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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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  0-24159

MIDDLEBURG FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

,

Registrant’s telephone number, including area code (703) 777-6327

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

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

Common Stock, par value $2.50 per share

(Title of class)

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 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 definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [ X ]

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.  $91,383,147

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.  3,798,053 shares of Common Stock as of March 9, 2005

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2005 Annual Meeting of Shareholders – Part III

TABLE OF CONTENTS

PART I

Page

ITEM 1.

BUSINESS

3

ITEM 2.

PROPERTIES

15

ITEM 3.

LEGAL PROCEEDINGS

16

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE

OF SECURITY HOLDERS

16

PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED

STOCKHOLDER MATTERS AND ISSUER PURCHASES OF

 EQUITY SECURITIES

17

ITEM 6.

SELECTED FINANCIAL DATA

19

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATION

19

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT

MARKET RISK

49

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

51

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS

ON ACCOUNTING AND FINANCIAL DISCLOSURE

51

ITEM 9A.

CONTROLS AND PROCEDURES

51

ITEM 9B.

OTHER INFORMATION

53

PART III

ITEM 10.

DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

53

ITEM 11.

EXECUTIVE COMPENSATION

53

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL

OWNERS AND MANAGEMENT AND RELATED

STOCKHOLDER MATTERS

54

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

54

ITEM 14.

PRINCIPAL ACCOUNTING FEES AND SERVICES

54

PART IV

ITEM 15.

EXHIBITS, FINANCIAL STATEMENT SCHEDULES

54

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PART I

ITEM 1.

BUSINESS

General

Middleburg Financial Corporation (the “Company”) is a bank holding company that was incorporated under Virginia law in 1993.  The Company changed its name in May 2002 from “Independent Community Bankshares, Inc.” to “Middleburg Financial Corporation.”  The Company conducts its primary operations through three wholly owned subsidiaries, Middleburg Bank (the “Bank”), Tredegar Trust Company (“Tredegar”), both of which are chartered under Virginia law, and Gilkison Patterson Investment Advisors, Inc. (“GPIA”), which  is a SEC registered investment advisor.

The Bank has six full service branches and one limited service facility.  The Bank has its main office at 111 West Washington Street, Middleburg, Virginia 20117, and has offices in Ashburn, Leesburg, Purcellville and Reston, Virginia.  The Bank opened for business on July 1, 1924.

Tredegar has its main office at 821 East Main Street, Richmond, Virginia 23219, and a branch office in Middleburg, Virginia.  Tredegar opened for business in January 1994.

GPIA has its main office at 1901 North Beauregard Street, Alexandria, VA  22311.

The Bank serves western Loudoun County and the northern part of Fairfax County.  Loudoun County is in northwestern Virginia and included in the Washington-Baltimore Metropolitan statistical area.  Loudoun County’s population is approximately 229,000 as of June 30, 2004, with over one-third of the population located in the Company’s markets.  The local economy is driven by service industries requiring a high skill level, self-employed individuals, the equine industry and the independently wealthy.  Fairfax County is in northern Virginia and is included in the Washington-Baltimore Metropolitan statistical area.  Fairfax County’s population is approximately 1,022,000 as of January 31, 2004.  The local economy is driven by service industries and federal, state and local governments.  Tredegar serves primarily the greater Richmond area including the counties of Henrico, Chesterfield, Hanover, Goochland and Powhatan, as well as Fairfax and Loudoun Counties.  However, Tredegar does have clients outside of its primary market.  Richmond is the state capital of Virginia, and the greater Richmond area has a population in excess of 997,000 as of the 2000 U. S. Census.  GPIA primarily serves the District of Columbia metropolitan area including contingent markets in Virginia and Maryland but also has clients in 25 other states.  

The Company, through its subsidiaries, offers a wide range of banking, fiduciary and investment management services available to both individuals and small businesses.  The banking services include various types of checking and savings deposit accounts, and the making of business, real estate, development, mortgage, home equity, automobile and other installment, demand and term loans.  Also, the Bank offers ATMs at all locations, internet banking, travelers’ checks, money orders, safe deposit rentals, collections, notary public, wire services and other traditional bank services to its customers.  Tredegar provides a variety of investment management and fiduciary services including trust and estate settlement.  Tredegar can also serve as escrow agent, attorney-in-fact, guardian of property or trustee of an IRA.  GPIA provides fee based investment management services for its clients.  

The Bank has one wholly owned subsidiary, Middleburg Bank Service Corporation.  Middleburg Bank Service Corporation is a partner in a limited liability company, Bankers Title Shenandoah, LLC, which sells title insurance to its members.  Middleburg Bank Service Corporation has also invested in two other limited liability companies, Virginia Bankers Insurance Center, LLC and Bankers Investment Group, LLC.  Virginia Bankers Insurance Center, LLC acts as a broker for insurance sales for its member

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banks and Bankers Investment Group act as a broker dealer for sales of investment products to clients of its member banks.  The Company has two wholly owned subsidiaries, ICBI Capital Trust I and MFC Capital Trust II, which are Delaware Business Trusts that the Company formed in connection with the issuance of trust preferred debt in November 2001 and December 2003.

On April 15, 2003, the Bank acquired 40% of the issued and outstanding membership interest units of Southern Trust Mortgage, LLC (“Southern Trust”).  The Bank acquired the membership interest units in equal proportion from the seven members of Southern Trust, all of whom own, in the aggregate, the remaining issued and outstanding units of Southern Trust.  Southern Trust is a regional mortgage lender headquartered in Norfolk, Virginia and has offices in Virginia, Maryland, North Carolina, South Carolina and Georgia.

As of December 31, 2004, the Company had a total of 171 full time equivalent employees.  The Company considers relations with its employees to be excellent.  The Company’s employees are not represented by a collective bargaining unit.

Segment Reporting

The Company operates in a decentralized fashion in two principal business activities: banking services and trust and investment advisory services.  Revenue from banking activities consists primarily of interest earned on loans and investment securities and service charges on deposit accounts through the Bank.  Through the Bank’s 40% investment in Southern Trust, the Company also recognizes its share of the net income from the Southern Trust investment in the other income section of the Bank’s income statement.

Revenues from trust and investment advisory activities are comprised mostly of fees based upon the market value of the accounts under administration. The trust and investment advisory services are conducted by two subsidiaries of the Company, Tredegar and GPIA.

The banking segment has assets in custody with Tredegar and accordingly pays Tredegar a monthly fee. The banking segment also pays interest to both Tredegar and GPIA on deposit accounts each company has at the Bank.  GPIA pays the Company a management fee each month for accounting and other services provided.  Transactions related to these relationships are eliminated to reach consolidated totals.   

The following tables present segment information for the years ended December 31, 2004 and 2003.

Competition

The Company faces significant competition for both loans and deposits.  Competition for loans comes from commercial banks, savings and loan associations and savings banks, mortgage banking subsidiaries of regional commercial banks, subsidiaries of national mortgage bankers, insurance companies, and other institutional lenders.  Its most direct competition for deposits has historically come from savings and loan associations and savings banks, commercial banks, credit unions and other financial institutions.  Based upon total deposits at June 30, 2004 as reported to the FDIC, the Company has the second largest share of deposits with 18.3% market share among the banking organizations operating in Loudoun County, Virginia.  With its acquisition of First Virginia Banks in July 2003, BB&T Corporation has gained the largest share of deposits in the market.  Statistical data for Fairfax County did not include our Reston location as of the latest FDIC report.  The Company also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds.

Tredegar competes for clients and accounts with banks, other financial institutions and money managers.  Even though many of these institutions have been engaged in the trust or investment management business for a considerably longer period of time than Tredegar and have significantly greater resources, Tredegar has grown through its commitment to quality trust and investment management services and a local community approach to business.

GPIA competes for its clients and accounts with other money managers and investment brokerage firms.  Like the rest of the Company, GPIA is dedicated to quality service and high investment performance for its clients.  GPIA, which was formerly known as Kahn Brothers Investment Management Company, has successfully operated in its markets for 23 years.  Upon entering into a purchase option with the Company, KBIMC changed its name to “Gilkison Patterson Investment Advisors, Inc.”

Lending Activities

Credit Policies

The principal risk associated with each of the categories of loans in the Bank’s portfolio is the creditworthiness of its borrowers.  Within each category, such risk is increased or decreased, depending on prevailing economic conditions.  In an effort to manage the risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position and level of experience.  The

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risk associated with real estate mortgage loans, commercial and consumer loans varies, based on market employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay indebtedness.  The risk associated with real estate construction loans varies, based on the supply and demand for the type of real estate under construction.

The Bank has written policies and procedures to help manage credit risk.  The Bank  utilizes an outside third party loan review process that includes regular portfolio reviews to establish loss exposure and to ascertain compliance with the Bank’s loan policy.  

The Bank uses a Directors Loan Committee to approve loans.  The Directors Loan Committee is composed of five Directors, of which four are independent Directors.  The Directors Loan Committee approves new credits, renewed  and modified credits that exceed officer loan authorities.  The chairman of the Directors Loan Committee is the president and CEO of the Bank.   A quorum is reached when three members are present, of which two are independent Directors.  The approval of an application is met with four votes.   In addition, the Directors Loan Committee reports all new loans reviewed and approved  to the Bank’s Board of Directors monthly.  Monthly reports shared with the Directors Loan Committee include names and monetary amounts of all new credits in excess of $12,500 which had been extended; a watch list including names, monetary amounts, risk rating and payment status; non accruals and charge offs as recommended and a list of overdrafts.   The Directors Loan Committee also reviews lending policies proposed by management.

In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its annual financial statements including commitments to extend credit.  At December 31, 2004, commitments to extend credit totaled $71.0 million.

Construction Lending

The Bank makes local construction loans, primarily residential, and land acquisition and development loans.  The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained.  At December 31, 2004, construction, land and land development loans outstanding were $45.5 million, or 13.0%, of gross loans.  Approximately 95% of these loans are concentrated in the Loudoun County, Virginia markets.  The average life of a construction loan is approximately 12 months and it reprices monthly to meet the market, typically prime plus one percent.  Because the interest rate charged on these loans floats with the market, the construction loans help the Company in managing its interest rate risk.  Construction lending entails significant additional risks, compared with residential mortgage lending.  Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Another risk involved in construction lending is attributable to the fact that loan funds are advanced upon the security of the land or home under construction, which value is estimated prior to the completion of construction.  Thus, it is more difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios.  To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 75% to 85% of appraised value, in addition to analyzing the creditworthiness of its borrowers.  The Bank  also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners.

Commercial Business Loans

Commercial business loans generally have a higher degree of risk than residential mortgage loans, but have higher yields.  To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers.  Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from his employment and other income and are secured by real estate whose value

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tends to be readily ascertainable.  In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory.  As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself.  Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.  The Bank has an outside third party loan review and monitoring  process to regularly assess the repayment ability of commercial borrowers.  At December 31, 2004, commercial loans totaled $27.1 million, or 7.8% of the total loan portfolio.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches.  At December 31, 2004, commercial real estate loans aggregated $125.3 million, or 35.9%, of the Bank’s gross loans.

In its underwriting of commercial real estate, the Bank may lend, under internal policy, up to 80% of the secured property’s appraised value. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending.  Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy generally. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios and the borrower’s creditworthiness, prior credit history and reputation.  The Bank also evaluates the location of the security property and typically requires personal guarantees or endorsements of the borrowers’ principal owners.  

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan originator solicitation, referrals by real estate professionals, existing or new bank clients and purchases of whole loans from Southern Trust.  Loan applications are taken by a Bank loan officer.  As part of the application process, information is gathered concerning income, employment and credit history of the applicant.  Loans are underwritten using the Bank’s underwriting guidelines.  Security for the majority of the Bank’s residential lending is in the form of owner occupied one-to-four-family dwellings. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Board of Directors.  

The Bank also originates a non-conforming adjustable rate product with a higher entry level rate and margin than that of the conforming adjustable rate products.  This non-conforming loan provides yet another outlet for loans not meeting secondary market guidelines.  The Bank keeps these loans in its loan portfolio.  Interest rates on adjustable rate products offered by the Bank are tied to fixed rates issued by the Federal Home Loan Bank of Atlanta plus a spread.  The Bank’s ARM products contain interest rate caps at adjustment periods and rate ceilings based on a cap over and above the original interest rate.  

At December 31, 2004, $135.7 million, or 38.9%, of the Bank’s loan portfolio consisted of one-to four-family residential real estate loans.  Of the $135.7 million, $89.7 million were fixed rate mortgages while the remaining $46.0 million were adjustable rate mortgages.   The fixed rate loans are typically 3, 5, 7 or 10 year balloons amortized over a 30 year period.  The Bank has about $21.8 million in fixed rate loans that have maturities of 15 years or greater.  Approximately 57.4% of the $51.4 million of fixed rate loans have maturities of 5 years or less.   

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In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and if required, flood insurance.  Flood determination letters with life of loan tracking are obtained on all federally related transactions with improvements serving as security for the transaction. The Company does require escrows for real estate taxes and insurance.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans, installment and demand loans, credit cards, and home equity lines of credit and loans.  At December 31, 2004, the Bank had consumer loans of $11.9 million or 3.4% of gross loans.  Such loans are generally made to customers with which the Bank has a pre-existing relationship.  The Bank currently originates all of its consumer loans in its geographic market area.  Most of the consumer loans are tied to the prime lending rate and reprice monthly.

Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles.  In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.  The remaining deficiency often does not warrant further substantial collection efforts against the borrower.  In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.  Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolven cy laws, may limit the amount which can be recovered on such loans.  Such loans may also give rise to claims and defenses by a consumer  borrower against an assignee of collateral securing the loan such as the Bank, and a borrower may be able to assert against such assignee claims and defenses which it has against the seller of the underlying collateral.  Consumer loan delinquencies often increase over time as the loans age.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.  Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Supervision and Regulation

General

As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System.  As a state-chartered commercial bank, the Bank is subject to regulation, supervision and examination by the Virginia State Corporation Commission’s Bureau of Financial Institutions.  It is also subject to regulation, supervision and examination by the Federal Reserve Board.  Other federal and state laws, including various consumer and compliance laws, govern the activities of the Bank, the investments that it makes and the aggregate amount of loans that it may grant to one borrower.

The following description summarizes the significant federal and state laws applicable to the Company and its subsidiaries.  To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.

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The Bank Holding Company Act

Under the Bank Holding Company Act, the Company is subject to periodic examination by the Federal Reserve and required to file periodic reports regarding its operations and any additional information that the Federal Reserve may require.  Activities at the bank holding company level are limited to:

•

banking, managing or controlling banks;

•

furnishing services to or performing services for its subsidiaries; and

•

engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.

Some of the activities that the Federal Reserve Board has determined by regulation to be proper incidents to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.

With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

•

acquiring substantially all the assets of any bank;

•

acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or

•

merging or consolidating with another bank holding company.

In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company.  Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company.  Control is rebuttably presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and either has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction.  The regulations provide a procedure for challenging this rebuttable control presumption.

In November 1999, Congress enacted the Gramm-Leach-Bliley Act, which made substantial revisions to the statutory restrictions separating banking activities from other financial activities.  Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.”  As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities.  Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries.  For example, insurance activities would be subject to supervision and regulation by state insurance authorities.  Although the Company has not elected to become a financial holding company in order to exercise the broader activity powers provided by the GLBA, the Company will likely elect do so in the future.

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Payment of Dividends

The Company is a legal entity separate and distinct from its banking and other subsidiaries.  The majority of the Company’s revenues are from dividends paid to the Company by its subsidiaries.  The Bank is subject to laws and regulations that limit the amount of dividends it can pay.  In addition, both the Company and the Bank are subject to various regulatory restrictions relating to the payment of dividends, including requirements to maintain capital at or above regulatory minimums.  Banking regulators have indicated that banking organizations should generally pay dividends only if the organization’s net income available to common shareholders over the past year has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition ..  The Company does not expect that any of these laws, regulations or policies will materially affect the ability of the Bank to pay dividends.  During the year ended December 31, 2004, the Bank declared $2.2 million in dividends payable to the Company.  

The FDIC has the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice.  The FDIC has indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.  

Insurance of Accounts, Assessments and Regulation by the FDIC

The deposits of the Bank are insured by the FDIC up to the limits set forth under applicable law.  The deposits of the Bank subsidiary are subject to the deposit insurance assessments of the Bank Insurance Fund (“BIF”) of the FDIC.

The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations.  For example, depository institutions insured by the BIF that are “well capitalized” and that present few or no supervisory concerns are required to pay only the statutory minimum assessment of $2,000 annually for deposit insurance, while all other banks are required to pay premiums ranging from .03% to .27% of domestic deposits.  These rate schedules are subject to future adjustments by the FDIC. In addition, the FDIC has authority to impose special assessments from time to time.

The FDIC is authorized to prohibit any BIF-insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the respective insurance fund.  Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital.  If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC.  The Company is not aware of any existing circumstances that could result in termination of any of the Bank’s deposit insurance.

Capital Requirements

The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises.  Under the risk-based capital requirements, the Company and the Bank are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%.  At least half of the total capital must be composed of  “Tier 1 Capital,” which is defined as common equity, retained earnings

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and qualifying perpetual preferred stock, less certain intangibles.  The remainder may consist of  “Tier 2 Capital,” which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance.  In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations.  Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  In sum, the capital measures used by the federal banking regulators are:

•

the Total Capital ratio, which is the total of Tier 1 Capital and Tier 2 Capital;

•

the Tier 1 Capital ratio; and

•

the leverage ratio.

Under these regulations, a bank will be:

•

“well capitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1 Capital ratio of 6% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;

•

“adequately capitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1 Capital ratio of 4% or greater, and a leverage ratio of 4% or greater – or 3% in certain circumstances – and is not well capitalized;

•

“undercapitalized” if it has a Total Capital ratio of less than 8% or greater, a Tier 1 Capital ratio of less than 4% - or 3% in certain circumstances;

•

“significantly undercapitalized” if it has a Total Capital ratio of less than 6%, a Tier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%; or

•

“critically undercapitalized” if its tangible equity is equal to or less than 2% of average quarterly tangible assets.

The risk-based capital standards of the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy.  The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FDIC.  These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers.  The Bank presently maintains sufficient capital to remain in compliance with these capital requirements.

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Other Safety and Soundness Regulations

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent.  For example, under the requirements of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise.  In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC f or any loss suffered or reasonably anticipated by the FDIC as a result of the insolvency of commonly controlled insured depository institutions or for any assistance provided by the FDIC to commonly controlled insured depository institutions in danger of failure.  The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in the best interests of the deposit insurance funds.  The FDIC’s claim for reimbursement under the cross guarantee provisions is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and nonaffiliated holders of subordinated debt of the commonly controlled insured depository institutions.

Interstate Banking and Branching

Current federal law authorizes interstate acquisitions of banks and bank holding companies without geographic limitation.  Effective June 1, 1997, a bank headquartered in one state is authorized to merge with a bank headquartered in another state, as long as neither of the states had opted out of such interstate merger authority prior to such date.  After a bank has acquired branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law.

Monetary Policy

The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board.  The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowing and changes in reserve requirements against deposits held by all federally insured banks.  The Federal Reserve Board’s monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.  In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary fiscal authorities, including the Federal Reserve Board, no prediction can be made as to possible future changes in i nterest rates, deposit levels, loan demand or the business and earnings of the Bank.

Federal Reserve System

In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits.  NOW accounts, money market deposit accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements, as are any non-personal time deposits at an institution.  For net transaction accounts in 2005, the first $7.0 million, up from $6.6 million in 2004, will be exempt from reserve requirements.  A three percent reserve ratio will be assessed on net transaction accounts over $7.0 million up to and including $47.4 million, up from $45.4 million in 2004.  A 10 percent reserve ratio will be applied above $47.6 million. These percentages are subject to adjustment by the Federal Reserve Board. &nbs p;Because required reserves must be maintained in

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the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets.

Transactions with Affiliates

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act.  An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank.  Generally, Sections 23A and 23B (i) limit the extent to which the Bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a nonaffiliate.  The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.

Loans to Insiders

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks.  Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one borrower limit.  Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100,000,000, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus.  Section 22(h) also prohibits loans, above amounts prescribed by the appropriate f ederal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting.  The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000).  Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

Community Reinvestment Act

Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice.  The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs.  Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard.  Banking regulators consider a depository institution’s Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution.  An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiaries.

The Gramm-Leach-Bliley Act and federal bank regulators have made various changes to the Community Reinvestment Act.  Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulatory. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial

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subsidiary if any of its bank subsidiaries received less than a “satisfactory” rating in its latest Community Reinvestment Act examination.

Fair Lending; Consumer Laws

In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business.  Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers experience discrimination in their efforts to obtain loans from depository and other lending institutions.  These agencies have brought litigation against depository institutions alleging discrimination against borrowers.  Many of these suits have been settled, in some cases for material sums, short of a full trial.

Recently, these governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations.  These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.

Gramm-Leach-Bliley Act of 1999

 The Gramm-Leach-Bliley Act of 1999 was signed into law on November 12, 1999.  The GLBA covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies.  The following description summarizes some of its significant provisions.

The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms.  It also permits bank holding companies to elect to become financial holding companies.  A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities.  In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating.

The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities.  Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law.  Under the new law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.

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The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the Securities and Exchange Commission for securities affiliates, and state insurance regulators for insurance affiliates.  It repeals the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Securities Exchange Act of 1934, as amended.  It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a set of activities in which a bank may engage without being deemed a “dealer.”  Additionally, t he new law makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.

The GLBA contains extensive customer privacy protection provisions.  Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information.  The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure.  An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes.  The GLBA also provides that the states may adopt customer privacy protections that are more strict than those contained in the act.

Bank Secrecy Act

Under the Bank Secrecy Act, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction.  Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury.  In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.  The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution’s compliance with the BSA when reviewing applications from a financial institution.  As part of its BSA program, the USA PATRIOT Act also requires a financial institution to follow recently implemented customer identification procedures when opening accounts for new customers and to review lists of individuals and entities who are prohibited from opening accounts at financial institutions.

Future Regulatory Uncertainty

Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, the Company cannot forecast how federal regulation of financial institutions may change in the future and impact its operations.  Although Congress in recent years has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, the Company fully expects that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.

Tredegar

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Tredegar operates as a trust subsidiary of the Company.  It is subject to supervision and regulation by the Virginia State Corporation Commission’s Bureau of Financial Institutions and the Federal Reserve Board.

State and federal regulators have substantial discretion and latitude in the exercise of their supervisory and regulatory authority over Tredegar, including the statutory authority to promulgate regulations affecting the conduct of business and the operations of Tredegar.  They also have the ability to exercise substantial remedial powers with respect to Tredegar in the event that it determines that Tredegar is not in compliance with applicable laws, orders or regulations governing its operations, is operating in an unsafe or unsound manner, or is engaging in any irregular practices.

GPIA

GPIA operates as a non-banking subsidiary of the Company.  It is subject to supervision and regulation by the Securities and Exchange Commission under the Investment Advisors Act.  

ITEM 2.

PROPERTIES

The headquarters building of the Company and the Bank, which also serves as a branch office for Tredegar, was completed in 1981 and is a two-story building of brick construction, with approximately 18,000 square feet of floor space, located at 111 West Washington Street, Middleburg, Virginia 20117.  The office operates nine teller windows, including three drive-up facilities and one stand-alone automatic teller machine.  The Bank owns the headquarters building.

The Purcellville bank branch was purchased in 1994 and is a one-story building with a basement of brick construction, with approximately 3,000 square feet of floor space, located at 431 East Main Street, Purcellville, Virginia 20132.  The office operates four teller windows, including three drive-up facilities and one drive-up automatic teller machine.  The Bank owns this branch building.

The Catoctin Circle, Leesburg bank branch was completed in 1997 and is a two-story building of brick construction, with approximately 6,000 square feet of floor space, located at 102 Catoctin Circle, S.E., Leesburg, Virginia 20175.  The office operates five teller windows, including three drive-up facilities and one drive-up automatic teller machine.  The Bank also owns this branch building.

The Fort Evans Road, Leesburg bank branch was completed in July 2002 and is a one-story building of brick construction with approximately 3,500 square feet of floor space, located at 211 Fort Evans Road, NE, Leesburg, Virginia 20176.  The office operates five teller windows, including three drive-up facilities and one drive-up automatic teller machine.  The Bank owns this branch building.  

The Leesburg limited service facility, located at 200 North King Street, was leased beginning April 1999.  The leased space consists of 200 square feet with one teller window and a stand-alone automated teller machine.  Transactions in this branch are limited to paying and receiving teller functions.  The initial term of this lease is five years with two additional renewal periods of five years each.  The annual lease expense associated with this location is $5,400.

The Ashburn bank branch, which is leased, opened in June 1999 and consists of 3,400 rentable square feet at 20955 Professional Plaza, Suite 100, Ashburn, Virginia 20147.  The office is a full service branch with five teller windows, three drive-up facilities and a drive-up automated teller machine.  The initial term of the lease is 15 years with two five-year renewal options.  The annual lease expense associated with this location is $76,000.

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The Reston bank branch opened in November 2004 and consists of one-story building of brick construction with approximately 3,500 square feet of floor space, located at 1779 Fountain Drive, Reston, Virginia, 20190.  The office is a full service branch with three double-stack drive-up facilities and a drive-up automated teller machine.  The Bank owns this branch building but leases the land upon which it resides.  The initial term of the lease is 10 years with two five-year renewal options.  The annual lease expense associated with this location is $222,000.  

The Leesburg operations building was completed June 2002.  The building is Class A office space and is home to deposit and loan operations, data processing, information technology, human resources, training and mortgage banking departments.  This building is a two story building with  18,000 square feet of floor space, located at 106 Catoctin Circle, SE, Leesburg, Virginia 20175.  The Bank owns this building.

Tredegar leases its main office at 821 East Main Street in Richmond, Virginia.  The lease is for a term of 15 years, with no renewal options.  The annual lease expense associated with this location is $168,000.

GPIA leases its main office at 1901 North Beauregard Avenue, Alexandria, Virginia, 22311.  The lease, which was entered into in May 2003, is for a term of 5 years, with no renewal options.   The space includes approximately 3,500 square feet of office space and 900 square feet of storage.   The annual lease expense associated with this location is $79,000.    

All of the Company’s properties are in good operating condition and are adequate for the Company’s present and anticipated future needs.

ITEM 3.

LEGAL PROCEEDINGS

There are no material pending legal proceedings to which the Company is a party or of which the property of the Company is subject.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders of the Company.

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PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Shares of the Company’s Common Stock trade on the Nasdaq SmallCap Market under the symbol “MBRG.”  The high and low sale prices per share for the Company’s Common Stock for each quarter of 2003 and 2004, and the amount of cash dividends per share in each quarter, are set forth in the table below.  All amounts have been adjusted to reflect a two-for-one stock split of the Common Stock in October 2003.  

Market Price and Dividends

As of March 14, 2005, the Company had approximately 1,750 shareholders of record.

The Company historically has paid cash dividends on a quarterly basis.  The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of the Company’s Board of Directors and will depend upon the earnings of the Company and its subsidiaries, principally the Bank, the financial condition of the Company and other factors, including general economic conditions and applicable governmental regulations and policies.  The Company or the Bank has paid regular cash dividends for over 204 consecutive quarters.

The Company did not repurchase any shares of Common Stock during the fourth quarter of 2004.  On June 16, 1999, the Company adopted a repurchase plan, which authorizes management to purchase up to $5.0 million of the Company’s common stock from time to time.

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ITEM 6.

SELECTED FINANCIAL DATA

The following consolidated summary sets forth the Company’s selected financial data for the periods and at the dates indicated.  The selected financial data have been derived from the Company’s audited financial statements for each of the five years that ended December 31, 2004, 2003, 2002, 2001 and 2000.

(1)

Amounts have been adjusted to reflect a two-for-one stock split of the Common Stock in October 2003.  

(2)

Amounts have been adjusted to reflect the application of FASB Interpretation No. 46R.  The common equity portion of the Trust Preferred entities has been deconsolidated and is included in Assets for all years reported.

(3)

The efficiency ratio is a key performance indicator in the Company’s industry.  The Company monitors this ratio in tandem with other key indicators for signals of potential trends that should be considered when making decisions regarding strategies related to such areas as asset liability management, business line development, and growth and expansion planning.  The ratio is computed by dividing non-interest expense by the sum of net interest income on a tax equivalent basis and non-interest income, net of any securities gains or losses.  It is a measure of the relationship between operating expenses to earnings.  Net interest income on a tax equivalent basis for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 were $29,974,000, $29,626,000, $25,484,000, $19,907,000 and $16,752,000.  See “Critical Accounting Policies” on page 22 for additional information.

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ITEM 7.

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

The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of the Company.  This discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and Notes to Consolidated Financial Statements.  It should also be read in conjunction with the “Caution About Forward Looking Statements” section at the end of this discussion.

Overview

The Company is headquartered in Middleburg, Virginia and conducts its primary operations through three wholly owned subsidiaries, the Bank, Tredegar and GPIA.  The Bank is a community bank serving western Loudoun County and northern Fairfax County, Virginia with six full service branches and one limited service facility.  Tredegar is a trust company headquartered in Richmond, Virginia with a branch office in Middleburg, Virginia. GPIA is a registered investment advisor headquartered in Alexandria, Virginia serving clients in 26 states.  

The Company generates a significant amount of its income from the net interest income earned by the Bank.  Net interest income is the difference between interest income and interest expense and the quality of the assets.  Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. The Bank’s cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon.  The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses.  Tredegar and GPIA generate fee income from providing investment management and trust services to its clients.  Investment management and trust fees are generally based upon the value of assets und er management, and, therefore can be significantly affected by fluctuation in the values of securities caused by changes in the capital markets.  

In 2004, the Company continued to realize the benefit of high growth rates in both assets and net interest income.  By December 31, 2004, total assets reached $606.1 million, an increase of 19.0%.  Total assets at December 31, 2003 were $509.4 million.  Loans, net of unearned income, grew 33.8% from $260.7 million at December 31, 2003 to $348.8 million at December 31, 2004.  This is the largest single year increase in portfolio loans in the past 10 years.  Considering the current interest rate environment, the Company has been cautious about the amount and type of loan growth it has added to the loan portfolio.  Additional staff, a solid local economy and the relationship with Southern Trust contributed to the strong loan growth experienced.  Total deposits increased $54.9 million from $370.0 million at December 31, 2003 to $424.9 million at December 31, 2004.  Low cost d eposits, including demand checking, interest checking, savings and money market accounts, continue to drive much of the growth in deposits.  The net interest margin declined from 4.75% for the year ended December 31, 2003 to 4.28% for the year ended December 31, 2004.  The decline is attributed to both the lower yields earned on new loan growth during a period of low interest rates and the Company’s increased reliance on borrowed money to fund the earning asset growth. The net interest margin compression of 47 basis points experienced in the first quarter of 2004 was offset slightly by strong earning asset growth thus providing a 7.4% increase in net interest income.  Results for 2004 were also favorably affected by the growth in revenues from Tredegar’s fiduciary fees and from the Bank’s investment in Bank Owned Life Insurance  (BOLI). Non-interest expenses grew at a rate of 9.9% for the 2004 year compared to 2003.  Expense related to regulatory compliance and branchi ng efforts contributed to this increase for 2004. Because of the Company’s plans for growth and expansion, it is expected that non-interest expense growth rates may exceed this level in the future.  The Company remains well capitalized with risk-adjusted core capital and total capital ratios well above the regulatory minimums.  Asset quality measures also remained consistently strong throughout the year.  The loan loss provision increased primarily due to loan growth.  

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The Company plans to expand the integration of Tredegar, GPIA and the Bank’s investment services department into a more focused wealth management program for all of the Company’s clients.  Also, through the affiliation with Southern Trust, the Bank plans to continue to increase its loan portfolio by purchasing high credit quality, low loan to value first deeds of trusts on residential property.  The Bank plans to continue its focus on low cost deposit growth with advertising campaigns that target potential clients affected by recent bank mergers.   Management has developed a branching strategy that includes expansion into Warrenton, Virginia (Fauquier County) in June 2005, and Sterling, Virginia (Loudoun County) in late 2006.  Other markets under consideration include Herndon and Chantilly (Loudoun County). Management will look for key lenders in those market s to join the Bank’s team to generate earning assets and awareness prior to the branch opening.  

The Company is not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on the registrant’s liquidity, capital resources or results of operations.

Recent Financial Developments

In February 2005, the Company executed a lease for a facility in Warrenton, Virginia.  The lease has an original term of 20 years, commencing March 1, 2005, and a minimum annual rent of $123,000 which will increase three percent per annum on each March 1st during the original lease term.  The Company has four options to renew the lease beyond the initial term, each of which is for a period of five years.  The Warrenton financial services center opening is tentatively planned for the second quarter of 2005.  The Company has already hired several staff members and loan officers to serve this market.  

The Reston bank branch, opened in November 2004 and consists of one-story building of brick construction with approximately 3,500 square feet of floor space, located at 1779 Fountain Drive, Reston, Virginia, 20190.  The office is a full service branch with three double-stack drive-up facilities and a drive-up automated teller machine.  The Bank owns this branch building but leases the land upon which it resides.  The initial term of the lease is 10 years with two five-year renewal options.  The annual lease expense associated with this location is $222,000.  

During 2004, the Company purchased $10.8 million of Bank Owned Life Insurance (BOLI). This investment is reflected in the other asset section of the Company’s balance sheet. The Company purchased BOLI to help offset increasing employee benefit costs.  

On April 15, 2003, the Bank acquired a 40% interest in Southern Trust.  Upon the acquisition of the minority interest in Southern Trust, the Bank’s existing mortgage operation was assumed by Southern Trust. In connection with the Southern Trust investment, the Bank entered into two loan participation agreements with Southern Trust.  One arrangement is a tri-party agreement among the Bank, Southern Trust and Colonial Bank, Southern Trust’s warehouse line lender.  The agreement details the arrangements by which the Bank purchases 99.0% of selected loans from Colonial Bank. The Bank charges Southern Trust a rate equal to the one month LIBOR rate at the time of purchase plus 170 basis points.  As noted in the tri-party agreement, the Bank does not intend to hold the purchased loans more than 30 days, Colonial Bank maintains the note documentation on behalf of the Bank , and the Bank will engage semi-annual testing to be conducted by a third party to validate Colonial Bank procedures.  At December 31, 2004, the balance of the Bank’s participated mortgages held for sale was $21.3 million.   The tri-party agreement is capped at $30.0 million.

The Bank also entered into a construction loan participation agreement with Southern Trust.  According to this agreement, the Bank can purchase 93% of selected construction loans and draws, up to $20.0 million in outstanding balances and $30.0 million in commitments. The Bank will charge Southern Trust an interest rate equal to the prime rate plus 75 basis points on the outstanding participated loans held

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by the Bank. Adjustments in rate related to movements in the prime rate will be made monthly.  There were $1.1 million in outstanding construction participation loans at December 31, 2004.   

 The Company exercised its option to buy GPIA in April 2002.  The terms of the transaction included a total purchase price of $6 million with 119,748 common shares of the Company issued to the shareholders of GPIA.  At the time of acquisition, GPIA had approximately $630 million of assets under management with clients in 30 states.   Clients who are located in Washington, DC, Maryland and Virginia account for approximately 68% of the assets under management.   Assets under management by both Tredegar and GPIA were approximately $1.1 billion at December 31, 2004.  

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to the Consolidated Financial Statements and this section are, to a large degree, dependent upon the accounting policies of the Company.  The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.  

Presented below is discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of the Bank’s financial condition and results of operations.  The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.  

Allowance for Loan Losses

The Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan and lease portfolio.  The Bank maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance:  the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan and lease portfolio; and the loan grading system.

The Bank evaluates various loans individually for impairment as required by Statement of Financial Accounting Standard (“SFAS”) No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures.  Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management.  The evaluations are based upon discounted expected cash flows or collateral valuations.  If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment.  If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies (“SFAS 5”) , with a group of loans that have similar characteristics.

For loans without individual measures of impairment, the Bank makes estimates of losses for groups of loans as required by SFAS 5.  Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type.  A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan.  The resulting estimate of losses for

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groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including:  borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.  

The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans and lease losses.  This estimate of losses is compared to the allowance for loan and lease losses of the Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made.  If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates.  If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses.  The Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties  and variability related to the factors used , and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high.  If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.  

Intangibles and Goodwill

The Bank has approximately $6.2 million in intangible assets and goodwill at December 31, 2004, a decrease of $338,000 since December 31, 2003.  On April 1, 2002, the Bank acquired GPIA, a registered investment advisor, for $6 million. Approximately $5.9 million of the purchase price was allocated to intangible assets and goodwill. In connection with this investment, a purchase price valuation (using FAS 141 and 142 as a guideline) was completed to determine the appropriate allocation to identified intangibles.  The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years.  Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of 7 years.  The remainder of the purchase price has been allocated to goodwill.  Approximately $1.0 million of the $6.2 million in intangible assets and goodwill at December 31, 2004 is attributable to the Company’s investment in Tredegar.

The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of management add to the success of the Bank.    For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future.  If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the Consolidated Financial Statements could result in a possible impairment of the intangible assets and goodwill or require an acceleration in the amortization expense.

In addition, FAS 142 requires that goodwill be tested annually using a two-step process.  The first step is to identify a potential impairment.  The second step measures the amount of the impairment loss, if any.  Processes and procedures have been identified for the two-step process.

When the Bank completes its ongoing review of the recoverability of intangible assets and goodwill, factors that are considered important to determining whether an impairment might exist include loss of customers acquired or significant withdrawals of the assets currently under management and/or early retirement or termination of key members of management.  Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Bank’s financial condition and results of operations.  

Tax-Equivalent Interest Income

Tax-equivalent interest income is gross interest income adjusted for the non-taxable interest income earned on municipal securities and corporate securities, which are dividend-received deduction eligible.  The effective tax rate of 34% is used in calculating tax equivalent income related to municipal securities and corporate securities.  A dividend-received deduction of 70% is used in determining tax-equivalent income related to corporate securities, as well.  

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Results of Operations

Net Income

Net income for 2004 was $7.1 million, a decrease of 13.4% from 2003’s net income of $8.2 million.  Net income for 2003 increased 30.2% over 2002’s net income of $6.3 million. For 2004, earnings per diluted share were $1.81 compared to $2.13 and $1.69 for 2003 and 2002, respectively.

Return on average assets (“ROA”) measures how effectively the Company employs its assets to produce net income.  The ROA for the Company decreased to 1.29% for the year ended December 31, 2004 from 1.78% for the same period in 2003.  The decrease in ROA in 2004 is the result of increases in capital expenditures related to the Bank’s branching strategy.  The increase in ROA in 2003 stems largely from equity earnings from the investment in Southern Trust.  The ROA for 2002 was 1.62%.  Return on average equity (“ROE”), another measure of earnings performance, indicates the amount of net income earned in relation to the total equity capital invested.  ROE decreased to 14.3% for the year ended December 31, 2004.   ROE was 18.3% and 17.2% for the years ended December 31, 2003 and 2002, respectively.

The following table reflects an analysis of the Company’s net interest income using the daily average balances of the Company’s assets and liabilities as of December 31.  Non accrual loans are included in the loan balances.

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Average Balances, Income and Expenses, Yields and Rates

(Years Ended December 31)

(1)

Income and yields are reported on tax equivalent basis assuming a federal tax rate of 34%.

(2)

Income and yields include dividends on preferred securities that are 70% excludable for tax purposes.

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Net Interest Income

Net interest income represents the principal source of earnings of the Company.  Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets.  Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income.

Net interest income on a fully tax-equivalent basis was $21.5 million for the year ended December 31, 2004.  This is an increase of 7.0% over the $20.1 million reported for the same period in 2003.  Net interest income for 2003 increased 10.7% over the $18.2 million reported for 2002.

The increase in net interest income in 2004 resulted primarily from the 18.2% growth in average earning assets.  The net interest margin decreased 47 basis points to 4.28%.  The average balance in the securities portfolio increased by $15.4 million while the tax-equivalent yield decreased 54 basis points to 4.84%.  The directives for the investment portfolio are focused on much shorter maturities and weighted average lives that have lower yields.  This directive coupled with lower number of security purchases throughout 2004 have impacted the overall investment portfolio yield.  The average loan portfolio volume increased 25.3% during 2004.  Conversely, the average yield on the loan portfolio decreased 69 basis points.  Growth in the loan portfolio helped offset the decline in loan yields to produce a 12.1% increase in loan interest income.  Loan demand continues to remain strong and the Bank has added commercial lenders in markets in which the Bank opened new facilities and markets in which the bank plans to build branches.

The average balance of low cost interest bearing accounts (interest bearing checking, savings and money market accounts) grew 20.7% to $190.5 million at December 31, 2004.  The cost of such funding decreased 10 basis points during the year ended December 31, 2004.  The average balances in certificates of deposit decreased 1.9%, while the interest expense associated with these deposits decreased 12.2% or $307,000.

The Company’s reliance on other funding sources, such as the Federal Home Loan Bank overnight advances, increased on average by $3.1 million with a related increase in interest expense of only $30,000.  During 2004, the Company increased its average long term borrowings (from the Federal Home Loan Bank) by $14.6 million.  Much of the increase in borrowings was related to the funding the growth experienced in the Bank’s loan portfolio  Total interest expense for 2004 was $6.0 million, a increase of $457,000 compared to the total interest expense for 2003.  With the anticipation of rising interest rates and a continued reliance on borrowings to fund the Company’s asset growth, interest expense is expected to increase.

Management expects that the net interest margin will remained relatively unchanged during  2005.  Based on conservative internal interest rate risk models and the assumption of a sustained rising rate environment, the Company expects net interest income to trend downward slightly throughout the next 12 months as mortgage related assets extend and funding costs rise quickly.  The expected decrease to net interest income could be as little as .74%  or $164,000 in a 12 month period of rising rates of 200 basis points.  It is anticipated that increased growth in earning assets will help mitigate the above mentioned impact to the Company’s net interest margin. The Asset/Liability Management Committee continues to focus on various strategies to maintain the net interest margin.  

The increase in net interest income in 2003 resulted from the 17.4% growth in average earning assets.  The 78 basis point decrease in earning assets yield was offset somewhat by a 61 basis point decrease in the cost of funding. The net interest margin decreased 29 basis points to 4.75%.  The average balance in the securities portfolio increased by $30.1 million while the tax-equivalent yield decreased 69 basis points to 5.38%.  The average loan portfolio volume increased 16.9% during 2003.  Conversely, the average yield on the loan portfolio decreased 93 basis points.  Loan demand was strong throughout 2003,

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however the decrease in average loan yield offset much of the potential growth in interest income from loan portfolio growth.    

The average balance of low cost interest bearing accounts (interest bearing checking, savings and money market accounts) grew 25.7% to $157.8 million at December 31, 2003.  The cost of such funding decreased 49 basis points over the year ended December 31, 2003.  The average balances in certificates of deposit increased 4.2%, while the interest expense associated with these deposits decreased 17.4% or $528,000.

The Company’s reliance on other funding sources, such as the Federal Home Loan Bank overnight advances, increased on average by $3.6 million with a related increase in interest expense of only $15,000.  During 2003, the Company increased its average long term borrowings (from the Federal Home Loan Bank and trust preferred issuance) by $4.6 million.  Total interest expense for 2003 was $5.6 million, a decrease of $948,000 compared to the total interest expense for 2002.

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The following table analyzes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates.  The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.  Non-accruing loans are included in the average outstanding loans.

Volume and Rate Analysis

(Tax Equivalent Basis)

(Years Ended December 31)

(1)

The change in interest, due to both rate and volume, has been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each.

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Provision for Loan Losses

The Company’s loan loss provision during 2004 and 2003 was $796,000 and $575,000, respectively.  The Company is committed to making loan loss provisions that maintain an allowance that adequately reflects the risk inherent in the loan portfolio.  This commitment is more fully discussed in the “Asset Quality” section below.

Non-interest Income

Non-interest income has been and will continue to be an important factor for increasing profitability.  Management recognizes this and continues to review and consider areas where non-interest income can be increased.  Non-interest income (excluding securities gains and losses) includes fees generated by the mortgage banking and investment sales departments of the Bank as well as by Tredegar and GPIA.  Non-interest income decreased 10.8% to $8.5 million for the year ended December 31, 2004, compared to $9.5 million for 2003.  During 2002 and for the first four months of 2003, mortgage banking income and certain loan fees related to mortgage banking were reported on a gross income basis.  All expenses of that department were reported within non-interest expenses.  All earnings of that department after April 30, 2003 are being reported as equity in earnings from affiliate, following the transfer of the Bank’s mortgage banking department to Southern Trust.  Equity in earnings from affiliate of $1.7 million and $1.9 million for the years ended December 31, 2004 and 2003 respectively, is the result of the 40% interest in Southern Trust.

The equity earnings in Southern Trust added $.28 per diluted share after tax for the year ended December 31, 2004. In 2004, Southern Trust closed $990.3 million in loans with 66.2% of that production attributable to purchase money financing.  Total construction loan closings were $10.4 million for the year ended December 31, 2004.  Southern Trust expects that production attributable to refinancings, which have leveled off, will continue to decrease slightly in the first quarter of 2005.  This  production decrease, and any decreases associated with the seasonality of home sales, are expected to be offset somewhat by an increase in purchase money financings and new construction loans.

Service charges, which include both deposit fees and certain loan fees, decreased 8.9% to $1.9 million for the year ended December 31, 2004, compared to $2.1 million for the year ended December 31, 2003.  Investment advisory fees of $2.1 million for the year ended December 31, 2004 are from GPIA.    Investment advisory fees increased 1.4% in 2004 compared to 2003 investment advisory fee balance.  GPIA is predominantly a fixed income money manager that bases its fee upon the market value of the accounts under management. Tredegar produced  fiduciary fees that increased 15.1% to $1.6 million for the year ended December 31, 2004, compared to $1.4 million for the same period in 2003.  Assets under administration at Tredegar grew 13.2% or $67.7 million to $578.3 million at December 31, 2004.  Fiduciary fees are also based primarily upon the market value of the accounts under administration.   

Investment sales fees decreased 25.5% to $671,000 for the year ended December 31, 2004, compared to $901,000 for the year ended December 31, 2003. A strategic decision was made to change the broker dealer clearing provider in the investment services department.  For a period of time after the system conversion, the investment services department had only two financial consultants down from five during the first nine months of 2003.  This has significantly impacted the level of revenue generated by the department when comparing the year over year results. The Company now has five financial consultants working inside each of the branches.    

Trust fee income increased 15.3% during 2003 to $1.4 million.  A significant portion of trust fees are based upon a percentage of the market value of the assets under management, so any increases in market value of the assets under management result in a similar increase in fees.  Tredegar’s accounts are typically invested in equities with a smaller allocation to fixed income securities.  The continued recovery

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in equity market values and the growth in assets under management have contributed to the growth in the fees.   GPIA’s investment advisory fees added $2.1 million to non-interest income for 2003.   Like Tredegar, their fees are based upon a percentage of the market value of the assets under management, however GPIA’s clients have substantially more invested in fixed income securities.  The fixed income market experienced significant fluctuations throughout 2003, ultimately causing marginal growth in fees in spite of good business development.  During 2003, service charges, which include both deposit fees and certain loan fees, increased 8.4% to $2.1 million.  During 2003, the Company realized $422,000 in net gains as a result of restructuring the investment portfolio in response to the change in the interest rate environment in 2003.  Total non-interest income for 2003 was $9.9 million, compared to $7.2 million for 2002.

Non-interest income for 2002 increased 28.0% to $7.2 million from $5.2 million in 2001.  The increase is due primarily to the increase on fees on loans held for sale, investment advisory fees and service charges on deposit accounts.  Due to historic low mortgage rates and increased refinancings, the mortgage banking department contributed an additional $452,000 of fees on loans held for sale during 2002.  The service charges and fees associated with deposit accounts increased 35.0% during 2002.  The increase in these fees was due primarily to a 30.5% increase in transaction oriented deposit account growth.

Noninterest Income

(Years Ended December 31)

Non-interest Expense

Non-interest expense increased 9.9% to $18.6 million for the year ended December 31, 2004, compared to $16.9 million for 2003.  Included in other operating expenses were some one-time costs associated with Sarbanes-Oxley 404 compliance, supplemental executive retirement benefits, and equity adjustments for ownership in Banker’s Investment, the Company’s broker-dealer. Also impacting salary and benefit expense is a severance payment to a former executive which was $112,000, net of tax.   The growth in salary expense was 8.9% during 2004.  Additions to staff to support branching and commercial lending have contributed to the increase in salaries and employee benefits during 2004.  Net occupancy and equipment expenses decreased 1.1% to $2.2 million for the year ended December 31, 2004, compared to $2.3 million for the same period in 2003.  As growth efforts continue to progress, the Company anticipates higher levels of occupancy expense to be incurred.  In February of 2005, the Company executed a lease for a facility in Warrenton, Virginia.  The lease has an original term of 20 years,

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commencing March 1, 2005, and a minimal annual rent of $123,000 which will increase three percent per annum on each March 1st during the original lease term.  The Company has four options to renew the lease beyond the initial term, each of which is for a period of five years.  The Warrenton financial services center opening is tentatively planned for the second quarter of 2005.  The Company has already hired several staff members and loan officers to serve this market.  

Advertising expense increased 24.3% in 2004 to $374,000.  During the first half of 2004, the Company conducted a campaign that was targeted specifically to grow checking accounts.  Computer operations expense increased from $640,000 for the year ended December 31, 2003 to $770,000 for the year ended December 31, 2004.  The increase is related to both the increased cost of computer related maintenance contracts and the increased number of the Company’s clients utilizing its online banking services and the increase in volume of online banking transactions. Clients meeting specific criteria are provided free online banking services by the Company.   

It is expected that non-interest expenses will increase at a faster pace in 2005.  Some of the increase will be associated with costs related to having additional facilities in 2005 and obtaining additional staffing to support branching growth and additional business development goals.  

Total non-interest expenses increased 8.8% or $1.4 million to $16.9 million in 2003.  Additions to staff to support business development, branching and the formation of a wealth management group have contributed to the increase in salaries and employee benefits during 2003.  The growth in salary expense was a marginal 6.6% during 2003 because the commissions and salary expense related mortgage banking were reported within the equity earnings from affiliate after April 30, 2003.   If the mortgage banking department of the Bank remained within the Bank after the acquisition of the minority interest in Southern Trust, salary and benefit expense would have been approximately $914,000 higher or increased 16.4% year over year.  Net occupancy and equipment expenses increased 22.1% to $2.3 million for the year ended December 31, 2003, compared to $1.9 million for the same period in 2002.   The building expansion program, which includes the operations center and the second Leesburg branch, continued to affect net occupancy and equipment expense year over year.   Advertising expense decreased in 2003 to $301,000 because the Bank focused more on in branch promotions and business development calling to increase sales rather than paid advertising.  Computer operations expense includes fees paid to a third party vendor for online banking services.  The online banking fees increased 31.6% from $159,000 for the year ended December 31, 2002 to $210,000 for the same period in 2003.  Other increases in computer operations relate to increases in support and maintenance fees paid to the application software and hardware vendors.  

Non-interest expenses increased 30.0% or $3.6 million to $15.5 million in 2002.  This increase resulted from both pressures to provide competitive salary and benefit programs and occupancy and equipment investments to position the Bank for future growth and productivity.

Non-interest Expenses

(Years Ended December 31)

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Income Taxes

Reported income tax expense was $2.8 million for 2004, a decrease of $663,000 compared to $3.4 million for 2003.  The effective tax rate for 2004 was 28.2% compared to 29.5% in 2003 and 27.0% in 2002.  Note 10 of the Company’s Consolidated Financial Statements provides a reconciliation between the amount of income tax expense computed using the federal statutory rate and the Company’s actual income tax expense.  Also included in Note 10 to the Consolidated Financial Statements is information regarding the principal items giving rise to deferred taxes for the two years ended December 31, 2004.

Summary of Financial Results by Quarter

The following table summarizes the major components of the Company’s results of operations for each quarter of the last three fiscal years.

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(1) Per share information has been adjusted to reflect a two-for-one stock split of the Common Stock in October 2003.

Financial Condition

Assets

The Company’s total assets were $606.1 million as of December 31, 2004 up $96.7 million or 19.0% from the $509.4 million level at December 31, 2003.  Securities decreased $20.2 million or 10.4% from 2003 to 2004.  Total loans, net of allowance for loan losses, increased by $87.3 million or 33.8% from 2003 to 2004, while deposits increased $54.9 million or 14.8% during the same period.  Borrowings from the Federal Home Loan Bank increased $11.3 million during 2004.  It is anticipated that the borrowings from the Federal Home Loan Bank will continue to rise should deposit growth not provide adequate funding for experienced asset growth.  Total shareholders’ equity at year end 2004 and 2003 was $51.6 million and $47.3 million, respectively.

Loans

The Company’s loan portfolio is its largest and most profitable component of earning assets, totaling 62.6% of average earning assets in 2004.  The Company continues to emphasize loan portfolio growth and diversification as a means of increasing earnings while minimizing credit risk.  Loans, net of unearned income, were $348.8 million at December 31, 2004, an increase of 33.8% from December 31, 2003’s total of $260.7 million.  The Bank developed a strong image advertising campaign during 2003 that focused on its commercial lenders.  This campaign built additional awareness within the market.  Additionally, the Bank has hired six loan officers since January 2004, each of whom have significant experience within the Fairfax, Fauquier and Loudoun County markets.  Upon the acquisition of the minority interest in Southern Trust, the Bank entered into a construction loan participation agreement with Southern Trust.  Under this agreement, the Bank can purchase 93% of selected construction loans and draws, up to $20.0 million in outstanding balances and $30.0 million in commitments. The Bank will charge Southern Trust an interest rate equal to the prime rate on the outstanding participated loans held by the Bank. Adjustments in rate related to movements in the prime rate will be made monthly.  There were $1.1 million in outstanding balances of these construction loans at December 31, 2004.  Additionally, the Bank also purchases residential real estate loans from selected Southern Trust offices within its market area.   The loans are secured by first deeds of trusts on the residential properties and are of good quality investment. At December 31, 2004, there were $25.7 million of outstanding loans that had been

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purchased from Southern Trust.  Each of these factors have contributed to the strong loan growth during  2004.  

Loans increased 22.9% from $212.1 million at December 31, 2002 to $260.7 million at December 31, 2003.  The loan to deposit ratio increased to 82.1% at December 31, 2004, compared to 70.5% at December 31, 2003 and 64.5% at December 31, 2002.

Loan Portfolio

(At December 31)

(1)

This category generally consists of commercial and industrial loans where real estate constitutes a source of collateral.

At December 31, 2004 residential real estate (1-4 family) portfolio loans constituted 32.8% of the total portfolio and increased $30.5 million during the year.  $24.9 million of this growth results from the loans that were purchased from Southern Trust. Real estate construction loans consist primarily of pre-sold 1-4 family residential loans along with a marginal amount of commercial construction loans.  Real estate construction loans increased to $45.5 million at December 31, 2004 and represent 13.1% of the total loan portfolio.  The Company’s one time closing construction/permanent loan product competes successfully in a high growth market like Loudoun County because the Company is local and can respond quickly to inspections and construction draw requests.  Non-farm, non-residential real estate loans are typically owner-occupied commercial buildings.  Non-farm, non-residential loans were 35.9% of the total loan portfolio at December 31, 2004.  The increase in the non-farm non-residential real estate loans is the result of both a strong image advertising campaign during 2003 and the hiring of several commercial business development officers during 2003 and 2004 each of whom have been successful in attracting new business to the Bank.  The branch network has also helped to support the loan portfolio diversification, such as increased commercial real estate loans.  Home equity lines and agricultural real estate loans were 6.1% and 0.90% of total loans, respectively, at December 31, 2004.

The Company’s commercial, financial and agricultural loan portfolio consists of secured and unsecured loans to small businesses.  At December 31, 2004, these loans comprised 7.8% of the loan portfolio.  This portfolio increased 33.4% in 2004 to $27.2 million.  The Company’s market area, Loudoun County, had been identified as one of the fastest growing Counties with the fastest rate of job creation in the Country. The market’s growth has contributed to the improved local economy, commercial spending and therefore the Bank’s increased commercial loan demand. Consumer installment loans primarily consist of unsecured installment credit and account for 3.5% of the loan portfolio.

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Consistent with its focus on providing community-based financial services, the Company generally does not extend loans outside its principal market area.  The Company’s market area for its lending services encompasses Fairfax, Fauquier and Loudoun Counties, where it operates full service branches.

The Company’s unfunded loan commitments totaled $71.0 million at December 31, 2004 and $50.5 million at December 31, 2003.  The increase in the amount of unfunded commitments is attributed in part to the increase in real estate construction financing as well as customer demand for credit line products, primarily home equity lines.

At December 31, 2004, the Company had no concentration of loans in any one industry in excess of 10% of its total loan portfolio.  However, because of the nature of the Company’s market, loan collateral is predominantly real estate.

The following table reflects the maturity distribution of selected loan categories:

Remaining Maturities of Selected Loan Categories

(At December 31, 2004)

Asset Quality

The Company has policies and procedures designed to control credit risk and to maintain the quality of its loan portfolio.  These include underwriting standards for new originations and ongoing monitoring and reporting of asset quality and adequacy of the allowance for loan losses.  Total non-performing assets, which consist of non-accrual loans, restructured loans and foreclosed property, were $1,000 at December 31, 2004.  This is a decrease of $364,000 from the December 31, 2003 balance of $365,000.  The majority of the decrease resulted from the pay off of a residential real estate loan.  Non-performing assets were $1.1 million at December 31, 2002.

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Non-performing Assets

Loans are placed on non-accrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due.  There are three negative implications for earnings when a loan is placed on non-accrual status.  First, all interest accrued but unpaid at the date that the loan is placed on non-accrual status is either deducted from interest income or written off as a loss.  Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid.  Finally, there may be actual losses that require additional provisions for loan losses be charged against earnings.  For real estate loans, upon foreclosure, the balance of the loan is transferred to “Other Real Estate Owned” (“OREO”) and carried at the lower of the outstanding loan balance or the fair market value of the property based on current appraisals and other current market trends.  If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off against the allowance for loan losses.  A review of the recorded property value is performed in conjunction with normal loan reviews, and if market conditions indicate that the recorded value exceeds the fair market value, additional write downs of the property value are charged directly to operations.

Non-performing Assets

(At December 31)

During 2004 and 2003, approximately $0 and $3,000, respectively, in additional interest income would have been recorded if the Company’s non-accrual loans had been current and in accordance with their original terms.

At December 31, 2004, the Bank had no potential problem loans.

The allowance for loan losses was 341,800% of non-performing loans at December 31, 2004, as the Bank only had $1,000 in non-performing assets on that date.   At December 31, 2003 and 2002 the allowance for loan losses was 714% and 217% of non-performing loans.  Management evaluates non-performing loans relative to their collateral value and makes appropriate reductions in the carrying value of those loans based on that review.

Allowance For Loan Losses

For a discussion of the Company’s accounting policies with respect to the allowance for loan losses, see “Critical Accounting Policies – Allowance for Loan Losses” above.

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The following table depicts the transactions, in summary form, that occurred to the allowance for loan losses in each year presented:

Allowance for Loan Losses

(Years Ended December 31)

The allowance for loan losses was $3.4 million at December 31, 2004, an increase of $813,000 from $2.6 million at December 31, 2003.  During 2004, the Bank increased its provision to the allowance for loan losses in response to the loan growth experienced during the year.  The allowance was $2.3 million at December 31, 2002.  In 2004, the Company’s net charge-offs (recoveries) decreased $294,000 from the previous year’s net charge-offs of $277,000.  Net charge-offs as a percentage of average loans were (0.01)% and 0.11% for 2004 and 2003 respectively.  The provision for loan losses was $796,000 for 2004 and $575,000 for 2003.

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The following table shows the balance and percentage of the Company’s allowance for loan losses allocated to each major category of loan:

Allocation of Allowance for Loan Losses

(At December 31)

The Company has allocated the allowance according to the amount deemed reasonably necessary to provide for the possibility of losses being incurred within each of the above categories of loans.  The allocation of the allowance as shown in the table above should not be interpreted as an indication that loan losses in future years will occur in the same proportions that they may have in prior years or that the allocation indicates future loan loss trends.  Additionally, the proportion allocated to each loan category is not the total amount that may be available for the future losses that could occur within such categories since the total allowance is a general allowance applicable to the total portfolio.

Securities

The Company manages its investment securities portfolio consistent with established policies that include guidelines for earnings, rate sensitivity, liquidity and pledging needs.  The Company holds bonds issued from the Commonwealth of Virginia and its political subdivisions with an aggregate market value of $3.2 million at December 31, 2004.  The aggregate holdings of these bonds approximate 6.2% of the Company’s shareholders’ equity.

The Company accounts for securities under Financial Accounting Standards Board (“FASB”) Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  This standard requires classification of investments into three categories, “held to maturity” (“HTM”), “available for sale” (“AFS”), or “trading,” as further defined in Note 1 to the Company’s Consolidated Financial Statements.  The Company does not maintain a trading account and has classified no securities in this category.  HTM securities are required to be carried on the financial statements at amortized cost.  AFS securities are carried on the financial statements at fair value.  The unrealized gains or losses, net of deferred income taxes, are reflected in shareholders’ equity.  The HTM classification places restrictions on the Company’s ability to sell securities or to transfer securities into the AFS classification.  Since the Company desires the flexibility to respond to changing balance sheet needs through investment portfolio

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management, it has chosen to classify only a small portion of its portfolio in this category.  At December 31, 2004, 1.6% of the portfolio was classified as HTM.

The Company holds in its loan and securities portfolios investments that adjust or float according to changes in “prime” lending rate.  These holdings are not considered speculative but instead necessary for good asset/liability management.

The carrying value of the securities portfolio was $174.4 million at December 31, 2004, a decrease of $20.2 million or 10.4% from the carrying value of $194.6 million at December 31, 2003.  The market value of the AFS securities at December 31, 2004 was $171.7 million.  The unrealized loss on the AFS securities was $1.3 million at December 31, 2004.  This loss was offset by the December 31, 2004 unrealized gain of $3.4 million. The net market value gain at December 31, 2004 is reflective of the continued low level of market interest rates.  The net unrealized gain on the AFS securities was $2.2 million at December 31, 2003.

Since the Bank anticipates much of the balance sheet growth to be experienced during 2005, if any, to be in the form of net portfolio loans, specific strategies will be executed during the early part of 2005 to maintain the investment portfolio at an amount comparable to the December 31, 2004 balances.  Because net loan growth is anticipated to come in at a faster rate during the beginning of 2005 than the later part of the year, an investment strategy is intended to be executed in order to increase the amount of earning assets for the Bank.  

Investment Securities Portfolio

(Years Ended December 31)

The carrying value of securities held to maturity at the dates indicated were as follows:

The carrying value of securities available for sale at the dates indicated were as follows:

The following table indicates the decreased return experienced by the Company during 2004.  The 2004 directives for the investment portfolio were focused on much shorter maturities and weighted average lives that have lower yields.  This directive coupled with the significant principal pay-downs

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experienced throughout 2004 have impacted the overall investment portfolio yield.  Securities with maturities greater than five years total $88.3 million and have an average yield greater than 5.3%.  The securities portfolio represents approximately 37.4% of the average earning assets of the Company.  For that reason, it is managed primarily to provide superior returns without sacrificing interest rate, market and credit risk.  Secondarily, through the asset/liability process, the Company considers the securities portfolio as a liquidity source in the event that funding is needed quickly within a 30-day period of time.

Maturity Distribution and Yields of Investment Securities

Taxable-Equivalent Basis

(At December 31, 2004)

(1)

Yields on tax-exempt securities have been computed on a tax-equivalent basis.

(2)

Amounts exclude Federal Reserve Stock of $563,400 and Federal Home Loan Bank Stock of $4,124,500.

Other Earning Assets

The Company’s average investments in federal funds sold and money market investments in 2004 were $2.3 million and $209,000, respectively.  The Company experienced decreases of $324,000 and $1.5 million in federal funds sold and money market investments, respectively, from the 2003 amounts.  Average investments in federal funds sold and money market investments in 2003 were $2.6 million and $1.7 million, respectively.  The decreases experienced in both the amount of funds available for investment in federal funds sold and money market investments during 2004 and 2003 reflect the Bank’s need to utilize available funds to support the growth in higher yielding assets like loans and investment securities.

Deposits

Deposits continue to be an important funding source and primary supply of the Company’s growth.  The Company’s strategy has been to increase its core deposits at the same time that it is controlling its cost of funds.  The maturation of the branch network, as well as increased advertising campaigns and bank mergers, have contributed to the significant growth in deposits over the last several

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years.  By monitoring interest rates within the local market and that of alternative funding sources, the Company is able to price the deposits effectively to develop a core base of deposits in each branch.

The following table is a summary of average deposits and average rates paid on those deposits:

Average Deposits and Rates Paid

(Years Ended December 31)