Grayson Bankshares (GSON) 10-Q 2009 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2009

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

of the Securities Exchange Act of 1934

For the transition period from ____________ to _____________

Commission File Number: 0-30535

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)

(276) 773-2811

(Registrant’s telephone number, including area code)

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes o No o

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.

Large accelerated filer o Accelerated filer o

Non-accelerated filer o (Do not check if smaller reporting company) Smaller reporting company x

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

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

1,718,968 shares of Common Stock, par value

$1.25 per share, outstanding as of May 13, 2009.

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets—March 31, 2009 (Unaudited)

and December 31, 2008 (Audited) 3

Unaudited Consolidated Statements of Income—Three Months Ended

March 31, 2009 and March 31, 2008 4

Consolidated Statements of Changes in Stockholders’ Equity—Three Months

Ended March 31, 2009 (Unaudited) and Year Ended December 31, 2008 (Audited) 5

Unaudited Consolidated Statements of Cash Flows—Three Months Ended

March 31, 2009 and March 31, 2008 6

Notes to Consolidated Financial Statements 7

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

and Results of Operations 13

Item 3. Quantitative and Qualitative Disclosures about Market Risk 16

Item 4. Controls and Procedures 17

PART II OTHER INFORMATION

Item 1. Legal Proceedings 18

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 18

Item 3. Defaults Upon Senior Securities 18

Item 4. Submission of Matters to a Vote of Security Holders 18

Item 5. Other Information 18

Item 6. Exhibits 18

Signatures 19

2

Part I. Financial Information

Item 1. Financial Statements

Grayson Bankshares, Inc. and Subsidiary

Consolidated Balance Sheets

March 31, 2009 and December 31, 2008

			March 31,		December 31,
Assets			2009		2008
			(Unaudited)		(Audited)
Cash and due from banks		$	11,347,134	$	9,536,772
Federal funds sold			21,048,950		11,149,718
Investment securities available for sale			44,666,107		46,413,054
Investment securities held to maturity
(fair value approximately $3,118,706 at March 31, 2009,
and $3,044,781 at December 31, 2008)			3,043,709		3,037,608
Restricted equity securities			1,731,750		1,731,750
Loans, net of allowance for loan losses of $3,366,560
at March 31, 2009 and $3,359,946 at December 31, 2008			264,348,851		267,889,087
Cash value of life insurance			7,852,892		7,774,892
Foreclosed assets			2,746,654		2,659,266
Property and equipment, net			11,186,030		11,115,033
Accrued income			2,657,883		3,124,540
Other assets			3,716,740		3,765,204
		$	374,346,700	$	368,196,924
Liabilities and Stockholders’ Equity
Liabilities
Deposits
Noninterest-bearing		$	42,320,964	$	41,883,404
Interest-bearing			268,492,066		263,846,770
	Total deposits		310,813,030		305,730,174
Long-term debt			30,000,000		30,000,000
Accrued interest payable			925,486		492,105
Other liabilities			3,069,599		2,957,950
			344,808,115		339,180,229
Commitments and contingencies			-		-
Stockholders’ equity
Preferred stock, $25 par value; 500,000
shares authorized; none issued			-		-
Common stock, $1.25 par value; 2,000,000 shares
authorized; 1,718,968 shares issued and
outstanding			2,148,710		2,148,710
Surplus			521,625		521,625
Retained earnings			28,593,603		28,302,082
Accumulated other comprehensive loss			(1,725,353)		(1,955,722)
			29,538,585		29,016,695
		$	374,346,700	$	368,196,924

See Notes to Consolidated Financial Statements.

3

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Income

For the Three Months ended March 31, 2009 and 2008

				Three Months Ended
				March 31,
				2009		2008
Interest income:				(Unaudited)		(Unaudited)
	Loans and fees on loans		$	4,574,039	$	5,089,085
	Federal funds sold			10,633		173,453
	Investment securities:
		Taxable		435,022		354,338
		Exempt from federal income tax		111,079		122,640
				5,130,773		5,739,516
Interest expense:
	Deposits			2,027,201		2,634,434
	Interest on borrowings			310,899		213,000
				2,338,100		2,847,434
		Net interest income		2,792,673		2,892,082
Provision for loan losses				134,834		75,000
	Net interest income after
		provision for loan losses		2,657,839		2,817,082
Noninterest income:
	Service charges on deposit accounts			209,150		217,524
	Increase in cash value of life insurance			78,000		81,000
	Net realized gains (losses) on securities			25,467		15,847
	Other income			160,815		168,057
				473,432		482,428
Noninterest expense:
	Salaries and employee benefits			1,641,713		1,432,077
	Occupancy expense			120,215		88,707
	Equipment expense			206,937		210,962
	Other expense			531,988		605,464
				2,500,853		2,337,210
		Income before income taxes		630,418		962,300
Income tax expense				167,000		271,000
	Net income		$	463,418	$	691,300
Basic earnings per share			$	0.27	$	0.40
Weighted average shares outstanding				1,718,968		1,718,968
Dividends declared per share			$	0.10	$	0.21

See Notes to Consolidated Financial Statements.

4

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Changes in Stockholders’ Equity

For the Three Months ended March 31, 2009 (unaudited) and the Year ended December 31, 2008 (audited)

											Accumulated
											Other
			Common Stock						Retained		Comprehensive
			Shares		Amount		Surplus		Earnings		Income (Loss)		Total
Balance, December 31, 2007			1,718,968	$	2,148,710	$	521,625	$	29,026,036	$	(1,405,498)	$	30,290,873
Comprehensive income
	Net income		-		-		-		754,359		-		754,359
	Net change in pension reserve
		net of income taxes of ($569,949)	-		-		-		-		(1,106,372)		(1,106,372)
	Net change in unrealized
	gain (loss) on investment
	securities available for
	sale, net of taxes of $845,135		-		-		-		-		1,640,558		1,640,558
	Reclassification adjustment,
	net of income taxes of ($558,636)		-	-		-		-			(1,084,410)		(1,084,410)
Total comprehensive income													204,135
	Dividends paid
	($.86 per share)		-		-		-		(1,478,313)		-		(1,478,313)
Balance, December 31, 2008			1,718,968	$	2,148,710	$	521,625	$	28,302,082	$	(1,955,722)	$	29,016,695
Comprehensive income
	Net income		-		-		-		463,418		-		463,418
	Net change in unrealized
	gain (loss) on investment
	securities available for
	sale, net of taxes of $127,334		-		-		-		-		247,177		247,177
	Reclassification adjustment,
	net of income taxes of ($8,659)		-		-		-		-		(16,808)		(16,808)
Total comprehensive income													693,787
	Dividends paid
	($.10 per share)		-		-		-		(171,897)		-		(171,897)
Balance, March 31, 2009			1,718,968	$	2,148,710	$	521,625	$	28,593,603	$	(1,725,353)	$	29,538,585

See Notes to Consolidated Financial Statements.

5

Grayson Bankshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

For the Three Months ended March 31, 2009 and 2008

						Three Months Ended
						March 31,
						2009		2008
						(Unaudited)		(Unaudited)
Cash flows from operating activities:
	Net income				$	463,418	$	691,300
	Adjustments to reconcile net income
		to net cash provided by operations:
			Depreciation and amortization			205,500		193,500
			Provision for loan losses			134,834		75,000
			Deferred income taxes			(48,000)		302,000
			Net realized (gains) losses on securities			(25,467)		(15,847)
			Accretion of discount on securities, net of
				amortization of premiums		15,297		(10,894)
			Deferred compensation			(2,845)		(11,842)
			Changes in assets and liabilities:
				Cash value of life insurance		(78,000)		(81,000)
				Accrued income		466,657		(40,656)
				Other assets		(22,213)		(113,872)
				Accrued interest payable		433,381		459,145
				Other liabilities		114,494		(889,178)
			Net cash provided by operating activities			1,657,056		557,656
Cash flows from investing activities:
	Net (increase) decrease in federal funds sold					(9,899,232)		219,900
	Purchases of investment securities					(11,048,603)		(15,538,660)
	Maturities and calls of investment securities					10,270,704		16,780,756
	Sales of investment securities					2,877,961		-
	Net decrease in loans					3,318,014		452,925
	Purchases of bank-owned life insurance					-		(2,000,000)
	Purchases of property and equipment, net of sales					(276,497)		(415,268)
		Net cash used in investing activities				(4,757,653)		(500,347)
Cash flows from financing activities:
	Net increase in deposits					5,082,856		725,421
	Dividends paid					(171,897)		(360,983)
			Net cash provided by financing activities			4,910,959		364,438
			Net increase in cash and cash equivalents			1,810,362		421,747
Cash and cash equivalents, beginning						9,536,772		10,746,139
Cash and cash equivalents, ending					$	11,347,134	$	11,167,886
Supplemental disclosure of cash flow information:
	Interest paid				$	1,904,719	$	2,388,289
	Taxes paid				$	190,000	$	-
Supplemental disclosure of noncash investing activities:
	Transfers of loans to foreclosed properties				$	87,388	$	75,000

See Notes to Consolidated Financial Statements.

6

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies

Organization

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”) in a bank holding company reorganization. The Bank was acquired by the Company on July 1, 1992.

The Bank was organized under the laws of the United States in 1900 and currently serves Grayson County, Virginia and surrounding areas through nine banking offices. As an FDIC-insured National Banking Association, the Bank is subject to regulation by the Comptroller of the Currency. The Company is regulated by the Board of Governors of the Federal Reserve System.

The consolidated financial statements as of March 31, 2009 and for the periods ended March 31, 2009 and 2008 included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the information furnished in the interim consolidated financial statements reflects all adjustments necessary to present fairly the Company’s consolidated financial position, results of operations, changes in stockholders’ equity and cash flows for such interim periods. Management believes that all interim period adjustments are of a normal recurring nature. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and the notes thereto as of December 31, 2008, included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008. The results of operations for the three-month period ended March 31, 2009 are not necessarily indicative of the results to be expected for the full year.

The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and the Bank, which is wholly owned. All significant intercompany transactions and balances have been eliminated in consolidation.

Recent Accounting Pronouncements

In February 2008, the FASB issued Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157. This FSP delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. The Company adopted the provisions of SFAS 157 for financial assets and liabilities effective January 1, 2008 and for nonfinancial assets and nonfinancial liabilities effective January 1, 2009. Refer to Note 7 for additional disclosures.

In October 2008, the FASB issued Staff Position (FSP) 157-3, Determining the Fair Value of a Financial Asset when the Market for That Asset Is Not Active. This FSP clarifies the application of SFAS No. 157 in a market that is not active. The impact of adoption was not material.

In April 2009, the FASB issued FASB Staff Position No. 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments,” (“FSP FAS 115-2 and 124-2”). FSP FAS 115-2 and 124-2 creates a new model for evaluating other-than-temporary impairment on debt securities. If an entity intends to sell a debt security, or cannot assert it is more likely than not that it will not have to sell the security before recovery, OTTI must be taken. If the entity does not intend to sell the debt security before recovery, but the entity does not expect to recover the entire amortized cost basis, then OTTI must be taken, but the amount of impairment is to be bifurcated between impairment due to credit (which is recorded through earnings) and noncredit impairment (which becomes a component of other comprehensive income (“OCI”) for both available-for-sale (“AFS”) and held-to-maturity securities (“HTM”)). For HTM securities, the amount in OCI will be amortized prospectively over the security’s remaining life. Upon adoption, a cumulative effect adjustment must be made to opening retained earnings in the

7

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

period adopted that reclassifies the noncredit portion of previously taken OTTI from retained earnings to accumulated OCI. This FSP also requires that annual disclosures required by SFAS 115 be presented in interim financial statements, and new disclosures are also required. FSP FAS 115-2 and 124-2 is effective for periods ending after June 15, 2009, with earlier adoption permitted. The Company has assessed the impact of adoption of FSP FAS 115-2 and 124-2 and does not expect a material effect on its financial position and results of operations.

In April 2009, the FASB issued FASB Staff Position No. 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments,” (“FSP FAS 107-1 and APB 28-1”). FSP FAS 107-1 and APB 28-1 requires companies to disclose the fair value of financial instruments within interim financial statements, adding to the current requirement to provide those disclosures annually. Since FSP FAS 107-1 and APB 28-1 addresses financial statement disclosure only, its adoption, effective June 30, 2009 will not impact the Company’s consolidated financial position of results of operations.

FSP SFAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly” recognizes that quoted prices may not be determinative of fair value when the volume and level of trading activity have significantly decreased. The evaluation of certain factors may necessitate that fair value be determined using a different valuation technique. Fair value should be the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction, not a forced liquidation or distressed sale. If a transaction is considered to not be orderly, little, if any, weight should be placed on the transaction price. If there is not sufficient information to conclude as to whether or not the transaction is orderly, the transaction price should be considered when estimating fair value. Quoted prices provided by pricing services may still be used when estimating fair value in accordance with SFAS 157; however, the entity should evaluate whether the quoted prices are based on current information and orderly transactions. Inputs and valuation techniques are required to be disclosed in addition to any changes in valuation techniques.

The Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 111 on April 9, 2009 to amend Topic 5.M., “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities” and to supplement FSP SFAS 115-2 and SFAS 124-2. SAB 111 maintains the staff’s previous views related to equity securities; however debt securities are excluded from its scope. The SAB provides that “other-than-temporary” impairment is not necessarily the same as “permanent” impairment and unless evidence exists to support a value equal to or greater than the carrying value of the equity security investment, a write-down to fair value should be recorded and accounted for as a realized loss. The SAB was effective upon issuance and had no impact on the Company’s financial position.

Note 2. Restrictions on Cash

To comply with banking regulations, the Bank is required to maintain certain average cash reserve balances. The daily average cash reserve requirement was approximately $2,695,000 and $2,413,000 for the periods including March 31, 2009 and December 31, 2008, respectively.

Note 3. Allowance for Loan Losses

The following is an analysis of the allowance for loan losses for the three months ended March 31, 2009 and 2008.

		2009		2008
Balance, beginning	$	3,359,946	$	2,757,745
Provision charged to expense		134,834		75,000
Recoveries of amounts charged off		7,546		22,962
Amounts charged off		(135,766)		(97,571)
Balance, ending	$	3,366,560	$	2,758,136

8

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 4. Income Taxes

A reconciliation of income tax expense computed at the statutory federal income tax rate to income tax expense included in the statements of income for the three months ended March 31, 2009 and 2008 follows:

		2009		2008
Tax at statutory federal rate	$	214,342	$	327,182
Tax exempt interest income		(39,625)		(47,089)
Other tax exempt income		(26,520)		(31,225)
Other		18,803		22,132
	$	167,000	$	271,000

Note 5. Employee Benefit Plan

The Bank has a qualified noncontributory defined benefit pension plan that covers substantially all of its employees. The benefits are primarily based on years of service and earnings. The following is a summary of net periodic pension costs for the three-month periods ended March 31, 2009 and 2008.

		2009		2008
Service cost	$	97,769	$	97,895
Interest cost		95,369		91,974
Expected return on plan assets		(89,534)		(110,609)
Amortization of net obligation at transition		(5)		(9)
Amortization of prior service cost		2,695		2,516
Amortization of net (gain) or loss		36,101		12,932
Net periodic benefit cost	$	142,395	$	94,699

Note 6. Commitments and Contingencies

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 March 31, 2009 and 2008 is as follows:

		2009		2008
Commitments to extend credit	$	18,771,928	$	19,366,161
Standby letters of credit		-		-
	$	18,771,928	$	19,366,161

Commitments to extend credit are agreements to lend to a customer, at a fixed or variable interest rate, 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 extension of credit, is based on management’s credit evaluation of the party.

9

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 6. Commitments and Contingencies, continued

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 that the Bank deems necessary.

Note 7. Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale, and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as foreclosed assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under SFAS 157, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include the use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

10

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 7. Fair Value, continued

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan”. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2009, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

Derivative Assets and Liabilities

Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. Management engages third-party intermediaries to determine the fair market value of these derivative instruments and classifies these instruments as Level 2. Examples of Level 2 derivatives are interest rate swaps, caps and floors. No derivative instruments were held as of March 31, 2009, or December 31, 2008.

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

11

Grayson Bankshares, Inc. and Subsidiary

Notes to Consolidated Financial Statements

Note 7. Fair Value, continued

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

March 31, 2009			Total		Level 1		Level 2		Level 3
	Investment securities available for sale	$	44,666,107	$	-	$	44,666,107	$	-
	Derivative assets		-		-		-		-
	Total assets at fair value	$	44,666,107	$	-	$	44,666,107	$	-
	Derivative liabilities		-		-		-		-
	Total liabilities at fair value	$	-	$	-	$	-	$	-
December 31, 2008			Total		Level 1		Level 2		Level 3
	Investment securities available for sale	$	46,413,054	$	-	$	46,413,054	$	-
	Derivative assets		-		-		-		-
	Total assets at fair value	$	46,413,054	$	-	$	46,413,054	$	-
	Derivative liabilities		-		-		-		-
	Total liabilities at fair value	$	-	$	-	$	-	$	-

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

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

March 31, 2009			Total		Level 1		Level 2		Level 3
	Loans	$	813,032	$	-	$	813,032	$	-
	Foreclosed assets		2,746,654		-		2,746,654		-
	Total assets at fair value	$	3,559,686	$	-	$	3,559,686	$	-
	Total liabilities at fair value	$	-	$	-	$	-	$	-
December 31, 2008			Total		Level 1		Level 2		Level 3
	Loans	$	494,024	$	-	$	494,024	$	-
	Foreclosed assets		2,659,266		-		2,659,266		-
	Total assets at fair value	$	3,153,290	$	-	$	3,153,290	$	-
	Total liabilities at fair value	$	-	$	-	$	-	S	-

12

Part I. Financial Information

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

General

The following discussion provides information about the major components of the results of operations and financial condition of the Company. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in this report.

Critical Accounting Policies

For a discussion of the Company’s critical accounting policies, including its allowance for loan losses, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

Results of Operations

Total interest income decreased by $608,743, or 10.61% for the quarter ended March 31, 2009 compared to the quarter ended March 31, 2008, while interest expense on deposits and other borrowings decreased by $509,334, or 17.89% over the same period. The decrease in interest income was attributable primarily to reductions in interest rates over the past year, thus leading to decreases in federal funds interest as well as interest on loans indexed to the prime lending rate. Federal funds rates averaged just over 3.00% in the first quarter of 2008, compared to a range of zero to 0.25% for the first quarter of 2009. Interest income on investment securities increased due to an increase in total investment securities in the first quarter of 2009 as compared to the same period last year. Interest expense on deposits decreased by $607,233 because of the aforementioned decrease in interest rates. Interest expense on borrowings increased by $97,899 due to increased borrowings outstanding at March 31, 2009 compared to March 31, 2008. The result was a decrease in net interest income of $99,409 or 3.44% in the first quarter of 2009 compared to the same period last year.

The provision for loan losses was $134,834 for the quarter ended March 31, 2009 and $75,000 for the same period in 2008. The increase was due primarily to increased charge-offs in the first quarter of 2009 as compared to the same quarter in 2008. The reserve for loan losses at March 31, 2009 was approximately 1.26% of total loans compared to 1.04% at March 31, 2008. Management believes the provision and the resulting allowance for loan losses are adequate.

Noninterest income was $473,732 in the first quarter of 2009 compared to $482,428 in the first quarter of 2008. There were no significant variances noted in noninterest income accounts in the quarter ended March 31, 2009, as compared to the same quarter in 2008. Service charges on deposit accounts decreased slightly, as did mortgage origination fees, while realized gains on securities increased during the period.

Noninterest expenses increased by $163,643, or 7.00%, for the quarter ended March 31, 2009 compared to the quarter ended March 31, 2008. The increase came as a result of normal increases in salaries, benefits and other operating expenses, as well as an increase in FDIC and OCC assessments.

The decreases in net interest margin and noninterest income combined with the increase in noninterest expenses led to a decrease in net income before taxes of $331,882, for the quarter ended March 31, 2009, compared to the same quarter in 2008. Income tax expense decreased accordingly from $271,000 for the first quarter of 2008 to $167,000 for the first quarter of 2009 resulting in a decrease in net income of $227,882, to $463,418, for the quarter compared to $691,300 for the same period last year.

13

Part I. Financial Information

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

Financial Condition

Total assets increased by $6,149,776, or 1.67%, from December 31, 2008 to March 31, 2009. Net loans decreased by $3,540,236, federal funds sold increased by $9,899,232 and investment securities decreased by $1,740,846. The increase in federal funds sold came as a result of deposit growth combined with slowing loan demand.

Total deposits increased by $5,082,856, or 1.66%, from December 31, 2008 to March 31, 2009. The deposit growth came despite continued decreases in deposit rates as most market competitors implemented similar rate decreases.

Stockholders’ equity totaled $29,538,585 at March 31, 2009 compared to $29,016,695 at December 31, 2008. The $521,890 increase was the result of earnings for the three months combined with an increase in the market value of securities classified as available for sale of $230,369, less the payment of dividends of $171,897.

Regulatory guidelines relating to capital adequacy provide minimum risk-based ratios at the Bank level which assess capital adequacy while encompassing all credit risks, including those related to off-balance sheet activities. The Bank exceeds all regulatory capital guidelines and is considered to be well-capitalized.

Liquidity and Capital Resources

Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss.Unsecured federal fund lines available from correspondent banks totaled $14,000,000 at March 31, 2009. No balances were outstanding on these lines at March 31, 2009 or December 31, 2008. Long-term debt consists of borrowings from the Federal Home Loan Bank and Deutsche Bank. Borrowings from the Federal Home Loan Bank, which are secured by a blanket collateral agreement on the Bank’s 1 to 4 family residential real estate loans, totaled $20,000,000 at March 31, 2009 and December 31, 2008. Borrowings from Deutsche Bank, which are secured by the pledging of specific investment securities, totaled $10,000,000 at each of March 31, 2009, and December 31, 2008. The unused credit line from the Federal Home Loan Bank as of March 31, 2009 is approximately $46,900,000.

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 Bank’s investment security portfolio also serves as a source of liquidity. 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 portion of its investment portfolio in unpledged assets that are less than 24 months to maturity. 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.

As a result of the steps described above, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

14

Part I. Financial Information

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

Forward-Looking Statements

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. For additional information on known and unknown risks, see the “Forward Looking Statements” section in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

15

Part I. Financial Information

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Not applicable to smaller reporting companies.

16

Part I. Financial Information

Item 4. 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 and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that evaluation, the Company’s President and Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiary) required to be included in its periodic filings with the Securities and Exchange Commission.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

��

17

Part II. Other Information

Item 1. Legal Proceedings

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

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

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

None

Item 5. Other Information

None

Item 6. Exhibits

31.1 Rule 13(a)-14(a) Certification of Chief Executive Officer.

31.2 Rule 13(a)-14(a) Certification of Chief Financial Officer.

32.1 Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.

Section 1350.

18

SIGNATURES

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

GRAYSON BANKSHARES, INC.

Date: May 15, 2009 By: /s/ Jacky K. Anderson

Jacky K. Anderson

President and Chief Executive Officer

By: /s/ Blake M. Edwards

Blake M. Edwards

Chief Financial Officer

19

Exhibit Index

Exhibit No. Description

31.1 Rule 13(a)-14(a) Certification of Chief Executive Officer.

31.2 Rule 13(a)-14(a) Certification of Chief Financial Officer.

32.1 Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.

Section 1350.