SOUTHERN FINANCIAL BANCORP INC /VA/ - 10-Q Quarterly Report

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U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15 (d)
of the Securities Exchange Act of 1934

For the Quarter Ended:
March 31, 2003

Commission File No.:
0-22836

SOUTHERN FINANCIAL BANCORP, INC.

Virginia
(State or other jurisdiction of
incorporation or organization)

54-1779978
(IRS Employer Identification Number)

37 East Main Street
Warrenton, Virginia
(address of principal executive office)

20186
(Zip Code)

Registrant’s Telephone Number, including area code: (540) 349-3900

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 o

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

As of April 30, 2003, there were 5,471,169 shares of the registrant’s Common Stock outstanding.

SOUTHERN FINANCIAL BANCORP, INC.
QUARTERLY REPORT ON FORM 10-Q
March 31, 2003

TABLE OF CONTENTS

			Page Number

PART I.	FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheets as of March 31, 2003 (Unaudited) and December 31, 2002	3

		Consolidated Statements of Income for the Three Months Ended March 31, 2003 and 2002 (Unaudited)	4

		Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2003 and 2002 (Unaudited)	5

		Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2003 and 2002 (Unaudited)	6

		Notes to Consolidated Financial Statements (Unaudited)	7 - 12

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13 - 18

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	18 - 19

	Item 4.	Controls and Procedures	19

PART II.	OTHER INFORMATION

	Item 1.	Legal Proceedings	20

	Item 2.	Changes in Securities	20

	Item 3.	Defaults upon Senior Securities	20

	Item 4.	Submission of Matters to a Vote of Security Holders	20

	Item 5.	Other Information	20

	Item 6.	Exhibits and Reports on Form 8-K	20

PART III.	SIGNATURES		21

CERTIFICATIONS

22 - 23

SOUTHERN FINANCIAL BANCORP, INC.
FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEETS

	March 31, 2003 (Unaudited)			December 31, 2002

Assets
Cash and due from banks	$	27,571,539		$	28,705,185
Overnight earning deposits		47,733,464			64,692,873
Investment securities - available for sale		166,796,018			203,562,648
Investment securities - held to maturity		78,526,035			—
Loan held for sale		6,587,828			513,784
Loans receivable, net		625,921,362			594,323,270
Cash surrender value of life insurance		22,619,133			22,287,418
Premises and equipment, net		8,949,487			8,264,400
Intangible assets, net		14,406,990			14,557,779
Other assets		28,145,972			33,319,634

Total assets	$	1,027,257,828		$	970,226,991


Liabilities and Stockholders’ Equity
Liabilities
Deposits	$	791,372,851		$	776,082,670
Advances from Federal Home Loan Bank - short term		10,000,000			—
Advances from Federal Home Loan Bank - long term		89,941,584			65,000,000
Company-obligated mandatorily redeemable securities of subsidiary holding solely parent debentures		13,000,000			13,000,000
Securities sold under agreements to repurchase		26,450,208			18,455,614
Other liabilities		13,789,284			16,385,601

Total liabilities		944,553,927			888,923,885


Stockholders’ equity
Preferred stock		129			129
Common stock		54,712			54,412
Capital in excess of par		81,616,042			81,166,827
Retained earnings		1,981,121			—
Accumulated other comprehensive income (loss)		(948,103	)		81,738

Total stockholders’ equity		82,703,901			81,303,106

Total liabilities and stockholders’ equity	$	1,027,257,828		$	970,226,991

The accompanying notes are an integral part of these consolidated financial statements.

SOUTHERN FINANCIAL BANCORP, INC.
FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF INCOME

	Three Months Ended March 31,

	2003			2002

Interest Income
Loans	$	10,060,798		$	8,035,356
Investment securities		2,872,049			4,784,886

Total interest income		12,932,847			12,820,242

Interest Expense
Deposits		2,683,582			3,718,160
Borrowings		846,897			972,502

Total interest expense		3,530,479			4,690,662

Net interest income		9,402,368			8,129,580
Provision for loan losses		1,215,000			1,500,000

Net interest income after provision for loan losses		8,187,368			6,629,580

Other Income
Account maintenance and electronic banking fees		776,932			643,781
Commercial service fees		169,547			116,689
Other loan fees		131,768			94,619
System maintenance and license fees		53,916			74,313
Income from bank owned life insurance		331,715			247,931
Gain on sale of loans		298,662			99,247
Loss on investment securities, net		(896,542	)		(385,474	)
Other		37,919			2,499

Total other income		903,917			893,605

Other expenses
Employee compensation and benefits		2,873,585			2,351,932
Premises, equipment and data processing		1,483,723			1,221,021
Other		836,611			681,022

Total other expenses		5,193,919			4,253,975

Income before income taxes		3,897,366			3,269,210
Provision for income taxes		1,190,700			1,041,192

Net income	$	2,706,666		$	2,228,018


Earnings per common share:
Basic	$	0.50		$	0.45
Diluted		0.48			0.43
Dividends declared per common share		0.13			0.10
Weighted average shares outstanding:
Basic		5,424,692			4,927,283
Diluted		5,697,478			5,135,726

The accompanying notes are an integral part of these consolidated financial statements

SOUTHERN FINANCIAL BANCORP, INC.
FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

	Three Months Ended March 31,

	2003			2002


Net income	$	2,706,666		$	2,228,018
Other comprehensive income:
Cash flow hedge:
Unrealized holding gain/(loss)		(89,572	)		45,202
Reclassification adjustment for net interest expense included in net income		192,765			167,425
Available-for-sale securities:
Unrealized holding loss		(2,584,106	)		(2,892,814	)
Reclassification adjustment for net losses included in net income		896,542			385,474

Other comprehensive loss before tax		(1,584,371	)		(2,294,713	)
Income tax benefit related to items of other comprehensive income		(554,530	)		(803,151	)

Other comprehensive loss, net of tax		(1,029,841	)		(1,491,562	)
Comprehensive income	$	1,676,825		$	736,456

The accompanying notes are an integral part of these consolidated financial statements

SOUTHERN FINANCIAL BANCORP, INC.
FINANCIAL STATEMENTS (UNAUDITED)

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Three Months Ended March 31,

	2003			2002

Cash flows from operating activities:
Net Income	$	2,706,666		$	2,228,018
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		370,605			382,800
Amortization of discounts or premiums on investment securities and loans, net		1,048,187			1,005,485
Provision for loan losses		1,215,000			1,500,000
Gain on sale of loans		(298,662	)		(99,247	)
Loss on sale of securities		896,542			385,474
Accretion of deferred loan fees		(453,201	)		(355,712	)
Loans originated - held for sale		(2,820,200	)		(2,329,350	)
Loans sold - held for sale		2,336,581			2,126,386
Decrease (increase) in other assets		2,839,569			(4,220,876	)
Decrease in other liabilities		(2,493,212	)		(7,709,701	)

Net cash provided by (used in) operating activities		5,347,875			(7,086,723	)

Cash flows from investing activities:
Increase in loans receivable		(36,331,820	)		(32,207,394	)
Purchase of investment securities, available-for-sale		(21,325,136	)		(125,006,063	)
Purchase of investment securities, held-to-maturity		(79,018,887	)		—
Sale of investment securities, available-for-sale		15,260,549			96,491,307
Paydowns of investment securities, available-for-sale		41,237,409			62,289,195
Paydowns of investment securities, held-to-maturity		482,216			—
Purchase of bank owned life insurance		—			(5,000,000	)
Increase in premises and equipment, net		(1,042,103	)		(277,288	)
Increase in other equity securities		(1,703,150	)		(675,000	)

Net cash used in investing activities		(82,440,922	)		(4,385,243	)

Cash flows from financing activities:
Net increase in deposits		16,363,928			3,728,704
Increase in advances from FHLB - short term		10,000,000			5,500,000
Increase in advances from FHLB - long term		25,000,000			—
Increase in securities sold under agreements to repurchase		7,994,594			—
Proceeds from issuance of common stock		367,015			—
Dividends on preferred and common stock		(725,545	)		(522,985	)

Net cash provided by financing activities		58,999,992			8,705,719

Net decrease in cash and cash equivalents		(18,093,055	)		(2,766,247	)
Cash and cash equivalents, beginning of period		93,398,058			28,458,557

Cash and cash equivalents, end of period	$	75,305,003		$	25,692,310

SUPPLEMENTAL DATA
Cash payments for interest on deposits and borrowings, net of cash payments on interest rate swaps	$	(1,752,048	)	$	892,296
Cash payments for income taxes	$	—		$	2,200,000

The accompanying notes are an integral part of these consolidated financial statements

SOUTHERN FINANCIAL BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q, and, therefore, do not include all information or footnotes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. However, all adjustments which are, in the opinion of management, necessary for a fair presentation have been included. All adjustments are of a normal recurring nature. The results of operations for the three-month period ended March 31, 2003 are not necessarily indicative of the results of the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes included in Southern Financial Bancorp, Inc.’s (“Southern Financial”) Annual Report and Form 10-K for the year ended December 31, 2002.

STOCK-BASED COMPENSATION

Southern Financial adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation” and Statement of Financial Accounting Standards No. 148 (SFAS 148), “Accounting for Stock-Based Compensation – Transition and Disclosure.” These statements allow an entity to continue to measure compensation cost for these plans using the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees.” Southern Financial has elected to follow APB 25 and related interpretations in accounting for its employee stock options.

Pro forma information regarding net income and earnings per share as required by SFAS 123 and SFAS 148 has been determined as if Southern Financial had accounted for its employee stock options under the fair value method. The fair value of all currently outstanding options was estimated at the date of the grant using a Black-Scholes option pricing model. Pro forma results are presented in the following table:

	March 31,

	2003			2002

Net income:
As reported	$	2,706,666		$	2,228,018
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards granted, net of related tax effects		(98,250	)		(101,737	)

Pro forma net income	$	2,608,416		$	2,126,281

Basic earnings per share:
As reported		0.50			0.45
Pro forma		0.48			0.43
Diluted earnings per share:
As reported		0.48			0.43
Pro forma		0.46			0.41

NOTE 2 – INVESTMENT SECURITIES

The following table sets forth the investment securities portfolio as of the dates indicated:

	March 31, 2003				December 31, 2002

	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value


Available-for-sale securities:
Mortgage-backed securities	$	64,736,509	$	65,407,490	$	74,340,004	$	74,892,117
Collateralized mortgage obligations		50,031,644		49,802,457		83,073,123		83,860,096
Obligations of counties and municipalities		9,901,062		10,000,000		9,900,275		10,000,000
Corporate obligations		34,144,598		33,080,294		28,046,561		26,996,571
U.S. Treasury and agency securities		1,252,234		1,270,834		2,257,579		2,282,071
Federal Home Loan Bank stock		5,000,000		5,000,000		3,500,000		3,500,000
Federal Reserve Bank stock		1,742,600		1,742,600		1,536,850		1,536,850
Other equity securities		492,343		492,343		494,943		494,943

Total classified as investment securities		167,300,990		166,796,018		203,149,335		203,562,648
Debt obligations classified as loans		23,977,533		24,184,343		31,566,894		32,542,983

	$	191,278,523	$	190,980,361	$	234,716,229	$	236,105,631

Held-to-maturity securities:
Mortgage-backed securities	$	30,366,192	$	30,604,770	$	—	$	—
Collateralized mortgage obligations		46,292,625		46,890,941		—		—
Corporate obligations		1,867,218		1,868,000		—		—

	$	78,526,035	$	79,363,711	$	—	$	—

NOTE 3 – DERIVATIVE FINANCIAL INSTRUMENTS

As part of our interest rate risk management, we make extensive use of interest rate swaps. Some of them are accounted for as cash flow hedges and some are accounted for as fair value hedges in accordance with SFAS 133. Cash flow hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities.

We use interest rate swaps that are accounted for as cash flow hedges to hedge the interest rate risk associated with pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce long-term rate deposits. Changes in the fair value of cash flow hedges are accounted for in other comprehensive income.

We also use interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is generally tied to three-month LIBOR. The combination of the swaps and the issuance of individual CDs operates to produce long-term floating rate deposits. The terms of the CDs and the interest rate swaps mirror each other and were committed simultaneously. Changes in the fair value of the fair value hedges are accounted for in the income statement, as are changes in the fair value of the certificates of deposit.

We also use interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the Federal Home Loan Bank of Atlanta (FHLB). Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is generally tied to three-month LIBOR. The combination of the swaps and the borrowing from FHLB operates to produce long-term fixed rate borrowings. The terms of the borrowings and the interest rate swaps mirror each other and were committed simultaneously. Changes in the fair value of the fair value hedges are accounted for in the income statement, as are changes in the fair value of the borrowings.

During the quarter ended March 31, 2003, we entered into interest rate swap agreements totaling $100 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. We also entered into an interest rate swap agreement totaling $25 million in connection with a $25 million borrowing from the FHLB. This interest rate swap agreement is also accounted for as a fair value hedge. During the quarter ended March 31, 2003, nine interest rate swaps with a notional amount of $67.5 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of March 31, 2003 had a notional amount of $345 million and an estimated fair value of $3.1 million. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of $(1.2) million. Interest rate swaps accounted for as fair value hedges had a notional amount of $325 million and an estimated fair value of $4.3 million.

During the quarter ended March 31, 2002, we entered into interest rate swap agreements totaling $82.5 million in connection with the issuance of like amounts of our certificates of deposit. These interest rate swap agreements are accounted for as fair value hedges. During the quarter ended March 31, 2002, two interest rate swaps with a notional amount of $20 million were terminated with no resulting gain or loss. Total interest rate swaps outstanding as of March 31, 2002 had a notional amount of $227.5 million and an estimated fair value of $(4.9) million. Interest rate swaps accounted for as cash flow hedges had a notional amount of $20 million and an estimated fair value of $(450) thousand. Interest rate swaps accounted for as fair value hedges had a notional amount of $207.5 million and an estimated fair value of $(4.5) million.

NOTE 4 - LOANS RECEIVABLE

Loans receivable consist of the following:

	March 31, 2003		December 31, 2002

Construction and land development
Residential	$	47,528,653	$	40,574,606
Commercial		55,858,345		42,052,397
Mortgage
Residential		70,758,909		77,697,538
Multifamily Residential		8,808,927		9,437,833
Commercial		279,773,712		253,957,848
Commercial and Industrial		167,340,772		170,775,878
Consumer		9,689,354		12,889,502

Total loans receivable		639,758,672		607,385,602
Less:
Deferred loan fees, net		3,016,915		2,804,883
Allowance for loan losses		10,820,395		10,257,449

Loans receivable, net	$	625,921,362	$	594,323,270

Debt obligations in the amount of $24.2 million are classified as commercial and industrial loans in the table above as of March 31, 2003. Debt obligations in the amount of $32.5 million are classified as commercial and industrial loans as of December 31, 2002.

The following sets forth information regarding the allowance for loan losses:

	Three Months Ended 3/31/03			Three Months Ended 3/31/02


Allowance at beginning of period	$	10,257,449		$	7,354,289

Provision for losses charged to income		1,215,000			1,500,000
Charge-offs		(1,560,310	)		(1,580,857	)
Recoveries		908,256			288,202


Allowance at end of period	$	10,820,395		$	7,561,634

The following table sets forth information regarding past due and nonperforming assets as of the periods indicated:

	At March 31, 2003			At December 31, 2002


Accruing loans 90 days or more delinquent : Commercial and industrial	$	—		$	153,792


Nonperforming loans:
Mortgage-residential		—			158,593
Mortgage-commercial		1,071,455			874,114
Commercial and industrial (1)		2,964,022			1,238,608

Subtotal		4,035,477			2,271,315


Other real estate owned		—			—


Total nonperforming assets	$	4,035,477		$	2,271,315


Nonperforming assets to total assets		0.39	%		0.23	%
Nonperforming assets to total loans and other real estate owned		0.63	%		0.37	%

(1)

Includes $1,523,893 and $822,127 of loans guaranteed by the Small Business Administration (SBA) at March 31, 2003 and December 31, 2002 respectively.

NOTE 5 – EARNINGS PER SHARE

The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of potential dilutive common stock:

	For the three months ended

	March 31, 2003						March 31, 2002

	Amount			Shares	Per Share Amount		Amount			Shares	Per Share Amount


Net income	$	2,706,666					$	2,228,018
Preferred dividends		(2,797	)					(2,963	)

Basic earnings per share	$	2,703,869		5,424,692	$	0.50	$	2,225,055		4,927,283	$	0.45

Effect of dilutive securities:
Stock options				246,545						180,644
Convertible preferred stock				26,241						27,799

Diluted earnings per share	$	2,706,666		5,697,478	$	0.48	$	2,228,018		5,135,726	$	0.43

NOTE 6 – INTANGIBLE ASSETS

Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” (SFAS 142) was issued in June 2001. It discontinues amortization of intangible assets unless they have finite useful lives, and, instead, requires that they be tested at least annually for impairment by comparing their fair values with their recorded amounts. SFAS No. 142 also requires disclosure of the changes in the carrying amounts of goodwill from period to period, the carrying amounts of intangible assets by major intangible asset class for those subject to and not subject to amortization, and the estimated intangible asset amortization expense for the next five years. We adopted SFAS No. 142 as of January 1, 2002, and therefore, discontinued the amortization of goodwill on January 1, 2002. We have evaluated impairment of goodwill under SFAS No. 142 as of June 30, 2002, and we have determined there is no impairment of the goodwill.

During the quarter ended March 31, 2003, a third party completed valuation reports related to the acquisition of the loan portfolio and the core deposits resulting from the merger with Metro-County Bank of Virginia in the third quarter of 2002. Certain adjustments were made to goodwill and core deposit intangible assets based on these valuation reports, and the effect on amortization expense was not material.

Data concerning various intangible assets is presented in the following tables:

	March 31, 2003					December 31, 2002					March 31, 2002

	Gross Carrying Value		Accumulated Amortization			Gross Carrying Value		Accumulated Amortization			Gross Carrying Value		Accumulated Amortization


Amortizable core deposit intangibles	$	2,996,377	$	(521,800	)	$	3,966,163	$	(446,800	)	$	1,566,163	$	(248,900	)
Amortizable other intangibles		361,300		(224,530	)		361,300		(219,430	)		361,300		(167,883	)
Unamortizable goodwill		11,940,843		(145,200	)		11,041,746		(145,200	)		1,586,651		(145,200	)

Amortization expense:

	Other		Core Deposit Intangibles

Three months ended March 31, 2003	$	5,100	$	75,000
Three months ended March 31, 2002		17,184		39,300

Estimated amortization expense:

	Other		Core Deposit Intangibles

Nine months ended December 31, 2003	$	15,300	$	225,000
Year ended December 31,
2004	$	20,400	$	300,000
2005		20,400		300,000
2006		20,400		300,000
2007		20,400		300,000
2008		20,400		300,000

NOTE 7 – LETTERS OF CREDIT

The Bank issues financial standby letters of credit and performance standby letters of credit. A financial standby letter of credit obligates the Bank to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument. A performance standby letter of credit obligates the Bank to pay a third-party beneficiary when a customer fails to perform some contractual non-financial obligation. Both types of standby letters of credit are generally issued for terms ranging from six months to three years. The Bank generally requires collateral to support the letters of credit in excess of the contractual amount of the instruments and essentially uses the same credit policies in issuing letters of credit as it does for on-balance sheet instruments. At March 31, 2003, the Bank had performance standby letters of credit outstanding in the amount of $7.1 million and financial standby letters of credit outstanding in the amount of $1.1. Financial Accounting Standards Board Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN No. 45), took effect January 1, 2003, and did not have a material impact on the Company.

NOTE 8 – SUBSEQUENT EVENT

On April 10, 2003, Southern Financial issued $10 million of Trust Preferred Securities as part of the MM Community Funding IX, LTD pooled underwriting. The Trust Preferred Securities have a floating rate priced at the three-month LIBOR plus 3.25% and mature in 30 years and are classified as long-term subordinated debt securities, which qualify as capital for regulatory banking purposes with certain limitations. We anticipate that all of the proceeds will qualify for Tier I regulatory capital for both the bank and the holding company.

SOUTHERN FINANCIAL BANCORP, INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Financial Condition

Total assets increased to $1.0 billion at March 31, 2003, from $970.2 million at December 31, 2002, an increase of 5.9%. During the first quarter of 2003 loans closed totaled $75.9 million compared with $57.4 million during the first quarter of 2002. Total loans receivable increased 47.9% from March 31, 2002 to March 31, 2003, in part as a result of the $71 million in loans acquired through the Metro-County acquisition that was completed during the third quarter of 2002. Loan growth, excluding the Metro-County acquisition, increased 31.02% from March 31, 2002. For the quarter, investment securities increased to $245.3 million, or 20.5% including $78.5 million of securities purchased and classified as held to maturity. Deposits and borrowings combined with proceeds from investment security repayments and sales funded the loan growth.

Results of Operations

Our operating results depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings. Operating results are also affected by the level of our noninterest income, including income or loss from the sale of loans and fees and service charges on deposit accounts, and by the level of our operating expenses, including compensation, premises and equipment and income taxes.

The following table presents, for the periods indicated, average balances of and weighted average yields on interest-earning assets and average balances of and weighted average effective rates paid on interest-bearing liabilities. Calculations have been made utilizing daily average balances, and the effect of the interest rate swaps is reflected in the average rate on deposits. Loan balances do not include non-accrual loans.

	Three Months Ended March 31,

	2003						2002

	Average Outstanding Balance		Interest Earned/ Paid		Average Yield/Rate Rate		Average Outstanding Balance		Interest Earned/ Paid		Average Yield/Rate Rate

	($ in thousands)
Assets:
Interest-earning assets:
Loans	$	623,878	$	10,061	6.45	%	$	421,969	$	8,035	7.66	%
Securities		224,630		2,823	5.03			326,669		4,753	5.82
Investments		16,864		49	1.17			7,993		32	1.58

Total interest-earning assets		865,372		12,933	5.98	%		756,631		12,820	6.78	%
Less allowance for loan losses		10,518						7,758

Total interest-earning assets, net of allowance		854,854						748,873
Noninterest-earning assets:
Bank owned life insurance		22,419						18,017
Other noninterest-earning assets		60,311						37,848

Total assets	$	937,584					$	804,738


Liabilities and Stockholders’ Equity:
Interest-bearing liabilities:
Interest-bearing demand deposits	$	41,833	$	50	0.48	%	$	35,168	$	101	1.16	%
Savings and money market accounts		112,296		224	0.80			93,057		378	1.65
Time deposits		478,882		2,409	2.01			429,545		3,239	3.06
Other borrowings		108,792		489	1.80			92,860		615	2.65
Company-obligated mandatorily redeemable 11.0% preferred securities of Southern Financial Capital Trust I		5,000		143	11.44			5,000		143	11.44
Company-obligated mandatorily redeemable 10.60% preferred securities of Southern Financial Statutory Trust I		8,000		215	10.74			8,000		215	10.74

Total interest-bearing liabilities		754,803		3,530	1.87	%		663,630		4,691	2.83	%
Noninterest-bearing liabilities:
Demand deposits		83,102						66,012
Other liabilities		17,960						9,850

Total liabilities		855,865						739,492
Stockholders’ equity		81,719						65,246

Total liabilities and stockholder’ equity	$	937,584					$	804,738


Net interest income			$	9,403					$	8,129

Net interest spread					4.11	%					3.95	%
Net interest margin					4.35	%					4.30	%

The following table presents information regarding changes in interest income and interest expense for the periods indicated for each major category of interest-earning asset and interest-bearing liability which distinguishes between the changes attributable to changes in volume (changes in volume multiplied by old rate) and changes in rate (changes in rate multiplied by old volume). The dollar amount of changes in interest income and interest expense attributable to changes in rate/volume (change in rate multiplied by change in volume) have been allocated between rate and volume variances based on the percentage relationship of such variances to each other.

	The Three Months Ended March 31, 2003 Compared to The Three Months Ended March 31, 2002

	Volume			Rate			Net

	($ in thousands)
Interest income
Loans receivable	$	3,442		$	(1,416	)	$	2,026
Investments		(1,189	)		(724	)		(1,913	)

Total interest income		2,253			(2,140	)		113

Interest expense
Interest-bearing deposits		468			(1,502	)		(1,034	)
Borrowings		140			(265	)		(125	)

Total interest expense		608			(1,767	)		(1,159	)

Net interest income		1,645			(373	)		1,272

Our net income was $2.7 million ($.48 diluted earnings per share) for the quarter ended March 31, 2003, an increase in net income of 21.5% over the $2.2 million ($.43 diluted earnings per share) earned for the quarter ended March 31, 2002 Earnings per share for the prior year has been restated to reflect the first quarter 2003 stock dividend. The increase in net income for the quarter ended March 31, 2003 compared with the prior year first quarter was primarily due to increased net interest income and an increased margin. Fee income also increased while the provision for loan losses decreased. Net income was negatively impacted by an increase in net losses on investment securities and other assets, included in other income, and increased operating expenses.

Net interest income for the quarter was $9.4 million, an increase of 15.7% over the same quarter in the prior year. The increase in net interest income was primarily due to growth in earning assets resulting from loan originations, loans acquired through the Metro County Bank merger, and purchases of investment securities. Average earning assets increased 14.4% to $865 million for the quarter ended March 31, 2003 compared with the same quarter in 2002. The net interest margin was 4.35% and 4.30% for the same respective quarters. The higher level of loans outstanding relative to investment securities combined with the declining cost of funds contributed to the improved margin during the first quarter of 2003 compared with the first quarter of 2002. In addition, the margin also improved from 4.12% during the fourth quarter of 2002 to the 4.35% for the first quarter of 2003, due to a further decline in the cost of funds, despite a slight reduction in average earning assets during the two respective quarters.

Credit quality for the first quarter of 2003 remained sound. For the quarters ended March 31, 2003 and 2002, annualized net charge-offs were .42% and 1.22% of average loans, respectively, and .65% for the quarter ended December 31, 2002. The ratios of allowance for loan losses to loans receivable outstanding at March 31, 2003 and 2002 were 1.70% and 1.68%, respectively, compared with 1.70% as of December 31, 2002. At both March 31, 2003 and 2002, the ratio of nonperforming assets to total assets was .24% compared with .15% at December 31, 2002. We continue to monitor the loan portfolio and make charge-offs we deem appropriate, particularly given the uncertainty in the U.S. economy. Due to the uncertainty of risks in the loan portfolio, management’s judgement of the amount of the allowance necessary to absorb loan losses is approximate; however, management believes that the allowance for loan losses at March 31, 2003 is the amount necessary to absorb known and inherent losses in the loan portfolio at that date.

Total other income increased to $904 thousand from $894 thousand for the quarters ended March 31, 2003 and 2002, respectively. During the first quarters of 2003 and 2002, Southern Financial recognized net securities losses totaling $897 thousand and $385 thousand, respectively. Securities losses for the quarter were comprised of net securities gains on sales

totaling $863 thousand offset by $1.8 million of write-downs of residential interest-only strips included in our investment securities portfolio. The additional write downs resulted from accelerated prepayments of the underlying residential mortgage loans which further lowered the value of the interest-only securities. The remaining balance of the residential interest only securities totaled $468 thousand at March 31, 2003. The components of non-interest income other than net gains and losses on investment securities and other assets, increased by 38.0% for the quarters ended March 31, 2003 and 2002, respectively. Areas of increase included account maintenance and electronic banking fees, other loan fees, fees generated from commercial service products including lockbox fees, and the increase in the cash surrender value of bank owned life insurance and gains on sale of loans.

Total non-interest expenses for the quarter were $5.2 million, an increase of 22.1% when compared to the first quarter of 2002. This increase was largely due to approximately $700 thousand of operating expenses associated with Metro-County Bank. The components of non-interest expense other than those associated with Metro-County, increased 8.6%. Employee compensation and benefits, which represents 55% of total expenses, increased 22.2%, of which 12.1% resulted from the Metro-County merger, with the remaining increase due to merit increases and other new hires to support the expanding customer base. Including the Metro-County related expenses, the efficiency ratio remained strong at 45.80% for the first quarter of 2003 compared with 44.61% and 45.68% for the quarters ended March 31, 2002 and December 31, 2002. The efficiency ratio remained below 50% since the first quarter of 2002.

Regulatory Capital Requirements

At March 31, 2003 we exceeded all regulatory capital standards.

Liquidity

The objective of our liquidity management is to assure the ability to meet our financial obligations. These obligations include the payment of deposits on demand or at maturity, the repayment of borrowings at maturity, and the ability to fund loan commitments and other new business opportunities. We obtain funding from a variety of sources, including customer deposit accounts, customer certificates of deposit and payments on our loans and investments. Historically, our level of core deposits has been insufficient to fully fund our lending activities. Therefore, we must seek funding from additional sources, including brokered certificates of deposit, available-for-sale investment securities, lines of credit from the Federal Home Loan Bank of Atlanta and reverse repurchase agreement borrowings from approved securities dealers. In addition, we use derivative products such as interest rate swaps to enhance our liquidity through the issuance of long-term liabilities to match with our long-term assets. We also enhance our liquidity by monitoring unfunded loan commitments, which reduces unexpected funding requirements.

During the three months ended March 31, 2003, we funded our financial obligations with deposits, borrowings from the Federal Home Loan Bank of Atlanta, and sales of investment securities. At March 31, 2003, we had $49.0 million of unfunded lines of credit and undisbursed construction loan funds of $46.5 million. Approved loan commitments were $13.2 million at March 31, 2003. It is anticipated that funding requirements for these commitments can be met from the normal sources of funds.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with the accounting principles generally accepted in the United States of America and conform with general practices in the banking industry. The preparation of financial statements in conformity with these principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on information available at the date of the financial statements and could differ from actual results. The more critical of the accounting policies involves the determination of the allowance for loan losses and accounting for derivative financial instruments.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses, which is charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is a current estimate of the known and inherent losses in the present portfolio based upon management’s evaluation of the loan portfolio. Estimates of losses inherent in the portfolio involve the exercise of judgment and the use of assumptions. The evaluations take into consideration such factors as changes in the nature, volume and quality of the loan portfolio, prior loss experience, level of nonperforming loans, current and anticipated general economic conditions and the

value and adequacy of collateral. Changes in the estimate of losses may occur due to changing economic conditions and the economic conditions of borrowers.

A loan is considered impaired when, based on all current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the agreement, including all scheduled principal and interest payments. Such impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate or, as a practical expedient, impairment may be measured based on the loan’s observable market price, or if, the loan is collateral – dependent, the fair value of the collateral. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through a valuation allowance. Loans for which foreclosure is probable continue to be accounted for as loans.

Each impaired loan is evaluated individually to determine the income recognition policy. Generally, payments received are applied in accordance with the contractual terms of the note or as a reduction of principal.

Derivative Financial Instruments

As part of our interest rate risk management, we use interest rate swaps that are accounted for as both cash flow and fair value hedges in accordance with Statement of Financial Accounting Standards No. 133. Cash flow hedges are used to hedge variable interest rate assets or liabilities and fair value hedges are used to hedge fixed rate assets or liabilities. At the inception of the hedge, the risk management objective and strategy, the hedged risk, the derivative instrument, the hedged item and how hedge effectiveness will be assessed initially and on an ongoing basis are documented. At inception of the hedge and on an ongoing basis, the hedge must be deemed to be highly effective in hedging the hedged risk in order to qualify for hedge accounting. Effectiveness is measured by comparing the change in LIBOR (which the interest rate swap is priced from) to the change in the rate underlying the hedged asset or liability. If high correlation is not achieved, the hedging designation is discontinued with the change in the fair value of the interest rate swap recorded as other income or expense. In the event that any derivative that meets the requirements for hedge accounting or hedged item is terminated or sold, the gain or loss on the derivative will be amortized over the remaining life of the item hedged. Interest to be received or paid on the interest rate swaps is accrued monthly.

We use interest rate swaps that are accounted for as cash flow hedges to hedge the issuance of pools of certificates of deposit (CDs) which reprice with changes in market interest rates. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is tied to three-month LIBOR, which approximates the issuance rate on the pool of CDs. The combination of the swaps and the issuance of the pool of CDs operates to produce long-term fixed rate deposits. The fair value of the interest rate swap is recorded in other assets in the consolidated balance sheets with changes in the fair value included in other comprehensive income. To the extent that the hedge is not completely effective, the ineffective portion is charged or credited to other income or expense in the consolidated statements of income. The amounts recorded in other comprehensive income are subsequently reclassified into interest expense as a yield adjustment in the same period in which the related interest on the CDs affect earnings.

We also use interest rate swaps that are accounted for as fair value hedges to hedge the issuance of individual fixed rate CDs. Under the terms of these interest rate swaps, we are the fixed rate receiver and the floating rate payer. The floating rate on the interest rate swaps is generally tied to three-month LIBOR, which approximates the issuance rate on the individual CDs. The combination of the swaps and the issuance of the individual CDs operates to produce long-term floating rate deposits. The terms of the CDs and the interest rate swaps mirror each other and were committed to simultaneously. Both the interest rate swap (included in other assets in the consolidated balance sheets) and the CDs are recorded at fair value, with changes in fair value included in the statements of income as interest expense.

We also use interest rate swaps that are accounted for as fair value hedges to hedge floating rate borrowings from the FHLB. Under the terms of these interest rate swaps, we are the fixed rate payer and the floating rate receiver. The floating rate on the interest rate swaps is generally tied to three-month LIBOR, which approximates the rate on the borrowings. The combination of the swaps and the borrowings operates to produce long-term fixed rate borrowings. The terms of the borrowings and the interest rate swaps mirror each other and were committed to simultaneously. Both the interest rate swap (included in other assets in the consolidated balance sheets) and the borrowings are recorded at fair value, with changes in fair value included in the statements of income as interest expense.

We incorporate all items from the consolidated balance sheet as well as off-balance sheet items such as derivative items used to hedge balance sheet items in an overall assessment of its interest rate risk. All on-balance sheet items and off-balance sheet items are incorporated in a report that is generated quarterly by a third pary that assesses the interest rate risk in different interest rate environments. The report shows how the market value of our portfolio value of equity changes when interest rates rise or fall 1%, 2%, and 3%. The report also shows the change in net interest income in the same interest rate

change scenarios.

Special Note Regarding Forward-looking Information

Certain statements under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Quarterly Report and the documents incorporated herein by reference constitute “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Southern Financial, or industry results, to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in Southern Financial’s market area, inflation, fluctuations in interest rates, changes in government regulations and competition, which will, among other things, impact demand for loans and banking services; the ability of Southern Financial to implement its business strategy; and changes in, or the failure to comply with, government regulations.

Forward-looking statements are intended to apply only at the time they are made. Moreover, whether or not stated in connection with a forward-looking statement, Southern Financial undertakes no obligation to correct or update a forward-looking statement should Southern Financial later become aware that it is not likely to be achieved. If Southern Financial were to update or correct a forward-looking statement, investors and others should not conclude that Southern Financial would make additional updates or corrections thereafter.

Item 3 – Quantitative and Qualitative Disclosure about Market Risk

We are engaged primarily in the business of investing funds obtained from deposits and borrowings into interest-bearing loans and investments. Consequently, our earnings depend to a significant extent on our net interest income, which is the difference between the interest income on loans and investments and the interest expense on deposits and borrowing. To the extent that our interest-bearing liabilities do not reprice or mature at the same time as our interest-bearing assets, we are subject to interest rate risk and corresponding fluctuations in net interest income. We have employed asset/liability management policies that attempt to manage our interest-earning assets and interest-bearing liabilities, thereby attempting to control the volatility of net interest income, without having to incur unacceptable levels of credit or investment risk.

We actively manage our overall exposure to changes in interest rates. In managing our funding, we first attempt to gauge the direction of interest rates, which will determine how much sensitivity we are willing to take. If rates are decreasing, we seek to fund with liabilities that reprice in the near future. If rates are rising, we attempt to do the opposite. When necessary, we will enter into interest rate swaps, financial options or forward delivery contracts for the purpose of reducing interest rate risk.

Management uses a duration gap of equity approach to manage our interest rate risk and reviews quarterly interest sensitivity reports prepared for us by a third party. This approach uses a model which generates estimates of the change in our market value of portfolio equity (“MVPE”) over a range of interest rate scenarios. MVPE is the present value of expected cash flows from assets, liabilities and off-balance sheet contracts using standard industry assumptions about estimated loan prepayment rates, reinvestment rates and deposit decay rates.

With respect to our residential mortgage loan portfolio, it is our policy to retain those mortgage loans which have an adjustable interest rate and to sell most fixed rate mortgage loans originated into the secondary market. In addition, our commercial loans generally have rates that are tied to the prime rate, the one-year Constant Maturity Treasury (“CMT”) rate as reported by the Federal Reserve Board, or the three-year CMT rate. Both of these actions help control our exposure to rising interest rates.

The following table prepared by a third party sets forth an analysis of our interest rate risk as measured by the estimated change in MVPE resulting from instantaneous and sustained parallel shifts in the yield curve (plus or minus 300 basis points, measured in 100 basis point increments) as of March 31, 2003 and December 31, 2002:

Sensitivity of Market Value of Portfolio Equity
As of March 31, 2003
(dollars in thousands)

Change in Interest Rates In Basis Points (Rate Shock)	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of

	Amount		$ Change From Base			% Change From Base		Total Assets		Portfolio Equity Book Value

Up 300	$	83,159	$	(28,862	)	(25.76	)%	8.10	%	100.55	%
Up 200		92,834		(19,187	)	(17.13	)	9.04		112.25
Up 100		102,889		(9,132	)	(8.15	)	10.02		124.41
Base		112,021		—		—		10.91		135.45
Down 100		118,890		6,869		6.13		11.57		143.75
Down 200		120,127		8,106		7.24		11.69		145.25
Down 300		124,285		12,264		10.95		12.10		150.28

Sensitivity of Market Value of Portfolio Equity
As of December 31, 2002
(dollars in thousands)

Change in Interest Rates In Basis Points (Rate Shock)	Market Value of Portfolio Equity							Market Value of Portfolio Equity as a % of

	Amount		$ Change From Base			% Change From Base		Total Assets		Portfolio Equity Book Value

Up 300	$	77,014	$	(19,033	)	(19.82	)%	7.94	%	94.72	%
Up 200		85,031		(11,016	)	(11.47	)	8.76		104.59
Up 100		93,808		(2,239	)	(2.33	)	9.67		115.38
Base		96,047		—		0.00		9.90		118.13
Down 100		100,057		4,010		4.18		10.31		123.07
Down 200		99,367		3,320		3.46		10.24		122.22
Down 300		97,493		1,446		1.51		10.05		119.91

The change in the market value of portfolio equity in the base case from $96.0 million at December 31, 2002 to $112.0 million at March 31, 2003 is due primarily to the fact that we were able to increase the spread to market rates on commercial loans and to decrease the spread to market rates on certificates of deposit during the quarter. This is also the reason that all of the percentage changes are greater as of March 31, 2003 than as of December 31, 2002.

Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. Modeling changes in MVPE requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. Accordingly, although the MVPE table provides an indication of our interest rate risk exposure at a particular point in time, such measurement is not intended to and does not provide a precise forecast of the effect of changes in market interest rates on our worth.

Item 4 - Controls and Procedures

Our management, including the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures within 90 days of the filing of this quarterly report, and , based on their evaluation, the Chief Executive Officer and the Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

SOUTHERN FINANCIAL BANCORP, INC.

Part II. OTHER INFORMATION

Item 1.

LEGAL PROCEEDINGS

The bank and we are involved in legal proceedings arising in the normal course of business from time to time. Management believes that neither we nor the bank are a party to, nor is any of our property the subject of, any material pending or threatened legal proceedings which, if determined adversely, would have a material adverse effect upon our consolidated position, results of operations or cash flows.

Item 2.

CHANGES IN SECURITIES

Not applicable

Item 3.

DEFAULTS UPON SENIOR SECURITIES

Not applicable

Item 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable

Item 5.

OTHER INFORMATION

Not applicable

Item 6.

EXHIBITS AND REPORTS ON FORM 8-K

Exhibits Required
99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes- Oxley Act of 2002

Reports on Form 8-K
No reports on Form 8-K were filed during the quarter ended March 31, 2003.

SOUTHERN FINANCIAL BANCORP, INC.

Part III. SIGNATURES

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

			SOUTHERN FINANCIAL BANCORP, INC.
			(Registrant)
Date 5/15/2003			/s/ GEORGIA S. DERRICO

			Georgia S. Derrico Chairman and Chief Executive Officer (Duly Authorized Representative)


Date 5/15/2003			/s/ WILLIAM H. LAGOS

			William H. Lagos Senior Vice President and Controller Principal Accounting Officer (Duly Authorized Representative)

I, Georgia S. Derrico, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Southern Financial Bancorp, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

May 15, 2003


/s/ GEORGIA S. DERRICO

Georgia S. Derrico Chairman and Chief Executive Officer

I, Patricia A. Ferrick, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Southern Financial Bancorp, Inc.;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

May 15, 2003


/s/ PATRICIA A. FERRICK

Patricia A. Ferrick Chief Financial Officer and Senior Vice President

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