This report contains forward-looking statements intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such because the context of the statement will include words such as we "believe," "anticipate," "expect" or words of similar meaning. Similarly, statements that describe our future plans, objectives or goals are also forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those currently anticipated, including: general and local economic conditions; changes in interest rates, deposit flows, loan demand, real estate values and competition; changes in legislation or regulation; changes in accounting principles, policies or guidelines; our ability to manage growth; and other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services.

Management's discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. You should read this discussion in conjunction with our consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2008.

Overview

We are a commercial bank holding company that was incorporated on June 5, 2002. Effective June 28, 2002, North State Bank became our wholly owned subsidiary. In March 2004, we formed North State Statutory Trust I, in December 2005 we formed North State Statutory Trust II and in November 2007 we established a third subsidiary trust, North State Statutory Trust III, all of which issued trust preferred securities to provide additional capital for general corporate purposes, including expansion of North State Bank. In October 2007, we acquired approximately 5.6% of Beacon Title Agency, LLC, a title insurance agency. Our only business is the ownership and operation of North State Bank, the three subsidiary trusts and our investment in Beacon Title Agency.

North State Bank is a commercial bank that was incorporated under the laws of the State of North Carolina on May 25, 2000 and began operations on June 1, 2000. The Bank is a full service community bank providing banking services through eight locations: its main office in North Raleigh; one office in the North Hills section of Raleigh, North Carolina; one office in West Raleigh; one office in downtown Raleigh; one office in Garner, North Carolina; one office serving the Wake Forest area of North Carolina; one office in Wilmington, North Carolina; and a loan production office in Morehead City, North Carolina. We anticipate construction to be completed on our new North Raleigh multi-story full-service banking office and corporate headquarters in late spring 2009.

Comparison of Financial Condition at March 31, 2009 and December 31, 2008

Total assets at March 31, 2009 were $720.6 million, an increase of $54.9 million or 8.24% over December 31, 2008 primarily due to additional investments in certificates of deposit with other insured banking institutions. Although our loan portfolio at $549.6 million represents our largest earning asset component at 76.3% of total assets, loans grew a modest $3.2 million during the first quarter of 2009 as loan growth has continued to slow from the first half of 2008. Our total short-term earning assets grew $39.3 million to $116.2 million and marketable investments decreased $11.2 million to $25.2 million at March 31, 2009 compared to December 31, 2008. Our asset growth was funded by growth in deposits, up $29.9 million or 4.9% to $642.6 million at March 31, 2009 compared to total deposits of $612.7 million at December 31, 2008. An increase of $45.6 million in core deposits and slower loan growth during the first three months of 2009 provided the opportunity to reduce our levels of wholesale brokered certificates of deposit and non-brokered internet deposits during the first three months of 2009. Our core deposit growth is a result of our efforts to seek opportunities to develop banking relationships with our

niche customers throughout all our markets in general and through the launching of our new property management division "CommunityPLUS". Short-term borrowings increased $2.2 million from December 31, 2008 to $10.0 million at March 31, 2009. We continue to have no exposure to subprime loans and chose not to participate in the Capital Purchase Plan of the U.S. Government's Troubled Asset Relief Program, or TARP.

Substantially all of our investments are accounted for as available for sale under Financial Accounting Standards Board, or FASB, No. 115 and are presented at their fair market value. Our available for sale investment portfolio decreased $11.2 million to $25.2 million from $36.4 million at December 31, 2008. During January and February 2009, management sold $15.3 million of its U.S. government securities and obligations of U.S. governmental agencies and $1.4 million of its state and municipal securities, respectively, for net gains of $464,000. The decision to sell a substantial part of the securities portfolio was due to concerns over the continued negative downturn in real estate markets and the rising mortgage delinquency and foreclosure rates and the effect of the underlying mortgages on mortgage backed securities in general. Given the Federal Home Loan Bank ("FHLB") system's large exposure to non-agency mortgage backed securities, management felt it was prudent to reduce the Company's exposure to the FHLB debt instruments. The same general concern about the effect of current and possible future economic events led management to conclude it was desirable to reduce the Company's exposure to municipal debt. We have no holdings in Fannie Mae or Freddie Mac preferred stock and no holdings in non-agency mortgage-backed securities. The Bank owns $750,000 in corporate bonds that are accounted for as held to maturity and are stated at book value.

We had no overnight investments in Federal Funds sold as of March 31, 2009 compared to $105,000 as of December 31 2009 as we continue to utilize our Federal Reserve account for our overnight excess funds. Our interest-earning deposits with banks as of March 31, 2009 included $60.5 million in excess overnight funds in our Federal Reserve account compared to $54.0 million as of December 31, 2008. Certificates of deposit with various federally insured banking institutions increased to $54.9 million as of March 31, 2009 compared to $21.8 million as of December 31, 2008. These certificates of deposit are fully insured by the FDIC.

Loan production grew less than 1.0% during the first three months of 2009 to $549.6 million as of March 31, 2009 compared to $546.4 million at December 31, 2008. The slow loan growth is attributable to our emphasis on our historic niche of mutually-beneficial relationship lending rather than making loans without related deposit accounts. Commercial real-estate and real-estate construction loans continue to represent approximately 76.6% of the loan portfolio as of March 31, 2009.

The allowance for loan losses was $7.2 million at March 31, 2009 compared to $6.4 million at December 31, 2008 representing 1.31% and 1.17% respectively, of loans outstanding at each date. The level of the allowance relative to gross loans was increased primarily due to additional specific reserves for impaired loans. We established the allowance for loan losses at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio at March 31, 2009. We monitor the allowance regularly.

Our premises and equipment grew $1.4 million during the first three months of 2009 to $13.6 million. The increase reflects additions for costs on construction of our new multi-story building for our North Raleigh banking and new corporate offices which are scheduled for completion in late spring 2009. Other assets decreased slightly and FHLB stock remained unchanged from December 31, 2008.

A key source of funding, deposits grew in total $29.9 million to $642.3 million as of March 31, 2009. Slower loan growth and successful building of our local deposit funds provided the opportunity to begin reducing non-traditional funding sources outside our local market areas during the first three months of 2009.

For the first three months of 2009, total time deposits decreased $10.8 million to $294.5 million as of March 31, 2009; however the decrease was due to reduced levels of non-traditional funds sources. These non-traditional funding sources of wholesale brokered time deposits and internet time deposits decreased $27.5 million and $4.1 million, respectively, from December 31, 2008. These funding sources represented 24.8% of total time deposits as of March 31, 2009, down from 34.2% as of December 31, 2008. Other time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program grew $1.8 million to $30.6 million as of March 31, 2009 from $28.7 million as of December 31, 2008. The CDARS program provides full FDIC insurance on deposit balances greater than posted FDIC limits by exchanging larger depository relationships with other CDARS members. Time deposits over $100,000, excluding internet deposits, increased $14.0 million to $122.0 million as of March 31, 2009. Traditional core time deposits less than $100,000 grew to $69.0 million, up $4.9 million over December 31, 2008. Time deposits represent 45.8% of our deposits outstanding as of March 31, 2009 compared to 49.8% as of December 31, 2008.

Interest-bearing transaction accounts which are savings, money market and interest checking accounts grew to $256.1 million as of March 31, 2009, an increase of $35.3 million over December 31, 2008. These core deposits increased to 39.9% of total deposits as of March 31, 2009 from 36.0% of total deposits as of December 31, 2008. Non-interest bearing deposits increased $5.3 million to $92.0 million over December 31, 2008. In total, our traditional core deposits, which exclude internet, CDARS, wholesale brokered and time deposits greater than $100,000, grew $45.6 million to $417.1 million, representing 64.9% of total deposits as of March 31, 2009 compared to 60.6% of total deposits outstanding at December 31, 2008. Our ability to maintain and grow these core deposits is a result of our continued efforts to emphasize relationship banking with our customers in which we aim to obtain the customers borrowing and deposit relationship. Our efforts to grow core deposits will continue to be a top priority during 2009 and beyond as we work to build banking relationships and reduce, and eventually eliminate, non-relationship lending.

As another source of funding to support our balance sheet, short-term borrowings as of March 31, 2009 were $10.0 million, up slightly from $7.8 million as of December 31, 2008, consisting entirely of securities sold under repurchase agreement. Long-term borrowings remained unchanged at $27.3 million as of March 31, 2009.

As of March 31, 2009, shareholders' equity increased $564,000 to $36.1 million. The increase was provided by net income of $833,000 and the conversion of 4,968 stock options into common stock. The exercise of these options contributed $41,000 to our total shareholders' equity while stock-based compensation added $36,000. Other comprehensive income components decreased shareholders' equity as of March 31, 2009 by $346,000.

Comparison of Results of Operations for the Three-Month Periods Ended March 31, 2009 and 2008

Net Income. For the three-month period ended March 31, 2009, net income was $833,000 compared to $629,000 for the corresponding three-month period of 2008, representing a 32.4% increase. On a diluted share basis, earnings were $.11 and $.09 per share, respectively, for the three-month periods ended March 31, 2009 and 2008.

The increase in earnings is primarily attributable to gains from security sales during the first three months of 2009 of $464,000 or approximately $285,000 net of income taxes; however, our net interest income increased $270,000 or 5.6% over the prior year period. These increases in earnings and a decline in noninterest expense of $203,000 as a result of expense reduction initiatives offset an increase in provision for loan losses of $459,000.

Net Interest Income. Net interest income was $5.1 million for the first three-month period of 2009 compared to $4.8 million for the prior year period. The $270,000 increase in net interest income was attributable to additional interest income generated by an overall increase in average interest-earning assets and the effect of much lower interest rates paid on deposits which offset the higher levels of interest-bearing liabilities.

Interest income for the three-month period ended March 31, 2009 decreased $392,000 or 4.4% over the prior year period. Interest income is affected by changes in average interest-earning asset volumes and interest rates. For the three-month period ending March 31, 2009, the impact of lower interest rates was more significant than the growth in interest-earning asset volumes resulting in the net decrease in interest income. The prime rate for the first three-month period of 2009 was an average of 297 basis points lower than in the first quarter of 2008, effectively reducing interest income approximately $2.3 million. The overall growth of $28.1 million in average interest-earning asset volume for the same corresponding periods provided additional interest income of approximately $1.9 million which partially offset the reduced interest income from lower rates.

Total interest expense decreased $662,000 overall, of this decrease, $507,000 was due to decreased deposit interest expense, for the three-month period ended March 31, 2009 compared to the prior year period. As with interest income, lower interest rates were the primary factor for the overall decrease in interest expense. Lower interest rates as a result of repricing our interest-bearing deposits to reflect market conditions reduced total interest expense by approximately $2.1 million. However, growth in average interest-bearing deposits of $152.0 million, primarily time deposits under $100,000, increased total interest expense by approximately $1.5 million for the three months ended March 31, 2009 compared to the prior year period. Interest expense on average short-term and long-term borrowings decreased $137,000 and $18,000, respectively, over the prior year period as interest rates on these funds were lowered as a result of the lower rate environment. Noninterest-bearing demand deposits were up on average $4.4 million during the three-month period ended March 31, 2009.

Overall, net interest income for the three-month period ended March 31, 2009 increased $270,000 or 5.6%, compared to the same period in 2008. The net interest margin for the three-month period was 3.08% compared to 3.75% for the prior year period.

The following table contains information relating to our average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing annualized income or expense by the average balances of assets or liabilities, respectively, for the periods presented.

                                               Three Months Ended                   Three Months Ended
                                                 March 31, 2009                       March 31, 2008
                                         Average                 Average      Average                 Average
                                         Balance     Interest     Rate        Balance     Interest     Rate
                                             (Dollars in thousands)               (Dollars in thousands)
Interest-earning assets:
Loans (1)                               $ 548,221   $    8,044      5.95 %   $ 482,313   $    8,500      7.09 %
Investments available for sale             25,434          272      4.34 %      33,366          394      4.75 %
Investments held to maturity                  750           13      7.03 %          -            -
Fed funds sold                                 38           -       0.00 %       5,804           48      3.33 %
Other interest-earning assets              97,904          267      1.11 %       2,703           46      6.84 %

Total interest-earning assets             672,347        8,596      5.19 %     524,186        8,988      6.90 %

Other assets                               24,122                               19,845

Total assets                            $ 696,469                            $ 544,031

Interest-bearing liabilities:
Deposits:
NOW & Money Market                      $ 219,345          521      0.96 %   $ 204,362        1,555      3.06 %
Savings                                       905           -       0.00 %         813            1      0.49 %
Time deposits over $100,000               124,910        1,177      3.82 %      93,400        1,187      5.11 %
Other time deposits                       182,500        1,467      3.26 %      77,119          929      4.85 %
Short-term borrowings                       9,263            9      0.39 %      17,565          146      3.34 %
Long-term debt                             27,308          309      4.59 %      25,559          327      5.15 %

Total interest-bearing liabilities        564,231        3,483      2.50 %     418,818        4,145      3.98 %

Demand deposits                            92,053                               87,671
Other liabilities                           3,799                                4,168
Shareholders' equity                       36,386                               33,374

Total liabilities and shareholders'
equity                                  $ 696,469                            $ 544,031

Net interest income and interest rate
spread                                              $    5,113      2.69 %               $    4,843      2.92 %

Net yield on average interest-earning
assets                                                              3.08 %                               3.72 %

Ratio of average interest-earning
assets to average interest-bearing
liabilities                                                       119.16 %                             125.16 %

(1) Nonaccrual loans are included in loan amounts.

Provision for Loan Losses. The provision for loan losses increased $459,000 during the three-month period ended March 31, 2009 to $885,000 compared to $426,000 for the same period in 2008. Provisions for loan losses are charged to income to bring the allowance for loan losses to a level considered appropriate by our management. The increase in the provision for the three-month period ended March 31, 2009 is principally in response to probable losses identified in our SFAS No. 114 evaluation. All classified loans are individually analyzed for impairment as detailed in SFAS No. 114. Net charge-offs were $60,000 for the three-month period ended March 31, 2009 compared to net charge-offs of $2,000 for the prior year period.

Nonperforming loans increased to $6.8 million or 1.24% of loans as of March 31, 2009 compared to $5.1 million or .93% of period-end loans as of December 31, 2008. A substantial portion of the increase in nonperforming loans for the three months ended March 31, 2009 is attributable to one loan for $918,000 to a commercial customer for an owner-occupied commercial building. The specific loan of this customer relationship was analyzed for impairment in accordance with SFAS No. 114 and our management concluded a specific impairment reserve of $92,000 was necessary. Remaining in nonperforming loans as of March 31, 2009 from year-end 2008 are loans to two individual residential real estate builders for various real estate construction loans totaling $1.4 million and $735,000, respectively. The loans within these builder relationships have been analyzed for impairment in

accordance with SFAS No. 114 and our management concluded that additional specific impairment reserve allowances of $50,000 and $8,100, respectively, were necessary. Our SFAS No. 114 analysis on the remaining $3.8 million of nonperforming loans resulted in additional impairment reserves of $825,000 for outstanding loans with balances of $2.5 million represented by 18 various loans with an average loan balance less than $150,000 to 11 borrowers.

There were no accruing loans 90 days or more past due as of March 31, 2009 or December 31 2008.

As of March 31, 2009, we also identified and evaluated $3.6 million of potential problem loans primarily as a result of information regarding possible credit problems of the related borrowers. These loans were performing in accordance with the original terms of the loans and not past due as of March 31, 2009 with the exception of two loans that were 30-89 days past due. Management considered these loans in assessing the adequacy of our allowance for loan losses. Although these loans were represented by 18 individual loans to 11 borrowers, a single commercial real estate loan of $1.9 million was the largest while the remaining 17 individual loans averaged less than $100,000. Approximately $927,000 of these remaining potential problem loans are also secured by real estate and approximately $721,000 are secured with inventory, equipment or are unsecured.

Other real estate owned at March 31, 2009 consists of six properties acquired through foreclosure with the largest dollar value representing $2.1 million in a commercial building acquired from the settlement of a loan attributable to a single-practice physician who died unexpectedly. The property is currently under tenant lease and no additional loss is probable. We have reviewed recent appraisals of all properties included in other real estate and believe that the fair values, less estimated costs to sell, equal or exceed their carrying value.

The loan loss allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. As of March 31, 2009, our allowance as a percentage of loans was 1.31%, up from 1.17% at December 31, 2008. As discussed above, as of March 31, 2009, our recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $6.8 million. As a result, we provided for probable losses through specific impairment reserve allowances of $975,000 on $5.5 million of these loans. Management's analysis determined the collateral on the remaining $1.3 million of impaired loans is adequate and no additional specific reserve allowance is necessary. Our allowance for loan loss model provided approximately $929,500 of reserves for the $3.6 million potential problem loans discussed above. The allowance for loan losses was established at a level management considers adequate to provide for probable loan losses based on our assessment of our loan portfolio as of March 31, 2009. We regularly monitor our loan portfolio and our allowance for loan losses.

The increase in the level of the allowance relative to gross loans resulted primarily from the increase in the actual impairment allocated to specific loans. The actual impairment increased to $1.9 million as of March 31, 2009 from $1.2 million as of December 31, 2008, representing an approximate 12 basis point increase in the allowance as a percentage of total loans outstanding. Once a loan is considered impaired, it is not included in the determination of the SFAS 5 component of the allowance, discussed below.

While we believe that our management uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. Because these factors and management's assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Also, as an important component of their periodic examination process, regulatory agencies review our allowance for loan losses and may require additional provisions for estimated losses based on judgments that differ from those of management. Additional information regarding our

allowance for loan losses and loan loss experience is presented in our 2008 Annual Report on Form 10-K for the year ended December 31, 2008.

Noninterest Income. For the three-month period ended March 31, 2009, non-interest income excluding security gains of $464,000, decreased $79,000 to $224,000 from $303,000 for the corresponding period in the prior year. Service charges and fees on deposits increased $19,000 for the three months ended March 31, 2009 compared to the prior year period due to continued efforts to reduce the volume of fees waived on accounts and lower earnings credit rates on accounts. Merchant and other loan fees were down $46,000 over the prior year period. The termination of our mortgage department during the second quarter of 2008 effectively reduced noninterest income approximately $41,000 for the first quarter of 2009. Fees from annuity sales and other fees generated from wealth management services provided $27,600 in non-interest income, down $23,700 over the prior year period. We expect wealth management income to remain slow as a result of current financial market conditions.

Noninterest Expense. We began expense reducing initiatives during the first quarter of 2009 in an effort to partially offset increasingly higher regulatory assessments, specifically FDIC insurance premiums, as well any other unexpected changes due to the current economic environment. Total non-interest expense for the three-month period ended March 31, 2009 decreased $203,000 to $3.5 million, with salaries and benefits representing the largest expense category at $1.7 million. This compares to total noninterest expense for the three-month period ended March 31, 2008 of $3.7 million with salaries and benefits of $2.1 million. Total personnel expense for the three-month period ended March 31, 2009 decreased $375,000. Full time equivalent employees from the prior year period remained essentially the same although there were changes in staffing positions. Our efforts to reduce noninterest expense provided much of the decrease in overall personnel expense. For the first three-month period of 2009 compared to the first three-month period of 2008, incentive and other payroll bonuses decreased $108,000 while salaries and related benefits and costs decreased approximately $45,000. The remaining decrease in overall personnel expense is primarily the result of higher per loan origination cost adjustments implemented in late 2008.

Occupancy and equipment costs increased $65,000 to $646,000 for the three-month period ended March 31, 2009 compared to the same period last year. These costs include additional lease expense for expansion in our current operations area which began in May 2008. Overall, lease expense increased approximately $67,000 over the prior year period. Other non-interest expenses increased $107,000 over prior year period primarily due to increased regulatory expenses. FDIC insurance and state regulatory assessments increased $148,000 over the prior year period . . .