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CapitalSouth Bancorp 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Graphic
  6.  
CapitalSouth BANCORP
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2008
Or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission file number: 000-51660
(CAPITALSOUTH BANCORP LOGO)
(Exact name of registrant as specified in its charter)
     
Delaware   63-1026645
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
2340 Woodcrest Place    
Birmingham, Alabama   35209
(Address of principal executive offices)   (Zip Code)
(205) 870-1939
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
     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 o   Non-accelerated filer o   Smaller reporting company þ
        (Do not check if a smaller reporting company)    
     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o                     No þ          
     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
     
Class   Outstanding at August 12, 2008
     
Common Stock, $1.00 par value per share   4,156,810 shares
 
 

 


 

CAPITALSOUTH BANCORP
Report on Form 10-Q
June 30, 2008
TABLE OF CONTENTS
         
       
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 EX-31.1 Section 302 Certification of the CEO
 EX-31.2 Section 302 Certification of the CFO
 EX-32.1 Section 906 Certification of the CEO & CFO
FORWARD-LOOKING STATEMENTS
Some of our statements contained in this Form 10-Q and in other documents that we incorporate by reference into this report, including matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, are “forward-looking statements” that are based upon our current expectations and projections about current events. Forward-looking statements relate to future events or our future financial performance and include statements about the competitiveness of the banking industry, potential regulatory obligations, our entrance and expansion into other markets, our other business strategies and other statements that are not historical facts. Forward-looking statements are not guarantees of performance or results. We intend these forward-looking statements to be covered by the safe harbor provisions for “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and we include this statement for purposes of these safe harbor provisions. When we use words like “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” and similar expressions, you should consider them as identifying forward-looking statements, although we may use other phrasing. These forward-looking statements involve risks and uncertainties and are based on our beliefs and assumptions, and on the information available to us at the time that these disclosures were prepared. These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors, including, but not limited to, the following: the effects of future economic conditions, including inflation or a decrease in residential housing values; governmental monetary and fiscal policies, as well as legislative and regulatory changes; our ability to maintain required capital levels and adequate sources of funding and liquidity; the risks of changes in interest rates on the level and composition of deposits, loan demand and the values of loan collateral, securities and interest sensitive assets and liabilities; the effects of terrorism and efforts to combat it; credit risks; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in our market area and elsewhere, including institutions operating regionally, nationally and internationally, together with competitors offering banking products and services by mail, telephone and the Internet; our ability to receive dividends from our subsidiary; our ability to service our debt obligations if we are unable to receive dividends from our subsidiary; the effects of critical accounting policies and judgments; fluctuations in our stock price; the effect of any mergers, acquisitions or other transactions to which we or our subsidiary may from time to time be a party, including our ability to successfully integrate any businesses that we acquire; and the failure of assumptions underlying the establishment of our allowance for loan losses. All written or oral forward-looking statements attributable to CapitalSouth Bancorp are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.

 


Table of Contents

PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
CAPITALSOUTH BANCORP AND SUBSIDIARIES
Consolidated Balance Sheet
(Unaudited)
                 
    June 30,     December 31,  
    2008     2007  
ASSETS
               
Cash and due from banks
  $ 8,808,741     $ 8,647,193  
Federal funds sold
    35,768       230,064  
 
           
Cash and cash equivalents
    8,844,509       8,877,257  
Securities available-for-sale
    63,316,823       49,772,919  
Securities held-to-maturity, fair values of $32,947,570 and $33,163,493 at June 30, 2008 and December 31, 2007, respectively
    33,124,867       33,253,999  
Federal Home Loan Bank stock
    3,910,600       5,646,000  
Federal Reserve Bank stock
    2,075,702       2,256,702  
Loans held-for-sale
    3,521,197       7,419,085  
Loans, net of unearned income
    589,060,082       622,111,298  
Allowance for loan losses
    (16,082,392 )     (8,876,419 )
 
           
Net loans
    572,977,690       613,234,879  
Premises and equipment, net
    21,323,409       18,791,945  
Other real estate owned
    9,915,618       3,499,162  
Goodwill
          9,629,842  
Other intangibles, net
    806,683       930,995  
Bank-owned life insurance
    4,816,454       4,719,788  
Deferred tax asset, net
    6,369,911       3,867,613  
Other assets
    5,191,626       5,575,270  
 
           
Total assets
  $ 736,195,089     $ 767,475,456  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Deposits:
               
Interest-bearing
  $ 555,254,872     $ 531,088,455  
Noninterest-bearing
    66,838,520       62,255,103  
 
           
Total deposits
    622,093,392       593,343,558  
Federal funds purchased
    25,811,040       62,898,140  
Borrowed funds
    29,042,306       33,935,281  
Repurchase agreements
    567,881       683,907  
Subordinated debentures and other notes payable
    24,242,628       23,053,064  
Other liabilities
    4,680,532       7,061,708  
 
           
Total liabilities
    706,437,779       720,975,658  
 
           
Stockholders’ equity:
               
Preferred stock, $0.01 par value. Authorized 500,000 shares; issued and outstanding none
           
Common stock, $1 par value. Authorized 16,500,000 shares at June 30, 2008 and 7,500,000 at December 31, 2007, respectively; issued 4,241,640 and 4,235,952, shares at June 30, 2008 and December 31, 2007, respectively; outstanding 4,156,810 and 4,151,122 shares at June 30, 2008 and December 31, 2007, respectively
    4,241,640       4,235,952  
Treasury stock, at cost, 84,830 shares at June 30, 2008 and December 31, 2007, respectively
    (1,255,060 )     (1,255,060 )
Paid-in surplus
    45,865,347       45,841,834  
Accumulated deficit
    (18,676,625 )     (2,444,797 )
Accumulated other comprehensive (loss) income, net
    (417,992 )     121,869  
 
           
Total stockholders’ equity
    29,757,310       46,499,798  
 
           
Total liabilities and stockholders’ equity
  $ 736,195,089     $ 767,475,456  
 
           
See accompanying notes to consolidated financial statements.

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Table of Contents

CAPITALSOUTH BANCORP AND SUBSIDIARIES
Consolidated Statement of Income
(Unaudited)
                                 
    For the Three Months Ended     For the Six Months Ended  
    June 30,     June 30,  
    2008     2007     2008     2007  
Interest income:
                               
Interest and fees on loans
  $ 9,099,388     $ 8,166,995     $ 19,730,091     $ 15,874,809  
Interest on securities
    921,464       836,361       1,829,226       1,687,569  
Interest on other earning assets
    110,974       72,578       213,782       193,235  
 
                       
Total interest income
    10,131,826       9,075,934       21,773,099       17,755,613  
 
                       
Interest expense:
                               
Interest on deposits
    5,054,724       4,489,096       10,681,918       8,912,288  
Interest on debt
    806,315       336,336       2,072,826       639,312  
 
                       
Total interest expense
    5,861,039       4,825,432       12,754,744       9,551,600  
 
                       
Net interest income
    4,270,787       4,250,502       9,018,355       8,204,013  
Provision for loan losses
    9,349,531       225,378       10,007,281       361,628  
 
                       
Net interest (loss) income after provision for loan losses
    (5,078,744 )     4,025,124       (988,926 )     7,842,385  
 
                       
Noninterest income:
                               
Service charges on deposits
    403,669       316,513       774,986       616,194  
Investment banking income, net
    1,035       38,822       3,132       201,261  
Business Capital Group loan income
    18,252       408,143       90,030       586,982  
Bank-owned life insurance
    48,333       43,518       96,666       87,036  
Gain on sale of mortgage loans
    168,556             444,712        
(Loss) gain on sale or impairment of securities
    (78,158 )           200,220        
Other noninterest income
    172,358       47,378       325,890       81,366  
 
                       
Total noninterest income
    734,045       854,374       1,935,636       1,572,839  
 
                       
Noninterest expense:
                               
Salaries and employee benefits
    2,540,963       2,011,280       5,083,679       4,016,410  
Occupancy and equipment expense
    982,592       535,169       1,856,569       1,088,321  
Professional fees
    439,336       373,713       783,668       742,788  
Advertising
    103,835       42,004       230,779       143,940  
Other real estate expense
    1,252,073       999       1,354,722       32,682  
Other noninterest expense
    936,726       524,715       1,878,080       1,012,652  
Goodwill impairment charge
    9,362,813             9,362,813        
 
                       
Total noninterest expense
    15,618,338       3,487,880       20,550,310       7,036,793  
 
                       
(Loss) income before income tax
    (19,963,037 )     1,391,618       (19,603,600 )     2,378,431  
Income tax (benefit) provision
    (3,567,722 )     494,961       (3,530,173 )     775,194  
 
                       
Net (loss) income
  $ (16,395,315 )   $ 896,657     $ (16,073,427 )   $ 1,603,237  
 
                       
 
                               
Basic (loss) earnings per share
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.54  
Basic weighted average shares outstanding
    4,153,835       2,992,990       4,152,592       2,987,190  
Diluted (loss) earnings per share
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.53  
Diluted weighted average shares outstanding
    4,153,835       3,010,659       4,152,592       3,013,124  
See accompanying notes to consolidated financial statements.

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CAPITALSOUTH BANCORP AND SUBSIDIARIES
Consolidated Statement of Stockholders’ Equity and Comprehensive Income
Six Months Ended June 30, 2008
(Unaudited)
                                                         
                                            Accumulated        
    Common Stock                             Other     Total  
    Shares             Treasury     Paid-in     Accumulated     Comprehensive     Stockholders’  
    Outstanding     Amount     Stock     Surplus     Deficit     Income (Loss), Net     Equity  
Balance, December 31, 2007
    4,151,122     $ 4,235,952     $ (1,255,060 )   $ 45,841,834     $ (2,444,797 )   $ 121,869     $ 46,499,798  
Change in accounting principle
                            (158,401 )           (158,401 )
 
                                         
Adjusted balance at January 1, 2008
    4,151,122       4,235,952       (1,255,060 )     45,841,834       (2,603,198 )     121,869       46,341,397  
Comprehensive loss:
                                                       
Net loss
                            (16,073,427 )           (16,073,427 )
Change in fair value of securities available-for-sale, net
                                  (539,861 )     (539,861 )
 
                                                     
Total comprehensive loss
                                                    (16,613,288 )
Common stock issued for director fees
    5,688       5,688             23,513                   29,201  
 
                                         
Balance, June 30, 2008
    4,156,810     $ 4,241,640     $ (1,255,060 )   $ 45,865,347     $ (18,676,625 )   $ (417,992 )   $ 29,757,310  
 
                                         
See accompanying notes to consolidated financial statements.

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CAPITALSOUTH BANCORP AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
                 
    Six Months Ended  
    June 30,  
    2008     2007  
Cash flows from operating activities:
               
Net (loss) income
  $ (16,073,427 )   $ 1,603,237  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation
    783,067       465,007  
Provision for loan losses
    10,007,281       361,628  
Deferred tax benefit
    (2,360,814 )     (178,690 )
Amortization and accretion, net
    14,256       56,452  
Goodwill impairment charge
    9,362,813        
Director fees, paid in common stock
    29,201       121,026  
Share-based compensation
          74,092  
Net gain on sale or impairment of securities
    (200,220 )      
Gain on sale of loans held-for-sale
    (444,712 )      
Loss on sale of other real estate owned
    122,194       27,155  
Write-down of other real estate owned
    1,093,458        
Gain on disposal of premises and equipment and other assets
    (70,929 )      
Originations of loans held-for-sale
    (49,766,848 )      
Proceeds from sale of loans
    54,109,448        
Net decrease (increase) in other assets
    598,230       (265,232 )
Net decrease in other liabilities
    (2,366,838 )     (619,160 )
 
           
Net cash provided by operating activities
    4,836,160       1,645,515  
 
           
Cash flows from investing activities:
               
Purchases of securities available-for-sale
    (32,299,000 )     (504,844 )
Proceeds from sales, maturities and paydowns of securities available-for-sale
    18,097,506       1,936,124  
Purchases of securities held-to-maturity
    (1,100,000 )     (2,243,558 )
Proceeds from paydowns of securities held-to-maturity
    1,378,236       2,388,391  
Purchases of Federal Home Loan Bank stock
    (6,378,000 )     (2,382,500 )
Sales of Federal Home Loan Bank stock
    8,113,400       2,188,800  
Sale of Federal Reserve Bank stock
    181,000        
Proceeds from the sale of minority interest
    120,975        
Loan payments (originations), net
    21,277,075       (30,812,720 )
Purchases of premises and equipment
    (3,316,240 )     (1,116,950 )
Proceeds from disposal of premises and equipment
    2,189        
Proceeds from the sale of other real estate owned and repossessed assets, net
    1,494,696       272,463  
 
           
Net cash provided by (used in) investing activities
    7,571,837       (30,274,794 )
 
           
Cash flows from financing activities:
               
Net increase in deposits
    28,832,205       24,364,890  
Net (decrease) increase in federal funds purchased
    (37,087,100 )     4,022,300  
Repayments and maturities of borrowed funds
    (10,000,000 )      
Proceeds from issuance of borrowed funds
    5,000,000        
Net (decrease) increase in repurchase agreements
    (116,026 )     65,267  
Increase in notes payable
    2,000,000        
Repayment of notes payable
    (800,000 )      
Cash dividends paid
    (269,824 )     (357,844 )
Exercise of stock options
          15,434  
 
           
Net cash (used in) provided by financing activities
    (12,440,745 )     28,110,047  
 
           
Net decrease in cash and cash equivalents
    (32,748 )     (519,232 )
Cash and cash equivalents, beginning of period
    8,877,257       7,444,684  
 
           
Cash and cash equivalents, end of period
  $ 8,844,509     $ 6,925,452  
 
           
See accompanying notes to consolidated financial statements.

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CAPITALSOUTH BANCORP AND SUBSIDIARIES
Notes to the Consolidated Financial Statements
(Unaudited)
Note 1 — General
The consolidated financial statements in this report have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission, including Regulation S-X, and have not been audited. These financial statements do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations are not necessarily indicative of the results of operations which CapitalSouth Bancorp (the “Company”) may achieve for future interim periods or the entire year. For further information, refer to the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2007.
Note 2 — Cash and Cash Flows
Cash on hand, cash items in process of collection, amounts due from banks, and federal funds sold are included in cash and cash equivalents. The following supplemental cash flow information addresses certain cash payments and noncash transactions for the six months ended June 30, 2008 and 2007, respectively:
                 
    Six Months
    Ended June 30,
    2008   2007
Supplemental information on cash payments:
               
Interest paid
  $ 12,340,475     $ 9,703,824  
Income taxes paid
    338,261       789,850  
 
               
Supplemental information on noncash transactions:
               
Transfers of loans to other real estate owned and repossessions
    9,141,304       216,000  
Note 3 — Comprehensive (Loss) Income
The primary component of the differences between net (loss) income and comprehensive (loss) income for the Company is the change in fair value on available-for-sale securities. Total comprehensive (loss) income for the three months and six months ended June 30, 2008 and 2007, respectively, was as follows:
                                 
    Three Months     Six Months  
    Ended June 30,     Ended June 30,  
    2008     2007     2008     2007  
Net (loss) income
  $ (16,395,315 )   $ 896,657     $ (16,073,427 )   $ 1,603,237  
Change in fair value of securities available-for-sale, net of tax
    (854,554 )     (276,925 )     (539,861 )     (230,936 )
 
                       
Comprehensive (loss) income, net of tax
  $ (17,249,869 )   $ 619,732     $ (16,613,288 )   $ 1,372,301  
 
                       
Note 4 — Earnings Per Share
The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding options using the treasury stock method. The computation of basic and diluted earnings per share for the three months and six months ended June 30, 2008 and 2007 is as follows:
                                 
    Three Months     Six Months  
    Ended June 30,     Ended June 30,  
    2008     2007     2008     2007  
Net (loss) income
  $ (16,395,315 )   $ 896,657     $ (16,073,427 )   $ 1,603,237  
Denominator:
                               
Weighted average common shares outstanding
    4,153,835       2,992,990       4,152,592       2,987,190  
Equivalent shares issuable upon exercise of stock options
          17,669             25,934  
 
                       
Diluted weighted average common shares outstanding
    4,153,835       3,010,659       4,152,592       3,013,124  
 
                       
Net (loss) income per share:
                               
Basic
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.54  
Diluted
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.53  
All stock options are excluded from the computation of diluted earnings per share for the three months and six months ended June 30, 2008, because the impact would be anti-dilutive. There were 18,000 stock options excluded in the 2007 per share calculation for the three and six months ended June 30, 2007.

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Note 5 — Accounting Estimates
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and the valuation of deferred tax assets.
A substantial portion of the Company’s loans are secured by real estate in central Alabama and Northeast Florida. Accordingly, the ultimate collectability of a substantial portion of the Company’s loan portfolio is susceptible to changes in market conditions in these areas. Management believes the allowance for losses on loans is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions.
Additionally, while Management believes that, while the Company’s net deferred tax assets are currently more likely than not of being realized, further deterioration of the Company’s expected future profitability could have a material impact on Management’s assessment of the realizability of these deferred tax assets.
Note 6 — Goodwill Impairment
In light of recent and significant adverse changes in the general business climate and the continued downturn in financial stocks and its impact on the fair value of the Company’s Commercial Banking reporting segment, the Company evaluated its remaining goodwill to determine the amount of impairment indicated in conformity with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. This analysis determined that the carrying value of the reporting unit was higher than the fair value of the reporting unit and resulted in a second quarter non-cash charge of $9.4 million for impaired goodwill, eliminating the remaining balance of goodwill primarily generated in the 2007 acquisition of Monticello Bancshares, Inc. This charge had no effect on the Company’s liquidity, regulatory capital, or daily operations.
The Company tested other intangible assets for impairment in conformity with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, as of December 31, 2007 and June 30, 2008 and determined that there was no impairment at those dates. The primary component of the other intangible assets is the core deposit intangible recorded in connection with the Monticello transaction. We have reviewed our runoff experience and other assumptions used in calculating the core deposit intangible for deposits purchased in that transaction compared to our model used to determine the core deposit intangible value and found no indication of impairment. See Note 12 for further discussion of goodwill.
Note 7 — Adoption of New Accounting Pronouncements
Effective January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of SFAS Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, which permits an entity to measure certain financial assets and financial liabilities at fair value. The objective of SFAS No. 159 is to improve financial reporting by allowing entities to mitigate volatility in reported earnings caused by the measurement of related assets and liabilities using different attributes without having to apply complex hedge accounting provisions. Under SFAS No. 159, entities that elect the fair value option (by instrument) will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option election is irrevocable unless a new election date occurs. SFAS No. 159 establishes presentation and disclosure requirements to help financial statement users understand the effect of the entity’s election on its earnings, but does not eliminate disclosure requirements of other accounting standards. Assets and liabilities that are measured at fair value must be displayed on the face of the balance sheet. The Company chose not to elect the fair value option for its financial assets and financial liabilities existing at January 1, 2008 and did not elect the fair value option on financial assets and financial liabilities transacted in the six months ended June 30, 2008. Therefore, the adoption of SFAS No. 159 had no impact on the Company’s consolidated financial statements.
Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, for financial assets and financial liabilities and any other assets and liabilities carried at fair value. This pronouncement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. On November 14, 2007, The Financial Accounting Standards Board (“FASB”) issued SFAS 157-2, Effective Date of FASB Statement No. 157. SFAS No. 157-2 delays the effective date of Statement No. 157 for other non-financial assets and non-financial liabilities until fiscal years beginning after November 15, 2008. The Company’s adoption of SFAS No. 157 did not have a material effect on the Company’s consolidated financial statements for financial assets and financial liabilities and any other assets and liabilities carried at fair value.

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Note 7 — Adoption of New Accounting Pronouncements, Continued
Effective January 1, 2008, the Company adopted Emerging Issues Task Force (EITF) Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Agreements. EITF Issue No. 06-4 addresses accounting for split-dollar life insurance arrangements after the employer purchases a life insurance policy on a covered employee. This Issue states that an obligation arises as a result of a substantive agreement with an employee to provide future postretirement benefits. Under EITF Issue No. 06-4, the obligation is not settled upon entering into an insurance arrangement. Since the obligation is not settled, a liability should be recognized in accordance with applicable authoritative guidance. The impact of the implementation of EITF Issue No. 06-4 was a reduction in retained earnings of $158,401, an increase in deferred income taxes of $97,085, and an increase in other liabilities of $255,486.
Note 8 — Share-Based Compensation Plans
Under the Company’s 2005 Stock Incentive Plan, there are 91,000 remaining shares authorized for issuance. The maximum term of the options granted under the plan is 10 years.
The following table summarizes stock option activity during the six months ended June 30, 2008:
                         
                    Weighted  
            Weighted     average  
            average     remaining  
            exercise     contractual  
    Shares     price     life (years)  
Outstanding, at January 1, 2008
    153,400     $ 15.29          
Granted
                   
Exercised
                   
Forfeited
    (6,000 )     15.10          
 
                   
Outstanding, at June 30, 2008
    147,400     $ 15.30       5.70  
 
                 
Exercisable, at June 30, 2008
    121,727     $ 15.11       5.01  
 
                 
As of June 30, 2008, the total unrecognized compensation cost related to unvested options not yet expensed was $148,183. The unrecognized compensation cost is expected to be recognized over a weighted average period of 1.13 years.
Note 9 — Fair Value Measurement
Effective January 1, 2008, the Company adopted the methods of fair value as described in SFAS No. 157, Fair Value Measurements, to value its financial assets and financial liabilities measured at fair value. As defined in SFAS No. 157, fair value is based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels, which are described below:
Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.
Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.
Level 3: Unobservable inputs are used when little or no market data is available. The fair value hierarchy gives the lowest priority to Level 3 inputs.
In determining fair value, the Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible, as well as considers counterparty credit risk in its assessment of fair value.

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Note 9 — Fair Value Measurement, Continued
The following table presents the fair value hierarchy of financial assets and financial liabilities measured at fair value as of June 30, 2008:
                                 
    Fair Value Measurements at June 30, 2008 Using  
    Quoted Prices     Significant             Total  
    in Active     Other     Significant     Carrying  
    Markets for     Observable     Unobservable     Value in the  
    Identical Assets     Inputs     Inputs     Consolidated  
Description   (Level 1)     (Level 2)     (Level 3)     Balance Sheet  
    (Dollar amounts in thousands)  
Assets and Liabilities Measured on a Recurring Basis:
                               
Available-for-sale securities
  $     $ 63,316,823     $     $ 63,316,823  
Interest rate swap derivative assets
          378,572             378,572  
 
                       
Total assets at fair value (1)
  $     $ 63,695,395     $     $ 63,695,395  
 
                       
 
                               
Interest rate swap derivative liabilities
  $     $ 373,170     $     $ 373,170  
 
                       
Total liabilities at fair value (1)
  $     $ 373,170     $     $ 373,170  
 
                       
 
                               
Assets Measured on a Nonrecurring Basis
                               
Impaired loans
  $     $     $ 33,065,553     $ 33,065,553  
 
                       
 
(1)   The Company chose not to elect the fair value option as prescribed by SFAS No. 159 for its financial assets and liabilities that had not been previously carried at fair value. Therefore, material financial assets and liabilities are not carried at fair value, such as the Company’s securities held-to-maturity, investment in the Federal Reserve and FHLB, and short- and long-term debt obligations are still reported at their carrying values.
Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the accompanying balance sheet, as well as the general classification of such instruments pursuant to the valuation hierarchy.
     Available-for-Sale Securities
Where quoted market prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified in Level 3 of the hierarchy.
     Interest Rate Swaps
The fair value is estimated by a third party using inputs that are observable or that can be corroborated by observable market data and, therefore, are classified within Level 2 of the valuation hierarchy. These fair value estimations include primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. Fair value estimates related to the Company’s hedged deposits are derived in the same manner.
     Impaired Loans
Loans are considered impaired under SFAS No. 114, Accounting by Creditors for Impairment of Loans, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan — Income Recognition and Disclosure, when full payment under the loan terms is not expected. Impaired loans are carried at the present value of estimated future cash flows using the loan’s existing rate or the fair value of collateral if the loan is collateral dependent. Impaired loans are subject to nonrecurring fair value adjustment. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations require the allowance for loan losses to increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when Management believes the uncollectability of a loan is confirmed. This valuation would be considered Level 3, consisting of appraisals of underlying collateral and discounted cash flow analysis.
Although the Company has not elected the fair value option for additional financial assets and financial liabilities existing at January 1, 2008 or transacted in the six months ended June 30, 2008, any future transacted financial asset or financial liability will be evaluated for the fair value election as prescribed by SFAS No. 159 and fair valued under the provisions of SFAS No. 157.

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Note 10 — Recent Accounting Pronouncements
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. This Statement is effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not expect SFAS No. 162 to have a material impact on its Consolidated Financial Statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, as an amendment to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 161 requires that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. The fair value of derivative instruments and their gains and losses will need to be presented in tabular format in order to present a more complete picture of the effects of using derivative instruments. SFAS No. 161 is effective for financial statements issued for fiscal years beginning after November 15, 2008. The Company is currently evaluating the impact of adopting this pronouncement.
Note 11 — Subsequent Events
As of June 30, 2008 the Company is in default on the covenants of the $5.0 million Parent Company line of credit as outlined in the terms of the agreement. The Bank is required under this agreement to maintain a Tier 1 Capital ratio of 7.0% and Tier 1 Capital of $55,000,000. As of June 30, 2008 the Bank had a Tier 1 Capital ratio of 6.7% and Tier 1 Capital of $50,750,000. The Company has met with the Alabama Bankers Bank and obtained a verbal commitment to waive these covenants. However, if the Company is unable to obtain this waiver, Alabama Bankers Bank has the right to declare the entire balance of the loan due and payable, which could have a material adverse effect on the Company’s liquidity and ability to meet other obligations. Based on conversations with the Alabama Bankers Bank, the Company does not expect any negative impact on the financial statements.

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Note 12 — Business Segment Information
The Company has three reporting segments composed of commercial banking, mortgage banking and corporate and other. The primary segment is commercial banking which consists of commercial loan and deposit services as well as the activities of the banking office locations. The Company added a new reporting segment as a result of the acquisition of Monticello Bancshares, Inc. (Monticello) which has wholesale mortgage banking activities. Wholesale mortgage banking focuses on the origination and sale of residential mortgage loans to investors in the secondary residential mortgage market. The third segment is corporate and other, which is composed of the parent company and all other entities of the Company not directly related to commercial or mortgage banking. The following table presents financial information for each reportable segment as of June 30, 2008 and December 31, 2007 and for the three months and six months ended June 30, 2008 and 2007:
                                 
    For the Three Months and Six Months Ended  
    June 30, 2008 and 2007  
    Commercial     Mortgage     Corporate &     Total  
    Banking     Banking     Other     Company  
    (Dollar amounts in thousands)  
For the three months ended June 30, 2008:
                               
Net interest income (expense)
  $ 4,435     $ 68     $ (232 )   $ 4,271  
Provision for loan losses
    9,351       (1 )           9,350  
Noninterest income
    486       237       11       734  
Noninterest expense
    15,107       337       174       15,618  
Income tax (benefit) expense
    (3,435 )     5       (138 )     (3,568 )
 
                       
Net (loss) income
  $ (16,102 )   $ (36 )   $ (257 )   $ (16,395 )
 
                       
For the three months ended June 30, 2007:
                               
Net interest income (expense)
  $ 4,360     $     $ (109 )   $ 4,251  
Provision for loan losses
    225                   225  
Noninterest income
    854                   854  
Noninterest expense
    3,343             145       3,488  
Income tax expense (benefit)
    593             (98 )     495  
 
                       
Net income (loss)
  $ 1,053     $     $ (156 )   $ 897  
 
                       
For the six months ended June 30, 2008:
                               
Net interest income (expense)
  $ 9,458     $ 110     $ (550 )   $ 9,018  
Provision for loan losses
    10,008       (1 )           10,007  
Noninterest income
    1,240       614       82       1,936  
Noninterest expense
    19,645       645       260       20,550  
Income tax (benefit) expense
    (3,293 )     17       (254 )     (3,530 )
 
                       
Net income (loss)
  $ (15,662 )   $ 63     $ (474 )   $ (16,073 )
 
                       
For the six months ended June 30, 2007:
                               
Net interest income (expense)
  $ 8,419     $     $ (215 )   $ 8,204  
Provision for loan losses
    362                   362  
Noninterest income
    1,573                   1,573  
Noninterest expense
    6,790             247       7,037  
Income tax expense (benefit)
    946             (171 )     775  
 
                       
Net income (loss)
  $ 1,894     $     $ (291 )   $ 1,603  
 
                       
As of June 30, 2008:
                               
Goodwill
  $     $     $     $  
Other intangibles, net
    807                   807  
Other Assets
    727,682       6,736       970       735,388  
 
                       
End of period assets
  $ 728,489     $ 6,736     $ 970     $ 736,195  
 
                       
As of December 31, 2007:
                               
Goodwill
  $ 9,592     $     $ 38     $ 9,630  
Other intangibles, net
    931                   931  
Other Assets
    746,109       10,580       225       756,914  
 
                       
End of period assets
  $ 756,632     $ 10,580     $ 263     $ 767,475  
 
                       
Substantially all of the Company’s goodwill was attributable to the commercial banking segment. All of the Company’s other identifiable intangible assets are attributable to the commercial banking segment. The Company evaluated its goodwill and other identifiable assets at December 31, 2007 and June 30, 2008. The Company recorded an impairment charge for goodwill at December 31, 2007 of $17.0 million and $9.4 million as of June 30, 2008. No impairment was noted in the other identifiable intangible assets.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is designed to provide a better understanding of various factors related to the results of operations and financial condition of CapitalSouth Bancorp (the “Company”) and its wholly-owned subsidiary, CapitalSouth Bank (the “Bank”). This discussion is intended to supplement and highlight information contained in the accompanying unaudited consolidated financial statements as of and for the three months and six months ended June 30, 2008 and 2007.
Business
The Company is a bank holding company established in 1990 under the name Financial Investors of the South, Inc., and incorporated under the laws of the State of Delaware. The name was changed in September 2005 to CapitalSouth Bancorp. The Bank is an Alabama banking corporation and a member of the Federal Reserve System and it has been in continuous operation since 1975. The Bank is headquartered in Birmingham, Alabama, and operates 12 full service banking offices located in metropolitan Birmingham, Montgomery and Hunstville, Alabama, and Jacksonville, Florida. The Bank operates a wholesale residential mortgage loan subsidiary, Mortgage Lion, Inc., in Fitzgerald, Georgia. The Company also serves the needs of the Latino population in Birmingham, Alabama through “Banco Hispano”.
Overview
Results for the three and six month periods ended June 30, 2008 continue to reflect difficult market conditions. The Company reported a net loss of $16,395,000, or $3.95 per diluted share, in the second quarter of 2008 and a net loss of $16,073,000, or $3.87 per diluted share, for the six months ended June 30, 2008, each of which included a $9,363,000 goodwill impairment charge. Additionally, the Company’s earnings were negatively impacted by a deferred tax asset valuation adjustment of $500,000 as well as a $9,350,000 increase in the provision for loan losses during the second quarter of 2008. However, for the six months ended June 30, 2008 our results also include increases in interest income and noninterest income largely due to an expansion in the Company’s loans and core deposits due to the Monticello acquisition.
As of June 30, 2008 compared to December 31, 2007, the Company reported a 4.08% decrease in total assets. Total assets at June 30, 2008 were $736,195,000, compared to $767,475,000 at December 31, 2007. The decline was mainly attributable to a decline in the loan portfolio resulting from the shift away from real estate construction and acquisition and development loans due to the softening in the economy. Additionally, the Company recorded an additional goodwill impairment charge during the period and significantly increased the allowance for loan losses. The Company’s loan portfolio totaled $589,060,000 at the end of the second quarter of 2008, down 5.31% from $622,111,000 at December 31, 2007. Deposits increased from $593,344,000 at December 31, 2007 to $622,093,000 at June 30, 2008. The decline in loans and growth in deposits resulted in a $37,087,000 decline in federal funds purchased for the six months ended June 30, 2008. Stockholders’ equity at June 30, 2008, totaled $29,757,000, down 36.01% from $46,500,000 at December 31, 2007. Book value per share was $7.16 at June 30, 2008, versus $11.20 at year end 2007. The decline in stockholders’ equity resulted from the year-to-date net loss the Company has experienced during the first six months of 2008, due primarily to the goodwill impairment charge and additional provision expense. Tangible book value per share decreased to $6.96 per share at June 30, 2008, from $8.66 at December 31, 2007.
The net operating loss for the second quarter, which excludes the non-cash goodwill impairment charge, totaled $7,032,000 or $1.69 per diluted share compared with net operating income of $897,000 or $0.30 per diluted share for the second quarter of 2007. For the first half of 2008, the Company reported a net operating loss of $6,710,000 or $1.62 per diluted share compared with net operating income of $1,603,000 or $0.53 per diluted share for the year-earlier period. The decline in net operating income for the 2008 period was due primarily to a $9,350,000 provision for loan losses for the second quarter of 2008, prompted by increased nonperforming assets associated with continued deterioration in macroeconomic conditions, specifically in the residential real estate sector. The provision in the second quarter of 2007 was $225,000. Per share amounts for the second quarter and first six months of 2008 also reflect an increase of 38% in the number of weighted average diluted shares outstanding primarily due to shares issued in the Company’s September 2007 acquisition of Monticello Bancshares. Additionally, the Company provided a valuation allowance against its deferred tax assets in the amount of $500,000 as a result of the net operating loss in conformity with SFAS No. 109, Accounting for Income Taxes.
GAAP Reconciliation and Management Explanation for Non-GAAP Financial Measures
The information set forth above contains certain financial information determined by methods other than in accordance with generally accepted accounting policies (GAAP). These non-GAAP financial measures are “net operating income to average assets,” “net operating income to average equity,” “return on average tangible equity,” “return on average tangible assets,” “net operating income to average tangible equity,” “average tangible equity to average tangible assets,” “net operating income to average tangible assets” and “tangible book value per share.” Our management uses these non-GAAP measures in its analysis of CapitalSouth’s performance.

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“Net Operating income” is defined as net income less the effect of the non-cash goodwill impairment charge. “Return on average tangible equity” is defined as earnings for the period divided by average equity reduced by average goodwill and other intangible assets. “Return on average tangible assets” is defined as earnings for the period divided by average assets reduced by average goodwill and other intangible assets. Our management includes these measures because it believes that they are important when measuring CapitalSouth’s performance against entities with varying levels of goodwill and other intangibles. These measures are used by many investors as part of their analysis of the bank holding company’s performance.
“Average tangible equity to average tangible assets” is defined as average total equity reduced by recorded average intangible assets divided by average total assets reduced by recorded average intangible assets. This measure is important to many investors in the marketplace who are interested in the equity to assets ratio exclusive of the effect of changes in average intangible assets on average equity and average total assets.
“Tangible book value per share” is defined as total equity reduced by recorded intangible assets divided by total common shares outstanding. This measure is important to many investors in the marketplace who are interested in changes from period to period in book value per share exclusive of changes in intangible assets. Goodwill, an intangible asset that is recorded in a purchase business combination, has the effect of increasing total book value while not increasing the tangible book value of the Company.
These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, and are not necessarily comparable to non-GAAP performance measures which may be presented by other bank holding companies. The following reconciliation table provides a more detailed analysis of these non-GAAP performance measures.
                                 
    For the Three Months Ended June 30,     For the Six Months Ended June 30,  
    2008     2007     2008     2007  
    (Dollar amounts in thousands, except per share amounts)  
Book value of equity
  $ 29,757     $ 42,657     $ 29,757     $ 42,657  
Intangible assets
    807       1,276       807       1,276  
 
                       
Book value of tangible equity
  $ 28,950     $ 41,381     $ 28,950     $ 41,381  
 
                       
Average assets
  $ 755,168     $ 504,062     $ 760,968     $ 497,629  
Average intangible assets
    10,277       1,276       10,392       1,276  
 
                       
Average tangible assets
  $ 744,891     $ 502,786     $ 750,576     $ 496,353  
 
                       
Return on average assets
    (8.73 %)     0.71 %     (4.25 %)     0.65 %
Effect of average intangible assets
    (0.12 %)     0.01 %     (0.06 %)     0.00 %
 
                       
Return on average tangible assets
    (8.85 %)     0.72 %     (4.31 %)     0.65 %
 
                       
Average equity
  $ 46,779     $ 42,700     $ 47,094     $ 42,293  
Average intangible assets
    10,315       1,276       10,429       1,276  
 
                       
Average tangible equity
  $ 36,464     $ 41,424     $ 36,665     $ 41,017  
 
                       
Return on average equity
    (140.96 %)     8.43 %     (68.64 %)     7.64 %
Effect of average intangible assets
    (39.87 %)     0.26 %     (19.52 %)     0.24 %
 
                       
Return on average tangible equity
    (180.83 %)     8.69 %     (88.16 %)     7.88 %
 
                       
Net operating (loss) income
  $ (7,032 )   $ 897     $ (6,710 )   $ 1,603  
Goodwill impairment charge
    9,363             9,363        
 
                       
Net (loss) income
  $ (16,395 )   $ 897     $ (16,073 )   $ 1,603  
 
                       
Per share:
                               
Book value
  $ 7.16     $ 14.23     $ 7.16     $ 14.23  
Effect of intangible assets
    0.20       0.43       0.20       0.43  
 
                       
Tangible book value
  $ 6.96     $ 13.80     $ 6.96     $ 13.80  
 
                       
Net operating (loss) income
  $ (1.69 )   $ 0.30     $ (1.62 )   $ 0.54  
Goodwill impairment charge
    (2.26 )           (2.25 )      
 
                       
Net (loss) income
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.54  
 
                       
Per diluted share:
                               
Net operating (loss) income
  $ (1.69 )   $ 0.30     $ (1.62 )   $ 0.53  
Goodwill impairment charge
    (2.26 )           (2.25 )      
 
                       
Net (loss) income
  $ (3.95 )   $ 0.30     $ (3.87 )   $ 0.53  
 
                       
percentages are annualized
                               

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Critical Accounting Policies
The accounting and financial policies of the Company conform to accounting principles generally accepted in the United States and to general practices within the banking industry. The allowance for loan losses, valuation of other real estate owned, and goodwill impairment are accounting policies applied by the Company which are deemed critical. Critical accounting policies are defined as policies which are important to the portrayal of the Company’s financial condition and results of operations and require management’s most difficult, subjective or complex judgments. These estimates and judgments involve significant uncertainties and are susceptible to change. If different conditions exist or occur, depending upon the magnitude of the changes, our actual financial condition and financial results could differ significantly.
Other real estate owned, consisting of properties obtained through foreclosure or in satisfaction of loans, is reported at the lower of cost or fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Gains or losses on sale and any subsequent adjustments in value are recorded as a component of noninterest expense.
With the deterioration of goodwill and the subsequent write-down of all remaining goodwill on the Company’s balance sheet, goodwill impairment will cease to be a critical accounting policy for the Company after the second quarter of 2008. For a more detailed discussion on these critical accounting policies, see “Critical Accounting Policies and Estimates” on page 31 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Recent Developments
The State Banking Department of Alabama and the Federal Reserve Bank of Atlanta recently completed the fieldwork for a regularly scheduled examination of the Bank during the second quarter. The reported results of the Company reflect discussions with regulators on the allowance for loan losses and loan charge-offs, among other matters. The Company has been advised orally that a formal enforcement action will be issued because of the impact of the high level of nonperforming assets on the financial performance of the Bank. Though the particular terms of such enforcement action are not known at this time, the Company expects that it will require improvement in Bank earnings, lower nonperforming loan levels, increased Bank capital, revisions to various policies as well as other possible corrective actions.
The Company has already begun taking steps consistent with meeting these requirements. The Company has filed a registration statement for a rights offering for shares of its common stock. The registration statement has not become effective but the Company anticipates it being declared effective by the SEC in the third quarter of 2008 and concluding and closing the offering prior to year end.
Financial Condition
Investment Securities and Federal Funds Sold
Investment securities totaled $96,441,690 at June 30, 2008 and $83,026,918 at December 31, 2007. The following table shows the amortized cost of the Company’s securities by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.
                                         
Maturity of Investment Securities - Amortized Cost
June 30, 2008
 
    Less than     One year to     Five years to     More than        
    one year     five years     ten years     ten years     Total  
U. S. Government agency securities
  $ 3,999,643     $ 29,992,025     $ 19,343,401     $ 3,626,268     $ 56,961,337  
Mortgage-backed securities
          7,407,106       3,537,915       1,012,355       11,957,376  
Collateralized mortgage obligations
                2,607,585       3,868,071       6,475,656  
Municipal securities
    779,775       1,793,655       13,021,125       4,035,290       19,629,845  
Corporate securities
          1,034,998       1,021,361             2,056,359  
 
                             
Total
  $ 4,779,418     $ 40,227,784     $ 39,531,387     $ 12,541,984     $ 97,080,573  
 
                             
Tax equivalent yield
    3.96 %     3.88 %     4.42 %     4.36 %        
 
                               
On a quarterly basis, the Company makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. The Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; recent events specific to the issuer or industry; and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss

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in securities gains (losses). Gross unrealized losses at June 30, 2008, are primarily caused by interest rate changes. The Company has reviewed these securities in accordance with its accounting policy for other-than-temporary impairment discussed above and recorded $78,000 in impairment losses on its available-for-sale securities sold after quarter end at a loss. The Company does not consider any other securities to be other-than-temporarily impaired. However, without recovery in the near term such that liquidity returns to the markets and spreads return to levels that reflect underlying credit characteristics, additional other-than-temporary impairments may occur in future periods.
All securities held are traded in liquid markets. As of June 30, 2008, the Company owned securities from three issuers in which the aggregate book value from these issuers exceeded 10% of stockholders’ equity. As of June 30, 2008, the book value and fair value of the securities from each of these issuers was as follows:
                 
    Book Value   Fair Value
Federal National Mortgage Association
  $ 21,397,086     $ 21,159,592  
Federal Home Loan Mortgage Corporation
    15,030,719       15,011,361  
Federal Home Loan Bank
    27,348,602       27,204,036  
At June 30, 2008, the Company had $35,768 in federal funds sold compared with $230,064 in federal funds sold at December 31, 2007.
Loans
Total loans were $589,060,000 at June 30, 2008, a decrease of $33,051,000, or 5.31%, over total loans of $622,111,000 at December 31, 2007. Due to the general deterioration in the real estate sector, the Company has tightened its credit criteria for loans secured by real estate. We are actively reducing our concentration of construction loans and land acquisition and development loans. Accordingly, we have reduced our balances outstanding in these type loans by $27,967,000 or 14.2% since year-end.
The following table details the change in the loan portfolio composition, including loans held-for-sale, for the periods ending June 30, and March 31, 2008 and December 31, 2007:
                                                 
    June 30, 2008     March 31, 2008     December 31, 2007  
    Amount     %     Amount     %     Amount     %  
    (Dollar amounts in thousands)  
Loans
                                               
Construction and land development
  $ 168,491       28.43 %   $ 186,819       30.31 %   $ 196,458       31.21 %
Farmland
    7,871       1.33       10,573       1.72       7,909       1.26  
1-4 family residential
    134,768       22.74       138,080       22.40       144,520       22.96  
Multifamily
    25,657       4.33       29,155       4.73       30,009       4.77  
Nonfarm nonresidential
    148,396       25.04       140,534       22.80       141,240       22.44  
Commercial & industrial
    99,665       16.82       103,414       16.78       101,652       16.15  
Consumer
    7,733       1.30       7,779       1.26       7,742       1.23  
 
                                   
Total loans, net
  $ 592,581       100.00 %   $ 616,354       100.00 %   $ 629,530       100.00 %
 
                                   
Asset Quality
The allowance for loan losses is established and maintained at levels management deems adequate to absorb anticipated credit losses from identified and otherwise inherent risks in the loan portfolio as of the balance sheet date. In assessing the adequacy of the allowance, we review the quality of, and risks in, loans in the portfolio. We also consider such factors as:
    specific known risks;
 
    our loan loss experience;
 
    adverse situations that may affect a borrower’s ability to repay;
 
    the status and amount of past due and nonperforming loans;
 
    underlying estimated values of collateral securing loans;
 
    current and anticipated economic conditions; and
 
    other factors which management believes affect the allowance for loan losses.
An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by our credit administration department and presented to our subsidiary bank’s board of directors on a monthly basis. In addition, loan reviews are performed regularly on the quality of the loan portfolio and related adequacy of the allowance by an individual independent of the lending function. We have outsourced loan review of loans in excess of $3 million to an experienced loan review company which reviews these loans and provides reports approximately two times per year. Based on our analysis, which includes risk factors such as charge-off rates, past dues and loan growth, we may determine our future loan loss provision needs to increase or decrease in order for us to maintain the allowance at a level sufficient to absorb

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inherent credit losses. If we become aware that any of these factors have materially changed, our estimate of credit losses in the loan portfolio and the related allowance could also change. All loans have a risk grade assigned at the time the loan is booked. These risk grades are evaluated periodically for appropriateness based on the performance of the borrower and as new information is received on the borrower’s financial condition. The related allowance is determined based on the risk grade assigned to the loan unless the loan is classified as special mention, substandard, doubtful or loss. Once a loan is classified, an evaluation is made on a specific allowance to be assigned. Accordingly, changes in classification of a loan may change the amount of allowance allocated for that loan. The allowance for loan losses is replenished through a provision for loan losses that is charged against our earnings. As a result, variations in the allowance directly affect our earnings.
While it is the Company’s policy to provide for loan losses in the current period when a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise.
The Company recorded annualized net charge-offs, as a percentage of average loans, of 1.37% in the second quarter of 2008 compared with net charge-offs of 0.49% in the first quarter of 2008. Charge-offs in the first and second quarters consisted of 35.8% and 37.4% respectively, related to write-downs taken on loans being transferred into Other Real Estate Owned (“OREO”) based on updated valuations. In evaluating the adequacy of the allowance for loan losses, the Company continues to update external appraisals on the properties underlying the nonperforming loans and thus provide additional reserves as needed for collateral deficiencies or changes in macroeconomic factors. Charge-offs reduce the allowance balance and accordingly have an impact on the calculation of the adequacy of the allowance. We determine the required allowance based on the composition of the loan portfolio, its classifications, any known collateral deficiencies, past due status and general economic conditions. We provide for any shortfall in the calculated allowance compared to our recorded allowance for loan losses through the provision for loan losses. The Company increased its loan loss provision to $9,350,000 in the second quarter of 2008 compared with $658,000 in the first quarter of 2008 based on updated collateral valuations, general market conditions, and the impact of regulatory actions. The allowance for loan losses was 2.73% of total period-end net loans and 46.00% of period-end nonperforming loans as of June 30, 2008, compared with 1.44% and 30.93% respectively, at March 31, 2008. Based on current appraisal valuations and other valuation data, the Company believes that reserves are adequate to absorb future losses in the loan portfolio.
                         
Analysis of Changes in Allowance for Loan Losses
 
    Six Months Ended     Year Ended  
    June 30,     December 31,  
    2008     2007     2007  
    (Dollar amounts in thousands)  
Allowance for loan losses:
                       
Beginning of period
  $ 8,876     $ 4,329     $ 4,329  
Provision for loan losses
    10,007       362       3,516  
 
                 
Sub-total
    18,883       4,691       7,845  
 
                       
Charged-off loans:
                       
Real estate loans
    356       1       319  
Installment loans
    112       13       26  
Commercial loans 1
    2,360       1        
Other loans
                148  
 
                 
Total charged-off
    2,828       15       493  
 
                       
Recoveries of charged-off loans
Real estate loans
          13       20  
Installment loans
    20       18       31  
Commercial loans 1
    7       2       11  
 
                 
Total recoveries
    27       33       62  
 
                 
Net charged-off (recovered) loans
    2,801       (18 )     431  
Acquired allowance for loan losses
                1,462  
 
                 
Allowance for loan losses — end of period
  $ 16,082     $ 4,709     $ 8,876  
 
                 
 
1   Commercial loans include both commercial real estate loans and commercial and industrial loans.
The Company evaluates the adequacy of its allowance for loan losses based on the type of loan, its past due status, its internal rating and general market conditions which might impact one or more segments of our portfolio due to the type or location of the collateral or industry. At the point in time that a loan is rated by our internal rating system, an assessment is made of the

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value of the underlying collateral either in the form of updated appraisals or other professional estimates, some of which may be internally generated. Based on the likelihood of the loss and any deficiency noted in collateral value, a reserve is established to cover any exposure noted by the evaluation. These reserves are established at the time the exposure is determined which may precede the loan being placed on nonaccrual status.
The following table shows the specific loan loss reserve allocated to each loan type and current estimated value of the real estate collateral:
                         
    June 30, 2008  
            Allocated     Current  
    Loan     Allowance     Estimated  
    Balance     for Losses     Value  
    (Dollar amounts in thousands)  
Nonaccrual loans:
                       
Residential acquisition and development
  $ 13,961     $ 350     $ 14,822  
Residential construction
    4,395       273       4,853  
Single family residential real estate
    4,918       621       7,786  
Commercial construction
    3,631       493       4,474  
Commercial acquisition and development
    3,638       45       4,179  
Owner-occupied commercial real estate
    1,187       43       2,098  
Non-owner occupied commercial real estate
    887       46       808  
 
                 
Total nonaccrual real estate secured loans
    32,617       1,871     $ 39,020  
 
                     
Commercial
    2,216       295          
Consumer
    130       52          
 
                   
Total nonaccrual loans
  $ 34,963     $ 2,218          
 
                   
During the second quarter, non-performing assets increased to $45,394,000, or 7.79%, of period-end loans and other real estate, up from $2,147,000, or 0.53%, in the year-earlier quarter and from $17,430,000, or 2.79%, in the fourth quarter of 2007. The increase reflects rapidly deteriorating economic conditions and growing weakness in the residential real estate sector across the Company’s markets since the latter half of 2007. The increase in non-performing assets in the second quarter of 2008 versus the second quarter of 2007 also reflected $4.6 million in non-performing assets associated with the Monticello acquisition which were recorded at their estimated fair values as part of the purchase accounting adjustments, which were below their original book value and accordingly had no additional reserve allocated at that time.
At June 30, 2008, the Company’s nonperforming loan portfolio was 93% secured by real estate. These loans have a current loan-to-value ratio of 83.6% based on updated collateral valuations. Our allocated reserves lower the Company’s overall exposure to 78.8% of the current collateral value. Of the total real estate secured nonperforming loans, we have 3.63% secured by owner-occupied commercial real estate and 11% secured by single family residential real estate. Owner-occupied loans are not subject to the same level of risk as other commercial real estate loans in the current real estate environment due to the source of repayment coming from other sources and not the ultimate liquidation of the collateral. Loans secured by income producing commercial property are subject to real estate market risk factors, such as rental rates and vacancy rates that can affect the ability of the property to generate sufficient income to support the loan. Additionally loans that require liquidation of collateral to satisfy the loan are impacted severely by the slowness in the real estate sector.
CapitalSouth has historically had a very low level of nonperforming assets prior to 2007. At June 30, 2008, 93% of nonperforming assets were secured by real estate. Assessments were made at period end of the collateral value supporting the nonperforming loans and a significant provision was made to the allowance for any estimated deficiencies. The Company has a long history of low levels of charge-offs and nonperforming loans. Accordingly, the allowance level in prior years has grown primarily as a result of growth in the portfolio, not due to nonperforming loans. Due to the underlying value of the real estate collateral on the nonperforming loans, additional provision was required but not at the percentage levels in prior years, as most of the allowance in prior years was for the performing portfolio. The following table shows the Banks historical nonperforming assets:
                                         
    June 30,     As of December 31,  
    2008     2007     2006     2005     2004  
            (Dollar amounts in thousands)          
Nonaccrual loans
  $ 34,963     $ 13,914     $ 1,661     $ 1,684     $ 1,299  
Troubled debt restructures
    515                          
Other real estate owned and repossessions
    9,916       3,516       508       111       381  
 
                             
Total nonperforming assets
  $ 45,394     $ 17,430     $ 2,169     $ 1,795     $ 1,680  
 
                             
Allowance for loan losses as a percent of period-end loans
    2.73 %     1.43 %     1.15 %     1.18 %     1.24 %
Allowance for loan losses as a percent of period-end nonperforming loans
    46.00 %     63.79 %     260.63 %     228.95 %     246.34 %

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CapitalSouth severely limited and substantially eliminated any new residential spec construction loans and residential construction and development loans through the implementation of very strict underwriting standards and increased approval requirements in response to a weakening real estate market. Additionally, the Company has been focusing more on its Commercial and Industrial (C&I) production with the latest additions to the production staff coming from experienced C&I lenders.
During the three and six month period ended June 30, 2008 the Bank transferred $3,705,564 and $6,574,242, respectively, to OREO. There were four properties transferred to OREO during the three month period and 12 properties in the six month period ended June 30, 2008.
The following table represents the composition of the Company’s nonperforming assets by type of collateral as of June 30, and March 31, 2008:
                 
    June 30, 2008     March 31, 2008  
    (Dollar amounts in thousands)  
NONPERFORMING ASSETS
               
Nonaccrual loans:
               
Residential acquisition and development
  $ 13,961     $ 11,300  
Residential construction
    4,395       5,237  
Single family residential real estate
    4,918       2,951  
Commercial construction
    3,631       2,196  
Commercial acquisition and development
    3,638       1,892  
Owner-occupied commercial real estate
    1,187       1,836  
Non-owner occupied commercial real estate
    887       1,402  
Commercial
    2,216       1,572  
Consumer
    130       20  
 
           
Total nonaccrual loans
    34,963       28,406  
Troubled debt restructures
    515        
Foreclosed properties and repossessions
    9,916       6,694  
 
           
Total nonperforming assets
    45,394       35,100  
As a % of loans, net and foreclosed properties and repossessions
    7.79 %     5.68 %
Loans past due 90 days or more and still accruing
           
Nonperforming assets included in loans held for sale:
               
Commercial
           
Consumer
           
 
           
Total nonperforming assets included in loans held for sale
           
 
           
Nonperforming assets related to loans and loans held for sale
  $ 45,394     $ 35,100  
 
           
As a % of loans, net, foreclosed properties and loans held for sale
    7.74 %     5.63 %
The current softness in the real estate sector has primarily been in the residential real estate market. Accordingly, at June 30, 2008 66.6% of our nonperforming loans are collateralized by residential real estate with 57.7% of the increase from the first quarter of 2008 in nonperforming loans coming from residential real estate secured loans. We have 68.8% of our residential real estate secured loans located in Florida, where the foreclosure process is a judicial process which slows our ability to foreclose and ultimately liquidate this collateral.
Deposits and Other Borrowings
Total deposits increased by 4.85% from December 31, 2007 to June 30, 2008. We believe our deposits will continue to increase in 2008 as a result of our increased presence in the Jacksonville, Florida market, our newer Alabama banking offices becoming more established in their markets and deposit campaigns planned to expand existing customer relationships as well as our efforts to develop new customer relationships. The Company has focused on increasing its “on balance sheet” liquidity by increasing its core funding base and decreasing non-core funding.
Federal funds purchased, borrowed funds and securities sold under agreements to repurchase were $55,421,227 as of June 30, 2008, compared to $97,517,328 at December 31, 2007. The decline in our reliance on this source of funds was due to the decline in loan balances and growth in core deposits.

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The following table details the maturities and rates of our term borrowings from the Federal Home Loan Bank of Atlanta as of June 30, 2008:
                                         
      Borrow                           Repricing   Maturity
       Date   Principal   Term   Rate   Frequency   Date
09/26/2003
  $ 5,000,000     5  years     3.539 %   Variable     09/26/2008  
10/01/1998
    3,000,000     10  years     4.940     Fixed     10/01/2008  
06/27/2007
    3,200,000  1    3  years     5.110     Fixed     06/28/2010  
03/24/2006
    3,000,000     7  years     4.580     Fixed     03/25/2013  
04/18/2008
    5,000,000     5  years     3.155     Fixed     04/18/2013  
06/24/2005
    10,000,000  2    10  years     3.710     Fixed     06/24/2015  
 
                                       
 
                    3.955 %                
 
                                       
 
(1)   Carrying value of $3,230,085 due to fair value purchase accounting adjustments related to the purchase of Monticello.
 
(2)   Carrying value of $9,812,222 due to fair value purchase accounting adjustments related to the purchase of Monticello.
For amounts and rates of our deposits by category, see the table “Average Consolidated Balance Sheets and Net Interest Analysis on a Fully Tax-Equivalent Basis” under the sub-heading “Net Interest Income.”
Subordinated Debentures
The Company wholly owns four Delaware statutory trusts; Financial Investors Statutory Trust I, Financial Investors Statutory Trust II, CapitalSouth Bancorp Statutory Trust I, and Monticello Statutory Trust II. These unconsolidated subsidiaries issued approximately $15.5 million in trust preferred securities, guaranteed by the Company on a subordinated basis. The Company obtained these proceeds through a note payable to the trust (junior subordinated debentures). As of June 30, 2008, $10.1 million of the notes payable to the trusts was classified as Tier 1 Capital for regulatory purposes. For regulatory purposes, the trust preferred securities represent minority investments in unconsolidated subsidiaries, which is currently included in Tier 1 Capital so long as it does not exceed 25% of total core components of capital. According to FASB Interpretation No. 46 (“FIN 46”) and Revised Amendment to FIN 46 (“FIN 46R”), the trust subsidiaries must be deconsolidated for accounting purposes. As a result of this accounting pronouncement, the Federal Reserve Board on March 1, 2005 announced changes to its capital adequacy rules, including the capital treatment of trust preferred securities. The Federal Reserve’s new rules, which took effect in early April 2005, permit the Company to continue to treat its outstanding trust preferred securities as Tier 1 Capital for the first 25 years of the 30 year term of the related junior subordinated notes. During the last five years preceding maturity, the amount included as capital will decline 20% per year. The Company will take these changes into consideration as it continuously monitors its capital plan.
Liquidity
Liquidity is defined as our ability to generate sufficient cash to fund current loan demand, deposit withdrawals, or other cash demands and disbursement needs, and otherwise to operate on an ongoing basis.
The retention of existing deposits and attraction of new deposit sources through new and existing customers is critical to our liquidity position. Through our banking offices, we offer a variety of deposit products at competitive market interest rates. Ensuring competitive rates and terms generally assists in the retention of maturing time deposits and liquid deposits. In the event of compression in liquidity due to a run-off in deposits, we have a liquidity policy and procedure that provides for certain actions under varying liquidity conditions. These actions include borrowing from the Federal Home Loan Bank of Atlanta and existing correspondent banks, selling or participating loans, and the curtailment of loan commitments and funding. At June 30, 2008, our liquid assets, represented by cash and due from banks, federal funds sold and available-for-sale securities, totaled $72.2 million. Additionally, we had available to us $5.0 million in an unsecured line of credit with our primary correspondent bank and additional borrowing availability at the Federal Home Loan Bank of Atlanta of approximately $58.0 million. Additionally, the Company has a secured line of credit with $2.0 million available. See Note 12 for further information on the Company’s current compliance with the loan covenants on the Parent Company line of credit. We believe these sources of funding are adequate to meet anticipated funding needs. Management meets on a weekly basis to review sources and uses of funding to determine the appropriate strategy to ensure an appropriate level of liquidity. We have increased our focus on the generation of core deposit funding to supplement our liquidity position. At the current time, our long-term liquidity needs primarily relate to funds required to support loan originations and commitments and deposit withdrawals.
Our regular sources of funding are from the growth of our deposit base, repayment of principal and interest on loans, the sale of loans and the renewal of time deposits.

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The following table reflects the contractual maturities of our term liabilities as of June 30, 2008. The amounts shown do not reflect any early withdrawal or prepayment assumptions.
                                         
            One year     Over one to     Over three     More than  
    Total     or less     three years     to five years     five years  
            (Dollar amounts in thousands)          
Certificates of deposit (1)
  $ 387,739     $ 348,365     $ 22,562     $ 16,811     $ 1  
Federal funds purchased and securities sold under agreement to repurchase
    26,379       26,379                    
FHLB borrowings
    29,042       8,000       3,230       8,000       9,812  
Operating lease obligations
    3,605       398       696       484       2,027  
Junior subordinated debentures (2)
    16,012                         16,012  
Notes payable
    8,230       3,600       3,130       1,500        
 
                             
Total
  $ 471,007     $ 386,742     $ 29,618     $ 26,795     $ 27,852  
 
                             
 
(1)   Certificates of deposit give customers rights to early withdrawal. Early withdrawals may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal.
 
(2)   The junior subordinated debentures consist of $5,000,000 that may be redeemed at anytime at the Company’s option with appropriate notice prior to the dividend payment dates, $3,000,000 that may be redeemed after December 15, 2009, $2,500,000 that may be redeemed after September 15, 2010 and $5,000,000 that may be redeemed after August 24, 2012.
Capital Resources
The following table compares the required capital ratios to the actual capital ratios maintained by the Company and the Bank. The total capital to risk adjusted assets ratio was below “well capitalized” at June 30, 2008 for the Company and the Bank. The lower actual capital ratios for June 30, 2008 and December 31, 2007 reflect the impact of the Monticello acquisition and increased provision expense. The acquisition of Monticello closed on September 14, 2007. The Company recognized goodwill impairment charges and additional provision expense at December 31, 2007 and June 30, 2008.
                                 
                    Actual
    Well   Adequately   CapitalSouth   CapitalSouth
    Capitalized   Capitalized   Bancorp   Bank
June 30, 2008
                               
Tier 1 capital to risk adjusted assets
    6.0 %     4.0 %     6.2 %     8.4 %
Total capital to risk adjusted assets
    10.0       8.0       8.4       9.7  
Tier 1 capital to average assets
    5.0       4.0       5.0       6.7  
 
                               
December 31, 2007
                               
Tier 1 capital to risk adjusted assets
    6.0 %     4.0 %     8.2 %     9.2 %
Total capital to risk adjusted assets
    10.0       8.0       9.4       10.5  
Tier 1 capital to average assets
    5.0       4.0       6.5       7.4  
 
                               
June 30, 2007
                               
Tier 1 capital to risk adjusted assets
    6.0 %     4.0 %     11.7 %     10.6 %
Total capital to risk adjusted assets
    10.0       8.0       12.8       11.7  
Tier 1 capital to average assets
    5.0       4.0       10.0       8.9  
The Company has taken several steps to bring the capital ratios for the Company and the Bank back to a “well capitalized” position. These steps include shrinking the balance sheet, discontinuing the payment of dividends to shareholders and raising additional capital through a proposed rights offering to current shareholders and standby purchasers. As of June 30, 2008, the Company has no material commitment to make additional capital expenditures.
Off-Balance-Sheet Arrangements
We are party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. These commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
Our exposure to credit loss is represented by the contractual amount of these commitments. We follow the same credit policies in making these commitments as we do for on-balance-sheet instruments.
Our maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at June 30, 2008 was as follows (amounts in thousands):
         
Commitments to extend credit
  $ 70,787  
Standby letters of credit
    356  

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Commitments to extend credit are agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer.
In connection with wholesale mortgage loan production activities, the Company routinely enters into short-term commitments to fund residential mortgage loans. This is commonly referred to as interest rate locks. The Company utilizes forward sales commitments to economically mitigate the risk of potential decreases in the value of the loans that would result from the exercise of the loan commitments. The notional amounts of these mortgage loan origination commitments and the related forward sales commitments were approximately $5.4 million at June 30, 2008. The fair value of the origination commitments was a gain of approximately $39,600 at June 30, 2008, and the fair value of the forward sales commitments was a loss of approximately $32,700 at June 30, 2008.
Results of Operations
Net Interest Income
Net interest income for the second quarter of 2008 increased slightly to $4,271,000 from $4,251,000 in the year-earlier period, reflecting primarily an increase in interest-earning assets due to the Monticello acquisition. Net interest margin declined in the second quarter to 2.51% versus 3.61% in the same quarter last year and was down from 2.74% in the first quarter of 2008 due to the impact of the decline in the prime rate, change in the mix of our funding sources, as well as the increase in nonperforming assets. Interest income reversed or foregone on nonperforming loans reduced second quarter 2008 net interest margin by 52 basis points. For the first six months of 2008, net interest income increased 10% to $9,018,000 from $8,204,000 in the prior-year period. Net interest margin declined in the first half of 2008 to 2.63% from 3.56% in the same period last year. Interest income reversed or foregone on nonperforming loans reduced net interest margin by 48 basis points in the first six months of 2008. Management believes margin pressure will continue throughout the year due to the impact of nonperforming loans.
Total interest income for the quarter ended June 30, 2008 was $10,132,000, an increase of $1,056,000, or 11.63%, compared to the same quarter last year. Average earning assets increased 45.87% for the three month period ended June 30, 2008 as compared to the same period in 2007. The acquisition of Monticello accounted for most of the increase. Total interest income for the six months ended June 30, 2008 was $21,773,000, an increase of $4,017,000, or 22.63%, compared to the same quarter last year. Average earning assets increased 49.66% for the six month period ended June 30, 2008 as compared to the same period in 2007. The acquisition of Monticello accounted the majority of the increase. Approximately 54% of the Company’s loans are tied to variable rate indices and, accordingly, the income recognized on these loans fluctuates with changes in the market rate of interest. The average prime rate for the three and six month periods ending June 30, 2008 were 5.08% and 5.65%, respectively, compared to 8.25% for the same periods in 2007.
Total interest expense was $5,861,000 for the second quarter of 2008 or a 21.46% increase compared to the same period in 2007. This increase in interest expense was due to the $243.5 million, or 61.02%, increase in average interest bearing liabilities for the three months ended June 30, 2008 as compared to the same period in 2007. The acquisition of Monticello accounted for the majority of the increase. The largest average balance increases were in time deposits under $100,000, federal funds purchased, and FHLB advances. For the six month period ending June 30, 2008 interest expense was $12,755,000, a 33.54% increase compared to the same period in 2007. This increase in interest expense was due to the $253.0 million, or 64.11%, increase in average interest bearing liabilities for the six months ended June 30, 2008 as compared to the same period in 2007. The acquisition of Monticello accounted for the majority of the increase. The rate paid on interest-bearing liabilities decreased from 4.85% and 4.88% for the three and six months ended June 30, 2007, respectively to 3.67% and 3.96%, respectively, for the same periods in 2008 reflecting the impact of the decreases in market rates due to a lower fed funds rate and a shift to more rate sensitive funding sources.

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CAPITALSOUTH BANCORP AND SUBSIDIARIES
Average Balance Sheet and Net Interest Analysis on a Fully Tax-Equivalent Basis
For the Three Months Ended June 30, 2008 and 2007
                                                 
    2008     2007  
    Average     Income/     Yield/     Average     Income/     Yield/  
    Balance     Expense     Rate     Balance     Expense     Rate  
                    (Dollar amounts in thousands)                  
Assets
                                               
Earning assets:
                                               
Loans, net of unearned income
  $ 604,376     $ 9,102       6.06 %   $ 396,617     $ 8,186       8.28 %
Investment securities (1)
    89,610       1,025       4.60       78,618       891       4.55  
Other earning assets
    6,792       111       6.57       5,193       73       5.64  
 
                                   
Total earning assets
    700,778       10,238       5.88       480,428       9,150       7.64  
 
                                       
 
                                               
Other assets
    54,390                       23,634                  
 
                                           
Total assets
  $ 755,168                     $ 504,062                  
 
                                           
 
                                               
Liabilities and shareholders’ equity
                                               
Interest-bearing liabilities:
                                               
NOW and money market accounts
  $ 167,947     $ 990       2.37     $ 157,637     $ 1,664       4.23  
Savings deposits
    4,373       9       0.83       3,219       3       0.37  
Time deposits < $100,000
    320,903       3,436       4.31       184,737       2,415       5.24  
Time deposits > $100,000
    54,480       589       4.35       26,390       333       5.06  
State of Alabama time deposits
    6,030       31       2.07       6,030       75       4.99  
Federal funds purchased
    34,700       210       2.43       6,547       92       5.64  
FHLB advances
    29,744       330       4.46       6,000       89       5.95  
Repurchase agreements
    742       3       1.63       792       3       1.52  
Subordinated debentures and other long-term debt
    23,671       263       4.47       7,733       152       7.88  
 
                                   
Total interest-bearing liabilities
    642,590       5,861       3.67       399,085       4,826       4.85  
 
                                   
 
                                               
Net interest spread
          $ 4,377       2.21             $ 4,324       2.79  
 
                                           
 
                                               
Noninterest-bearing demand deposits
  $ 59,160                     $ 58,718                  
Accrued expenses and other liabilities
    6,639                       3,559                  
Stockholders’ equity
    46,495                       43,100                  
Unrealized gain / (loss) on securities
    284                       (400 )                
 
                                           
Total liabilities and stockholders’ equity
  $ 755,168                     $ 504,062                  
 
                                           
 
                                               
Impact of noninterest-bearing sources and other changes in balance sheet composition
                    0.30                       0.82  
 
                                           
 
Net interest margin
                    2.51 %                     3.61 %
 
                                           
 
(1)   Excludes fair market value adjustment on investment securities available-for-sale.

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CAPITALSOUTH BANCORP AND SUBSIDIARIES
Average Balance Sheet and Net Interest Analysis on a Fully Tax-Equivalent Basis
For the Six Months Ended June 30, 2008 and 2007
                                                 
    2008     2007  
    Average     Income/     Yield/     Average     Income/     Yield/  
    Balance     Expense     Rate     Balance     Expense     Rate  
                    (Dollar amounts in thousands)                  
Assets
                                               
Earning assets:
                                               
Loans, net of unearned income
  $ 614,235     $ 19,771       6.47 %   $ 387,433     $ 15,912       8.28 %
Investment securities (1)
    87,287       2,035       4.69       79,162       1,804       4.60  
Other earning assets
    7,384       214       5.83       7,093       193       5.49  
 
                                   
Total earning assets
    708,906       22,020       6.25       473,688       17,909       7.62  
 
                                       
 
                                               
Other assets
    52,062                       23,941                  
 
                                           
Total assets
  $ 760,968                     $ 497,629                  
 
                                           
 
                                               
Liabilities and shareholders’ equity
                                               
Interest-bearing liabilities:
                                               
NOW and money market accounts
  $ 173,093     $ 2,335       2.71     $ 153,426     $ 3,310       4.35  
Savings deposits
    4,401       18       0.82       3,289       6       0.37  
Time deposits < $100,000
    303,802       6,912       4.58       185,670       4,789       5.20  
Time deposits > $100,000
    58,671       1,340       4.59       26,277       658       5.05  
State of Alabama time deposits
    6,030       77       2.57       6,030       149       4.98  
Federal funds purchased
    45,570       728       3.21       5,479       152       5.59  
FHLB advances
    31,852       727       4.59       6,000       178       5.98  
Repurchase agreements
    770       6       1.57       813       7       1.74  
Subordinated debentures and other long-term debt
    23,587       612       5.22       7,733       303       7.90  
 
                                   
Total interest-bearing liabilities
    647,776       12,755       3.96       394,717       9,552       4.88  
 
                                   
 
                                               
Net interest spread
          $ 9,265       2.29             $ 8,357       2.74  
 
                                           
 
                                               
Noninterest-bearing demand deposits
    59,485                       56,889                  
Accrued expenses and other liabilities
    6,613                       3,730                  
Stockholders’ equity
    46,760                       42,733                  
Unrealized gain / (loss) on securities
    334                       (440 )                
 
                                           
Total liabilities and stockholders’ equity
  $ 760,968                     $ 497,629                  
 
                                           
 
                                               
Impact of noninterest-bearing sources and other changes in balance sheet composition
                    0.34                       0.82  
 
                                           
 
Net interest margin
                    2.63 %                     3.56 %
 
                                           
 
(1)   Excludes fair market value adjustment on investment securities available-for-sale.

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The following table reflects changes in the net interest margin as a result of changes in the volume and rate of interest-bearing assets and liabilities. Changes as a result of mix or the number of days in the period have been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
Change in Interest Income and Expense on a Tax-Equivalent Basis
                         
    Three Months Ended June 30, 2008 Compared to  
    Three Months Ended June 30, 2007  
    Increase (Decrease) in Interest Income and Expense  
    Due to Changes in:  
    Volume     Rate     Total  
    (Dollar amounts in thousands)  
Interest-earning assets:
                       
Loans, net of unearned income
  $ 3,124     $ (2,208 )   $ 916  
Investment securities
    125       9       134  
Other earning assets
    26       12       38  
 
                 
Total earning assets
  $ 3,275     $ (2,187 )   $ 1,088  
 
                 
 
                       
Interest-bearing liabilities
                       
NOW and money market accounts
  $ 54     $ (728 )   $ (674 )
Savings deposits
    2       4       6  
Time deposits < $100k
    1,406       (385 )     1,021  
Time deposits > $100k
    304       (48 )     256  
State of Alabama time deposits
          (44 )     (44 )
Federal funds purchased
    170       (52 )     118  
FHLB advances
    263       (22 )     241  
Repurchase agreements
                 
Other borrowings
    177       (66 )     111  
 
                 
Total interest-bearing liabilities
    2,376       (1,341 )     1,035  
 
                 
Increase (decrease) in net interest income
  $ 899     $ (846 )   $ 53  
 
                 
                         
    Six Months Ended June 30, 2008 Compared to  
    Six Months Ended June 30, 2007  
    Increase (Decrease) in Interest Income and Expense  
    Due to Changes in:  
    Volume     Rate     Total  
    (Dollar amounts in thousands)  
Interest-earning assets:
                       
Loans, net of unearned income
  $ 7,314     $ (3,455 )   $ 3,859  
Investment securities
    193       38       231  
Other earning assets
    1       20       21  
 
                 
Total earning assets
  $ 7,508     $ (3,397 )   $ 4,111  
 
                 
 
                       
Interest-bearing liabilities
                       
NOW and money market accounts
  $ 280     $ (1,255 )   $ (975 )
Savings deposits
    5       7       12  
Time deposits < $100k
    2,692       (569 )     2,123  
Time deposits > $100k
    740       (58 )     682  
State of Alabama time deposits
          (72 )     (72 )
Federal funds purchased
    640       (64 )     576  
FHLB advances
    590       (41 )     549  
Repurchase agreements
          (1 )     (1 )
Other borrowings
    412       (103 )     309  
 
                 
Total interest-bearing liabilities
    5,359       (2,156 )     3,203  
 
                 
Increase (decrease) in net interest income
  $ 2,149     $ (1,241 )   $ 908  
 
                 

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Provision for Loan Losses
The provision for loan losses charged to operations during the three months ended June 30, 2008 was $9,350,000 compared to $225,000 in the same period of 2007. For the six month period ended June 30, 2008 the provision for loan losses was $10,007,000 compared to $362,000 for the same period of 2007. In the fourth quarter of 2007, the Company experienced an unprecedented increase in nonperforming assets. In response, management performed an extensive review of the entire loan portfolio with an emphasis on loans secured by real estate which made up over 82% of the Company’s loan portfolio as of June 30, 2008 to determine loss exposure. The majority of the nonperforming loans were secured by real estate. Discounts were applied to appraised values to estimate the Bank’s total exposure given the downturn in real estate values until new appraisals could be obtained. These estimates were the basis for determining the large increase in the allowance at year end. In prior years, provisions to the allowance had largely been driven by the high growth in the loan portfolio. The increase in the provision in the second quarter of 2008, as well as the fourth quarter of 2007, reflects the Company’s assessment of exposure in the loan portfolio based on updated valuations, the impact of the general weakening in the economy on our portfolio, and the impact of regulatory actions. Net loan charge-offs for the second quarter of 2008 were $2,801,000 compared to net recoveries of $18,000 for the same period in 2007. Annualized net charge-offs as a percentage of average loans were 1.37% for the three months ended June 30, 2008 compared to annualized net recoveries of (0.02)% for the same period in 2007. The increase in charge-offs reflects the impact of foreclosure increases and the resulting write-down of the loans to their estimated market value previously provided for in the allowance for loan losses. The rising level of nonperforming loans reflects a progression from past due loans on classified status to an assessment that the future collection of the past due interest is in question and, accordingly, that the accrual should be suspended.
Noninterest Income
Noninterest income for the second quarter declined 14% to $734,000 compared with $854,000 in the year-earlier period, due primarily to reduced Business Capital Group income, which also has been negatively affected by softness in the real estate sector. Higher income from deposit service fees and income from the Bank’s newly acquired mortgage division in the form of gains on sales of mortgage loans offset some of the impact of the decline in Business Capital Group income. Losses on the impairment of investment securities held in the available-for-sale portfolio were incurred as the Company repositioned its investment portfolio away from tax-exempt securities due to its taxable loss for the quarter and to create additional liquidity. For the six months ended June 30, 2008, noninterest income increased 23% to $1,936,000 from $1,573,000 in the year-earlier period, largely due to gains on sales of mortgage loans.
Noninterest Income
                                                 
    Three Months Ended June 30,     Six Months Ended June 30,  
            Percent                     Percent        
    2008     Change     2007     2008     Change     2007  
Service charges on deposit accounts
  $ 403,669       27.54 %   $ 316,513     $ 774,986       25.77 %   $ 616,194  
 
                                               
Investment banking income, net
    1,035       (97.33 )     38,822       3,132       (98.44 )     201,261  
 
                                               
Business Capital Group loan income
    18,252       (95.53 )     408,143       90,030       (84.66 )     586,982  
Bank-owned life insurance
    48,333       11.06       43,518       96,666       11.06       87,036  
Gain on sale of mortgage loans
    168,556     NM             444,712     NM        
(Loss) gain on sale of investment securities
    (78,158 )   NM             200,220     NM        
Other income
    172,358       263.79       47,378       325,890       300.52       81,366  
 
                                       
Total noninterest income
  $ 734,045       (14.08 )%   $ 854,374     $ 1,935,636       23.07 %   $ 1,572,839  
 
                                       
 
NM - Not Meaningful
Total service charges, including non-sufficient funds fees, were $404,000 for the second quarter of 2008, an increase of $87,000, or 27.54%, from the same period in 2007. For the six month period service charges, including non-sufficient funds fees, were $775,000, an increase of $159,000, or 25.77%, from the same period in 2007. The increase is a direct reflection of the growth in the Company’s core transaction deposit accounts. At the end of the second quarter of 2008, the Company had 10,588 transaction accounts compared with 7,471 transaction accounts at the end of the second quarter 2007. We anticipate this growth will continue in 2008 with the contribution of the new Alabama branches opened in the first quarter 2008 and the two additional locations acquired from Monticello.

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Business Capital Group loan income is recognized when loan sale transactions are completed and is not a monthly recurring income stream. Projects financed through our Business Capital Group occur sporadically throughout the year. Accordingly, the large decrease in income for the three month period ended June 30, 2008 compared to the same period in 2007 reflects projects closing earlier in the year in 2007 compared to 2008 as well as the impact of the softening economy on this line of business. The gain on sale of mortgage loans reflects income recognized from the wholesale mortgage segment acquired in the Monticello transaction. Sales of loans by our Business Capital Group and wholesale marketing segment qualify for sales accounting treatment in accordance with SFAS No. 140, Accounting For Transfers and Servicing of Financial Assets, as we have “surrendered control over the transferred assets” within the definition set forth in SFAS No. 140 paragraph 9. We have effectively isolated these loans, and the loans are beyond our reach in all respects. The investor purchasing the loan has the right to pledge or maintain effective control over the loans. The sales contain no recourse provisions, and we do not retain any rights or obligations to service loans sold by our Business Capital Group and wholesale marketing segment.
The loss on sale or impairment of securities for the three months ended June 30, 2008 reflects an impairment loss recognized on select securities in the Bank’s available-for-sale portfolio that were sold at a loss subsequent to quarter-end. The Bank recognized a gain on the sale of investment securities from the Bank’s available-for-sale portfolio and of a minority interest in another bank for the six month period of 2008. The Bank did not sell any securities during the first six months of 2007.
The primary factor in the increase in other income for the three months ended June 30, 2008 compared to the same period in 2007 is income from fees generated by the Mortgage Division acquired with the Monticello acquisition of $74,000 in 2008 compared to $0 in 2007. Other income also includes income on bank-owned life insurance which was $48,000 for the second quarter of 2008 compared to $44,000 for the same period in 2007. For the six months ending June 30, 2008, fees generated by the Mortgage Division were $169,000, compared to $0 in 2007 and bank-owned life insurance was $97,000 compared to $87,000 for the same period of 2007. Life insurance with cash surrender values in the amounts of approximately $4.8 million and $4.6 million at June 30, 2008 and 2007, respectively, is available to fund payments necessary under the terms of certain existing deferred compensation and supplemental income plans maintained for the benefit of our directors and certain executive officers (including CapitalSouth Bank directors). This life insurance is subject to split-dollar agreements whereby death benefits under the policies will be split between CapitalSouth Bank and the designated beneficiaries of the directors and executive officers. The economic value of the split-dollar benefit is taxable to the executives and directors as part of their total compensation each year.
Noninterest Expense
Noninterest expense for the second quarter increased to $15,618,000 from $3,488,000 in the same period last year, due primarily the impact of the goodwill impairment charge. Noninterest expense for the second quarter of 2008, excluding the impairment charge, was $6,256,000, or 79% higher from the year-earlier quarter. This reflects the impact of the incremental costs associated with the Monticello acquisition which included the addition of two branch locations, a mortgage origination facility and 52 additional full-time equivalent employees. The Bank also opened two de novo branch offices in 2008. The Bank had higher occupancy costs in 2008 due to the addition of Monticello and the two new branches, and expenses associated with an increase in OREO. For the six months ended June 30, 2008, noninterest expense was $20,550,000 compared with $7,037,000 in the prior-year period; excluding the impairment charge, noninterest expense increased 59% to $11,187,000 in the first half of 2008, reflecting generally the same factors that accounted for the increase in the second quarter.
Noninterest Expense
                                                 
    Three Months Ended June 30,     Six Months Ended June 30,  
            Percent                     Percent        
    2008     Change     2007     2008     Change     2007  
Salaries and employee benefits
  $ 2,540,963       26.34 %   $ 2,011,280     $ 5,083,679       26.57 %   $ 4,016,410  
Occupancy and equipment expense
    982,592       83.60       535,169       1,856,569       70.59       1,088,321  
Professional fees
    439,336       17.56       373,713       783,668       5.50       742,788  
Advertising
    103,835       147.20       42,004       230,779       60.33       143,940  
Other real estate expense
    1,252,073     NM       999       1,354,722     NM       32,682  
Other noninterest expense
    936,726       78.52       524,715       1,878,080       85.46       1,012,652  
Goodwill impairment
    9,362,813     NM             9,362,813     NM        
 
                                       
Total noninterest income
  $ 15,618,338       347.79 %   $ 3,487,880     $ 20,550,310       192.04 %   $ 7,036,793  
 
                                       
 
NM - Not Meaningful
Salaries and benefits for the three months ended June 30, 2008 increased $530,000, or 26.34%, compared to the same period in 2007. For the six months ended June 30, 2008, salaries and benefits increased $1,068,000, or 26.57%, compared to the same period in 2007. As of June 30, 2008, the Company had 151 full time equivalent employees compared to 112 at June 30, 2007. The primary reasons for this increase in staff are the employees added with the Monticello acquisition and staff increases for the two de novo branches opened in the first quarter of 2008.

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Occupancy and equipment expense for the three months ended June 30, 2008 increased $447,000, or 83.60% compared to the same period in 2007. For the six months ending June 30, 2008, occupancy and equipment expense increased $768,000, or 70.59%, compared to the same period in 2007. These expenses were impacted substantially by the acquisition of Monticello, the opening of two de novo branches and the renovation of the corporate headquarters.
Professional fees for the three months ended June 30, 2008 increased $66,000, or 17.56%, compared to the same period in 2007. For the six month period, professional fees increased $41,000, or 5.50%, compared to the same period in 2007. This increase was primarily due to additional accounting fees and consulting fees incurred in association with the analysis potential goodwill impairment.
Advertising expenses increased $62,000, or 147.20% for the three month period ended June 30, 2008 compared to the same period in 2007. For the six month period, advertising fees increased $87,000, or 60.33%, compared to the same period in 2007. This increase is due to increased marketing as deposit growth has become increasingly competitive and as a result of the opening of our new locations in the Jacksonville, Florida and Huntsville, Alabama markets.
Other real estate expense for the three and six month periods ending June 30, 2008 was $1,252,000 and $1,355,000, respectively. The other real estate expenses for the same periods in 2007 were $999 and $33,000, respectively. This expense is directly related to the increase in OREO and includes write-down of OREO value, gain or loss on the disposal of OREO, legal fees and any costs associated with the maintenance of OREO property. The amount of write-down and gain or loss on the sale of OREO for the three and six month periods ending June 30, 2008 were $1,137,000 and $1,216,000, respectively, compared to $0 and $27,000 for the same period in 2007. The Bank expects to have elevated expenses associated with its other real estate portfolio until these assets can be liquidated.
Other expenses for the three month period ended June 30, 2008 increased $412,000, or 78.52%, compared to the same period in 2007. For the six month period, other expenses increased $865,000, or 85.46%, compared to the same period of 2007. Expenses with significant increases for this comparison include Federal Deposit Insurance Corporation expense due to deposit growth and changes in our assessments under the Federal Deposit Insurance Reform Act of 2005, expenses related to OREO and communication expenses resulting from the acquisition of Monticello.
The Company recognized a goodwill impairment charge of $9,363,000 during the second quarter of 2008 due to recent and significant adverse changes in the general business climate and its impact on the fair value of our stock. Based on our evaluation of goodwill at June 30, 2008, we determined that the remaining balance of goodwill was impaired, and accordingly eliminated all remaining goodwill from the balance sheet.
Income Taxes
The Company recorded a benefit for income taxes of $3.6 million and $3.5 million for the three and six month periods ending June 30, 2008, respectively, compared to a provision for income tax of $495,000 and $775,000 for the same periods in 2007. The effective tax rates for the three and six month periods ending June 30, 2008 were (17.87)% and (18.01)%, respectively, and 35.57% and 32.59%, respectively, for the same periods of 2007. The 2008 rate was affected by a $500,000 valuation allowance provided for deferred tax assets as a result of the Bank’s evaluation of impairment of the deferred taxes recorded as of June 30, 2008 in conformity with SFAS No. 109, Accounting for Income Taxes. The primary permanent differences relate to tax-free income on municipal securities. The decrease in the effective tax rate is primarily attributable to the cumulative net loss for 2008 and an increase in the amount of tax-free interest income on municipal securities in total due to the tax-free securities added from the Monticello acquisition.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate risk is one of the most significant market risks affecting CapitalSouth. Other types of market risk, such as foreign currency risk and commodity price risk, do not arise in the normal course of our business activities. Interest rate risk can be defined as the exposure to changes in market interest rates that could adversely affect our net interest income or market value of equity. The ongoing monitoring and management of this risk is an important component of our asset and liability management process, which is governed by policies established by the board of directors of our subsidiary bank, and carried out by the Asset/Liability Committee. The Committee’s objective is to manage exposure to interest rate risk over both the one year planning cycle and the longer term strategic horizon while, at the same time, ensuring a stable and steadily increasing flow of net interest income. Interest rate risk management activities include establishing guidelines for the repricing characteristics of new business flow, pricing of deposit products, and investment security purchase and sale strategies.
The primary measurement of interest rate risk consists of projections of earnings at risk, which is determined through computerized modeling. The modeling assumes a static balance sheet and incorporates the balances, rates, maturities and repricing characteristics of our subsidiary bank’s existing assets and liabilities, including off-balance sheet financial instruments. Net interest income is first computed under the model assuming no change in market interest rates. These

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results are then compared to the results of other interest rate scenarios where interest rates are moved (shocked) up and down 100 and 200 basis points (BP). Time horizons of six months, one year, two years, and five years are analyzed. The impact of embedded options in products such as callable and mortgage-backed securities, real estate mortgage loans and callable borrowings are considered. The Company compares the changes in net interest income in the shock-up and shock-down scenarios to the net interest income in an unchanged rate scenario. The Asset/Liability Committee utilizes the results of this modeling (shock modeling) to quantify the estimated exposure of net interest income to changes in market interest rates.
The results of the shock modeling as of June 30, 2008, indicate a decreased exposure in the level of net interest income to increases in interest rates when compared to the model as of March 31, 2008. The Company has recently extended maturities on funding sources to better protect our net interest margin. The Bank’s market value of equity is exposed to increases in interest rates. The static shock model scenarios considered changes of 100 and 200 basis points. The model assumes in the decreasing rate scenarios the existence of hypothetical floors on NOW account deposits, savings deposits and money market deposits. These floors limit the cost reductions for these deposits in a decreasing interest rate environment given the current historically low levels of market interest rates. The model also takes into consideration changing prepayment speeds for the loan and mortgage-backed securities portfolios in the varying interest rate environments.
Net Interest Income Sensitivity Summary
As of June 30, 2008
                                         
    Down   Down           Up   Up
    200 BP   100 BP   Current   100 BP   200 BP
            (Dollar amounts in thousands)        
Annualized net interest income
  $ 18,835     $ 18,662     $ 18,136     $ 18,168     $ 18,088  
$ change net interest income
    699       526               32       (48 )
% change net interest income
    3.85 %     2.90 %             0.18 %     (0.26 )%
Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan and security prepayments, deposit run-offs and pricing and reinvestment strategies, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions we may take in response to changes in interest rates. We cannot assure that our actual net interest income would increase or decrease by the amounts computed by the simulations.
The Bank also monitors the repricing terms of our assets and liabilities through gap matrix reports for the rates in unchanged, rising and falling interest rate scenarios. The reports illustrate, at designated time frames, the dollar amount of assets and liabilities maturing or repricing.
ITEM 4T. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of June 30, 2008, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded the Company’s disclosure controls and procedures were effective, in all material respects, to provide reasonable assurance that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within time periods specified in the Securities and Exchange Commission’s rules and regulations, and such information is accumulated and communicated to the Company’s management, including the CEO and CFO, as appropriate, to allow timely decisions regarding disclosure.
Changes in Internal Control over Financial Reporting
Our CEO and CFO have concluded that during the period covered by this report there were no changes in our internal controls that materially affected or are reasonably likely to materially affect our internal control over financial reporting.

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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
For information regarding legal proceedings involving the Company, refer to Part I, “Item 3. Legal Proceedings” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The description of legal proceedings in such Annual Report on Form 10-K remains accurate as of the end of the period covered by this report.
ITEM 1A. RISK FACTORS
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, which could materially affect the Company’s business, financial condition or future results. The risks described in the Company’s Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to the Company or that are currently deemed to be immaterial also may materially adversely affect the Company’s business, financial condition and/or operating results.
A significant portion of our loan portfolio could become under-collateralized due to the real estate market decline, which could have a material adverse effect on our asset quality, capital structure and profitability.
A significant portion of our loan portfolio is comprised of loans secured by commercial and residential construction and land acquisition and development loans. As of June 30, 2008, $168.5 million, or 28.4% of our total loans, are classified as Construction and Development loans, $181.9 million, or 30.7% of our total loans, are classified as Commercial Real Estate loans and $134.8 million, or 22.7% of our total loans, are classified as 1 — 4 Family Residential loans. Construction and Development loans represent the highest level of risk for the Company due to current market conditions and represent 72% of our nonperforming loans. Other Commercial Real Estate loans have not been as severely impacted by the recent economic downturns. In our Other Commercial Real Estate loan portfolio, 55% of the loans cover owner-occupied real estate which has a lower risk element than non-owner occupied. Owner-occupied commercial real estate generally has a lower risk profile since business owners are obligated to repay the debt, and accordingly the loan is not dependent on the liquidation of the collateral as the source of repayment. Currently, only 12% of the Company’s nonperforming loans are Other Commercial Real Estate loans. Our 1 — 4 Family Residential loans have continued to perform well with only moderate increases in delinquencies. Delinquencies of 30 days and over increased from 2.52% as of December 31, 2007 to 4.18% as of March 31, 2008, but dropped back down to 2.02% as of June 30, 2008. 1-4 Family Residential loans past due 30 days or more was only 1.03% of total 1-4 Family Residential loans outstanding as of June 30, 2008. These 1 — 4 Family Residential loans represent 14% of our nonperforming loans.
With the recent real estate market downturn and slowing economic conditions, we are subject to increased lending risks in the form of loan defaults as a result of the high concentration of real estate lending in our loan portfolio. All of CapitalSouth’s markets have experienced a slowdown in residential real estate sales which has, in turn, increased residential lot and home inventory, with the Jacksonville market experiencing the most severe impact. The National Association of Realtors reported a nationwide drop in single-family home prices of 7.7% in the first quarter of 2008, in addition to previous large decreases in single-family home prices. In our most difficult market, Jacksonville, Florida, single-family home prices decreased by 6% in the first quarter of 2008. According to the Alabama Center for Real Estate for the six month period ended June 30, 2008 the Alabama markets were not as negatively affected. The Birmingham and Huntsville markets experienced a 1.8% and 2.0%, respectively, increase in average home prices and the Montgomery market experienced a 1.2% decrease. The decrease in single-family home sales prices is symptomatic of the increases in inventory we have experienced across our markets. Excess residential lot and home inventory, combined with the limited availability of residential mortgage financing due to tighter credit underwriting standards, has resulted in downward pressure on residential values and increased marketing time for residential properties. However, in comparing the percent change in median home prices in our footprint markets to the percent change in the national average of median home prices, all of our markets have experienced significantly less depreciation than the national average. However, certain broader economic conditions in our markets, including unemployment, remain higher than the national average.
Our decisions regarding credit risk could be inaccurate and our allowance for loan losses may be inadequate, which would materially and adversely affect our business, financial condition, results of operations and future prospects.
Our loan customers may not repay their loans according to the terms of such loans, and the collateral securing the payment of those loans may be insufficient to assure repayment. We may experience significant loan losses, which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses that we consider adequate to absorb losses inherent in the loan portfolio based on our assessment of the information available. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans,

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trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions and other pertinent information. Additionally, the Company is incorporating current economic conditions and the impact that it is having on our historical loss experience. As we expand into new markets, our determination of the size of the allowance could be understated due to our lack of familiarity with market-specific factors.
If our assumptions are wrong, our current allowance may not be sufficient to cover our loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. Our allowance for loan losses as of June 30, 2008, December 31, 2007, December 31, 2006, and December 31, 2005 was $16.1 million, $8.9 million, $4.3 million and $3.9 million, respectively.
The following table presents information on nonperforming assets and the allowance for loan losses as of June 30, 2008, June 30, 2007 and December 31, 2007.
                         
                    As of/for the
    As of/for the Six Months Ended   Year Ended
    June 30,   June 30,   December 31,
    2008   2007   2007
Nonperforming assets/Assets
    6.17 %     0.42 %     2.27 %
Annualized net charge-off/Average loans
    0.91       (0.01 )     0.09  
Allowance for loan losses/Loans
    2.73       1.16       1.43  
During the second quarter of 2008, nonperforming assets increased to $45,392,000, or 7.79% of period-end loans and other real estate, which was up from $2,147,000, or 0.53%, in the year-earlier quarter and up from $35,100,000, or 5.68%, at December 31, 2008. The increase reflects rapidly deteriorating economic conditions and growing weakness in the residential real estate sector across our markets since the latter half of 2007. This increase in nonperforming assets for the first six months of 2008 versus the same period of 2007 also reflected the addition of $4.9 million in nonperforming assets purchased in connection with the acquisition of Monticello Bancshares. These assets were recorded at their estimated fair values as part of the purchase accounting adjustments, which were below their original book value. As of June 30, 2008, 93% of our nonperforming loans were secured by real estate. In evaluating the adequacy of the allowance for loan losses, we obtained updated external appraisals on many of the properties underlying the nonperforming loans or performed internal valuations based on current market conditions. We recorded annualized net charge-offs, as a percentage of average loans, of 0.91% in the first six months of 2008 compared with net recoveries of 0.01% in the same period in 2007 and 0.09% in the in 2007. Approximately 37% of the charge-offs taken in the first six months of 2008 were associated with marking assets to market value as they moved to be categorized as OREO.
In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize further loan charge-offs based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results.
We expect to enter into a formal enforcement action with the Federal Reserve Board and the Alabama State Banking Department, and we expect such orders to place significant restrictions on our operations.
Under applicable laws, the Federal Reserve Board, as our primary federal regulator, the FDIC as our deposit insurer, and the Alabama State Banking Department as our chartering authority, have the ability to impose substantial sanctions, restrictions and requirements on us if they determine, upon examination or otherwise, violations of laws with which we must comply, or weaknesses or failures with respect to general standards of safety and soundness. Applicable law prohibits disclosure of specific examination findings by the institution although formal enforcement actions are routinely disclosed by the regulatory authorities. On June 14, 2008, the Federal Reserve Board and the Alabama State Banking Department notified us that they intended to issue a formal enforcement action primarily due to the high level of nonperforming assets and the resulting impact on the Company’s financial condition identified in their most recent safety and soundness examination of the Bank. These actions generally require certain corrective steps, impose limits on activities (such as lending, deposit taking, acquisitions or branching), prescribe lending parameters (such as loan types, volumes and terms) and require additional capital to be raised. In many cases, policies must be revised by the institution and submitted to the regulatory authority for approval within time frames prescribed by the regulatory authorities. Failure to adhere to the requirements of the actions, once issued, can result in more severe penalties. Generally, these enforcement actions can be lifted only after a subsequent examination substantiates complete correction of the underlying issues.
An inability to improve our regulatory capital position could adversely affect our operations.
At June 30, 2008, CapitalSouth Bank was classified as “adequately capitalized.” As a result of our capital levels: (i) our loans to one borrower limit has been reduced, which affects the size of the loans that we can originate and also requires us to refuse to renew loans that exceed our lower loans to one borrower limit, both of which could negatively impact our earnings; (ii) we

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cannot renew or accept brokered deposits without prior regulatory approval; and (iii) we will pay higher insurance premiums to the Federal Deposit Insurance Corporation, which will reduce our earnings. To mitigate or resolve these restrictions, we are attempting to raise additional capital through the common stock rights offering and reduce the Bank’s assets to improve our capital ratios to satisfy the “well capitalized” requirements. If we are unable to raise additional capital or reduce our assets on favorable terms, we will be required to continue to operate under these restrictions.
Our holding company structure and regulations applicable to us can restrict our ability to provide liquidity to meet our obligations.
Our business operations and related generation of cash flow principally occur in our subsidiary bank. Significant parts of our capital markets obligations, including payment on secured debt under our $5.0 million line of credit, and unsecured junior debt incurred in connection with our acquisition of Monticello Bancshares, along with dividends on trust preferred securities and the related debentures, are obligations of the holding company. Historically, the holding company has relied upon dividends from our subsidiary bank to fund these types of obligations. Due to our net loss in 2007, which subjects us to a requirement to obtain discretionary regulatory approval in order to pay dividends from our subsidiary bank to the holding company, we are uncertain whether we can continue to operate in this manner. Although such approval was obtained with respect to the first quarter of 2008, we may not be able to obtain such approval in the future or, if approval to pay dividends is granted, what conditions may be associated with such approval. At the present time, the holding company has limited resources in order to meet its obligations in the absence of payment of dividends from our subsidiary bank. These resources include a limited amount of cash on hand and the ability to make further draws on its line of credit, which matures on January 18, 2009. In light of these circumstances, we may determine that it is necessary or appropriate to raise capital or seek other financing sources and/or take steps to reduce our cash payment obligation at the holding company level; provided, however, that if the rights offering is completed successfully, we are not likely to seek additional infusions of capital in the near future.
Current economic conditions require us to raise additional regulatory capital in the future, and unavailability of additional regulatory capital could adversely affect our financial condition and results of operations.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We must also maintain adequate funding sources in the normal course of business to support our operations and fund outstanding liabilities. Our ability to maintain capital levels, sources of funding and liquidity could be impacted by changes in the capital markets in which we operate. Our ratio of total capital to risk adjusted assets was 8.4%, 9.4% and 12.8% as of June 30, 2008, December 31, 2007 and June 30, 2007, respectively. The Bank’s ratio of total capital to risk adjusted assets was 9.7%, 10.5% and 11.7% as of June 30, 2008, December 31, 2007 and June 30, 2007, respectively. The primary factor that contributed to the decrease in the Company’s total capital to risk adjusted asset ratio was the acquisition of Monticello Bancshares in September of 2007. Additionally, loan loss provisions of $2,130,000 during the fourth quarter of 2007 and $10,007,000 during the six months ended June 30, 2008 contributed to the decrease in total capital to risk adjusted assets at both the Company and the Bank. We anticipate issuing additional capital to restore the Company’s and the Bank’s total risk based capital ratios to well capitalized levels. Our ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may not be able to raise additional capital on terms acceptable to us, if at all.
Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits and certain other restrictions on its business. Due to the Bank’s status as adequately capitalized, we have submitted a capital plan to the Superintendent of Banks of the State Banking Department of Alabama but it has not yet been approved.
Competition from other financial institutions may adversely affect our profitability.
The banking business is highly competitive, and we experience strong competition from many other financial institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other financial institutions that operate in our primary market areas and elsewhere.
We compete with these institutions both in attracting deposits and in making loans. In addition, we must attract our customer base from other existing financial institutions and from new residents. Many of our competitors are well-established and much larger financial institutions. In particular, our market areas are dominated by large national and regional financial institutions. Larger competitors often target markets within their franchise to raise deposits by pricing those deposits above market rates while offsetting that cost in other less competitive markets. Due to our size and smaller footprint, we do not have the ability to offset these type marketing strategies which increases our cost of funding. Larger competitors may employ similar strategies with respect to making loans which causes further margin compression. We focus more on commercial depositors due to our smaller branch network which is not as convenient for the consumer depositor. This niche focus limits the types of accounts that we are able to attract. While we believe we can and do successfully compete with

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these other financial institutions in our markets, we may face a competitive disadvantage as a result of our smaller size, in some cases, and lack of geographic diversification.
Additionally, the Birmingham MSA has experienced a high level of bank consolidation activity in recent years. As a result of several high profile mergers, Birmingham has changed from a city that boasted the headquarters of four large regional banks to a single large bank holding company. The increase in merger activity has resulted in the formation of large numbers of new community banks in the Birmingham MSA, each of which competes for many of the same customers. If we are unable to maintain our customer base or otherwise compete with the level of service offered by these newer community banks, our financial condition and results of operations may be affected adversely.
Our plans for future expansion and bank acquisitions depend, in some instances, on factors beyond our control, and an unsuccessful attempt to achieve growth through acquisitions could have a material adverse effect on our business, financial condition, results of operations and future prospects.
We expect to continue to engage in new branch expansion in the future. We may also seek to acquire other financial institutions. Expansion involves a number of risks, including:
    the costs associated with establishing new locations and retaining experienced local management;
 
    time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;
 
    our potential inability to finance an acquisition without diluting the interests of our existing stockholders;
 
    the diversion of our management’s attention to the negotiation of transactions, which may detract from their business productivity; and
 
    our entry into new markets in which we may lack experience.
We opened two new branch locations in the first quarter of 2008, one in Madison, Alabama and the other in Jacksonville, Florida. The cost of operating these branch locations is expected to exceed the revenue they produce until sufficient new accounts are opened to make them profitable. Experienced banking office personnel have been hired from the local market to staff these new locations to attract loan and deposit relationships to these new locations. We have other marketing plans to attract new client relationships to these locations. Should these new locations not generate sufficient new accounts, they could negatively impact our profits for a period longer than anticipated in our model. If these branch locations continue to be unprofitable, our future ability to expand and acquire other banks could be hindered and this could have a material adverse effect on our business, financial condition, results of operations and future prospects.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On June 5, 2008 the annual meeting of the stockholders of the Company was held. The following numbered matters were considered by the stockholders and the following tables list the results of the stockholders’ vote. With respect to the election of directors, the table indicates votes cast for or withheld for the nominees for director. With respect to the ratification and approval of the appointment of the independent registered public accounting firm for 2008 and the approval to increase the number of authorized shares of common stock, the table indicates the votes abstaining or cast for or against the matter. The following is a tabulation of the voting:
1.   Election of three directors to serve three-year terms until such directors’ successors are elected and qualified at the 2011 Annual Meeting of Stockholders of the Company:
                 
    Votes   Votes
          Name   For   Withheld
James C. Bowen
    2,874,376       53,467  
H. Bradford Dunn
    2,888,766       39,077  
Stanley L. Graves
    2,888,766       39,077  
2.   Ratification of the appointment of KPMG LLP as principal independent auditors of the Company:
                         
    Votes        
    For   Against   Abstentions
 
    2,909,613       6,272       15,558  
3.   Approval of the amendment to the Restated Certificate of Incorporation to increase the number of authorized shares of common stock from 7,500,000 shares to 16,500,000 shares:
                         
    Votes        
    For   Against   Abstentions
 
    2,828,740       79,077       20,026  
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
     
Number   Description
 
   
31.1
  Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a)
 
   
31.2
  Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a)
 
   
32.1
  Certification pursuant to Section 1350

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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
         
    CAPITALSOUTH BANCORP
 
 
         August 14, 2008  By:   /s/ W. Dan Puckett    
    W. Dan Puckett   
    Chief Executive Officer and
Chairman of the Board of Directors 
 
 
         
     
         August 14, 2008  By:   /s/ Carol W. Marsh    
    Carol W. Marsh   
    Chief Financial Officer   

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