UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(mark one)

OR

Commission file number 0-15956

Bank of Granite Corporation

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)   Yes [x]   No [  ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock, $1 par value
13,364,032 shares outstanding as of October 31, 2004

Exhibit Index begins on page 38

1

Index

2

Item 1. Financial Statements

Bank of Granite Corporation

See notes to consolidated condensed financial statements.

3

Bank of Granite Corporation

See notes to consolidated condensed financial statements.

4

Bank of Granite Corporation

See notes to consolidated condensed financial statements.

5

Bank of Granite Corporation

Consolidated Condensed Statements of Changes in
Shareholders’ Equity (unaudited)

See notes to consolidated condensed financial statements.

6

Bank of Granite Corporation

Consolidated Condensed Statements of Cash Flows
(unaudited)

See notes to consolidated condensed financial statements.

(continued on next page)

7

Bank of Granite Corporation

Consolidated Condensed Statements of Cash Flows
(unaudited) — (concluded)

See notes to consolidated condensed financial statements.

8

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements
September 30, 2004
(unaudited)

1. UNAUDITED FINANCIAL STATEMENTS

The consolidated condensed balance sheet as of September 30, 2004, the consolidated condensed statements of income and of comprehensive income for the three and nine month periods ended September 30, 2004 and 2003, and the consolidated condensed statements of changes in shareholders’ equity and of cash flows for the nine month periods ended September 30, 2004 and 2003 are unaudited and reflect all adjustments of a normal recurring nature which are, in the opinion of management, necessary for a fair presentation of the interim period financial statements.

The unaudited interim consolidated condensed financial statements of the Company have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These interim consolidated condensed financial statements should be read in conjunction with the Company’s December 31, 2003 audited consolidated financial statements and notes thereto included in the Company’s 2003 Annual Report on Form 10-K.

The consolidated financial statements include the Company’s two wholly-owned subsidiaries, Bank of Granite (the “Bank”), a full service commercial bank, and Granite Mortgage, Inc. (“Granite Mortgage”), a mortgage banking company.

The accounting policies followed are set forth in Note 1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 on file with the Securities and Exchange Commission. There were no changes in significant accounting policies during the nine months ended September 30, 2004.

2. EARNINGS PER SHARE

Earnings per share have been computed using the weighted average number of shares of common stock and potentially dilutive common stock equivalents outstanding as follows:

9

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements (continued)
September 30, 2004
(unaudited)

3. COMMITMENTS AND CONTINGENCIES

In the normal course of business there are various commitments and contingent liabilities such as commitments to extend credit, which are not reflected on the financial statements. Management does not anticipate any significant losses will result from these transactions. The unfunded portion of loan commitments and standby letters of credit as of September 30, 2004 and December 31, 2003 were as follows:

The Company’s risk management policy provides for the use of certain derivatives and financial instruments in managing certain risks. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Managed risk includes the risk associated with changes in interest rates associated with mortgage loans held for sale. Granite Mortgage uses two types of financial instruments to manage risk. These financial instruments, commonly referred to as derivatives, consists of contracts to forward sell mortgage-backed securities and options to forward sell securities. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument. Granite Mortgage uses derivatives primarily to hedge against changes in the market values of the mortgage loans it generates and sells.

As required by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” Granite Mortgage classifies its derivative financial instruments as a hedge of an exposure to changes in cash flow from forecasted transactions (sales of loans to third parties) (“cash flow hedge”). For a qualifying cash flow hedge, changes in the value of the derivatives that have been highly effective as hedges are recognized in other comprehensive income. For cash flow hedges, net income may be affected to the extent that changes in the value of the derivative instruments do not perfectly offset changes in the cash flow of the hedged asset or liability.

10

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements (continued)
September 30, 2004
(unaudited)

4. STOCK-BASED COMPENSATION

The Company accounts for compensation costs related to the Company’s employee stock option plan using the intrinsic value method. Therefore, no compensation cost has been recognized for stock option awards because the options are granted at exercise prices based on the market value of the Company’s stock on the date of grant. Had compensation cost for the Company’s employee stock option plan been determined using the fair value method, the Company’s pro forma net income and earnings per share would have been as follows:

The Company computes its estimate of option compensation expense associated with the fair value method using The Black Scholes Model. The following assumptions were used:

5. GOODWILL AND INTANGIBLE ASSETS

During 2003, the Company’s acquisition of First Commerce Corporation generated goodwill of $10,847,355 and core deposit intangible assets of $630,013. Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” uses a non-amortization approach to account for purchased goodwill and intangible assets with fininte useful lives are amortized over their useful lives. The carrying value of the core deposit intangible asset totaled $489,688, net of accumulated amortization of $140,325, as of September 30, 2004. This intangible asset was determined by management to meet the criteria for recognition apart from goodwill and to have a finite life of 10 years. Amortization expense associated with the core deposit intangible asset was $83,049 for the nine month period ended September 30, 2004. Annual expense is expected to range from approximately $109,000 in 2004 to $63,000 in 2008.

11

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements (continued)
September 30, 2004
(unaudited)

SFAS No. 142 requires that goodwill be tested for impairment annually at the same time each year and on an interim basis when events or circumstances change. The Company elected to perform its annual goodwill impairment test as of May 31. Management completed the annual goodwill impairment test as of May 31, 2004 and believes goodwill was not impaired.

6. SEGMENT DISCLOSURES

The Company’s operations are divided into three reportable business segments: Community Banking, Mortgage Banking and Other. These operating segments have been identified based on the Company’s organizational structure. The segments require unique technology and marketing strategies and offer different products and services. While the Company is managed as an integrated organization, individual executive managers are held accountable for the operations of these business segments.

The Company measures and presents information for internal reporting purposes in a variety of different ways. Information for the Company’s reportable segments is available based on organizational structure, product offerings and customer relationships. The internal reporting system presently utilized by management in the planning and measuring of operating activities, as well as the system to which most managers are held accountable, is based on organizational structure.

The Company emphasizes revenue growth by focusing on client service, sales effectiveness and relationship management. The segment results contained herein are presented based on internal management accounting policies that were designed to support these strategic objectives. Unlike financial accounting, there is no comprehensive authoritative body of guidance for management accounting equivalent to generally accepted accounting principles. Therefore, the performance of the segments is not necessarily comparable with the Company’s consolidated results or with similar information presented by other financial institutions. Additionally, because of the interrelationships of the various segments, the information presented is not indicative of how the segments would perform if they operated as independent entities.

COMMUNITY BANKING

The Company’s Community Banking segment serves individual and business customers by offering a variety of loan and deposit products and other financial services.

MORTGAGE BANKING

The Mortgage Banking segment originates and sells mortgage loan products. Mortgage loan products include fixed-rate and adjustable-rate government and conventional loans for the purpose of constructing, purchasing or refinancing owner-occupied properties. Mortgage loans are typically sold to other financial institutions and government agencies. The Mortgage Banking segment earns interest on loans held in its warehouse and in its portfolio, earns fee income from originations and recognizes gains or losses from the sale of mortgage loans.

OTHER

The Company’s Other segment represents primarily treasury and administration activities. Included in this segment are certain investments and commercial paper issued to the Bank’s commercial sweep account customers.

12

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements (continued)
September 30, 2004
(unaudited)

The following table presents selected financial information for reportable business segments for the three and nine month periods ended September 30, 2004 and 2003.

13

Bank of Granite Corporation

Notes to Consolidated Condensed Financial Statements (continued)
September 30, 2004
(unaudited)

7. NEW ACCOUNTING STANDARDS

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities—an Interpretation of Accounting Research Bulletin 51—Consolidated Financial Statements.” This interpretation provides guidance related to identifying variable interest entities and determining whether such entities should be consolidated. FIN 46 requires an enterprise to consolidate a variable interest entity when the enterprise (a) absorbs a majority of the variable interest entity’s expected losses, (b) receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Prior to the effective date of FIN 46, entities were generally consolidated by an enterprise that had control through ownership of a majority voting interest in the entity. FIN 46 originally applied immediately to variable interest entities created or obtained after January 31, 2003. During 2003, the Bank did not participate in the creation of, or obtain a new variable interest in, any variable interest entity. In December 2003, the FASB issued FIN 46R, a revision to FIN 46, which modified certain requirements of FIN 46 and allowed for the optional deferral of the effective date of FIN 46R for annual or interim periods ending after March 15, 2004. As disclosed in the Quarterly Report on Form 10-Q for the period ended September 30, 2003, the Company completed its assessment of the trust preferred securities and determined that these statutory business trusts should no longer be consolidated entities. Accordingly, the statutory business trusts were reclassified to debt in accordance with FIN 46. The remaining provisions of FIN 46R did not have a material impact on the consolidated results of operations or consolidated financial condition of the Company.

On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments” (“SAB 105”). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (“IRLC”), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, “Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133.” Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company adopted the provisions of SAB 105 effective April 1, 2004. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either the Company’s consolidated financial position or consolidated results of operations.

In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) released EITF Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” The Issue provided guidance for evaluating whether an investmen investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. On September 30, 2004, the EITF delayed the effective date of paragraphs 10-20 of EITF Issue 03-01. As of September 30, 2004, the Company held certain investment positions that it purchased at premiums with unrealized losses that, in the aggregate, were not material to the Company’s consolidated financial position or consolidated results of operations. These investments were in U.S. government agency obligations and local government obligations, the cash flows of which are guaranteed by the U.S. government agencies or the taxing authority of the local government and, therefore, it is expected that the securities would not be settled at a price less than their amortized cost. Because the decline in market value was caused by interest rate increases and not credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company has not recognized any other-than-temporary impairment in connection with these investments.

14

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies

     The accounting and reporting policies of the Company and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. The critical accounting and reporting policies include the Company’s accounting for investment securities, mortgage loans held for sale, derivatives and the allowance for loan losses. In particular, the Company’s accounting policies relating to the allowance for loan losses involve the use of estimates and require significant judgments to be made by management. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position or consolidated results of operations. Please see the discussions below under the captions “Provisions and Allowance for Loan Losses” and “Investment Securities Available for Sale.” Also, please refer to Note 1 in the “Notes to Consolidated Financial Statements” under Item 8, “Financial Statements & Supplementary Data” in the Company’s Annual Report for the year ended December 31, 2003 on Form 10-K on file with the Securities and Exchange Commission for additional information regarding all of the Company’s critical and significant accounting policies.

     LOANS — Loans that management has the intent and ability to hold for the foreseeable future are reported at their outstanding principal balances adjusted for any deferred fees or costs. Substantially all loans earn interest on the level yield method based on the daily outstanding balance.

     PROVISIONS AND ALLOWANCE FOR LOAN LOSSES — The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb probable losses in the portfolio. Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, periodic and systematic loan reviews, historical loan loss experience, value of the collateral and other risk factors.

     Specific allowance is made and maintained to absorb losses for individually identified borrowers. These losses are assessed on an account-by-account basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of underlying collateral. Included in the review of individual loans are those that are impaired as provided in SFAS No. 114, “Accounting for Creditors for Impairment for a Loan.” Loans that are deemed to be impaired (i.e. probable that the Company will be unable to collect all amounts due according to the terms of the loan agreement) are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical matter, at the loan’s observable market value or fair value of the collateral if the loan is collateral dependent. A reserve is established to record the difference between the stated loan amount and the present value or market value of the impaired loan. Impaired loans may be valued on a loan-by-loan basis (e.g., loans with risk characteristics unique to an individual borrower) or on an aggregate basis (e.g., loans with similar risk characteristics). The Company’s policy for recognition of interest income on impaired loans is the same as its interest income recognition policy for non-impaired loans. The Company discontinues the accrual of interest when the collectibility of such interest becomes doubtful. Recovery of the carrying value of loans is dependent to some extent on future economic, operating and other conditions that may be beyond the Company’s control. For the pools of similar loans that have not been specifically identified, estimates of losses are largely based on charge-off trends, expected default rates, general economic conditions and overall portfolio quality. This evaluation is inherently subjective as it requires material estimates and unanticipated future adverse changes in such conditions could result in material adjustments to the allowance for loan losses that could adversely impact earnings in future periods.

15

     INVESTMENT SECURITIES — Non-equity securities not classified as either “held to maturity” securities or trading securities, and equity securities not classified as trading securities, are classified as “available for sale securities” and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of consolidated shareholders’ equity. The fair values of these securities are based on quoted market prices, dealer quotes and prices obtained from independent pricing services. Available for sale and held to maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review is inherently subjective as it requires material estimates and judgments, including an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer and the Company’s ability and intent to hold the security to maturity. Declines in the fair value of the individual held to maturity and available for sale securities below their costs that are other-than-temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in consolidated earnings as realized losses.

     MORTGAGE LOANS HELD FOR SALE — The Company originates certain residential mortgage loans with the intent to sell. Mortgage loans held for sale are reported at the lower of cost or market value on an aggregate loan portfolio basis. Gains or losses realized on the sales of mortgage loans are recognized at the time of sale and are determined by the difference between the net sales proceeds and the carrying value of the loans sold, adjusted for any servicing assets or liabilities related to the loans sold. Gains and losses on sales of mortgage loans are included in noninterest income.

     DERIVATIVES AND HEDGING ACTIVITIES — The Company enters into derivative contracts to hedge certain assets, liabilities, and probable forecasted transactions. On the date the Company enters into a derivative contract, the derivative instrument is designated as: (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (a “fair value” hedge); (2) a hedge of the variability in expected future cash flows associated with an existing recognized asset or liability or a forecasted transaction (a “cash flow” hedge); or (3) held for other risk management purposes (“risk management derivatives”).

     The Company’s primary derivative transactions involve cash flow hedges. See “Liquidity, Interest Rate Sensitivity and Market Risks” below. In a cash flow hedge, the effective portion of the changes in the fair value of the hedging derivative is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings during the same period in which the hedged item affects earnings. The change in fair value of any ineffective portion of the hedging derivative is recognized immediately in earnings.

     The Company formally documents the relationship between the hedging instruments and hedged items, as well as its risk management objective and strategy before undertaking the hedge. To qualify for hedge accounting, the derivatives and related hedged items must be designated as a hedge. Both at the inception of the hedge and on an ongoing basis, the Company assesses whether the hedging relationship is expected to be highly effective in offsetting changes in fair value or cash flows of hedged items. If it is determined that the derivative instrument is not highly effective as a hedge, hedge accounting is discontinued and changes in fair value are included in the statement of income.

16

Changes in Financial Condition

September 30, 2004 Compared With December 31, 2003

     Total assets increased $32,623,429, or 3.36%, from December 31, 2003 to September 30, 2004. Earning assets increased $34,069,602, or 3.78%, over the same nine month period. As reflected in the table below, loans, the largest earning asset, increased $37,489,873, or 5.24%, over the same period, primarily because of a $33,839,621 increase as of September 30, 2004 in loans of the Bank and a $3,650,252 increase in the level of construction and bridge loans of Granite Mortgage. Mortgage loans held for sale by Granite Mortgage decreased by $1,699,441, or 7.36%, as of September 30, 2004, due to lower mortgage origination and refinancing activities primarily because of higher mortgage interest rates. Investment securities decreased $3,979,532, or 2.50%, because calls and maturities of debt securities were used in part to fund loan growth. Cash and cash equivalents decreased $1,506,203, or 4.48%. Accrued interest receivable increased $885,157, or 15.75%. Also during this period, other assets increased $1,133,659, or 14.93%, primarily due to a $941,374, or 26.75% increase in the deferred tax assets of the Bank.

     Loans at September 30, 2004 and December 31, 2003 were as follows:

     Funding the asset growth was a combination of earnings retained and growth in deposits and borrowings. Deposits increased $37,572,872, or 5.11%, from December 31, 2003 to September 30, 2004. Noninterest-bearing demand deposits increased $7,670,337, or 5.60%, over the same nine month period, while interest-bearing demand deposits increased $50,433,265, or 21.19%, over the same nine month period. The increase in interest-bearing demand deposits reflected a $19,368,526, or 18.82%, increase in NOW account deposits and a $31,064,739, or 23%, increase in money market deposits, the latter primarily due to the Bank’s premium money market account that carried an aggressively competitive rate. Part of the growth in interest-bearing demand accounts was attributable to the movement of funds by customers to demand accounts from time deposits in an apparent effort to remain liquid in a rising rate environment. Savings deposits increased $1,112,748, or 4.28%, from December 31, 2003 to September 30, 2004. Time deposits decreased $21,643,478, or 6.48%, over the nine month period. Time deposits greater than $100,000 decreased $12,523,910, or 7.79%, while other time deposits decreased $9,119,568, or 5.26%. primarily for the reason cited above. The Company’s loan to deposit ratio was 97.50% as of September 30, 2004 compared to 101.83% as of December 31, 2003, while the Bank’s loan to deposit ratio was 93.05% compared to 94.06% when comparing the same dates.

     The Company has sources of funding in addition to deposits, in the form of overnight and other short-term borrowings as well as other longer-term borrowings. Overnight borrowings are primarily in the form of federal funds purchased and commercial deposit products that sweep balances overnight into securities sold under agreements to repurchase or commercial paper issued by the Company. From December 31, 2003 to September 30, 2004, such overnight borrowings decreased $1,249,412, or 4.96%, reflecting a decrease of $5,645,065, or 72.47%, in overnight borrowings from federal funds purchased,

17

advances from the Federal Home Loan Bank and securities sold under agreements to repurchase, substantially offset by an increase of $4,395,653, or 25.24%, in volumes of commercial paper. Other borrowings increased $4,761,225, or 7.29%, reflecting an increase in the Bank’s other borrowings.

     Common stock outstanding decreased 218,032 shares, or 1.60%, from December 31, 2003 to September 30, 2004, due to shares repurchased under the Company’s stock repurchase plan, partially offset by shares issued in connection with the exercise of stock options. From December 31, 2003 through September 30, 2004, the Company issued 83,449 shares of its common stock at an average price of $10.73 under its stock option plans. Also from December 31, 2003 through September 30, 2004, the Company repurchased 301,481 shares of its common stock at an average price of $19.97. See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds.” Earnings retained were $4,543,474 for the first nine months of 2004, after paying cash dividends of $4,881,461. Accumulated other comprehensive income, net of deferred income taxes, decreased $241,112, or 31.37%, from December 31, 2003 to September 30, 2004, primarily because the value of securities available for sale and mortgages held for sale declined as interest rates on longer term bonds rose during the period.

Liquidity, Interest Rate Sensitivity and Market Risks

     The objectives of the Company’s liquidity management policy include providing adequate funds to meet the cash needs of both depositors and borrowers, as well as providing funds to meet the basic needs for on-going operations of the Company and regulatory requirements. Depositor cash needs, particularly those of commercial depositors, can fluctuate significantly depending on both business and economic cycles, while both retail and commercial deposits can fluctuate significantly based on the yields and returns available from alternative investment opportunities. Borrower cash needs are also often dependent upon business and economic cycles. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the forms of unfunded commitments to extend credit and standby letters of credit. As of September 30, 2004 such unfunded commitments to extend credit were $120,888,885, while commitments in the form of standby letters of credit totaled $5,438,680. The Company has a common stock repurchase plan, which it uses (1) to reduce the number of shares outstanding when its share price in the market makes repurchases advantageous and (2) to manage capital levels. The Company repurchases its shares in the open market, subject to legal requirements and the repurchase rules of the Nasdaq Stock Market®, the stock exchange on which the Company’s common stock is listed, and through unsolicited privately negotiated transactions. See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds.” The Company’s share repurchases are funded through the payment of dividends to the Company by its subsidiaries, principally the Bank. Because such dividend payments have the effect of reducing the subsidiaries’ capital and liquidity positions, the subsidiaries consider both capital and liquidity levels needed to support current and future business activities when deciding the dividend amounts appropriate to fund share repurchases. The Company plans to continue to repurchase its shares, subject to regulatory requirements and market conditions, for the foreseeable future, while maintaining a well capitalized level. Although shares repurchased are available for reissuance, the Company has not historically reissued, nor does it currently anticipate reissuing, repurchased shares. See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds.”

     Granite Mortgage waits until its mortgage loans close to arrange for the sale of the loans. This method allows Granite Mortgage to bundle mortgage loans and obtain better pricing compared with the sale of individual mortgage loans. However, this method also introduces interest rate risk to Granite Mortgage’s loans in process since rates may fluctuate subsequent to Granite Mortgage’s rate commitment to the mortgage customer. In order to minimize the risk that interest rates may move against Granite Mortgage subsequent to the rate commitment, Granite Mortgage enters into hedge contracts to “forward sell”

18

mortgage-backed securities at the same time as the rate commitment. When the mortgage loans are ultimately sold, Granite Mortgage then buys the mortgage-backed security, thereby completing the hedge contract. Granite Mortgage classifies all of its hedge contracts in accordance with SFAS No. 133 as a hedge of an exposure to changes in cash flows from forecasted transactions, referred to as a “cash flow” hedge. As of September 30, 2004, Granite Mortgage held approximately $17,510,000 in open mortgage-backed security commitments with an estimated market value of approximately $17,495,000, an unrealized loss of approximately $15,000. For the quarterly period ended September 30, 2004, there were realized losses on hedged mortgage loan commitments of $170,000 and realized losses of $139,000 on commitments to sell mortgage-backed securities.

     Through its 2003 acquisition of First Commerce Corporation, the Company acquired a statutory business trust, First Commerce Capital Trust I, created by First Commerce in 2001 to facilitate the issuance of a $5,000,000 trust preferred security through a pooled trust preferred securities offering. First Commerce issued this security in an effort to increase its regulatory capital. This security bears a variable interest rate based on the sixty-day LIBOR plus 375 basis points, matures in 2031 and is callable at par in 2006.

     Neither the Company nor its subsidiaries have historically incurred off-balance sheet obligations through the use of or investment in off-balance sheet derivative financial instruments or structured finance or special purpose entities organized as corporations, partnerships or limited liability companies or trusts. The Bank and Granite Mortgage both had contractual off-balance sheet obligations in the form of noncancelable operating leases with unrelated vendors, though such obligations and the related lease expenses were not material to the Company’s financial condition as of September 30, 2004 and December 31, 2003 or its results of operations for the periods then ended.

     Liquidity requirements of the Bank are primarily met through two categories of funding. The first is core deposits, which includes demand deposits, savings accounts and certificates of deposits. The Bank considers these to be a stable portion of the Bank’s liability mix and the result of on-going stable consumer and commercial banking relationships. At September 30, 2004, the Bank’s core deposits, defined as total deposits excluding time deposits of $100,000 or more, totaled $624,415,167, or 80.8% of the Bank’s total deposits, compared to $574,318,385, or 78.1% of the Bank’s total deposits as of December 31, 2003.

     The other principal methods of funding used by the Bank are large denomination certificates of deposit, federal funds purchased, repurchase agreements and other short and intermediate term borrowings. The Bank’s policy is to emphasize core deposit growth rather than growth through purchased or brokered time deposits because core deposits tend to be a more stable source of funding and purchased or brokered time deposits often have a higher cost of funds. During periods of weak demand for its deposit products, the Bank maintains several credit facilities under which it may borrow on a short-term basis. As of September 30, 2004, the Bank had three unsecured lines of overnight borrowing capacity with its correspondent banks, which totaled $21,000,000. In addition, the Bank uses its capacity to pledge assets to serve as collateral to borrow on a secured basis. As of September 30, 2004, the Bank had investment securities pledged to secure an overnight funding line of approximately $8,250,000 with the Federal Reserve Bank. The Bank also has significant capacity to pledge its loans secured by first liens on residential and commercial real estate as collateral for additional borrowings from the Federal Home Loan Bank during periods when loan demand exceeds deposit growth or when the interest rates on such borrowings compare favorably to interest rates on deposit products. As of September 30, 2004, the Bank had a line of credit totaling approximately $112,777,000, collateralized by its pledged residential and commercial real estate loans, of which approximately $29,000,000 was outstanding and included in other borrowings and approximately $83,777,000 was remaining capacity to borrow.

19

     Granite Mortgage temporarily funds its mortgages, from the time of origination until the time of sale, through the use of a warehouse line of credit from one of the Company’s correspondent financial institutions. Granite Mortgage requests changes in the amount of the line of credit based on its estimated funding needs. As of September 30, 2004, the line was secured by approximately $23,735,000 of the mortgage loans originated by Granite Mortgage. The Company serves as guarantor under the terms of this line. As of September 30, 2004 and December 31, 2003, this line of credit was $40,000,000 and $50,000,000, respectively.

     The Company has a $10,000,000 unsecured line of credit from one of the Bank’s correspondent banks. The line matures June 30, 2006 and bears an interest rate of one-month LIBOR plus 120 basis points, with interest payable quarterly. As of September 30, 2004, the Company had not borrowed any funds against this line of credit.

     The majority of the Company’s deposits are rate-sensitive instruments with rates that tend to fluctuate with market rates. These deposits, coupled with the Company’s short-term certificates of deposit, have increased the opportunities for deposit repricing. The Company places great significance on monitoring and managing the Company’s asset/liability position. The Company’s policy of managing its interest margin (or net yield on interest-earning assets) is to maximize net interest income while maintaining a stable deposit base. The Company’s deposit base is not generally subject to the level of volatility experienced in national financial markets in recent years; however, the Company does realize the importance of minimizing such volatility while at the same time maintaining and improving earnings. A common method used to manage interest rate sensitivity is to measure, over various time periods, the difference or gap between the volume of interest-earning assets and interest-bearing liabilities repricing over a specific time period. However, this method addresses only the magnitude of funding mismatches and does not address the magnitude or relative timing of rate changes. Therefore, management prepares on a regular basis earnings projections based on a range of interest rate scenarios of rising, flat and declining rates in order to more accurately measure interest rate risk.

     Interest-bearing liabilities and the loan portfolio are generally repriced to current market rates. The Company’s balance sheet is asset-sensitive, meaning that in a given period there will be more assets than liabilities subject to immediate repricing as the market rates change. Because most of the Company’s loans are at variable rates, they reprice more rapidly than rate sensitive interest-bearing deposits. During periods of rising rates, this results in increased net interest income. The opposite occurs during periods of declining rates.

     The Company uses interest sensitivity analysis to measure the sensitivity of projected earnings to changes in interest rates. The sensitivity analysis takes into account the current contractual agreements that the Company has on deposits, borrowings, loans, investments and any commitments to enter into those transactions. The Company monitors interest sensitivity by means of computer models that incorporate the current volumes, average rates, scheduled maturities and payments and repricing opportunities of asset and liability portfolios. Using this information, the model estimates earnings based on projected portfolio balances under multiple interest rate scenarios. In an effort to estimate the effects of pure interest-rate risk, the Company assumes no growth in its balance sheet, because to do so could have the effect of distorting the balance sheet’s sensitivity to changing interest rates. The Company simulates the effects of interest rate changes on its earnings by assuming no change in interest rates as its base case scenario and either (1) gradually increasing or decreasing interest rates by 3% over a twelve-month period or (2) immediately increasing or decreasing interest rates by 1%, 2%, 3% and 4%, as discussed below. Although these

20

methods are subject to the accuracy of the assumptions that underlie the process and do not take into account the pricing strategies that management would undertake in response to sudden interest rate changes, the Company believes that these methods provide a better indication of the sensitivity of earnings to changes in interest rates than other analyses.

     Income simulation through modeling is one tool that the Company uses in the asset/liability management process. The Company also considers a number of other factors in determining its asset/liability and interest rate sensitivity management strategies. Management strives to determine the most likely outlook for the economy and interest rates by analyzing external factors, including published economic projections and data, the effects of likely monetary and fiscal policies as well as any enacted or prospective regulatory changes. The Company’s current and prospective liquidity position, current balance sheet volumes and projected growth, accessibility of funds for short-term needs and capital maintenance are also considered. This data is combined with various interest rate scenarios to provide management with information necessary to analyze interest sensitivity and to aid in the development of strategies to manage the Company’s balance sheet.

     As discussed above, the Bank simulates net interest income under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks.” “Rate shocks” measure the estimated theoretical impact on the Bank’s tax equivalent net interest income and market value of equity from hypothetical immediate changes of plus and minus 1%, 2%, 3% and 4% as compared to the estimated theoretical impact of rates remaining unchanged. The prospective effects of these hypothetical interest rate changes is based upon numerous assumptions including relative and estimated levels of key interest rates. “Rate shocks” modeling is of limited usefulness because it does not take into account the pricing strategies management would undertake in response to the depicted sudden and sustained rate changes.

     The Company has not experienced a change in the mix of its rate-sensitive assets and liabilities or in interest rates in the market that it believes would result in a material change in the Company’s analysis of its interest rate sensitivity as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Results of Operations

For the Three Month Period Ended September 30, 2004 Compared With
the Same Period in 2003 and for the Nine Month Period Ended
September 30, 2004 Compared With the Same Period in 2003

     During the three month period ended September 30, 2004, the Company’s net income decreased 26.31% to $3,117,918 from the $4,231,091 earned in the same period of 2003. The decline resulted from lower mortgage origination income, continued narrower net interest margins and higher overhead expenses associated with new banking offices opened or acquired over the last 18 months. For essentially the same reasons, year-to-date net income was also lower. For the first nine months of 2004, net income was $9,424,935, down $2,562,496, or 21.38%, from the $11,987,431 earned in the same year-to-date period of 2003. The year-to-date earnings also reflect the after-tax charge announced in the first quarter of approximately $294,000, or $0.02 per share, related to a contract payout of a former executive officer.

21

Net Interest Income for the Quarterly Periods

     During the three month period ended September 30, 2004, the Company’s net interest income increased slightly by $10,821, or 0.10%, compared to the three months ended September 30, 2003, primarily due to the Company’s growth in rate-sensitive assets and liabilities being offset by declining loan yields and rising funding costs. Although loan volumes grew, the growth occurred primarily in the Bank’s newer market areas where competitive pressures resulted in lower profit margins on loans. The Company’s net interest margin averaged 4.62% during the three month period compared to 4.82% during the same period in 2003. For a discussion of the Company’s asset-sensitivity and the related effects on the Company’s net interest income and net interest margins, please see “Liquidity, Interest Rate Sensitivity and Market Risks” above.

     During the quarter ended September 30, 2004, interest income increased $96,498, or 0.71%, from the same period last year, primarily because higher volumes of loan and investment assets were mostly offset by reduced interest income due to lower yields on loans and lower volumes of mortgages originated during the period. As discussed above, the loan growth occurred in the Bank’s more competitive newer markets. Interest and fees on loans increased $842,071, or 8.25%, while mortgage interest and fees declined $785,676, or 42.70%, due to higher mortgage rates during the quarter and a resulting decline in mortgage originations. Yields on loans averaged 6.27% for the quarter, down from 6.64% for the same quarter last year, even though the prime lending rate during the three month period averaged 4.32% compared to 4.06% during the same period in 2003. Gross loans averaged $768,106,984 compared to $719,344,132 last year, an increase of $48,762,852, or 6.78%. Average loans of the Bank were $735,997,791 compared to $664,057,961 last year, an increase of $71,939,830, or 10.83%, while average loans of Granite Mortgage were $32,109,193 compared to $55,286,171 last year, a decrease of $23,176,978, or 41.92%. The levels of mortgage origination and refinancing activities are very sensitive to changes in interest rates in that higher mortgage interest rates generally have the effect of reducing both mortgage originations and refinancings, while sustained low mortgage interest rates eventually have the effect of reducing refinancings as the demand for such refinancings becomes satisfied.

     Interest expense increased $85,677, or 2.70%, primarily because of higher volumes of interest-bearing deposits and other borrowings, partially offset by lower rates on interest-bearing liabilities. Overall, rates on interest-bearing deposits averaged 1.69% for the quarter, down from 1.75% for the same quarter last year. Total interest-bearing deposits averaged $630,050,931 compared to $586,021,023 last year, an increase of $44,029,908, or 7.51%. NOW account deposits averaged $123,870,164 compared to $97,732,619 last year, an increase of $26,137,545, or 26.74%. Money market deposits averaged $162,630,497 compared to $128,218,552 last year, an increase of $34,411,945, or 26.84%. Time deposits averaged $316,254,970 compared to $332,554,916 last year, a decrease of $16,299,946, or 4.90%. Time deposits generally pay a higher rate of interest than most other types of deposits. The Company attributes part of the growth in interest-bearing demand accounts to the movement of funds by customers to the demand accounts from time deposits in order to remain liquid in a rising rate environment. The Company has not historically relied upon “out-of-market” or “brokered” deposits as a significant source of funding.

22

     Overnight and other borrowings averaged $90,489,256 compared to $103,429,462 last year, a decrease of $12,940,206, or 12.51%, due to a decrease of $22,420,742, or 44.49%, in temporary borrowings of Granite Mortgage primarily due to lower mortgage origination activity, partially offset by an increase of $8,318,500, or 40.84%, in average overnight and other borrowings of the Company and an increase of $1,162,036, or 3.56%, in average overnight and other borrowings of the Bank. Overnight borrowings averaged $27,814,226 compared to $18,006,303 last year, an increase of $9,807,923, or 54.47%, reflecting an increase of $7,549,268, or 46.79%, in average overnight borrowings in the form of commercial paper related to the commercial deposit sweep arrangements of the Bank, and an increase of $2,258,655, or 120.75%, in average overnight borrowings in the form of federal funds purchased and securities sold under agreements to repurchase of the Bank. Other borrowings averaged $62,675,030 compared to $85,423,159 last year, a decrease of $22,748,129, or 26.63%, primarily due to a decrease of $22,420,742, or 44.49%, in temporary borrowings of Granite Mortgage primarily due to lower mortgage origination activity. Other borrowings were the principal source of funding for the mortgage origination activities of Granite Mortgage.

Net Interest Income for the Year-to-Date Periods

     The Company’s net interest income increased $2,471,749, or 8.56%, during the nine month period ended September 30, 2004 compared to the same period in 2003, primarily due to higher volumes of interest-earning assets and interest-bearing liabilities resulting from the Company’s expansion through newly opened and acquired offices during 2003. Loans in the new offices averaged $160,075,404 in the nine months ended September 30, 2004 compared to $40,797,323 for the same year-to-date period in 2003, while interest-bearing deposits in those offices averaged $114,836,061 in the first nine months of 2004 compared to $30,944,386 in the same period of 2003. For the nine month period ended September 30, 2004, the Company’s net interest income increased $2,471,749, or 8.56%, compared to the same period in 2003, primarily because income from new loan volumes was partially offset by the combination of lower loan yields and higher interest expense from the growth in deposits. As was the case for the quarterly period, a substantial portion of the loan growth occurred in the Bank’s newer markets where competitive pressures reduce loan profitability margins. The Company’s net interest margin averaged 4.71% for the year-to-date period, down from 5.18% for the same period last year. For a discussion of the Company’s asset-sensitivity and the related effects on the Company’s net interest income and net interest margins, please see “Liquidity, Interest Rate Sensitivity and Market Risks” above.

     For the nine month period ended September 30, 2004, higher loan and deposit volumes led to higher interest income and expense. During the first nine months of 2004, interest income increased $3,648,353, or 9.83%, from the same period last year primarily because the growth in interest income from higher volumes of commercial and consumer loans was only partially offset by reduced interest income due to lower volumes of mortgage loans and lower yields on loans in general. Interest and fees from loans increased $4,387,254, or 15.62%, due to higher average volumes during the year-to-date period, while interest and fees from mortgages decreased $1,351,277, or 29.72%, due to lower mortgage volumes. As discussed above, the growth in the Bank’s loan volumes occurred primarily in the Bank’s newer markets, where competition places downward pressure on loan yields. Yields on loans averaged 6.31% for the year-to-date period, down from 6.94% for the same period last year, while the prime rate during the nine month period averaged 4.13% compared to 4.17% during the same period in 2003. Gross loans averaged $755,346,224 compared to $628,368,352 last year, an increase of $126,977,872, or 20.21%. Average loans of the Bank were $725,364,127 compared to $583,533,227 last year, an increase of

23

$141,830,900, or 24.31%, while average loans of Granite Mortgage were $29,982,097 compared to $44,835,125 last year, a decrease of $14,853,028, or 33.13%. Average loans in the Bank’s offices opened and acquired during 2003 were $160,075,404 during the first nine months of 2004, an increase of $115,278,081 over the new offices’ average loans in the 2003 year-to-date period. Interest on securities and overnight investments increased $612,376, or 13.63%, due to higher average volumes invested during the period. Average securities and overnight investments were $162,248,491 compared to $147,281,014 last year, an increase of $14,967,477, or 10.16%.

     Interest expense increased $1,176,604, or 14.29%, primarily because of higher volumes of interest-bearing deposits and other borrowings, partially offset by lower rates on interest-bearing deposits and other borrowings. Rates on interest-bearing deposits averaged 1.69% for the year-to-date period, down from 1.87% for the same period last year. Interest-bearing deposits averaged $614,363,809 compared to $506,587,157 last year, an increase of $107,776,652, or 21.28%. Average interest-bearing deposits in the Bank’s offices opened and acquired during 2003 were $114,836,061 during the first nine months of 2004, an increase of $83,891,675 over the new offices’ average interest-bearing deposits in the 2003 year-to-date period. Savings, NOW and money market deposits averaged $290,945,147 compared to $226,265,809 last year, an increase of $64,679,338, or 28.59%. Of the increase, growth in average volumes of $36,381,468 were attributable to the offices added in 2003. Time deposits averaged $323,418,662 compared to $280,321,348 last year, an increase of $43,097,314, or 15.37%. Average time deposits grew $47,507,885 in the offices opened or acquired in 2003. The Company attributes part of the growth in interest-bearing demand accounts to the movement of funds by customers to the demand accounts from time deposits in order to remain liquid in a rising rate environment. Overnight and other borrowings averaged $95,991,662 compared to $76,082,746 last year, an increase of $19,908,916, or 26.17%, reflecting an increase of $33,810,870 in average overnight and other borrowings of the Bank and the commercial paper issued by the Company, partially offset by a decrease of $13,901,954, in temporary borrowings of Granite Mortgage primarily due to lower mortgage origination activity. Overnight borrowings averaged $32,287,216 compared to $16,494,179 last year, an increase of $15,793,037, or 95.75%, reflecting an increase of $7,732,235 in average overnight borrowings in the form of federal funds purchased and securities sold under agreements to repurchase of the Bank and an increase of $8,060,802 in average overnight borrowings in the form of commercial paper related to the commercial deposit sweep arrangements of the Bank. Other borrowings averaged $63,704,446 compared to $59,588,567 last year, an increase of $4,115,879, or 6.91%. reflecting an increase of $14,428,089 in average borrowings of the Bank and an increase of $3,589,744 in higher overnight borrowings in the form of commercial paper related to the commercial deposit sweep arrangements of the Bank, partially offset by a decrease of $13,901,954 in temporary borrowings of Granite Mortgage primarily due to lower mortgage origination activity. Other borrowings were the principal source of funding for the mortgage origination activities of Granite Mortgage.

24

Provisions for Loan Losses, Allowance for Loan Losses
  and Discussions of Asset Quality

     The risks inherent in the Company’s loan portfolio, including the adequacy of the allowance or reserve for loan losses, are significant estimates that are based on management’s assumptions regarding, among other factors, general and local economic conditions, which are difficult to predict and are beyond the Company’s control. In estimating these risks and the related loss reserve levels, management also considers the financial conditions of specific borrowers and credit concentrations with specific borrowers, groups of borrowers and industries.

     Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectibility becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of seven risk grades, each grade indicating a different level of loss reserves. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amounts receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party risk assessment group, regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan as well as the level of reserves deemed appropriate for the loan. Furthermore, loans and commitments of $500,000 or more made during the month, as well as commercial loans past due 30 days or more, are reviewed monthly by the Bank’s Board of Directors. The Bank’s Board of Directors also reviews monthly an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.

     As an additional measure, the Bank engages an independent third party risk assessment group to review the underwriting, documentation, risk grading analyses and the methodology of determining the adequacy of the allowance for losses. This independent third party determines its own selection criteria to select loan relationships for review and evaluation. The third party’s evaluation and report is shared with management, the Bank’s Audit Committee and ultimately, the Bank’s Board of Directors.

     Management considers certain commercial loans with weaker credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk. In estimating reserve levels, the Bank also aggregates non-graded loans into pools of similar credits and reviews the historical loss experience associated with these pools as additional criteria to allocate the allowance to each category.

     Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

25

     The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. Generally, all loans with outstanding balances of $10,000 or greater that have been identified as impaired are reviewed on a monthly basis in order to determine whether a specific allowance is required. A loan is considered impaired when, based on current information, it is probable that the Company will not receive all amounts due in accordance with the contractual terms of the loan agreement. Once a loan has been identified as impaired, management measures impairment in accordance with SFAS 114 “Accounting By Creditors for Impairment of a Loan.” When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Company’s loss exposure for each credit, given the payment status, financial condition of the borrower, and value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.

     The general allowance reflects the best estimate of probable losses that exist within the portfolios of loans that have not been specifically identified. The general allowance for the commercial loan portfolio is established considering several factors including: current loan grades, historical loss rates, estimated future cash flows available to service the loan, and the results of individual loan reviews and analyses. Commercial loans are assigned a loan grade and the loss percentages assigned for each loan grade are determined based on periodic evaluation of actual loss experience over a period of time and management’s estimate of probable incurred losses as well as other factors that are known at the time when the appropriate level for the allowance for loan losses is assessed, including the average term of the portfolio. The allowance for loan losses for consumer loans, mortgage loans, and leases is determined based on past due levels and historical and projected loss rates relative to each portfolio.

     The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.

     Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. While management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company. There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the periods ended September 30, 2004 as compared to the twelve months ended December 31, 2003. Such revisions, estimates and assumptions are made in the period in which the supporting factors indicate that loss levels may vary from the previous estimates.

     Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require the recognition of adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

26

     The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance for loan losses in the accounting period in which they are determined by management to be uncollectible. Recoveries during the period are credited to the allowance for loan losses.

     General economic trends greatly affect loan losses, and no assurances can be made that further charges to the loan loss allowance may not be significant in relation to the amount provided during a particular period or that further evaluation of the loan portfolio based on conditions then prevailing may not require sizable additions to the allowance, thus necessitating similarly sizable charges to operations. Due to unfavorable economic trends in the Catawba Valley region of the Company’s market area and the higher levels of nonperforming loans resulting from the weakened local economy, management believed it prudent to charge operations in the amounts of $1,677,889 and $4,026,901 for the three and nine month periods ended September 30, 2004, respectively, to provide for future losses related to uncollectible loans and to reflect the growth in the Company’s loan portfolio. The 2004 provisions for loan losses compared to $1,139,250 and $3,423,631, respectively, for the comparable periods in 2003. At September 30, 2004, the loan loss reserve was 1.73% of net loans outstanding compared to 1.53% as of December 31, 2003 and 1.64% at September 30, 2003. The following table and subsequent discussion present an analysis of changes in the allowance for loan losses for the quarter-to-date and year-to-date periods.

27

     Though year-to-date charge-offs through September 30, 2004 were lower than those in the same period of 2003, the economic signals in the Company’s Catawba Valley market area were somewhat mixed as reflected in the Company’s levels of charge-offs, loans with higher risk grades, and nonperforming loans. In the third quarter of 2004, the Company charged off $874,752, an increase of $140,010 over the comparable period in 2003. Charge-offs for the 2004 quarterly period included $503,972 in commercial loans and $18,679 in installment loans that were in default. Year-to date charge-offs were $2,350,391, a decrease of $863,366 over the comparable period in 2003. Charge-offs for the 2004 year-to-date period included $756,908 in real estate loans, $720,318 in commercial loans and $565,806 in installment loans that were in default. The effects of a lingering recession in the Company’s Catawba Valley market area were also evidenced by increases in the Company’s allowance for loan losses as presented above, continued high, though slightly improved, nonperforming asset levels as presented below, and the increase in loans with higher risk grades. The amount of loans with the three highest risk grades totaled approximately $13,767,000 at September 30, 2004 as compared with $12,046,000 and $10,958,000 at December 31, 2003 and September 30, 2003, respectively. Some portions of the Catawba Valley economy are beginning to show signs of growth and new markets added through acquisition and opening new banking offices should help diversify the Company’s loan base, but it is difficult to determine when the Catawba Valley economy will return to sustainable growth.

     Nonperforming assets at September 30, 2004 and December 31, 2003 were as follows:

     If interest from nonaccrual loans had been recognized in accordance with the original terms of the loans, the estimated gross interest income for the third quarter that would have been recorded was approximately $102,000, while the interest income recognized on such loans was approximately $1,000 for the quarter. For the year-to-date periods, $299,000 in interest income would have been recognized in accordance with the original terms of the nonaccrual loans, while interest income recognized was approximately $38,000.

     The Company’s investment in impaired loans at September 30, 2004 and December 31, 2003 was as follows:

28

     Loans are classified as non-accrual when the accrual of interest on such loans is discontinued because management believes that such interest will not be collected in a reasonable period of time. The recorded accrued interest receivable deemed uncollectible is reversed to the extent it was accrued in the current year or charged-off to the extent it was accrued in previous years. A loan classified as non-accrual is returned to accrual status when the obligation has been brought current, has performed in accordance with its contractual terms, and the ultimate collection of principal and interest is no longer doubtful.

     When comparing September 30, 2004 with September 30, 2003, the recorded investment in loans that are considered to be impaired under SFAS No. 114 was $8,587,614 ($5,686,758 of which was on a non-accrual basis) and $11,767,188 ($6,805,517 of which was on a non-accrual basis), respectively. The average recorded balance of impaired loans during the first nine months of 2004 and 2003 was not significantly different from the balance at September 30, 2004 and 2003, respectively. The related allowance for loan losses determined in accordance with SFAS No. 114 for these loans was $3,740,932 and $2,595,272 at September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004 and 2003, the Company recognized interest income on those impaired loans of approximately $230,653 and $241,480, respectively.

Noninterest Income and Expenses for the Quarterly Periods

     For the quarter ended September 30, 2004, total noninterest income was $2,850,046, down $1,433,642, or 33.47%, from $4,283,688 earned in the same period of 2003, primarily because of lower fees from mortgage originations. Fees on deposit accounts were $1,423,633 during the third quarter, up only $20,718, or 1.48%, from $1,402,915 earned in the third quarter of 2003. Other service fees and commissions were $199,512 for the third quarter of 2004, down $51,554, or 20.53%, from $251,066 earned in the same period of 2003. Mortgage origination fee income was $923,600 for the third quarter of 2004, down $1,484,887, or 61.65%, from $2,408,487 earned in the same period of 2003. As mortgage rates rose, beginning in the fourth quarter 2003, profitability from mortgage origination activity dropped dramatically and continued at lower levels throughout the third quarter of 2004, as new mortgages had to be priced more competitively to maximize mortgage volumes. The rise in mortgage interest rates also reduced income from gains realized on mortgages sold during the period. Mortgage loans originated during the three months ended September 30, 2004 and 2003 were $90,579,365 and $125,450,857, respectively. The levels of mortgage origination and refinancing activities, and the related profitability of those activities, are very sensitive to changes in interest rates in that higher mortgage interest rates generally have the effect of reducing both mortgage originations and refinancings, while sustained low mortgage interest rates eventually have the effect of reducing refinancings as the demand for such refinancings becomes satisfied. There were no significant gains or losses on sales of securities in the third quarter of 2004 or 2003.

     Third quarter 2004 noninterest expenses, or overhead, totaled $7,075,974, down $94,332, or 1.32%, from $7,170,306 in the same quarter of 2003, primarily because of lower overhead costs associated with lower mortgage origination activity, partially offset by higher overhead costs of the Bank. Overhead costs related to mortgage originations were $1,576,547 for the third quarter of 2004, a decrease of $920,441, or 36.86%, from the mortgage overhead expenses of $2,496,988 for the third quarter of 2003. The Bank’s overhead costs were $5,401,548 for the third quarter of 2004, an increase of $795,127, or 17.26%, over the costs of $4,606,421 for the third quarter of 2003. Of the $795,127 increase, approximately $140,000 reflected the overhead costs of the Bank’s new offices opened or acquired in the last three quarters of 2003.

     Personnel costs, the largest of the overhead expenses, were $4,318,726 during the quarter, down $259,377, or 5.67%, from $4,578,103 in 2003. Of the $259,377 decrease in personnel costs, $771,804 were decreased personnel related to mortgage operations, partially offset by a $512,427 increase in the personnel costs related to banking operations. The $512,427 increase in the Bank’s personnel costs included $312,691 in increased salary expense and $199,736 in increased benefits expense. Consolidated

29

salaries and wages were $3,514,359 during the quarter, down $477,581, or 11.96%, from $3,991,940 in 2003, while employee benefits were $804,367, up $218,204, or 37.23%, compared to $586,163 in the third quarter of 2003. Mortgage-related salaries fell $790,272 or 43.84%.

     Noninterest expenses other than for personnel increased $165,045, or 6.37%, to $2,757,248 during the quarter from $2,592,203 incurred in the same period of 2003. Of the $165,045 increase, the nonpersonnel costs of the Bank increased $282,700, which was partially offset by a $148,637 decrease in the nonpersonnel costs of Granite Mortgage. Banking offices opened or acquired since the first quarter of 2003 accounted for approximately $112,000 of the Bank’s increase. Occupancy expenses for the quarter were $424,226, up $79,601, from $344,625 in the same period of 2003, while equipment expenses were $529,457 during the third quarter, up $151,992, from $377,465 in the same period of 2003. Third quarter other noninterest expenses were $1,803,565 in 2004, down $66,548, or 3.56%, from $1,870,113 in the same quarter a year ago. Of the $66,548 decrease, Granite Mortgage’s other noninterest costs decreased $195,252, which was partially offset by a $97,722 increase in the other noninterest costs of the Bank. Income tax expense was $1,498,707 for the quarter, down $753,955, or 33.47%, from $2,252,662 for the 2003 third quarter. The effective tax rates were 32.46% and 34.74% for the third quarters of 2004 and 2003, respectively.

30

Noninterest Income and Expenses for the Year-to-Date Periods

     For the nine months ended September 30, 2004, total noninterest income was $8,373,736, down $3,060,412, or 26.77%, from $11,434,148 earned in the first nine months of 2003, primarily because of lower fees from mortgage originations. Mortgage origination fee income was $2,830,157 for the first three quarters of 2004, down $2,993,491, or 51.40%, from $5,823,648 earned in the same period of 2003. As was the case for the third quarter, the rise in mortgage rates that began in the fourth quarter of 2003 decreased both the levels of mortgage origination activity and the profitability of mortgages originated, which continued throughout the 2004 year-to-date period. Mortgage loans originated during the nine months ended September 30, 2004 and 2003 were $215,039,117 and $349,226,855, respectively. The levels of mortgage origination and refinancing activities are very sensitive to changes in interest rates in that higher mortgage interest rates generally have the effect of reducing both mortgage originations and refinancings, while sustained low mortgage interest rates eventually have the effect of reducing refinancings as the demand for such refinancings becomes satisfied. Fees on deposit accounts were $4,004,137 during the first nine months of 2004, down $169,840, or 4.07%, from $4,173,977 in the same period of 2003. Also for the year-to-date period, other service fees and commissions were $617,916, down $78,423, or 11.26%, from $696,339 in 2003. Included in other service fees was fee income from sales of annuities of $188,836 for 2004, down $24,855, or 11.63%, from $213,691 earned in the same period of 2003. Year-to-date gains on sales and calls of securities were $14,347 compared to $12,665 earned in the same period of 2003. Other noninterest income was $907,179 during the nine months ended September 30, 2004, up $179,660, or 24.69%, from $727,519 in the same period of 2003, primarily due to income from the Bank’s investment in bank owned life insurance.

     Total noninterest expenses were $21,759,191 during the first nine months of 2004, up $3,082,238, or 16.50%, from $18,676,953 in the same period of 2003. As was the case for the third quarter, the year-to-date changes in the various overhead categories included costs associated with banking activities, partially offset by lower costs associated with the slowdown in mortgage origination activities. The Bank’s overhead costs were $16,541,089 for the first nine months of 2004, an increase of $4,362,256, or 35.82%, over the costs of $12,178,833 for the same period of 2003. Of the $4,362,256 increase, approximately $2,495,000 reflected the overhead costs of the Bank’s banking offices opened and acquired in the last three quarters of 2003, including a personnel charge of approximately $490,000 related to the departure of a former executive officer in the first quarter of 2004. The increase in the Bank’s overhead costs were partially offset by a $1,382,653 decrease in the overhead costs resulting from a decline in mortgage origination activity.

     Total personnel costs, the largest of the overhead expenses, were $13,707,135 during the first nine months of 2004, up $1,507,030, or 12.35%, from $12,200,105 in the same period of 2003. Included in the change in personnel costs was an increase of $782,365 in salaries and wages and an increase of $724,665 in employee benefits. Personnel costs related to banking activities increased $2,769,667, which were partially offset by a $1,262,637 decrease in personnel costs related to mortgage origination activities. The $2,769,667 increase in the Bank’s personnel costs included approximately $1,603,000 in personnel costs related to banking offices opened and acquired in the last three quarters of 2003, including approximately $490,000 in nonrecurring personnel costs related to the departure of a former executive officer. Salaries and wages were $11,133,533 during the first nine months of 2004, up $782,365, or 7.56%, from $10,351,168 in the same period of 2003. The increase in salaries and wages consisted of $2,082,503 related to banking operations, partially offset by a $1,300,138 decrease related to mortgage operations. Employee benefits were $2,573,602, up $724,665, or 39.19%, from $1,848,937. Of this increase, $687,164 were related to banking operations and $37,501 were related to mortgage operations.

31

     Noninterest expenses, other than for personnel, increased $1,575,208, or 24.32%, to $8,052,056 during the first nine months of 2004 from the $6,476,848 incurred in the same period of 2003. Of the $1,575,208 increase, the Bank’s nonpersonnel costs increased $1,592,589, partially offset by a $120,016 decrease in Granite Mortgage’s nonpersonnel costs. The new banking offices opened or acquired since the first quarter of 2003 accounted for approximately $893,000 of the Bank’s increase in overhead other than personnel. Year-to-date occupancy expenses were $1,259,183, up $416,099, or 49.35%, from $843,084 in 2003, and equipment expenses were $1,424,852, up $448,166, or 45.89%, from $976,686 in the same year-to-date period of 2003. The occupancy and equipment expense increases were due in large part to the new banking offices added in 2003 and a new core computer system added in early 2004. Other noninterest expenses were $5,368,021 for the nine months ended September 30, 2004, up $710,943, or 15.27%, from $4,657,078 in the same period of 2003. Of the $710,943 increase in other noninterest expenses, $839,085 were related to banking operations, which were partially offset by a $230,777 decrease in other noninterest expenses related to mortgage operations. Year-to-date income tax expense was $4,520,553 in 2004, down $1,711,675, or 27.46%, from $6,232,228 in 2003. The year-to-date effective tax rates were 32.42% and 34.21% for 2004 and 2003, respectively.

Off-Balance Sheet Arrangements

     The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Therefore, the derivative liabilities recorded on the balance sheet as of September 30, 2004 do not represent the amounts that may ultimately be paid under these contracts. Further discussions of derivative instruments are included above under “Liquidity, Interest Rate Sensitivity And Market Risks” and in Note 3 under “Notes to Consolidated Financial Statements.”

32

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     The information required by this item is included in Item 2, Management’s Discussion of Financial Condition and Results of Operations, above, under the caption “Liquidity, Interest Rate Sensitivity and Market Risks.”

Item 4. Controls and Procedures

     As of the end of the period covered by this report, the Company’s management carried out an evaluation, under the supervision and with the participation of the Company’s chief executive officer and chief financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in its periodic reports filed with the Securities and Exchange Commission. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. In addition, no change in the Company’s internal control over financial reporting has occurred during, or subsequent to, the period covered by this report that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.

Disclosures About Forward Looking Statements

     The discussions included in Part I of this document contain statements that may be deemed forward looking statements within the meaning of the Private Securities Litigation Act of 1995, including Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results to differ materially from these statements. For the purposes of these discussions, any statements that are not statements of historical fact may be deemed to be forward looking statements. Such statements are often characterized by the use of qualifying words such as “expects,” “anticipates,” “believes,” “estimates,” “plans,” “projects,” or other statements concerning opinions or judgments of the Company and its management about future events. The accuracy of such forward looking statements could be affected by certain factors, including but not limited to, the financial success or changing conditions or strategies of the Company’s customers or vendors, fluctuations in interest rates, actions of government regulators, the availability of capital and personnel, and general economic conditions.

33

Part II — Other Information

Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds

     The Company purchases shares of its common stock in open-market and occasional privately negotiated transactions pursuant to publicly announced share repurchase programs. Share repurchase transactions for the three months ended September 30, 2004 are set forth below.

(1)

For the three months ended September 30, 2004, 91,557 shares were purchased in open-market transactions. The Company does not repurchase shares in connection with disqualifying dispositions of shares issued under its stock option plans. Optionees execute these transactions through independent, third-party brokers.

(2)

The Company has not historically established expiration dates for its share repurchase programs.

(3)

Currently active repurchase program in the amount of $10,000,000 announced February 12, 2004.

34

Item 6 — Exhibits and Reports on Form 8-K

Exhibits, Financial Statement Schedules and Reports on Forms 8-K included in or incorporated by reference into this filing were filed with the Securities and Exchange Commission. Bank of Granite Corporation provides these documents through its Internet site at www.bankofgranite.com or by mail upon written request.

35

36

Signatures

     Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

37

Exhibit Index

38