Grayson Bankshares (GSON) 10-K 2007 FY Annual report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

Commission file number 0-24159

GRAYSON BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia (State or other jurisdiction of incorporation or organization)	54-1647596 (I.R.S. Employer Identification No.)
113 West Main Street Independence, Virginia (Address of principal executive offices)	24348 (Zip Code)

Registrant’s telephone number, including area code (276) 773-2811

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
None	n/a

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $1.25 per share

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o Nox

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

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

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

Large accelerated filer o	Accelerated filer o
Non-accelerated filer o (Do not check if smaller reporting company)	Smaller reporting companyx

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $49,763,070

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. 1,718,968 shares of Common Stock as of March 30, 2008

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2008 Annual Meeting of Shareholders – Part III

Portions of the Company’s 2007 Annual Report – Part II

TABLE OF CONTENTS

PART I
		Page
ITEM 1.	BUSINESS	1
ITEM 1A.	RISK FACTORS	6
ITEM 1B.	UNRESOLVED STAFF COMMENTS	8
ITEM 2.	PROPERTIES	9
ITEM 3.	LEGAL PROCEEDINGS	10
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	10
PART II
ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
	STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
	EQUITY SECURITIES	10
ITEM 6.	SELECTED FINANCIAL DATA	11
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
	CONDITION AND RESULTS OF OPERATION	12
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
	MARKET RISK	29
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	32
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
	ON ACCOUNTING AND FINANCIAL DISCLOSURE	32
ITEM 9A(T).	CONTROLS AND PROCEDURES	32
ITEM 9B.	OTHER INFORMATION	33
PART III
ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
	GOVERNANCE	33
ITEM 11.	EXECUTIVE COMPENSATION	33
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
	MANAGEMENT AND RELATED STOCKHOLDER MATTERS	34
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
	AND DIRECTOR INDEPENDENCE	34
ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES	34
PART IV
ITEM 15	EXHIBITS, FINANCIAL STATEMENT SCHEDULES	35

PART I

Item 1. Business

General

Grayson Bankshares, Inc. (the Company) was incorporated as a Virginia corporation on February 3, 1992 to acquire 100% of the stock of The Grayson National Bank (the Bank). The Bank was acquired by the Company on July 1, 1992. The Grayson National Bank was founded in 1900 and currently serves Grayson County and surrounding areas through nine banking offices located in the towns of Independence and Hillsville, the localities of Elk Creek, Troutdale and Whitetop, the City of Galax, and Carroll County, Virginia, and the Town of Sparta, North Carolina.

The Bank operates for the primary purpose of meeting the banking needs of individuals and small to medium sized businesses in the Bank’s service area, while developing personal, hometown associations with these customers. The Bank offers a wide range of banking services including checking and savings accounts; commercial, installment, mortgage and personal loans; credit and debit cards; internet banking and online bill paying; safe deposit boxes; and other associated services. The Bank’s primary sources of revenue are interest income from its lending activities, and, to a lesser extent, from its investment portfolio. The Bank also earns fees from lending and deposit activities. The major expenses of the Bank are interest on deposit accounts and general and administrative expenses, such as salaries, occupancy and related expenses.

Lending Activities

The Bank’s lending services include real estate, commercial, agricultural and consumer loans. The loan portfolio constituted 79.86% of the interest earning assets of the Bank at December 31, 2007 and has historically produced the highest interest rate spread above the cost of funds. The Bank’s loan personnel have the authority to extend credit under guidelines established and approved by the Board of Directors. Any aggregate credit which exceeds the authority of the loan officer is forwarded to the Officers’ Loan Committee for approval. The Officers’ Loan Committee is composed of the Bank President and all loan officers. All aggregate credits that exceed the lending authority of the Officer’s Loan Committee are presented to the Directors’ Loan Committee for consideration. The Directors’ Loan Committee has the authority to approve loans up to $1.0 million of total indebtedness to a single customer. All loans in excess of that amount must be presented to the full Board of Directors for ultimate approval or denial. The Officers’ and Directors’ Loan Committees not only act as approval bodies to ensure consistent application of the Bank’s loan policy but also provide valuable insight through communication and pooling of knowledge, judgment and experience of their respective members.

The Bank has in the past and intends to continue to make most types of real estate loans, including, but not limited to, single and multi-family housing, farm loans, residential and commercial construction loans and loans for commercial real estate. At the end of 2007, the Bank had 46.05% of the loan portfolio in single and multi-family housing, 15.85% in non-farm, non-residential real estate loans, 10.93% in farm related real estate loans and 12.39% in real estate construction and development loans.

The Bank’s loan portfolio includes commercial and agricultural production loans totaling 8.78% of the portfolio at year-end 2007. Consumer loans make up approximately 6.00% of the total loan portfolio. Consumer loans include loans for household expenditures, car loans and other loans to individuals. While this category has experienced a greater percentage of charge-offs than the other classifications, the Bank is committed to continue to make this type of loan to fill the needs of the Bank’s customer base.

All loans in the Bank’s portfolio are subject to risk from the state of the economy in the Bank’s area and also that of the nation. The Bank has used and continues to use conservative loan-to-value ratios and thorough credit evaluation to lessen the risk on all types of loans. The use of conservative appraisals

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has also reduced exposure on real estate loans. Thorough credit checks and evaluation of past internal credit history has helped to reduce the amount of risk related to consumer loans. Government guarantees of loans are used when appropriate, but apply to a minimal percentage of the portfolio. Commercial loans are evaluated by collateral value and ability to service debt. Businesses seeking loans must have a good product line and sales, responsible management, and demonstrated cash flows sufficient to service the debt.

Investments

The Bank invests a portion of its assets in U.S. Treasury, U.S. Government agency and U.S. Government sponsored enterprise securities, state, county and municipal obligations, and equity securities. The Bank’s investments are managed in relation to loan demand and deposit growth, and are generally used to provide for the investment of excess funds at reduced yields and risks relative to increases in loan demand or to offset fluctuations in deposits. For additional information relating to investments, see “Investment Securities” in Part II, Item 7.

Deposit Activities

Deposits are the major source of funds for lending and other investment activities. The Bank considers the majority of its regular savings, demand, NOW and money market deposits and small denomination certificates of deposit to be core deposits. These accounts comprised approximately 75.92% of the Bank’s total deposits at December 31, 2007. Certificates of deposit in denominations of $100,000 or more represented the remaining 24.08% of deposits at year-end.

Market Area

The Company’s market area consists primarily of the counties of Grayson and Carroll, and the independent city of Galax, in Virginia, as well as Alleghany county in North Carolina. The market area is rural and employment was once dominated by furniture and textile manufacturing. As those industries have declined, employment has shifted to healthcare, retail and service, light manufacturing, tourism and agriculture. Though improving some in recent years, unemployment in the area remains above the state average. As of September 30, 2007 the unemployment rates in Grayson and Carroll counties and the City of Galax were 4.8%, 5.4%, and 5.5% respectively, as compared to the 3.0% average for the State of Virginia. The 4.4% unemployment rate in Alleghany county, North Carolina was slightly better than the state average rate of 4.8%. Estimated annual median family income in the market area is approximately $44,000.

Competition

The Company encounters strong competition both in making loans and attracting deposits. The deregulation of the banking industry and the widespread enactment of state laws that permit multi-bank holding companies as well as an increasing level of interstate banking have created a highly competitive environment for commercial banking. In one or more aspects of its business, the Company competes with other commercial banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Many of these competitors have substantially greater resources and lending limits and may offer certain services that we do not currently provide. In addition, many of the Company’s competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks. Recent federal and state legislation has heightened the competitive environment in which financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly.

To compete, the Company relies upon specialized services, responsive handling of customer needs, and personal contacts by its officers, directors, and staff. Large multi-branch banking competitors

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tend to compete primarily by rate and the number and location of branches, while smaller, independent financial institutions tend to compete primarily by rate and personal service.

Currently in Grayson County, the Company competes with only two other commercial banks, which operate a total of two branch banking facilities. As of June 30, 2007, the Company held 84.49% of the deposits in Grayson County. In the City of Galax, the Company competes with five other commercial banks. Since opening in May of 1996, we have captured a market share of 16.79% of deposits to become the third largest holder of deposits in the market. Wachovia Bank, NA, leads the Galax market with 28.65% of deposits as of June 30, 2007. In Alleghany County, North Carolina and Carroll County, Virginia, the Company held market shares of 12.16% and 16.41%, respectively, at June 30, 2007.

Employees

At December 31, 2007, the Company had 115 total employees representing 111 full time equivalents, none of which are represented by a union or covered by a collective bargaining agreement. Management considers employee relations to be good.

Government Supervision and Regulation

The following discussion is a summary of the principal laws and regulations that comprise the regulatory framework applicable to the Company and the Bank. Other laws and regulations that govern various aspects of the operations of banks and bank holding companies are not described herein, although violations of such laws and regulations could result in supervisory enforcement action against the Company or the Bank. The following descriptions, as well as descriptions of laws and regulations contained elsewhere in this filing, summarize the material terms of the principal laws and regulations and are qualified in their entirety by reference to applicable laws and regulations.

As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956 (as amended, the “BHCA”) and the examination and reporting requirements of the Federal Reserve. Under the BHCA, a bank holding company may not directly or indirectly acquire ownership or control of more than 5% of the voting shares or substantially all of the assets of any additional bank or merge or consolidate with another bank holding company without the prior approval of the Federal Reserve. The BHCA also generally limits the activities of a bank holding company to that of banking, managing or controlling banks, or any other activity which is determined to be so closely related to banking or to managing or controlling banks that an exception is allowed for those activities.

As a national bank, the Bank is subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”). The Bank is also subject to regulation, supervision and examination by the FDIC. Federal law also governs the activities in which the Bank may engage, the investments it may make and limits the aggregate amount of loans that may be granted to one borrower to 15% of the bank’s capital and surplus. Various consumer and compliance laws and regulations also affect the Bank’s operations.

The earnings of the Bank, and therefore the earnings of the Company, are affected by general economic conditions, management policies and the legislative and governmental actions of various regulatory authorities, including those referred to above.

The OCC will conduct regular examinations of the Bank, reviewing such matters as the adequacy of loan loss reserves, quality of loans and investments, management practices, compliance with laws, and other aspects of its operations. In addition to these regular examinations, the Bank must furnish the OCC with periodic reports containing a full and accurate statement of its affairs. Supervision, regulation and examination of banks by these agencies are intended primarily for the protection of depositors rather than shareholders.

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Insurance of Accounts, Assessments and Regulation by the FDIC. The deposits of the Bank are insured by the FDIC up to the limits set forth under applicable law. The deposits of the Bank are also subject to the deposit insurance assessments of the Deposit Insurance Fund (“DIF”) of the FDIC.

The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations. For example, depository institutions insured by the DIF that are “well capitalized” and that present few or no supervisory concerns are required to pay a minimum assessment of between 0.05% and 0.07% of assessable deposits annually for deposit insurance, while all other banks are required to pay premiums ranging from 0.10% to 0.43% of assessable deposits. These rate schedules are subject to future adjustments by the FDIC. In addition, the FDIC has authority to impose special assessments from time to time.

The FDIC is authorized to prohibit any DIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund. Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. Management is aware of no existing circumstances that could result in termination of the Bank’s deposit insurance.

Capital. The OCC and the Federal Reserve have issued risk-based and leverage capital guidelines applicable to banking organizations they supervise. Under the risk-based capital requirements, the Company and the Bank are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital is to be composed of common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” and, together with Tier 1 capital, “total capital”).

In addition, each of the Federal banking regulatory agencies has established minimum leverage capital ratio requirements for banking organizations. These requirements provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% for bank holding companies that are rated a composite “1” and 4% for all other bank holding companies. Bank holding companies are expected to maintain higher than minimum capital ratios if they have supervisory, financial, operational or managerial weaknesses, or if they are anticipating or experiencing significant growth.

The risk-based capital standards of the OCC and the Federal Reserve explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a bank’s capital adequacy. The OCC and the Federal Reserve also have recently issued additional capital guidelines for bank holding companies that engage in certain trading activities.

Other Safety and Soundness Regulations. There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by Federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve with respect to bank holding

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company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise. In addition, the “cross-guarantee” provisions of Federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the DIF as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in the best interests of the DIF. The FDIC’s claim for reimbursement is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institution.

The Federal banking agencies also have broad powers under current Federal law to take prompt corrective action to resolve problems of insured depository institutions. The Federal Deposit Insurance Act requires that the federal banking agencies establish five capital levels for insured depository institutions - “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” It also requires or permits such agencies to take certain supervisory actions should an insured institution’s capital level fall. For example, an “adequately capitalized” institution is restricted from accepting brokered deposits. An “undercapitalized” or “significantly undercapitalized” institution must develop a capital restoration plan and is subject to a number of mandatory and discretionary supervisory actions. These powers and authorities are in addition to the traditional powers of the Federal banking agencies to deal with undercapitalized institutions.

Federal regulatory authorities also have broad enforcement powers over the Company and the Bank, including the power to impose fines and other civil and criminal penalties, and to appoint a receiver in order to conserve the assets of any such institution for the benefit of depositors and other creditors.

Payment of Dividends. The Company is a legal entity separate and distinct from the Bank. Virtually all of the revenues of the Company results from dividends paid to the Company by the Bank. Under OCC regulations a national bank may not declare a dividend in excess of its undivided profits. Additionally, a national bank may not declare a dividend if the total amount of all dividends, including the proposed dividend, declared by the national bank in any calendar year exceeds the total of the national bank’s retained net income of that year to date, combined with its retained net income of the two preceding years, unless the dividend is approved by the OCC. A national bank may not declare or pay any dividend if, after making the dividend, the national bank would be “undercapitalized,” as defined in regulations of the OCC. The Company is subject to state laws that limit the amount of dividends it can pay. In addition, the Company is subject to various general regulatory policies relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The Federal Reserve has indicated that banking organizations should generally pay dividends only if (1) the organization’s net income available to common shareholders over the past year has been sufficient to fully fund the dividends and (2) the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition.

Community Reinvestment. The requirements of the Community Reinvestment Act (“CRA”) are applicable to the Bank. The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those institutions. A financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to twelve assessment factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility.

Interstate Banking and Branching. Current Federal law authorizes interstate acquisitions of banks and bank holding companies without geographic limitation. Effective June 1, 1997, a bank headquartered in one state is able to merge with a bank headquartered in another state, as long as neither of the states has opted out of such interstate merger authority prior to such date. States are authorized to

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enact laws permitting such interstate bank merger transactions prior to June 1, 1997, as well as authorizing a bank to establish “de novo” interstate branches. Virginia enacted early “opt in” laws, permitting interstate bank merger transactions. Once a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable Federal or state law.

Economic and Monetary Polices. The operations of the Company are affected not only by general economic conditions, but also by the economic and monetary policies of various regulatory authorities. In particular, the Federal Reserve regulates money, credit and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Item 1A. Risks Factors

We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.

During the last five years, we have experienced significant growth, and a key aspect of our business strategy is our continued growth and expansion. Our ability to continue to grow depends, in part, upon our ability to:

• open new branch offices or acquire existing branches or other financial institutions;

• attract deposits to those locations; and

• identify attractive loan and investment opportunities.

We may not be able to successfully implement our growth strategy if we are unable to identify attractive markets, locations or opportunities to expand in the future. Our ability to manage our growth successfully also will depend on whether we can maintain capital levels adequate to support our growth, maintain cost controls and asset quality and successfully integrate any businesses we acquire into our organization.

As we continue to implement our growth strategy by opening new branches or acquiring branches or other banks, we expect to incur increased personnel, occupancy and other operating expenses. In the case of new branches, we must absorb those higher expenses while we begin to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets.

We may incur losses if we are unable to successfully manage interest rate risk.

Our profitability will depend in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits and the volume of loan originations in our mortgage-origination office. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.

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We may be adversely affected by economic conditions in our market area.

We are located in southwestern Virginia and northwestern North Carolina, and our local economy is heavily influenced by the furniture and textile industries, both of which have been in decline in recent years. Changes in the economy may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control, would impact these local economic conditions and the demand for banking products and services generally, which could negatively affect our financial condition and performance.

The subprime mortgage crisis and its impact on credit markets may negatively affect our business.

Neither the Company nor the Bank have engaged in subprime lending and therefore we have no risk directly related to the origination of subprime loans. However, our business may be negatively affected by the impact of the subprime mortgage crisis on the economy in general as well as on the equity and credit markets. If the subprime mortgage crisis leads to a general decrease in real estate values then our loan collateral values could decline. A decrease in the market value of large financial institutions may also lead to decreased market valuations for smaller financial institutions, resulting in a decrease in the value of our stock. Also, because we hold municipal bonds in our investment portfolio, the failure or ratings downgrade of bond insurers resulting from their investment in subprime lending could lead to a decrease in the market value of those investments.

Our concentration in loans secured by real estate may increase our credit losses, which would negatively affect our financial results.

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. A major change in the real estate market, such as a deterioration in the value of this collateral, or in the local or national economy, could adversely affect our customers’ ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected.

We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control, and these losses may exceed our current estimates. Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance.

Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

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Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions for deposits, loans and other financial services in our market area. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.

Our profitability and the value of your investment may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Some of these regulations may increase our costs and thus place other financial institutions that are not subject to similar regulation in stronger, more favorable competitive positions.

The costs of being a public company are proportionately higher for small companies like us due to the requirement of the Sarbanes-Oxley Act.

The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Securities and Exchange Commission have increased the scope, complexity, and cost of corporate governance, reporting, and disclosure practices. These regulations are applicable to our company. We expect to experience increasing compliance costs, including costs related to internal controls and the requirement that our auditors attest to and report on management’s assessment of our internal controls, as a result of the Sarbanes-Oxley Act. These necessary costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors.

Item 1B. Unresolved Staff Comments

None.

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Item 2.Properties

The Company and the Bank are headquartered in the Main Office at 113 West Main Street, Independence, Virginia. The Bank owns and operates branches at the following locations:

NAME OF OFFICE	LOCATION/ TELEPHONE NUMBER	BANKING FUNCTIONS OFFERED
Main Office	113 West Main Street	Full Service
	Independence, Virginia 24348	24 Hour Teller
	(276) 773-2811
East Independence Office	802 East Main Street	Full Service
	Independence, Virginia 24348	24 Hour Teller
	(276) 773-2811
Elk Creek Office	60 Comers Rock Road	Full Service
	Elk Creek, Virginia 24326	24 Hour Teller
	(276) 655-4011
Troutdale Office	101 Ripshin Road	Full Service
	Troutdale, Virginia 24378	24 Hour Teller
	(276) 677-3722
Galax Office	209 West Grayson Street	Full Service
	Galax, Virginia 24333	24 Hour Teller
	(276) 238-2411
Carroll Office	8417 Carrollton Pike	Full Service
	Galax, Virginia 24333	24 Hour Teller
	(276) 238-8112
Sparta Office	98 South Grayson Street	Full Service
	Sparta, North Carolina 28675	24 Hour Teller
	(336) 372-2811
Hillsville Office	419 South Main Street	Full Service
	Hillsville, Virginia 24343	24 Hour Teller
	(276) 728-2810
Whitetop Office	16303 Highlands Parkway	Full Service
	Whitetop, Virginia 24292	24 Hour Teller
	(276) 388-3811

The Bank has a conference center located at 558 East Main Street, Independence, Virginia that is used for various board and committee meetings, as well as continuing education and training programs for bank employees. The Bank is currently constructing an operations center adjacent to the main office in Independence, Virginia. Construction is scheduled to be complete in the third quarter of 2008.

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Item 3. Legal Proceedings

In the ordinary course of operations, the Company and the Bank expect to be parties to various legal proceedings. At present, there are no pending or threatened proceedings against the Company or the Bank that, if determined adversely, would have a material effect on the business, results of operations, or financial position of the Company or the Bank.

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

No matters were submitted to a vote of security holders during the forth quarter of 2007.

PART II

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

Shares of the Company’s Common Stock are neither listed on any stock exchange nor quoted on any market and trade infrequently. Shares of Common Stock have periodically been sold in a limited number of privately negotiated transactions. Based on information available to it, the Company believes that from January 1, 2006 to December 31, 2007, the selling price of shares of Common Stock ranged from $28.00 to $32.00. There may, however, have been other transactions at other prices not known to the Company.

Market Price and Dividends
		Sales Price ($)		Dividends ($)
		High	Low
2006:
	1st quarter	30.00	29.00	0.20
	2nd quarter	32.00	28.00	0.20
	3rd quarter	32.00	30.00	0.20
	4th quarter	32.00	29.00	0.30
2007:	1st quarter	32.00	29.00	0.20
	2nd quarter	30.00	29.00	0.20
	3rd quarter	30.00	28.00	0.20
	4th quarter	29.00	28.00	0.26

As of March 30, 2008, there were approximately 800 record holders of Common Stock. There were no Company repurchases of the Common Stock during 2007 or 2006.

Dividend Policy

The Company historically has paid cash dividends on a quarterly basis. The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiaries, principally the Bank, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies as discussed in Item 1., “Business – Supervision and Regulation – Payment of Dividends,” above.

The Company’s ability to distribute cash dividends will depend primarily on the ability of the Bank to pay dividends to it. As a national bank, the Bank is subject to certain restrictions on our reserves and capital imposed by federal banking statutes and regulations. Furthermore, under Virginia law, the Company may not declare or pay a cash dividend on its capital stock if it is insolvent or if the payment of

10

the dividend would render it insolvent or unable to pay its obligations as they become due in the ordinary course of business. For additional information on these limitations, see “Item 1. Business – Government Supervision and Regulation – Payment of Dividends” above.

Item 6. Selected Financial Data¹

The following consolidated summary sets forth the Company’s selected financial data for the periods and at the dates indicated. The selected financial data have been derived from the Company’s audited financial statements for each of the five years that ended December 31, 2007, 2006, 2005, 2004 and 2003.

		2007	2006	2005	2004	2003
Summary of Operations
	Interest income	$22,884	$20,623	$17,148	$14,656	$13,842
	Interest expense	10,834	8,636	5,802	4,474	5,637
	Net interest income	12,050	11,987	11,346	10,182	8,205
	Provision for loan losses	465	520	504	390	410
	Other income	1,973	1,673	1,415	1,607	2,662
	Other expense	9,095	8,670	7,945	6,943	5,812
	Income taxes	1,296	1,323	1,204	1,215	1,306
	Net income	$3,167	$3,147	$3,108	$3,241	$3,339
Per Share Data
	Net income	$1.84	$1.83	$1.81	$1.89	$1.94
	Cash dividends declared	.86	.90	.68	.60	1.00
	Book value	17.62	16.47	16.15	15.23	14.31
	Estimated market value2	29.00	30.00	30.00	32.00	32.00
Year-end Balance Sheet Summary
	Loans, net	$263,729	$245,517	$217,091	$196,912	$176,155
	Investment securities	42,573	40,848	39,279	37,909	46,282
	Total assets	361,486	333,604	304,165	270,215	263,865
	Deposits	309,174	282,246	250,400	231,059	228,219
	Stockholders’ equity	30,291	28,304	27,753	26,177	24,601
Selected Ratios
	Return on average assets	0.93%	1.01%	1.09%	1.23%	1.32%
	Return on average equity	10.77%	10.85%	11.43%	12.56%	13.66%
	Average equity to average assets	8.67%	9.33%	9.55%	9.76%	9.66%
	1 In thousands of dollars, except per share data.
	2 Provided at the trade date nearest year end.

11

Management Discussion and Analysis

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

Overview

Management’s Discussion and Analysis is provided to assist in the understanding and evaluation of Grayson Bankshares, Inc.’s financial condition and its results of operations. The following discussion should be read in conjunction with the Company’s consolidated financial statements.

Grayson Bankshares, Inc. (the Company) was incorporated as a Virginia corporation on February 3, 1992 to acquire the stock of The Grayson National Bank (the Bank). The Bank was acquired by the Company on July 1, 1992. The Grayson National Bank was founded in 1900 and currently serves Grayson County, Virginia and surrounding areas through nine banking offices located in the towns of Independence and Hillsville, the localities of Elk Creek, Troutdale, and Whitetop, the City of Galax and Carroll County, Virginia, and the town of Sparta, North Carolina.

The Bank operates for the primary purpose of meeting the banking needs of individuals and small to medium sized businesses in the Bank’s service area, while developing personal, hometown associations with these customers. The Bank offers a wide range of banking services including checking and savings accounts; commercial, installment, mortgage and personal loans; safe deposit boxes; and other associated services. The Bank’s primary sources of revenue are interest income from its lending activities, and, to a lesser extent, from its investment portfolio. The Bank also earns fees from lending and deposit activities. The major expenses of the Bank are interest on deposit accounts and general and administrative expenses, such as salaries, occupancy and related expenses.

The earnings position of the Company remains strong. Grayson Bankshares, Inc. experienced net earnings of $3,167,501 for 2007 compared to $3,147,221 for 2006, and $3,108,307 for 2005. Dividends paid to stockholders amounted to $0.86 per share for 2007 compared to $0.90 per share for 2006.

The total assets of Grayson Bankshares, Inc. grew to $361,486,399 from $333,604,275, an 8.36% increase, continuing our strategy to grow the Company. Average equity to average assets indicates that the Company has a strong capital position with a ratio of 8.67% during 2007.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The notes to the audited consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2007 contain a summary of its significant accounting policies. Management believes the Company’s policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments, such as the recoverability of intangible assets and other-than-temporary impairment of investment securities, involve a higher degree of complexity and require management to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, management considers the policies related to those areas as critical.

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Statements of Financial Accounting Standards (“SFAS”) 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable, and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market, and the loan balance.

12

Management Discussion and Analysis

The allowance for loan losses has three basic components: (i) the formula allowance, (ii) the specific allowance, and (iii) the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, expected cash flows and fair market value of collateral are used to estimate these losses. The use of these values is inherently subjective and our actual losses could be greater or less that the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowance.

Accounting for intangible assets is as prescribed by SFAS 142, Goodwill and Other Intangible Assets. The Company accounts for recognized intangible assets based on their estimated useful lives. Intangible assets with finite useful lives are amortized, while intangible assets with an indefinite useful life are not amortized.

Estimated useful lives of intangible assets are based on an analysis of pertinent factors, including (as applicable):

• the expected use of the asset;

• the expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate;

• any legal, regulatory, or contractual provision that may limit the useful life;

• any legal, regulatory, or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost;

• the effects of obsolescence, demand, competition, and other economic factors; and

• the level of maintenance expenditures required to obtain the expected future cash flows from the asset.

Straight-line amortization is used to expense recognized amortizable intangible assets since a method that more closely reflects the pattern in which the economic benefits of the intangible assets are consumed cannot reliably be determined. Intangible assets are not written off in the period of acquisition unless they become impaired during that period.

The Company evaluates the remaining useful life of each intangible asset that is being amortized each reporting period to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of the intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset shall be amortized prospectively of that revised remaining useful life.

If an intangible asset that is being amortized is subsequently determined to have an indefinite useful life, the asset will be tested for impairment. That intangible asset will no longer be amortized and will be accounted for in the same manner as intangible assets that are not subject to amortization.

Intangible assets that are not subject to amortization are reviewed for impairment in accordance with SFAS 144 and tested annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of the intangible asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount of the intangible assets becomes its new accounting basis. Subsequent reversal of a previously recognized impairment loss is not allowed.

13

Management Discussion and Analysis

Table 1. Net Interest Income and Average Balances (dollars in thousands)

	2007			2006			2005
		Interest			Interest			Interest
	Average	Income/	Yield/	Average	Income/	Yield/	Average	Income/	Yield/
	Balance	Expense	Cost	Balance	Expense	Cost	Balance	Expense	Cost
Interest earning assets:
Federal funds sold	$ 15,583	$ 772	4.95%	$ 12,402	$ 614	4.95%	$ 12,575	$ 405	3.22%
Investment securities	38,727	1,779	4.60%	41,271	1,815	4.40%	38,208	1,612	4.22%
Loans	259,009	20,333	7.85%	235,046	18,194	7.74%	212,513	15,131	7.12%
Total	313,319	22,884		288,719	20,623		263,296	17,148
Yield on average
interest-earning assets			7.30%			7.14%			6.51%
Non interest-earning assets:
Cash and due from banks	9,660			8,089			8,494
Premises and equipment	8,338			7,357			7,217
Interest receivable and other	11,507			10,420			9,113
Allowance for loan losses	(2,874)			(2,737)			(2,685)
Unrealized gain/(loss) on securities	(732)			(981)			(539)
Total	25,899			22,148			21,600
Total assets	$339,218			$310,867			$284,896
Interest-bearing liabilities:
Demand deposits	$ 19,366	172	0.89%	$ 20,605	184	0.89%	$ 21,923	193	0.88%
Savings deposits	36,162	490	1.35%	41,384	563	1.36%	47,932	628	1.31%
Time deposits	197,779	9,649	4.88%	162,804	6,945	4.27%	135,517	4,126	3.04%
Borrowings	12,438	523	4.20%	18,918	944	4.99%	18,493	855	4.62%
Total	265,745	10,834		243,711	8,636		223,865	5,802
Cost on average
interest-bearing liabilities			4.08%			3.54%			2.59%
Non interest-bearing
liabilities:
Demand deposits	40,892			37,250			33,150
Interest payable and other	3,162			891			679
Total	44,054			38,141			33,829
Total liabilities	309,799			281,852			257,694
Stockholder's equity:	29,419			29,015			27,202
Total liabilities and
stockholder's equity	$339,218			$310,867			$284,896
Net interest income		$ 12,050			$ 11,987			$ 11,346
Net yield on
interest-earning assets			3.85%			4.15%			4.31%

14

Management Discussion and Analysis

Table 2. Rate/Volume Variance Analysis (thousands)

	2007 Compared to 2006			2006 Compared to 2005
	Interest	Variance		Interest	Variance
	Income/	Attributable To		Income/	Attributable To
	Expense			Expense
	Variance	Rate	Volume	Variance	Rate	Volume
Interest-earning assets:
Federal funds sold	$ 158	$ -	$ 158	$ 209	$ 215	$ (6)
Investment securities	(36)	80	(116)	203	71	132
Loans	2,139	261	1,878	3,063	1,381	1,682
Total	2,261	341	1,920	3,475	1,667	1,808
Interest-bearing liabilities:
Demand deposits	(12)	-	(12)	(9)	-	(9)
Savings deposits	(73)	(4)	(69)	(65)	23	(88)
Time deposits	2,704	1,080	1,624	2,819	1,882	937
Borrowings	(421)	(133)	(288)	89	69	20
Total	2,198	943	1,255	2,834	1,974	860
Net interest income	$ 63	$ (602)	$ 665	$ 641	$ (307)	$ 948

Net Interest Income

Net interest income, the principal source of Company earnings, is the amount of income generated by earning assets (primarily loans and investment securities) less the interest expense incurred on interest-bearing liabilities (primarily deposits used to fund earning assets). Table 1 summarizes the major components of net interest income for the past three years and also provides yields and average balances.

Total interest income in 2007 increased by 10.97% to $22.89 million from $20.62 million in 2006 after an increase from $17.15 million in 2005. The increase in total interest income in 2007 was due primarily to an increase in average loans outstanding of 10.20%. The growth in loans, as will as the increase in loans as a percentage of total interest-earning assets led to an overall increase in yield on average interest-earning assets of 16 basis points from 2006 to 2007. The increase in total interest income in 2006, as compared to 2005, was due to an increase in average loans outstanding of as well as to overall increases in interest rates for all categories of interest earning assets. Total interest expense increased by approximately $2.20 million in 2007 after an increase of $2.83 million in 2006. The increases in 2007 and 2006 were due primarily to increases in interest rates on time deposits coupled with a significant increase in the average balance of time deposits outstanding. The higher short-term interest rates on certificates of deposit in 2006 and 2007 led not only to new growth in certificates of deposit, but also to the migration of funds from savings and money market accounts into the higher yielding certificates. The effects of changes in volumes and rates on net interest income in 2007 compared to 2006, and 2006 compared to 2005 are shown in Table 2.

The increase in interest income was offset by the increase in interest expense resulting in a decrease in net yield on interest-earning assets of 30 basis points to 3.85% in 2007 compared to 4.15% in 2006.

15

Management Discussion and Analysis

Provision for Credit Losses

The allowance for credit losses is established to provide for expected losses in the Bank’s loan portfolio. Management determines the provision for credit losses required to maintain an allowance adequate to provide for probable losses. Some of the factors considered in making this decision are the collectibility of past due loans, volume of new loans, composition of the loan portfolio, and general economic outlook.

At the end of 2007, the loan loss reserve was $2,757,745 compared to $2,901,997 in 2006 and $2,678,055 in 2005. The Bank’s allowance for loan losses, as a percentage of total loans, at the end of 2007 was 1.03%, compared to 1.17% in 2006, and 1.22% in 2005. The decrease in the loan loss reserve from 2006 to 2007 was due to an increased level of loan charge-offs in 2007.

Additional information is contained in Tables 12 and 13, and is discussed in Nonperforming and Problem Assets.

Other Income

Noninterest income consists of revenues generated from a broad range of financial services and activities. The majority of noninterest income is traditionally a result of service charges on deposit accounts including charges for insufficient funds checks and fees charged for nondeposit services. Noninterest income increased by $300,015, or 17.93%, to $1,972,916 in 2007 from $1,672,901 in 2006. Noninterest income in 2005 totaled $1,415,203. The increase from 2006 to 2007 was due to primarily to the implementation of an overdraft privilege plan in April of 2007 that led to an increase in service charges on deposit accounts. The increase from 2005 to 2006 was primarily due to non-recurring gains from investment repurchase agreements and the termination of an interest-rate swap. These gains are generally non-recurring in nature, and as such, management does not anticipate similar gains in the future. The primary sources of noninterest income for the past three years are summarized in Table 3.

Table 3. Sources of Noninterest Income (thousands)

	2007	2006	2005
Service charges on deposit accounts	$ 828	$ 581	$ 528
Increase in cash value of life insurance	225	225	222
Mortgage origination fees	207	177	182
Insurance commissions	14	23	22
Safe deposit box rental	39	38	34
Gain on the sale of securities	(9)	46	4
Gain on interest rate swaps/contracts	99	51	-
Other income	570	532	423
Total noninterest income	$ 1,973	$ 1,673	$ 1,415

16

Management Discussion and Analysis

Other Expense

The major components of noninterest expense for the past three years are illustrated at Table 4.

Total noninterest expense increased by $424,743 in 2007 and $725,491 in 2006, which represents increases of 4.90% and 9.13% respectively. The majority of the increase from 2006 to 2007 was the result of ordinary annual increases in employee salaries and benefits. The increase from 2005 to 2006 was due to salary and benefit increases, as well as to branching activity and losses in the disposal of foreclosed properties.

Table 4. Sources of Noninterest Expense (thousands)

	2007	2006	2005
Salaries & wages	$ 3,884	$ 3,540	$ 3,334
Employee benefits	1,759	1,694	1,596
Total personnel expense	5,643	5,234	4,930
Director fees	167	162	149
Occupancy expense	345	304	300
Computer charges	265	276	191
Other equipment expense	839	811	751
FDIC/OCC assessments	140	122	114
Insurance	88	75	82
Professional fees	134	116	114
Advertising	194	204	220
Postage and freight	219	178	156
Supplies	160	155	178
Franchise tax	183	195	183
Telephone	156	144	137
Travel, dues & meetings	126	124	111
Other expense	436	570	329
Total noninterest expense	$ 9,095	$ 8,670	$ 7,945

The overhead efficiency ratio of noninterest expense to adjusted total revenue (net interest income plus noninterest income) was 64.8% in 2007, 63.5% in 2006 and 62.3% in 2005.

Income Taxes

Income tax expense is based on amounts reported in the statements of income (after adjustments for non-taxable income and non-deductible expenses) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The deferred tax assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.

17

Management Discussion and Analysis

Income tax expense (substantially all Federal) was $1,296,031 in 2007, $1,322,443 in 2006 and $1,204,081 in 2005 resulting in effective tax rates of 29.0%, 29.6% and 27.9% respectively. The increase in the effective tax rate for 2006 was due to a decrease in the percentage of tax-exempt income.

The Company’s deferred income tax benefits and liabilities result primarily from temporary differences (discussed above) in the provisions for credit losses, valuation reserves, non-accrual interest income, depreciation, deferred compensation, deferred income, pension expense and investment security discount accretion.

Net deferred tax benefits of $1,073,317 and $1,524,131 are included in other assets at December 31, 2007 and 2006 respectively. At December 31, 2007, net deferred tax benefits included $217,721 of deferred tax assets applicable to unrealized losses on investment securities available for sale, and $506,324 of deferred tax assets applicable to unfunded projected pension benefit obligations. Accordingly, these amounts were not charged to income but recorded directly to the related stockholders’ equity account.

Analysis of Financial Condition

Average earning assets increased 8.52% from December 31, 2006 to December 31, 2007. Total earning assets represented 92.37% of total average assets in 2007 and 92.88% in 2006. The mix of average earning assets changed only slightly from 2006 to 2007 as loan growth remained strong.

Table 5. Average Asset Mix (dollars in thousands)

	2007		2006
	Average		Average
	Balance	%	Balance	%
Earning assets:
Loans	$ 259,009	76.36%	$ 235,046	75.61%
Investment securities	38,727	11.42%	41,271	13.28%
Federal funds sold	15,583	4.59%	12,402	3.99%
Deposits in other banks	-	0.00%	-	0.00%
Total earning assets	313,319	92.37%	288,719	92.88%
Nonearning assets:
Cash and due from banks	9,660	2.85%	8,089	2.60%
Premises and equipment	8,338	2.46%	7,357	2.37%
Other assets	11,507	3.39%	10,420	3.35%
Allowance for loan losses	(2,874)	-0.85%	(2,737)	-0.88%
Unrealized gain/(loss) on securities	$ (732)	-0.22%	$ (981)	-0.32%
Total nonearning assets	$ 25,899	7.63%	$ 22,148	7.12%
Total assets	$ 339,218	100.00%	$ 310,867	100.00%

Average loans for 2007 represented 76.36% of total average assets compared to 75.61% in 2006. Average federal funds sold increased from 3.99% to 4.59% of total average assets while average investment securities decreased from 13.28% to 11.42% of total average assets over the same time period. The balances of nonearning assets increased from 7.12% in 2006 to 7.63% in 2007.

18

Management Discussion and Analysis

Loans

Average loans totaled $259.0 million over the year ended December 31, 2007. This represents an increase of 10.20% over the average of $235.0 million for 2006. Average loans increased by 10.60% from 2005 to 2006.

The loan portfolio consists primarily of real estate and commercial loans. These loans accounted for 92.71% of the total loan portfolio at December 31, 2007. This is up from the 92.18% that the two categories maintained at December 31, 2006. The amount of loans outstanding by type at December 31, 2007 and December 31, 2006 and the maturity distribution for variable and fixed rate loans as of December 31, 2007 are presented in Tables 6 & 7 respectively.

Table 6. Loan Portfolio Summary (dollars in thousands)

	December 31, 2007		December 31, 2006		December 31, 2005
	Amount	%	Amount	%	Amount	%
Construction and development	$ 33,017	12.39%	$ 30,725	12.37%	$ 22,244	10.12%
Residential, 1-4 families	121,074	45.44%	111,089	44.72%	102,614	46.69%
Residential, 5 or more families	1,638	0.61%	1,572	0.63%	675	0.31%
Farmland	29,134	10.93%	27,979	11.26%	21,695	9.87%
Nonfarm, nonresidential	42,237	15.85%	39,350	15.84%	35,613	16.20%
Total real estate	$ 227,100	85.22%	$ 210,715	84.82%	$ 182,841	83.19%
Agricultural	3,445	1.29%	3,774	1.52%	3,071	1.40%
Commercial	19,950	7.49%	18,294	7.36%	18,745	8.53%
Consumer	14,330	5.38%	14,106	5.68%	14,112	6.42%
Other	1,662	0.62%	1,530	0.62%	1,000	0.46%
Total	$ 266,487	100.00%	$ 248,419	100.00%	$ 219,769	100.00%

	December 31, 2004		December 31, 2003
	Amount	%	Amount	%
Construction and development	$ 19,454	9.75%	$ 14,530	8.14%
Residential, 1-4 families	94,655	47.44%	83,824	46.95%
Residential, 5 or more families	692	0.35%	321	0.18%
Farmland	18,387	9.21%	15,640	8.76%
Nonfarm, nonresidential	31,485	15.78%	31,902	17.86%
Total real estate	$ 164,673	82.53%	146,217	81.89%
Agricultural	2,891	1.45%	3,152	1.77%
Commercial	17,603	8.82%	15,093	8.45%
Consumer	13,657	6.85%	13,040	7.30%
Other	698	0.35%	1,048	0.59%
Total	$ 199,522	100.00%	$ 178,550	100.00%

19

Management Discussion and Analysis

Table 7. Maturity Schedule of Loans (dollars in thousands), as of December 31, 2007

	Real	Agricultural	Consumer	Total
	Estate	and Commercial	and Other	Amount	%
Fixed rate loans:
Three months or less	$ 11,960	$ 3,900	$ 2,050	$ 17,910	6.72%
Over three to twelve months	31,849	2,269	2,887	37,005	13.88%
Over one year to five years	15,930	3,588	9,873	29,391	11.03%
Over five years	34,306	446	684	35,436	13.30%
Total fixed rate loans	$ 94,045	$ 10,203	$ 15,494	$ 119,742	44.93%
Variable rate loans:
Three months or less	$ 27,454	$ 6,383	$ 332	$ 34,169	12.83%
Over three to twelve months	16,919	4,950	98	21,967	8.24%
Over one year to five years	41,469	1,751	68	43,288	16.24%
Over five years	47,213	108	-	47,321	17.76%
Total variable rate loans	$ 133,055	$ 13,192	$ 498	$ 146,745	55.07%
Total loans:
Three months or less	$ 39,414	$ 10,283	$ 2,382	$ 52,079	19.55%
Over three to twelve months	48,768	7,219	2,985	58,972	22.12%
Over one year to five years	57,399	5,339	9,941	72,679	27.27%
Over five years	81,519	554	684	82,757	31.06%
Total loans	$ 227,100	$ 23,395	$ 15,992	$ 266,487	100.00%

Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulations also influence interest rates. On average, loans yielded 7.85% in 2007 compared to an average yield of 7.74% in 2006.

Investment Securities

The Bank uses its investment portfolio to provide liquidity for unexpected deposit decreases or loan generation, to meet the Bank’s interest rate sensitivity goals, and to generate income.

Management of the investment portfolio has always been conservative with the majority of investments taking the form of purchases of U.S. Treasury, U.S. Government Agencies and State and Municipal bonds, as well as investment grade corporate bond issues. Management views the investment portfolio as a source of income, and purchases securities with the intent of retaining them until maturity. However, adjustments are necessary in the portfolio to provide an adequate source of liquidity which can be used to meet funding requirements for loan demand and deposit fluctuations and to control interest rate risk. Therefore, from time to time, management may sell certain securities prior to their maturity. Table 8 presents the investment portfolio at the end of 2007 by major types of investments and contractual maturity ranges. Investment securities in Table 8 may have repricing or call options that are earlier than the contractual maturity date.

Total investment securities increased by approximately $1.7 million from December 31, 2006 to December 31, 2007. Most of the investment growth came late in 2007 and therefore the average balance of investment securities was lower in 2007 than in 2006. The average yield of the investment portfolio increased to 4.60% for the year ended December 31, 2007 compared to 4.40% for 2006.

20

Management Discussion and Analysis

Table 8. Investment Securities - Maturity/Yield Schedule (dollars in thousands)

	In One	After One	After Five	After	Book	Market	Book	Book
	Year or	Through	Through	Ten	Value	Value	Value	Value
	Less	Five Years	Ten Years	Years	12/31/07	12/31/07	12/31/06	12/31/05
Investment Securities:
U.S. Government agencies	$ 716	$ 3,247	$ 3,798	$ 8,227	$ 15,988	$ 15,371	$ 26,455	$ 26,852
Mortgage-backed securities	1	85	2,625	10,903	13,614	13,668	5,029	3,515
State and municipal securities	-	1,080	2,031	9,371	12,482	12,455	8,658	8,184
Corporate securities	-	-	-	-	-	-	200	199
Total	$ 717	$ 4,412	$ 8,454	$ 28,501	$ 42,084	$ 41,494	$ 40,342	$ 38,750
Weighted average yields:
U.S. Government agencies	3.71%	5.13%	5.17%	4.35%	4.66%
Mortgage-backed securities	7.00%	5.09%	4.95%	5.27%	5.21%
State and municipal securities	0.00%	5.04%	6.02%	5.78%	5.76%
Total	3.71%	5.11%	5.31%	5.17%	5.18%
(Yields are stated on a tax-equivalent basis)

Deposits

The Bank relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid assets. More specifically, core deposits (total deposits less certificates of deposit in denominations of $100,000 or more) are the primary funding source. The Bank’s balance sheet growth is largely determined by the availability of deposits in its markets, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios. Market conditions have resulted in depositors shopping for deposit rates more than in the past. An increased customer awareness of interest rates adds to the importance of rate management. The Bank’s management must continuously monitor market pricing, competitor’s rates, and the internal interest rate spreads to maintain the Bank’s growth and profitability. The Bank attempts to structure rates so as to promote deposit and asset growth while at the same time increasing overall profitability of the Bank.

Average total deposits for the year ended December 31, 2007 amounted to $294.2 million, which was an increase of $32.2 million, or 12.3% over 2006. Average core deposits totaled $225.2 million in 2007 representing a 7.5% increase over the $209.4 million in 2006. The percentage of the Bank’s average deposits that are interest-bearing increased from 85.8% in 2006 to 86.1% in 2007. Average demand deposits, which earn no interest, increased 9.8% from $37.3 million in 2006 to $40.9 million in 2007. Average deposits for the periods ended December 31, 2007 and December 31, 2006 are summarized in Table 9.

21

Management Discussion and Analysis

Table 9. Deposit Mix (dollars in thousands)

	2007			2006
	Average	% of Total	Average	Average	% of Total	Average
	Balance	Deposits	Rate Paid	Balance	Deposits	Rate Paid
Interest-bearing deposits:
NOW accounts	$ 19,366	6.6%	0.89%	$ 20,605	7.9%	0.89%
Money Market	7,633	2.6%	1.75%	9,293	3.5%	1.75%
Savings	28,529	9.7%	1.25%	32,091	12.2%	1.25%
Individual retirement accounts	32,375	11.0%	4.78%	28,315	10.8%	4.42%
Small denomination certificates	96,454	32.8%	4.80%	81,894	31.3%	4.16%
Large denomination certificates	68,950	23.4%	5.03%	52,595	20.1%	4.35%
Total interest-bearing deposits	253,307	86.1%	4.07%	224,793	85.8%	3.42%
Noninterest-bearing deposits	40,892	13.9%	0.00%	37,250	14.2%	0.00%
Total deposits	$ 294,199	100.0%	3.50%	$ 262,043	100.0%	2.94%

		2005
	Average	% of Total	Average
	Balance	Deposits	Rate Paid
Interest-bearing deposits:
NOW accounts	$ 21,923	9.2%	0.88%
Money Market	10,900	4.6%	1.51%
Savings	37,032	15.5%	1.25%
Individual retirement accounts	23,796	10.0%	3.58%
Small denomination certificates	70,115	29.4%	2.84%
Large denomination certificates	41,606	17.4%	3.08%
Total interest-bearing deposits	205,372	86.1%	2.41%
Noninterest-bearing deposits	33,150	13.9%	0.00%
Total deposits	$ 238,522	100.0%	2.07%

The average balance of certificates of deposit issued in denominations of $100,000 or more increased by $16.4 million, or 31.10%, for the year ended December 31, 2007. The strategy of management has been to support loan and investment growth with core deposits and not to aggressively solicit the more volatile, large denomination certificates of deposit, however, recent market increases in short-term certificate rates prompted many customers to move money from savings and money market accounts to certificates of deposit. Table 10 provides maturity information relating to certificates of deposit of $100,000 or more at December 31, 2007.

22

Management Discussion and Analysis

Table 10. Large Denomination Certificate of Deposit Maturities (thousands)

Analysis of certificates of deposit of $100,000 or more at December 31, 2007:
Remaining maturity of three months or less	$ 17,988
Remaining maturity over three months through six months	22,654
Remaining maturity over six months through twelve months	22,833
Remaining maturity over twelve months	10,991
Total time deposits of $100,000 or more	$ 74,466

Equity

Stockholders’ equity amounted to $30.3 million at December 31, 2007, a 7.02% increase over the 2006 year-end total of $28.3 million. The increase resulted from earnings of $3,167,501, less dividends paid and changes in pension reserves and unrealized depreciation of investment securities classified as available for sale. The Company paid dividends of $0.86, $0.90 and $0.68 per share in 2007, 2006 and 2005, respectively.

Regulatory guidelines relating to capital adequacy provide minimum risk-based ratios which assess capital adequacy while encompassing all credit risks, including those related to off-balance sheet activities. Capital ratios under these guidelines are computed by weighing the relative risk of each asset category to derive risk-adjusted assets. The risk-based capital guidelines require minimum ratios of core (Tier 1) capital (common stockholders’ equity) to risk-weighted assets of 4.0% and total regulatory capital (core capital plus allowance for loan losses up to 1.25% of risk-weighted assets) to risk-weighted assets of 8.0%. As of December 31, 2007 the Bank has a ratio of Tier 1 capital to risk-weighted assets of 11.3% and a ratio of total capital to risk-weighted assets of 12.4%.

Table 11. Bank’s Year-end Risk-Based Capital (dollars in thousands)

	2007	2006
Tier 1 capital	$ 27,977	$ 26,199
Qualifying allowance for loan losses
(limited to 1.25% of risk-weighted assets)	2,758	2,884
Total regulatory capital	$ 30,735	$ 29,083
Total risk-weighted assets	$ 247,413	$ 230,718
Tier 1 capital as a percentage of
risk-weighted assets	11.3%	11.4%
Total regulatory capital as a percentage of
risk-weighted assets	12.4%	12.6%
Leverage ratio*	7.9%	8.0%
*Tier 1 capital divided by average total assets for
the quarter ended December 31 of each year.

23

Management Discussion and Analysis

In addition, a minimum leverage ratio of Tier 1 capital to average total assets for the previous quarter is required by federal bank regulators, ranging from 3% to 5%, subject to the regulator’s evaluation of the Bank’s overall safety and soundness. As of December 31, 2007, the Bank had a ratio of year-end Tier 1 capital to average total assets for the fourth quarter of 2007 of 7.9%. Table 11 sets forth summary information with respect to the Bank’s capital ratios at December 31, 2007. All capital ratio levels indicate that the Bank is well capitalized.

Nonperforming and Problem Assets

Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and attempts to manage them effectively. The Bank attempts to use shorter-term loans and, although a portion of the loans have been made based upon the value of collateral, the underwriting decision is generally based on the cash flow of the borrower as the source of repayment rather than the value of the collateral. The Bank also attempts to reduce repayment risk by adhering to internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies.

Nonperforming assets at December 31, 2007 and 2006 are analyzed in Table 12.

Table 12. Nonperforming Assets (dollars in thousands)

	December 31, 2007		December 31, 2006		December 31, 2005
		% of		% of		% of
	Amount	Loans	Amount	Loans	Amount	Loans
Nonaccrual loans	$ 4,108	1.5%	$ 867	0.3%	$ 992	0.4%
Restructured loans	469	0.2%	480	0.2%	1,114	0.5%
Loans past due 90 days or more	518	0.2%	733	0.3%	550	0.3%
Total nonperforming assets	$ 5,095	1.9%	$ 2,080	0.8%	$ 2,656	1.2%

	December 31, 2004		December 31, 2003
		% of		% of
	Amount	Loans	Amount	Loans
Nonaccrual loans	$ 690	0.3%	$ 1,435	0.8%
Restructured loans	1,802	0.9%	484	0.3%
Loans past due 90 days or more	635	0.3%	2,119	1.2%
Total nonperforming assets	$ 3,127	1.5%	$ 4,038	2.3%

Total nonperforming assets were 1.9% and 0.8% of total outstanding loans as of December 31, 2007 and 2006, respectively. The increase is due primarily to one commercial real estate loan that was placed in nonaccrual status in 2007 with a principal balance of approximately $2.4 million. The loan is secured by a first deed of trust on real estate with an appraised value of $4.0 million, therefore management anticipates eventual receipt of all principal owed on this loan. More information on nonperforming assets can be found in Note 5of the “Notes to Consolidated Financial Statements” found in the company’s 2007 Annual Report on Form 10-K.

24

Management Discussion and Analysis

The allowance for loan losses is maintained at a level adequate to absorb potential losses. Some of the factors which management considers in determining the appropriate level of the allowance for loan losses are: past loss experience, an evaluation of the current loan portfolio, identified loan problems, the loan volume outstanding, the present and expected economic conditions in general, and in particular, how such conditions relate to the market area that the Bank serves. Bank regulators also periodically review the Bank’s loans and other assets to assess their quality. Loans deemed uncollectible are charged to the allowance. Provisions for loan losses and recoveries on loans previously charged off are added to the allowance. The accrual of interest on a loan is discontinued when, in the opinion of management, there is an indication that the borrower may be unable to meet payments as they become due.

To quantify the specific elements of the allowance for loan losses, the Bank begins by establishing a specific reserve for loans that have been identified as being impaired. This reserve is determined by comparing the principal balance of the loan with the net present value of the future anticipated cash flows or the fair market value of the related collateral. The bank then reviews certain loans in the portfolio and assigns grades to loans which have been reviewed. Loans which are adversely classified are given a specific allowance based on the historical loss experience of similar type loans in each adverse grade. The remaining portfolio is segregated into loan pools consistent with regulatory guidelines. An allocation is then made to the reserve for these loan pools based on the bank’s historical loss experience with further adjustments for external factors such as current loan volume and general economic conditions. The allowance is allocated according to the amount deemed to be reasonably necessary to provide for the possibility of losses being incurred within the respective categories of loans, although the entire allowance is available to absorb any actual charge-offs that may occur.

The provision for loan losses, net charge-offs and the activity in the allowance for loan losses is detailed in Table 13. The allocation of the reserve for loan losses is detailed in Table 14.

Table 13. Loan Losses

	2007	2006	2005	2004	2003
Allowance for loan losses, beginning	$ 2,901,997	$ 2,678,055	$ 2,609,759	$ 2,395,387	$ 2,189,028
Provision for loan losses, added	465,143	520,000	504,468	390,000	410,000
Charge-offs:
Real estate	(283,658)	(45,330)	(100,340)	(42,827)	(26,195)
Commercial and agricultural	(236,571)	(199,372)	(202,760)	(78,959)	(86,627)
Consumer and other	(179,836)	(148,971)	(162,462)	(154,703)	(194,601)
Recoveries:
Real estate	19,515	6,000	143	1,456	5,308
Commercial and agricultural	22,515	35,426	4,975	69,042	52,056
Consumer and other	48,640	56,189	24,272	30,363	46,418
Net charge-offs	(609,395)	(296,058)	(436,172)	(175,628)	(203,641)
Allowance for loan losses, ending	$ 2,757,745	$ 2,901,997	$ 2,678,055	$ 2,609,759	$ 2,395,387
Ratio of net charge-offs during the period
to average loans outstanding during the period:	0.023%	0.013%	0.020%	0.009%	0.012%

25

Management Discussion and Analysis

Table 14. Allocation of the Reserve for Loan Losses (thousands)

	2007		2006		2005
		% of		% of		% of
		Loans to		Loans to		Loans to
Balance at the end of the period applicable to:	Amount	Total Loans	Amount	Total Loans	Amount	Total Loans
Commercial and agricultural	$ 594	8.78%	$ 1,193	8.88%	$ 842	9.93%
Real estate - construction	253	12.39%	-	12.37%	-	10.12%
Real estate - mortgage	1,665	72.83%	791	72.45%	734	73.07%
Consumer and other	246	6.00%	918	6.30%	1,102	6.88%
Total	$ 2,758	100.00%	$ 2,902	100.00%	$ 2,678	100.00%

	2004		2003
		% of		% of
		Loans to		Loans to
Balance at the end of the period applicable to:	Amount	Total Loans	Amount	Total Loans
Commercial and agricultural	$ 569	10.27%	$ 773	10.22%
Real estate - construction	-	9.75%	-	8.14%
Real estate - mortgage	663	72.78%	559	73.75%
Consumer and other	1,378	7.20%	1,063	7.89%
Total	$ 2,610	100.00%	$ 2,395	100.00%

Financial Instruments with Off-Balance-Sheet Risk

The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Bank’s commitments at December 31, 2007 and 2006 is as follows:

	2007	2006
Commitments to extend credit	$20,296,854	$19,691,878
Standby letters of credit	-	-
	$20,296,854	$19,691,878

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon

26

Management Discussion and Analysis

extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Bank deems necessary.

Impact of Inflation and Changing Prices

The consolidated financial statements and the accompanying notes presented elsewhere in this document have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all Company assets and liabilities are monetary in nature, therefore the impact of inflation is reflected primarily in the increased cost of operations. As a result, interest rates have a greater impact on performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

Table 15. Key Financial Ratios

	2007	2006	2005
Return on average assets	0.93%	1.01%	1.09%
Return on average equity	10.77%	10.85%	11.43%
Dividend payout ratio	46.67%	49.16%	37.61%
Average equity to average assets	8.67%	9.33%	9.55%

27

Management Discussion and Analysis

Table 16. Quarterly Data (unaudited) (dollars in thousands, except per share data)

	Years Ended December 31,
	2007				2006
	Fourth	Third	Second	First	Fourth	Third	Second	First
	Quarter	Quarter	Quarter	Quarter	Quarter	Quarter	Quarter	Quarter
Interest and dividend income	$ 5,937	$ 5,673	$ 5,777	$ 5,497	$ 5,478	$ 5,300	$ 5,081	$ 4,763
Interest expense	2,796	2,719	2,698	2,621	2,606	2,223	1,969	1,837
Net interest income	3,141	2,954	3,079	2,876	2,872	3,077	3,112	2,926
Provision for loan losses	192	139	75	60	120	150	137	113
Net interest income, after
provision for loan losses	2,949	2,815	3,004	2,816	2,752	2,927	2,975	2,813
Noninterest income	471	556	434	574	376	495	408	405
Noninterest expenses	2,387	2,267	2,318	2,183	2,231	2,295	2,139	2,016
Income before income taxes	1,033	1,104	1,120	1,207	897	1,127	1,244	1,202
Provision for income taxes	293	307	333	363	265	322	372	364
Net income	$ 740	$ 797	$ 787	$ 844	$ 632	$ 805	$ 872	$ 838
Net income per share	$ 0.43	$ 0.46	$ 0.46	$ 0.49	$ 0.37	$ 0.47	$ 0.51	$ 0.49

28

Item 7A.Quantitative and Qualitative Disclosure about Market Risk

The principal goals of the Bank’s asset and liability management strategy are the maintenance of adequate liquidity and the management of interest rate risk. Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss. Interest rate risk management balances the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Bank from wide fluctuations in its net interest income which could result from interest rate changes.

Management must insure that adequate funds are available at all times to meet the needs of its customers. On the asset side of the balance sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity. On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates, federal fund lines from correspondent banks, borrowings from the Federal Home Loan Bank, as well as the ability to generate funds through the issuance of long-term debt and equity.

The liquidity ratio (the level of liquid assets divided by total deposits plus short-term liabilities) was 19.3% at December 31, 2007 compared to 17.8% at December 31, 2006. These ratios are considered to be adequate by management.

The Bank uses cash and federal funds sold to meet its daily funding needs. If funding needs are met through holdings of excess cash and federal funds, then profits might be sacrificed as higher-yielding investments are foregone in the interest of liquidity. Therefore management determines, based on such items as loan demand and deposit activity, an appropriate level of cash and federal funds and seeks to maintain that level.

The primary goals of the investment portfolio are liquidity management and maturity gap management. As investment securities mature the proceeds are reinvested in federal funds sold if the federal funds level needs to be increased, otherwise the proceeds are reinvested in similar investment securities. The majority of investment security transactions consist of replacing securities that have been called or matured. The Bank keeps a significant portion of its investment portfolio in unpledged assets that are less than 60 months to maturity or next repricing date. These investments are a preferred source of funds in that they can be disposed of in any interest rate environment without causing significant damage to that quarter’s profits.

Interest rate risk is the effect that changes in interest rates would have on interest income and interest expense as interest-sensitive assets and interest-sensitive liabilities either reprice or mature. Management attempts to maintain the portfolios of interest-earning assets and interest-bearing liabilities with maturities or repricing opportunities at levels that will afford protection from erosion of net interest margin, to the extent practical, from changes in interest rates. Table 17 shows the sensitivity of the Bank’s balance sheet on December 31, 2007. This table reflects the sensitivity of the balance sheet as of that specific date and is not necessarily indicative of the position on other dates. At December 31, 2006, the Bank appeared to be cumulatively asset-sensitive (interest-earning assets subject to interest rate changes exceeding interest-bearing liabilities subject to changes in interest rates). However, in the one year window liabilities subject to change in interest rates exceed assets subject to interest rate changes (non asset-sensitive).

Matching sensitive positions alone does not ensure the Bank has no interest rate risk. The repricing characteristics of assets are different from the repricing characteristics of funding sources. Thus, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.

29

Table 17. Interest Rate Sensitivity (dollars in thousands)

	December 31, 2007
	Maturities/Repricing
	1 to 3	4 to 12	13 to 60	Over 60
	Months	Months	Months	Months	Total
Interest-Earning Assets:
Federal funds sold	$ 24,637	$ -	$ -	$ -	$ 24,637
Investments	9,477	2,957	19,982	9,668	42,084
Loans	75,052	52,789	82,589	56,057	266,487
Total	$ 109,166	$ 55,746	$ 102,571	$ 65,725	$ 333,208
Interest-Bearing Liabilities:
NOW accounts	$ 20,422	$ -	$ -	$ -	$ 20,422
Money market	7,386	-	-	-	7,386
Savings	28,437	-	-	-	28,437
Time Deposits	48,146	108,784	51,368	-	208,298
Borrowings	10,000	-	10,000	-	20,000
Total	$ 114,391	$ 108,784	$ 61,368	$ -	$ 284,543
Interest sensitivity gap	$ (5,225)	$ (53,038)	$ 41,203	$ 65,725	$ 48,665
Cumulative interest
sensitivity gap	$ (5,225)	$ (58,263)	$ (17,060)	$ 48,665	$ 48,665
Ratio of sensitivity gap to
total earning assets	-1.6%	-15.9%	12.4%	19.7%	14.6%
Cumulative ratio of sensitivity
gap to total earning assets	-1.6%	-17.5%	-5.1%	14.6%	14.6%

The Company uses a number of tools to monitor its interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap between rate sensitive assets and rate sensitive liabilities over various time periods (as displayed in Table 17).

The earnings simulation model forecasts annual net income under a variety of scenarios that incorporate changes in the absolute level of interest rates, changes in the shape of the yield curve, and changes in interest rate relationships. Management evaluates the effect on net interest income and present value equity from gradual changes in rates of up to 300 basis points up or down over a 12-month period. Table 18 presents the Bank’s forecasts for changes in net income and market value of equity as of December 31, 2007.

30

Table 18. Interest Rate Risk (dollars in thousands)

Rate Shocked Net Interest Income and Market Value of Equity
Rate Change	-300bp	-200bp	-100bp	0bp	+100bp	+200bp	+300bp
Net Interest Income:
Net interest income	$ 10,407	$ 10,976	$ 11,529	$ 12,126	$ 12,608	$ 13,050	$ 13,475
Change	$ (1,719)	$ (1,150)	$ (597)	$ -	$ 482	$ 924	$ 1,349
Change percentage	-14%	-9%	-5%		4%	8%	11%
Market Value of Equity	$ 37,023	$ 37,349	$ 37,199	$ 35,828	$ 35,594	$ 34,742	$ 33,289

31

Item 8.Financial Statements and Supplementary Data.

Pursuant to General Instruction G(2) of Form 10-K, the following financial statements in the Company's 2007 Annual Report to Shareholders are incorporated herein by reference.

Independent Auditor's Report

Consolidated Balance Sheets as of December 31, 2007 and 2006

Consolidated Statements of Income for the Years Ended December 31, 2007, 2006, and 2005

Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2007, 2006, and 2005

Consolidated Statements of Cash Flows for the Years Ended December 31, 2007, 2006, and 2005

Notes to Consolidated Financial Statements

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

None.

Item 9A(T). Controls and Procedures

Disclosure Controls and Procedures

As of the end of the period covered by this report, we 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 along with the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s President and Chief Executive Officer along with the Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in our periodic SEC filings.

The Company also maintains a system of internal accounting controls that is designed to provide assurance that assets are safeguarded and that transactions are executed in accordance with management’s authorization and properly recorded. This system is continually reviewed and is augmented by written policies and procedures, the careful selection and training of qualified personnel and an internal audit program to monitor its effectiveness. There were no changes in our internal control over financial reporting identified in connection with the evaluation of it that occurred during our last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

Internal Control Over Financial Reporting

Management’s Report on Internal Control Over Financial Reporting.

To the Stockholders

Grayson Bankshares, Inc.

Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.

Management is also responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting includes those policies and procedures that pertain to the Company’s ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or

32

overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.

In order to ensure that the Company’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2007. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on this assessment, management believes the Company maintained effective internal control over financial reporting as of December 31, 2007.

The Board of Directors, acting through its Audit Committee, is responsible for the oversight of the Company’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent auditor and approves decisions regarding the appointment or removal of the Company Auditor. It meets periodically with management, the independent auditors and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Company in addition to reviewing the Company’s financial reports. The independent auditors and the internal auditors have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matter which they believe should be brought to the attention of the Audit Committee.

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

/s/ Jacky K. Anderson	/s/ Blake M. Edwards
Jacky K. Anderson, President & CEO	Blake M. Edwards, CFO

Item 9B. Other Information

None.

PART III

Item 10. Directors, Executive Officers and Corporate Governance

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Election of Directors,” (except for the information set forth under the headings, “Election of Directors—Security Ownership of Management” and “Election of Directors—Security Ownership of Certain Beneficial Owners“) and “Corporate Governance and the Board of Directors—Code of Ethics” in the Company’s Proxy Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by reference.

Item 11. Executive Compensation

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Executive Compensation” in the Company’s Proxy Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by reference.

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Item 12. Security Ownership of Certain Beneficial Owners and Management

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings “Election of Directors--Security Ownership of Management” and “Election of Directors--Security Ownership of Certain Beneficial Owners” in the Company’s Proxy Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by reference.

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

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Transactions with Management” and “Corporate Governance and the Board of Directors—Independence of Directors” in the Company’s Proxy Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by reference.

Item 14. Principal Accounting Fees and Services

Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading “Audit Information” (except for information set forth under the heading “Audit Information—Audit Committee Report”) in the Company’s Proxy Statement for the 2008 Annual Meeting of Shareholders is incorporated herein by reference.

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PART IV

Item 15. Exhibits, Financial Statement Schedules

(a)	(1) and (2). The response to this portion of Item 15 is submitted as a separate section of this report.
	(3). Exhibits:
	3.1	Articles of Incorporation of the Company, incorporated herein by reference to Exhibit 3.1 of the Company’s Registration Statement on Form 10, File No. 0-30535.
	3.2	Bylaws of the Company, incorporated herein by reference to Exhibit 3.2 of the Company’s Registration Statement on Form 10, File No. 0-30535.
	13.1	2007 Annual Report to Shareholders.
	21.1	Subsidiary of the Company.
	31.1	Rule 13a-14(a) Certification of Chief Executive Officer.
	31.2	Rule 13a-14(a) Certification of Chief Financial Officer.
	32.1	Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350.
(b)	Exhibits
	The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted as a separate section of this report.
(c)	Financial Statement Schedules
	The response to this portion of Item 15 is submitted as a separate section of this report.

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SIGNATURES

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

		GRAYSON BANKSHARES, INC.
Date:	March 30, 2008	By:	/s/ Jacky K. Anderson
			Jacky K. Anderson President and Chief Executive Officer

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

Signature	Title	Date
/s/ Jacky K. Anderson	President and	March 30, 2008
Jacky K. Anderson	Chief Executive Officer
	(Principal Executive Officer)
/s/ Blake M. Edwards, Jr.	Chief Financial Officer	March 30, 2008
Blake M. Edwards, Jr.	(Principal Financial and Accounting Officer)
/s/ Bryan L. Edwards	Director	March 30, 2008
Bryan L. Edwards
/s/ Dennis B. Gambill	Director	March 30, 2008
Dennis B. Gambill
/s/ Julian L. Givens	Director	March 30, 2008
Julian L. Givens
	Director
Jack E. Guynn, Jr.
	Director
Thomas M. Jackson, Jr.
	Director	March 30, 2008
/s/ Jean W. Lindsey
Jean W. Lindsey

Signature	Title	Date
/s/ Carl J. Richardson	Director	March 30, 2008
Carl J. Richardson
	Director
Charles T. Sturgill
	Director
J. David Vaughn

INDEX OF EXHIBITS

The following exhibits are filed with this Annual Report on Form 10-K.

3.1	Articles of Incorporation of the Company, incorporated herein by reference to Exhibit 3.1 of the Company’s Registration Statement on Form 10, File No. 0-30535.
3.2	Bylaws of the Company, incorporated herein by reference to Exhibit 3.2 of the Company’s Registration Statement on Form 10, File No. 0-30535.
13.1	2007 Annual Report to Shareholders.
21.1	Subsidiary of the Company.
31.1	Rule 13a-14(a) Certification of Chief Executive Officer.
31.2	Rule 13a-14(a) Certification of Chief Financial Officer.
32.1	Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. § 1350.