8,095		5,710
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		15,718		15,379		15,884
NON-INTEREST INCOME
Fees from mortgage operations		3,492		2,620		-
Other		1,597		1,856		1,168
Total non-interest income		5,089		4,476		1,168
NON-INTEREST EXPENSE
Salaries and employee benefits		9,448		8,400		6,430
Occupancy and equipment		2,730		2,774		2,758
Data processing and other outsourced services		1,486		1,466		1,200
Net cost of foreclosed assets		1,618		1,587		807
Other		3,787		3,809		3,942
Total non-interest expense		19,069		18,036		15,137
INCOME BEFORE INCOME TAXES		1,738		1,819		1,915
INCOME TAXES		601		795		817
NET INCOME	$	1,137	$	1,024	$	1,098
NET INCOME PER COMMON SHARE:
Basic	$	0.15	$	0.14	$	0.15
Diluted	$	0.15	$	0.14	$	0.15
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		7,427,976		7,363,618		7,179,744
Diluted		7,431,544		7,389,397		7,316,292

See accompanying notes.

F-4

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31, 2011, 2010 and 2009

	2011			2010			2009
	(Dollars in thousands)
Net income	$	1,137		$	1,024		$	1,098
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding gains (losses) on available for sale securities		826			(6	)		137
Tax effect		(318	)		2			(53	)
Reclassification of net gain recognized in net income		(374	)		(741	)		(464	)
Tax effect		144			286			179
		278			(459	)		(201	)
Cash flow hedging activities:
Reclassification of gains recognized in net income		-			-			(804	)
Tax effect		-			-			310
		-			-			(494	)
Total other comprehensive income (loss)		278			(459	)		(695	)
Comprehensive income	$	1,415		$	565		$	403

See accompanying notes.

F-5

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Years Ended December 31, 2011, 2010 and 2009

							Accumulated
							other			Total
	Common Stock				Retained		comprehensive			shareholders'
	Shares		Amount		earnings		income (loss)			equity
	(Dollars in thousands)
Balance as of December 31, 2008		7,171,268	$	20,648	$	13,804	$	1,094		$	35,546
Net income		-		-		1,098		-			1,098
Other comprehensive loss, net of tax		-		-		-		(695	)		(695	)
Stock based compensation		-		119		-		-			119
Stock options exercised including income tax benefit of $9		27,245		98		-		-			98
Balance as of December 31, 2009		7,198,513		20,865		14,902		399			36,166
Net income		-		-		1,024		-			1,024
Other comprehensive loss, net of tax		-		-		-		(459	)		(459	)
Stock based compensation		-		100		-		-			100
Stock options exercised including income tax benefit of $60		229,463		671		-		-			671
Balance as of December 31, 2010		7,427,976		21,636		15,926		(60	)		37,502
Net income		-		-		1,137		-			1,137
Other comprehensive income, net of tax		-		-		-		278			278
Stock based compensation		-		72		-		-			72
Balance as of December 31, 2011		7,427,976	$	21,708	$	17,063	$	218		$	38,989

See accompanying notes.

F-6

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2011, 2010 and 2009

	2011			2010			2009
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,137		$	1,024		$	1,098
Adjustments to reconcile net income to net cash provided (used) by operating activities:
Provision for loan losses		6,749			8,095			5,710
Provision for foreclosed assets		1,384			1,148			697
Depreciation and amortization		889			927			914
Deferred income taxes		364			(987	)		(213	)
Net amortization (accretion) of premiums and discounts on investment securities		31			(13	)		-
Impairment loss on nonmarketable securities		-			-			134
Originations of mortgage loans held for sale		(438,043	)		(363,278	)		-
Proceeds from sales of mortgage loans held for sale		439,868			312,634			-
Amortization of gain on termination of derivative instrument		-			-			(804	)
Net realized gain on sale of investment securities available for sale		(374	)		(741	)		(464	)
Gain on sale of equity interest in investment		-			-			(18	)
Income from bank owned life insurance		(146	)		-			-
Loss on sale of foreclosed assets		60			183			38
Stock based compensation		72			100			119
Changes in assets and liabilities:
(Increase) decrease  in other assets		(756	)		2,752			(6,656	)
Decrease in accrued interest receivable		213			157			360
Decrease in accrued expenses and other liabilities		(304	)		(208	)		(763	)
Decrease in accrued interest payable		(284	)		(543	)		(519	)
Net cash provided (used) by operating activities		10,860			(38,750	)		(367	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in certificates of deposit with banks		198			49,998			(28,354	)
Proceeds from sales of investment securities available for sale		19,721			21,049			17,157
Proceeds from maturities and repayments of investment securities available for sale		10,069			17,107			6,491
Purchase of investment securities available for sale		(32,678	)		(23,985	)		(10,503	)
Redemption (purchase) of Federal Home Loan Bank stock		200			2			(252	)
Purchase of bank owned life insurance		(10,000	)		-			-
Purchase of investment accounted for under the cost method		-			(500	)		-
Net decrease (increase) in loans		(423	)		6,862			18,667
Purchases of premises and equipment		(247	)		(882	)		(3,472	)
Proceeds from sale of equity interest in investment		-			-			32
Proceeds from sales of foreclosed assets		3,784			5,996			782
Capital expenditures on foreclosed assets		(70	)		(169	)		(136	)
Net cash provided (used) by investing activities		(9,446	)		75,478			412
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in short term borrowings		(3,542	)		(2,488	)		(1,679	)
Repayments on long-term borrowings		(23	)		(21	)		(21	)
Net increase (decrease) in deposits		1,691			(44,140	)		(5,790	)
Excess tax benefits from exercise of stock options		-			60			9
Proceeds from exercise of stock options		-			611			89
Net cash used by financing activities		(1,874	)		(45,978	)		(7,392	)

See accompanying notes.

F-7

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

Years Ended December 31, 2011, 2010 and 2009

2011	2010	2009
(Dollars in thousands)

NET DECREASE IN CASH AND CASH EQUIVALENTS	$	(460	)	$	(9,250	)	$	(7,347	)
CASH AND CASH EQUIVALENTS, BEGINNING		49,833			59,083			66,430
CASH AND CASH EQUIVALENTS, ENDING	$	49,373		$	49,833		$	59,083
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Interest paid	$	5,633		$	8,030		$	12,365
Income taxes paid		462			551			1,535
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING ACTIVITIES
Unrealized gain (loss) on investment securities available for sale, net of tax	$	278		$	(459	)	$	(201	)
Unrealized loss on hedging activities, net of tax		-			-			(494	)
Transfer of loans to foreclosed assets		2,713			9,183			2,376

See accompanying notes.

F-8

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE A - ORGANIZATION AND OPERATIONS

On June 28, 2002, North State Bancorp (the “Company”) was formed as a holding company for North State Bank (the “Bank”).  Upon formation, one share of the Company’s $1.00 par value common stock was exchanged for each of the outstanding shares of the Bank’s $5.00 par value common stock.  On May 9, 2007, the Company’s shareholders approved the decrease of the Company’s par value of common stock from $1.00 per share to no par value per share.  The Company currently has no operations and conducts no business on its own other than owning the Bank, North State Statutory Trust I, North State Statutory Trust II and North State Statutory Trust III, all of which are wholly-owned subsidiaries of the Company. The Company is subject to the rules and regulations of the Federal Reserve Bank and the North Carolina Commissioner of Banks.

The Bank was incorporated May 25, 2000 and began banking operations on June 1, 2000. The Bank is engaged in general commercial and retail banking in central North Carolina, principally Wake County, and in southeast North Carolina in New Hanover County, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks. The Bank undergoes periodic examinations by those regulatory authorities. The Bank’s wholly-owned subsidiary, North State Wealth Advisors, Inc., offers wealth management and brokerage services. 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.  In June 2011, the Bank established a wholly owned subsidiary, North State Title, LLC, which owns 67% of Title Group, LLC, a title insurance agency.

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying consolidated financial statements include the accounts and transactions of North State Bancorp and its wholly owned subsidiary North State Bank. All significant intercompany transactions and balances are eliminated in consolidation.  North State Bancorp and its subsidiary are collectively referred to herein as the “Company”.

Under Financial Accounting Standards Board (“FASB”) accounting pronouncement for the consolidation of variable interest entities, North State Statutory Trust I, North State Statutory Trust II and North State Statutory Trust III are not included in the Company’s consolidated financial statements.  The junior subordinated debentures issued by the Company to the three Trusts are included in long-term debt and the Company’s equity interest in the three Trusts is included in other assets.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses.

Cash and Cash Equivalents

For the purpose of presentation in the statement of cash flows, cash and cash equivalents include cash and due from banks and interest-earning deposits with banks.

Certificates of Deposit with Banks

Certificates of deposits with banks typically have an original maturity of one year or less. Certificates of deposit as of December 31, 2010 bearing interest at a rate of 1.15% matured in January 2011.

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 generally determined at the date of purchase.

F-9

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Investment Securities (Continued)

Certain equity security investments that do not have readily determinable fair values and for which the Company does not exercise significant influence are carried at cost.  As a requirement for membership, the Company invests in stock of the Federal Home Loan Bank of Atlanta (“FHLB”).  As of December 31, 2011 and 2010, these equity securities totaled $1.1 million and $1.3 million, respectively.  Due to the redemption provisions of the FHLB, the Company estimates that fair value equals cost.  All the equity securities are reviewed for impairment at least annually or sooner if events or changes in circumstances indicate the carrying value may not be recoverable. For the year ended December 31, 2009, the Company recorded an impairment loss of $134,000 on stock owned in Silverton Bank.

Loans Held for Sale

Loans held for sale represent single-family, residential first mortgage loans on a pre-sold basis originated by our mortgage division.  Generally, commitments to sell these loans are made after the intent to proceed with mortgage applications are initiated with borrowers, and all necessary components of the loan are approved according to secondary market underwriting standards of the investor that purchases the loan. Upon closing, these loans, together with their servicing rights, are sold to mortgage loan investors under prearranged terms.  Loans held for sale are subsequently measured at the lower of cost or fair value on an aggregated basis within the consolidated balance sheet under the caption “loans held for sale”. The Company recognizes certain origination and service release fees from the sale, which are included in non-interest income in the consolidated statements of operations.  The Company is exposed to certain risks relating to its ongoing mortgage origination business. The Company enters into interest rate lock commitments and forward commitments to sell mortgages. Interest rate lock commitments are entered into to manage interest rate risk associated with the Company’s fixed rate loan commitments. The period of time between the issuance of a loan commitment and the closing and sale of the loan generally ranges from 30 to 60 days. Such interest rate lock commitments and forward-loan-sale commitments represent derivative instruments which are required to be carried at fair value. These derivative instruments do not qualify as hedges under the Derivatives and Hedging topic of the FASB Accounting Standards Codification. The fair value of the Company’s written loan commitments are based on current secondary market pricing and included on the consolidated balance sheet in other assets and in noninterest income on the consolidated statement of operations.  Forward loan sale commitments are generally equal and offsetting to interest rate loan commitments.The gains and losses from the future sales of the mortgages are recognized when the Company, the borrower and the investor enter into the loan contract and the resulting gain or loss is recorded in the  statement of operations.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans.  Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan. Interest income is recorded as earned on an accrual basis.

Unsecured loans are charged-off against the Company’s allowance for loan losses as soon as the loan becomes uncollectible. Unsecured loans are considered uncollectible when no regularly scheduled monthly payment has been made within three months and the analysis of the borrower and any guarantors would indicate no further support can be provided, the loan matured over 90 days ago and has not been renewed or extended or the borrower files for bankruptcy. Secured loans are considered uncollectible when the liquidation of collateral is deemed to be the most likely source of repayment and the collateral or guarantors are deemed unable to repay any shortfall. Once secured loans reach 90 days past due, they are placed into non-accrual status. If the loan is deemed to be solely collateral dependent, the principal balance is written down immediately to reflect the current market valuation based on current independent appraisal/evaluation. Included in the write-down is the estimated expense to liquidate the property and typically an additional allowance for the foreclosure discount. Generally, if the loan is unsecured the loan must be charged-off in full while if it is secured the loan is charged down to the net liquidation value of the collateral.

Loans, including impaired loans, are generally 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.

F-10

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans (Continued)

While a loan (including an impaired loan) is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding. When the future collectability of the recorded loan balance is not in doubt, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

Troubled Debt Restructured loans are loans that have been modified due to deterioration in the borrower’s financial condition, resulting in more favorable terms for the borrower. Accrual of interest is continued for restructured loans when the borrower was performing prior to the 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 borrower has established a sustained period of performance under the restructured terms of at least six months.

Allowance for Loan Losses

The provision for loan losses is based upon management’s estimate of the amount needed to maintain the allowance for loan losses at an adequate level. In evaluating the allowance for loan losses, the Company prepares an analysis of its current loan portfolio using historical loss rates, other identified factors, and data from its portfolio to calculate a general reserve for loan losses.  The Company applies a charge-off rate based on charge-off history, current impairments and management’s judgment applied to seven classes of loans in its current loan portfolio.  In addition, the Company has identified seven factors that are considered as indicators of changes in the level of risk of loss inherent with the Company’s loan portfolio. These factors are payment performance, overall portfolio quality utilizing weighted average risk rating, general economic factors such as unemployment, delinquency and charge-off rates, regulatory examination results, the interest rate environment, levels of highly leveraged transactions and levels of commercial real estate concentrations, which address the risks associated with construction, development and non-owner occupied commercial real estate lending.  Each of these factors is assigned a level of risk and this risk factor is applied to only the general pool of loans.  In addition to the general reserve calculation, all loans risk rated “substandard”, “doubtful” and “loss” are reviewed for probable losses and if management determines a loan to be impaired it is removed from its homogeneous group and individually analyzed for impairment.  Other groups of loans may also be selected for impairment review.  A loan is considered impaired when, based on current information and events, it is considered probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the original contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the original effective interest rate, or upon the fair value of the collateral if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, a valuation allowance is established as a component of the allowance for loan losses.

While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require the Company to recognize adjustments to the allowance for loan losses based on their judgments about information available to them at the time of their examination.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on the straight-line method over the estimated useful lives of the assets which are 3 - 10 years for furniture and equipment and 30 - 40 years for buildings. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are charged to operations as incurred and additions and improvements to premises and equipment are capitalized. Upon sale or retirement, the cost and related accumulated depreciation are removed from the accounts and any gains or losses are reflected in current operations. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable.

F-11

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Foreclosed Assets

Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value less anticipated selling costs at the date of foreclosure, establishing a new cost basis. Principal and interest losses existing at the time of acquisition of such assets are charged against the allowance for loan losses and interest income, respectively. The initial recorded value may be subsequently reduced by additional valuation allowances, which are charged to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value.  Costs related to the improvement of the property are capitalized, whereas those

related to holding the property are expensed. Revenue and expenses from operations and changes in the valuation allowance are included in other expenses.

Bank Owned Life Insurance

Bank owned life insurance is carried at cash surrender value as determined by the insurer. The carrying value of life insurance approximates fair value.

Income Taxes

Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the tax basis of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized.

Tax positions are analyzed in accordance with generally accepted accounting principles. Interest recognized as a result of the Company’s  analysis of tax positions would be classified as interest expense. Penalties would be classified as noninterest expense.

Stock Compensation Plans

The Company is required to recognize the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (presumptively the vesting period).  The Company is also required to measure the cost of employee services received in exchange for an award based on the grant-date fair value of the award as well as to report excess tax benefits as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.

As of December 31, 2011, the Company had one stock-based compensation plan, which is more fully described in Note O.

Earnings Per Common Share

Basic earnings per share represent 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 solely 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:

	2011		2010		2009
	(Dollars in thousands)
Weighted average number of common shares used in computing basic net income per share		7,427,976		7,363,618		7,179,744
Effect of dilutive stock options		3,568		25,779		136,548
Weighted average number of common shares and dilutive potential shares used in computing diluted net income per share		7,431,544		7,389,397		7,316,292

F-12

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Earnings Per Common Share (Continued)

For the years ended December 31, 2011, 2010 and 2009 there were 95,787,  105,787, and 76,550, respectively, anti-dilutive shares excluded from the calculation of total dilutive weighted average shares due to the exercise price exceeding the average market price for the year.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, such as unrealized gains and losses on investment securities available for sale, net of income taxes and unrealized holding gains on hedge instruments, net of income taxes, are reported as a separate component of the equity section of the balance sheet . Such items, along with net income, are components of total comprehensive income.

Accumulated other comprehensive income (loss) consists of the following:

	For the Years Ended December 31,
	2011			2010			2009
	(Dollars in thousands)
Accumulated other comprehensive income (loss):
Unrealized holding gains (losses) on available for sale securities	$	358		$	(94	)	$	653
Tax effect		(140	)		34			(254	)
Net unrealized holding gains (losses) on available for sale securities		218			(60	)		399
Total accumululated other comprehensive income (loss)	$	218		$	(60	)	$	399

Derivative Instruments

The Company’s deposit and loan activities are vulnerable to interest rate risk.  The associated variability in cash flows may impact the results of operations of the Company.  The Company’s hedging strategy is generally intended to take advantage of opportunities to reduce, to the extent possible, unpredictable cash flows.  The Company may employ a variety of common derivative products that are instruments used by financial institutions to manage interest rate risk.  The financial instruments that may be used as part of a hedging strategy include swaps, caps, floors and collars.

Under accounting guidelines for derivative instruments and hedging activities, derivative financial instruments generally are required to be carried at fair value.  Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges.

Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

The Company does not enter into derivative financial instruments for speculative or trading purposes.

The Company utilized a stand-alone derivative financial instrument, in the form of an interest rate floor, in its asset/liability management program during 2008.  The floor was designated as a cash flow hedge of the overall changes in cash flows on the first prime-rate-based interest payments received by the Company each calendar month during the term of the hedge that, in the aggregate for each period, are interest payments on principal from specified loan portfolios greater than or equal to the notional amount of the floor.  During the first quarter of 2008, the Company terminated the interest rate floor agreement. The contractual maturity of the floor was November 1, 2009. During the life of the floor, pre-tax gains of approximately $1.5 million were deferred in accumulated other comprehensive income (AOCI) in accordance with cash flow hedge accounting rules.  The amounts deferred in AOCI were reclassified out of equity into earnings over the remaining 19 months of the original contract. As required, amounts deferred in AOCI werereclassified into earnings in the same periods during which the originally hedged cash flows (prime-based interest payments on loan assets) effect earnings, as long as the originally hedged cash flows were probable of occurring (i.e. the principal amount of designated prime-based loans match or exceed the notional amount of the terminated floor through November 1, 2009).

F-13

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Segment Reporting

Management is required by accounting pronouncements governing the disclosures about segments of an enterprise and related information to report selected financial and descriptive information about reportable operating segments.  It also establishes standards for related disclosures about products and services, geographic areas, and major customers.  Generally, disclosures are required for segments internally identified to evaluate performance and resource allocation.  In all material respects, the Company’s operations are entirely within the commercial and retail banking segment and the consolidated financial statements presented herein reflect the results of that segment. Included as a division of the Bank, NSB Mortgage is reported as a separate segment as well as the parent Company.  Segment information regarding the Bank, NSB Mortgage and the parent Company are fully described in Note Q. Also, the Company has no foreign operations or customers.

Recent Accounting Pronouncements

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 adoption did not have an impact on the Company’s 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 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 adoption of this statement is not expected to have a material impact on the Company’s consolidated financial statements.

In April 2011, the 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 adopted the update of this standard during the quarter ended September 30, 2011. The adoption did not have a material impact on the Company’s consolidated financial statements.

In September 2011, the FASB issued ASU 2011-08, an update to ASC 350, Intangibles – Goodwill and Other. This update allows an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessment, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, it will have to perform the first step of the two-step impairment test. Under the amendments in this update, an entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment test. An entity may resume performing the qualitative assessment in any subsequent period. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. The Company adopted ASU 2011-08 in the third quarter of 2011, which did not have a significant impact on the Company’s 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 adoption of this statement did not have a material impact on the consolidated financial statements.

F-14

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recent Accounting Pronouncements (Continued)

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

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 December 31, 2011
			Gross		Gross
	Amortized		unrealized		unrealized		Fair
	cost		gains		losses		value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	12,559	$	358	$	-	$	12,917
Total securities available for sale	$	12,559	$	358	$	-	$	12,917
Securities held to maturity:
Corporate securities	$	250	$	-	$	49		201
Total securities held to maturity	$	250	$	-	$	49	$	201

	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

The following table shows at December 31, 2011 and 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.  As of December 31, 2011, the Company did not hold any available for sale securities with unrealized losses. Unrealized losses on available for sale securities as of December 31, 2010 relate to one government-sponsored residential mortgage-backed security. The unrealized losses on held to maturity securities for December 31, 2011 and 2010 relate to one corporate security.   All unrealized losses on investment securities are not considered to be other-than-temporary, because they are related to changes in interest rates, lack of liquidity and demand in the general investment market and do not affect the expected cash flows of the underlying collateral or the issuer. Since the Company does not intend to sell the impaired corporate bond prior to recovery and it is more likely than not the Company will not be required to sell this imparied security prior to recovery, it is not deemed to be other than temporarily impaired.

F-15

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE C - INVESTMENT SECURITIES (Continued)

	As of December 31, 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 held to maturity:
Corporate securities	$	-	$	-	$	201	$	49	$	201	$	49
Total securities held to maturity	$	-	$	-	$	201	$	49	$	201	$	49
	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 at December 31, 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 December 31, 2011
	Amortized		Fair
	Cost		Value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities
Due within one year	$	86	$	87
Due after one but within five years		153		164
Due after five but within ten years		3,860		3,930
Due after ten years		8,460		8,736
	$	12,559	$	12,917
Securities held to maturity:
Corporate Securities
Due after five but within ten years	$	250	$	201
	$	250	$	201

Securities with a carrying value of $1.7 million and $8.8 million as of December 31, 2011 and 2010, respectively, were pledged to secure securities sold under agreements to repurchase and public deposits.

During 2011 and 2010, proceeds from the sales of investment securities of $19.7 million and $21.0 million resulted in gross gains of $374,000 and $741,000 during 2011 and 2010, respectively and gross gains and gross losses of $470,000 and $6,000, respectively during 2009.

F-16

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D - LOANS

The following is a summary of loans segregated by loan category:

	December 31, 2011					December 31, 2010
			% of					% of
			Total					Total
	Amount		Loans			Amount		Loans
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	27,323		5.6	%	$	51,058		10.2	%
Commercial construction, all land development and land loans		47,524		9.7	%		82,136		16.5	%
Residential properties		105,226		21.5	%		98,451		19.7	%
Residential mortgage (1)		39,829		8.1	%		-		-
Commercial real estate - other		228,256		46.5	%		221,350		44.3	%
Total real estate secured loans		448,158		91.4	%		452,995		90.7	%
Other non-real estate loans:
Commercial and industrial		38,435		7.8	%		42,884		8.6	%
Consumer and other		3,862		0.8	%		3,644		0.7	%
Total loans held for investment	$	490,455		100.0	%	$	499,523		100.0	%
Single-family residential mortgages held for sale	$	49,728				$	51,472
(1) Single-family residential mortgages originated through NSB Mortgage held for investment.

Included in the table above are unamortized loan costs(fees) of $500,000 and ($253,000) as of December 31, 2011 and 2010, respectively. 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 the local economic conditions. Construction and land development loans, including residential and commercial  loans, decreased $58.3 million from the prior year-end as loans were paid off, charged-off or completed and moved to longer-term financing and new lending for these classes was minimized. Residential mortgages are a new class of loans for 2011 as selected mortgages originated through NSB Mortgage were retained in our held for investment loan portfolio.

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

Real estate construction loans:

Residential construction

The Company provides financing to builders for the construction of speculative and pre-sold custom homes, and from time to time, financing for custom homes where the home buyer is the borrower.  Residential construction loans typically are for periods of 12 months or less and the homes are sold to consumers who obtain permanent financing. The loans are underwritten utilizing independent appraisals, sensitivity analysis of absorption and financial analysis of the borrower.

Commercial construction

Commercial real estate construction and land development loans are also underwritten utilizing independent appraisals, sensitivity analysis of absorption and financial analysis of the general contractors and borrowers.  Commercial construction loans are generally based upon estimates of costs and value associated with the as-completed project. These estimates may be inaccurate. The 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 or sales of developed property.

All construction 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, government regulation of real property, general economic conditions and the availability of long-term financing.

F-17

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

Residential properties

Residential real estate secured loans are subject to underwriting based on the purpose of the loan. Residential real estate properties secured by income-producing property typically have a loan-to-value ratio of 85% or less. Residential real estate properties secured by the primary residence of the borrower typically have a loan-to-value ratio less than 90%. Also included are loans that are underwritten and secured by second liens and home equity lines of credit which are revolving extensions of credit that are secured by first or second liens on owner-occupied residential real estate.

Residential mortgage

Residential mortgage loans represent one-to-four family loans originated through NSB Mortgage and selected by the Company to be retained in its portfolio. These loans are subject to strict underwriting standards which are at a minimum per the FREDDIE MAC guidelines and typically have terms within 10 to 15 years with moderate loan-to-value ratios, typically less than 70% and with credit scores typically exceeding 740.

Commercial real estate - other

Commercial real estate secured loans are subject to underwriting standards similar to those for commercial construction loans. These loans are either cash flow loans or 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. For these loans, the Company also utilizes third-party experts to provide insight and guidance about economic conditions and trends within its market areas.

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 be 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 guarantee. 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.

Consumer and other

Consumer and other loans include automobile loans, boat and recreational vehicle financing, other secured or unsecured loans and loans to tax exempt entities. Consumer loans generally carry greater risk than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Consumer loan collections are sensitive to job loss, illness and other personal factors. The Company manages risks inherent in consumer and other lending by following established credit guidelines and underwriting practices designed to minimize the risk of loans.

The Company maintains an independent loan review function that reviews and validates the credit risk program 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 have 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 December 31, 2011 and 2010, mortgage loans held for sale were $49.7 million and $51.5 million, respectively.

F-18

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

Related party loans

The Company has had loan transactions with its directors and executive officers. Such loans were made in the ordinary course of business and on substantially the same terms and collateral as those for comparable transactions prevailing at the time and did not involve more than the normal risk of collectability or present other unfavorable features.

A summary of related party loan transactions is as follows:
(Dollars in thousands)
Balance as of December 31, 2010	$	38,981
Additional borrowings		7,533
Loan repayments		(6,687	)
Balance as of December 31, 2011	$	39,827

At December 31, 2011 and 2010, the Company had pre-approved but unused lines of credit totaling $2.2 million and $2.4 million to executive officers, directors and their affiliates.

Nonperforming assets include nonaccrual loans, troubled debt restructured loans (nonaccrual and accrual), and foreclosed assets.  Residential mortgages are not included as a class of nonperforming assets because these loans are a new product and have not experienced any performance issues as of year-end 2011.

Nonaccrual loans

For all classes of loans, 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.

Nonaccrual loans as of December 31, 2011 were $24.0 million compared to $11.5 million as of December 31, 2010. The approximate amount of interest income foregone on nonaccrual loans during the year was $1.3 million for 2011, $875,000 for 2010, and $704,000 for 2009.

Past due loans

An age analysis of past due loans segregated by loan class as of December 31, 2011 and 2010 is as follows:

F-19

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

	As of December 31, 2011
											Accruing Loans
	30 - 89 Days		Over 90		Total Past				Total		90 or more
	Past Due (1)		Days (2)		Due		Current (3)		Loans		Days Past Due
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	2,020	$	6,986	$	9,006	$	18,317	$	27,323	$	-
Commercial construction, all land development and land loans		1,194		9,107		10,301		37,223		47,524		-
Residential properties		605		1,629		2,234		102,992		105,226		-
Residential mortgage (4)		-		-		-		39,829		39,829		-
Commercial real estate - other		314		1,850		2,164		226,092		228,256		-
Total real estate secured loans		4,133		19,572		23,705		424,453		448,158		-
Other non-real estate loans:
Commercial and industrial		93		464		557		37,878		38,435		-
Consumer and other		-		-		-		3,862		3,862		-
Total loans held for investment	$	4,226	$	20,036	$	24,262	$	466,193	$	490,455	$	-

(1)	Includes approximately $3.0 million of loans in nonaccrual status of which approximately $2.0 million are residential construction, $896,000 are commercial construction and $113,000 are residential properties. Includes approximately $1.6 million of potential problem loans of which approximately $1.3 million are residential construction and $275,000 are residential properties.
(2)	All loans past due 90 days or more are in nonaccrual status.
(3)	Includes approximately $955,000 of loans in nonaccrual status of which approximately $250,000 are commercial construction and $705,000 are residential properties. Includes approximately $281,000 of potential problem loans of which approximately $174,000 are residential properties, $93,000 are commercial real estate-other and $14,000 are consumer.
(4)	Single-family residential mortgages originated through NSB Mortgage, held for investment.

	As of December 31, 2010
											Accruing Loans
	30 - 89 Days		Over 90		Total Past				Total		90 or more
	Past Due (1)		Days (2)		Due		Current (3)		Loans		Days Past Due
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	1,274	$	3,079	$	7,432	$	46,705	$	54,137	$	-
Commercial construction, all land development and land loans		4,801		2,462		7,263		74,873		82,136		-
Residential properties		2,510		1,863		4,373		94,077		98,450		131
Commercial real estate - other		1,554		438		1,992		219,612		221,604		-
Total real estate secured loans		10,139		7,842		21,060		435,267		456,327		131
Other non-real estate loans:
Commercial and industrial		1,797		602		2,399		40,485		42,884		-
Consumer and other		11		-		11		3,380		3,391		-
Total loans held for investment	$	11,947	$	8,444	$	23,470	$	479,132	$	502,602	$	131

(1)	Includes approximately $2.5 million of loans in nonaccrual status of which approximately $520,000 are residential construction, $965,000 are residential properties, $993,000 are commercial and industrial and $11,000 are consumer.
(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 in nonaccrual status of which approximately $457,000 are residential construction, $230,000 are commercial construction and $3,000 are commercial real estate other. Includes approximately $1.2 million of potential problem loans of which $522,000 are commercial construction, $200,000 are residential properties, and $461,000 are commercial and industrial.

F-20

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

Impaired loans

For all classes of loans, interest payments on impaired loans 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 troubled debt restructured loans when the borrower was performing prior to the restructuring and there is reasonable assurance of repayment and continued performance under the modified terms. Accrual of interest on troubled debt restructured loans in nonaccrual status is resumed when the borrower has established a sustained period of performance under the restructured terms of at least six months. Information regarding impaired loans segregated by loan class as of and for the year ended December 31, 2011 and 2010 is as follows.

										For the year ended
	As of December 31, 2011									December 31, 2011
	Unpaid									Average		Interest
	Principal		Partial			Recorded		Related		Recorded		Income
	Balance		Charge-offs			Investment		Allowance		Investment		Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Real estate secured loans:
Residential construction	$	5,789	$	(1,166	)	$	4,636	$	-	$	7,183	$	131
Commercial construction, all land development and land loans		8,680		(1,666	)		7,030		-		6,207		158
Residential properties		6,517		(2,161	)		4,359		-		4,303		83
Commercial real estate - other		6,686		(2,445	)		4,250		-		5,128		153
Total real estate secured loans		27,672		(7,438	)		20,275		-		22,821		525
Other non-real estate loans:
Commercial and industrial		593		(574	)		20		-		231		4
Consumer and other		-		-			-		-		13		1
Total	$	28,265	$	(8,012	)	$	20,295	$	-	$	23,065	$	530
Impaired with a related allowance recorded:
Real estate secured loans:
Residential construction	$	7,543	$	(72	)	$	7,475	$	756	$	3,513	$	79
Commercial construction, all land development and land loans		6,230		(379	)		5,851		1,370		4,539		14
Residential properties		66		-			66		17		69		-
Commercial real estate - other		621		-			621		211		623		-
Total real estate secured loans		14,460		(451	)		14,013		2,354		8,744		93
Other non-real estate loans:
Commercial and industrial		461		-			461		200		422		-
Consumer and other		-		-			-		-		-		-
Total	$	14,921	$	(451	)	$	14,474	$	2,554	$	9,166	$	93
Total impaired:
Commercial	$	23,271	$	(5,064	)	$	18,233	$	1,781	$	17,150	$	329
Residential		19,915		(3,399	)		16,536		773		15,068		293
Consumer		-		-			-		-		13		1
Total	$	43,186	$	(8,463	)	$	34,769	$	2,554	$	32,231	$	623

F-21

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

										For the year ended
	As of December 31, 2010									December 31, 2010
	Unpaid									Average		Interest
	Principal		Partial			Recorded		Related		Recorded		Income
	Balance		Charge-offs			Investment		Allowance		Investment		Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Real estate secured loans:
Residential construction	$	3,454	$	(83	)	$	3,375	$	-	$	3,033	$	96
Commercial construction, all land development and land loans		7,341		(35	)		7,341		-		6,740		204
Residential properties		989		-			989		-		873		-
Commercial real estate - other		3,924		-			3,933		-		4,499		217
Total real estate secured loans		15,708		(118	)		15,638		-		15,145		517
Other non-real estate loans:
Commercial and industrial		1,282		(150	)		1,143		-		1,211		56
Consumer and other		45		(14	)		31		-		39		2
Total	$	17,035	$	(282	)	$	16,812	$	-	$	16,395	$	575
Impaired with a related allowance recorded:
Real estate secured loans:
Residential construction	$	2,763		(57	)	$	2,706	$	188	$	2,283	$	-
Commercial construction, all land development and land loans		321		-			321		96		350		-
Residential properties		1,708		-			1,708		1,009		875		-
Commercial real estate - other		201		-			201		111		98		-
Total real estate secured loans		4,993		(57	)		4,936		1,404		3,606		-
Other non-real estate loans:
Commercial and industrial		1,934		(390	)		1,544		697		845		-
Total	$	6,927	$	(447	)	$	6,480	$	2,101	$	4,451	$	-
Total impaired:
Commercial	$	15,003	$	(575	)	$	14,483	$	904	$	13,743	$	477
Residential		8,914		(140	)		8,778		1,197		7,064		96
Consumer		45		(14	)		31		-		39		2
Total	$	23,962	$	(729	)	$	23,292	$	2,101	$	20,846	$	575

Each loan risk rated “substandard”, “doubtful” and “loss” is reviewed to determine if it is an impaired loan.  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 allocated 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.

F-22

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

As of December 31, 2011, the recorded investment in loans considered impaired totaled $34.8 million. The Company provided specific reserves of $2.6 million for probable losses on impaired loan balances of $14.5 million.  Management analyzed $20.3 million of impaired loans and determined the collateral to be adequate and no additional specific reserve allowance was necessary after recording approximately $8.1 million in life-to-date partial charge-offs related to December 31, 2011 loan balances of approximately $4.6 million.Total impaired loans as of December 31, 2011 include $10.7 million of restructured but still accruing loans and $10.6 million restructured nonaccrual loans. Nonaccrual TDRs are up $10.1 million over the prior year-end as approximately $8.2 million of accruing TDRs as of year-end 2010 declined to nonaccrual status by year-end 2011. In total, impaired TDRs represent $21.3 million of December 31, 2011 impaired loans. The loans were restructured for various concessions due to financial difficulties of the borrower such as forgiveness of accrued interest, below market interest rate or extended payment terms. In addition, there were five potential problem loans outstanding as of December 31, 2011 with loan balances of $1.9 million, the largest of $1.4 million for residential construction and the remaining primarily secured by residential properties.

The determination for the potential problem loans primarily was the result of information regarding possible, although not probable, credit problems of the related borrowers. Potential problem loans are not included in the table above.Although these loans are not currently impaired, they have been considered by management in assessing the adequacy of its allowance for loan losses as of December 31, 2011and allocated specific reserves of $295,000 included in the allowance for loan losses as of December 31, 2011 for three of the potential problem loans with outstanding loan balances of $1.8 million.  As of year-end, $1.6 million of the potential problem loans were 30 to 59 days past due and the remaining were currently performing and not past due. Potential problem loans as of year-end 2010 have been charged off or are currently nonaccrual.

As of December 31, 2010, the recorded investment in loans that management considered impaired totaled $23.3 million including $11.8 million in restructured but still accruing loans and six restructured nonaccrual loans for $520,000, for a combined 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. 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 rating, 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 if left uncorrected could result in deterioration or (2) were classified as substandard accruing or substandard nonaccruing have made improvements to their financial profile but do not yet meet the definition of a pass grade.

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 weakness 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, any guarantors or of the collateral pledged.  These loans are individually analyzed for impairment.

Doubtful – These loans have all the weaknesses of substandard, nonaccruing 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 this worthless loan even though partial recovery may be affected in the future.

F-23

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

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

	As of December 31, 2011
	Real Estate Loans										Non-Real Estate Loans
	Construction				Residential		Residential				Commercial &		Consumer &
	Residential		Commercial		Properties		Mortgage (1)		Commercial		Industrial		Other		Total
	(Dollars in thousands)
Pass	$	7,048	$	28,632	$	85,956	$	39,829	$	210,446	$	35,301	$	3,848	$	411,060
Special mention		4,410		4,489		8,378		-		12,098		2,509		14		31,898
Substandard accruing		6,858		3,920		8,541		-		3,862		161		-		23,342
Substandard nonaccruing		9,007		10,252		2,351		-		1,850		464		-		23,924
Doubtful		-		231		-		-		-		-		-		231
Loss		-		-		-		-		-		-		-		-
Total by exposure	$	27,323	$	47,524	$	105,226	$	39,829	$	228,256	$	38,435	$	3,862	$	490,455

(1)  Single-family residential mortgages originated through NSB Mortgage, held for investment.

	As of December 31, 2010
	Real Estate Loans								Non-Real Estate Loans
	Construction				Residential				Commercial &		Consumer &
	Residential		Commercial		Properties		Commercial		Industrial		Other		Total
	(Dollars in thousands)
Pass	$	28,520	$	59,248	$	86,491	$	210,118	$	38,616	$	3,534	$	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	$	82,136	$	98,451	$	221,350	$	42,884	$	3,644	$	499,523

As discussed above, TDR loans generally occur when a borrower is experiencing, or is expected to experience, financial difficulties in the near-term. As a result, a concessionary modification with more favorable terms that would not otherwise be considered may be granted  to the borrower with the intent to prevent further difficulties and improve the likelihood of  recovery of the loan. The modifications resulting in a TDR have generally involved a reduction of interest rate or extension of term of the loan or a combination of both. We do not generally forgive principal as part of a loan modification.  Also when possible, additional collateral or guarantor support is obtained when modifying the loan. All TDRs are individually reviewed and analyzed for impairment during management’s monthly evaluation of the allowance for loan losses. The specific allowance is based on the present value of expected cash flows or the fair value of the collateral or the loan’s observable market price.

For the year 2011, the following table presents a breakdown of the types of concessions made by loan class. TDR below market interest rate concessions may also have had an extension of term granted as well.

F-24

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

	Total TDRs
	Year ended December 31, 2011
	Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Below market interest rate:
Real estate secured loans:
Commercial construction, all land development and land loans		2	$	551	$	375
Residential properties		2		538		528
Total real estate secured loans		4		1,089		903
Extended payment terms:
Real estate secured loans:
Residential construction		3		3,087		3,087
Commercial construction, all land development and land loans		2		1,076		1,076
Residential properties		2		415		415
Total real estate secured loans		7		4,578		4,578
Other non-real estate loans:
Commercial and industrial		1		48		-
Total		8		4,626		4,578
Below market rate and extended payment terms:
Real estate secured loans:
Commercial construction, all land development and land loans		1		2,023		2,023
Residential properties		1		444		444
Commercial real estate - other		1		333		332
Total real estate secured loans		3		2,800		2,799
Refinace for interest carry and cash out:
Real estate secured loans:
Commercial construction, all land development and land loans		1		292		290
Residential properties		1		314		314
Total real estate secured loans		2		606		604
Total troubled debt restructured loans		17	$	9,121	$	8,884

The following table presents loans that were modified as troubled debt restructurings within the previous 12 months and for which there was a payment default where payment under the modified terms had been 30 days or more past due at any month end during the year ended December 31, 2011.

F-25

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE D – LOANS (Continued)

	Total TDRs
	Year ended December 31, 2011
	Number of loans		Recorded Investment
	(Dollars in thousands)
Below market interest rate:
Real estate secured loans:
Commercial construction, all land development and land loans		2	$	375
Residential properties		2		528
Total real estate secured loans		4		903
Extended payment terms:
Real estate secured loans:
Residential construction		3		3,087
Commercial construction, all land development and land loans		2		1,076
Residential properties		2		415
Total real estate secured loans		7		4,578
Below market rate and extended payment terms:
Real estate secured loans:
Commercial construction, all land development and land loans		1		2,023
Residential properties		1		444
Commercial real estate - other		1		332
Total real estate secured loans		3		2,799
Refinace for interest carry and cash out:
Real estate secured loans:
Residential properties		1		314
Total real estate secured loans		1		314
Total troubled debt restructured loans		15	$	8,594

The following table presents the successes and failures of the types of modifications within the previous 12 months as of December 31, 2011.

	Paid in full				Paying as restructured				Converted to non-accrual				Foreclosure/Default
	Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment
	(Dollars in thousands)
Below market interest rate		-	$	-		-	$	-		2	$	375		2	$	528
Extended payment terms		-		-		-		-		-		-		3		2,799
Below market rate and extended payment terms		-		-		-		-		1		776		7		3,802
Refinace for interest carry and cash out		-		-		1		290		1		314		-		-
Total		-	$	-		1	$	290		4	$	1,465		12	$	7,129

F-26

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE E - ALLOWANCE FOR LOAN LOSSES

An analysis of the allowance for loan losses for the years ended December 31, 2011, 2010 and 2009 follows:

	For the years ended December 31,
	2011			2010			2009
	(Dollars in thousands)
Allowance for loan losses beginning of period	$	9,935		$	8,581		$	6,376
Provision for loan losses		6,749			8,095			5,710
Loans charged off		(7,548	)		(6,832	)		(3,510	)
Less recoveries		770			91			5
Net charge-offs		(6,778	)		(6,741	)		(3,505	)
Allowance for loan losses end of period	$	9,906		$	9,935		$	8,581

The allowance for probable loan losses is a reserve established through a provision for probable 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. Overall, the allowance for loan losses was unchanged from the prior year-end amount of $9.9 million, however there were changes in the composition of the allowance for loan losses.  An increase in impairment reserves of $453,000 over the prior year was offset by an overall decline in the general reserve. Significant declines in higher risk residential and commercial construction and land development loans coupled with improvements in various other general risk factors applied to the general loan portfolio offset the  increase to the general reserve due to a significantly higher charge-off factor. For the residential property loans, the ending overall reserve balance declined $731,000 from the prior year end due to substantially lower impairment reserves for this class of loans as of year-end 2011.  However, the general reserve as a percentage of residential property loans outstanding increased to 1.58% as of year-end 2011 from 1.39% for the prior year-end. 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.

The table below details activity in the allowance for probable loan losses by segregated loan category for the years ended December 31, 2011 and 2010.  Allocation of a portion of the allowance to one class of loan does not preclude its availability to absorb losses in other classes.

F-27

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE E - ALLOWANCE FOR LOAN LOSSES (Continued)

Allowance for Loan Losses and Recorded Investment in Loans
For the Year Ended December 31, 2011
	Real Estate Loans														Non-Real Estate Loans
	Construction						Residential			Residential					Commercial &			Consumer &
	Residential			Commercial			Properties			Mortgage (1)		Commercial			Industrial			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,475		$	2,269		$	2,339		$	-	$	2,464		$	1,354		$	34		$	9,935
Charge-offs		(1,015	)		(1,875	)		(2,316	)		-		(1,755	)		(531	)		(56	)		(7,548	)
Recoveries		31			55			538			-		16			97			33			770
Provision		1,006			2,334			1,047			40		2,454			(157	)		25			6,749
Ending balance	$	1,497		$	2,783		$	1,608		$	40	$	3,179		$	763		$	36		$	9,906
Ending balance, individually evaluated for impairment	$	756		$	1,370		$	17		$	-	$	211		$	200		$	-		$	2,554
Ending balance, collectively evaluated for impairment	$	741		$	1,413		$	1,591		$	40	$	2,968		$	563		$	36		$	7,352
Loans:
Ending balance	$	27,323		$	47,524		$	105,226		$	39,829	$	228,256		$	38,435		$	3,862		$	490,455
Ending balance, individually evaluated for impairment	$	12,065		$	12,881		$	4,425		$	-	$	4,871		$	481		$	-		$	34,723
Ending balance, collectively evaluated for impairment	$	15,258		$	34,643		$	100,801		$	39,829	$	223,385		$	37,954		$	3,862		$	455,732

(1)  Single-family residential mortgages originated through NSB Mortgage, held for investment.

Allowance for Loan Losses and Recorded Investment in Loans
For the Year Ended December 31, 2010
	Real Estate Loans												Non-Real Estate Loans
	Construction						Residential						Commercial &			Consumer &
	Residential			Commercial			Properties			Commercial			Industrial			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,753		$	2,604		$	1,276		$	2,023		$	870		$	55		$	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			13			8,095
Ending balance	$	1,475		$	2,269		$	2,339		$	2,464		$	1,354		$	34		$	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		$	34		$	7,834
Loans:
Ending balance	$	51,058		$	82,136		$	98,451		$	221,350		$	42,884		$	3,644		$	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		$	74,474		$	95,754		$	217,216		$	40,197		$	3,613		$	476,231

F-28

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE F - PREMISES AND EQUIPMENT

Following is a summary of premises and equipment:

	As of December 31,
	2011			2010
	(Dollars in thousands)
Land	$	4,703		$	4,703
Buildings		8,377			8,373
Leasehold improvements		2,134			2,132
Furniture, fixtures and equipment		5,247			5,006
		20,461			20,214
Accumulated depreciation		(6,302	)		(5,413	)
Total	$	14,159		$	14,801

Depreciation and amortization amounting to $889,000 in 2011, $927,000 in 2010, and $914,000 in 2009 is included in occupancy and equipment expense.

The Company leases office facilities under non-cancelable operating leases.  Future minimum lease payments required under the leases are as follows:

	For the Years Ended
	December 31,
	(Dollars in thousands)
2012	$	1,052
2013		1,064
2014		1,088
2015		796
2016		713
Thereafter		2,818
	$	7,531

Total building and equipment rental expense for the years ended December 31, 2011, 2010 and 2009 amounted to $1.2 million. Rent expense is included in occupancy and equipment expenses. The Company currently does not have any related party lease agreements. The leases have various lease terms and some of the leases have annual renewal options which are deemed probable.

NOTE G - DEPOSITS

The aggregate amount of time deposits in denominations of $100,000 or more as of December 31, 2011 and 2010 was approximately $91.6 million and $98.8 million, respectively.

As of December 31, 2011, the scheduled maturities of time deposits were as follows:

F-29

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE G – DEPOSITS (Continued)

	As of December 31, 2011
	Less than		$100,000
	$100,000		or more		Total
	(Dollars in thousands)
2012	$	47,424	$	58,466		105,890
2013		10,054		12,674		22,728
2014		3,427		15,244		18,671
2015		2,224		3,702		5,926
2016		188		1,439		1,627
after 2016		1		107		108
	$	63,318	$	91,632	$	154,950

NOTE H – BORROWINGS

A summary of borrowings are as follows:

	As of December 31,
	2011		2010
	(Dollars in thousands)
Short-term borrowings:
Repurchase agreements	$	73	$	3,615
	$	73	$	3,615
Long-term borrowings
FHLB advances	$	781	$	804
Subordinated debentures		11,000		11,000
Junior subordinated debentures		15,465		15,465
	$	27,246	$	27,269

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

	Carrying Value as of December 31,				Maturity	Interest
	2011		2010		Date	Rate
	(Dollars in thousands)
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 debentures outstanding as of December 31, 2011 and 2010 are as follows:

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

F-30

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE H – BORROWINGS (Continued)

Short-term Borrowings

The Company had repurchase agreements outstanding in the amount of $73,000 and $3.6 million as of December 31, 2011 and 2010, respectively.  Securities sold under agreements to repurchase generally mature within one to four days from the transaction date and are collateralized by U.S. Government securities and obligations of U.S. government agencies or Government-sponsored residential mortgage-backed securities.  These repurchase agreements are due within one year and are classified as short-term borrowings in the accompanying consolidated balance sheets. Interest rates for repurchase agreements vary from .05% to .10% as of December 31, 2011.

As of  and throughout the years ended December 31, 2011 and 2010, the Company had no outstanding Federal Home Loan Bank (“FHLB”) short-term advances.  Currently, any advances are secured by cash or other assets available for collateralization.

As of December 31, 2011, the Company had pre-approved available lines of credit totaling approximately $169.8 million with various financial institutions and the Federal Reserve for borrowing on a short-term basis, with no amounts outstanding at that date.  These lines are subject to annual renewals with varying interest rates.

Long-term Debt

On March 17, 2004, the Company issued $5.2 million of junior subordinated debentures to North State Statutory Trust I (“Trust I”) in exchange for the proceeds of trust preferred securities issued by Trust I.  On December 15, 2005, the Company issued $5.2 million of junior subordinated debentures to North State Statutory Trust II (“Trust II”) in exchange for the proceeds of trust preferred securities issued by Trust II.  On November 28, 2007, the Company issued $5.2 million of junior subordinated debentures to North State

Statutory Trust III (“Trust III”) in exchange for the proceeds of trust preferred securities issued by Trust III.  Trust I, Trust II and Trust III are wholly owned by the Company.  The junior subordinated deferrable interest debentures are included in long-term debt and the Company’s equity interests in Trust I, Trust II and Trust III are included in other assets.

The junior subordinated debentures for Trust I pay interest quarterly at an annual rate, reset quarterly, equal to 3-month LIBOR plus 2.79%.  The debentures became redeemable in whole or in part on June 17, 2009, and on any January 17, April 17, July17

or October 17 thereafter.  Redemption is mandatory at April 17, 2034.  The Company has fully and unconditionally guaranteed the repayment of the trust preferred securities.  The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.

The junior subordinated debentures for Trust II pay interest quarterly at an annual rate, reset quarterly, equal to 3-month LIBOR plus 1.65%.  The debentures became redeemable in whole or in part on March 15, 2011, on any January 15, April 15, July 15 or October 15 thereafter.  Redemption is mandatory at April 15, 2035.  The Company has fully and unconditionally guaranteed the repayment of the trust preferred securities.  The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.

The junior subordinated debentures for Trust III pay interest quarterly at an annual rate, reset quarterly, equal to 3-month LIBOR plus 2.75%.  The debentures are redeemable in whole or in part on March 15, 2013, on any January 15, April 15, July 15 or October 15 thereafter.  Redemption is mandatory at December 15, 2037.  The Company has fully and unconditionally guaranteed the repayment of the trust preferred securities.  The Company’s obligation under the guarantee is unsecured and subordinate to senior and subordinated indebtedness of the Company.

Effective March 31, 2011, the Federal Reserve rules limit the aggregate amount of restricted core capital elements, including trust preferred securities that can be included in Tier I capital to not more than 25% of total core capital elements, net of goodwill, less any associated tax liability.  The new rule also limits the aggregate amount of restricted core capital elements (including trust preferred securities), term subordinated debt and limited life preferred stock that can be included in Tier II capital to 50% of Tier I capital.

On May 13, 2008, the Bank issued $9.8 million and, on July 1, 2008, $1.2 million of floating-rate subordinated notes due June 30, 2018.  Interest on the notes is payable quarterly in arrears on March 31, June 30, September 30 and December 31 of each year beginning with June 30, 2008.  The interest rate on the notes is based on 3-month LIBOR plus 3.50% and resets quarterly on the 15th of March, June, September and December of each year. The Bank may redeem some or all of the notes at any time beginning on June 30, 2013 at a price equal to 100% of the principal amount of the notes redeemed plus accrued but unpaid interest to the redemption date. The subordinated notes are included in long-term borrowings and currently qualify 100% as Tier II capital. To qualify for Tier II capital, the subordinated notes must have an original weighted average maturity of at least five years and are discounted 20% each year after the remaining maturity is five years or less. The portion of qualifying subordinated notes that remains after discounting, if any, is limited to 50% of Tier I capital.

F-31

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE H – BORROWINGS (Continued)

Long-term Debt (Continued)

As of December 31, 2011 and 2010, the Company had $781,000 and $804,000, respectively, in a long-term FHLB advance.  This advance, maturing on October 7, 2025, funds a qualified Community Investment Program loan.  The Company pays 2.00% interest for the advance with the loan earning 4.00%. This advance is secured by cash as of December 31, 2011 and 2010.

NOTE I - INCOME TAXES

The significant components of the provision for income taxes for the years ended December 31, 2011, 2010 and 2009 are as follows:

	2011		2010			2009
	(Dollars in thousands)
Current tax expense (benefit):
Federal	$	145	$	1,538		$	727
State		92		244			303
		237		1,782			1,030
Deferred tax provision:
Federal		233		(1,006	)		(147	)
State		79		(59	)		(109	)
		312		(1,065	)		(256	)
Provision for income tax expense before adjustment to deferred tax asset valuation allowance		549		717			774
Increase in valuation allowance		52		78			43
Net provision for income taxes	$	601	$	795		$	817

The difference between the provision for income taxes and the amounts computed by applying the statutory federal income tax rate of 34% to income before income taxes is summarized below:

	2011			2010			2009
	(Dollars in thousands)
Expected income tax expense	$	591		$	618		$	651
Increase (decrease) resulting from:
State income taxes, net of federal tax effect		113			114			87
Adjustment to deferred tax asset valuation allowance		52			78			43
Credits		(82	)		(47	)		(29	)
Other, net		(73	)		32			65
Provision for income taxes	$	601		$	795		$	817

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.  Significant components of deferred taxes at December 31, 2011 and 2010 are as follows:

F-32

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE I – INCOME TAXES (Continued)

	2011			2010
	(Dollars in thousands)
Deferred tax assets relating to:
Allowance for loan losses	$	3,819		$	3,775
Deferred compensation		45			71
Unrealized loss on available for sale securities		-			32
Capital loss carryforward		40			40
Foreclosed assets		209			213
Interest on nonaccrual loans		79			44
Lease obligations		152			144
CAHEC investment		14			17
State net operating loss carrryforwards		323			270
Total deferred tax assets		4,681			4,606
Less:  Valuation allowance		(362	)		(310	)
Net deferred tax asset		4,319			4,296
Deferred tax liabilities relating to:
Deferred loan origination fees		(745	)		(323	)
Goodwill		(7	)		(4	)
Property and equipment		(243	)		(309	)
Prepaid expenses		(159	)		(101	)
Unrealized gain on available for sale securities		(140	)		-
Total deferred tax liabilities		(1,294	)		(737	)
Net recorded deferred tax assets included in other assets	$	3,025		$	3,559

It is the Company’s policy to recognize interest and penalties associated with uncertain tax positions as components of income taxes.  There were no interest or penalties accrued during 2011 or 2010.  The Company’s federal and state income tax returns are subject to examination for the years 2008, 2009, and 2010. There were no uncertain tax positions as of December 31, 2011 or 2010. The valuation allowance is related to a state net operating loss and capital loss carryforwards.

NOTE J – OTHER NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE

The major components of non-interest income for the years ended December 31, 2011, 2010 and 2009 are as follows:

F-33

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE J – OTHER NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE (Continued)

	2011		2010		2009
	(Dollars in thousands)
Merchant and other loan fees	$	98	$	114	$	136
Service charges and fees on deposit accounts		403		402		432
Gain on sale of equity interest in investment		-		-		18
Gain on sale of investment securities		374		741		464
Impairment loss on nonmarketable securities		-		-		(134	)
Income from bank owned life insurance		146		-		-
Other		576		599		252
Total other non-interest income	$	1,597	$	1,856	$	1,168

The major components of other non-interest expense for the years ended December 31, 2011, 2010 and 2009 are as follows:

	2011		2010		2009
	(Dollars in thousands)
Professional fees	$	372	$	478	$	419
Postage, printing & office supplies		168		160		120
Advertising and promotion		90		133		134
Telephone		291		238		218
Directors fees		189		40		17
FDIC insurance premiums		919		1,346		1,766
Other		1,758		1,414		1,268
Total other non-interest expense	$	3,787	$	3,809	$	3,942

NOTE K - REGULATORY MATTERS

The Bank, as a North Carolina banking corporation, may pay cash dividends to the Company only out of undivided profits as determined pursuant to North Carolina General Statutes Section 53-87. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such limitation is in the public interest and is necessary to ensure financial soundness of the bank.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.  Prompt corrective action provisions are not applicable to bank holding companies.

As of December 31, 2011, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum amounts and ratios. There are no conditions or events since that notification that management believes have changed the Bank’s category. Based on the current economic 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 for the Bank.

F-34

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE K - REGULATORY MATTERS (Continued)

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios, as prescribed by regulations, of total and Tier I capital to risk-weighted assets and of Tier I capital to average assets. As of December 31, 2011 and 2010, the Company and the Bank met their respective capital adequacy requirements.

Information regarding the Bank’s capital and capital ratios is set forth below:

											Minimum to be well
						Minimum for capital					capitalized under prompt
	Actual					adequacy purposes					corrective action provisions
	Actual		Ratio			Actual		Ratio			Actual		Ratio
	(Dollars in thousands)
As of December 31, 2011
Total capital to risk-weighted assets	$	69,799		13.87	%	$	40,253		8.00	%	$	50,316		10.00	%
Tier I capital to risk-weighted assets		52,458		10.43	%		20,126		4.00	%		30,190		6.00	%
Tier I capital to average assets		52,458		8.37	%		25,078		4.00	%		31,348		5.00	%
As of December 31, 2010
Total capital to risk-weighted assets	$	68,425		12.99	%	$	42,141		8.00	%	$	52,677		10.00	%
Tier I capital to risk-weighted assets		50,799		9.64	%		21,071		4.00	%		31,606		6.00	%
Tier I capital to average assets		50,799		8.04	%		25,280		4.00	%		31,600		5.00	%

The Company is also subject to these capital requirements. Information regarding the Company’s capital and capital ratios is set forth below:

	December 31, 2011					December 31, 2010
	Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
Total capital to risk-weighted assets	$	70,861		14.08	%	$	70,518		13.37	%
Tier I capital to risk-weighted assets		50,938		10.12	%		49,895		9.46	%
Tier I capital to average assets		50,938		8.12	%		49,895		7.89	%

The mortgage bank segment qualifies as a U.S. Department of Housing and Urban Development, or HUD, approved Title II nonsupervised mortgagee and issues mortgages insured by HUD. A Title II nonsupervised mortgagee must maintain an adjusted  net worth equal to a minimum of $250,000 plus 1% of mortgage volume in excess of $25 million, up to a maximum net worth of $1 million.  Possible penalties related to noncompliance with this minimum net worth requirement includes the revocation of the Bank’s license to issue HUD insured mortgages, which may have a material adverse effect on the Bank’s financial condition and results of operations. For the years ended December 31, 2011 and 2010, the mortgage company was required to maintain $1 million in adjusted net worth. As of December 31, 2011 and 2010, the mortgage company’s adjusted net worth was $3.9 million and $2.5 million, respectively, which exceeds the required minimum net worth requirements.

NOTE L – OFF-BALANCE SHEET RISK

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

F-35

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE L –OFF-BALANCE SHEET RISK (Continued)

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit. The liability related to off balance sheet commitments is not considered material as of December 31, 2011 or 2010.

A summary of the contract amount of the Company’s exposure to off-balance sheet credit risk as of December 31, 2011 is as follows (Dollars in thousands):

Financial instruments whose contract amounts represent credit risk:
Undisbursed lines of credit	$	28,386
Commitments to extend credit		9,890
Letters of credit		1,385
Commitments to originate mortgage loans, fixed and variable		124,872
	$	164,533

NOTE M - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS

Financial instruments include cash and due from banks, interest-bearing deposits with banks, certificates of deposit with banks, investments, accrued interest, loans, written loan commitments, bank owned life insurance, deposit accounts and borrowings. The Company has recorded certain assets at fair value as required by accounting standards on the proper disclosure of fair value of financial instruments. 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 and Interest-Earning Deposits With Banks

The carrying amounts are a reasonable estimate of fair value for cash and due from banks and interest-earning deposits with banks 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.

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 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.

F-36

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

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

Bank Owned Life Insurance

The carrying value of life insurance approximates fair value as this investment is carried at cash surrender value as determined by the insurer.

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.

Financial Instruments with Off-Balance Sheet Risk

With regard to financial instruments with off-balance sheet risk discussed in Note L, the estimated fair value of future financing commitments is not deemed material.

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

	December 31, 2011				December 31, 2010
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	9,826	$	9,826	$	5,974	$	5,974
Interest-earning deposits with banks		39,547		39,547		43,859		43,859
Certificates of deposit with banks		-		-		198		198
Investment securities available for sale		12,917		12,917		9,234		9,234
Investment securities held to maturity		250		201		250		211
Loans held for sale		49,728		49,728		51,472		51,472
Loans, net		480,549		487,617		489,588		490,131
Accrued interest receivable		1,441		1,441		1,654		1,654
Stock in the Federal Home Loan Bank		1,073		1,028		1,273		1,273
Bank owned life insurance		10,146		10,146		-		-
Written loan commitments		946		946		411		411
Financial liabilities:
Deposits	$	564,439	$	565,344	$	562,748	$	562,640
Short-term borrowings		73		73		3,615		3,615
Long-term borrowings		27,246		27,310		27,269		27,253
Accrued interest payable		897		897		1,181		1,181

F-37

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE N - 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.

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

·      Level 3 – Valuations for assets and liabilities that are derived from other valuation methodologies,  including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or brokered traded

transactions.  Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

The following is a description of valuation methodologies used by the Company for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

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

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 December 31, 2011 averaged 33.6%. As of December 31, 2011, the amount of fair value associated with these written loan commitments was $946,000, 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. The fair value of interest rate lock commitments is based on servicing rate premium, origination income net of originations costs, and changes in loan pricing between the commitment date and period end, typically month end. The fair value of forward sales commitments is based on changes in loan pricing between the commitment date and period end. The commitments to sell mortgages are generally equal and offsetting to the interest rate lock commitment, both of whose fair values are deemed to be immaterial as of December 31, 2011 and 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 impaired, management measures the 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 or 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 December 31, 2011, a portion of the Company’s impaired loans was 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 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.

F-38

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE N - FAIR VALUE MEASUREMENT (Continued)

Foreclosed Assets

Foreclosed assets are adjusted to fair value, less cost to sale, upon transfer of the loans to foreclosed assets. Subsequently, foreclosed 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 December 31, 2011
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage- backed securities	$	12,917	$	-	$	12,917	$	-
Written loan commitments		946		-		-		946
Total	$	13,863	$	-	$	12,917	$	946
	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
Total	$	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 years ended December 31, 2011 and 2010.

	Written Loan Commitments
	For the year ended December 31,
	2011		2010
	(Dollars in thousands)
Balance, beginning of year	$	411	$	-
Gains included in other income		535		411
Balance, end of year	$	946	$	411

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.

F-39

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE N - FAIR VALUE MEASUREMENT (Continued)

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

	As of December 31, 2011
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Impaired loans	$	16,309	$	-	$	4,348	$	11,961
Foreclosed assets	$	2,851	$	-	$	562	$	2,289
	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

As of December 31, 2011 all level 2 nonrecurring impaired loans and foreclosed assets have sales contracts or commitments to purchase. No further market driven discounts were applied to the December 31, 2010 impaired loans that required transfers between Level 2 and Level 3 as of year-end 2011. Approximately $1.8 million of the December 31, 2009 level 2 impaired loans were transferred to level 3 as of December 31, 2010 as a result of further market driven discounts.

NOTE O - EMPLOYEE AND DIRECTOR BENEFIT PLANS

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 estimated based on the Company’s historical volatility over a period similar to the expected life of the option grant.  The expected term of the options is based upon the average life of previously 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 years ended December 31, 2011 and 2010.

F-40

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE O - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

Stock Option Plan (Continued)

	Years Ended December 31,
	2011			2010			2010
Estimated fair value of options granted	$	2.47		$	1.97		$	2.80
Assumptions in estimating option values:
Risk-free interest rate		3.12	%		2.39	%		1.89	%
Dividend yield		0	%		0	%		0	%
Expected volatility		59.8	%		39.6% - 41.0	%		40.4
Expected life	7 years			6.5 - 7 years			6 years

A summary of option activity under the stock option plan for the year ended December 31, 2011 is as follows:

				Weighted Average
						Remaining	Aggregate
				Exercise		Contractual	Intrinsic
	Shares			Price		Term	Value
							(in thousands)
Outstanding as of December 31, 2010		140,503		$	8.51	5.19 years	$	9
Granted		10,000		$	4.00
Exercised		-			-
Forfeited		(25,000	)	$	12.10
Expired		-			-
Outstanding as of December 31, 2011		125,503		$	7.43	4.10 years	$	-
Exercisable as of December 31, 2011		103,584		$	7.65	3.23 years	$	-

	Range of Exercise Prices
	Number of		Number of
	options		options
	outstanding		exercisable
$3.22 - $5.15		65,303		51,286
$6.37 - $12.25		48,700		43,098
$17.00 - $18.50		11,500		9,200
		125,503		103,584

	Nonvested Shares
				Weighted
				Average Grant
	Shares			Date Fair Value
Nonvested, December 31, 2010		38,527		$	9.64
Granted		10,000		$	2.47
Vested		(10,608	)	$	11.49
Forfeited		(16,000	)	$	14.94
Nonvested, December 31, 2011		21,919		$	6.38

F-41

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE O - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)

Stock Option Plan (Continued)

No stock options were exercised during 2011. For the year ended December 31, 2010, the intrinsic value of options exercised was approximately $400,000.  During the second quarter of 2011, 10,000 options were granted with a fair value of $2.47. During 2010, 10,000 options were granted during the first quarter with a fair value of $2.11 and 5,000 options were granted during the second quarter with a fair value of $1.68 per option.  The fair value of options vested was approximately $72,000 and $100,000 for the years ended December 31, 2011 and 2010, respectively. As of December 31, 2011, approximately $55,000 of share-based compensation expense remained to be recognized over a weighted average period of approximately three years.

Cash received from option exercises under share-based payment arrangements for the year ended December 31, 2010 was approximately $611,000.  Tax benefits of $60,000 were realized for tax deductions from option exercise of the share-based payment arrangements during the year ended December 31, 2010.

Employment Agreements

The Company has entered into an employment agreement with its chief executive officer to ensure a stable and competent management base. This agreement provides for benefits as spelled out in the contract and cannot be terminated by the Board of Directors, except for cause, without prejudicing the officer’s right to receive certain vested rights, including compensation. In the event of a change in control of the Company, as outlined in the agreement, the acquirer will be bound to the terms of this contract.

The Company has entered into agreements with four executive officers and two non-executive officers that provide for severance pay benefits in the event of a change in control of the Company that results in the termination of such officers or diminished compensation, duties or benefits.

The Company has entered into an employment agreement with one non-executive officer related to the acquisition of Affliated Mortgage in 2010.

Deferred Compensation Plan for Directors

In December 2001, the Company implemented a non-qualifying deferred compensation plan for directors. Under the plan, a participating director could elect to defer receipt of all or a portion of his or her director fees that would otherwise be payable in cash. At the end of each calendar year, the fees electively deferred during the year were converted, using a formula based upon 125% of the dollar amount of fees deferred and the fair value of the Company’s common stock at the close of business on the preceding January 1, into a hypothetical number of shares (the “phantom shares”) credited to the participating director’s account.  The then current value of all phantom shares accumulated under the plan were payable to the participating director, or to his or her designated beneficiary, upon

retirement, disability or death. Provisions of $613,000 in 2006 and $399,000 in 2005 were expensed to provide for future obligations payable under this plan.  At December 31, 2006 and December 31, 2005, the outstanding deferred obligations were $1.3 million and $719,000, respectively. Effective December 31, 2006, the amount of phantom shares credited to a director under the plan was converted to a cash amount based on a value of $24.00 per phantom share.  Beginning January 1, 2007, this amount was credited to a bookkeeping account for each director, and each month a rate of earnings will be credited to the account for the month equal to the 3-month LIBOR rate in effect on the last business day of the month plus 2%.

Beginning in 2007, the Company implemented a new deferred compensation plan for directors.  Under this plan, a director could elect to defer the payment of all or a portion of his or her director’s fees that would otherwise have been paid currently.  During September 2007, the board of directors waived the equity compensation portion of the 2007 deferred compensation plan for fiscal 2007 and in December 2007 terminated the equity compensation portion in its entirety. The fees deferred were to be increased by 25% and credited to a bookkeeping account kept by the Company for the director, however beginning January 1, 2008, the 25% fee was ceased and in May 2008, the board of directors terminated deferral of director’s fees for fiscal years after 2008. The outstanding deferred director compensation obligation was approximately $117,000 and $184,000, respectively, as of December 31, 2011 and 2010.

401(k) Retirement Plan

The Company maintains a qualified 401(k) plan for regular full or part-time employees. Under the plan, employees may contribute up to an annual maximum as determined under the Internal Revenue Code. The Company matches 100% of such contributions not exceeding 6% of the participants’ compensation. In addition, the board of directors can authorize additional discretionary contributions to the plan. The plan provides that employees’ contributions are 100% vested at all times.  Company contributions are 100% vested for the years beginning on or after January 1, 2008. The Company began expense reduction initiatives early in 2009 which included the temporary suspension of the Company’s matching contributions which continued through the years 2011 and 2010.  The expense related to the 401(k) plan contributions for the year ended December 31, 2009 totaled approximately $108,000.

F-42

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE P - PARENT COMPANY FINANCIAL DATA

Following are the condensed financial statements of North State Bancorp as of December 31, 2011 and 2010 and for the years ended December 31, 2011, 2010 and 2009:

Condensed Statements of Financial Condition
December 31, 2011 and 2010
	2011		2010
	(Dollars in thousands)
Assets
Cash	$	908	$	1,145
Investment in North State Bank		52,868		50,880
Investment in North State Statutory Trust I		155		155
Investment in North State Statutory Trust II		155		155
Investment in North State Statutory Trust III		155		155
Other assets		239		495
Total Assets	$	54,480	$	52,985
Liabilities and Shareholders' equity
Other liabilities	$	26	$	18
Long-term borrowings		15,465		15,465
Shareholders' equity
Common stock		21,708		21,636
Retained earnings		17,063		15,926
Accumulated other comprehensive income (loss)		218		(60	)
Total shareholders' equity		38,989		37,502
Total liabilities and shareholders' equity	$	54,480	$	52,985

Condensed Statements of Operations
Years Ended December 31, 2011, 2010 and 2009
	2011			2010			2009
	(Dollars in thousands)
Equity in undistributed earnings of bank subsidiary	$	1,638		$	741		$	850
Dividend income from bank subsidiary		-			750			754
Interest income		25			45			54
Interest expense		(434	)		(429	)		(536	)
Other expense		(351	)		(324	)		(285	)
Tax benefit		259			241			261
Net income	$	1,137		$	1,024		$	1,098

F-43

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE P - PARENT COMPANY FINANCIAL DATA (Continued)

Condensed Statements of Cash Flows
Years Ended December 31, 2011, 2010 and 2009
	2011			2010			2009
	(Dollars in thousands)
Cash flows from operating activities:
Net income	$	1,137		$	1,024		$	1,098
Adjustments to reconcile net income to net cash
(used) provided by operating activities:
Amortization		2			2			2
Stock based compensation		72			100			119
Gain on sale of investment in Beacon Title		-			-			(18	)
Equity in undistributed earnings of subsidiaries		(1,638	)		(741	)		(850	)
Changes in assets and liabilities:
(Increase) decrease in other assets		254			(308	)		(86	)
Increase (decrease) in other liabilities		8			(2	)		(53	)
Net cash (used) provided by operating activities		(165	)		75			212
Cash flows from investing activities:
Proceeds from sale of investment in Beacon Title		-			-			32
Investment in subsidiaries		(72	)		588			625
Net cash (used) provided by investing activities		(72	)		588			657
Cash flows from financing activities:
Proceeds from stock options exercised		-			611			89
Excess tax benefits from stock options		-			60			9
Dividends from bank subsidiary		-			(750	)		(754	)
Net cash used by financing activities		-			(79	)		(656	)
Net (decrease) increase in cash and cash equivalents		(237	)		584			213
Cash and cash equivalents, beginning		1,145			561			348
Cash and cash equivalents, ending	$	908		$	1,145		$	561

NOTE Q – 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 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 years ended December 31, 2011 and 2010.  Segment reporting disclosure was not required for 2009 as the mortgage division was not established until February 2010.

F-44

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2011, 2010 and 2009

NOTE Q – BUSINESS SEGMENT INFORMATION (Continued)

	As of or for the Year Ended December 31, 2011
	Bank			NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	25,322		$	2,454	$	25		$	(11	)	$	27,790
Total interest expense		4,900			-		434			(11	)		5,323
Net interest income		20,422			2,454		(409	)		-			22,467
Provision for loan losses		6,749			-		-			-			6,749
Net interest income after provision for loan losses		13,673			2,454		(409	)		-			15,718
Noninterest income		1,597			3,492		1,638			(1,638	)		5,089
Noninterest expense		15,449			3,269		351			-			19,069
Income before income taxes		(179	)		2,677		878			(1,638	)		1,738
Income taxes		(62	)		922		(259	)		-			601
Net income (loss)	$	(117	)	$	1,755	$	1,137		$	(1,638	)	$	1,137
Total assets	$	541,014		$	91,172	$	54,480		$	(53,776	)	$	632,890
Net loans		440,055			40,494		-			-			480,549
Loans held for sale		-			49,728		-			-			49,728
Goodwill		-			141		-			-			141

	As of or for the Year Ended December 31, 2010
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	29,478	$	1,472	$	45		$	(33	)	$	30,962
Total interest expense		7,092		-		429			(33	)		7,488
Net interest income		22,386		1,472		(384	)		-			23,474
Provision for loan losses		8,095		-		-			-			8,095
Net interest income after provision for loan losses		14,291		1,472		(384	)		-			15,379
Noninterest income		1,838		2,638		1,491			(1,491	)		4,476
Noninterest expense		15,326		2,386		324			-			18,036
Income before income taxes		803		1,724		783			(1,491	)		1,819
Income taxes		283		753		(241	)		-			795
Net income (loss)	$	520	$	971	$	1,024		$	(1,491	)	$	1,024
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

F-45

SIGNATURES

Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	North State Bancorp
Date: March 30, 2012	By:	/s/  Larry D. Barbour
		Larry D. Barbour, President and Chief Executive Officer

Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.

Signature	Title	Date
/s/ Larry D. Barbour	President, Chief Executive Officer and Director	March 30, 2012
Larry D. Barbour	(principal executive officer)
/s/ Kirk A. Whorf	Chief Financial Officer (principal financial	March 30, 2012
Kirk A. Whorf	officer)
/s/ JoAnn B. Bratton	Controller (principal accounting officer)	March 30, 2012
JoAnn B. Bratton
/s/ Forrest H. Ball	Director	March 30, 2012
Forrest H. Ball
/s/ James C. Branch	Director	March 30, 2012
James C. Branch
/s/ Charles T. Francis	Director	March 30, 2012
Charles T. Francis
/s/ Glenn Futrell	Director	March 30, 2012
Glenn Futrell
	Director	March 30, 2012
Jeanette W. Hyde
/s/ J. Keith Keener	Director	March 30, 2012
J. Keith Keener
/s/ Burley B. Mitchell, Jr.	Director	March 30, 2012
Burley B. Mitchell, Jr.
/s/ Barry W. Partlo	Director	March 30, 2012
Barry W. Partlo
/s/ W. Harold Perry	Director	March 30, 2012
W. Harold Perry
/s/ Fred J. Smith, Jr.	Director	March 30, 2012
Fred J. Smith, Jr.
/s/ Jack M. Stancil	Director	March 30, 2012
Jack M. Stancil

S-1