North State Bancorp (NSBC) 10-Q 2012 Q2 Quarterly report

U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C.  20549

FORM 10-Q

[ X ]  Quarterly Report Pursuant to  Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2012

or

[    ]  Transition Report Pursuant to Section 13

or 15(d) of the Securities Exchange Act of 1934

For the transition period ended

Commission File Number -          000-49898               

	NORTH STATE BANCORP
(Exact name of small business issuer as specified in its charter)
NORTH CAROLINA		65-1177289
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification Number)
6204 FALLS OF THE NEUSE ROAD,  RALEIGH, NORTH CAROLINA 27609
(Address of principal executive office)
	(919) 787-9696
	(Issuer’s telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     X    No _____

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes     X    No _____

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

Large accelerated filer [  ]       Accelerated filer [  ]       Non-accelerated filer [  ] (Do not check if a smaller reporting company)       Smaller reporting company [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12 b-2 of the Exchange Act):

Yes _____  No     X    

As of August 14, 2012 7,427,976shares of the registrant’s common stock, no par value per share, were outstanding. The registrant has no other classes of securities outstanding.

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
	Consolidated Balance Sheets June 30, 2012 and December 31, 2011	3
	Consolidated Statements of Operations Three and Six Months Ended June 30, 2012 and 2011	4
	Consolidated Statements of Comprehensive Income Three and Six Months Ended June 30, 2012 and 2011	5
	Consolidated Statements of Changes in Shareholders’ Equity Six Months Ended June 30, 2012 and 2011	6
	Consolidated Statements of Cash Flows Six Months Ended June 30, 2012 and 2011	7
	Notes to Consolidated Financial Statements	8
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	47
Item 4 -	Controls and Procedures	48
Part II.	OTHER INFORMATION
Item 1A -	Risk Factors	49
Item 6 -	Exhibits	49

NORTH STATE BANCORP

CONSOLIDATED BALANCE SHEETS

ASSETS	June 30, 2012  (unaudited)		December 31, 2011  *
	(Dollars in thousands)
Cash and due from banks	$	8,835	$	9,826
Interest-earning deposits with banks		40,205		39,547
Investment securities available for sale, at fair value		20,771		12,917
Investment securities held to maturity, at amortized cost		250		250
Loans held for sale		88,188		49,728
Loans		482,825		490,455
Less allowance for loan losses		8,355		9,906
Net loans		474,470		480,549
Accrued interest receivable		1,322		1,441
Stock in the Federal Home Loan Bank of Atlanta, at cost		1,004		1,073
Premises and equipment, net		13,865		14,159
Foreclosed assets		8,084		2,851
Prepaid FDIC insurance		2,391		2,777
Bank owned life insurance		10,335		10,146
Other assets		7,828		7,626
TOTAL ASSETS	$	677,548	$	632,890
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Demand	$	155,275	$	145,185
Savings, money market and NOW		290,345		264,304
Time		162,189		154,950
Total deposits		607,809		564,439
Accrued interest payable		1,090		897
Short-term borrowings		-		73
Long-term borrowings		27,235		27,246
Accrued expenses and other liabilities		1,787		1,246
TOTAL LIABILITIES		637,921		593,901
Commitments
Shareholders' equity:
Preferred stock, no par value, 1,000,000 shares authorized, none issued		-		-
Common stock, no par value; 10,000,000 shares authorized; 7,427,976 shares issued and outstanding June 30, 2012 and December 31, 2011		21,729		21,708
Retained earnings		17,882		17,063
Accumulated other comprehensive income		16		218
TOTAL SHAREHOLDERS' EQUITY		39,627		38,989
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	677,548	$	632,890

* Derived from audited consolidated financial statements.

See accompanying notes.

3

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

 

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
	(Dollars in thousands, except per share data)
INTEREST INCOME
Loans	$	5,810	$	6,156	$	11,945	$	12,816
Loans held for sale		663		272		893		546
Investments		58		242		109		347
Dividends and interest-earning deposits		63		64		97		105
Total interest income		6,594		6,734		13,044		13,814
INTEREST EXPENSE
Savings, money market and NOW		307		401		640		881
Time deposits		518		717		1,056		1,487
Short-term borrowings		-		1		-		2
Long-term borrowings		244		230		484		461
Total interest expense		1,069		1,349		2,180		2,831
Net interest income		5,525		5,385		10,864		10,983
PROVISION FOR LOAN LOSSES		1,363		1,418		2,894		2,433
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		4,162		3,967		7,970		8,550
NON-INTEREST INCOME
Merchant and other loan fees		37		27		90		53
Service charges and fees on deposits		98		98		196		196
Gain on sale of investment securities		-		329		106		329
Fees from mortgage operations		1,544		536		2,488		1,033
Fees from wealth management services		80		135		147		221
Income from bank owned life insurance		92		-		189		-
Other		59		40		111		76
Total non-interest income		1,910		1,165		3,327		1,908
NON-INTEREST EXPENSE
Salaries and employee benefits		2,773		2,266		5,386		4,569
Occupancy and equipment		692		702		1,348		1,405
Professional fees		89		86		185		168
Advertising and promotion		23		33		44		62
Data processing and other outsourced services		531		443		1,032		913
FDIC insurance		198		358		395		690
Net cost of foreclosed assets		100		561		242		1,052
Telecommunications		92		70		165		142
Mortgage processing costs		68		20		149		81
Other		626		411		1,166		870
Total non-interest expense		5,192		4,950		10,112		9,952
INCOME BEFORE INCOME TAXES		880		182		1,185		506
INCOME TAXES		297		71		366		192
NET INCOME	$	583	$	111	$	819	$	314
NET INCOME PER COMMON SHARE:
Basic	$	0.08	$	0.01	$	0.11	$	0.04
Diluted	$	0.08	$	0.01	$	0.11	$	0.04
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic		7,427,976		7,427,976		7,427,976		7,427,976
Diluted		7,427,976		7,431,682		7,427,976		7,432,884

See accompanying notes.

4

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Net income	$	583		$	111		$	819		$	314
Other comprehensive income (loss):
Securities available for sale:
Unrealized holding gains (losses) on available for sale securities		(24	)		792			(226	)		762
Tax effect		9			(305	)		89			(294	)
Reclassification of net gain recognized in net income		-			(329	)		(106	)		(329	)
Tax effect		-			127			41			127
Total other comprehensive income (loss)		(15	)		285			(202	)		266
Comprehensive income	$	568		$	396		$	617		$	580

See accompanying notes.

5

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

	Common Stock				Retained		Accumulated other comprehensive			Total shareholders'
	Shares		Amount		earnings		income (loss)			equity
	(Dollars in thousands)
Balance as of December 31, 2010		7,427,976	$	21,636	$	15,926	$	(60	)	$	37,502
Net income		-		-		314		-			314
Other comprehensive income, net of tax		-		-		-		266			266
Stock based compensation		-		50		-		-			50
Balance as of June 30, 2011		7,427,976	$	21,686	$	16,240	$	206		$	38,132
Balance as of December 31, 2011		7,427,976	$	21,708	$	17,063	$	218		$	38,989
Net income		-		-		819		-			819
Other comprehensive loss, net of tax		-		-		-		(202	)		(202	)
Stock based compensation		-		21		-		-			21
Balance as of June 30, 2012		7,427,976	$	21,729	$	17,882	$	16		$	39,627

See accompanying notes.

6

NORTH STATE BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Six months ended June 30,
	2012			2011
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	819		$	314
Adjustments to reconcile net income to net cash provided (used) by operating activities:
Provision for loan losses		2,894			2,433
Depreciation and amortization		411			453
Net amortization of premiums and discounts on investment securities		93			1
Originations of mortgage loans held for sale		(288,232	)		(157,799	)
Proceeds from sales of mortgage loans held for sale		248,863			161,757
Net realized gains on sale of investment securities available for sale		(106	)		(329	)
Income from bank owned life insurance		(189	)		-
Loss on sale of foreclosed assets		92			67
Provision for foreclosed assets		38			957
Stock based compensation		21			50
Changes in assets and liabilities:
Decrease in other assets		1,223			723
Decrease in accrued interest receivable		119			230
Increase (decrease) in accrued expenses and other liabilities		541			(246	)
Increase in accrued interest payable		193			127
Net cash provided (used) by operating activities		(33,220	)		8,738
CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in certificates of deposit with banks		-			(537	)
Proceeds from sales of investment securities available for sale		9,209			17,785
Proceeds from maturities and repayments of investment securities available for sale		2,592			7,876
Purchases of investment securities available for sale		(19,974	)		(32,677	)
Sale of Federal Home Loan Bank stock		69			46
Net decrease (increase) in loans		(3,745	)		13,510
Purchases of premises and equipment		(117	)		(139	)
Proceeds from sales of foreclosed assets		1,567			2,090
Capital expenditures on foreclosed assets		-			(71	)
Net cash provided (used) by investing activities		(10,399	)		7,883
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in short-term borrowings		(73	)		(154	)
Repayments on long-term borrowings		(11	)		(11	)
Net increase in deposit accounts		43,370			4,126
Net cash provided by financing activities		43,286			3,961
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(333	)		20,582
CASH AND CASH EQUIVALENTS, BEGINNING		49,373			49,833
CASH AND CASH EQUIVALENTS, ENDING	$	49,040		$	70,415

See accompanying notes.

7

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE A – BASIS OF PRESENTATION

In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of June 30, 2012 and December 31, 2011 and for the three and six-month periods ended June 30, 2012 and 2011, in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated financial statements include the accounts and transactions of North State Bancorp (the “Company”) and its wholly-owned subsidiary, North State Bank (the “Bank”).

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 in Wake County, and in southeast North Carolina in New Hanover County, operating under the banking laws of North Carolina and under 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 another wholly-owned subsidiary, North State Title, LLC, which owns 67% of Title Group, LLC, a title insurance agency.

All significant intercompany transactions and balances are eliminated in consolidation.  The preparation of consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements, as well as the amounts of income and expense during the reporting period.  Actual results could differ from those estimates. Operating results for the three and six-month periods ended June 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.

The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the consolidated financial statements filed as part of the Company’s 2011 Annual Report on Form 10-K for the year ended December 31, 2011. This quarterly report should be read in conjunction with the Annual Report.

NOTE B – RECENT ACCOUNTING PRONOUCEMENTS

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 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 Company adopted this statement during the quarter ended March 31, 2012, which resulted in additional disclosures related to fair value.

ASU No. 2011-11, amendments to ASC 210-20, Balance Sheet: Disclosures about Offsetting Assets and Liabilities, was issued by FASB during the quarter ended December 2011.  The amendments in this update require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. This update affects all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement.  This information is intended to enable users of an entity’s financial statements to evaluate the effect or potential effect of netting arrangements on an entity’s financial position, including the effect or potential effect of rights to setoff associated with certain financial instruments and derivative instruments in the scope of this update. The amendments are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial statements.

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

NOTE C - INVESTMENT SECURITIES

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

8

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE C - INVESTMENT SECURITIES (Continued)

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

	As of June 30, 2012
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	20,745	$	123	$	97	$	20,771
Total securities available for sale	$	20,745	$	123	$	97	$	20,771
Securities held to maturity:
Corporate securities	$	250	$	-	$	49	$	201
Total securities held to maturity	$	250	$	-	$	49	$	201

	As of December 31, 2011
	Amortized cost		Gross unrealized gains		Gross unrealized losses		Fair 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

The following table shows as of June 30, 2012 and 2011 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.  Unrealized losses on available for sale securities as of June 30, 2012 relate to four government-sponsored residential mortgage-backed securities. All four of these securities had been in a loss position for less than 12 months. As of December 31, 2011, the Company did not hold any available for sale securities with unrealized losses. The unrealized losses on held to maturity securities as of June 30, 2012 and December 31, 2011 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.

9

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE C - INVESTMENT SECURITIES (Continued)

	As of June 30, 2012
	Less than 12 months				12 months of more				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage- backed securities	$	10,965	$	97	$	-	$	-	$	10,965	$	97
Total securities available for sale	$	10,965	$	97	$	-	$	-	$	10,965	$	97
Securities held to maturity:
Corporate securities	$	-	$	-	$	201	$	49	$	201	$	49
Total securities held to maturity	$	-	$	-	$	201	$	49	$	201	$	49

	As of December 31, 2011
	Less than 12 months				12 months of more				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(Dollars in thousands)
Securities held to maturity:
Corporate securities	$	-	$	-	$	201	$	49	$	201	$	49
Total securities held to maturity	$	-	$	-	$	201	$	49	$	201	$	49

The amortized cost and fair values of securities available for sale and securities held to maturity as of June 30, 2012 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	As of June 30, 2012
	Amortized  Cost		Fair  Value
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities
Due after ten years	$	20,745	$	20,771
	$	20,745	$	20,771
Securities held to maturity:
Corporate securities
Due after five but within ten years	$	250	$	201
	$	250	$	201

Securities with a carrying value of $3.4 million and $1.7 million as of June 30, 2012 and December 31, 2011, respectively, were pledged to secure securities sold under agreements to repurchase and public deposits.

During the six-month period ended June 30, 2012, proceeds from the sales of investment securities of $9.2 million resulted in gross gains of $106,000. There were no security sales during the three-month period ended June 30, 2012.  During the three and six-month periods ended June 30, 2011, proceeds from the sales of investment securities of $17.8 million resulted in gross gains of $329,000.

10

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE D - COMMITMENTS

A summary of the contract amount of the Company’s exposure to off-balance sheet credit risk as of June 30, 2012 is as follows:

	June 30, 2012
	(Dollars in thousands)
Financial instruments whose contract amounts represent credit risk:
Undisbursed lines of credit	$	32,660
Other commitments to extend credit		14,189
Letters of credit		1,221
Commitments to originate mortgage loans, fixed and variable		132,126
	$	180,196

NOTE E - LOANS

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

	June 30, 2012					December 31, 2011
	Amount		% of Total Loans			Amount		% of Total Loans
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	22,419		4.6	%	$	27,323		5.6	%
Commercial construction, all land development and land loans		44,355		9.2	%		47,524		9.7	%
Residential properties		100,370		20.8	%		104,561		21.3	%
Residential mortgage (1)		63,816		13.2	%		40,494		8.3	%
Commercial real estate - other		210,977		43.7	%		228,256		46.5	%
Total real estate secured loans		441,937		91.5	%		448,158		91.4	%
Other non-real estate loans:
Commercial and industrial		37,178		7.7	%		38,435		7.8	%
Consumer and other		3,710		0.8	%		3,862		0.8	%
Total loans held for investment	$	482,825		100.0	%	$	490,455		100.0	%
Single-family residential mortgages held for sale	$	88,188				$	49,728

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

Included in the table above are net unamortized loan costs of $984,000 and $500,000 as of June 30, 2012 and December 31, 2011, 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 local economic conditions. Commercial construction and land development loans decreased $3.2 million from year-end 2011 as loans were paid off, charged-off or completed and moved to longer-term financing. Other non-construction commercial real-estate secured loans also decreased $17.3 million from year-end 2011, as new commercial real estate lending remained slow. Retained residential mortgages originated through NSB Mortgage increased $22.9 million over year-end 2011.

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

11

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

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.

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 single-family mortgage 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 Federal Home Loan Mortgage Corporation (“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.

12

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

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 June 30, 2012 and December 31, 2011, mortgage loans held for sale were $88.2 million and $49.7 million, respectively.

Nonperforming assets

Nonperforming assets include nonaccrual loans, troubled debt restructured loans, or “TDR” (nonaccrual and accrual), and foreclosed assets.

Nonaccrual loans

Nonaccrual loans as of June 30, 2012 were $17.0 million compared to $24.0 million as of December 31, 2011. 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.

Past due loans

An age analysis of past due loans segregated by loan class as of June 30, 2012 and December 31, 2011 are as follows:

	As of June 30, 2012
	30 - 89 Days Past Due (1)		Over 90 Days (2)		Total Past Due		Current (3)		Total Loans		Accruing Loans 90 or More Days Past Due
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	417	$	1,758	$	2,175	$	20,244	$	22,419	$	-
Commercial construction, all land development and land loans		156		6,038		6,194		38,161		44,355		-
Residential properties		1,217		1,558		2,775		97,595		100,370		200
Residential mortgage (4)		-		-		-		63,816		63,816		-
Commercial real estate - other		821		1,643		2,464		208,513		210,977		-
Total real estate secured loans		2,611		10,997		13,608		428,329		441,937		200
Other non-real estate loans:
Commercial and industrial		20		309		329		36,849		37,178		-
Consumer and other		35		-		35		3,675		3,710		-
Total loans held for investment	$	2,666	$	11,306	$	13,972	$	468,853	$	482,825	$	200

(1) Total loans past due 30 - 89 days includes two residential real estate loans totaling approximately $637,000 and one commercial real estate loan for approximately $329,000.

(2) All in nonaccrual status.

(3) Includes $3.2 million residential construction, $297,000 commercial construction, $588,000 residential properties and $632,000 commercialreal estate nonaccrual loans and two potential problem loans totaling approximately $568,000 for commercial and residential real estate.

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

13

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	As of December 31, 2011
	30 - 89 Days Past Due (1)		Over 90 Days (2)		Total Past Due		Current (3)		Total Loans		Accruing Loans 90 or more 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.

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 TDR 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 TDR 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 three and six months ended June 30, 2012 and 2011 and as of and for the year ended December 31, 2011 is as follows.

14

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	As of June 30, 2012									For the three months ended June 30, 2012				For the six months ended June 30, 2012
	Unpaid Principal Balance		Partial Charge-offs			Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Real estate secured loans:
Residential construction	$	7,466	$	(263	)	$	7,203	$	-	$	4,381	$	124	$	3,763	$	141
Commercial construction, all land development and land loans		10,214		(1,923	)		8,291		-		9,131		27		8,948		51
Residential properties		6,072		(470	)		5,602		-		5,375		41		4,078		58
Commercial real estate - other		5,796		(1,075	)		4,721		-		4,499		26		4,279		58
Total real estate secured loans		29,548		(3,731	)		25,817		-		23,386		218		21,068		308
Other non-real estate loans:
Commercial and industrial		509		(200	)		309		-		442		-		460		-
Consumer and other		11		-			11		-		12		-		12		-
Total loans held for investment	$	30,068	$	(3,931	)	$	26,137	$	-	$	23,840	$	218	$	21,540	$	308
Impaired with a related allowance recorded:
Real estate secured loans:
Residential construction	$	3,196	$	-		$	3,196	$	473	$	3,208	$	-	$	2,142	$	-
Commercial construction, all land development and land loans		353		-			353		118		354		-		255		-
Residential properties		61		-			61		17		62		-		63		-
Commercial real estate - other		617		-			617		211		616		-		618		-
Total real estate secured loans	$	4,227	$	-		$	4,227	$	819	$	4,240	$	-	$	3,078	$	-
Total impaired
Commercial	$	17,489	$	(3,198	)	$	14,291	$	329	$	15,042	$	53	$	14,560	$	109
Residential		16,795		(733	)		16,062		490		13,026		165		10,046		199
Consumer		11		-			11		-		12		-		12		-
Total	$	34,295	$	(3,931	)	$	30,364	$	819	$	28,080	$	218	$	24,618	$	308

15

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	As of June 30, 2011									For the three months ended June 30, 2011				For the six months ended June 30, 2011
	Unpaid Principal Balance		Partial Charge-offs			Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment			Interest Income Recognized
	(Dollars in thousands)
Impaired with no related allowance recorded:
Real estate secured loans:
Residential construction	$	7,199	$	(241	)	$	6,958	$	-	$	7,126	$	14	$	6,482		$	41
Commercial construction, all land development and land loans		6,738		(349	)		6,389		-		6,389		3		5,667			33
Residential properties		4,616		(1,341	)		3,275		-		3,396		6		3,183			31
Commercial real estate - other		4,802		(195	)		4,607		-		4,513		32		4,537			73
Total real estate secured loans		23,355		(2,126	)		21,229		-		21,424		55		19,869			178
Other non-real estate loans:
Commercial and industrial		448		(284	)		164		-		275		2		406			3
Consumer and other		45		(14	)		31		-		35		1		32			1
Total loans held for investment	$	23,848	$	(2,424	)	$	21,424	$	-	$	21,734	$	58	$	20,307		$	182
																��
Impaired with a related allowance recorded:
Real estate secured loans:
Residential construction	$	3,684	$	-		$	3,684	$	92	$	3,684	$	-	$	2,756		$	-
Commercial construction, all land development and land loans		4,393		(35	)		4,358		740		4,081		-		4,016			-
Residential properties		1,362		-			1,362		341		1,181		-		868			-
Commercial real estate - other		3,035		(804	)		2,231		861		2,218		-		2,006			-
Total real estate secured loans		12,474		(839	)		11,635		2,034		11,164		-		9,646			-
Other non-real estate loans:
Commercial and industrial		784		-			784		300		784		-		707			-
Consumer and other		45		-			45		45		45		-		37			-
Total loans held for investment	$	13,303	$	(839	)	$	12,464	$	2,379	$	11,993	$	-	$	10,390		$	-
Total impaired
Commercial	$	20,200	$	(1,667	)	$	18,533	$	1,901	$	18,260	$	37	$	17,339		$	109
Residential		16,861		(1,582	)		15,279		433		15,387		20		13,289			72
Consumer		90		(14	)		76		45		80		1		69			1
Total	$	37,151	$	(3,263	)	$	33,888	$	2,379	$	33,727	$	58	$	30,697		$	182

16

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	As of December 31, 2011									For the year ended December 31, 2011
	Unpaid Principal Balance		Partial Charge-offs			Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income 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

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.

Total impaired loans as of June 30, 2012 include $13.4 million of restructured but still accruing loans and $11.8 million of restructured nonaccrual loans. Nonaccrual TDRs are up $1.2 million over year-end 2011.  Approximately $3.3 million of accruing TDRs as of year-end 2011 declined to nonaccrual status as of June 30, 2012. In total, TDRs represent $25.2 million of June 30, 2012 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 two potential problem loans outstanding as of June 30, 2012 with combined loan balances of $568,000 secured by commercial and residential real estate.

17

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

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 June 30, 2012 and no specific reserves were allocated for these loans.  Both potential problem loans were past due as of June 30, 2012.  Of the $1.9 million potential problem loans as of year-end 2011, the largest loan of $1.4 million was downgraded to nonaccrual status as of June 30, 2012.

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.

18

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

Information regarding the Company’s credit risk by internally assigned risk grades as of June 30, 2012 and December 31, 2011 follows:

	As of June 30, 2012
	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	$	9,124	$	30,690	$	82,504	$	63,816	$	191,264	$	34,017	$	3,466	$	414,881
Special mention		4,696		4,667		8,492		-		13,765		2,806		244		34,670
Substandard accruing		3,645		2,663		6,591		-		3,344		46		-		16,289
Substandard nonaccruing		4,954		6,335		2,783		-		2,604		309		-		16,985
Total by exposure	$	22,419	$	44,355	$	100,370	$	63,816	$	210,977	$	37,178	$	3,710	$	482,825

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

	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 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 three and six-months ended June 30, 2012, 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.

19

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	Troubled Debt Restructured Loans
	Three Months Ended June 30, 2012						Six Months Ended June 30, 2012
	Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
	(Dollars in thousands)
Below market interest rate:
Real estate secured loans:
Residential properties		1	$	1,754	$	1,754		1	$	1,754	$	1,754
Extended payment terms:
Real estate secured loans:
Residential construction		-		-		-		1		1,356		1,341
Total troubled debt restructured loans		1	$	1,754	$	1,754		2	$	3,110	$	3,095

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 three and six-months ended June 30, 2012.

20

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE E – LOANS (Continued)

	Troubled Debt Restructured Loans
	Three Months ended June 30, 2012				Six Months ended June 30, 2012
	Number of loans		Recorded Investment		Number of loans		Recorded Investment
	(Dollars in thousands)
Below market interest rate:
Real estate secured loans:
Commercial construction, all land development and land loans		1	$	2,023		1	$	2,023
Residential properties		1		198		1		198
Commercial real estate - other		1		632		1		632
Total real estate secured loans		3		2,853		3		2,853
Extended payment terms:
Real estate secured loans:
Residential construction		3		3,196		4		4,408
Commercial construction, all land development and land loans		1		297		1		297
Residential properties		2		412		2		412
Total real estate secured loans		6		3,905		7		5,117
Below market rate and extended payment terms:
Real estate secured loans:
Residential properties		1		439		1		439
Commercial real estate - other		1		329		1		329
Total real estate secured loans		2		768		2		768
Refinace for interest carry and cash out:
Real estate secured loans:
Residential properties		1		309		1		309
Total real estate secured loans		1		309		1		309
Total troubled debt restructured loans		12	$	7,835		13	$	9,047

The following table presents the successes and failures of the types of modifications within the previous 12 months as of

June 30, 2012.

	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	$	830		1	$	2,023
Extended payment terms		-		-		-		-		5		3,664		2	$	1,453
Below market rate and extended payment terms		-		-		-		-		3		1,077		-		-
Refinace for interest carry and cash out		-		-		1		288		-		-		-		-
Total		-	$	-		1	$	288		10	$	5,571		3	$	3,476

NOTE F - ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense for estimated loan losses inherent in the loan portfolio.  The allowance is maintained at a level which management considers adequate to provide for probable loan losses based on its assessment of various factors affecting the loan portfolio. Overall, the allowance for loan losses declined $1.6 million from the 2011 year-end amount of $9.9 million.  Impairment reserves decreased $2.0 million while the general reserve increased approximately $478,000 over year-end 2011 primarily due to a higher potential charge-off rate applied to the general commercial loan portfolio.  The allowance for loan losses as a percentage of loans outstanding decreased to 1.73% as of June 30, 2012 from 2.02% from year-end 2011 due to $4.4 million in net charge-offs and fewer impairment reserves. Additional information regarding the Company’s policies and methodology used to estimate the allowance for possible loan losses is presented in Note B- Summary of Significant Accounting Policies of  the financial statements contained in the Company’s 2011 Annual Report on Form 10-K.

21

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE F - ALLOWANCE FOR LOAN LOSSES (Continued)

The table below details activity in the allowance for probable loan losses by segregated loan category for the three and six-months ended June 30, 2012 and 2011.  Allocation of a portion of the allowance to one class of loan does not preclude its availability to absorb losses in other classes.

	For the Three Months Ended June 30, 2012
	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	$	1,237		$	2,316		$	1,547		$	51	$	3,213	$	739		$	39		$	9,142
Charge-offs		(669	)		(1,224	)		(81	)		-		-		(265	)		(11	)		(2,250	)
Recoveries		11			10			27			-		11		40			1			100
Provision		456			755			12			13		20		98			9			1,363
Ending balance	$	1,035		$	1,857		$	1,505		$	64	$	3,244	$	612		$	38		$	8,355
Ending balance, individually evaluated for impairment	$	473		$	118		$	17		$	-	$	211	$	-		$	-		$	819
Ending balance, collectively evaluated for impairment	$	562		$	1,739		$	1,488		$	64	$	3,033	$	612		$	38		$	7,536
Loans:
Ending balance	$	22,419		$	44,355		$	100,370		$	63,816	$	210,977	$	37,178		$	3,710		$	482,825
Ending balance, individually evaluated for impairment	$	10,399		$	8,644		$	5,663		$	-	$	5,338	$	309		$	11		$	30,364
Ending balance, collectively evaluated for impairment	$	12,020		$	35,711		$	94,707		$	63,816	$	205,639	$	36,869		$	3,699		$	452,461

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

	For the Six Months Ended June 30, 2012
	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	$	1,497		$	2,783		$	1,608		$	40	$	3,179	$	763		$	36		$	9,906
Charge-offs		(1,508	)		(2,503	)		(255	)		-		-		(306	)		(11	)		(4,583	)
Recoveries		17			27			35			-		16		42			1			138
Provision		1,029			1,550			117			24		49		113			12			2,894
Ending balance	$	1,035		$	1,857		$	1,505		$	64	$	3,244	$	612		$	38		$	8,355
Ending balance, individually evaluated for impairment	$	473		$	118		$	17		$	-	$	211	$	-		$	-		$	819
Ending balance, collectively evaluated for impairment	$	562		$	1,739		$	1,488		$	64	$	3,033	$	612		$	38		$	7,536
Loans:
Ending balance	$	22,419		$	44,355		$	100,370		$	63,816	$	210,977	$	37,178		$	3,710		$	482,825
Ending balance, individually evaluated for impairment	$	10,399		$	8,644		$	5,663		$	-	$	5,338	$	309		$	11		$	30,364
Ending balance, collectively evaluated for impairment	$	12,020		$	35,711		$	94,707		$	63,816	$	205,639	$	36,869		$	3,699		$	452,461

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

22

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE F - ALLOWANCE FOR LOAN LOSSES (Continued)

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

	For the Six Months Ended June 30, 2011
	Real Estate Loans												Non-Real Estate Loans
	Construction												Commercial &
	Residential			Commercial			Residential			Commercial			Industrial			Consumer			Other			Total
	(Dollars in thousands)
Allowance for loan losses:
Beginning balance	$	1,475		$	2,269		$	2,339		$	2,464		$	1,354		$	30		$	4		$	9,935
Charge-offs		(164	)		(96	)		(1,342	)		(609	)		(367	)		(11	)		-			(2,589	)
Recoveries		30			-			1			16			90			28			-			165
Provision		(370	)		815			1,019			1,082			(133	)		21			(1	)		2,433
Ending balance	$	971		$	2,988		$	2,017		$	2,953		$	944		$	68		$	3		$	9,944
Ending balance, individually evaluated for impairment	$	92		$	740		$	341		$	861		$	300		$	45		$	-		$	2,379
Ending balance, collectively evaluated for impairment	$	879		$	2,248		$	1,676		$	2,092		$	644		$	23		$	3		$	7,565
Loans:
Ending balance	$	37,036		$	76,627		$	121,485		$	207,159		$	37,127		$	2,905		$	382		$	482,721
Ending balance, individually evaluated for impairment	$	10,642		$	10,747		$	4,637		$	6,838		$	948		$	76		$	-		$	33,888
Ending balance, collectively evaluated for impairment	$	26,394		$	65,880		$	116,848		$	200,321		$	36,179		$	2,829		$	382		$	448,833

NOTE G – NET INCOME PER SHARE

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

23

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE G – NET INCOME PER SHARE (Continued)

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

	Three Months Ended June 30,				Six Months Ended June 30,
	2012		2011		2012		2011
Weighted average number of common shares used incomputing basic net income per share		7,427,976		7,427,976		7,427,976		7,427,976
Effect of dilutive stock options		-		3,706		-		4,908
Weighted average number of common shares and dilutive potential shares used in computing diluted net income per share		7,427,976		7,431,682		7,427,976		7,432,884

Due to the exercise price exceeding the average market price, the following anti-dilutive shares were excluded from the calculation of total dilutive weighted average shares. Anti-dilutive shares for the three and six-months ended June 30, 2012 were 118,752 and 115,787 for the corresponding prior year periods.

NOTE H - FAIR VALUE MEASUREMENTS

The Company estimates fair value for certain financial assets and liabilities based on fair value accounting guidance. Fair value measurements are based on the inputs used in valuation, gives priority to quoted prices in active markets, and requires that observable inputs be used in the valuations when available.  The disclosure of fair value estimates in the fair value accounting guidance hierarchy is based on whether the significant inputs into the valuation are observable. In determining the level of the hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The level in the fair value hierarchy within which the fair value measurement is reported is based on the lowest level input that is significant to the measurement in its entirety. 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 tradedtransactions.  Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.

Valuation of Assets and Liabilities Reported at Fair Value in Financial Statements

The fair value of a financial instrument is the estimated amount at which the instrument could be exchanged in an orderly transaction between knowledgeable, unrelated, willing parties. The estimated fair value of a financial instrument may differ from the amount that could be realized if sold in an immediate sale such as a forced transaction. Additionally, the valuation of investments is more subjective when markets are less liquid due to the lack of market based inputs, which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur.

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 and foreclosed assets.  The nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

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

24

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE H - FAIR VALUE MEASUREMENTS (Continued)

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. Factors contributing to the fall out rate include changes in prevailing interest rates from the time of the interest rate lock commitment as well as other factors such as lower than anticipated appraised values. As of June 30, 2012 the fall out rate averaged 32.5%.   As of June 30, 2012, the amount of fair value associated with these written loan commitments was $918,000, which was included in other assets.  As of December 31, 2011, fall out rates averaged 33.6% and the amount of fair value associated with written loan commitments was $946,000. 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 June 30, 2012 and December 31, 2011.

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 June 30, 2012, the majority of the Company’s impaired loans were evaluated based on the fair value of the collateral. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or discounts applied to 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 due to factors such as current market price corrections, the number of qualifying buyers available, or the level of inventory of like property and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. The unobservable inputs include collateral discounts in a range of 5 – 40% of appraised value. The valuation techniques for the level 3 impaired loans are consistent with techniques used in prior periods.

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 due to factors such as current market price corrections, the number of qualifying buyers available, or the level of inventory of like property and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3. The unobservable inputs include collateral discounts in a range of 5 – 40% to appraised values as well as a general cost of sales rate of 6%. The valuation techniques for the level 3 impaired loans are consistent with techniques used in prior periods.

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

25

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE H - FAIR VALUE MEASUREMENTS (Continued)

	As of June 30, 2012
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Securities available for sale:
Government-sponsored residential mortgage-backed securities	$	20,771	$	-	$	20,771	$	-
Written loan commitments		918		-		-		918
Total	$	21,689	$	-	$	20,771	$	918

	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

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 six-month periods ended June 30, 2012 and 2011.

	Written Loan Commitments
	For the three months ended June 30,				For the six months ended June 30,
	2012		2011		2012			2011
	(Dollars in thousands)
Balance, beginning of period	$	530	$	463	$	946		$	411
Gains (losses) included in other income		388		93		(28	)		93
Balance, end of period	$	918	$	41	$	918		$	504

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

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

26

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE H - FAIR VALUE MEASUREMENTS (Continued)

	As of June 30, 2012
	Total		Level 1		Level 2		Level 3
	(Dollars in thousands)
Impaired loans	$	10,036	$	-	$	152	$	9,884
Foreclosed assets	$	8,084	$	-	$	151	$	7,933

	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 June 30, 2012, 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, 2011 impaired loans that required transfers between Level 2 and Level 3 as of June 30, 2012 other than one foreclosed property for $25,000 which was transferred to Level 3 as of June 30, 2012, which the Company considers as immaterial.

Financial Assets and Liabilities Disclosed, but Not Carried, at Fair Value in Financial Statements

Financial instruments include cash and due from banks, interest-bearing deposits with banks, investments, accrued interest, loans, written loan commitments, 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.

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. The fair values are based on market observable inputs and are disclosed at Level 2 hierarchy.  Fair value for investment securities held to maturity is determined internally based on a discounted cash flow valuation technique utilizing a discount rate based on the three-month LIBOR rate. Estimates of fair value developed internally are disclosed at Level 3 of the hierarchy. The valuation technique for the level 3 securities is consistent with techniques used in prior periods.

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 and are carried at Level 3 of the hierarchy. The fair value of impaired loans measured on a nonrecurring basis are determined internally utilizing one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value or discounted cash flows. A portion of the Company’s June 30, 2012 impaired loans was evaluated based on the fair 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 impaired loan as nonrecurring Level 2 of the hierarchy. 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 a nonrecurring Level 3. The carrying amount of loans held for sale is a reasonable estimate of fair value since they will be sold in a short period and are carried at Level 3 of the hierarchy. This does not include consideration of liquidity that market participants would use to value such loans.

27

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE H - FAIR VALUE MEASUREMENTS (Continued)

Financial Assets and Liabilities Disclosed, but Not Carried, at Fair Value in Financial Statements (Continued)

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 and is carried at Level 2 of the hierarchy.

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 and are carried at Level 3 of the hierarchy.

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 and are carried at Level 3 of the hierarchy.

Accrued Interest

The carrying amounts of accrued interest approximate fair value and is carried at Level 3 of the hierarchy.

Financial Instruments with Off-Balance Sheet Risk

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

The following table presents the carrying value and estimated fair value of the Company's financial assets and liabilities disclosed, but not carried, at fair value as of June 30, 2012 and the level within the fair value hierarchy at which such financial instruments are measured on a recurring and non-recurring basis.

28

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE H - FAIR VALUE MEASUREMENTS (Continued)

Financial Assets and Liabilities Disclosed, but Not Carried, at Fair Value in Financial Statements (Continued)

	June 30, 2012
	Carrying Amount		Estimated Fair Value		Level 1		Level 2		Level 3
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	8,835	$	8,835	$	8,835	$	-	$	-
Interest-earning deposits with banks		40,205		40,205		40,205		-		-
Investment securities available for sale		20,771		20,771		-		20,771		-
Investment securities held to maturity		250		201		-		-		201
Loans held for sale		88,188		88,188		-		-		88,188
Loans, net		474,470		478,239		-		152		478,087
Accrued interest receivable		1,322		1,322		-		-		1,322
Stock in the Federal Home Loan Bank		1,004		1,004		-		1,004		-
Written loan commitments		918		918		-		-		918
Financial liabilities:
Deposits	$	607,809	$	608,590	$	-	$	-	$	608,590
Long-term borrowings		27,235		27,318		-		-		27,318
Accrued interest payable		1,090		1,090		-		-		1,090

The Company did not have any transfers between Level 1 and Level 2. The following table presents the carrying values and estimated fair values of the Company's financial instruments disclosed, but not carried, at fair value as of December 31, 2011.

	December 31, 2011
	Carrying Amount		Estimated Fair Value
	(Dollars in thousands)
Financial assets:
Cash and due from banks	$	9,826	$	9,826
Interest-earning deposits with banks		39,547		39,547
Investment securities available for sale		12,917		12,917
Investment securities held to maturity		250		201
Loans held for sale		49,728		49,728
Loans, net		480,549		487,617
Accrued interest receivable		1,441		1,441
Stock in the Federal Home Loan Bank		1,073		1,028
Written loan commitments		946		946
Financial liabilities:
Deposits	$	564,439	$	565,344
Short-term borrowings		73		73
Long-term borrowings		27,246		27,310
Accrued interest payable		897		897

29

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE I – 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, one full-service office in Wilmington, New Hanover County, North Carolina and a mortgage loan office in Chapel Hill, 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 June 30, 2012 and December 31, 2011and for the three and six-month periods ended June 30, 2012 and 2011.

	As of June 30, 2012
	Bank		NSB Mortgage		Parent Company		Eliminations			Total Company
	(Dollars in thousands)
Total assets	$	523,781	$	153,212	$	55,117	$	(54,562	)	$	677,548
Net loans		410,654		63,816		-		-			474,470
Loans held for sale		-		88,188		-		-			88,188
Goodwill		-		141		-		-			141

	As of December 31, 2011
	Bank		NSB Mortgage		Parent Company		Eliminations			Total Company
	(Dollars in thousands)
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

	For the Three Months Ended June 30, 2012
	Bank			NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	5,463		$	1,128	$	6		$	(3	)	$	6,594
Total interest expense		959			-		113			(3	)		1,069
Net interest income (loss)		4,504			1,128		(107	)		-			5,525
Provision for loan losses		1,363			-		-			-			1,363
Net interest income (loss) after provision for loan losses		3,141			1,128		(107	)		-			4,162
Noninterest income		361			1,549		706			(706	)		1,910
Noninterest expense		4,005			1,107		80			-			5,192
Income (loss) before income taxes		(503	)		1,570		519			(706	)		880
Income taxes		(147	)		508		(64	)		-			297
Net income (loss)	$	(356	)	$	1,062	$	583		$	(706	)	$	583

30

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE I – BUSINESS SEGMENT INFORMATION (Continued)

	For the Six Months Ended June 30, 2012
	Bank			NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	11,281		$	1,757	$	13		$	(7	)	$	13,044
Total interest expense		1,959			-		228			(7	)		2,180
Net interest income (loss)		9,322			1,757		(215	)		-			10,864
Provision for loan losses		2,894			-		-			-			2,894
Net interest income (loss) after provision for loan losses		6,428			1,757		(215	)		-			7,970
Noninterest income		835			2,492		1,053			(1,053	)		3,327
Noninterest expense		7,810			2,163		139			-			10,112
Income (loss) before income taxes		(547	)		2,086		699			(1,053	)		1,185
Income taxes		(173	)		659		(120	)		-			366
Net income (loss)	$	(374	)	$	1,427	$	819		$	(1,053	)	$	819

	For the Three Months Ended June 30, 2011
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	6,353	$	377	$	8		$	(4	)	$	6,734
Total interest expense		1,246		-		107			(4	)		1,349
Net interest income (loss)		5,107		377		(99	)		-			5,385
Provision for loan losses		1,418		-		-			-			1,418
Net interest income (loss) after provision for loan losses		3,689		377		(99	)		-			3,967
Noninterest income		625		540		250			(250	)		1,165
Noninterest expense		4,249		590		111			-			4,950
Income (loss) before income taxes		65		327		40			(250	)		182
Income taxes		25		117		(71	)		-			71
Net income (loss)	$	40	$	210	$	111		$	(250	)	$	111

31

NORTH STATE BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

NOTE I – BUSINESS SEGMENT INFORMATION (Continued)

	For the Six Months Ended June 30, 2011
	Bank		NSB Mortgage		Parent Company			Eliminations			Total Company
	(Dollars in thousands)
Total interest income	$	13,065	$	742	$	15		$	(8	)	$	13,814
Total interest expense		2,621		-		218			(8	)		2,831
Net interest income (loss)		10,444		742		(203	)		-			10,983
Provision for loan losses		2,433		-		-			-			2,433
Net interest income (loss) after provision for loan losses		8,011		742		(203	)		-			8,550
Noninterest income		865		1,043		550			(550	)		1,908
Noninterest expense		8,450		1,349		153			-			9,952
Income (loss) before income taxes		426		436		194			(550	)		506
Income taxes		155		157		(120	)		-			192
Net income (loss)	$	271	$	279	$	314		$	(550	)	$	314

NOTE J – SUBSEQUENT EVENTS

On July 18, 2012, the Bank entered into two agreements with Larry D. Barbour, President and Chief Executive Officer of the Company and the Bank.  Both agreements were effective as of July 1, 2012.

Pursuant to the terms of a Separation Benefit Agreement, upon Mr. Barbour’s “separation form service” for any reason other than death, the Bank will pay to Mr. Barbour or his beneficiary $75,000 on the seventh month following the date of separation of service and thereafter will pay Mr. Barbour $12,500 monthly, up to an aggregate maximum of $2,250,000, if fully vested.  The separation benefit vests monthly over 72 months beginning on July 31, 2012.

Pursuant to the terms of a Second Amendment to Agreement between the Bank and Mr. Barbour, in the event of termination of Mr. Barbour’s employment due to his disability, the Bank will engage Mr. Barbour as a consultant, for no more than 37 hours per month and at a rate to be determined by the Bank and Mr. Barbour, beginning on the date of the termination of his employment and continuing until June 30, 2018, unless earlier terminated in the event of Mr. Barbour’s death, resignation or for “cause”.

32

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

This report contains forward-looking statements intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995.  These forward-looking statements can generally be identified as such because the context of the statement will include words such as we “believe,” “anticipate,” “expect” or words of similar meaning.  Similarly, statements that describe our future plans, objectives or goals are also forward-looking statements.  Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those currently anticipated, including: general and local economic conditions; changes in real estate values; changes in interest rates, deposit flows, and loan demand; changes in legislation or regulation including regulatory assessments; changes in accounting principles, policies or guidelines; competition;  other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services; our ability to manage growth; and factors set out in our Annual Report on Form 10-K for the year ended December 31, 2011 and our other filings with the Securities and Exchange Commission.

Management’s discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. You should read this discussion in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011.

Recent Market Developments in the Banking Industry

Although the economy showed some signs of improvement and increased business activity during the first three months of 2012, business activity slowed during the second three-month period ended June 30, 2012. Many areas continue to struggle as a result of the prolonged deep recession. Unemployment rates remain high compared to pre-recession levels and residential and commercial real estate prices, in some areas, continue to decline and experience foreclosures. Our future earnings and financial condition could be negatively impacted if business activity and the current economy continue to be sluggish for an extended period or further declines into recession. In addition, recently enacted laws as a result of the financial crisis and potential further imposition of new laws and regulations and regulatory assessments from the U.S. government could significantly impact our operations in the future.

Our financial performance generally, and in particular the ability of our borrowing customers to pay interest on and repay principal of outstanding loans, is highly dependent upon the business environment in the markets where we operate in Wake and New Hanover counties, in North Carolina. The effect of the prolonged recession continues to financially stress many of our customers.  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 “Comparison of Results of Operations for the Three and Six-Month Periods Ended June 30, 2012 and 2011- Provision for Loan Losses” and “Asset Quality and Allowance for Loan Losses.”

Overview

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

North State Bank is a North Carolina chartered banking corporation. The Bank, which offers a full array of commercial and retail banking services, opened for business on June 1, 2000. Through the Bank, we currently operate six full-service banking offices located in Raleigh, Garner and Wake Forest, North Carolina, 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.  A division of the Bank, North State Bank Mortgage, or NSB Mortgage, originates and sells 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.

33

Comparison of Financial Condition as of June 30, 2012 and December 31, 2011

Total assets as of June 30, 2012 increased $44.7 million to $677.5 million from $632.9 million as of December 31, 2011.  The increase was driven by deposit growth which primarily funded growth in our held for sale mortgage pipeline. Mortgage loans held for sale grew to $88.2 million, up $38.5 million from year-end 2011 and our available for sale investment security portfolio increased $7.9 million to $20.8 million, from $12.9 million as of year-end 2011.  Our portfolio of loans held for investment declined $7.6 million to $482.8 million, representing 71.3% of our total assets as of June 30, 2012 compared to 77.5% as of year-end 2011.  New commercial loan growth continues to be soft due to overall sluggish business activity in our market areas and increased competition within our customer groups. Simultaneously as new loan growth has slowed, loan payouts, loan charge-offs and transfers to foreclosed assets continue to reduce the loan portfolio.  Our assets are primarily funded through deposits, which grew $43.4 million to $607.8 million as of June 30, 2012 compared to $564.4 million as of year-end 2011. In addition to deposit growth, our deposit mix continues to improve as lower-costing transaction deposits have increased as a percent of total deposits from year-end 2011 due to our continued emphasis on building and maintaining core deposits.

As of  June 30, 2012, our interest-earning deposits with banks included $36.9 million in excess overnight funds in our Federal Reserve account and $3.3 million held at correspondent banks compared to $36.0 million and $3.5 million, respectively, as of year-end 2011 as growth in our core deposit funds have outpaced  loan demand. Our available for sale investment portfolio as of June 30, 2012 consisted of $20.8 million of government-sponsored residential mortgage-backed securities compared to $12.9 million as of year-end 2011. During the first three-month period of 2012, we sold $9.4 million of government-sponsored residential mortgage-backed securities for a gain of $106,000. During the six-month period ended June 30, 2012 we received $2.6 million in maturities and cash flows from government-sponsored residential mortgage-backed securities. We re-deployed funds from sales, maturities and cash flows into $20.0 million of same type securities. All of our investments are accounted for as available for sale and are presented at their fair market value with the exception of $250,000 in a single corporate bond that is accounted for as held to maturity and are carried at book value.

Our portfolio of loans decreased $7.7 million or 1.6% to $482.8 million as of June 30, 2012 compared to $490.5 million as of year-end 2011. The decline in the loan portfolio reflects a continued cycle of higher levels of loan payoffs over new loan volume, $4.4 million of net charge-offs as well as $6.9 million of transfers to foreclosed assets.  New commercial loan demand remains slow due to the combined effects of the prolonged recession and increased competition for lending opportunities among our targeted customer groups. We continue to communicate with our target customers to obtain a better understanding and knowledge of their businesses so we can respond to their borrowing needs in the future as the economy recovers. To partially offset the impact of soft demand on our commercial portfolio, we continue to retain select mortgages from NSB Mortgage (see the discussion regarding our residential real-estate loans). Included in our held for investment portfolio are $63.8 million of single-family residential mortgages originated through NSB Mortgage. This loan category grew $23.3 million from $40.5 million as of year-end 2011.  Excluding mortgage loans originated and retained through NSB Mortgage, our held for investment loan portfolio declined $31.0 million from year-end 2011.

The table below is a summary of our loans outstanding by major category as of June 30, 2012 and December 31, 2011.

34

					Increase (decrease)
	June 30, 2012		December 31, 2011		$			%
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	22,419	$	27,323	$	(4,904	)	-17.9	%
Commercial construction, all land development and other land loans		44,355		47,524		(3,169	)	-6.7	%
Residential properties		100,370		104,561		(4,191	)	-4.0	%
Residential mortgage (1)		63,816		40,494		23,322		-
Commercial real estate - other		210,977		228,256		(17,279	)	-7.6	%
Total real estate secured loans		441,937		448,158		(6,221	)	-1.4	%
Other non-real estate loans:
Commercial and industrial		37,178		38,435		(1,257	)	-3.3	%
Consumer and other		3,710		3,862		(152	)	-3.9	%
Total loans held for investment	$	482,825	$	490,455	$	(7,630	)	-1.6	%
Mortgage loans held for sale	$	88,188	$	49,728	$	38,460		77.3	%

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

As of June 30, 2012, our loan portfolio remains primarily secured by real estate with $441.9 million or 91.5% of loans outstanding compared to $448.2 million or 91.4% as of year-end 2011. 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 the economic environment showed some improvement in the first quarter of 2012, it softened in the second quarter, and  a further downturn or continued sluggish market conditions could result in an increased number of borrowers not making payments on or repaying real estate loans and the value of the collateral securing these loans could decline further as well. Adverse effects to our customers’ businesses correspondingly result in adverse effects to our financial condition and results of operations due to our high level of loans secured by real estate in the markets we serve.

We continue to minimize our exposure and limit new lending for commercial construction and land development loans, specifically new builder/developer lending. Our long-term plan is to minimize construction and land development lending. Commercial real-estate-secured construction and land development loans decreased $3.2 million to 9.2% of loans outstanding from 9.73% as of year-end 2011 and 16.4% as of year-end 2010 as construction projects have paid off or completed and moved to longer-term financing. In total, commercial real estate secured loans including construction and land development declined $20.4 million from year-end 2011, representing 52.9% of loans outstanding compared to 56.2% as of year-end 2011. 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. Of the properties securing these commercial real estate loans, approximately14.1% are located within our New Hanover County market and 85.9% are located within our Wake County market.

Residential real-estate loans including construction loans grew $14.2 million to $186.6 million over year-end 2011, including $63.8 million originated through NSB Mortgage, and represented approximately 38.7% of the loan portfolio as of June 30, 2012 compared to 35.2% of the loan portfolio as of year-end 2011.  These single-family construction, residential property and home equity lines of credit are typically secured by the primary residence of the borrower and the combined loan-to-value ratio is usually less than 90%. The growth in this loan category is attributable to mortgages originated and selected to be retained through NSB Mortgage which grew $23.3 million over year-end 2011.  These single-family residential mortgage loans that are 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. Other residential real-estate and construction loans declined $9.1 million from year-end 2011.

Non-real estate commercial and industrial loans declined slightly to $37.2 million or 7.7% of loans from 7.8% as of year-end 2011.

35

Loan originations from within our NSB Mortgage division are held for sale, with the exception of select loans discussed above that are retained within our loan portfolio.  Mortgage loan originations represent single-family residential first mortgage loans on a pre-sold basis that have been approved for purchase by secondary investors. The mortgages are underwritten at a minimum per FREDDIE MAC guidelines and are typically sold to investors within two to three weeks after closing.  Mortgage originations are subject to volatility due to interest rates and home sales.  During the six-month period ended June 30, 2012, mortgage loan originations gradually increased reflecting increased refinancing activity and to a lesser extent home purchases.  As of June 30, 2012, our mortgage loans held for sale pipeline was $88.2 million compared to $49.7 million as of year-end 2011.

The following table is a summary of our loans outstanding by major category for the total Bank, New Hanover and Wake Counties and mortgages originated through NSB Mortgage and held for investment.

	Total Bank					New Hanover County					Wake County					Residential Mortgage (1)
	June 30, 2012
			% of					% of					% of					% of
			Total					Total Bank					Total Bank					Total Bank
	Amount		Loans			Amount		Loans			Amount		Loans			Amount		Loans
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	22,419		4.6	%	$	1,882		0.4	%	$	20,537		4.3	%	$	-		-
Commercial construction, all land development and land loans		44,355		9.2	%		9,854		2.0	%		34,501		7.1	%		-		-
Residential properties		100,370		20.8	%		13,703		2.8	%		86,667		17.9	%		-		-
Residential mortgage (1)		63,816		13.2	%		-		-			-		-			63,816		13.2	%
Commercial real estate - other		210,977		43.7	%		26,092		5.4	%		184,885		38.3	%		-		-
Total real estate secured loans		441,937		91.5	%		51,531		10.7	%		326,590		67.6	%		63,816		13.2	%
																	-		-
Other non-real estate loans:
Commercial and industrial		37,178		7.7	%		4,793		1.0	%		32,385		6.7	%		-		-
Consumer and other		3,710		0.8	%		475		0.1	%		3,235		0.7	%		-		-
Total loans held for investment	$	482,825		100.0	%	$	56,799		11.8	%	$	362,210		75.0	%	$	63,816		13.2	%
Single-family residential mortgages held for sale	$	88,188

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

The allowance for loan losses was $8.4 million as of June 30, 2012 and $9.9 million as of December 31, 2011, representing 1.73% and 2.02%, respectively, of loans outstanding at each date. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The allowance for loan losses decreased $1.7 million due to fewer impairment reserves which more than offset an increase of $478,000 in general reserves. The impairment reserve decrease was the result of charge-offs to year-end 2011 loan impairments. The general reserve increase was primarily due to a higher potential charge-off rate over year-end 2011 applied to the general commercial loan portfolio. Although our general reserves increased over year-end 2011, the increase was minimized due to changes in our loan portfolio composition. We continue to add lower-risk, single-family residential mortgages originated through NSB Mortgage to our held for investment portfolio which have replaced decreases in our more traditional commercial portfolio of loans which typically carry higher risk. We established the allowance for loan losses at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio as of June 30, 2012. We monitor the allowance monthly.  See “Asset Quality and Allowance for Loan Losses” for additional details.

Our premises and equipment remained substantially unchanged from year-end 2011 at $13.9 million. Foreclosed assets increased $5.2 million to $8.1 million as of June 30, 2012 from $2.9 million as of December 31, 2011, reflecting $6.9 million of additional properties, sales of $1.6 million and valuation adjustments on foreclosed properties of $38,000 during the six-month period ended June 30, 2012.  Additional discussion regarding foreclosed assets is included in the section “Asset Quality and Allowance for Loan Losses.”

As of June 30, 2012, our deposits were $607.8 million, an increase of $43.4 million from $564.4 million as of year-end 2011, with continued improvement in deposit mix and growth in relationship driven core deposits. Traditional core deposits grew $37.8 million while non-relationship jumbo time deposits continued to decline. None of our current deposit funds are obtained through non-traditional funding sources such as wholesale brokered certificates of deposit or internet certificates of deposit as we ceased obtaining wholesale brokered time deposits in early 2010 and ceased obtaining internet deposits in early 2011. The table below presents deposits by major categories as of June 30, 2012 and December 31, 2011.

36

					Increase (decrease)
	June 30, 2012		December 31, 2011		$			%
	(Dollars in thousands)
Demand deposits	$	155,275	$	145,185	$	10,090		6.9	%
Savings, money market and NOW		290,345		264,304		26,041		9.9	%
Time less than $100,000		65,013		63,318		1,695		2.7	%
Total traditional core deposits (1)		510,633		472,807		37,826		8.0	%
Time $100,000 or greater		69,020		69,711		(691	)	-1.0	%
CDARS deposits (2)		28,156		21,921		6,235		28.4	%
Total deposits	$	607,809	$	564,439	$	43,370		7.7	%
CommunityPLUS division deposit funds included above:
Demand deposits	$	85,676	$	74,049	$	11,627		15.7	%
Savings, money market and NOW		125,561		114,136		11,425		10.0	%
Time deposits		72,882		62,017		10,865		17.5	%
Total CommunityPLUS deposits	$	284,119	$	250,202	$	33,917		13.6	%

(1) Excludes CDARS and time deposits $100,000 or greater.

(2) CDARS - Certificate of Deposit Account Registry Service

Our deposit mix continues to improve as we emphasize relationship deposits with individuals and entities within our market areas of Wake and New Hanover counties of North Carolina and through the success of our property management division “CommunityPLUS” with customers within North Carolina, Texas, Maryland, South Carolina, Illinois, Colorado and New Mexico. Deposits funded through this division significantly contribute to our strong core deposit base.  Our ability to attract and provide specialized services required of companies within this industry has significantly contributed to our strong core deposit base and improvement in deposit mix.  As of June 30, 2012, deposits in this division represented approximately 46.7% of our total deposits, up from 44.3% as of year-end 2011, 35.6% as of year-end 2010, 24.7% as of year-end 2009 and 8.4% as of year-end 2008.  Deposits from “CommunityPLUS” grew $33.9 million or 13.6% over year-end 2011 to $284.1 million as of June 30, 2012 with most of the growth from non-interest bearing demand deposits.

Overall, noninterest-bearing demand deposits and low-cost interest-bearing transaction accounts continue to represent the largest component of our deposit mix, 25.5% and 47.8%, respectively, of total deposits as of June 30, 2012 compared to 25.7% and 46.8%, respectively, as of year-end 2011.  Total noninterest-bearing demand deposits grew $10.1 million and low-cost interest-bearing transaction deposits grew $26.0 million over year-end 2011.  “CommunityPLUS” continues to be the key factor to the planned growth in these low-costing core deposit funds. Noninterest-bearing demand deposits and interest-bearing transaction deposits provided through “CommunityPLUS” grew approximately $11.6 million and $11.4 million, respectively, over year-end 2011.

Time deposits, including the Certificate of Deposit Account Registry Service, or CDARS, grew $7.2 million to $162.2 million over year-end 2011, however, decreased to 26.7% of total deposits from 27.5% as of year-end 2011.  Time deposits funded through “CommunityPLUS” grew $10.9 million, $5.9 million within the CDARS program for the same period. Overall deposits through participation in CDARS grew $6.2 million over year-end 2011. The CDARS program provides full Federal Deposit Insurance Corporation, or FDIC, insurance on deposit balances greater than posted FDIC limits by exchanging larger depository relationships with other CDARS members. Total time deposits of $100,000 or more, excluding CDARS deposit funds, increased $1.7 million from year-end 2011, however we continue to monitor time deposits for profitability and reduce non-relationship or single-service customer accounts.

Our focus for the future will be to continue to grow traditional core deposits with our customers with whom we seek to obtain the customers’ primary borrowing and deposit relationship as well as our “CommunityPLUS” customers. Strong core deposit growth continues to minimize our need for short-term borrowings. We had no short-term borrowings as of June 30, 2012 compared to $73,000 as of year-end 2011 which consisted solely of securities sold under repurchase agreements. Long-term borrowings remained unchanged from year-end 2011 at $27.2 million, consisting primarily of $11.0 million of subordinated notes and $15.5 million in junior subordinated debentures.

37

Shareholders’ equity increased $638,000 primarily provided by net income of $819,000 and a decline of $202,000 in other comprehensive income.

Comparison of Results of Operations for the Three-Month Periods Ended June 30, 2012 and 2011

Net Income.  A higher level of net income over the prior year period was primarily driven by higher fees from our mortgage operations coupled with lower foreclosed asset costs and improvements overall in nonperforming assets. For the three-month period ended June 30, 2012, net income was $583,000 compared to $111,000 for the corresponding three-month period of 2011, representing an increase of $472,000 or 425.2%.  On a diluted share basis, earnings were $.08 and $.01 per share, respectively, for the same periods. Although earnings continue to be lower compared to pre-recession levels, credit quality-related costs are improving. Improvements in recession-related lending costs coupled with additional income generated from our mortgage division provided the opportunity for us to re-instate several director and employee benefits that had been suspended as cost savings initiatives at the beginning of the recession. We will continue to closely monitor our loan portfolio and nonperforming assets and will re-enact cost-savings initiatives if necessary should there be another downturn in the economy or an extended period of slow recovery. Our earnings continue to be impacted by our declining commercial loan base as a direct result of the prolonged recession and increased competition. Favorable changes in deposit mix continue to minimize the effect of the reduced interest income from our commercial loan portfolio in addition to interest income generated from mortgage loans originated and selected for retention from NSB Mortgage. Compared to the prior year period, for the three-month period ended June 30, 2012, improvements in net interest income, provision for loan losses, noninterest income and reduced foreclosed assets costs offset noninterest expense, primarily, higher personnel costs. For the three months ended June 30, 2012, return on average assets was .35% compared to .07% for the prior year  period while for the same periods return on average equity was 5.86% compared to 1.17%.

Net Interest Income. Net interest income was $5.5 million for the three-month period ended June 30, 2012, an increase of $140,000 or 2.6% compared to the prior year period. For the same periods, interest income decreased $140,000 or 2.1% and interest expense decreased $280,000 or 20.8%.  Beneficial changes in our deposit mix with a corresponding reduction in interest expense substantially reduced the effect of the lower 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 three months ended June 30, 2012 was $6.6 million compared to $6.7 million for the prior year period.  The reduction in interest income is primarily due to lower yields on our loan portfolio, our largest earning asset. The decline in average loan yield of 41 basis points effectively reduced interest income by approximately $488,000. The effect of the lower loan yield was partially offset as other earning assets, specifically mortgage loans held for sale, grew an average of $36.3 million which provided additional interest income of approximately $386,000.  A lower level of nonaccrual loans also contributed to the increase in interest income. No interest income is recognized when loans are on nonaccrual status. Accrued interest is reversed and future interest accruals are suspended at the time loans are placed on nonaccrual status. During the three-month period ended June 30, 2012, loans on nonaccrual status averaged approximately $17.6 million, representing an estimated quarterly loss of interest income of $222,000 compared to average nonaccrual loans of $25.8 million, representing an estimated quarterly loss of interest income of $353,000 for the prior year period. In summary, lower yields effectively reduced total interest income approximately $573,000 while a $30.9 million increase in average interest-earning asset volume effectively increased total interest income approximately $433,000.

Our continued improvement in deposit mix resulting from the successful building of our core deposits with corresponding repricing to lower costing products were the key factors for the overall decrease in deposit interest expense over the prior year period. Deposit interest expense for the three-month period ended June 30, 2012 was $825,000 compared to $1.1 million for the prior year three-month period, a decrease of $293,000. Average time deposits decreased $12.2 million from the prior year period primarily in non-core, single-service time deposits of $100,000 or more. These higher-costing deposits were replaced with lower costing interest checking, money market and non-interest-bearing transaction deposits which grew in total an average of $49.3 million, of which $21.1 million were in non-interest-bearing demand deposits.  Overall lower rates effectively reduced deposit interest expense approximately $277,000 while interest expense was reduced approximately $16,000 from improvements in interest-bearing deposit mix.

The yield on our earning assets averaged 4.31% during the three months ended June 30, 2012 compared to 4.62% during for the prior year period.  During the same periods, the cost of our interest-bearing liabilities averaged .91% compared to 1.18%.  Overall, our net interest margin during this period, excluding average nonaccrual loans, decreased 9 basis points to 3.61% compared to 3.70%.

38

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

	Three Months Ended June 30, 2012							Three Months Ended June 30, 2011
	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
	(Dollars in thousands)
Interest-earning assets:
Loans (1)	$	461,048	$	5,810		5.07	%	$	450,266	$	6,156		5.48	%
Loans held for sale		61,969		663		4.30	%		25,706		272		4.24	%
Investments available for sale		14,614		55		1.51	%		30,774		242		3.15	%
Investments held to maturity		250		3		4.83	%		250		2		3.21	%
Other interest-earning assets		77,033		63		0.33	%		77,051		62		0.32	%
Total interest-earning assets		614,914		6,594		4.31	%		584,047		6,734		4.62	%
Other assets		55,618							52,271
Total assets	$	670,532						$	636,318
Interest-bearing liabilities:
Deposits:
Savings, money market and NOW	$	282,187		307		0.44	%	$	253,906		401		0.63	%
Time deposits over $100,000		68,841		269		1.57	%		82,451		379		1.84	%
Other time deposits		93,042		249		1.08	%		91,619		338		1.48	%
Short-term borrowings		12		-		0.00	%		4,494		1		0.09	%
Long-term borrowings		27,237		244		3.60	%		27,261		230		3.38	%
Total interest-bearing liabilities		471,319		1,069		0.91	%		459,731		1,349		1.18	%
Noninterest-bearing demand deposits		157,220							136,170
Other liabilities		1,967							2,333
Shareholders' equity		40,026							38,084
Total liabilities and shareholders' equity	$	670,532						$	636,318
Net interest income and interest rate spread			$	5,525		3.40	%			$	5,385		3.45	%
Net yield on average interest-earning assets						3.61	%						3.70	%
Ratio of average interest-earning assets to average interest-bearing liabilities						130.47	%						127.04	%
Net yield on average interest-earning assets including nonaccrual loans						3.51	%						3.54	%

(1) Nonaccrual loans are excluded in loan amounts.

Provision for Loan Losses.  The provision for loan losses was $1.4 million for the three-month period ended June 30, 2012, a $55,000 or 3.9% decrease from the prior year period.  Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by management. The provision for loan losses was down primarily due to an 66% reduction in impaired reserves as of June 30, 2012 compared to June 30, 2011 which more than offset the effect of higher charge-offs over the prior year period. Net charge-offs for the three month period ended June 30, 2012 were .45% of average loans compared to .17% for the prior year period. The allowance for loan losses was $8.4 million as of June 30, 2012 or 1.73% of loans outstanding compared to $9.9 million or 2.02% of loans outstanding as of year-end 2011. See “Asset Quality and Allowance for Loan Losses” for additional detail.

Non-interest Income. Non-interest income increased $745,000 or 63.9% to $1.9 million for the three-month period ended June 30, 2012 compared to the prior year period.  Included in noninterest income for the three-month period ended June 30, 2011 are security gains of $329,000. Excluding security gains, non-interest income grew $1.1 million over the prior year period. There were no security sale gains or losses in the current year period. Fees generated from mortgage operations were $1.5 million, up $1.0 million over the prior year period resulting from a substantial increase in refinancing activity as well as home purchases compared to the prior year period. Fees from annuity sales and other fees generated from our wealth management services division provided $80,000 in non-interest income, down $55,000 from the prior year period.  We anticipate income from these services to improve as the economy recovers.  Our purchase of $10.0 million of bank owned life insurance in the third quarter of 2011 provided additional noninterest income of $92,000 for the three-month period ended June 30, 2012.  As a percentage of average assets, non-interest income increased to 1.15% compared to .73% for the three-month periods ended June 30, 2012 and 2011, respectively.

39

Non-interest Expense. Non-interest expense for the three-month period ended June 30, 2012 increased overall $242,000 or 4.9% to $5.2 million from $5.0 million for the prior year period. The increase is primarily attributable to higher personnel costs. Lower foreclosed asset costs and reduced FDIC insurance premiums offset higher personnel and other noninterest expense. As anticipated, we reinstated some of the director and employee benefits that had been suspended as cost-savings initiatives at the beginning of the recession to partially offset asset quality and related costs due to the economic environment.

Salaries and other personnel expense represent our largest expense category at $2.8 million for the three-month period ended June 30, 2012, up $507,000 from the prior year period with $438,000 of the increase attributable to our mortgage division. Compared to the prior year three-month period, current year personnel expense for our mortgage division includes nine additional personnel including mortgage loan originators, management and support personnel. Personnel expense for the three-month period ended June 30, 2012 includes $98,000 for reinstated 401k matching benefits as well as increases for modest merit increases distributed to all employees throughout the Bank. We currently continue to temporarily suspend incentive bonuses. As a percentage of average assets, personnel expense increased to 1.66% for the three-month period ended June 30, 2012 compared to 1.43% for the prior year period.

Occupancy and equipment costs decreased $10,000 to $692,000 for the three-month period ended June 30, 2012. Building lease expense is down approximately $27,000 from the prior year period due to the termination of our original downtown office building lease in October 2011 while other occupancy expenses such as computer and software for additional employees increased approximately $15,000.  Key changes to operating costs from the prior year period include foreclosed asset costs and FDIC insurance costs. Subsequent to foreclosure, valuations are periodically performed on foreclosed asset properties. We did not incur any further subsequent valuation write-downs during the current three-month period. Additional valuation write-downs for the prior year period were $487,000.  During the current year three-month period, sales of $583,000 in foreclosed property resulted in additional losses of $34,000 compared to $38,000 in losses for the prior year period.  Also, FDIC insurance costs were down $160,000 from the prior year three-month period due to changes in the calculation of the insurance assessment from deposit-based to asset-based. Data processing and other outsourced processing expenses grew $88,000 over the prior year period primarily due to growth in our CommunityPLUS deposits accounts. There were no other significant changes in other noninterest expense for the three-month period. Including net costs related to foreclosed assets, our non-interest expense as a percentage of average assets was 3.11% for the three-month period ended June 30, 2012 compared to 3.12% for the prior year three-month period.

We recorded $297,000 and $71,000, respectively, in income tax expense for the three-month periods ended June 30, 2012 and 2011.  Income tax expense as a percentage of pretax income for these periods was 33.8% and 39.0%, respectively.  The effective tax rate was lower in the current year period due to additional permanent tax differences, primarily income from bank owned life insurance. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

Comparison of Results of Operations for the Six-Month Periods Ended June 30, 2012 and 2011

Net Income.  Net income for the six-month period ended June 30, 2012 was $819,000, up $505,000 or 160.8% over the prior year period, primarily driven by higher fees from our mortgage operations coupled with lower foreclosed asset costs and improvements overall in nonperforming assets. On a diluted share basis, earnings for the periods were $0.11 and $0.04 per share, respectively. Our earnings continue to be impacted by our declining commercial loan base as a direct result of the prolonged recession and increased competition. Favorable changes in deposit mix continue to minimize the effect of reduced interest income from our commercial loan portfolio along with additional interest income generated from mortgage loans originated and selected for retention through NSB Mortgage. For the six months ended June 30, 2012, return on average assets was .25% compared to .01% for the prior year  period while for the same periods return on average equity was 4.17% compared to 1.67%.

40

Net Interest Income. Net interest income for the six months ended June 30, 2012 decreased $119,000 or 1.1% from the prior year period to $10.9 million. For the same periods, interest income decreased $770,000 or 5.6% and interest expense decreased $651,000 or 23.0%. The overall decline in net interest income is the result of decreased commercial loan volume, our highest yielding asset, due to soft demand and increased competition within our markets. Beneficial changes in our deposit mix with a corresponding reduction in interest expense substantially reduced the effect of the lower 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 six months ended June 30, 2012 was $13.0 million compared to $13.8 million for the prior year period.  The reduction in interest income is primarily due to lower yields on our loan portfolio, our largest earning asset. The decline in average loan yield of 40 basis points, effectively reduced interest income by approximately $898,000. The effect of lower loan yields was minimized by growth in our mortgage loans held for sale pipeline which grew an average of $28.0 million and provided additional interest income of approximately $507,000.  A lower level of nonaccrual loans also helped to offset the effect of lower yields. During the six-month period ended June 30, 2012, loans on nonaccrual status averaged approximately $19.9 million, representing an estimated six month loss of interest income of $510,000 compared to average nonaccrual loans of $22.1 million, representing an estimated six month loss of interest income of $612,000 for the prior year period. In summary, lower yields effectively reduced total interest income approximately $1.1 million while a net $13.0 million increase in average interest-earning asset volume effectively increased total interest income approximately $375,000.

Improvement in deposit mix with corresponding lower rates were the key factors for the overall decrease in deposit interest expense over the prior year period. Deposit interest expense for the six-month period ended June 30, 2012 was $2.2 million compared to $2.8 million for the prior year six-month period, a decrease of $651,000. Average time deposits decreased $20.4 million from the prior year period primarily in non-core, single-service time deposits of $100,000 or more. These higher-costing deposits were replaced with lower costing interest checking, money market and non-interest-bearing transaction deposits which grew in total an average of $43.3 million, of which $19.6 million were in non-interest-bearing demand deposits.  Overall lower rates effectively reduced deposit interest expense approximately$569,000 and improvements in interest-bearing deposit mix reduced interest expense approximately $103,000. A 16 basis point increase in rate on our long-term borrowings increased interest expense approximately $21,000.

The yield on our earning assets averaged 4.33% during the six months ended June 30, 2012 compared to 4.70% during for the prior year period.  During the same periods, the cost of our interest-bearing liabilities averaged .95% compared to 1.23%.  Overall our net interest margin during this period, excluding average nonaccrual loans, decreased 13 basis points to 3.61% compared to 3.74%.

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

41

	Six Months Ended June 30, 2012							Six Months Ended June 30, 2011
	Average				Average			Average				Average
	Balance		Interest		Rate			Balance		Interest		Rate
	(Dollars in thousands)
Interest-earning assets:
Loans (1)	$	464,277	$	11,945		5.17	%	$	463,254	$	12,816		5.58	%
Loans held for sale		55,153		893		3.26	%		27,182		546		4.05	%
Investments available for sale		10,652		103		1.94	%		23,181		342		2.98	%
Investments held to maturity		250		6		4.83	%		250		5		4.03	%
Other interest-earning assets		75,295		97		0.26	%		78,720		105		0.27	%
Total interest-earning assets		605,627		13,044		4.33	%		592,587		13,814		4.70	%
Other assets		55,389							48,550
Total assets	$	661,016						$	641,137
Interest-bearing liabilities:
Deposits:
Savings, money market and NOW	$	275,941		640		0.47	%	$	252,261		881		0.70	%
Time deposits over $100,000		68,451		545		1.60	%		86,990		803		1.86	%
Other time deposits		91,501		511		1.12	%		93,358		684		1.48	%
Short-term borrowings		105		-		0.00	%		4,467		2		0.09	%
Long-term borrowings		27,240		484		3.57	%		27,263		461		3.41	%
Total interest-bearing liabilities		463,238		2,180		0.95	%		464,339		2,831		1.23	%
Noninterest-bearing demand deposits		156,181							136,551
Other liabilities		2,082							2,227
Shareholders' equity		39,515							38,020
Total liabilities and shareholders' equity	$	661,016						$	641,137
Net interest income and interest rate spread			$	10,864		3.38	%			$	10,983		3.47	%
Net yield on average interest-earning assets						3.61	%						3.74	%
Ratio of average interest-earning assets to average interest-bearing liabilities						130.74	%						127.62	%
Net yield on average interest-earning assets including nonaccrual loans						3.49	%						3.60	%

(1) Nonaccrual loans are excluded in loan amounts.

Provision for Loan Losses.  The provision for loan losses was $2.9 million for the six-month period ended June 30, 2012, a $461,000 or 18.9% increase from the prior year period.  Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by management. The provision for loan losses was up due to significantly higher charge-offs and a corresponding higher charge-off rate applied to the general reserve over the prior year period. As a percent of average loans, net charge-offs increased to .92% from .50% for the same periods. The allowance for loan losses was $8.4 million as of June 30, 2012 or 1.73% of loans outstanding compared to $9.9 million or 2.02% of loans outstanding as of year-end 2011. See “Asset Quality and Allowance for Loan Losses” for additional detail.

Non-interest Income. Non-interest income was $3.3 million for the six months ended June 30, 2012 compared to $1.9 million for the prior year period, an increase of $1.4 million, or 74.4%.  Excluding securities gains, non-interest income increased $1.6 million or 104.0% for the same periods. Security gains were $106,000 and $329,000, respectively, for the six months ended June 30, 2012 and 2011. Fees generated from mortgage operations were $2.5 million, up $1.5 million over the prior year period resulting from a substantial increase in refinancing activity as well as home purchases compared to the prior year period. Fees from annuity sales and other fees generated from our wealth management services division provided $147,000 in non-interest income, down $74,000 from the prior year period. Our purchase of $10.0 million of bank owned life insurance in the third quarter of 2011 provided additional noninterest income of $189,000 for the six-month period ended June 30, 2012.  As a percentage of average assets, non-interest income increased to 1.01% compared to .60% for the six-month periods ended June 30, 2012 and 2011, respectively.

42

Non-interest Expense. Non-interest expense for the six-month period ended June 30, 2012 increased overall $160,000 or 1.6% to $10.1 million from $10.0 million for the prior year period. The increase is attributable to higher personnel costs. Lower foreclosed asset costs and reduced FDIC insurance premiums offset higher personnel and other noninterest expense. As anticipated, we reinstated some of the director and employee benefits that had been suspended as cost-savings initiatives at the beginning of the recession to partially offset asset quality and related costs due to the economic environment.

Salaries and other personnel expense represent our largest expense category at $5.4 million for the six-month period ended June 30, 2012, up $817,000 from the prior year period with $698,000 or 85.4% of the increase attributable to our mortgage division. Compared to June 30, 2011, current year personnel expense for our mortgage division includes nine additional personnel including mortgage loan originators, management and support personnel. Personnel expense for the six-month period ended June 30, 2012 includes $201,000 for reinstated 401k matching benefits as well as increases for modest merit increases distributed to all employees throughout the Bank. We currently continue to temporarily suspend incentive bonuses. As a percentage of average assets, personnel expense increased to 1.64% for the six-month period ended June 30, 2012 compared to 1.44% for the prior year period.

Occupancy and equipment costs decreased $57,000 to $1.3 million for the six-month period ended June 30, 2012. Building lease expense is down approximately $54,000 from the prior year period due to the termination of our original downtown office building lease in October 2011 while other occupancy expenses such as computer and software for additional employees increased approximately $18,000.  Key changes to operating costs from the prior year period include foreclosed asset costs and FDIC insurance costs. Subsequent to foreclosure, valuations are periodically performed on foreclosed asset properties. Subsequent valuation write-downs during the current six-month period ended June 30, 2012 were $38,000 compared to additional valuation write-downs of $957,000 for the prior year period.  During the current year six-month period, sales of $1.6 million in foreclosed property resulted in additional net losses of $92,000 compared to $66,000 in net losses for the prior year period.  Also FDIC insurance costs were down $295,000 from the prior year six-month period due to changes in the calculation of the insurance assessment from deposit-based to asset-based. Data processing and other outsourced processing expenses grew $119,000 over the prior year period primarily due to growth in our CommunityPLUS deposits accounts. There were no other significant changes in other noninterest expense for the three-month period. Including net costs related to foreclosed assets, our non-interest expense as a percentage of average assets was 3.08% for the six-month period ended June 30, 2012 compared to 3.13% for the prior year period.

We recorded $366,000 and $192,000, respectively, in income tax expense for the six-month periods ended June 30, 2012 and 2011.  Income tax expense as a percentage of pretax income for these periods was 30.9% and 37.9%, respectively.  The effective tax rate was lower in the current year period due to additional permanent tax differences, primarily income from bank owned life insurance. Management has evaluated our tax positions and has concluded that we have no uncertain tax positions.

Asset Quality and Allowance for Loan Losses

Nonperforming assets as of June 30, 2012 were comprised of $17.0 million in nonaccrual loans and $8.1 million in foreclosed assets. Included in nonaccrual loans were $11.8 non-accruing troubled debt restructured loans, or TDRs. In addition to the above nonperforming assets, there were two accruing potential problem loans totaling $568,000 secured by residential and commercial real-estate and accruing TDRs of $13.4 million. As of year-end 2011, nonperforming assets were comprised of $13.4 million nonaccrual loans, $10.6 million nonaccrual TDRs and foreclosed assets of $2.9 million. Potential problems loans were $1.9 million and accruing TDRs were $10.7 million as of year-end 2011. There were $200,000 of accruing loans past due 90 days or more as of June 30, 2012 and none as of  year-end 2011.  A TDR is a loan where a concessionary modification was granted to the borrower due to current or expected financial difficulties of the borrower. Concessions we have granted to customers experiencing financial difficulties resulting in a TDR include reduction in interest rate, extended payment terms or forgiveness of interest.

As a percent of loans, total nonaccrual loans were 3.5% and 4.9%, respectively, as of June 30, 2012 and year-end 2011. The markets in which we operate experienced some improvement in business activity in the first quarter of 2012, but it weakened in the second quarter and remains sluggish compared to pre-recession levels which directly impacts our level of nonperforming assets and past due loans.  Our borrowers tied to the residential and commercial real estate industry have particularly been impacted due to restrictions on cash-flows resulting from slow-moving real estate sales.  Nonaccrual loans for residential and commercial construction and land development comprise 66.5% of our nonaccrual loans as of June 30, 2012, down from 80.2% as of year-end 2011.  Our level of accruing 30-89 days past due loans were $1.7 million as of June 30, 2012, and $1.2 million as of year-end 2011, a downward trend compared to levels during 2009, 2010 and early 2011.

43

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

	June 30, 2012			December 31, 2011
	(Dollars in thousands)
Nonaccrual loans	$	5,194		$	13,436
Troubled debt restructured nonaccrual loans		11,791			10,584
Total nonaccrual loans		16,985			24,020
Foreclosed assets		8,084			2,851
Total nonperforming assets	$	25,069		$	26,871
Accruing loans past due 90 days or more	$	200		$	-
Troubled debt restructured accruing loans	$	13,379		$	10,703
Potential problem loans	$	568		$	1,912
Allowance for loan losses	$	8,355		$	9,906
Nonaccrual loans to period end loans		3.52	%		4.90	%
Allowance for loan losses to period end loans		1.73	%		2.02	%
Nonperforming assets to total assets		3.70	%		4.25	%
Ratio of allowance for loan losses to nonaccrual loans (x)		0.49			0.41

As of June 30, 2012, 98.2% of our nonaccrual loans were real-estate secured, with 42.4% represented within our New Hanover County market. Real-estate secured residential construction and commercial construction and land development loans comprised 66.5% of nonaccrual loans.

The following table is a summary of our nonaccrual loans by major category for the total Bank, New Hanover County and Wake County as of June 30, 2012.

	Nonaccrual Loan Composition as of June 30, 2012
	Total Bank					New Hanover County					Wake County
	Amount		% of Total  Nonaccrual  Loans			Amount		% of Total  Nonaccrual  Loans			Amount		% of Total Nonaccrual  Loans
						(Dollars in thousands)
Real estate secured loans:
Residential construction	$	4,954		29.2	%	$	1,758		10.4	%	$	3,196		18.8	%
Commercial construction, all land development and land loans		6,335		37.3	%		2,857		16.8	%		3,478		20.5	%
Residential properties		2,783		16.4	%		748		4.4	%		2,035		12.0	%
Commercial real estate - other		2,604		15.3	%		1,840		10.8	%		764		4.5	%
Total real estate secured loans		16,676		98.2	%		7,203		42.4	%		9,473		55.8	%
Other non-real estate loans:
Commercial and industrial		309		1.8	%		-		-			309		1.8	%
Total loans held for investment	$	16,985		100.0	%	$	7,203		42.4	%	$	9,782		57.6	%

An aggregate of $8.1 million of the nonaccrual loans as of June 30, 2012 is attributable to seven borrowers for various residential and commercial construction and land development loans, of which $4.4 million are located in our New Hanover County market area. The average exposure for these borrowers is approximately $1.2 million with the largest exposure to any one borrower included in our nonaccrual loans being $2.3 million. Each specific loan in these customer relationships was analyzed for impairment and our management concluded specific impairment reserves aggregating approximately $581,000 on these loans were necessary in addition to $1.8 million of partial charge-offs. Our impairment analysis on the remaining $8.9 million of nonaccrual loans resulted in additional impairment reserves of approximately $237,000 in addition to life-to-date partial charge-offs of $2.1 million.

44

As of June 30, 2012 we also identified and evaluated $568,000 of potential problem loans, primarily as a result of information regarding possible, although not probable, credit problems of the related borrowers. Both of the loans were past due as of June 30, 2012, one which was past due more than 90 days. Management considered these loans in assessing the adequacy of our allowance for loan losses.  These loans were represented by two individual loans and borrowers and were secured with residential and commercial real estate.  Of the $1.9 million of potential problem loans as of year-end 2011, the largest loan of $1.4 million is included in our June 30, 2012 nonaccrual loans.

Foreclosed assets increased to $8.1 million from $2.9 million as of year-end 2011. The properties acquired through foreclosure as of June 30, 2012 were comprised of $6.5 million in residential and commercial construction and land development properties, $277,000 in one-to-four family residential properties, and $1.3 million in commercial real-estate properties. The largest of these properties in terms of dollar size is approximately $3.0 million for residential lots located in our Wake Forest, North Carolina market area. During the six-month period ended June 30, 2012, sales of seven foreclosed properties with a carrying value of approximately $1.6 million were sold resulting in additional net losses of $92,000.  Periodic revaluations during the six-month period ended June 30, 2012 resulted in valuation losses of $38,000.  See Note E to our consolidated financial statements for additional detail regarding loans, nonaccrual loans and credit quality. The following table presents for the dates indicated information regarding foreclosed assets.

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Foreclosed assets beginning of  period	$	4,059		$	4,842		$	2,851		$	5,296
Loans transferred to foreclosed assets		4,642			449			6,930			868
Improvements to foreclosed assets		-			8			-			71
Proceeds from sales, net of selling expenses		(583	)		(1,653	)		(1,567	)		(2,091	)
Net loss on sale of foreclosed assets		(34	)		(38	)		(92	)		(66	)
		8,084			3,608			8,122			4,078
Valuation allowance for foreclosed assets		-			(487	)		(38	)		(957	)
Foreclosed assets end of period	$	8,084		$	3,121		$	8,084		$	3,121

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. See “Asset Quality and the Allowance for Losses” included in Item 7 of our Annual Report on Form 10-K for additional details regarding the allowance for loan losses.

Our loan loss allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries.  Net charge-offs were $2.2 million or .45% of average loans for the three-month period ended June 30, 2012 compared to $820,000 or .17% of average loans for the prior year three-month period. For the six month periods ended June 30, 2012 and 2011, net charge-offs were $4.4 million or .92% of average loans and $2.4 million or .50% of average loans, respectively. Substantially all of the net charge-offs for the three and six-month periods ended June 30, 2012 were real estate secured loans, with 48.1% and 58.6%, respectively, of net loan charge-offs within our New Hanover County market and the remaining  net charge-offs from loans within our Wake County market. Approximately 38.5% of the net charge-offs were loans for residential real estate property while 55.3% were for commercial real estate property. Our loan loss allowance as a percentage of loans outstanding was 1.73% as of June 30, 2012 and 2.02% as of year-end 2011. The impairment reserve decrease was the result of charge-offs to year-end 2011 loan impairments. The general reserve increase was primarily due to a higher potential charge-off rate over year-end 2011 applied to the general commercial loan portfolio. The general reserve increase was minimized due to changes in our loan portfolio composition. We continue to add lower-risk, single-family residential mortgages originated through NSB Mortgage to our held for investment portfolio which have replaced decreases in our more traditional commercial portfolio of loans which typically carry higher risk. The level of the loan loss allowance relative to gross loans declined primarily due to a lower impairment reserve which decreased $2.0 million from year-end 2011.  See Note E and Note F to our consolidated financial statements for additional detail regarding the allowance for loan losses. The following table is a summary of our net charge-offs by major category for the total Bank, New Hanover County and Wake County for the three and six months ended June 30, 2012.

45

	Net Charge-off Composition for the Three Months Ended June 30 , 2012
	Total Bank						New Hanover County						Wake County
	Amount			% of Net Charge-offs			Amount			% of Total Bank Net Charge-offs			Amount			% of Total Bank Net Charge-offs
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	658			30.6	%	$	6			0.3	%	$	652			30.3	%
Commercial construction, all land development and land loans		1,213			56.4	%		1,060			49.3	%		153			7.1	%
Residential properties		54			2.5	%		(8	)		-0.4	%		62			2.9	%
Commercial real estate - other		(10	)		-0.4	%		-			-			(10	)		-0.4	%
Total real estate secured loans		1,915			89.1	%		1,058			49.2	%		857			39.9	%
Other non-real estate loans:
Commercial and industrial		225			10.5	%		(23	)		-1.1	%		248			11.5	%
Consumer and other		10			0.5	%		-			-			10			0.5	%
Total loans held for investment	$	2,150			100.0	%	$	1,035			48.1	%	$	1,115			51.9	%

	Net Charge-off Composition for the Six Months Ended June 30 , 2012
	Total Bank						New Hanover County						Wake County
	Amount			% of Net Charge-offs			Amount			% of Total Bank Net Charge-offs			Amount			% of Total Bank Net Charge-offs
	(Dollars in thousands)
Real estate secured loans:
Residential construction	$	1,491			33.5	%	$	263			5.9	%	$	1,228			27.6	%
Commercial construction, all land development and land loans		2,475			55.7	%		2,204			49.6	%		271			6.1	%
Residential properties		220			4.9	%		163			3.7	%		57			1.3	%
Commercial real estate - other		(15	)		-0.3	%		-			-			(15	)		-0.3	%
Total real estate secured loans		4,171			93.8	%		2,630			59.2	%		1,541			34.7	%
Other non-real estate loans:
Commercial and industrial		264			5.9	%		(25	)		-0.6	%		289			6.5	%
Consumer and other		10			0.2	%		-			-			10			0.2	%
Total loans held for investment	$	4,445			100.0	%	$	2,605			58.6	%	$	1,840			41.4	%

Liquidity and Capital Resources

Our liquidity is a measure of our ability to fund loans, withdrawals and maturities of deposits, and other cash outflows in a cost effective manner.  Our principal sources of liquidity are deposits, scheduled payments and prepayments of loan principal, maturities of investment securities, access to liquid assets, and funds provided by operations. While scheduled loan payments and maturing investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. Liquid assets (consisting of cash and due from banks, interest-earning deposits with other banks, investment securities and loans classified as held for sale) comprised $158.0 million or 23.3% and $112.3 million or 17.7%, respectively, of our total assets as of June 30, 2012 and year-end 2011.

As a member of the FHLB, we may obtain advances of up to 10% of our Bank’s assets.  We are also authorized to borrow from the Federal Reserve Bank’s “discount window.”  As of June 30, 2012, we had pledged specific collateral for potential borrowing of up to $135.2 million from the “discount window.” As another source of short-term borrowings, we also utilize securities sold under agreements to repurchase.  As of June 30, 2012, we did not have any short-term borrowings and we had overnight excess funds of $36.9 million invested in our account at the Federal Reserve.

46

Total deposits were $607.8 million and $564.4 million, respectively, as of June 30, 2012 and year-end 2011.  Time deposits, which are the only deposit accounts that have stated maturity dates, are generally considered to be rate sensitive.  Time deposits represented 26.7% and 27.5%, respectively, of total deposits as of June 30, 2012 and year-end 2011. Time deposits of $100,000 or more represented 16.0% and 16.2%, respectively, of our total deposits as of June 30, 2012 and year-end 2011.  As of June 30, 2012 and year-end 2011, we had no wholesale brokered certificates of deposit or internet deposits.  Under FDIC regulations governing brokered deposits, well capitalized institutions are not subject to brokered deposit limitations. We believe that most of our time deposits are relationship-oriented. While we will need to pay competitive rates to retain deposits at their maturities, there are other subjective factors that we believe will determine their continued retention and we will continue to focus on developing full banking relationships with our customers. Based upon prior experience, we anticipate that a substantial portion of outstanding certificates of deposit will renew upon maturity. We closely monitor and evaluate our overall liquidity position on an ongoing basis and adjust our position as management deems appropriate.  We believe our liquidity position as of June 30, 2012 is adequate to meet our operating needs.

Short and long-term borrowings as of June 30, 2012 and year-end 2011 are as follows:

	June 30, 2012		December 31, 2011
	(Dollars in thousands)
Short-term borrowings:
Repurchase agreements	$	-	$	73
	$	-	$	73
Long-term borrowings:
FHLB advances	$	770	$	781
Subordinated debentures		11,000		11,000
Junior subordinated debentures		15,465		15,465
	$	27,235	$	27,246

A description of the trust preferred securities and related junior subordinated debentures outstanding as of June 30, 2012 and year-end 2011 is as follows:

	June 30, 2012		December 31, 2011		Maturity	Interest
	(Dollars in thousands)				Date	rate
North State Statutory Trust I	$	5,155	$	5,155	4/17/2034	3 mo LIBOR plus 2.79%, resets quarterly
North State Statutory Trust II		5,155		5,155	4/15/2035	3 mo LIBOR plus 1.65%, resets quarterly
North State Statutory Trust III		5,155	$	5,155	12/15/2037	3 mo LIBOR plus 2.75%, resets quarterly
	$	15,465	$	15,465

A description of the subordinated notes outstanding as of June 30, 2012 and year-end 2011 is as follows:

	June 30, 2012		December 31, 2011		Maturity	Interest
	(Dollars in thousands)				Date	rate
Floating rate subordinated notes	$	11,000	$	11,000	6/30/2018	3 mo LIBOR plus 3.50%, resets quarterly

As of June 30, 2012, our equity to assets ratio was 5.8%. The Bank's tier 1 leverage and tier 1 risk based capital ratios and its total risk based capital ratios were 8.00%, 10.49% and 13.90%, respectively, as of June 30, 2012 compared to 8.37%, 10.43% and 13.87% as of year-end 2011.  As of June 30, 2012, the Bank exceeded the minimum requirements of a "well capitalized" institution as defined by federal banking regulations. Our $11.0 million subordinated notes currently qualify 100% as Tier II capital.  Beginning July 1, 2013 the notes are scheduled for discounting 20% per year when the notes will have a remaining maturity of less than five years. Based on the current economic and regulatory environment, the Bank’s board of directors has decided to maintain a Tier I leverage ratio of 8.00% or more and a total risk based capital ratio of 12% or more. Our capital does not include any funds from the Capital Purchase Plan of the U.S. Government’s Troubled Asset Relief Program, or TARP.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

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

47

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

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

In addition to simulation of net interest income, we utilize a discounted net present value of cash flow analysis called Economic Value of Equity or “EVE”.  This methodology aids management in identifying long-term interest rate risk. Additional discussion of EVE is presented in Item 7, under “Asset/Liability Management” of our Annual Report on Form 10-K for the year ended December 31, 2011.

Item 4.  Controls and Procedures

(a) As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of June 30, 2012.

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

48

Part II.                 OTHER INFORMATION

Item 1A. Risk Factors.

There have been no material changes to the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011 except as set forth below.

We recently announced that we intend to deregister our common stock under the Securities Exchange Act of 1934.

On July 24, 2012, we announced that as a result of the enactment of the “Jumpstart Our Business Startups Act”, our Board of Directors had authorized us to pursue the deregistration of our common stock under the Securities Exchange Act of 1934, or the Exchange Act. We are eligible to deregister because we have fewer than 1,200 holders of record of our common stock.  We filed a Form 15 with the SEC on August 1, 2012 and, as result, we expect our obligation to file reports under the Exchange Act will be suspended in early November, 90 days after the filing of the Form 15.

While we do not believe that deregistration will affect trading in our common stock, which we expect will continue to be quoted on the Over The Counter Bulletin Board, or OTCBB, under the symbol “NSBC.OB”, the fact that we will no longer be subject to the reporting requirements of the Exchange Act might cause those firms who currently quote our common stock on the OTCBB to cease such quotations, which would be expected to have a material adverse affect on the liquidity of our common stock.

After the deregistration is effective, we will no longer file quarterly and annual reports, proxy statements and current reports with the SEC. While we expect to provide comprehensive quarterly press releases as to our financial position and financial performance and will continue to provide annual reports in accordance with generally accepted accounting principles and proxy statements to our shareholders, and our subsidiary, North State Bank, will continue to file call reports with the FDIC, we expect that the lack of SEC reporting will cause a decrease in the frequency, detail and scope of our financial and other reporting.  This could have a material adverse affect on the liquidity of our common stock.

Item 6.    Exhibits

Exhibit #                    Description

31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)

31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)

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

32.2 Certification by the Chief Financial Officer pursuant to 18 U.S.C. 1350 as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101 Financials provided in XBRL format

49

SIGNATURES

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

NORTH STATE BANCORP

Date: August 14, 2012	By:	/s/ Larry D. Barbour
		Larry D. Barbour
		President and Chief Executive Officer

Date: August 14, 2012	By:	/s/ Kirk A. Whorf
		Kirk A. Whorf
		Executive Vice President and Chief Financial Officer

50