Southeastern Bank Financial (SBFC) 10-Q 2009 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2009.

or

o Transition Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                    to                    .

Commission File No. 0-24172

Southeastern Bank Financial Corporation

(Exact name of registrant as specified in its charter)

Georgia	58-2005097
(State of Incorporation)	(I.R.S. Employer Identification No.)

3530 Wheeler Road, Augusta, Georgia 30909
(Address of principal executive offices)

(706) 738-6990

(Issuer’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Large accelerated filero	Accelerated filerþ	Non-accelerated filero	Smaller reporting companyo
		(do not check if a smaller reporting company)

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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:

6,672,826 shares of common stock, $3.00 par value per share, outstanding as of October 29, 2009.

SOUTHEASTERN BANK FINANCIAL CORPORATION
FORM 10-Q
INDEX

	Page
Part I
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008		3
Consolidated Statements of Income for the Three and Nine Months ended September 30, 2009 and 2008		5
Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2009 and 2008		7
Notes to Consolidated Financial Statements		9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Item 3. Quantitative and Qualitative Disclosures about Market Risk		50
Item 4. Controls and Procedures		50
Part IIOther Information
Item 1. Legal Proceedings		51
Item 1A. Risk Factors		51
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		51
Item 3. Defaults Upon Senior Securities		*
Item 4. Submission of Matters to a Vote of Security Holders		*
Item 5. Other Information		*
Item 6. Exhibits		52
Signature		53
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

* No information submitted under this caption

1

PART I

FINANCIAL INFORMATION

2

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

(Dollars in thousands, except share data)

	September 30,		December 31,
	2009		2008
	(Unaudited)
Assets
Cash and due from banks	$	74,172	$	24,860
Federal funds sold		7,300		9,780
Interest-bearing deposits in other banks		18,046		3,128
Cash and cash equivalents		99,518		37,768
Investment securities
Available-for-sale		313,461		299,339
Held-to-maturity, at cost (fair values of $491 and $698, respectively)		490		689
Loans held for sale		20,835		18,955
Loans		963,016		986,831
Less allowance for loan losses		16,826		14,742
Loans, net		946,190		972,089
Premises and equipment, net		32,331		33,960
Accrued interest receivable		6,369		7,085
Bank-owned life insurance		23,017		17,368
Restricted equity securities		6,338		6,571
Other real estate owned		15,619		5,734
Other assets		11,637		11,481
	$	1,475,805	$	1,411,039

3

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets
(Dollars in thousands, except share data)

	September 30,		December 31,
	2009		2008
	(Unaudited)
Liabilities and Stockholders’ Equity
Deposit
Noninterest-bearing	$	116,425	$	111,291
Interest-bearing:
NOW accounts		242,624		166,561
Savings		331,408		247,249
Money management accounts		42,846		50,404
Time deposits over $100		373,029		385,439
Other time deposits		152,416		178,608
		1,258,748		1,139,552
Federal funds purchased and securities sold under repurchase agreements		860		62,553
Advances from Federal Home Loan Bank		77,000		84,000
Other borrowed funds		600		—
Accrued interest payable and other liabilities		10,163		10,283
Subordinated debentures		22,947		20,000
Total liabilities		1,370,318		1,316,388
Stockholders’ equity:
Preferred stock, no par value; 10,000,000 shares authorized; 0 shares outstanding in 2009 and 2008, respectively		—		—
Common stock, $3.00 par value; 10,000,000 shares authorized; 6,672,118 and 5,987,674 shares issued and outstanding in 2009 and 2008, respectively		20,016		17,963
Additional paid-in capital		62,306		55,189
Retained earnings		22,110		21,455
Accumulated other comprehensive income, net		1,055		44
Total stockholders’ equity		105,487		94,651
	$	1,475,805	$	1,411,039

See accompanying notes to consolidated financial statements.

4

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income

(Dollars in thousands, except share data)

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Interest income:
Loans, including fees	$	14,218		$	15,003		$	42,228		$	46,483
Investment securities		3,294			3,345			10,964			9,944
Federal funds sold		22			188			62			375
Interest-bearing deposits in other banks		68			7			90			18
Total interest income		17,602			18,543			53,344			56,820
Interest expense:
Deposits		5,658			7,497			18,469			22,539
Federal funds purchased and securities sold under repurchase agreements		114			295			320			1,160
Other borrowings		1,009			1,009			2,928			3,072
Total interest expense		6,781			8,801			21,717			26,771
Net interest income		10,821			9,742			31,627			30,049
Provision for loan losses		4,879			2,073			14,741			4,996
Net interest income after provision for loan losses		5,942			7,669			16,886			25,053
Noninterest income:
Service charges and fees on deposits		1,846			1,955			5,224			5,446
Gain on sales of loans		1,945			1,529			6,643			4,365
(Loss) gain on sale of fixed assets		—			(1	)		(16	)		7
Investment securities gains, net		381			21			1,693			88
Other-than-temporary impairment losses (less $263 and $835 for the three and nine months ended, respectively, recognized in other comprehensive income, before taxes)		(356	)		—			(975	)		—
Retail investment income		326			277			854			841
Trust service fees		268			288			766			873
Increase in cash surrender value of bank-owned life insurance		256			190			649			548
Miscellaneous income		142			178			428			652
Total noninterest income		4,808			4,437			15,266			12,820
Noninterest expense:
Salaries and other personnel expense		5,469			5,202			16,927			15,755
Occupancy expenses		1,213			1,122			3,495			3,153
Other operating expenses		3,582			3,041			10,484			8,642
Total noninterest expense		10,264			9,365			30,906			27,550
Income before income taxes		486			2,741			1,246			10,323
Income tax (benefit) expense		(254	)		866			(187	)		3,405
Net income	$	740		$	1,875		$	1,433		$	6,918

5

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income
(Dollars in thousands, except share data)

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2009		2008		2009		2008
Basic net income per share	$	0.11	$	0.31	$	0.23	$	1.16
Diluted net income per share	$	0.11	$	0.31	$	0.23	$	1.15
Weighted average common shares outstanding		6,672,118		5,976,883		6,338,632		5,967,310
Weighted average number of common and common equivalent shares outstanding		6,672,388		6,018,584		6,344,275		6,010,367

See accompanying notes to consolidated financial statements.

6

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Dollars in thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2009			2008
Cash flows from operating activities:
Net income	$	1,433		$	6,918
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation		2,027			1,685
Provision for loan losses		14,741			4,996
Net investment securities gains		(718	)		(88	)
Net amortization of premium (accretion of discount) on investment securities		146			(133	)
Increase in CSV of bank-owned life insurance		(649	)		(548	)
Stock options compensation cost		141			155
Loss (gain) on disposal of premises and equipment		16			(7	)
Loss on the sale of other real estate		516			4
Gain on sales of loans		(6,643	)		(4,365	)
Real estate loans originated for sale		(289,322	)		(197,388	)
Proceeds from sales of real estate loans		294,086			197,869
Decrease in accrued interest receivable		716			980
Increase in other assets		(800	)		(1,329	)
Decrease in accrued interest payable and other liabilities		(120	)		(1,613	)
Net cash provided by operating activities		15,570			7,136
Cash flows from investing activities:
Proceeds from sales of available for sale securities		79,533			27,285
Proceeds from maturities of available for sale securities		111,070			59,853
Proceeds from maturities of held to maturity securities		203			765
Purchase of available for sale securities		(201,968	)		(89,165	)
Purchase of restricted equity securities		(322	)		(1,535	)
Proceeds from redemption of FHLB stock		23			—
Net increase in loans		(5,675	)		(117,943	)
Purchase of bank-owned life insurance		(5,000	)		—
Additions to premises and equipment		(685	)		(4,841	)
Proceeds from sale of other real estate		6,430			482
Proceeds from sale of premises and equipment		270			1,512
Net cash used in investing activities		(16,121	)		(123,587	)

7

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows
(Dollars in thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2009			2008
Cash flows from financing activities:
Net increase in deposits		119,196			173,618
Net decrease in federal funds purchased and securities sold under repurchase agreements		(61,693	)		(32,558	)
Advances from Federal Home Loan Bank		—			25,000
Payments of Federal Home Loan Bank advances		(7,000	)		—
Proceeds from subordinated debentures		2,947			—
Proceeds from other borrowed funds		600			—
Principal payments on other borrowed funds		—			(100	)
Purchase of treasury stock		(5	)		(445	)
Proceeds from issuance of common stock		9,010			—
Payment of cash dividends		(778	)		(2,191	)
Proceeds from stock options exercised		—			466
Proceeds from Directors’ stock purchase plan		24			25
Net cash provided by financing activities		62,301			163,815
Net increase in cash and cash equivalents	$	61,750		$	47,364
Cash and cash equivalents at beginning of period		37,768			25,058
Cash and cash equivalents at end of period	$	99,518		$	72,422
Supplemental disclosures of cash paid during the period for:
Interest	$	23,043		$	27,661
Income taxes	$	351		$	5,190
Supplemental information on noncash investing activities:
Loans transferred to other real estate	$	16,831		$	863

See accompanying notes to consolidated financial statements.

8

SOUTHEASTERN BANK FINANCIAL CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

September 30, 2009

Note 1 — Basis of Presentation

The accompanying consolidated financial statements include the accounts of Southeastern Bank Financial Corporation (the “Company”), and its wholly-owned subsidiaries, Georgia Bank & Trust Company of Augusta (the “Bank”) and Southern Bank & Trust (the “Thrift”). Significant intercompany transactions and accounts are eliminated in consolidation. Dollar amounts are rounded to thousands except share and per share data.

The financial statements for the three and nine months ended September 30, 2009 and 2008 are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2008.

In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations and cash flows for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations for the three and nine months ended September 30, 2009 are not necessarily indicative of the results of operations which the Company may achieve for the entire year.

Some items in the prior period financial statements were reclassified to conform to the current presentation.

Note 2 — Recent Accounting Pronouncements

In April 2009, the FASB amended existing guidance for determining whether impairment is other-than-temporary (OTTI) for debt securities. According to the amendment, an entity is required to assess whether it intends to sell, or it is more likely than not that it will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. If either of these criteria is met, the entire difference between amortized cost and fair value is recognized in earnings. For securities that do not meet the aforementioned criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income. Additionally, the standard

9

expands and increases the frequency of existing disclosures about other-than-temporary impairments for debt and equity securities. This standard is effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. Through the period ended March 31, 2009, the Company recognized cumulative other-than-temporary impairment charges of $908 for various securities. The Company adopted the standard effective April 1, 2009. As a result of implementing the new standard, the amount of OTTI recognized in income for the quarter ended September 30, 2009 was $356. Had the standard not been issued, the amount of OTTI that would have been recognized in income for the period would have been $619.

In April 2009, ASC 820-10,Fair Value Measurements and Disclosures,was issued.This standard emphasizes that even if there has been a significant decrease in the volume and level of activity, the objective of a fair value measurement remains the same. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants. The standard provides a number of factors to consider when evaluating whether there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity. In addition, when transactions or quoted prices are not considered orderly, adjustments to those prices based on the weight of available information may be needed to determine the appropriate fair value. The standard also requires increased disclosures. This standard is effective for interim and annual reporting periods ending after June 15, 2009, and shall be applied prospectively. Early adoption is permitted for periods ending after March 15, 2009. The adoption of this standard at June 30, 2009 did not have a material impact on the results of operations or financial position.

In April 2009, the FASB amended existing guidance to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies that were previously only required in annual financial statements. This standard is effective for interim reporting periods ending after June 15, 2009. The adoption of this standard at June 30, 2009 did not have a material impact on the results of operations or financial position as it only required disclosures which are included in Note 4.

10

Note 3 — Investment Securities

The following table summarizes the amortized cost and fair value of the available-for-sale and held-to-maturity investment securities portfolio at September 30, 2009 and the corresponding amounts of unrealized gains and losses therein:

	September 30, 2009
			Gross		Gross
	Amortized		unrealized		unrealized			Estimated
	cost		gains		losses			fair value
	(Dollars in Thousands)
Available for sale
Mortgage backed securities
U.S. GSE’s MBS — residential*	$	103,443		3,251		(16	)		106,678
U.S. GSE’s CMO		86,820		1,200		(208	)		87,812
Other CMO		9,254		—		(755	)		8,499
Total MBS	$	199,517		4,451		(979	)		202,989
Obligations of U.S. Government agencies	$	73,490		424		(266	)		73,648
Obligations of states and political subdivisions		26,122		658		(273	)		26,507
Corporate bonds		12,591		93		(2,377	)		10,307
Equity securities		14		—		(4	)		10
	$	311,734		5,626		(3,899	)		313,461
Held to maturity
Obligations of states and political subdivisions	$	490		1		—			491
	$	490		1		—			491

* Government sponsored entities

The amortized cost and fair value of the investment securities portfolio excluding equity securities are shown by expected maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.

11

	September 30, 2009
	Amortized		Estimated
	cost		fair value
	Dollars in Thousands
Available for sale:
One year or less	$	654		657
After one year through five years		6,366		6,367
After five years through ten years		46,528		46,670
After ten years		258,172		259,757
	$	311,720		313,451
Held to maturity:
One year or less		180		181
After one year through five years		310		310
		490		491

The following table summarizes the investment securities with unrealized losses at September 30, 2009 by aggregated major security type and length of time in a continuous unrealized loss position:

	September 30, 2009
	Less than 12 months				12 months or longer				Total
	Estimated		Unrealized		Estimated		Unrealized		Estimated		Unrealized
	fair value		loss		fair value		loss		fair value		loss
	(Dollars in Thousands)
Temporarily impaired
Mortgage backed securities
U.S. GSE’s MBS — residential	$	10,230		16		—		—		10,230		16
U.S. GSE’s CMO		21,586		202		808		6		22,394		208
Other CMO		458		192		6,195		300		6,653		492
Total MBS	$	32,274		410		7,003		306		39,277		716
Obligations of U.S. Government agencies	$	30,839		266		—		—		30,839		266
Obligations of states and political subdivisions		1,572		62		4,549		211		6,121		273
Corporate bonds		505		1,528		6,950		849		7,455		2,377
Equity securities		10		4		—		—		10		4
	$	65,200		2,270		18,502		1,366		83,702		3,636
Other-than-temporarily impaired
Mortgage backed securities
Other CMO	$	—		—		1,846		263		1,846		263
Total temporarily impaired and other-than-temporarily impaired	$	65,200		2,270		20,348		1,629		85,548		3,899

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Proceeds from sales and calls of securities available for sale were $190,603 and $87,138 for the nine months ended September 30, 2009 and 2008, respectively. Gross gains of $2,265 and $157 and gross losses of $575 and $84 were realized on these sales during 2009 and 2008, respectively.

Proceeds from sales and calls of securities available for sale were $41,697 and $21,783 for the three months ended September 30, 2009 and 2008, respectively. Gross gains of $386 and $40 and gross losses of $5 and $19 were realized on these sales during 2009 and 2008, respectively.

Other-Than-Temporary-Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities classified as available for sale or held-to-maturity are generally evaluated for OTTI under the provisions of ASC 320-10,Investments — Debt and Equity Securities.In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

13

As of September 30, 2009, the Company’s security portfolio consisted of 257 securities, 69 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s mortgage-backed and corporate securities, as discussed below:

Mortgage-backed Securities

At September 30, 2009, approximately 95.81% of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at September 30, 2009.

The Company’s mortgage-backed securities portfolio also includes twelve non-agency collateralized mortgage obligations with a market value of $8,499 which had unrealized losses of approximately $755 at September 30, 2009. These non-agency securities were rated AAA at purchase.

At September 30, 2009 five of these non-agency securities were rated below investment grade and a cash flow analysis was performed to evaluate OTTI. The assumptions used in the model include expected future default rates, loss severity and prepayments. The model also takes into account the structure of the security including credit support. Based on these assumptions the model calculates and projects the timing and amount of interest and principal payments expected for the security. In addition the model was used to “stress” each security, or make assumptions more severe than expected activity, to determine the degree to which assumptions could deteriorate before the security could no longer fully support repayment. Upon completion of the September 30, 2009 analysis, our model indicated other-than-temporary impairment on two of these securities. These securities had third quarter OTTI losses of $619, of which $356 was recorded as expense and $263 was recorded in other comprehensive income. Year to date these securities had OTTI losses of $1,310, of which $475 was recorded as expense and $835 was recorded in other comprehensive income. These two securities remained classified as available for sale at September 30, 2009.

At September 30, 2009, the fair values of four collateralized mortgage obligations totaling $4,197 were measured using Level 3 inputs because the market for them has become illiquid, as indicated by few, if any, trades during the period. These securities were previously measured using Level 2 inputs. The discount rates used in the valuation model were based on a yield that the market would require for collateralized mortgage obligations with maturities and risk characteristics similar to the securities being measured.

14

Corporate Securities

The Company holds thirteen corporate securities to eight issuers totaling $10,307 with an unrealized loss of $2,377. The Company’s unrealized losses on corporate securities relate primarily to its investment in single issuer corporate and corporate trust preferred securities. At September 30, 2009 three of the corporate securities were rated Speculative and five were rated Investment grade by at least one of the rating agencies, Moody’s, S&P and Fitch. Five of the securities to two issuers were not rated. None of the issuers were in default and to date all interest payments have been made as contracted. The Company considered several factors including the financial condition and near term prospects of the issuers and concluded that the decline in fair value was primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. Because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at September 30, 2009.

At September 30, 2009, the fair values of all thirteen corporate securities were measured using Level 3 inputs because the market for them has become illiquid, as indicated by few, if any, trades during the period. These securities, eight of which totaled $4,580 were previously measured using Level 2 inputs. The discount rates used in the valuation model were based on current spreads to U.S. Treasury rates of long-term corporate debt obligations with maturities and risk characteristics similar to the subordinated debentures being measured. An additional adjustment to the discount rate for illiquidity in the market for subordinated debentures was not considered necessary based on the illiquidity premium already present in the spreads used to estimate the discount rate.

In addition to the securities discussed above, the Company had an investment in the senior debt of Silverton Financial Services, Inc. of $500 for which an other-than-temporary impairment charge was taken in the first half of 2009.

The table below presents a rollforward of the credit losses recognized in earnings for the three month period ended September 30, 2009:

Beginning balance, July 1, 2009	$	619
Amounts related to credit loss for which an other-than-temporary impairment was not previously recognized		—
Additions/Subtractions
Amounts realized for securities sold during the period		—
Amounts related to securities for which the company intends to sell or that it will be more likely than not that the company will be required to sell prior to recovery of amortized cost basis		—
Reductions for increase in cash flows expected to be collected that are recognized over the remaining life of the security		—
Increases to the amount related to the credit loss for which other-than-temporary was previously recognized		356
Ending balance, September 30, 2009		975

15

The following details the two mortgage backed securities and one single issuer corporate debt security with OTTI at September 30, 2009 and the related credit losses recognized in earnings:

	Silverton
	Financial
	Services, Inc		CMO 1		CMO 2		Total
	(dollars in thousands)
Amount of other-than temporary-impairment related to credit losses at July 1, 2009	$	500	$	57	$	62	$	619
Addition for credit losses recognized in earnings		—		98		258		356
Amount of other-than temporary-impairment related to credit losses at September 30, 2009	$	500	$	155	$	320	$	975

Further deterioration in economic conditions could cause the Company to record additional impairment charges related to credit losses of up to $2,109 which is the carrying amount of these securities.

The following table details the credit ratings and the total impairment loss related to “all other factors” recorded as a component of accumulated other comprehensive income for the Company’s mortgage backed securities.

			Estimated
	Amortized		Fair		Unrealized			Ratings as of September 30, 2009
(dollars in thousands)	cost		Value		Losses			S&P	Fitch		Moodys
Silverton Financial Services, Inc.	$	—	$	—	$	—		NR	NR		NR
CMO 1		793		702		(91	)	CCC		C	NR
CMO 2		1,316		1,144		(172	)	CCC	NR		Caa2
Total	$	2,109	$	1,846	$	(263	)

Note 4 — Fair Value Measurements

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair values:

Level 1 — Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 — Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 3 — Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

16

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Loans Held for Sale: The fair value of loans held for sale is determined by individual third party sales contract prices for the specific loans held at each reporting period end (Level 2 inputs). The fair value adjustment is included in other assets.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Investments in Tax Credits: The fair values for tax credits are measured on a recurring basis and are based upon total credits and deductions remaining to be allocated and total estimated credits and deductions to be allocated (Level 3 inputs).

Other Real Estate Owned: The fair value of other real estate owned is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Management may adjust the appraised value for estimated costs to sell. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

17

Assets and Liabilities Measured on a Recurring Basis

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis by level within the hierarchy as of September 30, 2009 and December 31, 2008:

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2009		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Available-for-sale securities	$	313,461	$	30,351	$	268,605	$	14,505
Tax credits		455		—		—		455
Loans held for sale		20,835		—		20,835		—
Total	$	334,751	$	30,351	$	289,440	$	14,960

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	December 30,		Assets		Inputs		Inputs
	2008		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Available-for-sale securities	$	299,339	$	46	$	295,163	$	4,130
Tax credits		515		—		—		515
Loans held for sale		18,955		—		18,955		—
Total	$	318,809	$	46	$	314,118	$	4,645

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The tables below present a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of September 30, 2009 and September 30, 2008:

Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)

				Available-for-sale
	Tax credits			Securities			Total
	(dollars in thousands)
Beginning balance, January 1, 2009	$	515		$	4,130		$	4,645
Total gains or losses (realized/unrealized)
Included in earnings
Other-than-temporary impairment		—			(356	)		(356	)
Amortization of tax credit investment		(60	)		—			(60	)
Included in other comprehensive income		—			1,598			1,598
Transfers in and/or out of Level 3		—			9,133			9,133
Ending balance, September 30, 2009	$	455		$	14,505		$	14,960

Fair Value Measurements Using Significant Unobservable Inputs
(Level 3)

				Available-for-sale
	Tax credits			Securities		Total
	(dollars in thousands)
Beginning balance, January 1, 2008	$	594		$	—	$	594
Total gains or losses (realized/unrealized)
Included in earnings
Other-than-temporary impairment		—			—		—
Amortization of tax credit investment		(60	)		—		(60	)
Included in other comprehensive income		—			—		—
Transfers in and/or out of Level 3		—			4,412		4,412
Ending balance, September 30, 2008	$	534		$	4,412	$	4,946

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis as of September 30, 2009 and December 31, 2008 are summarized below:

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2009		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Impaired loans	$	11,160		—		—	$	11,160
Other real estate owned		15,619		—		—		15,619

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			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2008		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets:
Impaired loans	$	14,743		—		—	$	14,743
Other real estate owned		5,734		—		—		5,734

The following represents impairment charges recognized during the period:

Impaired loans, which are measured for impairment using the fair value of collateral for collateral-dependent loans, had a carrying amount of $14,069, with a valuation allowance of $2,909, resulting in an additional provision for loan losses of $3,181 and $10,827 for the three and nine months ended September 30, 2009, respectively. Impaired loans for which there is no specific allowance for credit losses had a carrying amount of $20,481 at September 30, 2009.

As of December 31, 2008 impaired loans had a carrying amount of $16,944, with a valuation allowance of $2,201. Impaired loans for which there is no specific allowance for credit losses had a carrying amount of $16,836 at December 31, 2008.

Other real estate owned, which is carried at lower of cost or fair value, was $15,619.

Disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value is required. Fair value estimates are made at a specific point 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 market 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.

Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.

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The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow and other valuation techniques. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather a good-faith estimate of the fair value of financial instruments held by the Company. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements.

The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:

(a)	Cash and Cash Equivalents
	Fair value equals the carrying value of such assets due to their nature.
(b)	Investment Securities
	The fair values of investment securities are determined as discussed above.
(c)	Loans
	The fair value of loans is calculated using discounted cash flows by loan type. The discount rate used to determine the present value of the loan portfolio is an estimated market rate that reflects the credit and interest rate risk inherent in the loan portfolio without considering widening credit spreads due to market illiquidity. The estimated maturity is based on the Company’s historical experience with repayments adjusted to estimate the effect of current market conditions. The carrying amount of related accrued interest receivable approximates its fair value and is not disclosed. The carrying amount of real estate loans originated for sale approximates their fair value. The allowance for loan losses is considered a reasonable discount for credit risk.
(d)	Deposits
	Fair values for certificates of deposit have been determined using discounted cash flows. The discount rate used is based on estimated market rates for deposits of similar remaining maturities. The carrying amounts of all other deposits, due to their short-term nature, approximate their fair values. The carrying amount of related accrued interest payable approximates its fair value and is not disclosed.

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(e)	Federal Funds Sold and Securities Sold Under Repurchase Agreements
	Fair value approximates the carrying value of such liabilities due to their short-term nature.
(f)	Other Borrowed Funds
	Fair value approximates the carrying value of such liabilities as the borrowings are at a variable rate of interest.
(g)	Advances from FHLB
	The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flows using an estimated interest rate based on the current rates available to the Company for debt of similar remaining maturities and collateral terms.
(h)	Subordinated debentures
	The fair value for subordinated debentures is calculated based upon current market spreads to LIBOR for debt of similar remaining maturities and collateral terms.
(i)	Commitments
	The difference between the carrying values and fair values of commitments to extend credit are not significant and are not disclosed.

The carrying amounts and estimated fair values of the Company’s financial instruments at September 30, 2009 and December 31, 2008 are as follows:

	September 30,
	2009
	Carrying		Estimated
	amount		fair value
	(Dollars in Thousands)
Financial assets:
Cash and cash equivalents	$	99,518		99,518
Investment securities		313,951		313,952
Loans, net		967,025		975,700
Financial liabilities:
Deposits		1,258,748		1,240,933
Federal funds purchased and securities sold under repurchase agreements		860		860
Other borrowed funds		600		600
Advances from FHLB		77,000		78,560
Subordinated debentures		22,947		14,760

22

	December 31,
	2008
	Carrying		Estimated
	amount		fair value
	(Dollars in Thousands)
Financial assets:
Cash and cash equivalents	$	37,768		37,768
Investment securities		300,028		300,037
Loans, net		991,044		997,338
Financial liabilities:
Deposits		1,139,552		1,141,627
Federal funds purchased and securities sold under repurchase agreements		62,553		62,553
Other borrowed funds		—		—
Advances from FHLB		84,000		76,090
Subordinated debentures		20,000		11,814

Note 5 — Comprehensive Income

Other comprehensive income for the Company consists of changes in net unrealized gains and losses on investment securities available for sale. Net income of $740 coupled with a $1,839 change in other comprehensive income for the quarter resulted in a total comprehensive income of $2,579 for the three months ended September 30, 2009 compared to total comprehensive loss of $4 for the three months ended September 30, 2008. Net income of $1,433 coupled with a year to date $1,011 change in other comprehensive income resulted in a total comprehensive income of $2,444 for the nine months ended September 30, 2009 compared to total comprehensive income of $2,792 for the nine months ended September 30, 2008.

Note 6 — Dividends Declared

On April 23, 2008, the Company declared a 10% stock dividend which was paid on June 2, 2008 to shareholders of record as of May 22, 2008. No fractional shares were issued. Shareholders entitled to fractional shares received cash for the fractional shares at a price equal to the closing price of the stock as of the record date, adjusted for the stock dividend. 542,343 additional shares of common stock and 854 shares of treasury stock were issued in connection with the stock dividend. The Company’s earnings per share has been adjusted accordingly for all periods presented.

On January 21, 2009, the Company declared a quarterly cash dividend of $0.13 per share on outstanding shares. The dividend was paid on February 18, 2009 to shareholders of record as of February 5, 2009.

23

The Company suspended the payment of quarterly cash dividends on the company’s common stock effective April 24, 2009. The Company considered the action prudent in order to maintain its capital position in the current state of the economy. The Company plans to reinstate the dividend payment at an appropriate time once economic conditions improve and stabilize.

Note 7 — Subsequent Events

The Company evaluated subsequent events up and through October 30, 2009, which is the date the financial statements were issued. As a result of that evaluation no subsequent events were identified that required recognition or disclosure in the financial statements.

24

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

(Dollar amounts are expressed in thousands unless otherwise noted)

Overview

Southeastern Bank Financial Corporation (the “Company”) operates two wholly-owned subsidiaries in the Augusta-Richmond County, GA-SC metropolitan area. Georgia Bank & Trust Company (the “Bank”) was organized by a group of local citizens and commenced business on August 28, 1989, with one branch location. Today, it is Augusta’s largest community banking company operating nine full service branches in Augusta, Martinez, and Evans, Georgia and one branch in Athens, Georgia. Mortgage origination offices are located in Augusta, Savannah and Athens, Georgia. SB&T Capital Corporation (the “LPO”) a wholly-owned subsidiary of the Bank, was organized on August 16, 2007 and opened an office in Greenville, South Carolina. Southern Bank & Trust (the “Thrift”), a federally chartered thrift, was organized by the Company during 2005 and 2006 and opened its main office on September 12, 2006. Today it operates three full service branches in North Augusta and Aiken, South Carolina. The Company’s Operations Center is located in Martinez, Georgia and services both subsidiaries.

During the second quarter the Company made the decision to cease originations of new loans in its Greenville, South Carolina office and allow the portfolio, primarily real estate loans, to decline over the life of the remaining loans. No exit costs were incurred as a result of the decision.

During the second quarter Georgia Bank & Trust withdrew from its partnership of 30% interest with NMF Asset Management, LLC. As a result the Bank wrote off its investment of $20 in the partnership in the second quarter.

The Company’s primary market includes Richmond and Columbia Counties in Georgia and Aiken County in South Carolina, all part of the Augusta-Richmond County, GA-SC metropolitan statistical area (MSA). The 2008 population of the Augusta-Richmond County, GA-SA MSA was 534,218, the second largest in Georgia and fourth largest in South Carolina. The Augusta market area has a diversified economy based principally on government, public utilities, health care, manufacturing, construction, and wholesale and retail trade. Augusta is one of the leading medical centers in the Southeast. The Company entered the Athens, GA market in December 2005. The 2008 population for the Athens-Clarke County, GA MSA was 189,264, ranked fifth in the state of Georgia. The Athens market area has a diversified economy based primarily on government, retail services, tourism, manufacturing, other services, and health care, with the largest share of government jobs in the state.

25

The Company’s services include the origination of residential and commercial real estate loans, construction and development loans, and commercial and consumer loans. The Company also offers a variety of deposit programs, including noninterest-bearing demand, interest checking, money management, savings, and time deposits. In the primary market area, Augusta-Richmond County, GA-SC metropolitan area, the Company had 16.70% of all deposits and was the second largest depository institution at June 30, 2009, as cited from the Federal Deposit Insurance Corporation’s website. Securities sold under repurchase agreements are also offered. Additional services include wealth management, trust, retail investment, and mortgage. As a matter of practice, most mortgage loans are sold in the secondary market; however, some mortgage loans are placed in the portfolio based on asset/liability management strategies. The Company continues to concentrate on increasing its market share through various new deposit and loan products and other financial services and by focusing on the customer relationship management philosophy. The Company is committed to building life-long relationships with its customers, employees, shareholders, and the communities it serves.

The Company’s primary source of income is from its lending activities followed by interest income from its investment activities, service charges and fees on deposits, and gain on sales of mortgage loans in the secondary market. Interest income on loans decreased during the first nine months of 2009 as compared to the first nine months of 2008 due to lower interest rates and increased levels of loans placed on nonaccrual offset in part by increased volumes. Interest income on investment securities increased primarily due to increased volumes. Service charges and fees on deposits decreased as a result of decreases in NSF income on retail checking accounts due primarily to decreased economic activity and was partially offset by increases in ATM/Debit card income. Declining mortgage rates and a significant increase in mortgage refinancing activity resulted in an increase in gain on sales of loans for the first nine months of 2009 as compared to the same period in 2008. Investment securities gains increased due to $2,268 in gains on sales of securities somewhat offset by an other-than-temporary impairment charge of $475 recognized on two mortgage-backed securities and a $1,033 impairment charge related to investments in the common stock and trust preferred securities of Silverton Financial Services, Inc., parent holding company of Silverton Bank, N.A., which was placed in receivership on May 1, 2009.

Table 1 — Selected Financial Data

	September 30,			December 31,			December 31,
	2009			2008			2004
	(Dollars in thousands)
Assets	$	1,475,805		$	1,411,039		$	706,517
Loans		983,851			1,005,786			494,170
Deposits		1,258,748			1,139,552			556,785
Annualized return on average total assets		0.13	%		0.57	%		1.29	%
Annualized return on average equity		1.93	%		8.48	%		15.50	%

26

The Company continues to experience growth although at a slower rate as evidenced in Table 1 above. The Company has also achieved increases in deposits and continues to provide returns on assets and equity although on a reduced level as noted in the table above. Annualized return on average total assets and annualized return on average equity have declined recently due primarily to increased levels of non-performing assets which have resulted in higher loan loss provisions. Net income for the year ended 2004 was $8.7 million compared to net income of $7.6 million at year end 2008. Net income for the nine months ended September 30, 2009 was $1.4 million compared to $6.9 million for the same period in 2008. Current market conditions along with increases to the provision for loan losses and impairment charges had a significant effect on net income for the year. The Company has paid cash dividends of $0.13 per share each quarter since 2004 but has elected to suspend dividends effective April 24, 2009 to conserve capital. The suspension of the dividend conserves approximately $3.5 million of capital per year.

The Company meets its liquidity needs by managing cash and due from banks, federal funds purchased and sold, maturity of investment securities, principal repayments from mortgage-backed securities, and draws on lines of credit. Additionally, liquidity can be managed through structuring deposit and loan maturities. The Company funds loan and investment growth with core deposits, securities sold under repurchase agreements, Federal Home Loan Bank advances and other wholesale funding including brokered certificates of deposit. During inflationary periods, interest rates generally increase and operating expenses generally rise. When interest rates rise, variable rate loans and investments produce higher earnings; however, deposit and other borrowings interest expense also rise. The Company monitors its interest rate risk as it applies to net income in a ramp up and down annually 200 basis points (2.00%) scenario and as it applies to economic value of equity in a shock up and down 200 (2.00%) basis points scenario. The Company monitors operating expenses through responsibility center budgeting.

Forward-Looking Statements

Southeastern Bank Financial Corporation may, from time to time, make written or oral forward-looking statements, including statements contained in the Company’s filings with the Securities and Exchange Commission (the “Commission”) and its reports to shareholders. Statements made in such documents, other than those concerning historical information, should be considered forward-looking and subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The Company’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors, including unanticipated changes in the Company’s local economies, the national economy, governmental monetary and fiscal policies, deposit levels, loan demand, loan collateral values and securities portfolio values; difficulties in interest rate risk management; the effects of competition in the banking business; difficulties in expanding the Company’s business into new markets; changes in governmental regulation relating to the banking industry, including regulations relating to branching and acquisitions; failure of assumptions underlying the establishment of reserves for loan losses, including the value of collateral underlying delinquent loans; and other factors. The Company cautions that such factors are not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by, or on behalf of, the Company.

27

Critical Accounting Estimates

The accounting and financial reporting policies of the Company and its subsidiaries conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Of these policies, management has identified the allowance for loan losses, determining the fair values of financial instruments, investment securities, income taxes, and other-than-temporary impairment as critical accounting estimates that requires difficult, subjective judgment and are important to the presentation of the financial condition and results of operations of the Company.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to expense, which affects the Company’s earnings directly. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. Subsequent recoveries are added to the allowance. The allowance is an amount that reflects management’s estimate of the level of incurred losses in the portfolio. Factors considered by management in determining the adequacy of the allowance include, but are not limited to: (1) detailed reviews of individual loans; (2) historical and current trends in loan charge-offs for the various portfolio segments evaluated; (3) the level of the allowance in relation to total loans and to historical loss levels; (4) levels and trends in non-performing and past due loans; (5) collateral values of properties securing loans; (6) management’s assessment of economic conditions. The Company’s Board of Directors reviews the recommendations of management regarding the appropriate level for the allowance for loan losses based upon these factors.

The provision for loan losses is the charge to operating earnings necessary to maintain an adequate allowance for loan losses. The Company has developed policies and procedures for evaluating the overall quality of its loan portfolio and the timely identification of problem credits. Management continues to review these policies and procedures and makes further improvements as needed. The adequacy of the Company’s allowance for loan losses and the effectiveness of the Company’s internal policies and procedures are also reviewed periodically by the Company’s regulators and the Company’s internal loan review personnel. The Company’s regulators may advise the Company to recognize additions to the allowance based upon their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result.

The Company continues to refine the methodology on which the level of the allowance for loan losses is based, by comparing historical loss ratios utilized to actual experience and by classifying loans for analysis based on similar risk characteristics. Cash receipts for accruing loans are applied to principal and interest under the contractual terms of the loan agreement; however, cash receipts on impaired and nonaccrual loans for which the accrual of interest has been discontinued are applied to principal and interest income depending upon the overall risk of principal loss to the Company.

28

Fair Value of Financial Instruments

A significant portion of the Company’s assets are financial instruments carried at fair value. This includes securities available for sale and certain loans held for sale. At September 30, 2009 and December 31, 2008 the percentage of total assets measured at fair value was 22.65% and 22.56% respectively. The majority of assets carried at fair value are based on either quoted market prices or market prices for similar instruments. At September 30, 2009, 4.48% of assets measured at fair value were based on significant unobservable inputs. This represents approximately 1.01% of the Company’s total assets. See Note 4 “Fair Value Measurements” in the “Notes to Consolidated Financial Statements” herein for additional disclosures regarding the fair value of financial instruments.

Investment Securities

The fair values for available-for-sale securities are generally based upon quoted market prices or observable market prices for similar instruments. These values take into account recent market activity as well as other market observable data such as interest rate, spread and prepayment information. When market observable data is not available, which generally occurs due to the lack of liquidity for certain securities, the valuation of the security is subjective and may involve substantial judgment. The Company conducts periodic reviews to identify and evaluate each available-for-sale security that has an unrealized loss for other-than-temporary impairment. An unrealized loss exists when the fair value of an individual security is less than its amortized cost basis. The primary factors the Company considers in determining whether an impairment is other-than-temporary are the financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer and the Company’s intent and ability to retain its investment in the issuer for a period of time to allow for any anticipated recovery in market value. As of September 30, 2009 the Company had approximately $14,505 of available-for-sale securities, which is approximately 0.981% of total assets, valued using unobservable inputs (Level 3). These securities were primarily non-agency mortgage-backed securities and subordinated debentures issued by financial institutions.

Results of Operations

The Company’s net income for the third quarter of 2009 was $740, which was a decrease of $1,135 (60.53%) compared to net income of $1,875 for the third quarter of 2008. Diluted net income per share for the three months ended September 30, 2009 was $0.11 compared to $0.31 for the three months ended September 30, 2008. Net income for the first nine months of 2009 was $1,433, a decrease of $5,485 (79.29%) compared with net income of $6,918 for the first nine months of 2008. The decrease in net income for the three and nine months ended September 30, 2009 as compared with the three and nine months ended September 30, 2008, was primarily a result of increases in the provision for loan losses due to increased levels of nonperforming assets. Interest income on loans decreased due to lower interest rates and increased levels of nonaccrual loans somewhat offset by increased volumes. Interest income on investment securities increased due to increased volumes. Interest expense on deposits, securities sold under repurchase agreements and other borrowings decreased as a result of lower interest rates offset in part by higher volumes of interest bearing liabilities.

29

Factors contributing to the increase in noninterest income for the nine months ended September 30, 2009, were increases in gain on sales of loans and in net investment securities gains somewhat offset by a decrease in trust service fees and service charges and fees on deposits.

Gain on sales of loans increased substantially as mortgage rates declined and mortgage refinancing activity increased. For the quarter gain on sales of loans increased from $1,529 to $1,945 or 27.21%. Year-to-date gains increased from $4,365 to $6,643 or 52.19%.

Net investment securities gains including OTTI losses for the quarter were $25 which increased $4 over 2008. Year to date net investment gains were $718, an increase of $630 over 2008. The increases are primarily due to $2,268 in gains recognized on sales of investment securities somewhat offset by losses recognized due to the failure of Silverton Bank National Association of $1,033 and other than temporary impairment charges for two securities which totaled $475.

Service charges and fees on deposits for the quarter were $1,846, a decrease of $109 or 5.58%. Year to date service charges were $5,224, a decrease of $222 or 4.08%. The decreases were primarily due to decreases in consumer NSF fees. The decline in NSF income was primarily due to reduced consumer activity which the Company attributes to the economic environment.

Noninterest expense totaled $10,264 for the quarter, an increase of $899 or 9.60%. Year-to-date noninterest expense totaled $30,906, an increase of $3,356 or 12.18%. The increases during the three and nine months ended September 30, 2009 compared to the same periods ended September 30, 2008 were primarily due to increased FDIC insurance expenses and increased commissions paid on mortgage production. For the nine month period FDIC insurance expense increased approximately $1,610 due a special assessment of $670 as well as an increase in the insurance rate over prior year which increased from approximately 7bp to 16bp of insured deposits during the comparable periods. Commissions paid on mortgage production increased approximately $639 as a result of increased mortgage production.

30

Table 2 — Selected Balance Sheet Data

	September 30,		December 31,		Variance
	2009		2008		Amount			%
	(Dollars in thousands)
Cash, due from banks and interest-bearing deposits	$	92,218	$	27,988	$	64,230			229.5	%
Federal funds sold		7,300		9,780		(2,480	)		(25.4	%)
Investment securities		313,951		300,028		13,923			4.6	%
Loans		983,851		1,005,786		(21,935	)		(2.2	%)
Other real estate owned		15,619		5,734		9,885			172.4	%
Assets		1,475,805		1,411,039		64,766			4.6	%
Deposits		1,258,748		1,139,552		119,196			10.5	%
Securities sold under repurchase agreements		860		62,553		(61,693	)		(98.6	%)
Advances from Federal Home Loan Bank		77,000		84,000		(7,000	)		(8.3	%)
Liabilities		1,370,318		1,316,388		53,930			4.1	%
Stockholders’ equity		105,487		94,651		10,836			11.4	%

Table 2 highlights significant changes in the balance sheet at September 30, 2009 as compared to December 31, 2008. Assets increased $64,766, primarily the result of higher balances in cash, due from banks and interest-bearing deposits in other banks which increased $64,230 from December 31, 2008 to $92,218 at September 30, 2009, $64,186 of which was held at the Federal Reserve Bank. Management has maintained an increased level of liquid funds in light of current economic conditions and volatility in the banking industry. Gross loans decreased $21,935 due primarily to decreased demand resulting from the slowing economy. The decreased demand caused normal principal repayments to exceed the originations of new loans during the year. In addition, loans decreased due to real estate acquired through foreclosure which increased $9,885. Investment securities increased $13,923 due to in part to the decrease in loans, the growth in deposits and for the purpose of managing the Company’s interest rate risk profile. Proceeds from sales and maturities and other purchases were partially reinvested in instruments that required a lower level of regulatory capital and that have lower levels of interest rate risk. The increase in assets was funded by an increase in deposits of $119,196, somewhat offset by decreases in securities sold under repurchase agreements of $61,693. The large increase in deposits included approximately $60,000 in public funds which moved from securities sold under repurchase agreements to NOW accounts.

The annualized return on average assets for the Company was 0.13% for the nine months ended September 30, 2009, compared to 0.71% for the same period last year. While total assets have increased $97,675 since third quarter 2008, net income has decreased $5,485 resulting in a decrease in ROA.

The annualized return on average stockholders’ equity was 1.93% for the nine months ended September 30, 2009, compared to 10.39% for the same period last year. The decrease is primarily attributable to the decrease in net income.

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Net Interest Income

The primary source of earnings for the Company is net interest income, which is the difference between income on interest-earning assets, such as loans and investment securities, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings. The following table shows the average balances of interest-earning assets and interest-bearing liabilities, annualized average yields earned and rates paid on those respective balances, and the actual interest income and interest expense for the periods indicated. Average balances are calculated based on daily balances, yields on non-taxable investments are not reported on a tax equivalent basis and average balances for loans include nonaccrual loans even though interest was not earned.

Table 3 — Average Balances, Income and Expenses, Yields and Rates

	Three Months Ended Sept. 30, 2009							Three Months Ended Sept. 30, 2008
			Annualized							Annualized
			Average			Amount				Average			Amount
	Average		Yield or			Paid or		Average		Yield or			Paid or
	Amount		Rate			Earned		Amount		Rate			Earned
	(Dollars in thousands)
Interest-earning assets:
Loans	$	981,976		5.69	%	$	14,218	$	968,298		6.09	%	$	15,003
Investment securities
Taxable		265,590		4.60	%		3,052		232,366		5.46	%		3,171
Tax-exempt		22,123		4.38	%		242		16,032		4.34	%		174
Federal funds sold		7,300		1.19	%		22		39,133		1.91	%		188
Interest-bearing deposits in other banks		61,940		0.43	%		68		500		5.40	%		7
Total interest-earning assets	$	1,338,929		5.18	%	$	17,602	$	1,256,329		5.82	%	$	18,543
Interest-bearing liabilities:
Deposits	$	1,079,093		2.08	%	$	5,658	$	962,011		3.09	%	$	7,497
Federal funds purchased / securities sold under repurchase agreements		57,907		0.78	%		114		59,266		1.97	%		295
Other borrowings		101,764		3.93	%		1,009		104,171		3.84	%		1,009
Total interest-bearing liabilities	$	1,238,764		2.17	%	$	6,781	$	1,125,448		3.10	%	$	8,801
Net interest margin/income:				3.17	%	$	10,821				3.04	%	$	9,742

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Table 4 — Average Balances, Income and Expenses, Yields and Rates

	Nine Months Ended Sept. 30, 2009							Nine Months Ended Sept. 30, 2008
			Annualized							Annualized
			Average			Amount				Average			Amount
	Average		Yield or			Paid or		Average		Yield or			Paid or
	Amount		Rate			Earned		Amount		Rate			Earned
	(Dollars in thousands)
Interest-earning assets:
Loans	$	989,637		5.65	%		42,228 $	$	937,175		6.54	%	$	46,483
Investment securities
Taxable		270,247		5.08	%		10,301		233,035		5.38	%		9,406
Tax-exempt		20,476		4.32	%		663		16,455		4.36	%		538
Federal funds sold		27,384		0.31	%		62		24,632		2.03	%		375
Interest-bearing deposits in other banks		34,921		0.34	%		90		500		5.00	%		18
Total interest-earning assets	$	1,342,665		5.27	%	$	53,344	$	1,211,797		6.20	%	$	56,820
Interest-bearing liabilities:
Deposits	$	1,076,330		2.29	%	$	18,469	$	918,478		3.27	%	$	22,539
Federal funds purchased / securities sold under repurchase agreements		53,933		0.79	%		320		62,043		2.49	%		1,160
Other borrowings		104,144		3.75	%		2,928		96,969		4.22	%		3,072
Total interest-bearing liabilities	$	1,234,407		2.35	%	$	21,717	$	1,077,490		3.31	%	$	26,771
Net interest margin/income:				3.11	%	$	31,627				3.25	%	$	30,049

Net interest income increased $1,079 (11.08%) during the three month period and $1,578 (5.25%) during the nine month period as compared to the same period in 2008. Loan interest income decreased $785 and $4,255 in the three and nine month periods, respectively, as a result of decreasing interest rates and increased levels of nonaccrual loans offset in part by growth in account balances. Deposit interest expense decreased $1,839 and $4,070 in the three and nine month periods, respectively, as a result of decreasing interest rates offset in part by the continued growth of account balances. Annualized loan yields for the quarter decreased from 6.09% to 5.69% and were impacted by decreases in market interest rates as well as increased levels of nonaccrual loans. Since September 30, 2008 the federal funds target rate declined from 2.00% to 0.25% which resulted in a decrease of 1.75% in the Bank’s prime rate from 5.00% to 3.25%. In addition, the level of nonaccrual loans resulted in the reversal of $908 in interest income which reduced the average loan yield by approximately 9 basis points. Due to the declining interest rate environment, the quarterly annualized average rate of interest bearing liabilities decreased from 3.10% to 2.17%. at September 30, 2009 compared to September 30, 2008. Other contributing factors during the nine month period included increases in interest income on investment securities and decreases in interest expense on securities sold under repurchase agreements.

33

The Company’s net interest margin for the three and nine months ended September 30, 2009 was 3.17% and 3.11% respectively as compared to 3.04% and 3.25% for the three and nine months ended September 30, 2008. This decrease in the net interest margin for the nine month period was impacted by increased levels of nonaccrual loans which resulted in the reversal of interest income of $142 and $908 for the three months and nine months periods respectively. This trend of increasing nonaccrual loans and the resultant impact on net interest income could continue as long as regional and national economic trends remain negative. The rate for earning assets decreased 64 basis points and 93 basis points for the three and nine month periods, respectively, with lower average yields on loans, interest-bearing deposits and federal funds sold accounting for most of the decrease. The cost to fund earning assets decreased 93 basis points and 96 basis points for the three and nine month periods, respectively, primarily due to lower rates on deposits and securities sold under repurchase agreements.

Changes in the net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, increases or decreases in the average rates earned and paid on such assets and liabilities, the ability to manage the earning asset portfolio, and the availability of particular sources of funds, such as noninterest-bearing deposits. The following tables present the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have impacted the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to changes attributable to change in volume (change in volume multiplied by prior rate), changes attributable to change in rate (change in rate multiplied by prior volume), and changes in rate/volume (change in rate multiplied by change in volume).

Table 5 — Rate/Volume Analysis

	Three Months Ended
	September 30, 2009 compared to September 30, 2008
	Increase (Decrease) due to
	Volume			Rate			Combined			Total
Interest-earning assets:
Loans		212			(983	)		(14	)		(785	)
Investment securities		529			(501	)		(79	)		(51	)
Federal funds sold		(153	)		(70	)		57			(166	)
Interest-bearing deposits in other banks		860			(6	)		(793	)		61
Total interest-earning assets		1,448			(1,560	)		(829	)		(941	)
Interest-bearing liabilities:
Deposits		912			(2,453	)		(298	)		(1,839	)
Federal funds purchased / securities sold under repurchase agreements		(7	)		(178	)		4			(181	)
Other borrowings		(23	)		24			(1	)		—
Total interest-bearing liabilities		882			(2,607	)		(295	)		(2,020	)
Net change in net interest income	$	566		$	1,047		$	(534	)	$	1,079

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Table 6 — Rate/Volume Analysis

	Nine Months Ended
	September 30, 2009 compared to September 30, 2008
	Increase (Decrease) due to
	Volume			Rate			Combined			Total
Interest-earning assets:
Loans		2,602			(6,494	)		(363	)		(4,255	)
Investment securities		1,643			(535	)		(88	)		1,020
Federal funds sold		42			(319	)		(36	)		(313	)
Interest-bearing deposits in other banks		1,239			(17	)		(1,150	)		72
Total interest-earning assets		5,526			(7,365	)		(1,637	)		(3,476	)
Interest-bearing liabilities:
Deposits		3,873			(6,778	)		(1,165	)		(4,070	)
Federal funds purchased / securities sold under repurchase agreements		(152	)		(793	)		105			(840	)
Other borrowings		227			(346	)		(25	)		(144	)
Total interest-bearing liabilities		3,948			(7,917	)		(1,085	)		(5,054	)
Net change in net interest income	$	1,578		$	552		$	(552	)	$	1,578

Provision for Loan Losses

The provision for loan losses is the charge to operating earnings necessary to maintain the allowance for loan losses at a level which, in management’s estimate, is adequate to cover the estimated amount of incurred losses in the loan portfolio. The provision for loan losses totaled $4,879 for the three months ended September 30, 2009 compared to $2,073 for the three months ended September 30, 2008 and $14,741 for the nine months ended September 30, 2009 compared to $4,996 for the same period in 2008. See “Allowance for Loan Losses” for further analysis of the provision for loan losses.

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Noninterest Income

Table 7 — Noninterest Income

	Three Months Ended											Nine Months Ended
	September 30,					Variance						September 30,					Variance
	2009		2008			Amount			%			2009			2008		Amount			%
	(Dollars in thousands)											(Dollars in thousands)
Service charges and fees on deposits	$	1,846	$	1,955		$	(109	)		(5.6	%)	$	5,224		$	5,446	$	(222	)		(4.1	%)
Gain on sales of loans		1,945		1,529			416			27.2	%		6,643			4,365		2,278			52.2	%
(Loss) gain on sale of fixed assets		—		(1	)		1			100.0	%		(16	)		7		(23	)		(328.6	%)
Investment securities gains, net of OTTI		25		21			4			19.0	%		718			88		630			715.9	%
Retail investment income		326		277			49			17.7	%		854			841		13			1.5	%
Trust services fees		268		288			(20	)		(6.9	%)		766			873		(107	)		(12.3	%)
Increase in cash surrender value of bank-owned life insurance		256		190			66			34.7	%		649			548		101			18.4	%
Miscellaneous income		142		178			(36	)		(20.2	%)		428			652		(224	)		(34.4	%)
Total noninterest income	$	4,808	$	4,437		$	371			8.4	%	$	15,266		$	12,820	$	2,446			19.1	%

Noninterest income increased $371 (8.36%) during the three month period and increased $2,446 (19.08%) during the nine month period as compared to the same periods in 2008. The most significant changes for the three and nine month periods were increases in gain on sales of loans and net investment securities gains somewhat offset by decreases in trust services fees and service charges and fees on deposits. The increased gain on sales of loans was due to a significant increase in refinancing volume. Net investment securities gains of $718 increased during the nine month period as compared to the same period in 2008 due primarily to $2,268 in gains on sales of securities offset by a $475 impairment charge for two securities deemed to be other-than-temporarily impaired and the $1,033 impairment loss on the common stock and trust preferred securities of Silverton Financial Services, Inc., parent holding company of Silverton Bank, N.A.

36

Noninterest Expense

Table 8 — Noninterest Expense

	Three Months Ended									Nine Months Ended
	September 30,				Variance					September 30,				Variance
	2009		2008		Amount		%			2009		2008		Amount		%
			(Dollars in thousands)									(Dollars in thousands)
Salaries and other personnel expense	$	5,469	$	5,202	$	267		5.1	%	$	16,927	$	15,755	$	1,172		7.4	%
Occupancy expenses		1,213		1,122		91		8.1	%		3,495		3,153		342		10.8	%
Other operating expenses		3,582		3,041		541		17.8	%		10,484		8,642		1,842		21.3	%
Total noninterest expense	$	10,264	$	9,365	$	899		9.6	%	$	30,906	$	27,550	$	3,356		12.2	%

Salaries and other personnel expenses:

Salaries and other personnel expense increased $267 (5.13%) during the three month period and $1,172 (7.44%) during the nine month period as compared to the same periods in 2008. This increase was primarily due to additional commission expense related to the increased level of mortgage originations.

Occupancy expenses:

Increases in occupancy expenses during the three and nine month periods were primarily due to increased depreciation expense as a result of the purchase of an upgraded mainframe computer and related software.

Other operating expenses:

Other operating expenses increased $541 (17.79%) for the three month period and $1,842 (21.31%) for the nine month period as compared to the same periods in 2008. The increase was due primarily to expenses and loss on sales associated with real estate acquired through foreclosure, a $276 prepayment penalty on an FHLB advance and a $1,610 increase in FDIC insurance expense as a result of increased accrual rates and a one time special assessment for FDIC insurance.

Income Taxes

The Company recognized an income tax benefit of $254 and $187 for the three and nine months ended September 30, 2009 respectively as compared to income tax expense of $866 and $3,405 for the same periods in 2008. The significant decrease in pretax income coupled with a higher proportion of nontaxable interest income resulted in a decrease in income tax expense and the effective income tax rate for the three and nine month periods.

37

Loans

The following table presents the composition of the Company’s loan portfolio as of September 30, 2009 and December 31, 2008.

Table 9 — Loan Portfolio Composition

	September 30, 2009						December 31, 2008
	Amount			%			Amount			%
				(Dollars in thousands)
Commercial financial and agricultural	$	97,743			10.15	%	$	109,751			11.12	%
Real estate
Commercial		311,930			32.39	%		266,362			26.49	%
Residential		215,546			22.38	%		212,856			21.57	%
Construction and development		313,550			32.56	%		369,731			37.47	%
Total real estate		841,026			87.33	%		848,949			86.29	%
Lease financing		—			0.00	%		33			0.00	%
Consumer
Direct		21,363			2.22	%		24,272			2.46	%
Indirect		2,250			0.23	%		3,319			0.34	%
Revolving		797			0.08	%		905			0.09	%
Total consumer		24,410			2.53	%		28,496			2.89	%
Deferred loan origination fees		(163	)		(0.02	%)		(398	)		(0.03	%)
Total	$	963,016			100.00	%	$	986,831			100.00	%

At September 30, 2009, the loan portfolio is comprised of 87.33% real estate loans. Commercial, financial and agricultural loans comprise 10.15%, and consumer loans comprise 2.53% of the portfolio.

While the Company has 87.33% of its loan portfolio composed of real estate loans, this percentage is not significantly higher than in previous years. Commercial real estate comprises 32.39% of the loan portfolio and consist of both non-owner occupied and owner occupied properties where the operations of the commercial entity provide the necessary cash flow to service the debt. For this portion of real estate loan portfolio, repayment is not dependent upon the sale of the real estate held as collateral. Construction and development (32.56%) has been an increasingly important portion of the real estate loan portfolio. The Company carefully monitors the loans in this category since the repayment of these loans is generally dependent upon the sale of the real estate in the normal course of business and can be impacted by national and local economic conditions. New construction and absorption of existing real estate inventory in the Company’s primary market area of the Augusta-Richmond County, GA-SC MSA have slowed and prices have declined but less than the national rate. Conditions on certain loans the Company has made in markets outside the Company’s primary market area are outlined in the table on page 45. The residential category, 22.38% of the portfolio, represents those loans that the Company chooses to maintain in its portfolio rather than selling into the secondary market for marketing and competitive reasons and commercial loans secured by residential real estate.

38

The Company has no large loan concentrations to individual borrowers. Unsecured loans at September 30, 2009 were $18.8 million.

Interest reserves are established for certain ADC (acquisition development and construction) loans based on the feasibility of the project, the timeframe for completion, the creditworthiness of the borrower and guarantors, and collateral. An interest reserve allows the borrower’s interest cost to be capitalized and added to the loan balance. As a matter of practice the Bank does not generally establish loan funded interest reserves on ADC loans; however, the Company’s loan portfolio includes six loans with interest reserves at September 30, 2009. The following tables detail the loans and accompanying interest reserves as of September 30, 2009 and December 31, 2008.

	September 30, 2009
			Reserves
	Balance		Original		Advanced		Remaining
			(Dollars in thousands)
Loan 1	$	4,246		138		138		—
Loan 2		8,498		300		117		183
Loan 3		2,546		255		255		—
Loan 4		455		30		30		—
Loan 5		167		10		10		—
Loan 6		1,175		81		78		3

	December 31, 2008
			Reserves
	Balance		Original		Advanced		Remaining
			(Dollars in thousands)
Loan 1	$	1,245		138		16		122
Loan 2		—		300		—		300
Loan 3		2,088		255		192		63
Loan 4		440		30		15		15
Loan 5		163		10		5		5
Loan 6		1,113		81		19		62

Underwriting for ADC loans with interest reserves follows the same process as those loans without reserves. In order for the bank to establish a loan-funded interest reserve, the borrower must have the ability to repay without the use of a reserve and a history of developing and stabilizing similar properties. All ADC loans, including those with interest reserves, are carefully monitored through periodic construction site inspections by Bank employees or third party inspectors to ensure projects are moving along as planned. The Bank assesses the appropriateness of the use of interest reserves during the entire term of the loan as well as the adequacy of the reserve. Collateral inspections are completed before approval of advances. Two of these loans have been extended; one due to delays and time needed to obtain current financial information on the guarantors and another to allow for completion of the final punch list and negotiation of the permanent loan. None of these loans have been restructured or are currently on nonaccrual.

39

Loan Review and Classification Process

The Company maintains a loan review and classification process which involves multiple officers of the Company and is designed to assess the general quality of credit underwriting and to promote early identification of potential problem loans. All loan officers are charged with the responsibility of risk rating all loans in their portfolios and updating the ratings, positively or negatively, on an ongoing basis as conditions warrant. Risk ratings are selected from an 8-point scale with ratings as follows: ratings 1- 4 Satisfactory (pass), rating 5 Watch (potential weakness), rating 6 Substandard (well-defined weakness), rating 7 Doubtful and rating 8 Loss.

When a loan officer originates a new loan, he documents the credit file with an offering sheet summary, supplemental underwriting analyses, relevant financial information and collateral evaluations. All of this information is used in the determination of the initial loan risk rating. Then, the Company’s Credit Administration department undertakes an independent credit review of that relationship in order to validate the lending officer’s rating. Lending relationships with total related exposure of $500 or greater are also placed into a tracking database and reviewed by Credit Administration personnel on an annual basis in conjunction with the receipt of updated borrower and guarantor financial information. The individual loan reviews analyze such items as: loan type; nature, type and estimated value of collateral; borrower and/or guarantor estimated financial strength; most recently available financial information; related loans and total borrower exposure; and current/anticipated performance of the loan. The results of such reviews are presented to Executive Management.

Through the review of delinquency reports, updated financial statements or other relevant information in the normal course of business, the lending officer and/or Credit Administration review personnel may determine that a loan relationship has weakened to the point that a criticized (loan grade 5) or classified (loan grade 6 through 8) status is warranted. When a loan relationship with total related exposure of $200 or greater is adversely graded (5 or 6), the lending officer is then charged with preparing a Classified/Watch report which outlines the background of the credit problem, current repayment status of the loans, current collateral evaluation and a workout plan of action. This plan may include goals to improve the credit rating, assisting the borrower in moving the loans to another institution and/or collateral liquidation. All such Classified/Watch reports are reviewed on a quarterly basis by members of Executive Management at a regularly scheduled meeting in which each lending officer presents the workout plans for his criticized credit relationships.

40

Depending upon the individual facts, circumstances and the result of the Classified/Watch review process, Executive Management may categorize the loan relationship as impaired. Once that determination has occurred, Executive Management in conjunction with Credit Administration personnel, will complete an evaluation of the collateral (for collateral-dependent loans) based upon appraisals in file adjusting for current market conditions and other local factors that may affect collateral value. This judgmental evaluation may produce an initial specific allowance for placement in the Company’s Allowance for Loan & Lease Losses calculation. As soon as practical, updated appraisals on the collateral backing that impaired loan relationship are ordered. When the updated appraisals are received, Executive Management with assistance from Credit Administration department personnel reviews the appraisal, and updates the specific allowance analysis for each loan relationship accordingly. The Director’s Loan Committee reviews on a quarterly basis the Classified/Watch reports including changes in credit grades of 5 or higher as well as all impaired loans, the related allowances and OREO.

In general, once the specific allowance has been finalized, Executive Management will authorize a charge-off prior to the following calendar quarter-end in which that reserve calculation is finalized.

The review process also provides for the upgrade of loans that show improvement since the last review.

Nonperforming Assets

Non-performing assets include nonaccrual loans, loans past due 90 days or more, restructured loans and other real estate owned. Table 10 shows the current and prior period amounts of non-performing assets. Non-performing assets were $56,579 at September 30, 2009, compared to $40,515 at December 31, 2008 and $38,282 at September 30, 2008. Significant changes from December 2008 to September 2009 include an $9,885 increase in other real estate owned and a $4,199 increase in nonaccrual loans.

There were $3,168 loans past due 90 days or more and still accruing at September 30, 2009 as compared to $7,298 at December 31, 2008 and none at September 30, 2008.

Restructured loans are loans on which the original terms have been modified in favor of the borrower or either principal or interest has been forgiven due to deterioration in the borrower’s financial condition. Restructured loans totaled $3,339 at September 30, 2009.

41

Table 10 — Non-Performing Assets
(Dollars in thousands)

	September 30, 2009			December 31, 2008			September 30, 2008
Nonaccrual loans:
Commercial financial and agricultural	$	602		$	261		$	181
Real Estate:
Commercial		2,299			3,491			3,734
Residential		4,383			2,815			3,002
Construction and development		31,299			27,908			30,795
Consumer:
Direct		397			306			192
Revolving		—			—			1
Total Nonaccrual loans		38,980			34,781			37,905
Restructured loans (1)		1,980			—			—
Other real estate owned		15,619			5,734			377
Total Non-performing assets	$	56,579		$	40,515		$	38,282
Loans past due 90 days or more and still accruing interest	$	3,168		$	7,298		$	—
Non-performing assets to total assets		3.83	%		2.87	%		2.78	%
Non-performing assets to total loans and OREO		5.78	%		4.08	%		3.88	%
Allowance for loan loss to total non-performing loans		43.17	%		42.39	%		35.66	%

(1) One restructured loan was on nonaccrual status as of 09/30/09 and is included in nonaccrual loans in the table.

The table below presents a roll forward of other real estate owned for the nine month period ended September 30, 2009 and September 30, 2008.

Table 11 — Other Real Estate Owned
(Dollars in thousands)

	2009			2008
Beginning balance, January 1	$	5,734		$	0
Additions		16,831			863
Sales		(6,430	)		(482	)
(Loss) gain on sale of OREO		(516	)		(4	)
Ending balance, September 30	$	15,619		$	377

42

The increase in other real estate owned is primarily due to the foreclosure of impaired loans, the most significant of which are included in the table below. The net increase in nonaccrual loans reflects increased levels of such loans offset by foreclosures and loans returned to accrual status due to improved performance. A significant portion of the increases were in ADC loans.

Nonaccrual

($000s)

Appraisal

Originated

Date

Trigger

Collateral

Allowance

Method

Date

ADC Loan — Georgia Loan Participation

$

1,076

04/02/07

11/06/08

delinquency

lots

—

collateral value

12/08

ADC Loan — Georgia Loan Participation

3,277

12/13/06

02/09/09

delinquency

land

—

collateral value

04/01/09

ADC Loan — Athens, Georgia

1,128

07/31/06-10/11/06

01/28/09

delinquency

houses

—

collateral value

05/22/09

ADC Loan — Georgia Loan Participation

1,793

12/06/06

09/17/08

delinquency

lots

—

collateral value

12/08

ADC Loan — Georgia Loan Participation

1,727

04/13/06

09/17/08

delinquency

lots

—

collateral value

In Process

CRE, 1-4 family lots, Consumer loans — CSRA

1,359

06/17/08-06/01/09

04/10/09

delinquency

various

351

collateral value

In Process

ADC Loan — Athens, Georgia

3,600

03/29/06

06/11/09

delinquency

condominums

1,400

collateral value

06/09

ADC Loan — CSRA

3,569

08/25/06

08/17/09

delinquency

lots

—

collateral value

09/09

ADC Loan — Athens, Georgia

3,350

01/12/05-07/26/06

4/08-6/08

delinquency

lots & land

—

collateral value

In Process

ADC Loan — Athens, Georgia

883

03/26/08

06/02/08

delinquency

lots

—

collateral value

In Process

ADC Loan — Athens, Georgia

4,279

08/18/06-01/10/07

01/28/09

delinquency

land & townhomes

515

collateral value

03/01/09

$

26,041

Other, net

12,939

Nonaccrual loans at September 30, 2009

$

38,980

The ratio of non-performing assets to total loans and other real estate was 5.78% at September 30, 2009 compared to 4.08% at December 31, 2008 and 3.88% at September 30, 2008. The ratio of allowance for loan losses to total non-performing loans was 43.17% at September 30, 2009 compared to 42.39% at December 31, 2008 and 35.66% at September 30, 2008. The resolution of non-performing assets continues to be a priority of management.

Allowance for Loan Losses

The allowance for loan losses represents an allocation for the estimated amount of incurred losses in the loan portfolio. The adequacy of the allowance for loan losses is evaluated periodically based on a review of all significant loans, with particular emphasis on impaired, non-accruing, past due, and other loans that management believes require special attention. The determination of the allowance for loan losses is considered a critical accounting estimate of the Company. See “Critical Accounting Estimates.”

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may advise additions to the allowance based on their judgments about information available to them at the time of their examination. Such regulatory guidance is considered, and the Company may recognize additions to the allowance as a result.

43

Additions to the allowance for loan losses are made periodically to maintain the allowance at an appropriate level based upon management’s analysis of risk in the loan portfolio. Loans determined to be uncollectible are charged to the allowance for loan losses and subsequent recoveries are added to the allowance. A provision for losses in the amount of $4,879 was charged to expense for the quarter ended September 30, 2009 compared to $2,073 for the quarter ended September 30, 2008, and $14,741 for the nine months ended September 30, 2009 compared to $4,996 for the nine months ended September 30, 2008. The increase in provision for loan losses for both three and nine month periods is primarily due to an increase in impaired loans and increased levels of classified/watch rated debt as well as management’s assessment of the current economic environment.

National economic conditions and real estate market conditions in several of the markets in which the Bank has outstanding loans contributed to the increase in impaired loans. These factors have combined to slow the rates of absorption for developers’ residential lots and builders’ completed homes. Significant portions of the overall level of impaired loans are in the Atlanta, Savannah and Athens markets. The following table provides selected asset quality information related to the acquisition development and construction loan portfolio as of September 30, 2009 and December 31, 2008.

44

Table 12 — Acquisition Development and Construction Loans

	September 30,			December 31,
	2009			2008
	(Dollars in thousands)
CSRA — primary market area
Period-end loans		242,171			266,156
FAS 114 Impaired loans		4,292			5,187
Classified/watch rated loans		27,000			9,879
Charge-offs % (annualized)		0.28	%		0.19	%
FAS 114 allowance / Impaired loans		0.91	%		0.00	%
FAS 5 Allowance / Loans not impaired %		1.13	%		0.67	%
Allowance / Charge-offs		4.09			4.78
Savannah, Georgia
Period-end loans		20,576			28,300
FAS 114 Impaired loans		1,464			2,645
Classified/watch rated loans		4,801			5,060
Charge-offs % (annualized)		12.16	%		3.18	%
FAS 114 allowance / Impaired loans		11.95	%		6.62	%
FAS 5 Allowance / Loans not impaired %		5.60	%		4.20	%
Allowance / Charge-offs		0.50			1.39
Athens, Georgia
Period-end loans		27,514			31,806
FAS 114 Impaired loans		13,216			8,772
Classified/watch rated loans		2,037			13,667
Charge-offs % (annualized)		19.42	%		1.78	%
FAS 114 allowance / Impaired loans		14.49	%		12.04	%
FAS 5 Allowance / Loans not impaired %		7.54	%		3.97	%
Allowance / Charge-offs		0.56			2.55
ADC Participations — Georgia
Period-end loans		14,956			21,676
FAS 114 Impaired loans		8,456			10,637
Classified/watch rated loans		6,500			48
Charge-offs % (annualized)		31.17	%		8.88	%
FAS 114 allowance / Impaired loans		0.67	%		4.09	%
FAS 5 Allowance / Loans not impaired %		3.00	%		9.55	%
Allowance / Charge-offs		0.05			0.77
ADC Participations — Florida
Period-end loans		4,927			8,005
FAS 114 Impaired loans		1,034			3,650
Classified/watch rated loans		—			704
Charge-offs % (annualized)		11.20	%		0.19	%
FAS 114 allowance / Impaired loans		0.00	%		11.34	%
FAS 5 Allowance / Loans not impaired %		3.01	%		4.27	%
Allowance / Charge-offs		0.21			2.00
Total ADC Impaired Loans		28,462			30,891
Total ADC Classified/Watch Loans		40,338			29,358

45

The increase in the allowance for loan losses as of September 30, 2009 as compared to September 30, 2008 is primarily due to increases in the allowance applicable to specific loans and increases to the allowance due to higher levels of classified and watch-rated debt as well as management’s assessment of current economic environment. Also impacting the allowance were charge-offs of $13,313 of which $10,299, or 77.36%, were related to ADC loans. Of the ADC charge-offs $3,910, or 37.96%, are related to collateral dependent ADC loan participations, $4,007 or 38.91% are related to ADC loans in the Athens, Georgia market and $1,877 or 18.23% are related to ADC loans in the Savannah, Georgia market. The provision for loan losses exceeded charge-offs during the quarter which contributed to an increase in the ratio of allowance for loan losses to total loans as noted in the table below.

Table 13 — Allowance for Loan Losses

	September 30,
	2009			2008
	(Dollars in thousands)
Total loans outstanding at end of period, net of unearned income	$	963,016		$	985,239
Average loans outstanding, net of unearned income	$	967,764		$	937,175
Balance of allowance for loan losses at beginning of year	$	14,742		$	11,800
Charge-offs:
Commercial, financial and agricultural		640			586
Real estate — acquisition, development and construction		10,299			2,301
Real estate — mortgage		1,874			340
Consumer		500			581
Total charge-offs		13,313			3,808
Recoveries of previous loan losses:
Commercial, financial and agricultural		317			276
Real estate — acquisition, development and construction		2			22
Real estate — mortgage		183			43
Consumer		154			187
Total recoveries		656			528
Net loan losses		12,657			3,280
Provision for loan losses		14,741			4,996
Balance of allowance for loan losses at end of period	$	16,826		$	13,516
Allowance for loan losses to period end loans		1.75	%		1.37	%
Net charge-offs to average loans		1.31	%		0.35	%

46

At September 30, 2009 the ratio of allowance for loan losses to total loans was 1.75% compared to 1.49% at December 31, 2008 and 1.37% at September 30, 2008. Management considers the current allowance for loan losses appropriate based upon its analysis of risk in the portfolio, although there can be no assurance that the assumptions underlying such analysis will continue to be correct.

Liquidity and Capital Resources

The Company has maintained adequate liquidity to meet operating and loan funding requirements despite current market conditions. The loan to deposit ratio at September 30, 2009 was 78.16% compared to 88.26% at December 31, 2008 and 88.86% at September 30, 2008. The decrease in the loan to deposit ratio from December 31, 2008 to September 30, 2009 reflects the decreased demand for loans resulting from the slowing economy coupled with an increased level of deposits. Deposits at September 30, 2009 and December 31, 2008 include $246,627 and $244,540 of brokered certificates of deposit, respectively. The Bank and the Thrift have also utilized borrowings from the Federal Home Loan Bank. They each maintain a line of credit with the Federal Home Loan Bank approximating 10% of their total assets. Federal Home Loan Bank advances are collateralized by eligible first mortgage loans, commercial real estate loans and investment securities. These borrowings totaled $77,000 at September 30, 2009. The Bank maintains repurchase lines of credit with SunTrust Robinson Humphrey, Atlanta, Georgia, for advances up to $20,000 of which no amounts were outstanding at September 30, 2009. The Bank has a federal funds purchased accommodation with SunTrust Bank, Atlanta, Georgia for advances up to $10,000. Effective May 1, 2009 Silverton Bank, N.A. was closed by the Office of the Comptroller of the Currency (OCC). The Federal Deposit Insurance Corporation (FDIC) created a bridge bank to take over the operations of Silverton Bank and the FDIC was appointed receiver. On July 29, 2009 federal funds purchased accommodations with the bridge bank in the amount of $16,700 for the Bank and $4,600 for the Thrift were discontinued. Management established another correspondent relationship with Center State Bank, Orlando, Florida, for a $10,000 repurchase line of credit. Additionally, liquidity needs can be supplemented by the structuring of the maturities of investment securities and the pricing and maturities on loans and deposits offered to customers. The Company also uses retail securities sold under repurchase agreements to fund growth. Retail securities sold under repurchase agreements were $860 at September 30, 2009.

During the second quarter of 2009, the Company issued to a related party, R.W. Pollard Enterprises, LLP a $2.9 million unsecured subordinated debenture in a private placement exempt from registration under Rule 506 of the Act, as amended. The proceeds were used to increase capital at Georgia Bank & Trust Company.

Stockholders’ equity to total assets was 7.15% at September 30, 2009 compared to 6.71% at December 31, 2008 and 6.57% at September 30, 2008. During the second quarter of 2009, the Company issued and sold 683,272 shares of common stock at a purchase price of $13.25 per share (representing aggregate proceeds of approximately $9.0 million) in a private placement pursuant to Rule 506 under the Securities Act of 1933, as amended (the “Act”). The proceeds were used to increase capital at Georgia Bank & Trust Company.

47

The capital of the Company exceeded all required regulatory guidelines at September 30, 2009. The Company’s Tier 1 risk-based, total risk-based and leverage capital ratios were 11.56%, 13.03%, and 8.46%, respectively, at September 30, 2009.

The following table reflects the current regulatory capital levels in more detail, including comparisons to the regulatory minimums.

Table 14 — Regulatory Capital Requirements
September 30, 2009
(Dollars in Thousands)

						Required for capital
	Actual					adequacy purposes					Excess
	Amount		Percent			Amount		Percent			Amount		Percent
Southeastern Bank Financial Corporation
Risk-based capital:
Tier 1 capital	$	124,288		11.56	%		43,003		4.00	%		81,285		7.56	%
Total capital		140,126		13.03	%		86,005		8.00	%		54,121		5.03	%
Tier 1 leverage ratio		124,288		8.46	%		58,771		4.00	%		65,517		4.46	%
Georgia Bank & Trust Company
Risk-based capital:
Tier 1 capital	$	109,276		11.55	%		37,841		4.00	%		71,435		7.55	%
Total capital		121,138		12.81	%		75,682		8.00	%		45,456		4.81	%
Tier 1 leverage ratio		109,276		8.31	%		59,142		4.50	%		50,134		3.81	%
Southern Bank & Trust
Risk-based capital:
Tier 1 capital	$	14,126		11.14	%		5,070		4.00	%		9,056		7.14	%
Total capital		15,716		12.40	%		10,140		8.00	%		5,576		4.40	%
Tier 1 leverage ratio		14,126		8.58	%		6,586		4.00	%		7,540		4.58	%

Georgia Bank & Trust Company is regulated by the Department of Banking and Finance of the State of Georgia (DBF). The DBF requires that state banks in Georgia generally maintain a minimum ratio of Tier 1 capital to total assets of four and one-half percent (4.50%).

Management is not aware of any other events or uncertainties that are reasonably likely to have a material effect on the Company’s liquidity, capital resources or operations.

48

Commitments and Contractual Obligations

The Company is a party to lines of credit with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Lines of credit are unfunded commitments to extend credit. These instruments involve, in varying degrees, exposure to credit and interest rate risk in excess of the amounts recognized in the financial statements. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for unfunded commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company evaluates construction and acquisition and development loans for the percentage completed before extending additional credit. The Company follows the same credit policies in making commitments and contractual obligations as it does for on-balance sheet instruments.

Unfunded commitments to extend credit where contract amounts represent potential credit risk totaled $193,877 at September 30, 2009. These commitments are primarily at variable interest rates.

The Company’s commitments are funded through internal funding sources of scheduled repayments of loans and sales and maturities of investment securities available for sale or external funding sources through acceptance of deposits from customers or borrowings from other financial institutions.

The following table is a summary of the Company’s commitments to extend credit, commitments under contractual leases as well as the Company’s contractual obligations, consisting of deposits, FHLB advances, which are subject to early termination options, and borrowed funds by contractual maturity date.

Table 15 — Commitments and Contractual Obligations
($ in thousands)

	Less than		1 – 3		3 – 5		More than
	1 Year		Years		Years		5 Years
Lines of credit	$	193,877		—		—		—
Lease agreements		362		506		88		70
Deposits		1,120,753		130,749		6,693		553
Securities sold under repurchase agreements		860		—		—		—
FHLB advances		10,000		15,000		13,000		39,000
Other borrowings		600		—		—		—
Total commitments and contractual obligations	$	1,326,452	$	146,255	$	19,781	$	39,623

Although management regularly monitors the balance of outstanding commitments to fund loans to ensure funding availability should the need arise, management believes that the risk of all customers fully drawing on all these lines of credit at the same time is remote.

49

Effects of Inflation and Changing Prices

Inflation generally increases the cost of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on the performance of a financial institution than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction and to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates. In addition, inflation can increase a financial institution’s cost of goods and services purchased, the cost of salaries and benefits, occupancy expense and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders’ equity. Mortgage originations and refinances tend to slow as interest rates increase, and can reduce the Company’s earnings from such activities and the income from the sale of residential mortgage loans in the secondary market.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As of September 30, 2009, there were no substantial changes in the interest rate sensitivity analysis or the sensitivity of market value of portfolio equity for various changes in interest rates calculated as of December 31, 2008. The foregoing disclosures related to the market risk of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2008 included in the Company’s 2008 Annual Report on Form 10-K.

Item 4. Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer (principal executive officer) and its Group Vice President and Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, such officers concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) that is required to be included in the Company’s periodic filings with the Securities and Exchange Commission. There have been no changes in the Company’s internal controls or, to the Company’s knowledge, in other factors during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

50

Part II
OTHER INFORMATION

Item 1. Legal Proceedings

There are no material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is subject.

Item 1A. Risk Factors

In addition to the other information set forth in this report and the additional risk factor set forth below, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, which could materially affect its business, financial condition or future results. The risks described below and in the Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to management or that management currently deems to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.

Oversupply of assets and declining real estate values in our markets has led, and may continue to lead, to a reduction of asset values resulting in significant write-downs that negatively affect our capital.

Many banks in our core markets and in the markets in which we hold participations are addressing capital and earnings issues by reducing significantly their asset bases. The resulting oversupply of assets, coupled with declining real estate and asset values based on general economic conditions, have resulted and may continue to result in steeply discounted market prices. Because these prices are then used as a reference in appraisals, the appraised values of the assets we hold, and therefore the value we must reflect in preparing our financial statements, is required to be written down to reflect these prices. This in turn reduces our asset and capital levels. If this oversupply continues and market conditions deteriorate or do not improve, our capital levels could decrease to a level that would materially impair our financial condition.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

On April 15, 2004, the Company announced the commencement of a stock repurchase program, pursuant to which it will, from time to time, repurchase up to 100,000 shares of its outstanding stock. The program does not have a stated expiration date. No stock repurchase programs were terminated during the third quarter of 2009 and there were no shares repurchased under the existing stock repurchase plan or otherwise during the third quarter.

51

Item 3. Defaults Upon Senior Securities

Not applicable

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

None

Item 5. Other Information

None

Item 6. Exhibits

31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

52

SOUTHEASTERN BANK FINANCIAL CORPORATION

Form 10-Q Signatures

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

	SOUTHEASTERN BANK FINANCIAL CORPORATION
Date: October 30, 2009	By:	/s/ Darrell R. Rains
		Darrell R. Rains
		Group Vice President, Chief Financial Officer
		(Duly Authorized Officer of Registrant and Principal Financial Officer)

53

EXHIBIT INDEX

Exhibit No.		Description
	31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

54