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 including regulatory assessments; changes in accounting principles, policies or guidelines; our ability to manage growth; other competitive, technological, governmental and regulatory factors affecting our operations, pricing, products, and services; and factors set out in our Annual Report on Form 10-K for the year ended December 31, 2008 and our other filings with the Securities and Exchange Commission.

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 in North Carolina: its new multi-story main office and corporate headquarters in North Raleigh; one office in the North Hills section of Raleigh; one office in West Raleigh; one office in downtown Raleigh; one office in Garner; one office serving the Wake Forest area; one office in Wilmington; and a loan production office in Morehead City.

Comparison of Financial Condition at June 30, 2009 and December 31, 2008

Total assets at June 30, 2009 were $711.2 million, an increase of $23.6 million or 3.4% over December 31, 2008. The increase in assets is reflected primarily in additional investments in certificates of deposit with other banking institutions, all fully guaranteed by the Federal Deposit Insurance Corporation "FDIC". Our loan portfolio of $549.4 million at June 30, 2009 represents our largest earning asset component at 77.3% of total assets, down from 79.5% at December 31, 2008 due to continued slow loan growth since the first half of 2008. Our total short-term earning assets, including certificates of deposit with other banking institutions, grew $28.6 million to $105.5 million and our available for sale investment portfolio decreased $10.1 million to $26.3 million at June 30, 2009 compared to December 31, 2008. Our asset growth was funded by growth in deposits, up $20.5 million or 3.4% to $633.2 million at June 30, 2009, compared to total deposits of $612.7 million at December 31, 2008. An increase of $34.8 million in core deposits and slower loan growth during the first six months of 2009 provided the opportunity to reduce our level of wholesale brokered certificates of deposit during the first six 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 $1.9 million from December 31, 2008 to $9.6 million at June 30, 2009 and long-term borrowings were unchanged. 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 $10.1 million to $26.3 million from $36.4 million at December 31, 2008. During January and February 2009, management sold $15.3 million of our 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, or FHLB, system's large exposure to non-agency mortgage backed securities, management felt it was prudent to reduce our 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 our 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 carried at book value.

We had no overnight investments in Federal Funds sold as of June 30, 2009 compared to $105,000 as of December 31, 2008 as we continue to utilize our Federal Reserve account for our overnight excess funds. Our interest-earning deposits with banks as of June 30, 2009 included $59.5 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 $45.5 million as of June 30, 2009 compared to $21.8 million as of December 31, 2008. These certificates of deposit are fully insured by the FDIC with an average remaining maturity of less than three months.

Loan production grew less than 1.0% during the first six months of 2009 to $549.4 million as of June 30, 2009 compared to $546.4 million at December 31, 2008. The slow loan growth is attributable to current economic conditions and our emphasis on our historic focus on mutually-beneficial relationship lending. Commercial real-estate and real-estate construction loans at June 30, 2008 as a percent of the loan portfolio is down slightly to approximately 76.2% from 76.7% at December 31, 2008.

The allowance for loan losses was $7.4 million at June 30, 2009 compared to $6.4 million at December 31, 2008, representing 1.34% 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 as well as overall increases to the general reserve. 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 June 30, 2009. We monitor the allowance regularly.

Our premises and equipment grew $2.2 million during the first six months of 2009 to $14.5 million. The increase reflects additions for costs on construction and furniture and equipment of our new multi-story building for our North Raleigh banking office and new corporate offices which opened on June 8, 2009. Other assets increased $2.3 million primarily due to an increase in other real estate owned. Other real estate owned increased to $4.0 million at June 30, 2009 from $2.3 million at December 31, 2008.

As a key source of funding, deposits grew $20.5 million to $633.2 million as of June 30, 2009, over $612.7 million as of December 31, 2008. Slower loan growth and successful building of our core deposit funds provided the opportunity to begin reducing non-traditional wholesale brokered certificates of deposit during the first six months of 2009.

Total time deposits decreased $6.4 million to $298.8 million as of June 30, 2009 compared to $305.3 million as of December 31, 2008; however, the key reason for the decrease was due to a reduction in the level of wholesale brokered time deposit funds. These brokered deposits were reduced $50.5 million from December 31, 2008 to $25.2 million at June 30, 2009 down to 8.4% of total time deposits as of June 30, 2009, from 24.8% as of December 31, 2008. Non-brokered internet deposits increased $28.5 million over December 31, 2008 to $57.3 million as of June 30, 2009 while other time deposits through participation in the Certificate of Deposit Account Registry Service, or CDARS, program remained substantially unchanged at $29.4 million as of June 30, 2009. 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 $7.1 million to $115.1 million as of June 30, 2009. Traditional core time deposits less than $100,000 grew to $71.9 million, up $7.8 million over December 31, 2008. Total time deposits represent 47.2% of our total deposits outstanding as of June 30, 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 $247.2 million as of June 30, 2009, an increase of $26.3 million over December 31, 2008. These core deposits increased to 39.0% of total deposits as of June 30, 2009 up from 36.1% of total deposits as of December 31, 2008. Non-interest bearing deposits remain substantially unchanged, up $619,000 to $87.2 million over December 31, 2008. In total, our traditional core deposits, which exclude internet, CDARS, wholesale brokered deposits and time deposits greater than $100,000, grew $34.8 million to $406.3 million, representing 64.2% of total deposits as of June 30, 2009 compared to 60.6% of total deposits outstanding at December 31, 2008. Deposit funds from our new property management division "CommunityPLUS" contributed $23.3 million of the increase in core deposits since December 31, 2008. Our ability to maintain and grow our traditional 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 June 30, 2009 were $9.6 million, up 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 June 30, 2009.

As of June 30, 2009, shareholders' equity increased $746,000 to $36.3 million. The increase was provided by net income of $1.3 million and the conversion of 7,245 stock options into common stock. The exercise of these options contributed $45,000 to our total shareholders' equity. Accumulated other comprehensive income components decreased shareholders' equity as of June 30, 2009 by $690,000.

Comparison of Results of Operations for the Three-Month Periods Ended June 30, 2009 and 2008

Net Income. For the three-month period ended June 30, 2009, net income was $493,000 compared to $643,000 for the corresponding three-month period of 2008, representing a decrease of 23.3%. On a diluted share basis, earnings were $.07 and $.09 per share, respectively, for the three-month periods ended June 30, 2009 and 2008.

The decrease in earnings for the period is primarily attributable to significantly higher FDIC insurance premiums, up $520,000, higher loan loss provision, up $228,000 and a $134,000 loss from the write-off of our former lead correspondent bank stock. These items were partially offset with increased net interest income of $211,000 and reductions of $554,000 in noninterest expenses, excluding FDIC premiums, largely as a result of expense reduction initiatives undertaken early in 2009.

Net Interest Income. Net interest income was $5.4 million for the three-month period ended June 30, 2009 compared to $5.2 million for the prior year period. The $211,000 increase in net interest income was attributable to overall growth in average interest-earning assets which helped to offset declines in yields and the impact of the lower interest rate environment on our funding costs.

Interest income for the three-month period ended June 30, 2009 decreased $331,000 or 3.7% over the prior year period. Interest income is affected by changes in average interest-earning asset volumes, interest rates and also by the level of loans on nonaccrual status. The level of loans where interest accrual was discontinued increased to $12.5 million as of June 30, 2009 compared to $2.2 million as of June 20, 2008. During the three-month period ended June 30, 2009, The Wall Street Journal prime interest rate averaged 183 basis points lower than in the same period for 2008. The impact of the declines in prime rate on our loan portfolio was minimized to a decrease of 77 basis points in average loan yield during this same period due to several factors. First we had a lower level of variable rate loans, which reprice with each reduction in the Wall Street Journal prime rate and represent approximately 32% of our loan portfolio as of June 30, 2009 compared to approximately 40% as of June 30, 2008 and second, whenever possible, management modifies our loan pricing to include interest rate floors on variable rate loans. Overall, lower yields on our interest-earning assets effectively reduced interest income approximately $1.6 million. The decrease in interest income due to lower rates was offset in part due to a $127.1 million increase in average interest-earning assets. Most of the growth, $97.9 million, was in lower yielding average short-term investments with an average yield of 1.01%. The overall interest-earning asset growth increased interest income by approximately $1.3 million, partially offsetting the decrease in interest income attributable to lower rates.

Total interest expense decreased $542,000 or 14.8% over the prior year period. As with interest income, pricing to reflect the lower interest rate environment was the primary factor for the overall decrease in interest expense. Lower interest rates paid on our interest-bearing deposits reduced total interest expense by approximately $1.6 million. Growth in average interest-bearing deposits of $141.9 million, primarily time deposits under $100,000, increased total interest expense by approximately $1.2 million for the three months ended June 30, 2009 compared to the prior year period. Interest expense on average short-term and long-term borrowings decreased $132,000 and $48,000, respectively, over the prior year period due to a decrease in interest rates paid on these borrowings as a result of the lower interest rate environment and also due to a decrease of $16.2 million in average short-term borrowings. Noninterest-bearing demand deposits were up on average $5.3 million during the three-month period ended June 30, 2009.

Overall, net interest income for the three-month period ended June 30, 2009 increased $211,000 or 4.1%, compared to the same period in 2008. The net interest margin for the three-month period was 3.20% compared to 3.79% 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
                                                June 30, 2009                         June 30, 2008
                                        Average                 Average       Average                 Average
                                        Balance     Interest     Rate         Balance     Interest     Rate
                                            (Dollars in thousands)                (Dollars in thousands)
Interest-earning assets:
Loans (1)                              $ 549,259   $    7,956      5.81 %    $ 515,113   $    8,422      6.58 %
Investments available for sale            27,045          293      4.35 %       28,494          362      5.11 %
Investments held to maturity                 750           10      5.35 %           -            -         -
Fed funds sold                                -            -         -           4,220           19      1.81 %
Other interest-earning assets            100,919          253      1.01 %        3,057           40      5.26 %

Total interest-earning assets            677,973        8,512      5.04 %      550,884        8,843      6.46 %


Other assets                              24,661                                18,632


Total assets                           $ 702,634                             $ 569,516


Interest-bearing liabilities:
Deposits:
NOW, money market and savings          $ 236,164          529      0.90 %    $ 215,523        1,167      2.18 %
Time deposits over $100,000              137,192        1,088      3.18 %       91,022        1,083      4.79 %
Other time deposits                      160,474        1,202      3.00 %       85,365          931      4.39 %
Short-term borrowings                     10,713            8      0.30 %       26,885          140      2.09 %
Long-term debt                            27,266          283      4.16 %       27,507          331      4.84 %

Total interest-bearing liabilities       571,809        3,110      2.18 %      446,302        3,652      3.29 %


Demand deposits                           89,557                                84,251
Other liabilities                          4,301                                 4,671
Shareholders' equity                      36,967                                34,292


Total liabilities and shareholders'
equity                                 $ 702,634                             $ 569,516


Net interest income and interest
rate spread                                        $    5,402      2.86 %                $    5,191      3.17 %


Net yield on average
interest-earning assets                                            3.20 %                                3.79 %


Ratio of average interest-earning
assets to average interest-bearing
liabilities                                                      118.57 %                              123.43 %

(1) Nonaccrual loans are included in loan amounts.

Provision for Loan Losses, Allowance for Loan Losses and Asset Quality. The provision for loan losses increased $228,000 during the three-month period ended June 30, 2009 to $899,000 compared to $671,000 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 June 30, 2009 is principally in response to probable losses identified in our SFAS No. 114 evaluation as well as increases in our general reserve due to an overall increase in the qualitative risk factors applied to our SFAS No. 5 pool of loans. These factors are examined for trends and the risk that they represent to our loan portfolio and have increased due to changes in general economic factors such as unemployment and loan delinquency and charge-off rates. All classified loans are individually analyzed for impairment as detailed in SFAS No. 114. Net charge-offs were $741,000 for the three-month period ended June 30, 2009 compared to net charge-offs of $794,000 for the prior year period.

Nonperforming loans increased to $12.5 million or 2.28% of loans as of June 30, 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 six months ended June 30, 2009 is attributable to four individual borrowers with various commercial loans totaling $921,000, $1.2 million, $905,000 and $2.7 million, respectively. Commercial loans to these borrowers are secured by various properties including an owner-

occupied commercial building, single family rental properties, residential building lots, commercially-zoned land and residential homes. Each specific loan in these customer relationships were analyzed for impairment in accordance with SFAS No. 114 and our management concluded specific impairment reserves of $92,000, $14,000, $11,000 and $32,000, respectively, on these loans were necessary. Our SFAS No. 114 analysis of the remaining $6.7 million of nonperforming loans resulted in additional impairment reserves of $1.0 million for outstanding loans with balances of $6.6 million represented by 42 various loans to 26 borrowers with an average loan balance of less than $160,000.

Accruing loans 90 days or more past due as of June 30, 2009 were $60,000 and there were no accruing loans past due 90 days of more as of December 31, 2008.

As of June 30, 2009, we also identified and evaluated $3.8 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 June 30, 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 ten individual loans to nine borrowers, a single commercial real estate loan of $1.9 million was the largest while the remaining nine individual loans averaged less than $210,000. Approximately $1.6 million of these remaining potential problem loans are secured by real estate and approximately $339,000 are secured with inventory or equipment or are unsecured.

Other real estate owned of $4.0 million at June 30, 2009 consists of 17 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. Also included in other real estate owned are ten new residential construction properties acquired through foreclosure from an individual residential real estate builder representing $1.3 million. Assets acquired through, or in lieu of, foreclosure are held for sale and are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell.

The loan loss allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. As of June 30, 2009, our allowance as a percentage of loans was 1.34%, up from 1.17% at December 31, 2008. As discussed above, as of June 30, 2009, our recorded investment in loans considered impaired in accordance with SFAS No. 114 totaled $12.5 million. As a result, we provided for probable losses through specific impairment reserve allowances of $1.2 million on $12.4 million of these loans. Our allowance for loan loss model provided approximately $585,000 of reserves for the $3.8 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 June 30, 2009. We regularly monitor our loan portfolio and our allowance for loan losses.

The increase in the level of the loan loss allowance relative to gross loans resulted primarily from the increase in the actual impairment reserves allocated to specific loans and an increase in the general reserve due to increases in risk factors overall on the remaining loan portfolio. The actual impairment reserve and additional reserve for potential problem loans increased to $1.8 million as of June 30, 2009 from $1.2 million as of December 31, 2008, representing an approximate nine basis point increase in the allowance as a percentage of total loans outstanding. A higher FAS 5 general reserve due to increases in risk factors applied to the FAS 5 pool of loans, net of loans charged off represented an approximate eight 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 reserve allowance.

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 June 30, 2009, non-interest income, excluding an investment loss of $134,000, decreased $64,000 to $257,000 from $321,000 for the three months ended June 30, 2008. During the three months ended June 30, 2009 we wrote off and recorded a loss of $134,000 on our stock investment in our former lead correspondent bank, Silverton Bank, which was placed into receivership by the FDIC in June 2009. Service charges and fees on deposits increased $19,000 for the three months ended June 30, 2009 compared to the prior year period due to continued efforts to reduce the volume of fees . . .