Southern Financial Bancorp (SFFB) 10-Q 2003 Q3 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: September 30, 2003 Commission File No.: 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 October 31, 2003, there were 6,074,319 shares of the registrant’s Common Stock outstanding.

SOUTHERN FINANCIAL BANCORP, INC.

QUARTERLY REPORT ON FORM 10-Q

September 30, 2003

TABLE OF CONTENTS

			Page Number
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
		Consolidated Balance Sheets as of September 30, 2003 (Unaudited) and December 31, 2002	3
		Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2003 and 2002 (Unaudited)	4
		Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2003 and 2002 (Unaudited)	5
		Consolidated Statements of Cash Flows for the Nine Months Ended September 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

SOUTHERN FINANCIAL BANCORP, INC.

FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

	September 30, 2003 (Unaudited)			December 31, 2002
Assets
Cash and due from banks	$	23,346		$	28,705
Overnight earning deposits		6,822			64,693
Investment securities - available for sale		153,082			203,563
Investment securities - held to maturity		237,992			—
Loans held for sale		13,406			514
Loans receivable, net		603,606			594,323
Cash surrender value of life insurance		23,138			22,287
Premises and equipment, net		9,073			8,264
Intangible assets, net		14,247			14,558
Other assets		22,194			33,320
Total assets	$	1,106,906		$	970,227
Liabilities and Stockholders’ Equity
Liabilities
Deposits	$	750,022		$	776,083
Advances from Federal Home Loan Bank - short term		35,000			—
Advances from Federal Home Loan Bank - long term		64,842			65,000
Company-obligated mandatorily redeemable securities of subsidiary holding solely parent debentures		23,000			13,000
Securities sold under agreements to repurchase		136,593			18,456
Other liabilities		10,228			16,385
Total liabilities		1,019,685			888,924
Stockholders’ equity
Preferred stock		—			—
Common stock		61			54
Capital in excess of par		89,365			81,167
Retained earnings		—			—
Accumulated other comprehensive income (loss)		(2,205	)		82
Total stockholders’ equity		87,221			81,303
Total liabilities and stockholders’ equity	$	1,106,906		$	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 September 30,					Nine Months Ended September 30,
	2003		2002			2003			2002
Interest Income
Loans	$	10,045	$	9,698		$	30,345		$	26,089
Investment securities		3,762		2,941			9,583			11,666
Total interest income		13,807		12,639			39,928			37,755
Interest Expense
Deposits		2,443		3,747			7,715			10,789
Borrowings		1,333		732			3,271			2,425
Total interest expense		3,776		4,479			10,986			13,214
Net interest income		10,031		8,160			28,942			24,541
Provision for loan losses		1,235		950			3,555			4,010
Net interest income after provision for loan losses		8,796		7,210			25,387			20,531
Other Income
Account maintenance and electronic banking fees		783		675			2,350			1,960
Commercial service fees		171		150			522			391
Other loan fees		188		89			440			297
System maintenance and license fees		43		43			152			176
Income from bank owned life insurance		240		293			851			834
Gain on sale of loans		560		217			1,272			465
Gain (loss) on investment securities, net		3		(103	)		(934	)		(405	)
Other		13		(15	)		299			(12	)
Total other income		2,001		1,349			4,952			3,706
Other Expense
Employee compensation and benefits		3,076		2,556			8,824			7,281
Premises, equipment and data processing		1,515		1,362			4,526			3,825
Other		1,070		719			2,886			2,119
Total other expense		5,661		4,637			16,236			13,225
Income before income taxes		5,136		3,922			14,103			11,012
Provision for income taxes		1,660		1,247			4,471			3,501
Net income	$	3,476	$	2,675		$	9,632		$	7,511
Earnings per common share:
Basic	$	0.58	$	0.47		$	1.61		$	1.36
Diluted		0.55		0.45			1.53			1.30
Dividends declared per common share		0.17		0.09			0.42			0.28
Weighted average shares outstanding:
Basic		6,026,827		5,670,470			5,992,725			5,505,839
Diluted		6,319,805		5,973,405			6,279,405			5,774,545

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 September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net income	$	3,476		$	2,675		$	9,632		$	7,511
Other comprehensive income (loss):
Cash flow hedge:
Unrealized holding gain (loss)		82			(546	)		(192	)		(1,136	)
Reclassification adjustment for net interest expense included in net income		214			176			608			514
Available-for-sale securities:
Unrealized holding loss		(2,676	)		(256	)		(4,868	)		(1,388	)
Reclassification adjustment for net (gains) losses included in net income		(3	)		103			934			405
Other comprehensive loss before tax		(2,383	)		(523	)		(3,518	)		(1,605	)
Income tax benefit related to items of other comprehensive income		(834	)		(183	)		(1,231	)		(562	)
Other comprehensive loss, net of tax		(1,549	)		(340	)		(2,287	)		(1,043	)
Comprehensive income	$	1,927		$	2,335		$	7,345		$	6,468

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)

	Nine Months Ended September 30,
	2003			2002
Cash flows from operating activities:
Net Income	$	9,632		$	7,511
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,123			1,189
Amortization of discounts or premiums on investment securities and loans, net		2,559			4,388
Provision for loan losses		3,555			4,010
Gain on sale of loans		(1,272	)		(465	)
Loss on sale of securities		934			405
Accretion of deferred loan fees		(1,508	)		(956	)
Loans originated - held for sale		(10,514	)		(5,820	)
Loans sold - held for sale		20,945			5,852
(Increase) decrease in other assets		5,648			(6,455	)
Decrease in other liabilities		(6,575	)		(8,060	)
Net cash provided by operating activities		24,527			1,599
Cash flows from investing activities:
Increase in loans receivable		(31,791	)		(117,098	)
Purchase of investment securities, available-for-sale		(87,785	)		(203,670	)
Purchase of investment securities, held-to-maturity		(258,005	)		—
Sale of investment securities, available-for-sale		58,278			155,221
Paydowns of investment securities, available-for-sale		75,649			112,660
Paydowns of investment securities, held-to-maturity		19,761			—
Purchase of bank owned life insurance		—			(5,000	)
Cash paid for merger		—			(6,842	)
Cash acquired from merger		—			13,719
Increase in premises and equipment, net		(1,887	)		(870	)
Increase in other equity securities		(2,336	)		(682	)
Net cash used in investing activities		(228,116	)		(52,562	)
Cash flows from financing activities:
Net increase (decrease) in deposits		(20,901	)		80,547
Increase (decrease) in advances from FHLB - short term		10,000			(23,500	)
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		118,137			5,682
Proceeds from issuance of common stock		383			8
Dividends on preferred and common stock		(2,260	)		(1,561	)
Net cash provided by financing activities		140,359			61,176
Net increase (decrease) in cash and cash equivalents		(63,230	)		10,213
Cash and cash equivalents, beginning of period		93,398			28,459
Cash and cash equivalents, end of period	$	30,168		$	38,672
Supplemental data:
Cash payments for interest on deposits and borrowings, net of cash payments on interest rate swaps	$	(4,651	)	$	(262	)
Cash payments for income taxes	$	375		$	5,530
Supplemental schedule of noncash investing and financing activities:
Issuance of common stock for purchase accounting acquisition	$	—		$	10,246
Common stock issued for stock dividend	$	21,950		$	—
Unrealized loss on investment securites available-for-sale	$	(3,934	)	$	(983	)
Unrealized gain (loss) on interest rate swaps	$	(5,962	)	$	8,205
Transfer to loans held for sale from loans receivable	$	22,216		$	—

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 nine-month periods ended September 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 September 30,						For the nine months ended September 30,
(in thousands, except per share data)	2003			2002			2003			2002
Net income:
As reported	$	3,476		$	2,675		$	9,632		$	7,511
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards granted, net of related tax effects		(202	)		(140	)		(446	)		(420	)
Pro forma net income	$	3,274		$	2,535		$	9,186		$	7,091
Basic earnings per share:
As reported		0.58			0.47			1.61			1.36
Pro forma		0.54			0.45			1.53			1.29
Diluted earnings per share:
As reported		0.55			0.45			1.53			1.30
Pro forma		0.52			0.42			1.46			1.23

7

NOTE 2 – INVESTMENT SECURITIES

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

	September 30, 2003				December 31, 2002
	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
	(dollars in thousands)
Available-for-sale securities:
Mortgage-backed securities	$	70,549	$	69,619	$	74,340	$	74,892
Collateralized mortgage obligations		36,973		35,958		83,073		83,860
Obligations of counties and municipalities		9,903		10,000		9,900		10,000
Corporate obligations		30,015		29,130		28,046		26,997
U.S. Treasury and agency securities		499		507		2,258		2,282
Federal Home Loan Bank stock		5,350		5,350		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		155,807		153,082		203,149		203,563
Debt obligations classified as loans		24,468		24,647		31,567		32,543
	$	180,275	$	177,729	$	234,716	$	236,106
Held-to-maturity securities:
Mortgage-backed securities	$	167,559	$	167,021	$	—	$	—
Collateralized mortgage obligations		67,431		67,494		—		—
Corporate obligations		3,002		2,933		—		—
	$	237,992	$	237,448	$	—	$	—

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 fixed 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 September 30, 2003, we entered into interest rate swap agreements totaling $50 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 September 30, 2003, six interest rate swaps with a notional amount of $45 million were terminated with no resulting gain or loss.

During the nine months ended September 30, 2003, we entered into interest rate swap agreements totaling $222.5 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 nine months ended September 30, 2003, 25 interest rate swaps with a notional amount of $187.5 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of September 30, 2003 had a notional amount of $347.5 million and an estimated fair value of $(603) thousand. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of $(892) thousand. Interest rate swaps accounted for as fair value hedges had a notional amount of $327.5 million and an estimated fair value of $290 thousand.

During the quarter ended September 30, 2002, we entered into interest rate swap agreements totaling $53 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 September 30, 2002, three interest rate swaps with a notional amount of $30 million were terminated with no resulting gain or loss.

During the nine months ended September 30, 2002, we entered into interest rate swap agreements totaling $230.5 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 nine months ended September 30, 2002, seven interest rate swaps with a notional amount of $70 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of September 30, 2002 had a notional amount of $320.5 million and an estimated fair value of $5.2 million. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of ($1.4) million. Interest rate swaps accounted for as fair value hedges had a notional amount of $300.5 million and an estimated fair value of $6.6 million.

NOTE 4 - LOANS RECEIVABLE

Loans receivable consist of the following:

	September 30, 2003		December 31, 2002
	(dollars in thousands)
Construction and land development
Residential	$	50,569	$	40,575
Commercial		52,512		42,052
Mortgage
Residential		55,760		77,697
Multifamily residential		8,629		9,438
Commercial		282,625		253,958
Commercial and industrial		158,849		170,776
Consumer		8,396		12,889
Total loans receivable		617,340		607,385
Less:
Deferred loan fees, net		3,119		2,805
Allowance for loan losses		10,615		10,257
Loans receivable, net	$	603,606	$	594,323

Debt obligations in the amount of $24.6 million are classified as commercial and industrial loans in the table above as of September 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:

	Nine Months Ended 9/30/2003			Nine Months Ended 9/30/2002
	(dollars in thousands)
Allowance at beginning of period	$	10,257		$	7,354
Acquired from Metro County Bank		—			1,350
Provision for losses charged to income		3,555			4,010
Charge-offs		(4,674	)		(3,132	)
Recoveries		1,477			683
Allowance at end of period	$	10,615		$	10,265

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

	At September 30, 2003			At December 31, 2002
	(dollars in thousands)
Accruing loans 90 days or more delinquent	$	—		$	154
Nonperforming loans:
Mortgage-residential		—			158
Mortgage-commercial		2,848			874
Commercial and industrial (1)		1,719			1,239
Subtotal		4,567			2,271
Other real estate owned		—			—
Total nonperforming assets	$	4,567		$	2,271
Nonperforming assets to total assets		0.41	%		0.23	%
Nonperforming assets to total loans and other real estate owned		0.74	%		0.37	%

(1) Includes $1.6 million and $822 thousand of loans guaranteed by the Small Business Admininstration (SBA) at September 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
	September 30, 2003					September 30, 2002
	(dollars in thousands, except per share amounts)
	Amount		Shares	Per Share Amount		Amount			Shares	Per Share Amount
Net income	$	3,476				$	2,675
Preferred dividends		—					(3	)
Basic earnings per share	$	3,476	6,026,827	$	0.58	$	2,672		5,670,470	$	0.47
Effect of dilutive securities:
Stock options			292,977						273,937
Convertible preferred stock			—						28,998
Diluted earnings per share	$	3,476	6,319,805	$	0.55	$	2,675		5,973,405	$	0.45

	For the nine months ended
	September 30, 2003					September 30, 2002
	(dollars in thousands, except per share amounts)
	Net Income		Shares	Per Share Amount		Net Income			Shares	Per Share Amount
Net income	$	9,632				$	7,511
Preferred dividends		—					(9	)
Basic earnings per share	$	9,632	5,992,725	$	1.61	$	7,502		5,505,839	$	1.36
Effect of dilutive securities:
Stock options			286,680						238,656
Convertible preferred stock			—						30,049
Diluted earnings per share	$	9,632	6,279,405	$	1.53	$	7,511		5,774,545	$	1.30

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. As of June 30, 2003, we completed the annual evaluation of 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:

	September 30, 2003					December 31, 2002					September 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	$	(671	)	$	3,966	$	(447	)	$	3,966	$	(348	)
Amortizable other intangibles		361		(235	)		361		(219	)		361		(202	)
Unamortizable goodwill		11,941		(145	)		11,042		(145	)		11,026		(145	)

Amortization expense:                 (dollars in thousands)	Other		Core Deposit Intangibles
Three months ended September 30, 2003	$	5	$	75
Three months ended September 30, 2002		17		59
Nine months ended September 30, 2003		15		225
Nine months ended September 30, 2002		52		138

Estimated amortization expense:                 (dollars in thousands)	Other		Core Deposit Intangibles
Three months ended December 31, 2003	$	5	$	75
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 September 30, 2003, the Bank had performance standby letters of credit outstanding in the amount of $10.8 million and financial standby letters of credit outstanding in the amount of $6.4 million. The disclosure provisions of 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 December 31, 2002, and the accounting provisions took effect January 1, 2003. At September 30, 2003 a liability of $92 thousand existed for letters of credit.

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 has determined that this statement will not have a material impact on its operations.

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. As originally issued, 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. In October 2003, the FASB issued FASB Staff Position No. 46-6 that defers the effective date for FIN 46 to the first interim or annual period ending after December 15, 2003 for variable interest entities created 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. The adoption of FIN 46 did not have a material impact on Southern Financial’s operations, equity, or financial condition.

NOTE 9 – PROPOSED MERGER

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.

NOTE 10 – SUBSEQUENT EVENT

On November 3, 2003, Southern Financial and Provident Bankshares Corporation (Provident) announced the signing of a definitive agreement for Southern Financial to be merged into Provident. The shareholders of Southern Financial will receive 1.0875 shares of Provident common stock and $11.125 in cash for each Southern Financial share held. The merger, which is subject to regulatory and shareholder approval, is expected to be completed in the second quarter of 2004.

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 September 30, 2003, from $970.2 million at December 31, 2002, an increase of 14.1%. Total loans receivable, including loans held for sale, increased $22.5 million or 3.7% compared with December 31, 2002. Loan closings for the nine months of 2003 totaled $200 million, $58 million of which closed during the third quarter. Much of the growth from the loan closings was offset by higher loan repayments, which were noted in the previous quarter as well. Investment securities increased to $391.1 million, or 92.1% from December 31, 2002 to September 30, 2003, and included $153.1 million of securities classified as held to maturity. The investment securities increased to partially lever the trust preferred securities issued during the second quarter. The increase in securities was funded by a series of borrowings with different terms to coincide with estimated prepayments of the securities.

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.

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	Nine Months Ended September 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	$	639,038	$	30,345	6.34	%	$	485,245	$	26,089	7.17	%
Securities		283,210		9,411	4.43			267,101		11,588	5.78
Investments		21,882		172	1.04			7,344		78	1.42
Total interest-earning assets		944,130		39,928	5.64	%		759,690		37,755	6.63	%
Less allowance for loan losses		10,825						8,489
Total interest-earning assets, net of allowance		933,305						751,201
Noninterest-earning assets:
Bank owned life insurance		22,707						20,457
Other noninterest-earning assets		60,736						40,673
Total assets	$	1,016,748					$	812,331
Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Interest-bearing demand deposits	$	44,023	$	137	0.41	%	$	37,608	$	320	1.13	%
Savings and money market accounts		109,258		571	0.70			98,746		1,174	1.59
Time deposits		500,680		7,007	1.87			452,561		9,295	2.74
Other borrowings		145,613		1,976	1.81			59,379		1,351	3.03
Company-obligated mandatorily redeemable 11.0% preferred securities of Southern Financial Capital Trust I		5,000		429	11.44			5,000		429	11.44
Company-obligated mandatorily redeemable 10.60% preferred securities of Southern Financial Statutory Trust I		8,000		645	10.74			8,000		645	10.74
Company-obligated mandatorily redeemable floating rate preferred securities of Southern Financial Capital Trust III		6,222		221	4.74			—		—	—
Total interest-bearing liabilities		818,796		10,986	1.79	%		661,294		13,214	2.66	%
Noninterest-bearing liabilities:
Demand deposits		91,532						70,685
Other liabilities		22,507						12,825
Total liabilities		932,835						744,804
Stockholders’ equity		83,913						67,527
Total liabilities and stockholder’ equity	$	1,016,748					$	812,331
Net interest income			$	28,942					$	24,541
Net interest spread					3.85	%					3.97	%
Net interest margin					4.09	%					4.31	%

15

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 Nine Months Ended September 30, 2003 Compared to The Nine Months Ended September 30, 2002
	Volume		Rate			Net
	(dollars in thousands)
Interest income
Loans receivable	$	7,543	$	(3,287	)	$	4,256
Investments		1,201		(3,284	)		(2,083	)
Total interest income		8,744		(6,571	)		2,173
Interest expense
Interest-bearing deposits		1,090		(4,164	)		(3,074	)
Borrowings		2,140		(1,294	)		846
Total interest expense		3,230		(5,458	)		(2,228	)
Net interest income	$	5,514	$	(1,113	)	$	4,401

Our net income was $3.5 million ($.55 diluted earnings per share) for the quarter ended September 30, 2003, an increase of 29.9% over the $2.7 million ($.45 diluted earnings per share) earned for the quarter ended September 30, 2002. All shares outstanding have been adjusted to reflect the 10% stock dividend declared on September 29, 2003. The increase in net income for the quarter ended September 30, 2003 compared with the prior year third quarter was primarily due to increased net interest income driven by the higher level of earning assets. In addition, net income was also positively impacted by increased fee income, and gains on sale of loans. Conversely, operating expenses and provision for loan losses increased for the quarter. For the nine months ended September 30, 2003, net income was $9.6 million ($1.53 diluted earnings per share), an increase of 28.2% from $7.5 million ($1.30 diluted earnings per share), for the nine months ended September 30, 2002. The increase was primarily due to earning asset growth and increased non-interest income, and a decrease in the 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 $10.0 million, an increase of 22.9% 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, and purchases of investment securities. Average earning assets increased 28.7% to $1.0 billion for the quarter ended September 30, 2003 compared with the same quarter in 2002. The net interest margin was 3.91% and 4.09% for the same respective quarters. The decline in the net interest margin in primarily the result of the larger increase in average investment securities compared with loans outstanding which reduced the overall yield on earning assets.

Net interest income for the nine months ended September 30, 2003 was $28.9 million, an increase of 17.9% 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 24.3% to $944.1 million for the nine months ended September 30, 2003 compared with the same period in 2002. The net interest margin was 4.09% and 4.31% for the same respective periods.

Credit quality for the third quarter of 2003 remained sound. For the quarters ended September 30, 2003 and 2002, annualized net charge-offs were .80% and ..47% of average loans, respectively. For the nine months ended September 30, 2003 and 2002, respectively, the annualized net charge-offs were the same at .67%. The ratios of allowance for loan losses to loans receivable outstanding were 1.73% and 1.70% at September 30, 2003 and 2002, respectively, and the ratio of nonperforming assets to total assets was .27% and .15%, for the same respective periods. We continue to monitor the loan portfolio and make 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 September 30, 2003 is the amount necessary to absorb known and inherent losses in the loan portfolio at that date.

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Total non-interest income increased to $2.0 million from $1.3 million for the quarters ended September 30, 2003 and 2002, respectively. Fee income increased 23.9% for the quarter ended September 30, 2003 compared with the prior year. Fee income includes account maintenance and electronic banking fees, commercial service fees, system maintenance fees and other loan fees. Non-interest income also includes income from bank owned life insurance, which declined slightly compared with the prior year. Gains on sale of loans, which include primarily the sales of SBA loans, increased compared with the prior year are also included in non-interest income.

Total non-interest expenses for the quarter were $5.7 million, an increase of 22.1% when compared to the third quarter of 2002. This increase was largely due to operating expenses associated with the de novo branch in Charlottesville that opened in February. Employee compensation and benefits, which represents 54.3% of non-interest expenses, increased 20.4%, due, in part, to personnel associated with the new branch, as well as general merit increases and other new hires to support the expanding customer base. The efficiency ratio remained strong at 46.44% for the third quarter of 2003 compared with 47.37% for the quarter ended September 30, 2002. The efficiency ratio has remained below 50% since the first quarter of 2002.

Regulatory Capital Requirements

At September 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 nine months ended September 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 September 30, 2003, we had $53.8 million of unfunded lines of credit and undisbursed construction loan funds of $59.4 million. Approved loan commitments were $22.2 million at September 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.

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.

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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 interest 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 CDs and the interest rate swaps have like terms and were committed to simultaneously. To the extent that the hedge is not completely effective, the ineffective portion is charged or credited to interest expense in the consolidated statements of income. 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 (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.

18

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 September 30, 2003 and December 31, 2002:

19

Sensitivity of Market Value of Portfolio Equity

As of September 30, 2003

(dollars in thousands)

Change in Interest Rates In Basis Points (Rate Shock)	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of
	Amount		$ Change From Base			% Change From Base		Total Assets		Portfolio Equity Book Value
Up 300	$	60,252	$	(50,870	)	(45.78	)%	5.44	%	69.08	%
Up 200		74,847		(36,275	)	(32.64	)	6.76		85.81
Up 100		91,641		(19,481	)	(17.53	)	8.28		105.07
Base		111,122		—		—		10.04		127.40
Down 100		123,403		12,281		11.05		11.15		141.48
Down 200		128,335		17,213		15.49		11.59		147.14
Down 300		135,879		24,757		22.28		12.28		155.79

Sensitivity of Market Value of Portfolio Equity

As of December 31, 2002

(dollars in thousands)

Change in Interest Rates In Basis Points (Rate Shock)	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of
	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 $111.1 million at September 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 period. The fact that all of the percentage changes are greater as of September 30, 2003 than as of December 31, 2002 is due to a $186 million increase in fixed-rate mortgage-backed securities.

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

Not applicable

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 Certifications of 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 July 17, 2003 to file as an exhibit a copy of our press release dated July 17, 2003 announcing our earnings for the three months ended June 30, 2003.

We filed a report on Form 8-K on July 24, 2003 to file as an exhibit a copy of our press release dated July 24, 2003 announcing the merger agreement with Essex Bancorp, Inc.

21

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 11/14/2003	/s/ Georgia S. Derrico
	Georgia S. Derrico
	Chairman and
	Chief Executive Officer
	(Duly Authorized Representative)
Date 11/14/2003	/s/ William H. Lagos
	William H. Lagos
	Senior Vice President and Controller
	Principal Accounting Officer
	(Duly Authorized Representative)

22