Southern Financial Bancorp (SFFB) 10-Q 2003 Q2 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15 (d)

of the Securities Exchange Act of 1934

For the Quarter Ended:	Commission File No.:
June 30, 2003	0-22836
SOUTHERN FINANCIAL BANCORP, INC.

Virginia	54-1779978
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification Number)
37 East Main Street
Warrenton, Virginia	20186
(address of principal executive office)	(Zip Code)

Registrant’s Telephone Number, including area code: (540) 349-3900

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  x        NO  ¨

As of July 22, 2003, there were 5,513,264 shares of the registrant’s Common Stock outstanding.

SOUTHERN FINANCIAL BANCORP, INC.

QUARTERLY REPORT ON FORM 10-Q

June 30, 2003

TABLE OF CONTENTS

	Page Number
PART I.    FINANCIAL INFORMATION
Item 1.    Financial Statements
Consolidated Balance Sheets as of June 30, 2003 (Unaudited) and December 31, 2002	3
Consolidated Statements of Income for the Three and Six Months Ended June 30, 2003 and 2002 (Unaudited)	4
Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2003 and 2002 (Unaudited)	5
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2003 and 2002 (Unaudited)	6
Notes to Consolidated Financial Statements (Unaudited)	7 - 13
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations	14 - 19
Item 3.    Quantitative and Qualitative Disclosures about Market Risk	19 - 20
Item 4.    Controls and Procedures	20
PART II.    OTHER INFORMATION
Item 1.    Legal Proceedings	21
Item 2.    Changes in Securities	21
Item 3.    Defaults upon Senior Securities	21
Item 4.    Submission of Matters to a Vote of Security Holders	21
Item 5.    Other Information	21
Item 6.    Exhibits and Reports on Form 8-K	21
PART III.    SIGNATURES	22
CERTIFICATIONS	23 - 25

2

SOUTHERN FINANCIAL BANCORP, INC.

FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

	June 30,
	2003			December 31,
	(Unaudited)			2002
Assets
Cash and due from banks	$	31,133		$	28,705
Overnight earning deposits		72,004			64,693
Investment securities—available for sale		162,408			203,563
Investment securities—held to maturity		129,943			—
Loans held for sale		12,670			514
Loans receivable, net		623,388			594,323
Cash surrender value of life insurance		22,898			22,287
Premises and equipment, net		9,257			8,264
Intangible assets, net		14,327			14,558
Other assets		27,347			33,320
Total assets	$	1,105,375		$	970,227
Liabilities and Stockholders’ Equity
Liabilities
Deposits	$	856,978		$	776,083
Advances from Federal Home Loan Bank—short term		3,000			—
Advances from Federal Home Loan Bank—long term		89,701			65,000
Company-obligated mandatorily redeemable securities of subsidiary holding solely parent debentures		23,000			13,000
Securities sold under agreements to repurchase		29,569			18,456
Other liabilities		18,115			16,385
Total liabilities		1,020,363			888,924
Stockholders’ equity
Preferred stock		—			—
Common stock		55			54
Capital in excess of par		81,714			81,167
Retained earnings		3,899			—
Accumulated other comprehensive income (loss)		(656	)		82
Total stockholders’ equity		85,012			81,303
Total liabilities and stockholders’ equity	$	1,105,375		$	970,227

The accompanying notes are an integral part of these consolidated financial statements.

3

SOUTHERN FINANCIAL BANCORP, INC.

FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands)

	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2003			2002		2003			2002
Interest Income
Loans	$	10,239		$	8,355	$	20,300		$	16,391
Investment securities		2,949			3,940		5,821			8,725
Total interest income		13,188			12,295		26,121			25,116
Interest Expense
Deposits		2,589			3,324		5,272			7,042
Borrowings		1,091			719		1,938			1,692
Total interest expense		3,680			4,043		7,210			8,734
Net interest income		9,508			8,252		18,911			16,382
Provision for loan losses		1,105			1,560		2,320			3,060
Net interest income after provision for loan losses		8,403			6,692		16,591			13,322
Other Income
Account maintenance and electronic banking fees		791			641		1,567			1,285
Commercial service fees		181			125		350			241
Other loan fees		120			113		252			208
System maintenance and license fees		55			59		109			133
Income from bank owned life insurance		279			294		611			542
Gain on sale of loans		414			147		712			247
Gain (loss) on investment securities, net		(40	)		83		(936	)		(302	)
Other		246			1		286			3
Total other income		2,046			1,463		2,951			2,357
Other Expense
Employee compensation and benefits		2,874			2,373		5,747			4,725
Premises, equipment and data processing		1,527			1,242		3,011			2,464
Other		979			718		1,816			1,399
Total other expense		5,380			4,333		10,574			8,588
Income before income taxes		5,069			3,822		8,968			7,091
Provision for income taxes		1,621			1,214		2,812			2,255
Net income	$	3,448		$	2,608	$	6,156		$	4,836
Earnings per common share:
Basic	$	0.63		$	0.53	$	1.13		$	0.98
Diluted		0.60			0.50		1.08			0.94
Dividends declared per common share		0.13			0.10		0.28			0.21
Weighted average shares outstanding:
Basic		5,439,575			4,931,166		5,432,175			4,929,235
Diluted		5,713,366			5,182,823		5,692,718			5,157,989

The accompanying notes are an integral part of these consolidated financial statements.

4

SOUTHERN FINANCIAL BANCORP, INC.

FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2003			2002			2003			2002
Net income	$	3,448		$	2,608		$	6,156		$	4,836
Other comprehensive income:
Cash flow hedge:
Unrealized holding loss		(184	)		(636	)		(274	)		(591	)
Reclassification adjustment for net interest expense included in net income		201			170			395			338
Available-for-sale securities:
Unrealized holding gain (loss)		392			1,761			(2,192	)		(1,132	)
Reclassification adjustment for net (gains) losses included in net income		40			(83	)		936			302
Other comprehensive income (loss) before tax		449			1,212			(1,135	)		(1,083	)
Income tax expense (benefit) related to items of other comprehensive income		157			424			(397	)		(379	)
Other comprehensive income (loss), net of tax		292			788			(738	)		(704	)
Comprehensive income	$	3,740		$	3,396		$	5,418		$	4,132

The accompanying notes are an integral part of these consolidated financial statements.

5

SOUTHERN FINANCIAL BANCORP, INC.

FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

	Six Months Ended
	June 30,
	2003			2002
Cash flows from operating activities:
Net Income	$	6,156		$	4,837
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		749			765
Amortization of discounts or premiums on investment securities and loans, net		1,885			2,343
Provision for loan losses		2,320			3,060
Gain on sale of loans		(712	)		(247	)
Loss on sale of securities		936			302
Accretion of deferred loan fees		(921	)		(641	)
Loans originated—held for sale		(7,494	)		(4,461	)
Loans sold—held for sale		11,733			4,545
(Increase) decrease in other assets		4,601			(4,042	)
Increase (decrease) in other liabilities		1,604			(8,455	)
Net cash provided by (used in) operating activities		20,857			(1,994	)
Cash flows from investing activities:
Increase in loans receivable		(45,624	)		(88,384	)
Purchase of investment securities, available-for-sale		(77,664	)		(130,531	)
Purchase of investment securities, held-to-maturity		(132,972	)		—
Sale of investment securities, available-for-sale		56,263			106,358
Paydowns of investment securities, available-for-sale		60,253			91,879
Paydowns of investment securities, held-to-maturity		2,950			—
Purchase of bank owned life insurance		—			(5,000	)
Increase in premises and equipment, net		(1,713	)		(482	)
Increase in other equity securities		(1,636	)		(375	)
Net cash used in investing activities		(140,143	)		(26,535	)
Cash flows from financing activities:
Net increase in deposits		81,061			13,937
Increase in advances from FHLB—short term		3,000			19,500
Increase in advances from FHLB—long term		25,000			—
Proceeds from Company-obligated mandatorily redeemable securities of subsidiary holding solely parent debentures		10,000			—
Increase in securities sold under agreements to repurchase		11,113			—
Proceeds from issuance of common stock		383			8
Dividends on preferred and common stock		(1,532	)		(1,041	)
Net cash provided by financing activities		129,025			32,404
Net increase in cash and cash equivalents		9,739			3,875
Cash and cash equivalents, beginning of period		93,398			28,459
Cash and cash equivalents, end of period	$	103,137		$	32,334
SUPPLEMENTAL DATA
Cash payments for interest on deposits and borrowings, net of cash payments on interest rate swaps	$	(2,575	)	$	520
Cash payments for income taxes	$	—		$	4,430

The accompanying notes are an integral part of these consolidated financial statements.

6

SOUTHERN FINANCIAL BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1—ORGANIZATION AND BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q, and, therefore, do not include all information or footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. However, all adjustments which are, in the opinion of management, necessary for a fair presentation have been included. All adjustments are of a normal recurring nature. The results of operations for the three and six-month periods ended June 30, 2003 are not necessarily indicative of the results of the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes included in Southern Financial Bancorp, Inc.’s (“Southern Financial”) Annual Report and Form 10-K for the year ended December 31, 2002.

STOCK-BASED COMPENSATION

Southern Financial adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation” and Statement of Financial Accounting Standards No. 148 (SFAS No. 148), “Accounting for Stock-Based Compensation—Transition and Disclosure.” These statements allow an entity to continue to measure compensation cost for these plans using the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (APB No.25), “Accounting for Stock Issued to Employees.” Southern Financial has elected to follow APB No. 25 and related interpretations in accounting for its employee stock options.

Pro forma information regarding net income and earnings per share as required by SFAS No. 123 and SFAS No. 148 has been determined as if Southern Financial had accounted for its employee stock options under the fair value method. The fair value of all currently outstanding options was estimated at the date of the grant using a Black-Scholes option pricing model. Pro forma results are presented in the following table:

	For the three months ended						For the six months ended
	June 30,						June 30,
(in thousands, except per share data)	2003			2002			2003			2002
Net income:
As reported	$	3,448		$	2,608		$	6,156		$	4,837
Deduct:  Total stock-based employee compensation expense determined under fair value based method for all awards granted, net of related tax effects		(146	)		(178	)		(244	)		(280	)
Pro forma net income	$	3,302		$	2,430		$	5,912		$	4,557
Basic earnings per share:
As reported		0.63			0.53			1.13			0.98
Pro forma		0.61			0.49			1.09			0.92
Diluted earnings per share:
As reported		0.60			0.50			1.08			0.94
Pro forma		0.58			0.47			1.04			0.88

7

NOTE 2—INVESTMENT SECURITIES

The following table sets forth the investment securities portfolio as of the dates indicated:

	June 30, 2003				December 31, 2002
	Amortized		Estimated		Amortized		Estimated
	Cost		Fair Value		Cost		Fair Value
			(dollars in thousands)
Available-for-sale securities:
Mortgage-backed securities	$	68,053	$	68,550	$	74,340	$	74,892
Collateralized mortgage obligations		34,678		34,341		83,073		83,860
Obligations of counties and municipalities		9,902		10,000		9,900		10,000
Corporate obligations		42,030		41,336		28,046		26,997
U.S. Treasury and agency securities		999		1,013		2,258		2,282
Federal Home Loan Bank stock		4,650		4,650		3,500		3,500
Federal Reserve Bank stock		2,034		2,034		1,537		1,537
Other equity securities		484		484		495		495
Total classified as investment securities		162,830		162,408		203,149		203,563
Debt obligations classified as loans		24,289		25,044		31,567		32,543
	$	187,119	$	187,452	$	234,716	$	236,106
Held-to-maturity securities:
Mortgage-backed securities	$	69,534	$	70,101	$	—	$	—
Collateralized mortgage obligations		57,391		58,440		—		—
Corporate obligations		3,018		3,074		—		—
	$	129,943	$	131,615	$	—	$	—

NOTE 3—DERIVATIVE FINANCIAL INSTRUMENTS

As part of our interest rate risk management, we make extensive use of interest rate swaps. Some of them are accounted for as cash flow hedges and some are accounted for as fair value hedges in accordance with SFAS 133. Cash flow hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities.

We use interest rate swaps that are accounted for as cash flow hedges to hedge the interest rate risk associated with pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce long-term rate deposits. Changes in the fair value of cash flow hedges are accounted for in other comprehensive income.

We also use interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is tied to three-month LIBOR. The combination of the swaps and the issuance of individual CDs operates to produce long-term floating rate deposits. The terms of the CDs and the interest rate swaps mirror each other and were committed simultaneously. Changes in the fair value of the fair value hedges are accounted for in the income statement, as are changes in the fair value of the certificates of deposit.

We also use interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the Federal Home Loan Bank of Atlanta (FHLB). Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is equal to three-month LIBOR. The combination of the swaps and the borrowing from FHLB operates to produce long-term fixed rate borrowings. The terms of the borrowings and the interest rate swaps mirror each other and were committed simultaneously. Changes in the fair value of the fair value hedges are accounted for in the income statement, as are changes in the fair value of the borrowings.

8

During the quarter ended June 30, 2003, we entered into interest rate swap agreements totaling $72.5 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. During the quarter ended June 30, 2003, ten interest rate swaps with a notional amount of $75 million were terminated with no resulting gain or loss.

During the six months ended June 30, 2003, we entered into interest rate swap agreements totaling $172.5 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. We also entered into an interest rate swap agreement totaling $25 million in connection with a $25 million borrowing from the FHLB. This interest rate swap agreement is also accounted for as a fair value hedge. During the six months ended June 30, 2003, 19 interest rate swaps with a notional amount of $142.5 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of June 30, 2003 had a notional amount of $342.5 million and an estimated fair value of $3.9 million. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of $(1.2) million. Interest rate swaps accounted for as fair value hedges had a notional amount of $322.5 million and an estimated fair value of $5.1 million.

During the quarter ended June 30, 2002, we entered into interest rate swap agreements totaling $90 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. During the quarter ended June 30, 2002, two interest rate swaps with a notional amount of $20 million were terminated with no resulting gain or loss.

During the six months ended June 30, 2002, we entered into interest rate swap agreements totaling $172.5 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. During the six months ended June 30, 2002, four interest rate swaps with a notional amount of $40 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of June 30, 2002 had a notional amount of $297.5 million and an estimated fair value of $1.7 million. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of ($888) thousand. Interest rate swaps accounted for as fair value hedges had a notional amount of $277.5 million and an estimated fair value of $2.6 million.

NOTE 4—LOANS RECEIVABLE

Loans receivable consist of the following:

	June 30,		December 31,
	2003		2002
	(dollars in thousands)
Construction and land development
Residential	$	50,727	$	40,575
Commercial		58,084		42,052
Mortgage
Residential		64,310		77,697
Multifamily Residential		8,685		9,438
Commercial		282,376		253,958
Commercial and Industrial		163,960		170,776
Consumer		9,139		12,889
Total loans receivable		637,281		607,385
Less:
Deferred loan fees, net		3,226		2,805
Allowance for loan losses		10,667		10,257
Loans receivable, net	$	623,388	$	594,323

Debt obligations in the amount of $25 million are classified as commercial and industrial loans in the table above as of June 30, 2003. Debt obligations in the amount of $32.5 million are classified as commercial and industrial loans as of December 31, 2002.

9

The following sets forth information regarding the allowance for loan losses:

	Six Months			Six Months
	Ended			Ended
	06/30/2003			06/30/2002
	(dollars in thousands)
Allowance at beginning of period	$	10,257		$	7,354
Provision for losses charged to income		2,320			3,060
Charge-offs		(3,026	)		(2,445	)
Recoveries		1,116			654
Allowance at end of period	$	10,667		$	8,623

The following table sets forth information regarding past due and nonperforming assets as of the periods indicated:

	At June 30,		At December 31,
	2003		2002
	(dollars in thousands)
Accruing loans 90 days or more delinquent:
Commercial and industrial	$	—	$	154
Nonperforming loans:
Mortgage-residential		—		158
Mortgage-commercial		249		874
Commercial and industrial (1)		4,044		1,239
Subtotal		4,293		2,271
Other real estate owned		—		—
Total nonperforming assets	$	4,293	$	2,271
Nonperforming assets to total assets		0.39%		0.23%
Nonperforming assets to total loans and other real estate owned		0.67%		0.37%

(1) Includes $1.7 million and $822 thousand of loans guaranteed by the Small Business Administration (SBA) at June 30, 2003 and December 31, 2002 respectively.

10

NOTE 5—EARNINGS PER SHARE

The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of potential dilutive common stock:

	For the three months ended
	June 30, 2003						June 30, 2002
	(Dollars in thousands, except per share amounts)
	Amount			Shares	Per Share Amount		Amount			Shares	Per Share Amount
Net income	$	3,448					$	2,608
Preferred dividends		(1	)					(3	)
Basic earnings per share	$	3,447		5,439,575	$	0.63	$	2,605		4,931,166	$	0.53
Effect of dilutive securities:
Stock options				265,781						223,859
Convertible preferred stock				8,010						27,799
Diluted earnings per share	$	3,448		5,713,366	$	0.60	$	2,608		5,182,823	$	0.50
	For the six months ended
	June 30, 2003						June 30, 2002
	(Dollars in thousands, except per share amounts)
	Net Income			Shares	Per Share Amount		Net Income			Shares	Per Share Amount
Net income	$	6,156					$	4,837
Preferred dividends		(4	)					(6	)
Basic earnings per share	$	6,152		5,432,175	$	1.13	$	4,831		4,929,235	$	0.98
Effect of dilutive securities:
Stock options				252,533						200,956
Convertible preferred stock				8,010						27,799
Diluted earnings per share	$	6,156		5,692,718	$	1.08	$	4,837		5,157,989	$	0.94

NOTE 6—INTANGIBLE ASSETS

Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” (SFAS No. 142) was issued in June 2001. It discontinues amortization of intangible assets unless they have finite useful lives, and, instead, requires that they be tested at least annually for impairment by comparing their fair values with their recorded amounts. SFAS No. 142 also requires disclosure of the changes in the carrying amounts of goodwill from period to period, the carrying amounts of intangible assets by major intangible asset class for those subject to and not subject to amortization, and the estimated intangible asset amortization expense for the next five years. We adopted SFAS No. 142 as of January 1, 2002, and therefore, discontinued the amortization of goodwill on January 1, 2002. During 2002, we evaluated impairment of goodwill under SFAS No. 142, and we determined there was no impairment of the goodwill.

During the quarter ended March 31, 2003, a third party completed valuation reports related to the acquisition of the loan portfolio and the core deposits resulting from the merger with Metro-County Bank of Virginia in the third quarter of 2002. Certain adjustments were made to goodwill and core deposit intangible assets based on these valuation reports, and the effect on amortization expense was not material.

11

Data concerning various intangible assets is presented in the following tables:

	June 30, 2003					December 31, 2002					June 30, 2002
(dollars in thousands)	Gross Carrying Value		Accumulated Amortization			Gross Carrying Value		Accumulated Amortization			Gross Carrying Value		Accumulated Amortization
Amortizable core deposit intangibles	$	2,996	$	(596	)	$	3,966	$	(447	)	$	1,566	$	(288	)
Amortizable other intangibles		361		(230	)		361		(219	)		361		(185	)
Unamortizable goodwill		11,941		(145	)		11,042		(145	)		1,587		(145	)

			Core Deposit
Amortization expense: (dollars in thousands)	Other		Intangibles
Three months ended June 30, 2003	$	5	$	75
Three months ended June 30, 2002		17		39
Six months ended June 30, 2003		10		150
Six months ended June 30, 2002		34		79
			Core Deposit
Estimated amortization expense: (dollars in thousands)	Other		Intangibles
Six months ended December 31, 2003	$	10	$	150
Year ended December 31,
2004	$	20	$	300
2005		20		300
2006		20		300
2007		20		300
2008		20		300

NOTE 7—LETTERS OF CREDIT

The Bank issues financial standby letters of credit and performance standby letters of credit. A financial standby letter of credit obligates the Bank to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument. A performance standby letter of credit obligates the Bank to pay a third-party beneficiary when a customer fails to perform some contractual non-financial obligation. Both types of standby letters of credit are generally issued for terms ranging from six months to three years. The Bank generally requires collateral to support the letters of credit in excess of the contractual amount of the instruments and essentially uses the same credit policies in issuing letters of credit as it does for on-balance sheet instruments. At June 30, 2003, the Bank had performance standby letters of credit outstanding in the amount of $9.8 million and financial standby letters of credit outstanding in the amount of $2.2 million. Financial Accounting Standards Board Interpretation 45,Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN No. 45), took effect January 1, 2003, and did not have a material impact on the Company.

12

NOTE 8—NEW FINANCIAL ACCOUNTING STANDARDS

On April 30, 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 requires that contracts with comparable characteristics be accounted for similarly, clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative, and clarifies when a derivative contains a financing component that warrants reporting in the statement of cash flows. SFAS No. 149 is effective on a prospective basis for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. Southern Financial is currently evaluating the impact SFAS No. 149 will have on its operations.

On May 30, 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity.” It establishes standards for issuers’ classification as liabilities in the statement of financial position of financial instruments that have characteristics of both liabilities and equity, including financial instruments that are mandatorily redeemable on a fixed or determinable date. Our Company-obligated mandatorily redeemable securities of subsidiary holding solely parent debentures (“trust preferred securities”) meet that description. The statement is effective at the beginning of the first interim period beginning after June 15, 2003. The current classification of our trust preferred securities is appropriate under the new statement; therefore the statement will not have a material impact on Southern Financial.

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities: an interpretation of ARB No. 51.” This interpretation addresses the issue of consolidation of variable interest entities, which were previously commonly referred to as special-purpose entities (“SPEs”). Generally, in a variable interest entity the equity investment at risk is not sufficient to allow the entity to function without subordinated financial support from other parties that absorb some of the expected losses and the equity investors do not have the essential characteristics of a controlling financial interest. According to FIN 46, if a business has a controlling financial interest in a variable interest entity, the assets, liabilities and operating results of the variable interest entity should be consolidated with the business, even if the business does not have voting control of the variable interest entity. FIN 46 also requires disclosure of other significant variable interests in other variable interest entities. FIN 46 applies immediately to variable interest entities created after January 31, 2003 and to interest in variable interest entities acquired after that date. FIN 46 also applies to the first interim or fiscal periods beginning after June 15, 2003 for those variable interest entities in which a business holds an interest that was acquired before February 1, 2003. Southern Financial currently has no variable interest entities that require consolidation of previously unconsolidated entities or disclosure in the financial statements.

FIN 46 may, however, have implications for how our trust preferred securities are reported in the consolidated financial statements. The trust formed to issue the trust preferred securities might no longer be consolidated if the economic risks associated with the trust are held by the holders of the trust preferred securities rather than Southern Financial, which has a controlling equity interest. It would mean that Southern Financial would no longer consolidate the trust preferred securities as minority interest but, rather, would hold debt payable to a related party. This change may also impact regulatory capital as further described in “Regulatory Capital Requirements” in Management’s Discussion and Analysis.

NOTE 9—SUBSEQUENT EVENT

Southern Financial signed a definitive merger agreement on July 24, 2003 providing for the merger of Essex Bancorp, Inc. (Essex) into Southern Financial Bancorp, Inc. Southern Financial will issue up to 896,178 shares of its common stock for all the issued and outstanding common stock of Essex. Immediately prior to the merger, the agreement affects a spin-off of Essex’s wholly-owned subsidiary, Essex Home Mortgage Servicing Corporation (LoanCare). Following the merger Southern Financial will own 24.9% of LoanCare. The transaction is expected to close in the first quarter of 2004, and the agreement is subject to customary conditions, including shareholder and regulatory approval.

13

SOUTHERN FINANCIAL BANCORP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Financial Condition

Total assets increased to $1.1 billion at June 30, 2003, from $970.2 million at December 31, 2002, an increase of 13.9%. Total loans receivable increased 27.8% compared from June 30, 2002 to June 30, 2003, in part as a result of the $71 million in loans acquired through the Metro-County acquisition that was completed during the third quarter of 2002. Loan growth increased 6.9% from December 31, 2002. Loans closed for the first six months of 2003 totaled $142.3 million, a 9.7% increase when compared with the first six months of 2002. Further, the loan pipeline as of June 30, 2003 was approximately $100 million, compared with approximately $55 million as of June 30, 2002. Investment securities increased to $292.4 million or 43.6% from December 31, 2002 to June 30, 2003, including $129.9 million of securities classified as held to maturity. The investment securities increased to partially lever the trust preferred securities issued during the second quarter. Deposits and borrowings funded the loan growth.

Results of Operations

Our operating results depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings. Operating results are also affected by the level of our noninterest income, including income or loss from the sale of loans and fees and service charges on deposit accounts, and by the level of our operating expenses, including compensation, premises and equipment and income taxes.

The following table presents, for the periods indicated, average balances of and weighted average yields on interest-earning assets and average balances of and weighted average effective rates paid on interest-bearing liabilities. Calculations have been made utilizing daily average balances, and the effect of the interest rate swaps is reflected in the average rate on deposits. Loan balances do not include non-accrual loans.

14

	Six Months Ended June 30,
	2003						2002
	Average Outstanding Balance		Interest Earned/ Paid		Average Yield/Rate Rate		Average Outstanding Balance		Interest Earned/ Paid		Average Yield/Rate Rate
	(dollars in thousands)
Assets:
Interest-earning assets:
Loans	$	636,955	$	20,300	6.40	%	$	446,734	$	16,391	7.34	%
Securities		247,754		5,717	4.62			285,789		8,671	6.07
Investments		18,185		104	1.14			8,151		54	1.32
Total interest-earning assets		902,894		26,121	5.79	%		740,674		25,116	6.78	%
Less allowance for loan losses		10,758						7,915
Total interest-earning assets, net of allowance		892,136						732,759
Noninterest-earning assets:
Bank owned life insurance		22,568						19,774
Other noninterest-earning assets		61,335						35,522
Total assets	$	976,039					$	788,055
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Interest-bearing demand deposits	$	43,556	$	101	0.46	%	$	35,820	$	199	1.11	%
Savings and money market accounts		108,539		414	0.76			91,280		736	1.61
Time deposits		491,115		4,757	1.94			438,228		6,107	2.79
Other borrowings		126,092		1,118	1.77			67,240		976	2.90
Company-obligated mandatorily redeemable 11.0% preferred securities of Southern Financial Capital Trust I		5,000		286	11.44			5,000		286	11.44
Company-obligated mandatorily redeemable 10.60% preferred securities of Southern Financial Statutory Trust I		8,000		430	10.74			8,000		430	10.74
Company-obligated mandatorily redeemable floating rate preferred securities of Southern Financial Capital Trust III		4,333		104	4.63			—		—	—
Total interest-bearing liabilities		786,635		7,210	1.83	%		645,568		8,734	2.71	%
Noninterest-bearing liabilities:
Demand deposits		87,288						66,842
Other liabilities		19,470						10,256
Total liabilities		893,393						722,666
Stockholders’ equity		82,646						65,389
Total liabilities and stockholder’ equity	$	976,039					$	788,055
Net interest income			$	18,911					$	16,382
Net interest spread					3.96	%					4.07	%
Net interest margin					4.19	%					4.42	%

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The following table presents information regarding changes in interest income and interest expense for the periods indicated for each major category of interest-earning asset and interest-bearing liability which distinguishes between the changes attributable to changes in volume (changes in volume multiplied by old rate) and changes in rate (changes in rate multiplied by old volume). The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) have been allocated between rate and volume variances based on the percentage relationship of such variances to each other.

	The Six Months Ended
	June 30, 2003
	Compared to
	The Six Months Ended
	June 30, 2002
	Volume			Rate			Net
	(dollars in thousands)
Interest income
Loans receivable	$	6,234		$	(2,325	)	$	3,909
Investments		(773	)		(2,131	)		(2,904	)
Total interest income		5,461			(4,456	)		1,005
Interest expense
Interest-bearing deposits		873			(2,643	)		(1,770	)
Borrowings		1,006			(760	)		246
Total interest expense		1,879			(3,403	)		(1,524	)
Net interest income	$	3,582		$	(1,053	)	$	2,529

Our net income was $3.4 million ($.60 diluted earnings per share) for the quarter ended June 30, 2003, an increase of 32.2% over the $2.6 million ($.50 diluted earnings per share) earned for the quarter ended June 30, 2002. The increase in net income for the quarter ended June 30, 2003 compared with the prior year second quarter was primarily due to increased net interest income driven by the higher level of earning assets. Net income was positively impacted by increased fee income, a decrease in the provision for loan losses, and net gains in other assets. Conversely, operating expenses and net losses on investment securities increased for the quarter. For the six months ended June 30, 2003, net income was $6.2 million ($1.08 diluted earnings per share), an increase of 27.3% from $4.8 million ($.94 diluted earnings per share), for the six months ended June 30, 2002. The increase was primarily due to earning asset growth and increased non-interest income, and decrease in provision for loan losses partially offset by increases in non-interest expenses and the provision for income taxes.

Net interest income for the quarter was $9.5 million, an increase of 15.2% over the same quarter in the prior year. The increase in net interest income was primarily due to growth in earning assets resulting from loan originations, loans acquired through the Metro County Bank merger, and purchases of investment securities. Average earning assets increased 30.4% to $940 million for the quarter ended June 30, 2003 compared with the same quarter in 2002. The net interest margin was 4.04% and 4.58% for the same respective quarters. The margin compression during the respective quarters resulted primarily from multiple Federal Reserve rate cuts, which contributed, to a reduction in the yields on loans and investment securities in excess of the reduction to our cost of funds. Further, the related prepayments accelerated the amortization of residential interest-only securities over the last four quarters, which negatively impacted the yield on investment securities. In addition, the margin compressed further during the second quarter of 2003 from 4.35% for the first quarter of 2003, primarily due to the issuance of $10 million in floating trust preferred debt in April of 2003, which increased the cost of funds compared with the previous quarter. The yield on earning assets declined further as we partially levered the trust preferred securities with investment securities versus loan growth.

Net interest income for the six months ended June 30, 2003 was $18.9 million, an increase of 15.4% over the same period in the prior year. The increase in net interest income was primarily due to growth in earning assets resulting from loan originations, loans acquired through the Metro County Bank merger, and purchases of investment securities. Average earning assets increased 21.9% to $902.9 million for the six months ended June 30, 2003 compared with the same period in 2002. The net interest margin was 4.19% and 4.42% for the same respective periods.

Credit quality for the second quarter of 2003 remained sound. For the quarters ended June 30, 2003 and 2002, annualized net charge-offs were .77% and .43% of average loans, respectively. For the six months ended June 30, 2003 and 2002, respectively, the annualized net charge-offs were .60% and .80%. The ratios of allowance for loan losses to loans receivable outstanding were 1.68% and 1.70% at June 30, 2003 and 2002, respectively, and the ratio of nonperforming assets to total assets was .39% and .28%, during the same respective periods. The ratio of nonperforming assets to total assets improved slightly from the first quarter of 2003 when it was .24%. We continue to monitor the loan portfolio and make

16

charge-offs we deem appropriate, particularly given the uncertainty in the U.S. economy. Due to the uncertainty of risks in the loan portfolio, management’s judgement of the amount of the allowance necessary to absorb loan losses is approximate; however, management believes that the allowance for loan losses at June 30, 2003 is the amount necessary to absorb known and inherent losses in the loan portfolio at that date.

Total non-interest income increased to $2.0 million from $1.5 million for the quarters ended June 30, 2003 and 2002, respectively. As of June 30, 2003, there was no remaining balance of residential interest-only securities after the second quarter write-down of $289 thousand. The components of non-interest income other than net gains and losses on investment securities and other assets increased by 33.8% for the quarters ended June 30, 2003 and 2002, respectively. Areas of increase included account maintenance and electronic banking fees, other loan fees, fees generated from commercial service products including lockbox fees, and gains on sale of loans.

Total non-interest expenses for the quarter were $5.4 million, an increase of 24.2% when compared to the second quarter of 2002. This increase was largely due to operating expenses associated with Metro-County Bank and the de novo branch in Charlottesville, which opened in February. Employee compensation and benefits, which represents 53.4% of total expenses, increased 21.1%, due to the personnel added from the Metro-County merger and the new branch, with the remaining increases due to merit increases and other new hires to support the expanding customer base. Including the Metro-County related expenses, the efficiency ratio remained strong at 46.68% for the second quarter of 2003 compared with 45.80% and 44.41% for the quarters ended March 31, 2003 and June 30, 2002. The efficiency ratio has remained below 50% since the first quarter of 2002.

Regulatory Capital Requirements

At June 30, 2003 we exceeded all regulatory capital standards.

As a result of FASB Financial Interpretation No. 46 (FIN 46), the trust formed by us to issue our trust preferred securities might no longer be consolidated, thus raising the issue of whether the debentures issued by this trust will continue to be recognized as regulatory capital. On July 2, 2003, however, the Federal Reserve issued instructions, stating that “Organizations should continue to include trust preferred securities… in their Tier I capital for regulatory capital purposes… until notice is given to the contrary.” Southern Financial is closely monitoring this issue.

Liquidity

The objective of our liquidity management is to assure the ability to meet our financial obligations. These obligations include the payment of deposits on demand or at maturity, the repayment of borrowings at maturity, and the ability to fund loan commitments and other new business opportunities. We obtain funding from a variety of sources, including customer deposit accounts, customer certificates of deposit and payments on our loans and investments. Historically, our level of core deposits has been insufficient to fully fund our lending activities. Therefore, we must seek funding from additional sources, including brokered certificates of deposit, available-for-sale investment securities, lines of credit from the Federal Home Loan Bank of Atlanta and reverse repurchase agreement borrowings from approved securities dealers. In addition, we use derivative products such as interest rate swaps to enhance our liquidity through the issuance of long-term liabilities to match with our long-term assets. We also enhance our liquidity by monitoring unfunded loan commitments, which reduces unexpected funding requirements.

During the six months ended June 30, 2003, we funded our financial obligations with deposits, borrowings from the Federal Home Loan Bank of Atlanta, issuance of capital trust securities, and sales of investment securities. At June 30, 2003, we had $51.5 million of unfunded lines of credit and undisbursed construction loan funds of $49.6 million. Approved loan commitments were $29.9 million at June 30, 2003. It is anticipated that funding requirements for these commitments can be met from the normal sources of funds.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with the accounting principles generally accepted in the United States of America and conform with general practices in the banking industry. The preparation of financial statements in conformity with these principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on information available at the date of the financial statements and could differ from actual results. The more critical of the accounting policies involves the determination of the allowance for loan losses and accounting for derivative financial instruments.

17

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses, which is charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is a current estimate of the known and inherent losses in the present portfolio based upon management’s evaluation of the loan portfolio. Estimates of losses inherent in the portfolio involve the exercise of judgment and the use of assumptions. The evaluations take into consideration such factors as changes in the nature, volume and quality of the loan portfolio, prior loss experience, level of nonperforming loans, current and anticipated general economic conditions and the value and adequacy of collateral. Changes in the estimate of losses may occur due to changing economic conditions and the economic conditions of borrowers.

A loan is considered impaired when, based on all current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the agreement, including all scheduled principal and interest payments. Such impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate or, as a practical expedient, impairment may be measured based on the loan’s observable market price, or if, the loan is collateral—dependent, the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Loans for which foreclosure is probable continue to be accounted for as loans.

Each impaired loan is evaluated individually to determine the income recognition policy. Generally, payments received are applied in accordance with the contractual terms of the note or as a reduction of principal.

Derivative Financial Instruments

As part of our interest rate risk management, we use interest rate swaps that are accounted for as both cash flow and fair value hedges in accordance with Statement of Financial Accounting Standards No. 133. Cash flow hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities. At the inception of the hedge, the risk management objective and strategy, the hedged risk, the derivative instrument, the hedged item and how hedge effectiveness will be assessed initially and on an ongoing basis are documented. At inception of the hedge and on an ongoing basis, the hedge must be deemed to be highly effective in hedging the hedged risk in order to qualify for hedge accounting. Effectiveness is measured by comparing the change in LIBOR (which the interest rate swap is priced from) to the change in the rate underlying the hedged asset or liability. If high correlation is not achieved, the hedging designation is discontinued with the change in the fair value of the interest rate swap recorded as other income or expense. In the event that any derivative that meets the requirements for hedge accounting or hedged item is terminated or sold, the gain or loss on the derivative will be amortized over the remaining life of the item hedged. Interest to be received or paid on the interest rate swaps is accrued monthly.

We use interest rate swaps that are accounted for as cash flow hedges to hedge the issuance of pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce long-term fixed rate deposits. The fair value of the interest rate swap is recorded in other assets in the consolidated balance sheets with changes in the fair value included in other comprehensive income. To the extent that the hedge is not completely effective, the ineffective portion is charged or credited to other income or expense in the consolidated statements of income. The amounts recorded in other comprehensive income are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the CDs affect earnings.

We also use interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the individual CDs. The combination of the swaps and the issuance of the individual CDs operates to produce long-term floating rate deposits. The terms of the CDs and the interest rate swaps mirror each other and were committed to simultaneously. Both the interest rate swap (included in other assets in the consolidated balance sheets) and the CDs are recorded at fair value, with changes in fair value included in the statements of income as interest expense.

We also use interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the FHLB. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is equal to three-month LIBOR, which is the same as the rate on the borrowings. The combination of the swaps and the borrowings operates to produce long-term fixed rate borrowings. The terms of the borrowings and the interest rate swaps mirror each other and were committed to simultaneously. Both the interest rate swap

18

(included in other assets in the consolidated balance sheets) and the borrowings are recorded at fair value, with changes in fair value included in the statements of income as interest expense.

We incorporate all items from the consolidated balance sheet as well as off-balance sheet items such as derivative items used to hedge balance sheet items in an overall assessment of its interest rate risk. All on-balance sheet items and off-balance sheet items are incorporated in a report that is generated quarterly by a third party that assesses the interest rate risk in different interest rate environments. The report shows how the market value of our portfolio value of equity changes when interest rates rise or fall 1%, 2%, and 3%. The report also shows the change in net interest income in the same interest rate change scenarios.

Special Note Regarding Forward-looking Information

Certain statements under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report and the documents incorporated herein by reference constitute “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Southern Financial, or industry results, to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in Southern Financial’s market area, inflation, fluctuations in interest rates, changes in government regulations and competition, which will, among other things, impact demand for loans and banking services; the ability of Southern Financial to implement its business strategy; and changes in, or the failure to comply with, government regulations.

Forward-looking statements are intended to apply only at the time they are made. Moreover, whether or not stated in connection with a forward-looking statement, Southern Financial undertakes no obligation to correct or update a forward-looking statement should Southern Financial later become aware that it is not likely to be achieved. If Southern Financial were to update or correct a forward-looking statement, investors and others should not conclude that Southern Financial would make additional updates or corrections thereafter.

Item 3—Quantitative and Qualitative Disclosure about Market Risk

We are engaged primarily in the business of investing funds obtained from deposits and borrowings into interest-bearing loans and investments. Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between the interest income on loans and investments and the interest expense on deposits and borrowing. To the extent that our interest-bearing liabilities do not reprice or mature at the same time as our interest-bearing assets, we are subject to interest rate risk and corresponding fluctuations in net interest income. We have employed asset/liability management policies that attempt to manage our interest-earning assets and interest-bearing liabilities, thereby attempting to control the volatility of net interest income, without having to incur unacceptable levels of credit or investment risk.

We actively manage our overall exposure to changes in interest rates. In managing our funding, we first attempt to gauge the direction of interest rates, which will determine how much sensitivity we are willing to take. If rates are decreasing, we seek to fund with liabilities that reprice in the near future. If rates are rising, we attempt to do the opposite. When necessary, we will enter into interest rate swaps, financial options or forward delivery contracts for the purpose of reducing interest rate risk.

Management uses a duration gap of equity approach to manage our interest rate risk and reviews quarterly interest sensitivity reports prepared for us by a third party. This approach uses a model which generates estimates of the change in our market value of portfolio equity (“MVPE”) over a range of interest rate scenarios. MVPE is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts using standard industry assumptions about estimated loan prepayment rates, reinvestment rates and deposit decay rates.

With respect to our residential mortgage loan portfolio, it is our policy to retain those mortgage loans which have an adjustable interest rate and to sell most fixed rate mortgage loans originated into the secondary market. In addition, our commercial loans generally have rates that are tied to the prime rate, the one-year Constant Maturity Treasury (“CMT”) rate as reported by the Federal Reserve Board, or the three-year CMT rate. Both of these actions help control our exposure to rising interest rates.

The following table prepared by a third party sets forth an analysis of our interest rate risk as measured by the estimated change in MVPE resulting from instantaneous and sustained parallel shifts in the yield curve (plus or minus 300 basis points, measured in 100 basis point increments) as of June 30, 2003 and December 31, 2002:

19

Sensitivity of Market Value of Portfolio Equity

As of June 30, 2003

(dollars in thousands)

Change in Interest Rates	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of
In Basis Points (Rate Shock)	Amount		$ Change From Base			% Change From Base		Total Assets		Portfolio Equity Book Value
Up 300	$	75,859	$	(37,297	)	(32.96	)%	6.86	%	89.23	%
Up 200		88,698		(24,458	)	(21.61	)	8.02		104.34
Up 100		102,169		(10,987	)	(9.71	)	9.24		120.18
Base		113,156		—		—		10.24		133.11
Down 100		119,298		6,142		5.43		10.79		140.33
Down 200		124,850		11,694		10.33		11.29		146.86
Down 300		130,692		17,536		15.50		11.82		153.73
Sensitivity of Market Value of Portfolio Equity As of December 31, 2002 (dollars in thousands)
Change in Interest Rates	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of
In Basis Points (Rate Shock)	Amount		$ Change From Base			% Change From Base		Total Assets		Portfolio Equity Book Value
Up 300	$	77,014	$	(19,033	)	(19.82	)%	7.94	%	94.72	%
Up 200		85,031		(11,016	)	(11.47	)	8.76		104.59
Up 100		93,808		(2,239	)	(2.33	)	9.67		115.38
Base		96,047		—		0.00		9.90		118.13
Down 100		100,057		4,010		4.18		10.31		123.07
Down 200		99,367		3,320		3.46		10.24		122.22
Down 300		97,493		1,446		1.51		10.05		119.91

The change in the market value of portfolio equity in the base case from $96.0 million at December 31, 2002 to $113.2 million at June 30, 2003 is due primarily to the fact that we were able to increase the spread to market rates on commercial loans and to decrease the spread to market rates on certificates of deposit during the quarter. This is also the reason that most of the percentage changes are greater as of June 30, 2003 than as of December 31, 2002.

Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. Modeling changes in MVPE requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. Accordingly, although the MVPE table provides an indication of our interest rate risk exposure at a particular point in time, such measurement is not intended to and does not provide a precise forecast of the effect of changes in market interest rates on our worth.

Item 4—Controls and Procedures

Our management, including the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report, and, based on their evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

20

SOUTHERN FINANCIAL BANCORP, INC.

Part II.    OTHER INFORMATION

Item 1.    LEGAL PROCEEDINGS

The bank and we are involved in legal proceedings arising in the normal course of business from time to time. Management believes that neither we nor the bank are a party to, nor is any of our property the subject of, any material pending or threatened legal proceedings which, if determined adversely, would have a material adverse effect upon our consolidated position, results of operations or cash flows.

Item 2.    CHANGES IN SECURITIES

Not applicable

Item 3.    DEFAULTS UPON SENIOR SECURITIES

Not applicable

Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Shareholders was held on April 24, 2003 at 2:00 p.m. at the Fauquier Springs Country Club, Springs Road, Warrenton, Virginia. The following is a summary of items voted upon at the meeting:

1. The following Directors were elected to serve three year terms expiring in the year 2006:

John C. Belotti (4,576,971 for; 21,864 against)

Neil J. Call (4,573,287 for; 25,548 against)

David de Give (4,550,013 for; 48,822 against)

R. Roderick Porter (4,552,153 for; 46,682 against)

2. A proposal to adopt the Southern Financial Bancorp, Inc. 2003 Stock Incentive Plan was approved by the following vote: for 4,283,596; against 300,359; abstain 23,480

3. The appointment of KPMG LLP as independent auditors for the year ending December 31, 2003 was approved by the following vote: for 4,598,829; against 2,453; abstain 6,152

Item 5.    OTHER INFORMATION

Not applicable

Item 6.    EXHIBITS AND REPORTS ON FORM 8-K

Exhibits Required

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

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

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

Reports on Form 8-K

We filed a report on Form 8-K on April 25, 2003 to file as an exhibit a copy of our press release dated April 24, 2003 announcing our earnings for the three months ended March 31, 2003.

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SOUTHERN FINANCIAL BANCORP, INC.

Part III.    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.

		SOUTHERN FINANCIAL BANCORP, INC.
		(Registrant)
Date	08/14/2003	/s/ Georgia S. Derrico
		Georgia S. Derrico
		Chairman and
		Chief Executive Officer
		(Duly Authorized Representative)
Date	08/14/2003	/s/ William H. Lagos
		William H. Lagos
		Senior Vice President and Controller
		Principal Accounting Officer
		(Duly Authorized Representative)

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