UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

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

For the transition period from                     to                    

Fauquier Bankshares, Inc.

(Exact name of registrant as specified in its charter)

Virginia		54-1288193
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

10 Courthouse Square, Warrenton, Virginia		20186
(Address of principal executive offices)		(Zip Code)

(540) 347-2700
(Registrant’s telephone number, including area code)

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

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

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

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

The registrant had 3,564,317 shares of common stock outstanding as of November 5, 2008.

 

 

FAUQUIER BANKSHARES, INC.
INDEX

		Page
Part I. FINANCIAL INFORMATION		3
Item 1. Financial Statements		3
Consolidated Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007		3
Consolidated Statements of Income (unaudited) for the Three Months Ended September 30, 2008 and 2007		4
Consolidated Statements of Income (unaudited) for the Nine Months Ended September 30, 2008 and 2007		5
Consolidated Statements of Changes in Shareholders’ Equity (unaudited) for the Nine Months Ended September 30, 2008 and 2007		6
Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended September 30, 2008 and 2007		7
Notes to Consolidated Financial Statements		8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3. Quantitative and Qualitative Disclosures About Market Risk		36
Item 4. Controls and Procedures		36
Part II. OTHER INFORMATION		36
Item 1. Legal Proceedings		36
Item 1A. Risk Factors		36
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		37
Item 3. Defaults Upon Senior Securities		37
Item 4. Submission of Matters to a Vote of Security Holders		37
Item 5. Other Information		37
Item 6. Exhibits		38
SIGNATURES		39

Part I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Fauquier Bankshares, Inc. and Subsidiaries

		September 30,				December 31,
		2008				2007
		(Unaudited)				(Audited)*
Assets
Cash and due from banks		$	13,652,340			$	16,708,922
Interest-bearing deposits in other banks			1,267,882				823,252
Federal funds sold			—				2,020,000
Securities available for sale			35,284,228				37,376,725
Loans, net of allowance for loan losses of $4,684,438 in 2008 and $4,185,209 in 2007			423,077,211				409,107,482
Bank premises and equipment, net			8,331,851				7,180,369
Accrued interest receivable			1,681,120				1,748,546
Other assets			16,465,251				14,930,932
Total assets		$	499,759,883			$	489,896,228
Liabilities and Shareholders’ Equity
Deposits:
Noninterest-bearing			65,139,676				76,080,935
Interest-bearing:
NOW accounts			77,441,602				90,169,640
Savings and money market accounts			115,406,759				127,472,913
Time certificates of deposit			147,635,155				110,835,435
Total interest-bearing			340,483,516				328,477,988
Total deposits			405,623,192				404,558,923
Federal Home Loan Bank advances			45,000,000				35,000,000
Company-obligated mandatorily redeemable capital securities			4,124,000				4,124,000
Other liabilities			4,421,845				4,385,553
Commitments and Contingencies			—				—
Total liabilities			459,169,037				448,068,476
Shareholders’ Equity
Common stock, par value, $3.13; authorized 8,000,000 shares: issued and outstanding, 2008: 3,566,286 (includes nonvested shares of 38,219); 2007: 3,537,354 shares (includes nonvested shares of 31,190)			11,042,850				10,974,293
Retained earnings			32,522,518				31,626,627
Accumulated other comprehensive income (loss), net			(2,974,522	)			(773,168	)
Total shareholders’ equity			40,590,846				41,827,752
Total liabilities and shareholders’ equity		$	499,759,883			$	489,896,228

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries

		2008				2007
Interest Income
Interest and fees on loans		$	6,701,211			$	7,227,839
Interest and dividends on securities available for sale:
Taxable interest income			366,630				372,966
Interest income exempt from federal income taxes			58,289				37,774
Dividends			59,978				47,046
Interest on federal funds sold			3				15,432
Interest on deposits in other banks			15,305				5,322
Total interest income			7,201,416				7,706,379
Interest Expense
Interest on deposits			1,761,639				2,542,449
Interest on federal funds purchased			23,877				45,709
Interest on Federal Home Loan Bank advances			519,870				436,153
Distribution on capital securities of subsidiary trusts			45,757				72,652
Total interest expense			2,351,143				3,096,963
Net interest income			4,850,273				4,609,416
Provision for loan losses			431,000				120,000
Net interest income after provision for loan losses			4,419,273				4,489,416
Other Income
Wealth management income			324,890				358,441
Service charges on deposit accounts			763,383				762,328
Other service charges, commissions and income			462,914				417,358
(Loss) on impairment of securities			(297,500	)			—
(Loss) on sale of other real estate owned			(3,000	)			—
Total other income			1,250,687				1,538,127
Other Expenses
Salaries and benefits			2,141,693				2,295,427
Net occupancy expense of premises			328,600				265,361
Furniture and equipment			313,889				306,121
Advertising expense			142,873				139,700
Consulting expense			261,178				226,930
Data processing expense			325,227				343,970
Other operating expenses			742,605				705,891
Total other expenses			4,256,065				4,283,400
Income before income taxes			1,413,895				1,744,143
Income tax expense			478,892				534,006
Net Income		$	935,003			$	1,210,137
Earnings per Share, basic		$	0.26			$	0.34
Earnings per Share, assuming dilution		$	0.26			$	0.34
Dividends per Share		$	0.20			$	0.20

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries

		2008				2007
Interest Income
Interest and fees on loans		$	20,089,996			$	21,739,829
Interest and dividends on securities available for sale:
Taxable interest income			1,028,308				1,108,418
Interest income exempt from federal income taxes			174,700				67,262
Dividends			183,098				190,450
Interest on federal funds sold			33,296				81,983
Interest on deposits in other banks			27,851				25,984
Total interest income			21,537,249				23,213,926
Interest Expense
Interest on deposits			5,485,364				7,503,724
Interest on federal funds purchased			87,236				184,154
Interest on Federal Home Loan Bank advances			1,401,345				1,339,757
Distribution on capital securities of subsidiary trusts			155,462				300,094
Total interest expense			7,129,407				9,327,729
Net interest income			14,407,842				13,886,197
Provision for loan losses			1,721,000				360,000
Net interest income after provision for loan losses			12,686,842				13,526,197
Other Income
Wealth management income			1,000,127				1,051,999
Service charges on deposit accounts			2,223,348				2,139,644
Other service charges, commissions and income			1,555,895				1,282,355
Gain on sale of other real estate owned			25,718				—
(Loss) on impairment of securities			(422,500	)			—
Realized gain on sale of securities			87,585				—
Total other income			4,470,173				4,473,998
Other Expenses
Salaries and benefits			6,768,719				6,956,868
Net occupancy expense of premises			958,926				798,644
Furniture and equipment			885,431				889,830
Advertising expense			468,469				421,793
Consulting expense			802,566				660,820
Data processing expense			987,569				956,511
Other operating expenses			2,175,367				2,053,162
Total other expenses			13,047,047				12,737,628
Income before income taxes			4,109,968				5,262,567
Income tax expense			1,224,045				1,600,519
Net Income		$	2,885,923			$	3,662,048
Earnings per Share, basic		$	0.82			$	1.05
Earnings per Share, assuming dilution		$	0.81			$	1.03
Dividends per Share		$	0.60			$	0.59

Fauquier Bankshares, Inc. and Subsidiaries

										Accumulated Other
		Common				Retained				Comprehensive				Comprehensive
		Stock				Earnings				Income (Loss)				Income				Total
Balance, December 31, 2006 as restated		$	10,789,521			$	28,962,409			$	(1,217,318	)						$	38,534,612
Comprehensive income:
Net income							3,662,048							$	3,662,048				3,662,048
Other comprehensive income net of tax:
Unrealized holding gains on securities available for sale, net of deferred income taxes of $73,738											143,138				143,138				143,138
Total comprehensive income														$	3,805,186
Cash dividends ($.59 per share)							(2,089,302	)											(2,089,302	)
Acquisition of 27,370 shares of common stock			(85,668	)			(516,802	)											(602,470	)
Amortization of unearned compensation, restricted stock awards							191,685												191,685
Issuance of common stock — nonvested shares (11,437 shares)			35,797				(35,797	)											—
Exercise of stock options			247,664				469,410												717,074
Balance, September 30, 2007		$	10,987,314			$	30,643,651			$	(1,074,180	)						$	40,556,785
Balance, December 31, 2007		$	10,974,293			$	31,626,627			$	(773,168	)						$	41,827,752
Comprehensive income:
Net income							2,885,923								2,885,923				2,885,923
Other comprehensive income net of tax:
Unrealized holding losses on securities available for sale, net of tax benefit of $1,145,186															(2,523,548	)
Less: reclassification adjustments, net of taxes of $12,721															322,194
Other comprehensive income net of tax benefit of $1,132,465											(2,201,354	)			(2,201,354	)			(2,201,354	)
Total comprehensive income															684,569
Effects of changing pension plan measurement date, pursuant to FAS158, net of deferred income tax benefit of $12,437							(24,144	)											(24,144	)
Initial implementation of EITF 06-4, net of income tax benefit of $6,433							(12,487	)											(12,487	)
Cash dividends ($.60 per share)							(2,140,915	)											(2,140,915	)
Acquisition of 7,332 shares of common stock			(22,949	)			(103,123	)											(126,072	)
Amortization of unearned compensation, restricted stock awards							244,227												244,227
Restricted stock forfeiture							(49,604	)											(49,604	)
Issuance of common stock — nonvested shares (10,315 shares)			32,286				(32,286	)											—
Exercise of stock options			59,220				128,300												187,520
Balance, September 30, 2008		$	11,042,850			$	32,522,518			$	(2,974,522	)						$	40,590,846

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries

		2008				2007
Cash Flows from Operating Activities
Net income		$	2,885,923			$	3,662,048
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			696,976				773,598
Provision for loan losses			1,721,000				360,000
Loss on impairment of securities			422,500				—
Gain on sale of securities			(87,585	)			—
Amortization (accretion) of security premiums, net			(7,486	)			3,049
Amortization of unearned compensation, net of forfeiture			194,623				191,685
Changes in assets and liabilities:
Decrease (increase) in other assets			(315,556	)			60,029
(Decrease) increase in other liabilities			(19,209	)			198,370
Net cash provided by operating activities			5,491,186				5,248,779
Cash Flows from Investing Activities
Proceeds from sale of securities available for sale			9,078,470				—
Proceeds from maturities, calls and principal payments of securities available for sale			3,710,672				2,951,459
Purchase of securities available for sale			(13,965,595	)			(3,816,728	)
Purchase of premises and equipment			(1,848,458	)			(462,804	)
(Purchase) proceeds from sale of other bank stock			(392,300	)			923,500
Net (increase) decrease in loans			(15,690,729	)			9,354,725
Net cash provided by (used in) investing activities			(19,107,940	)			8,950,152
Cash Flows from Financing Activities
Net (decrease) increase in demand deposits, NOW accounts and savings accounts			(35,735,451	)			12,308,976
Net (decrease) increase in certificates of deposit			36,799,720				(30,074,213	)
Federal Home Loan Bank advances			70,000,000				35,000,000
Federal Home Loan Bank principal repayments			(60,000,000	)			(55,000,000	)
Purchase of federal funds			—				4,400,000
Repayment of trust preferred securities			—				(4,124,000	)
Cash dividends paid on common stock			(2,140,915	)			(2,089,302	)
Issuance of common stock			187,520				717,074
Acquisition of common stock			(126,072	)			(602,470	)
Net cash provided by financing activities			8,984,802				(39,463,935	)
Increase (decrease) in cash and cash equivalents			(4,631,952	)			(25,265,004	)
Cash and Cash Equivalents
Beginning			19,552,174				41,679,655
Ending		$	14,920,222			$	16,414,651
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest		$	7,262,818			$	7,685,021
Income taxes		$	941,000			$	1,363,000
Supplemental Disclosures of Noncash Investing Activities
Unrealized gain (loss) on securities available for sale, net of tax effect		$	(2,523,548	)		$	143,138
FAS 158 Pension Liability Implementation Adjustment, net of tax effect		$	(24,144	)		$	—
Implementation of EITF 06-4, net of tax effect		$	(12,487	)		$	—

See accompanying Notes to Consolidated Financial Statements.

FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES

Note 1. General

The consolidated statements include the accounts of Fauquier Bankshares, Inc. (“the Company”) and its wholly-owned subsidiaries: The Fauquier Bank (“the Bank”), Fauquier Statutory Trust I and Fauquier Statutory Trust II; and the Bank’s wholly-owned subsidiary, Fauquier Bank Services, Inc. In consolidation, significant intercompany financial balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial positions as of September 30, 2008 and December 31, 2007 and the results of operations for the three and nine months ended September 30, 2008 and 2007. The notes included herein should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results expected for the full year.

Note 2. Securities

The amortized cost and fair value of securities available for sale, with unrealized gains and losses follows:

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				(Losses)				Value
		September 30, 2008
Obligations of U.S. Government corporations and agencies		$	24,342,106			$	134,979			$	(17,689	)		$	24,459,396
Obligations of states and political subdivisions			5,294,573				28,050				(185,317	)			5,137,306
Corporate Bonds			6,000,000				—				(3,789,850	)			2,210,150
Mutual Funds			300,804				—				(9,648	)			291,156
FHLMC Preferred Bank Stock			18,500				—				—				18,500
Restricted investments:
Federal Home Loan Bank Stock			2,905,800				—				—				2,905,800
Federal Reserve Bank Stock			99,000				—				—				99,000
Community Bankers’ Bank Stock			50,000				—				—				50,000
The Bankers Bank Stock			112,920				—				—				112,920
		$	39,123,703			$	163,029			$	(4,002,504	)		$	35,284,228

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				(Losses)				Value
		December 31, 2007
Obligations of U.S. Government corporations and agencies		$	23,080,415			$	30,014			$	(162,347	)		$	22,948,082
Obligations of states and political subdivisions			5,293,965				82,166				(3,948	)			5,372,183
Corporate Bonds			6,000,000				—				(348,750	)			5,651,250
Mutual Funds			291,581				—				(5,791	)			285,790
FHLMC Preferred Bank Stock			441,000				—				(97,000	)			344,000
Restricted investments:
Federal Home Loan Bank Stock			2,513,500				—				—				2,513,500
Federal Reserve Bank Stock			99,000				—				—				99,000
Community Bankers’ Bank Stock			50,000				—				—				50,000
The Bankers Bank Stock			112,920				—				—				112,920
		$	37,882,381			$	112,180			$	(617,836	)		$	37,376,725

The amortized cost and fair value of securities available for sale, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without penalties.

		September 30, 2008
		Amortized				Fair
		Cost				Value
Due in one year or less		$	4,106				4,103
Due after one year through five years			1,089,455				1,088,003
Due after five years through ten years			4,670,499				4,711,712
Due after ten years			29,872,619				26,003,034
Equity securities			3,487,024				3,477,376
		$	39,123,703			$	35,284,228

For the quarter and the nine months ended September 30, 2008, the Bank recognized a permanent impairment of $297,500 and $422,500, respectively on its 10,000 shares of Freddie Mac preferred stock. There were no other impairment losses on securities in the quarter and nine months ended September 30, 2008, or the quarter and nine month period ended September 30, 2007.

For the nine months ended September 30, 2008, gross realized gains from sales of securities available for sale amounted to $87,585. The proceeds from the sale of these securities, including the realized gain, amounted to $9.1 million. The tax expense applicable to this net realized gain amounted to $29,779. There were no securities sold in the quarter ended September 30, 2008 or the quarter and nine month period ended September 30, 2007

The following table shows the Company securities with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2008 and December 31, 2007.

September 30, 2008		Less than 12 Months								12 Months or More								Total
						Unrealized								Unrealized								Unrealized
Description of Securities		Fair Value				(Losses)				Fair Value				(Losses)				Fair Value				(Losses)
Obligations of U.S. Government, corporations and agencies		$	4,784,242			$	(17,689	)		$	—			$	—			$	4,784,242			$	(17,689	)
Obligations of states and political subdivisions			4,142,781				(185,317	)			—				—				4,142,781				(185,317	)
Corporate Bonds			1,436,040				(2,563,960	)			774,110				(1,225,890	)			2,210,150				(3,789,850	)
Subtotal, debt securities			10,363,063				(2,766,966	)			774,110				(1,225,890	)			11,137,173				(3,992,856	)
Mutual Funds			—				—				291,156				(9,648	)			291,156				(9,648	)
FHLMC Preferred Bank Stock			—				—				—				—				—				—
Total temporary impaired securities		$	10,363,063			$	(2,766,966	)		$	1,065,266			$	(1,235,538	)		$	11,428,329			$	(4,002,504	)

December 31, 2007		Less than 12 Months								12 Months or More								Total
						Unrealized								Unrealized								Unrealized
Description of Securities		Fair Value				(Losses)				Fair Value				(Losses)				Fair Value				(Losses)
Obligations of U.S. Government, corporations and agencies		$	—			$	—			$	17,798,157			$	(162,347	)		$	17,798,157			$	(162,347	)
Obligations of states and political subdivisions			899,333				(3,948	)			—				—				899,333				(3,948	)
Corporate Bonds			3,770,000				(230,000	)			1,881,250				(118,750	)			5,651,250				(348,750	)
Subtotal, debt securities			4,669,333				(233,948	)			19,679,407				(281,097	)			24,348,740				(515,045	)
Mutual Funds			—								285,790				(5,791	)			285,790				(5,791	)
FHLMC Preferred Bank Stock			344,000				(97,000	)			—				—				344,000				(97,000	)
Total temporary impaired securities		$	5,013,333			$	(330,948	)		$	19,965,197			$	(286,888	)		$	24,978,530			$	(617,836	)

The nature of securities which are temporarily impaired for a continuous 12 month period or more at September 30, 2008 can be segregated into two groups:

The first group consists of two corporate bonds, rated A2 by Moody’s, having a total amortized cost of $2.0 million with a temporary loss of approximately $1.2 million. These bonds have an estimated maturity of 26 years, but can be called at par on the five year anniversary, which will occur in 2008 and 2009. If not called, the bonds reprice every three months at a fixed rate index above the three-month London Interbank Offered Rate (“LIBOR”). These bonds are current, they have sufficient cash flow projections to satisfy the cash flow portion of the Other Than Temporary Impairment test under EITF 99-20 as of September 30, 2008, and the Company has the ability to hold these bonds to maturity. Please note that the Bank also has two additional corporate bonds of a similar nature, also rated A2 by Moody’s, which have not yet had a continuous impairment of 12 months. These two additional bonds have a total amortized cost of $4.0 million with a temporary loss of approximately $2.6 million. These bonds are also current, they also have sufficient cash flow projections to satisfy the cash flow portion of the Other Than Temporary Impairment test under EITF 99-20 as of September 30, 2008, and the Company has the ability to also hold these bonds to maturity.

The second group consists of a Community Reinvestment Act qualified investment bond fund with a temporary loss of approximately $10,000. The fund is a relatively small segment of the portfolio and the Company plans to hold it indefinitely.

The carrying value of securities pledged to secure deposits and for other purposes amounted to $26.0 million and $13.6 million at September 30, 2008 and December 31, 2007, respectively.

Note 3. Loans

     A summary of the balances of loans follows:

		September 30,				December 31,
		2008				2007
		(Thousands)
Real estate loans:
Construction		$	41,257			$	37,204
Secured by farmland			1,315				1,365
Secured by 1 — to — 4 family residential			174,053				170,983
Other real estate loans			146,877				132,918
Commercial and industrial loans (not secured by real estate)			36,821				38,203
Consumer installment loans			17,786				24,133
All other loans			10,122				8,824
Total loans		$	428,231			$	413,630
Unearned income			(470	)			(338	)
Allowance for loan losses			(4,684	)			(4,185	)
Net loans		$	423,077			$	409,107

Of the $146.9 million in other real estate loans, $88.3 million is owner occupied and $58.6 million is non-owner occupied.

Note 4. Allowance for Loan Losses

     Analysis of the allowance for loan losses follows:

		Nine Months				Nine Months				Twelve Months
		Ended				Ended				Ended
		September 30,				September 30,				December 31,
		2008				2007				2007
Balance at beginning of year		$	4,185,209			$	4,470,533			$	4,470,533
Provision for loan losses			1,721,000				360,000				717,000
Recoveries of loans previously charged-off			66,800				43,701				60,616
Loan losses charged-off			(1,288,571	)			(461,038	)			(1,062,940	)
Balance at end of year		$	4,684,438			$	4,413,196			$	4,185,209

     Nonperforming assets consist of the following:

(Dollars in thousands)		September 30,				December 31,				September 30,
		2008				2007				2007
Nonaccrual loans		$	4,457			$	1,906			$	1,240
Restructured loans			—				—				—
Total nonperforming loans		$	4,457			$	1,906			$	1,240
Foreclosed property			133				222				142
Total nonperforming assets		$	4,590			$	2,128			$	1,382

		September 30, 2008				December 31, 2007
Impaired loans for which an allowance has been provided		$	1,863,300			$	2,688,501
Impaired loans for which no allowance has been provided			3,389,723				1,247,461
		$	5,253,023			$	3,935,962
Allowance provided for impaired loans, included in the allowance for loan losses		$	1,274,158			$	1,392,236

						Twelve Months
		Nine Months Ended				Ended
		September 30, 2008				December 31, 2007
Average balance in impaired loans		$	5,201,012			$	4,359,817
Interest income recognized on impaired loans		$	199,884			$	261,257

Total loans past due 90 days or more and still accruing interest were $1,000 at September 30, 2008 and, $770,000, and $165,000 on December 31, 2007, and September 30, 2007, respectively.

The Company has adopted Financial Accounting Standards Board (“FASB”) Statement No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by FASB Statement No. 118, “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures.” FASB Statement No. 114, as amended, requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. FASB Statement No. 114, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

A loan is considered impaired when it is probable that the Bank will be unable to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered “insignificant” and would not indicate an impairment situation, if in management’s judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under FASB Statement No. 114. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

Note 5. Company-Obligated Mandatorily Redeemable Capital Securities

On March 26, 2002, the Company established a subsidiary trust that issued $4.0 million of capital securities as part of a pooled trust preferred security offering with other financial institutions (“Trust I”). The Company used the offering proceeds for the purposes of expansion and the repurchase of additional shares of its common stock. The interest rate on the capital security resets every three months at 3.60% above the then current three month LIBOR. Interest is paid quarterly. Under applicable regulatory guidelines, the capital securities are treated as Tier 1 capital for purposes of the Federal Reserve’s capital guidelines for bank holding companies, as long as the capital securities and all other cumulative preferred securities of the Company together do not exceed 25% of Tier 1 capital.

On September 21, 2006, the Company’s wholly-owned Connecticut statutory business trust privately issued $4 million face amount of the trust’s Floating Rate Capital Securities in a pooled capital securities offering (“Trust II”). Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The interest rate on the capital security resets every three months at 1.70% above the then current three month LIBOR. Interest is paid quarterly.

The purpose of the September 2006 Trust II issuance was to use the proceeds to redeem the existing capital securities of Trust I on March 26, 2007. Because of changes in the market pricing of capital securities from 2002 to 2006, the September 2006 issuance was priced 190 basis points less than that of the March 2002 issuance, and the repayment of the March 2002 issuance in March 2007 reduced the interest expense associated with the distribution on capital securities of subsidiary trust by $76,000 annually. The Company redeemed all the existing capital securities issued by Trust I on March 26, 2007.

Total capital securities at September 30, 2008 and 2007 were $4,124,000 for both respective dates. The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time after five years from the issue date. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.

Note 6. 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 dilutive potential common stock. Dilutive potential common stock had no effect on income available to common shareholders.

	Three Months								Three Months
	Ended								Ended
	September 30, 2008								September 30, 2007
					Per Share								Per Share
	Shares				Amount				Shares				Amount
		3,529,347			$	0.26				3,513,130			$	0.34
		31,184								45,179
		3,560,531			$	0.26				3,558,309			$	0.34
	Nine Months								Nine Months
	Ended								Ended
	September 30, 2008								September 30, 2007
					Per Share								Per Share
	Shares				Amount				Shares				Amount
		3,525,633			$	0.82				3,503,844			$	1.05
		33,384								63,522
		3,559,017			$	0.81				3,567,366			$	1.03

Note 7. Stock-Based Compensation

The Company has a stock-based compensation plan. Effective January 1, 2006 the Company adopted the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 123 (R), “Share-Based Payment,” which requires that the Company recognize expense related to the fair value of stock-based compensation awards in net income.

The nonvested shares are accounted for using the fair market value of the Company’s common stock on the date the restricted shares were awarded. The restricted shares issued to executive officers and directors are subject to a vesting period over the next three years. Compensation expense for nonvested shares amounted to $68,952 and $64,545 for the three months ended September 30, 2008 and 2007, respectively. Compensation expense for nonvested shares amounted to $194,623 and $191,685 for the nine months ended September 30, 2008 and 2007, respectively.

The Company did not grant options during the three months or nine months ended September 30, 2008 and 2007.

A summary of the status of the Omnibus Stock Ownership and Long-Term Incentive Plan and Non-employee Director Stock Option Plan ( collectively, the “Plans”) is presented below:

		Nine Months Ended
		September 30, 2008
						Weighted
						Average				Average
		Number of				Exercise				Intrinsic
		Shares				Price				Value (1)
Outstanding at January 1, 2008			96,100			$	9.85
Granted			—
Exercised			(18,920	)			9.91
Forfeited			—
Outstanding at September 30, 2008			77,180			$	9.84			$	434,523
Exercisable at end of quarter			77,180			$	9.84			$	434,523
Weighted-average fair value per option of options granted during the year			—

The total intrinsic value of options exercised during the nine months ended September 30, 2008 and 2007 was $132,774 and $1,207,531, respectively.

A summary of the status of the Company’s nonvested shares is presented below:

		Nine Months Ended
		September 30, 2008
						Weighted
						Average
		Number of				Exercise
		Shares				Price
Nonvested at January 1, 2008			31,190
Granted			19,692			$	17.70
Vested			(10,315	)
Forfeited, nonvested			(2,348	)		$	21.13
Nonvested at September 30, 2008			38,219

As of September 30, 2008, there was $402,988 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plans. That cost is expected to be recognized over an approximate period of 28 months.

Note 8. Employee Benefit Plan

The following table provides a reconciliation of the changes in the defined benefit pension plan’s obligations for the three and nine months ended September 30, 2008 and 2007.

		Three Months Ended
		September 30,
		2008				2007
Service cost		$	111,081			$	167,680
Interest cost			77,352				100,343
Expected return on plan assets			(149,050	)			(111,378	)
Amortization of transition (asset)			(4,745	)			1,942
Amortization of prior service cost			1,942				(4,745	)
Recognized net actuarial loss			—				5,258
Net periodic benefit cost		$	36,580			$	159,100

		Nine Months Ended
		September 30,
		2008				2007
Service cost		$	333,243			$	503,040
Interest cost			232,056				301,029
Expected return on plan assets			(447,150	)			(334,134	)
Amortization of transition (asset)			(14,235	)			5,826
Amortization of prior service cost			5,826				(14,235	)
Recognized net actuarial loss			—				15,774
Net periodic benefit cost		$	109,740			$	477,300

The Company previously disclosed in its financial statements for the year ended December 31, 2007, that there were no contributions made to its pension plan in 2007. As of September 30, 2008, the pension plan required no additional contributions.

On December 20, 2007, the Company’s Board of Directors approved the termination of the defined benefit pension plan effective on December 31, 2009, and effective January 1, 2010, the Company will replace the defined benefit pension plan with an enhanced 401(k) plan. On January 18, 2008, the assets within the defined benefit pension plan were redeployed from ownership in various equity and debt mutual fund investments, and into a short-term money market fund in order to preserve asset value until the plan is terminated.

Defined benefit pension plan expenses are projected to decrease from $636,000 in 2007 to approximately $150,000 in 2008 and nothing in 2009 and going forward. Expenses for the 401(k) plan are projected to increase from $134,000 in 2007 to approximately $140,000 in 2008 and 2009, and approximately $625,000 in 2010. Growth in 401(k) after 2010 is projected to increase approximately at the same rate of increase as salaries.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

In addition to the historical information contained herein, this report contains forward-looking statements. Forward-looking statements are based on certain assumptions and describe future plans, strategies, and expectations of the Company and the Bank, and are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” “may,” “will” or similar expressions. Although we believe our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain, and actual results could differ materially from those contemplated. Factors that could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the Bank’s loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area, our plans to expand our branch network and increase our market share, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements in this report and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

For additional discussion of risk factors that may cause our actual future results to differ materially from the results indicated within forward-looking statements, please see “Risk Factors” in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

GENERAL

Fauquier Bankshares, Inc. (“the Company”) was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. The Company is a registered bank holding company and owns all of the voting shares of The Fauquier Bank (“the Bank”). The Company engages in its business through the Bank, a Virginia state-chartered bank that commenced operations in 1902. The Company has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,566,286 shares of common stock, par value $3.13 per share, held by approximately 432 holders of record on September 30, 2008. The Bank has eight full service branch offices located in the Virginia communities of Warrenton, Catlett, The Plains, Sudley Road-Manassas, Old Town-Manassas, New Baltimore and Bealeton. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186. The Bank has leased properties in Haymarket, Virginia and Bristow, Virginia, where it plans to build its ninth and tenth full-service branch offices, respectively, scheduled to open during 2009.

The Bank’s general market area principally includes Fauquier County, western Prince William County, and neighboring communities and is located approximately fifty (50) miles southwest of Washington, D.C.

The Bank provides a range of consumer and commercial banking services to individuals, businesses and industries. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation. The basic services offered by the Bank include: demand interest bearing and non-interest bearing accounts, money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, direct deposits, notary services, night depository, prepaid debit cards, cashier’s checks, domestic collections, savings bonds, automated teller services, drive-in tellers, internet banking, telephone banking, and banking by mail. In addition, the Bank makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. The Bank provides automated teller machine (“ATM”) cards, as a part of the Star, NYCE, and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks. The Bank also is a member of the Certificate of Deposit Account Registry Service (“CDARS”). CDARs can provide a customer multi-million dollar FDIC insurance on CD investments through the transfer and/or exchange with other FDIC insured institutions. CDARS is a registered service mark of Promontory Interfinancial Network, LLC.

The Bank operates a Wealth Management Services (“WMS” or “Wealth Management”) division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services.

The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company; Infinex Investments, Inc., a full service broker/dealer; and Bankers Title Shenandoah, LLC, a title insurance company. Bankers Insurance consists of a consortium of 36 Virginia community bank owners; Infinex is owned by 57 banks in various states; and Bankers Title Shenandoah is owned by 17 Virginia community banks. On April 30, 2008, the Bank’s ownership of stock in BI Investments, LLC was exchanged for Infinex stock as part of a merger.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank’s lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank (“FHLB”) of Atlanta. Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank’s principal expenses are the interest paid on deposits and operating and general administrative expenses.

As is the case with banking institutions generally, the Bank’s operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System (“Federal Reserve”). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Virginia State Corporation Commission. Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. Please see “Risk Factors” in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

As of September 30, 2008, the Company had total consolidated assets of $499.8 million, total loans net of allowance for loan losses of $423.1 million, total consolidated deposits of $405.6 million, and total consolidated shareholders’ equity of $40.6 million.

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the Company’s transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable, (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” which requires adequate documentation to support the allowance for loan losses estimate.

The Company’s allowance for loan losses has two basic components: the specific allowance and the general allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans. The specific allowance uses various techniques to arrive at an estimate of loss. First, analysis of the borrower’s overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Then the migration of historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not allocated a specific allowance upon their review. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical and peer group delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the specific allowances.

EXECUTIVE OVERVIEW

This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community. The Company and the Bank’s primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management.

Net income of $935,000 for the third quarter of 2008 was a 22.7% decrease from the net income for the third quarter of 2007 of $1.21 million. Loans, net of reserve, totaling $423.1 million at September 30, 2008, increased 3.4% when compared with December 31, 2007, and increased 4.1% when compared with September 30, 2007. Deposits increased 0.3% compared with year-end 2007, and increased 1.8% when compared with September 30, 2007. Assets under WMS management, totaling $273.7 million in market value at September 30, 2008, declined 7.9% from $297.1 million in market value at September 30, 2007, primarily due to the decline in valuations of common stock under management. For example, from September 30, 2007 to September 30, 2008, stocks measured in the Standard & Poors’ 500 index declined by approximately 24.6%.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, competition for loans and deposits, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase in 2008 and beyond as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank’s net interest margin resulting from competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income.

During the third quarter of 2008, the Bank has seen its competition for deposits increase significantly. The pricing of retail deposits, which traditionally has been at an interest rate less than the interest rate on a FHLB of Atlanta advance of similar term, has exceeded the corresponding FHLB rate by 50 to 100 basis points or more. The increased cost of deposits has resulted in less net interest income and a narrower net interest margin. The intensified competition for deposits is, for the most part, the result of liquidity and capitalization pressures faced by many of the large multi-state financial institutions who compete in the Bank’s market area.

The Bank’s non-performing assets totaled $4.6 million or 1.07% of total loans at September 30, 2008, as compared with $2.1 million or 0.51% of total loans at December 31, 2007, and $1.38 million or 0.34% of total loans at September 30, 2007. The provision for loan losses was $431,000 for the third quarter of 2008 compared with $120,000 for the third quarter of 2007. Loan chargeoffs, net of recoveries, totaled $1.22 million or 0.29% of total loans for the first nine months of 2008, compared with $417,000 or 0.11% of total loans for the first nine months of 2007. The $311,000 increase in the provision for loan losses from third quarter 2007 to third quarter 2008 was largely in response to the increase in net loans and non-performing assets. Total allowance for loan losses was $4.7 million or 1.10% of total loans at September 30, 2008 compared with $4.2 million or 1.01% of loans at December 31, 2007.

Management seeks to continue the expansion of its branch network. The Bank has leased properties in Haymarket, Virginia and Bristow, Virginia, where it plans to build its ninth and tenth full-service branch offices, respectively, both scheduled to open in 2009. The Bank is looking toward these new retail markets for growth in deposits and WMS income. Management seeks to increase the level of its fee income from deposits and WMS through the increase of its market share within its marketplace.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2008 AND SEPTEMBER 30, 2007

NET INCOME

Net income was $935,000 for the third quarter of 2008, a 22.7% decrease from the third quarter of 2007 net income of $1.21 million. Earnings per share on a fully diluted basis were $0.26 in 2008 compared to $0.34 in 2007. Profitability as measured by return on average equity decreased from 11.68% in the third quarter of 2007 to 8.85% for the same period in 2008. Profitability as measured by return on average assets decreased from 0.99% to 0.73% over the same respective quarters in 2007 and 2008. The decline in net income and the corresponding profitability measures was primarily due to the increase in the provision for loan losses of $311,000 in the third quarter of 2008 compared with the third quarter of 2007, as well as a $298,000 permanent impairment loss on the Bank’s investment in Freddie Mac preferred stock.

NET INTEREST INCOME AND EXPENSE

Net interest income increased $241,000 or 5.2% to $4.85 million for the quarter ended September 30, 2008 from $4.61 million for the quarter ended September 30, 2007. The increase in net interest income was due to the Company’s net interest margin increasing from 4.02% in the third quarter of 2007 to 4.10% in the third quarter of 2008, primarily due to the positively sloped yield curve during the third quarter of 2008 compared with the flat and inverted yield curve during the third quarter of 2007. (A positively sloped yield curve is where the interest rate on longer-termed financial instruments exceeds the interest rate on shorter-termed financial instruments, all other factors being equal, while with an inverted yield curve, shorter-termed financial instruments have higher interest rates than longer-termed financial instruments.) The benefit of the positively sloped yield curve was partially offset by competitive pricing pressures, particularly on deposits. In addition, net interest income increased due to the impact of total average earning assets increasing from $454.0 million during the third quarter of 2007 to $470.9 million during the third quarter of 2008.

The net interest margin pressure caused by the economic environment of a flat and inverted yield curve proved to be challenging for the Bank during much of 2007. At September 30, 2004, just as the Federal Reserve’s Federal Open Market Committee (the “FMOC”) began raising the federal funds rate, the yield on a three month maturity treasury bond was 1.37% or 253 basis points below the 3.90% yield on a five year treasury and 332 basis points below the 4.69% yield on a 10 year treasury. At October 30, 2006, that yield had inverted to the point that a three month treasury was yielding 5.12%, while the five year and ten year treasury were yielding 4.74% and 4.77%, respectively. The yield curve changed from a more than 250 basis point premium for a longer investment to a position where there is no premium or, in fact, a discount. This presented funding and interest margin management pressures, as a flat or inverted yield curve significantly increased competition for deposits and their cost. While deposit costs rapidly increased, the lack of a similar movement in longer-term rates limited the yield increase on fixed rate loans.

The economic environment changed direction during the fourth quarter of 2007, when the FMOC began lowering the federal funds rate, and the shape of the yield curve became less flat and more positively sloped. Through September 30, 2008, the FMOC has continued the reduction of the federal funds rate. At September 30, 2008, the yield on a three month maturity treasury security was 0.92% or 206 basis points below the 2.98% yield on a five year treasury and 293 basis points below the 3.85% yield on a 10 year treasury. As a result, the Company’s net interest margin improved from 4.02% for the third quarter of 2007 to 4.10% for the third quarter of 2008. Offsetting the benefit of the positively sloped yield curve during the third quarter of 2008 has been the significant increase in competitive pricing for retail deposits.

Total interest income decreased $505,000 or 6.6% to $7.20 million for the third quarter of 2008 from $7.71 million for the third quarter of 2007. This decrease was primarily due to the 65 basis point decrease in the yield on average assets from third quarter 2007 to third quarter 2008. This was partially offset by the increase in total average earning assets of $16.9 million or 3.7%.

The average yield on loans decreased to 6.17% for the third quarter of 2008 compared with 6.90% for the third quarter of 2007. Average loan balances increased 4.0% from $412.7 million during the third quarter of 2007 to $429.4 million during the third quarter of 2008. Together, this resulted in a $527,000 or 7.3% decrease in interest and fee income from loans for the third quarter of 2008 compared with the same period in 2007.

Average investment security balances decreased $1.1 million from $39.3 million in the third quarter of 2007 to $38.2 million in the third quarter of 2008. The tax-equivalent average yield on investments increased from 4.85% for the third quarter of 2007 to 5.39% for the third quarter of 2008. Together, there was an increase in interest and dividend income on security investments of $27,000 or 5.9%, from $458,000 for the third quarter of 2007 to $485,000 for the third quarter of 2008. Interest income on federal funds sold decreased $15,000 from the third quarter of 2007 to the third quarter of 2008, reflecting a decline in the average balances from $1.3 million to nothing.

Total interest expense decreased $746,000 or 24.1% from $3.10 million for the third quarter of 2007 to $2.35 million for the third quarter of 2008 primarily due to the overall decline in shorter-term market interest rates. Interest paid on deposits decreased $781,000 or 30.7% from $2.54 million for the third quarter of 2007 to $1.76 million for the third quarter of 2008. Average Premium money market account balances decreased $9.6 million from third quarter 2007 to third quarter 2008, while their average rate decreased from 4.10% to 2.07% over the same period resulting in a decrease of $453,000 of interest expense for the third quarter of 2008. Average time deposit balances increased $1.9 million from third quarter of 2007 to the third quarter of 2008 while the average rate on time deposits decreased from 4.43% to 3.52% resulting in a decrease of $267,000 in interest expense for the third quarter of 2008. Average NOW deposit balances increased $11.7 million from the third quarter of 2007 to the third quarter of 2008 while the average rate on NOW accounts decreased from 1.30% to 0.90% resulting in a reduction of $45,000 in NOW interest expense for the third quarter of 2008.

Interest expense on federal funds purchased decreased $22,000 for the third quarter of 2008 when compared to the third quarter of 2007 due to the decline in the average fed funds rate from 5.76% to 2.40%, partially offset by the $807,000 increase in average federal funds purchased. Interest expense on FHLB of Atlanta advances increased $84,000 from the third quarter of 2007 to the third quarter of 2008 due to the increase in average FHLB advance balances of $25.7 million, mostly offset by the decrease in the average rate paid on FHLB advances from 5.30% to 3.51%. The average rate on total interest-bearing liabilities decreased from 3.32% for the third quarter of 2007 to 2.36% for the third quarter of 2008.

The following table sets forth information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
(Dollars in Thousands)

		Three Months Ended September 30, 2008												Three Months Ended September 30, 2007
		Average				Income/				Average				Average				Income/				Average
		Balances				Expense				Rate				Balances				Expense				Rate
ASSETS:
Loans
Taxable		$	417,624			$	6,596				6.19	%		$	404,429			$	7,137				6.90	%
Tax-exempt (1)			8,642				159				7.21	%			7,536				139				7.17	%
Nonaccrual (2)			3,089				—								744				—
Total Loans			429,355				6,755				6.17	%			412,709				7,276				6.90	%
Securities
Taxable			32,970				427				5.17	%			36,024				420				4.66	%
Tax-exempt (1)			5,265				88				6.71	%			3,299				57				6.94	%
Total securities			38,235				515				5.39	%			39,323				477				4.85	%
Deposits in banks			3,269				15				1.83	%			641				5				3.25	%
Federal funds sold			—				—								1,289				15				4.69	%
Total earning assets			470,859				7,285				6.08	%			453,962				7,773				6.72	%
Less: Reserve for loan losses			(4,491	)											(4,414	)
Cash and due from banks			14,658												14,292
Bank premises and equipment, net			8,451												7,350
Other assets			17,501												16,093
Total Assets		$	506,978											$	487,283
LIABILITIES & SHAREHOLDERS’ EQUITY:
Deposits
Demand deposits		$	66,170											$	73,072
Interest-bearing deposits
NOW accounts			82,685				186				0.90	%			70,966				232				1.30	%
Money market accounts			20,447				74				1.43	%			25,112				92				1.45	%
Premium money market accounts			68,990				359				2.07	%			78,628				812				4.10	%
Savings accounts			31,748				39				0.49	%			32,173				34				0.43	%
Time deposits			124,902				1,104				3.52	%			122,956				1,372				4.43	%
Total interest-bearing deposits			328,772				1,762				2.13	%			329,835				2,542				3.06	%
Federal funds purchased			3,953				24				2.40	%			3,146				46				5.76	%
Federal Home Loan Bank advances			57,880				519				3.51	%			32,207				436				5.30	%
Capital securities of subsidiary trust			4,124				46				4.34	%			4,124				73				6.89	%
Total interest-bearing liabilities			394,729				2,351				2.36	%			369,312				3,097				3.32	%
Other liabilities			4,041												3,811
Shareholders’ equity			42,038												41,088
Total Liabilities & Shareholders’ Equity		$	506,978											$	487,283
Net interest spread						$	4,934				3.72	%						$	4,676				3.40	%
Interest expense as a percent of average earning assets											1.98	%											2.70	%
Net interest margin											4.10	%											4.02	%