UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended                     December 31, 2004          

Commission file number                     0-15956          

Bank of Granite Corporation

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.00 par value

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

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

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12-b-2). Yes þ No o

     As of March 4, 2005, 13,281,106 shares of common stock, $1 par value, were outstanding. As of June 30, 2004, the aggregate market value of common stock held by non-affiliates was $258,532,008.

Documents Incorporated by Reference

     PART III: Definitive Proxy Statement dated March 18, 2005 as filed pursuant to Section 14 of the Securities Exchange Act of 1934 in connection with the 2005 Annual Meeting of Shareholders.

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FORM 10-K CROSS-REFERENCE INDEX

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PART I

ITEM 1 — BUSINESS

Bank of Granite Corporation (the “Company”) is a Delaware corporation that was organized June 1, 1987 as a bank holding company. The Company currently engages in no operations other than ownership and operation of Bank of Granite (the “Bank”), a state bank chartered under the laws of North Carolina on August 2, 1906 and Granite Mortgage, Inc. (“Granite Mortgage”), a mortgage bank chartered under the laws of North Carolina on June 24, 1985. Granite Mortgage was acquired by the Company on November 5, 1997. On July 15, 2003, the Company acquired First Commerce Corporation and its wholly owned subsidiary, First Commerce Bank (referred to herein collectively as “First Commerce”), and merged First Commerce Bank into the Bank on July 24, 2003. First Commerce Bank operated three banking offices in the Charlotte metropolitan area. The Company conducts its community banking business operations from 20 full-service offices and one loan-production office located in Caldwell, Catawba, Burke, Watauga, Wilkes, Mecklenburg and Forsyth counties in North Carolina. According to the Federal Deposit Insurance Corporation (the “FDIC”), the Bank ranked 10th in assets and 10th in deposits among North Carolina institutions as of September 30, 2004. The Company conducts its mortgage banking business operations from 13 offices in the Central and Southern Piedmont and Catawba Valley regions of North Carolina and in Hilton Head Island, South Carolina.

The Company conducts its business through three reportable business segments: Community Banking, Mortgage Banking and Other. The Community Banking segment offers a variety of loan and deposit products and other financial services. The Mortgage Banking segment originates, retains and sells mortgage loans. The Other segment includes activities at the holding company level such as corporate and shareholder relations and funding from the issuance of commercial paper and trust preferred securities. For financial information on the Company’s three business segments, see Note 20 “Operating Segments” of the “Notes to Consolidated Financial Statements.”

GENERAL BUSINESS

The Bank is an independent community bank. The Bank’s principal community banking activities include the taking of demand and time deposits and the making of loans, secured and unsecured, to individuals, associations, partnerships and corporations. The majority of its customers are individuals and small businesses. No material part of its business is dependent upon a single customer or a few customers whose loss would have an adverse effect on the business of the Bank. No material portion of the business of the Bank is seasonal.

Granite Mortgage’s principal mortgage banking activities include the origination and underwriting of mortgage loans to individuals. Granite Mortgage also sells mortgage servicing rights and appraisal services. Granite Mortgage specializes in government guaranteed mortgage products. The majority of its customers are individuals. No material part of its business is dependent upon a single customer or a few customers whose loss would have an adverse effect on the business of Granite Mortgage. The mortgage business is sensitive to changes in interest rates in the market. When rates decline, Granite Mortgage experiences an increase in its mortgage business. When rates rise, Granite Mortgage’s business declines. No material portion of the business of Granite Mortgage is seasonal.

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GENERAL DESCRIPTION OF ECONOMIC AREAS

Prior to 2003, the Company conducted its community banking operations primarily in Caldwell, Catawba and Burke counties of North Carolina. This area was historically known as a center for the manufacture of fiber optic and coaxial cable, furniture, and apparel. When the economy began to weaken in 2001, these counties were significantly impacted with a sudden and sustained rise in their unemployment rates. All of these industries faced massive layoffs of their workforces. In 2003, as opportunities arose to expand and diversify its market areas, the Company did so by entering three new markets where the local economies were more diversified and growing. The Bank opened new banking offices in Watauga County (Boone) and Wilkes County (Wilkesboro) in April and acquired First Commerce Bank and its three banking offices in Mecklenburg County (Charlotte and Cornelius) in July. In 2004, the Bank opened a banking office in Forsyth County (Winston-Salem). In 2005, the Bank plans to convert its loan production office in Mecklenburg County (Matthews) to a full-service banking office. The relative unemployment rates and the population growth in Mecklenburg County and Forsyth County, each as shown in the tables below, formed the primary basis for the Company’s decision to expand into those new markets.

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TERRITORY SERVED AND COMPETITION

The Bank operates community banking offices in the North Carolina cities of Granite Falls, Lenoir, Hudson, Newton, Morganton, Hickory, Boone, Wilkesboro, Charlotte, Cornelius, Conover and Winston-Salem, with a total of 20 full-service offices, as well as a loan-production office in Matthews. The Bank plans to convert its loan-production office in Matthews to a full-service banking office in 2005.

The Federal Deposit Insurance Corporation (the “FDIC”) collects deposit data from insured depository institutions as of June 30 of each year as presented below (deposit dollars in millions) .

The Bank’s community banking markets are highly competitive. In addition to competing with other large and small banks, which tend to be numerous, especially in the higher growth markets, the Bank also competes for both loan and deposit business with thrifts or savings institutions, credit unions, brokerage and insurance firms and other nonbank businesses, such as manufacturers and retailers.

The mortgage banking business is also highly competitive, with both bank and nonbank mortgage originators competing in the market. Granite Mortgage conducts its mortgage banking business from 13 offices in the North Carolina cities of Winston-Salem, Hickory, High Point, Lenoir, Morganton, Newton, Salisbury, Boone, Charlotte and Fayetteville, and from one office in Hilton Head Island, South Carolina.

The Company’s community banking and mortgage banking operations are both required to compete based on price in order to conduct business in each of the Company’s markets. However, the Company believes that its focus on and commitment to providing superior customer service is what distinguishes it from its competitors.

EMPLOYEES

As of December 31, 2004, the Bank had 253 and Granite Mortgage had 62 full-time equivalent employees. Each of the Bank and Granite Mortgage considers its relationship with its employees to be excellent.

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SUPERVISION AND REGULATION

The following summaries of statutes and regulations affecting bank holding companies, banks and mortgage banks do not purport to be complete. Such summaries are qualified in their entirety by reference to such statutes and regulations.

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is required to register as such with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “FRB”).

A bank holding company is required to file with the FRB annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval prior to acquiring, directly or indirectly, more than 5% of the voting stock of a bank, unless it already owns a majority of the voting stock of the bank. Furthermore, with limited exceptions, a bank holding company must engage only in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. One of the exceptions to this prohibition is the ownership of shares of a company the activities of which the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

The FRB has cease-and-desist powers over bank holding companies and non-banking subsidiaries where their action would constitute a serious threat to the safety, soundness or stability of a subsidiary bank.

Although the Company is not presently subject to any regulatory restrictions on dividends, the Company’s ability to pay dividends depends to a large extent on the amount of dividends paid by the Bank and any other subsidiaries. The Bank, as a North Carolina banking corporation, may pay dividends only out of undivided profits as determined pursuant to Section 53-87 of the North Carolina General Statutes. As of December 31, 2004, the Bank had undivided profits of approximately $94.1 million. Additionally, current federal regulations require that the Bank maintain a ratio of total capital to assets, as defined by regulatory authorities, in excess of 6%. As of December 31, 2004, this ratio was 13.20% for the Bank, leaving approximately $71.5 million of the Bank’s undivided profits available for the payment of dividends.

In an effort to achieve a measurement of capital adequacy that is more sensitive to the individual risk profiles of financial institutions, the various financial institution regulators mandate minimum capital regulations and guidelines that categorize various components of capital and types of assets and measure capital adequacy in relation to a particular institution’s relative levels of those capital components and the level of risk associated with various types of assets of that financial institution. The FDIC and the FRB statements of policy on “risk-based capital” require the Company to maintain a level of capital commensurate with the risk profile assigned to its assets in accordance with the policy statements. The capital standards call for minimum total capital of 8% of risk-adjusted assets. At December 31, 2004, the Company’s tier 1 ratio and total capital ratio to risk-adjusted assets were 16.0% and 17.2%, respectively. The Company’s leverage ratio at December 31, 2004 was 13.4%. The Company is in compliance with all regulatory capital requirements.

The Bank is subject to supervision and regulation, of which regular bank examinations are a part, by the FDIC and the North Carolina State Banking Commission (the “Banking Commission”). The Bank is a member of the FDIC, which currently insures the deposits of each member bank to a maximum of $100,000 per depositor. For this protection, each bank pays a semi-annual statutory assessment and is subject to the rules and regulations of the FDIC.

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Federal banking laws applicable to all depository financial institutions, among other things, (i) afford federal bank regulatory agencies with powers to prevent unsafe and unsound banking practices; (ii) restrict preferential loans by banks to “insiders” of banks; (iii) require banks to keep information on loans to major shareholders and executive officers, and (iv) bar certain director and officer interlocks between financial institutions. The prohibitions against preferential loans and certain director and officer interlocks may inhibit the ability of the Bank and the Company to obtain experienced and capable officers and directors, to replace presently proposed officers and directors, or to add to their number.

The Company is an “affiliate” of the Bank within the meaning of the Federal Reserve Act, which imposes restrictions on loans by the Bank to the Company and on investments by the Bank in the stock or securities of the Company, which serve as security for loans by the Bank to any borrower. The Company is also subject to certain restrictions with respect to engaging in the business of issuing, underwriting and distributing securities.

Shareholders of banks (including bank holding companies which own stock in banks) may be compelled by bank regulatory authorities to invest additional capital in the event their banks experience either significant loan losses or rapid growth of loans or deposits. In addition, the Company may also be required to provide additional capital to any additional banks that it acquires as a condition to obtaining the approvals and consents of regulatory authorities in connection with such acquisitions.

Granite Mortgage, as a mortgage bank, is regulated by the Banking Commission. Because Granite Mortgage is a nonbank subsidiary of a bank holding company, it is also regulated by the FRB. In addition, because Granite Mortgage underwrites mortgages guaranteed by the government, it is subject to other audits and examinations as required by the government agencies or the investors who purchase the mortgages.

The Company cannot predict what other legislation might be enacted or what other regulation might be adopted or, if enacted or adopted, the effect thereof.

EFFECTS OF GOVERNMENTAL MONETARY POLICY AND ECONOMIC CONTROLS

The Company is directly affected by governmental monetary policy and by regulatory measures affecting the banking industry in general. Of primary importance is the FRB, whose actions directly affect the money supply and, in general, affect banks’ lending abilities by increasing or decreasing the cost and availability of bank credit in order to combat recession and curb inflationary pressures in the economy by open market operations in the United States government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against bank deposits.

Deregulation of interest rates paid by banks on deposits and the types of deposits that may be offered by banks have eliminated minimum balance requirements and rate ceilings on various types of time deposit accounts. The effect of these specific actions and, in general, the deregulation of deposit interest rates have increased banks’ costs of funds and made them more sensitive to fluctuations in money market rates.

In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, predictions as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Company are difficult and have very limited reliability.

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INVESTMENT POLICIES

For a discussion of the Company’s investment policies, see “Investment Securities” of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this annual report.

LOAN PORTFOLIO

For a discussion of the Company’s loan portfolio, see “Loans” and “Provisions and Allowances for Loan Losses” of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this annual report.

AVAILABLE INFORMATION

Additional information about the Company and its business is available at the Company’s website, at www.bankofgranite.com. The Company’s filings with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934, are available, free of charge, on the Company’s website at www.bankofgranite.com under the heading “Investor Relations — SEC Filings.” These reports are available as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission. Information included on the Company’s website is not incorporated by reference into this annual report.

ITEM 2 — PROPERTIES

The Company indirectly owns and operates real estate through its ownership of the Bank and Granite Mortgage. The Bank occupies headquarters, operations and information technology center offices located in Granite Falls, North Carolina, which are owned. The Bank also owns its banking offices in the North Carolina cities and communities of Conover, Cornelius, Granite Falls, Hickory, Hudson, Lenoir, Morganton and Newton. The Bank leases its banking offices in the North Carolina cities and communities of Boone, Charlotte, Matthews, Wilkesboro and Winston-Salem. Management does not currently anticipate any problems with the renewal of its operating leases. Granite Mortgage occupies headquarters offices located in Winston-Salem, North Carolina, which are leased. Granite Mortgage also occupies mortgage origination offices in the North Carolina cities and communities of Boone, Charlotte, Conover, Fayetteville, Hickory, High Point, Lenoir, Morganton, Salisbury and Winston-Salem, and the South Carolina community of Hilton Head Island, all of which are leased. Management believes that the premises occupied by the Bank and Granite Mortgage are well-located and suitably equipped to serve and support the Company’s community banking and mortgage banking businesses. See also Note 5 “Premises and Equipment” of the “Notes to Consolidated Financial Statements.”

ITEM 3 — LEGAL PROCEEDINGS

There were no significant legal proceedings as of December 31, 2004.

ITEM 4 — SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of shareholders in the fourth quarter of 2004.

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PART II

The Company’s common stock, $1 par value, trades on The NASDAQ National Market® tier of The NASDAQ Stock Market® under the symbol GRAN. Price and volume information is contained in The Wall Street Journal® and most major daily newspapers in the NASDAQ section under the National Market System listings.

During 2004, the market participants making a market in the Company’s common stock with the highest volumes of Company shares traded were Goldman Sachs & Company, the National Stock Exchange, Knight Equity Markets, LP and Wachovia Capital Markets.

As of December 31, 2004, there were 13,316,102 shares outstanding, owned by approximately 2,700 shareholders of record and an estimated 4,200 holders of shares registered in street name or as beneficial owners. The following table presents the quarterly market sales prices and dividend information for the two years in the period ended December 31, 2004.

Quarterly Common Stock Market Price Ranges and Dividends

The following table sets forth information as of December 31, 2004 regarding shares of the Company’s common stock that may be issued upon exercise of options previously granted and currently outstanding under the Company’s stock option plans, as well as the number of shares available for the grant of options that had not been granted as of that date.

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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 most recent quarter ended December 31, 2004 are set forth below.

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ITEM 6 — SELECTED FINANCIAL DATA

The following table presents selected consolidated historical financial data of the Company for the periods indicated. This financial data should be read in conjunction with the Company’s consolidated financial statements and notes thereto.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Management’s Discussion and Analysis is provided to assist in understanding and evaluating the Company’s results of operations and financial condition. The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere herein. In 1987, the Company was formed under a plan whereby all previously issued shares of the Bank’s stock were exchanged for shares of the Company’s stock. The Bank then became a wholly owned subsidiary of the Company. In 1997, the Company acquired Granite Mortgage, a mortgage bank, through a merger, which was accounted for as a pooling of interests. In July 2003, the Company acquired First Commerce Corporation and its subsidiary bank through a merger, which was accounted for as a purchase transaction. All information presented is consolidated data unless otherwise specified.

This discussion is intended to provide a general overview of the Company’s performance in 2004 and outlook for 2005. Readers seeking a more in-depth discussion of 2004 are invited to read the more detailed discussions below as well as the consolidated financial statements and related notes included under Item 8 of this annual report.

The Year 2004 in Review

Earnings declined in 2004 primarily due to (1) lower profits from mortgage originations, (2) higher provisions for loan losses due to continued sluggish local economies in the Bank’s pre-expansion markets and (3) higher overhead costs in the Bank’s new markets. As expected, the Company’s mortgage origination volumes in 2004 were significantly lower than the unprecedented levels of 2003, principally because of lower volumes of refinancing activity. The decline that began in the fourth quarter of 2003 continued throughout 2004. The Bank continued to experience elevated levels of nonperforming loans as some of its local economies continued to struggle, resulting in the need for higher provisions for possible loan losses. In addition, the operating cost of the six full-service banking offices and one loan production office opened or acquired in the second, third and fourth quarters of 2003, as well as the full-service banking office opened in a new market in the fourth quarter of 2004, had a significant impact on the Bank’s 2004 earnings. Financial highlights are presented in the table below.

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Lower earnings from mortgage originations contributed to a year of lower earnings for the Company in 2004. Earnings of $12,718,220 in 2004 decreased 16.9% from the $15,307,893 earned in 2003. On a per share basis, earnings declined to $0.94 in 2004 compared to $1.13 in 2003. In 2004, the Company earned 1.28% on average assets and 9.02% on average equity. Its efficiency ratio was 53.17%. In 2003, the Company’s return on average assets, return on average equity and efficiency ratio were 1.78%, 11.40% and 46.81%, respectively.

Factors that significantly affected 2004 earnings and financial position:

	o	Granite Mortgage, the Company’s mortgage banking subsidiary, posted 2004 net income of only $534,630, a decrease of 76.2% from the $2,244,639 earned in 2003, primarily due to weak mortgage activity throughout 2004, which management attributes mainly to increases in mortgage interest rates. Mortgage volumes were $280,898,000 in 2004 compared to $421,174,000 in 2003, a decline of 33.3%.
	o	Net interest income increased $2,851,219, or 7.3%, as a result of growth in loans and deposits, but net interest margins contracted 36 basis points to 4.70% in 2004 compared to 5.06% in 2003 as the new volumes of loans and deposits were less profitable primarily due to lower yields on loans and higher costs of borrowings.
	o	During 2004, loan loss provisions increased $675,150, or 14.2%, to provide for possible charge-offs due to continued weak local economies. Total nonperforming loans improved slightly to $10,861,104 as of December 31, 2004 compared to $11,332,793 as of December 31, 2003.
	o	Other expenses, or operating overhead, increased $3,252,483, or 12.58%, of which $4,578,466 was related to the overhead costs of community banking operations, including full-year costs of the banking offices opened and acquired during 2003 and 2004, partially offset by a $1,501,545 reduction in the cost related to the production of lower volumes of mortgage originations.
	o	Loans grew by $62,292,798 or 8.7%, while deposits grew by $14,762,197, or 2%.
	o	During 2004, the Company repurchased 369,720 shares of its common stock for $7,439,376 or an average cost of $20.12 per share.

OUTLOOK FOR 2005

Beginning with its June 2004 meeting, the Federal Open Market Committee (the “FOMC”) began to gradually remove its monetary policy accommodation by increasing its overnight rate on funds by 25 basis points at each of its last five meetings of the 2004 calendar year. The FOMC stated in its December 2004 release that it perceived “the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal,” and hinted that it would continue to remove its monetary policy accommodation at a pace that is likely to be measured. As a result, some market forecasters are looking for short-term interest rates to move from the December 2004 level of 2.25% to a level in the range of 3.00% to 3.50% by the end of 2005.

After an economic bottom has occurred, banks may continue to experience higher than normal levels of nonperforming loans, even into the beginning of the subsequent recovery period. Also, as short-term interest rates begin to rise, asset-sensitive banks, such as the Bank, may experience improvement in net interest margins because the interest rates on their variable-rate assets increase more quickly than the rates on their fixed-rate sources of funding. For the Bank, this effect has been offset by more aggressive deposit pricing in an effort to more closely align deposit funding growth with loan growth.

The Company’s balance sheet remains moderately asset-sensitive because of its significant level of variable rate loans. Asset-sensitive means that when interest rates in the overall economy change, interest rates on the Company’s variable rate assets, primarily loans, change more rapidly than the interest rates on its deposits. Therefore, when interest rates rise, the Company’s interest income rises at a faster pace than the interest expense it pays on its time deposits and other fixed rate funding. Likewise, when interest rates fall, the Company’s interest income on loans declines at a faster pace than the interest it pays on time deposits and other fixed rate funding. In an effort to reduce its asset sensitivity, the Company has historically placed floors and ceilings on many of its variable rate commercial loans. Floors lessen the Company’s exposure to declining rates, while ceilings reduce the Company’s benefit from rising rates. The Company’s asset sensitivity may potentially be offset by an imbalance of

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the demand for deposits with the supply of deposits in the markets in which the Company conducts its business. If the Company has a need for deposits dollars to fund its loan growth, then it may raise its rates at a faster pace than it otherwise would raise them, resulting in an offset to the higher interest earned on its variable rate assets.

For 2005, some analysts are predicting an interest rate environment in which short-term interest rates will gradually rise throughout the year. As in previous periods of gradual interest rate increases, the Company anticipates it will continue to adjust both the mix and pricing of its rate-sensitive assets and liabilities so as to improve, to the extent possible, its net interest margin and spreads. In addition, longer term interest rates are anticipated to remain low relative to historical levels of the periods preceding the most recent low interest rate cycle. Granite Mortgage has historically performed better during periods of lower interest rates due to the effect that low longer term rates tend to have on the housing market, which can serve to partially offset the effects that asset sensitivity may have on net interest income. Granite Mortgage believes its mortgage originations in 2005 may meet or slightly exceed such origination activity in 2004, unless longer term rates rise sharply and thereby reduce the demand for mortgage financing.

The Company also plans to continue to grow its loan portfolio and to use both deposit growth and alternative borrowing sources to fund the loan growth. The Company believes that its credit quality controls remain effective and expects to maintain loan loss reserves as are deemed prudent based on its credit quality analysis.

Although 2005 may continue to bring a mixed economic environment, the Company is optimistic regarding its ability to perform under such varying economic circumstances. Efforts are underway to introduce the Company’s retail and commercial banking services to the Winston-Salem market, where it already has a significant mortgage presence. Entering into new markets, such as those added in 2003 and 2004, has a challenging effect on current earnings, but the Company believes the future benefits will outweigh the present challenges. Over the near term, the Company plans to focus on improving the profitability of its banking operations in the new markets added in the last two years. Over the longer term, the Company plans to continue to diversify and broaden its market and economic base, when determined prudent to do so, as it seeks sustainable earnings growth for its shareholders.

SEGMENT INFORMATION

Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information” requires public companies to report certain financial information about operating segments for which such information is available and utilized by the chief operating decision maker in determining the allocation of resources and also in assessing performance. Prior to 2003, the Company presented financial information as one segment as it had no distinct operating segments based on the requirements of SFAS No. 131. As a result of the 2003 acquisition of First Commerce by the Bank and as a part of the continued integration, management has re-evaluated its reportable operating segments and determined that it has the following segments in accordance with SFAS No. 131: Community Banking, Mortgage Banking and Other. The chief operating decision maker includes certain members of the Company’s management and board committees.

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 and conform to general practices within the banking industry. The more critical accounting and reporting policies include the Company’s accounting for securities, loans, the allowance for loan losses and income taxes. In particular, the Company’s accounting policies relating to the allowance for loan losses, investment securities and mortgage loans held for sale 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 “Loans,” “Provisions and Allowance for Loan Losses,” “Investment Securities,” “Mortgage Loans Held for Sale” and “Derivatives and Hedging Activities.” Also, please refer to Note 1 “Summary Of Significant Accounting Policies” in the “Notes to Consolidated Financial Statements” under Item 8, “Financial Statements & Supplementary Data” 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.

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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 are deemed to be impaired when the Company determines that it is probable the Company will be unable to collect all amounts due according to the terms of the loan agreement. Impaired loans 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, recorded as a specific reserve in the allowance for loan losses, 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 homogeneous pools of 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. The Company’s nonperforming assets were $12,140,740 and $13,108,030 as of December 31, 2004 and 2003, respectively, and its gross charge-offs were $3,038,449, $5,087,661 and $1,555,068 for 2004, 2003 and 2002, respectively.

INVESTMENT SECURITIES — 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 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 — Through its mortgage subsidiary, 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 asset or liability. 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 transactions involve cash flow hedges. 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.

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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.

RECENT ACQUISITION

On July 15, 2003, the Company completed its acquisition of First Commerce Corporation of Charlotte, North Carolina. As of July 15, 2003, First Commerce had total assets of approximately $171,042,000 and operated three banking offices in the Charlotte-Gastonia-Rock Hill metropolitan statistical area. Under the terms of the transaction, the Company issued 543,217 shares of common stock and paid $9,829,749 in cash to First Commerce shareholders. The transaction was accounted for as a purchase and resulted in approximately $11,393,000 in intangible assets.

RESULTS OF OPERATIONS

The following discussion relates to operations for the year ended December 31, 2004 compared to the year ended December 31, 2003, the year ended December 31, 2003 compared to the year ended December 31, 2002, and the year ended December 31, 2002 compared to the year ended December 31, 2001.

2004 COMPARED TO 2003

In 2004, the Company earned $12,718,220, or $0.94 per share, compared to $15,307,893, or $1.13 per share, in 2003. The earnings provided returns on average assets of 1.28% in 2004 compared to 1.78% in 2003 and returns on average equity of 9.02% in 2004 compared to 11.40% in 2003. The earnings decrease was primarily attributable to lower profits from mortgage operations, higher provisions for loan losses and increased overhead expenses, which were partially offset by higher net interest income.

The Company’s net interest income increased $2,851,219, or 7.25%, during 2004 compared to 2003. This increase was primarily because of increases in net interest income from new volumes, which were only partially offset by lower net interest income resulting from lower interest rates. The Company’s net interest margin averaged 4.70% for the year-to-date period, down from 5.06% for 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 “Net Interest Income” and “Liquidity, Interest Rate Sensitivity and Market Risks” below.

Higher loan volumes resulted in higher interest income for 2004. Interest income for 2004 increased $4,569,713, or 9.01%, from 2003 primarily because of growth in interest income from higher volumes of commercial loans, which was only partially offset by reduced interest income due to lower rates on both loans and investments in general. Interest and fees on loans increased $5,458,018, or 14.11%, due to higher average volumes during the year. Yields on loans averaged 6.36% for 2004, down from 6.79% for 2003. The prime rate averaged 4.31% during 2004 compared to 4.13% during 2003. Gross loans averaged $762,994,754 in 2004 compared to $654,288,794 in 2003, an increase of $108,705,960, or 16.61%. Average loans of the Bank were $731,856,005 compared to $612,278,824 in 2003, an increase of $119,577,181, or 19.53%, while average loans of Granite Mortgage were $31,138,749 compared to $42,009,970 in 2003, a decrease of $10,871,221, or 25.88%. The Bank’s average loans in 2004 reflected a full year of the volumes added by the new banking offices opened or acquired during 2003, while the 2003 average loans reflected a partial year of the added loan volumes. The decline in Granite Mortgage’s average loans resulted from mortgage originations of approximately $280,898,000 in 2004 compared to approximately $421,174,000 in 2003. 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 on securities and overnight investments increased $501,545, or 8.04%, due to higher average volumes during the period. The yield on investment securities and overnight investments declined to 5.00% in 2004 from 5.06% in 2003. Investment security yields declined 41 basis points when comparing 2004 and 2003. The decline in yield did not offset the increase in interest income resulting from higher average volumes of investment securities and overnight investments. Average securities and overnight investments were $161,737,648 compared to $153,042,239 in 2003, an increase of $8,695,409, or 5.68%.

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Interest expense increased $1,718,494, or 15.09%, primarily because of higher interest expense from higher volumes of interest-bearing liabilities, which was partially offset by lower rates on interest-bearing deposits. Rates on interest-bearing deposits averaged 1.73% for 2004, down from 1.83% for 2003. Interest-bearing deposits averaged $617,538,254 in 2004 compared to $530,436,580 in 2003, an increase of $87,101,674, or 16.42%. NOW deposits averaged $117,153,841 compared to $94,337,036 in 2003, an increase of $22,816,805, or 24.19%. Money market deposits averaged $152,453,153 in 2004 compared to $115,633,923 last year, an increase of $36,819,230, or 31.84%. Time deposits averaged $321,027,297 compared to $294,163,967 for the same periods, an increase of $26,863,330, or 9.13%. The Bank’s average deposits in 2004 reflected a full year of the volumes added by the new banking offices opened or acquired during 2003, while the 2003 averages reflected a partial year of the added deposit volumes. Overnight and other borrowings averaged $99,420,084 compared to $79,683,758 in 2003, an increase of $19,736,326, or 24.77%. Overnight borrowings averaged $35,575,198 compared to $17,762,252 in 2003, an increase of $17,812,946, or 100.29%. Other borrowings averaged $63,844,886 compared to $61,921,506 in 2003, an increase of $1,923,380, or 3.11%, primarily due to $5,000,000 in trust preferred debt outstanding the full-year in 2004 compared to less than six months in 2003. Other borrowings were the principal source of funding for the mortgage origination activities of Granite Mortgage.

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. Although the economy in the Catawba Valley region of the Company’s market area began to show signs of slight improvement, levels of nonperforming loans remained high and the credit quality of nonperforming loans further deteriorated, so management believed it prudent to charge operations in the amount of $5,439,160 in 2004 compared to $4,764,010 in 2003, to provide for future losses related to uncollectible loans.

While net charge-offs in 2004 were substantially lower than the unusually high level in 2003, the volume of net charge-offs in 2004 more closely approached the Company’s longer-term average volumes of net charge-offs. Charge-offs, net of recoveries, in 2004 were $2,573,044, a decrease of $2,089,215 from net charge-offs of $4,662,259 in 2003. The effects of a prolonged recession in the Company’s Catawba Valley market area were also evidenced by increases in the Company’s allowance for loan losses as presented below, nonperforming asset levels as presented below, and loans with higher risk grades. Nonperforming loans totaled $10,861,104 at the end of 2004 compared with $11,332,793 at the end of 2003. The amount of loans with the three highest risk grades totaled $14,245,082 at December 31, 2004 as compared with $12,046,107 at December 31, 2003. Some portions of the Bank’s local Catawba Valley economy are beginning to show signs of growth and the new markets should continue to help diversify the Bank’s loan base, but it is difficult to determine if or when the Catawba Valley economy will return to its former strength.

For 2004, total noninterest income was $11,256,723, down $3,181,017, or 22.03%, from $14,437,740 earned in 2003, primarily because of lower fees from mortgage originations. Fees on deposit accounts were $5,359,206 during 2004, down $177,848, or 3.219%, from $5,537,054 in 2003. Also, other service fees and commissions were $797,961, down $139,826, or 14.91%, from $937,787 in 2003, primarily due to lower fee income from sales of annuities, which decreased $88,176. A rise in mortgage rates in 2004 decreased mortgage origination activity. Mortgage origination fee income was $3,844,297 for 2004, down $3,047,874, or 44.22%, from $6,892,171 earned in 2003. Mortgage loans originated during 2004 and 2003 were approximately $280,898,000 and $421,174,000, 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. There were no significant gains or losses on sales of securities in 2004 or 2003. Although management continued to emphasize other nontraditional banking services, 2004 income from the sales of annuities and life insurance fell short of Company goals.

Total noninterest expenses were $29,114,940 during 2004, up $3,252,483, or 12.58%, from $25,862,457 in 2003. The changes in the various overhead categories included costs associated with higher operating expenses of the Bank, partially offset by lower cost of mortgage origination activities. Total personnel costs, the largest of the overhead expenses, were $17,898,831 during 2004, up $1,427,550, or 8.67%, from $16,471,281 in 2003. Of the $1,427,550 increase, $2,843,432 of increased personnel cost of banking operations were partially offset by a $1,415,892 reduction in the personnel cost of mortgage operations.

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Noninterest expenses other than for personnel increased 19.43% to $11,216,109 during 2004 from the $9,391,176 incurred in 2003. Of the $1,824,933 increase, the Bank’s nonpersonnel costs increased $1,735,024, while Granite Mortgage’s nonpersonnel costs decreased $85,653. Occupancy expenses were $1,729,986 in 2004, up $524,180, or 43.47%, from $1,205,806 in 2003, primarily reflecting the additional costs associated with a full year of occupancy cost in the Bank’s new markets in 2004 compared to less than a full year of such costs in 2003 and higher occupancy cost associated with mortgage operations. Equipment costs rose to $1,958,106 during 2004, up $570,128, or 41.08%, from $1,387,978 in 2003, as both the Bank and Granite Mortgage invested in the technology needed to support expanded market operations. Other noninterest expenses were $7,528,017 in 2004, up $730,625, or 10.75%, from $6,797,392 in 2003. Of the $730,625 increase in other noninterest expenses, $818,214 in increased cost related to banking operations and $175,562 in increased general corporate cost were partially offset by $263,151 in decreased cost related to mortgage operations. Income tax expenses were $6,142,307 in 2004, down $1,667,758, or 21.35%, from $7,810,065 in 2003. The effective tax rates were 32.57% and 33.78% for 2004 and 2003, respectively, with the decrease in 2004 being primarily attributable to lower relative levels of income taxable at the statutory tax rates.

2003 COMPARED TO 2002

In 2003, the Company earned $15,307,893, or $1.13 per share, compared to $15,102,300, or $1.11 per share, in 2002. The earnings provided returns on average assets of 1.78% in 2003 compared to 2.13% in 2002 and returns on average equity of 11.40% in 2003 compared to 11.98% in 2002. The earnings increase was primarily attributable to higher net interest income and income from mortgage originations, which were mostly offset by higher loan loss provisions and overhead costs.

The Company’s net interest income increased $4,398,581, or 12.60%, during 2003 compared to 2002. This increase was primarily because increases in net interest income from new volumes were only partially offset by lower net interest income resulting from lower interest rates. The Company’s net interest margin averaged 5.06% for 2003, down from 5.50% for 2002. 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 “Net Interest Income” and “Liquidity, Interest Rate Sensitivity and Market Risks” below.

Higher loan volumes led to higher interest income for 2003. Interest income for 2003 increased $4,985,650, or 10.91%, from 2002 primarily because of the growth in interest income from higher volumes of commercial and mortgage loans, which was only partially offset by reduced interest income due to lower rates on both loans and investments in general. Interest and fees on loans increased $5,781,538, or 14.95%, due to higher average volumes and rates during the year. Yields on loans averaged 6.79% for 2003, down from 7.34% for 2002. The prime rate averaged 4.13% during 2003 compared to 4.69% during 2002. Gross loans averaged $654,288,794 in 2003 compared to $526,758,803 in 2002, an increase of $127,529,991, or 24.21%. Average loans of the Bank were $612,278,824 compared to $504,520,592 in 2002, an increase of $107,758,232, or 21.36%, while average loans of Granite Mortgage were $42,009,970 compared to $22,238,211 in 2002, an increase of $19,771,759, or 88.91%. The growth in the Bank’s average loans was effected by $115,427,028 in loans acquired on July 15, 2003 from First Commerce and $40,963,425 in loans originated by the other Bank offices opened during 2003, although these loan volumes were included in the Bank’s averages for only a portion of the year. The growth in Granite Mortgage’s average loans resulted from mortgage originations of approximately $421,174,000 in 2003 compared to approximately $271,267,000 in 2002. Declining rates generally cause an increase in mortgage refinancings and, to a lesser extent, mortgage originations. Interest on securities and overnight investments decreased $795,888, or 11.31%, due to lower average yields earned during the period. The yield on investment securities and overnight investments declined to 5.06% in 2003 from 6.27% in 2002. Investment security yields declined 98 basis points when comparing 2003 and 2002. The decline in the yield more than offset the increase in the average balances for investment securities and overnight investments. Average securities and overnight investments were $153,042,239 compared to $139,926,649 last year, an increase of $13,115,590, or 9.37%. The Bank acquired investment securities of $27,240,789 in the First Commerce acquisition, which effected average investment balances for the last six months of 2003.

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Interest expense increased $587,069, or 5.43%, primarily because higher interest expense from higher volumes of interest-bearing liabilities was partially offset by lower interest expense from lower rates on interest-bearing deposits and other borrowings. Rates on interest-bearing deposits averaged 1.83% for 2003, down from 2.26% for 2002. Interest-bearing deposits averaged $530,436,580 in 2003 compared to $429,933,109 in 2002, an increase of $100,503,471, or 23.38%. NOW deposits averaged $94,337,036 compared to $83,761,379 in 2002, an increase of $10,575,657, or 12.63%. Money market deposits averaged $115,633,923 in 2003 compared to $53,107,539 in 2002, an increase of $62,526,384, or 117.74%. Time deposits averaged $294,163,967 compared to $266,835,606 for the same periods, an increase of $27,328,361, or 10.24%. The growth in the Bank’s average deposits was effected by $131,068,621 in deposits acquired on July 15, 2003 from First Commerce and $10,002,597 in deposits received by the other Bank offices opened during 2003, although these deposit volumes were included in the Bank’s averages for only a portion of the year. Overnight and other borrowings averaged $79,683,758 compared to $53,980,926 in 2002, an increase of $25,702,832, or 47.61%. Overnight borrowings averaged $17,762,252 compared to $33,426,013 in 2002, a decrease of $15,663,761, or 46.86%, reflecting a decrease of $17,215,106, or 85.81%, in average overnight borrowings in the form of federal funds purchased and securities sold under agreements to repurchase of the Bank, partially offset by an increase of $1,551,345, or 11.61%, in average overnight borrowings in the form of commercial paper related to the commercial deposit sweep arrangements of the Bank. Other borrowings averaged $61,921,506 compared to $20,554,913 in 2002, an increase of $41,366,593, or 201.25%, reflecting an increase of $20,463,181, or 1131.68%, in average borrowings of the Bank and an increase of $18,588,344, or 99.16%, in temporary borrowings of Granite Mortgage primarily due to higher mortgage origination activity. Other borrowings were the principal source of funding for the mortgage origination activities of Granite Mortgage. Included in average borrowings for the last six months of the year were $27,000,000 in borrowings assumed in the acquisition of First Commerce.

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 continued unfavorable economic trends in the Catawba Valley region of the Company’s market area and due to higher levels of nonperforming loans resulting from the weakened local economy, management believed it prudent to charge operations in the amount of $4,764,010 in 2003 compared to $3,492,382 in 2002, to provide for future losses related to uncollectible loans.

Also due to the continued weak local economy, charge-offs in 2003 were substantially higher than in 2002. Charge-offs, net of recoveries, in 2003 were $4,662,259, an increase of $3,578,011 over net charge-offs of $1,084,248 in 2002, of which $2,098,499 were related to commercial loans in default. The effects of a prolonged recession in the Company’s Catawba Valley market area were also evidenced by increases in the Company’s allowance for loan losses as presented below, nonperforming asset levels as presented below, and loans with higher risk grades. Nonperforming loans totaled $11,332,793 at the end of 2003 compared with $4,417,845 at the end of 2002. Nonperforming loans as of December 31, 2003 included $3,268,082 of loans where 80% of the balance is guaranteed under the federal government’s small business lending programs. The amount of loans with the three highest risk grades totaled $12,046,107 at December 31, 2003 as compared with $6,554,602 at December 31, 2002. Included in these three highest risk grades were the unguaranteed portions of approximately $1,136,000 of loans made under the federal government’s small business loan programs. Some portions of the Catawba Valley economy are beginning to show signs of growth and the new markets should help diversify the Company’s loan base, but it is difficult to determine if or when the Catawba Valley economy will return to its former strength.

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For 2003, total noninterest income was $14,437,740, up $3,040,035, or 26.67%, from $11,397,705 earned in 2002, primarily because of higher fees from mortgage originations. Fees on deposit accounts were $5,537,054 during 2003, up $134,764, or 2.49%, from $5,402,290 in 2002. Also, other service fees and commissions were $937,787, down $82,151, or 8.05%, from $1,019,938 in 2002, primarily due to lower fee income from sales of loans and annuities, which decreased $328,404. A further drop in mortgage rates in 2003 increased mortgage origination activity. Mortgage origination fee income was $6,892,171 for 2003, up $2,942,817, or 74.51%, from $3,949,354 earned in 2002. Mortgage loans originated during 2003 and 2002 were approximately $421,174,000 and $271,267,000, respectively. There were no significant gains or losses on sales of securities in the year-to-date periods of 2003 or 2002. Although management continued to emphasize other nontraditional banking services, 2003 income from the sales of annuities and life insurance fell short of Company goals.

Total noninterest expenses were $25,862,457 during 2003, up $5,546,223, or 27.30%, from $20,316,234 in 2002. The changes in the various overhead categories included costs associated with the increase in mortgage origination activities and the addition of newly opened banking offices and the banking offices acquired in the First Commerce transaction. Total personnel costs, the largest of the overhead expenses, were $16,471,281 during 2003, up $3,570,532, or 27.68%, from $12,900,749 in 2002. Of the $3,570,532 increase, $2,228,175 were related to mortgage operations, while $1,342,357 were related to banking operations.

Noninterest expenses other than for personnel increased 26.64% to $9,391,176 during 2003 from the $7,415,485 incurred in 2002. Of the $1,975,691 increase, the Bank’s nonpersonnel costs increased $1,227,573, while Granite Mortgage’s nonpersonnel costs increased $736,023. Occupancy expenses were $1,205,806 in 2003, up $295,578, or 32.47%, from $910,228 in 2002, primarily reflecting the additional occupancy costs associated with the newly opened banking offices and the banking offices acquired from First Commerce. Other noninterest expenses were $6,797,392 in 2003, up $1,680,807, or 32.85%, from $5,116,585 in 2002. Of the $1,680,807 increase in other noninterest expenses, $1,052,525 were related to banking operations, while $616,187 were related to mortgage operations. Year-to-date income tax expense was $7,810,065 in 2003, up $415,172, or 5.61%, from $7,394,893 in 2002. The year-to-date effective tax rates were 33.78% and 32.87% for 2003 and 2002, respectively, with the increase in 2003 being primarily attributable to lower relative levels of income from tax-exempt loans and investments.

2002 COMPARED TO 2001

In 2002, the Company earned $15,102,300, or $1.11 per share, compared to $13,808,555, or $0.99 per share, in 2001. The earnings provided returns on average assets of 2.13% in 2002 compared to 2.00% in 2001 and returns on average equity of 11.98% in 2002 compared to 11.29% in 2001. The earnings increase was primarily attributable to higher net interest income, lower loan loss provisions and increased income from mortgage originations, partially offset by increases in operating costs.

Net interest income, the Company’s largest source of revenues, increased 6.3% to $34,908,104 in 2002 from $32,840,650 in 2001. Interest income was $45,710,526 in 2002, down 12.6% from $52,284,219 in 2001, primarily due to lower interest rates from the previous year. The average yield on interest-earning assets was 7.12% in 2002 compared with 8.27% in 2001. Average interest-earning assets grew by $12,288,466, or 1.9%, primarily because average loans, the highest yielding asset category, grew by $47,027,071, or 9.8%. Interest expense decreased 44.4% to $10,802,422 in 2002 compared to $19,443,569 in 2001. The average cost of funds was 2.23% in 2001 compared with 4.11% in 2001. Lower rates on time deposits resulted in the significantly lower interest expense. Average balances in transaction accounts, such as noninterest-bearing demand accounts and interest-bearing savings, NOW and money market accounts, increased $30,090,980, or 13.3%, to $256,945,371 in 2002 from $226,854,391 in 2001. Average balances in time deposits decreased $35,338,224, or 11.7%, to $266,835,606 in 2002 from $302,173,830 in 2001. Average overnight borrowings, principally commercial account balances which are swept into the Company’s commercial paper overnight, grew by $19,238,103, or 135.6%, to $33,426,013 in 2002 from $14,187,910 in 2001. Average other borrowings, which are principally used to fund mortgage banking activities, increased $1,276,667, or 6.6%, to $20,554,913 in 2002 from $16,278,246 in 2001. Such other borrowings had maturities of less than one year.

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Primarily because of a recessionary economy, which was particularly severe in the Company’s local banking markets, the Company provided $3,492,382 for possible loan losses in 2002 compared with $4,216,772 in 2001. Although the 2002 provision was lower than the 2001 provision, it increased the Company’s allowance or reserve for loan losses to 1.59% of net loans outstanding at December 31, 2002 compared to 1.28% at December 31, 2001. Charge-offs, net of recoveries totaled $1,084,248 for 2002 compared with $4,142,051 for 2001. Nonperforming loans totaled $4,417,845 at the end of 2002 compared with $4,713,204 at the end of 2001.

Other income was $11,397,705 in 2002, an increase of $1,257,645, or 12.4%, from such revenues of $10,140,060 in 2001. Continued low interest rates resulted in increases in fees from both mortgage originations and annuity sales. Fee income from mortgage originations increased $827,202, or 26.5%, to $3,949,354 in 2002 from $3,122,152 in 2001. Also contributing to the increase in fee income was an increase of $214,140 in deposit fees. Mortgage origination activities have a tendency to increase during periods of sustained low interest rates, as was the case during 2002.

Other expenses, or overhead, increased $1,973,955, or 10.8%, to $20,316,234 in 2002 from $18,342,279 in 2001, primarily due to increased costs associated with higher mortgage origination activity. Personnel expenses, the largest component of overhead, increased to $12,900,749 in 2002 from $11,408,477 in 2001, primarily due to increases in expenses related to profit sharing, healthcare and higher production-related compensation resulting from increased mortgage origination activity.

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NET INTEREST INCOME

Net interest income (the difference between interest earned on interest-earning assets, primarily loans in the Bank, and interest paid on interest-bearing liabilities, primarily deposits in the Bank) represents the most significant portion of the Company’s earnings. It is management’s on-going policy to optimize net interest income. Net interest income totaled $42,157,904, $39,306,685, and $34,908,104 for 2004, 2003 and 2002 respectively, representing an increase of 7.3% for 2004 over 2003, an increase of 12.6% for 2003 over 2002, and an increase of 6.3% for 2002 from 2001. Interest rate spreads have been at least 4.25% over the last three years, and the Company continues efforts to optimize these favorable spreads by managing both loan and deposit rates in order to support the overall earnings growth. The following table presents the daily average balances, interest income and expense and average rates earned and paid on interest-earning assets and interest-bearing liabilities of the Company for the last three years.

AVERAGE BALANCES AND INTEREST INCOME ANALYSIS
for the years ended December 31,

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Changes in interest income and interest expense can result from changes in both volume and rates. The following table sets forth the dollar amount of increase (decrease) in interest income and interest expense resulting from changes in the volume of interest earning assets and interest bearing liabilities and from changes in yields and rates.

INTEREST RATE AND VOLUME VARIANCE ANALYSIS
for the years ended December 31,

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 December 31, 2004 and 2003, such unfunded commitments to extend credit were $138,012,770 and $120,746,272, respectively, while commitments in the form of standby letters of credit totaled $4,580,138 and $6,133,695, respectively.

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 market on which the Company’s common stock is listed, and through unsolicited privately negotiated transactions. 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 its 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. During 2004, the Company repurchased 369,720 shares of its common stock at an average price of $20.12.

Granite Mortgage arranges for the sale of most of the mortgage loans it originates after the mortgage loan closes, rather than obtaining purchase commitments from mortgage investors at the time the mortgage commitment is made to the mortgage customer. This method allows Granite Mortgage to bundle mortgage loans and obtain better pricing

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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 began entering into hedge contracts to “forward sell” mortgage-backed securities at the same time as the rate commitment. When the mortgage loan is 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 December 31, 2004, Granite Mortgage held $14,605,060 in open mortgage-backed security commitments with an estimated market value of $14,508,827, an unrealized loss of $96,233. For 2004, there were realized losses on hedged mortgage loan commitments of $824,204 and realized losses of $126,924 on commitments to sell mortgage-backed securities. In addition to the improved spreads resulting from more advantageous pricing from bundling mortgage loans for sale, Granite Mortgage production also believes that this management method increases production efficiencies.

Through its 2003 acquisition of First Commerce, 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 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.

Except for the hedging strategy, 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. As of December 31, 2004, payments due under such operating lease arrangements are $896,264 in 2005, $1,380,681 in the years 2006 through 2007, $1,029,709 in the years 2008 through 2009 and $1,451,978 in the years 2010 and thereafter. Further discussions are included under “Off-Balance Sheet Arrangements” below.

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 deposit. The Bank considers these to be a stable portion of the Bank’s liability mix and the result of ongoing stable consumer and commercial banking relationships. As of December 31, 2004, the Bank’s core deposits, defined as total deposits excluding time deposits of $100,000 or more, totaled $607,600,241, or 81.0%, of the Bank’s total deposits.

The other principal method of funding used by the Bank is through 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 as the cost of purchased or brokered time deposits is greater. 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 December 31, 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 December 31, 2004, the Bank had investment securities pledged to secure overnight funding lines in the approximate amounts of $8,250,000 with the Federal Reserve Bank. As of December 31, 2004, the Bank had no securities pledged to the Federal Home Loan Bank. The Bank also has pledged 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 December 31, 2004, the Bank had the capacity to borrow approximately $100,175,000 from the Federal Home Loan Bank against its pledged residential and commercial real estate loans. Overnight borrowings were $71,748,432 as of December 31, 2004, an increase of $46,543,261 from the $25,205,171 in overnight borrowings at December 31, 2003, as the Bank temporarily funded its loan growth, which outpaced its deposit growth, with overnight borrowings.

Granite Mortgage temporarily funds its mortgages, from the time of origination until the time of sale, through the use of a one-year warehouse line of credit from one of the Company’s correspondent financial institutions. For the years ended December 31, 2004 and 2003, this line of credit was $40,000,000 and $50,000,000, of which $29,478,614 and $26,107,383, respectively, were outstanding at year end. Granite Mortgage requests of credit based on its estimated funding needs for the year. The line is secured by the mortgage loans originated, and the Company serves as guarantor on this borrowing.

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The Company has an unsecured line of credit from one of the Bank’s correspondent banks for general corporate purposes, which expires June 30, 2006. The line is in the amount of $10,000,000 and bears an interest rate of one-month LIBOR plus 120 basis points, with interest payable quarterly. As of December 31, 2004 and 2003, 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 which 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 optimize net interest income while maintaining a stable deposit base. Because the Company has historically relied on deposits from its local market areas as its primary sources of funding, it has not historically sought out-of-market or brokered time deposits as a funding source, resulting in a deposit base that has not generally been subject to the volatility experienced in national financial markets in recent years. However, the Company does realize the importance of minimizing such funding 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.

INTEREST RATE SENSITIVITY (GAP ANALYSIS)
As of December 31, 2004

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The Company uses several modeling techniques to measure interest rate risk including the gap analysis previously discussed, the simulation of net interest income under gradual interest rate changes and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks.”

The following table summarizes the estimated theoretical impact on the Company’s tax equivalent net interest income from a gradual interest rate increase and decrease of 3%, prorated over a twelve-month period, and from hypothetical immediate and sustained interest rate increases and decreases of 1%, 2%, 3% and 4%, as compared to the estimated theoretical impact of rates remaining unchanged. The theoretical effects of these hypothetical interest rate changes are based upon numerous assumptions including relative and estimated levels of key interest rates. While such simulation modeling is useful in estimating interest rate risk inherent in the Company’s asset and liability positions, it is of limited usefulness because it does not take into account the asset and liability mix decisions and pricing strategies management would undertake in response to the depicted rate changes.

     The following table presents the maturity distribution of the Company’s loans by type, including fixed rate loans.

MATURITIES AND SENSITIVITIES OF LOANS TO CHANGES IN INTEREST RATES

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The Company’s rate paid on interest-bearing deposits declined to 1.73% in 2004 compared to 1.83% in 2003. The Company’s deposit growth was primarily reflected in transaction deposits, which increased $35,252,860.

Rate sensitive consumers chose to place funds in transaction deposit accounts because of increased liquidity and lower interest rate differentials to time deposits. Increased customer awareness of interest rates increases the importance of rate management by the Company. The Company’s management continuously monitors market pricing, competitor rates, and internal interest rate spreads in an effort to maintain the Company’s growth and profitability. Deposits continue to be the principal source of funds for continued growth, so the Company attempts to structure its rates so as to promote deposit and asset growth while at the same time increasing the overall profitability of the Company. The daily average amounts of deposits of the Bank are summarized below.

AVERAGE DEPOSITS
for the years ended December 31,