SOUTHERN FINANCIAL BANCORP INC /VA/ - 10-K Annual Report

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U.S. Securities and Exchange Commission
Washington, D.C. 20549

FORM 10-K

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
OR

[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the transition period from ________ to

For the year ended: Commission File No.:
December 31, 2001 0-22836

SOUTHERN FINANCIAL BANCORP, INC.
--------------------------------
(Exact name of registrant as specified in its charter)

Virginia 54-1779978
------------------------- ----------
(State or other jurisdiction (I.R.S. Employer or
of incorporation or organization) Identification Number)

37 East Main Street, Warrenton, Virginia 20186
----------------------------------------------
(Address of principal executive office)(Zip Code)

(540) 349-3900
--------------
(Registrant's telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12 (g) of the Act:

Common Stock, par value $0.01 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 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 considered herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to this Form 10-K. [_]

The aggregate market value of the Common Stock held by non-affiliates of the
registrant computed by reference to the last reported bid price of such stock as
of February 25, 2002 was $79,048,212 (3,451,887 shares @ $22.90 per share). For
purposes of this computation, it is assumed that directors, executive officers
and persons beneficially owning more than 5% of the Common Stock of the
registrant are affiliates. As of February 25, 2002, there were 4,284,594 shares
of the registrant's Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE
-----------------------------------

I. Portions of the Annual Report to Stockholders for the Year Ended December
31, 2001 are incorporated by reference into certain items of Parts I. and
II.

II. Portions of the Proxy Statement for the Annual Meeting of Stockholders to
be held on April 25, 2002 are incorporated by reference into certain items
of Part III.

Part I.
- -------

Item 1. Business
- ----------------

Overview

We were formed in 1995 as a bank holding company for Southern Financial
Bank (the Bank), which was chartered in 1986. Our financial performance has been
characterized by steady asset growth, consistent core earnings and sound asset
quality. We have grown through a combination of internal growth, the opening of
de novo branches and the acquisition of community banks and branches in our
market. We have established 13 branches and acquired one branch in the last 16
years. Two acquisitions, The Horizon Bank of Virginia in October 1999 and First
Savings Bank of Virginia in September 2000 added $205.0 million in assets,
provided us with six additional branch locations and enhanced our core deposit
base. We currently operate 20 full-service banking locations, 19 of which are
located in the northern Virginia cities of Warrenton, Herndon, Middleburg,
Winchester, Leesburg, Fairfax, Sterling, Woodbridge, Manassas and
Fredericksburg. In August 2001 we opened our twentieth branch in Georgetown in
the District of Columbia and, in January 2002 we opened a branch in
Charlottesville, Virginia.

We have expanded from our roots in Fairfax County, where we maintain
eight branches and 61% of our transactional deposits, to encompass a market area
extending from Winchester in northwest Virginia to Fredericksburg, approximately
100 miles to the southeast. This area has been characterized by high growth and
general affluence. As its economy has diversified away from a concentration in
government and government-related employment, northern Virginia has developed
into a major center for technology and telecommunications activities and has a
high concentration of small to medium-sized businesses representing a diverse
array of industries. In the process, Reston, Herndon, Tysons Corner and Fairfax
have become important stand alone employment centers similar to Stamford,
Connecticut and White Plains, New York, which have flourished outside of New
York City. As a result, the "bedroom communities" supporting business clusters
have pushed west to Loudoun and Fauquier Counties and south and west to
Stafford, Spotsylvania and Prince William Counties. We also believe that the
high growth and general affluence in certain of the areas adjoining our current
market area provide the same attractive expansion opportunities. In addition to
the District of Columbia, we believe that Montgomery County, Maryland and the
Richmond, Virginia area are also attractive targets. Upon the opening of our
branch in Charlottesville, our market area expands to include Albemarle, Greene
and Fluvanna Counties, all of which have experienced rapid population growth in
the last decade.

On September 1, 2000, we acquired all the outstanding common stock of
First Savings Bank of Virginia for 409,906 shares of our common stock. The
acquisition has been accounted for by the purchase method, and accordingly, the
results of operations of First Savings Bank have been included in our
consolidated financial statements from September 1, 2000. Goodwill of $1,646,651
was recorded, which is being amortized on a straight-line basis over 15 years
along with a core deposit premium of $1,566,163, which is being amortized over
10 years. In connection with our adoption of Statement No. 142, Goodwill and
Other Intangible Assets, beginning January 1, 2002, this goodwill will no longer
be amortized.

On December 28, 1999, we formed Southern Financial Capital Trust I, a
wholly-owned subsidiary, for the purpose of issuing redeemable capital
securities. On May 24, 2000, a $5 million offering of redeemable capital
securities was completed, and on September 7, 2000, $8 million of trust
preferred securities were issued through a pooled underwriting totaling
approximately $300 million.

On October 1, 1999, we completed our merger with The Horizon Bank of
Virginia ("Horizon"). The merger qualified as a tax-free exchange and was
accounted for as a pooling of interests. We issued .63 shares of our common
stock for each share of Horizon stock outstanding. A total of 1,045,523 shares
(after adjustment for fractional shares) of our common stock were issued as a
result of the merger. Horizon had no stock options outstanding prior to the
merger. Southern Financial and Horizon incurred $3,973,530 of merger-related
costs that were charged to operations during the year ended December 31, 1999.

Our principal business is the acquisition of deposits from the general
public through our home and branch offices and use of these deposits to fund our
loan and investment portfolios. We seek to be a full service community bank that
provides a wide variety of financial services to our middle market corporate
clients as well as to our retail clients. We are an active commercial lender
that often lends in conjunction with the Small Business Administration 7(a) and
504 loan programs. In addition, we are an active residential construction lender
and offer our retail clients permanent residential mortgage loan alternatives.
We also invest funds in mortgage-backed securities, securities issued by
agencies of the Federal Government, obligations of counties and municipalities
and corporate obligations.

The principal sources of funds for our lending and investment
activities are deposits, amortization and repayment of loans, proceeds from the
sales of loans, prepayments from mortgage-backed securities, repayments of
maturing investment securities, Federal Home Loan Bank advances and other
borrowed money.

Principal sources of revenue are interest and fees on loans and
investment securities, as well as fee income derived from the maintenance of
deposit accounts. Our principal expenses include interest paid on deposits and
advances from the Federal Home Loan Bank and other borrowings, and operating
expenses.

Lending Activities

Our primary strategic objective is to serve the small to medium-sized
business market with an array of unique and useful services, including a full
array of commercial mortgage and nonmortgage loans. These loans include
commercial real estate loans, construction to permanent loans, development and
builder loans, accounts receivable financing, lines of credit, equipment and
vehicle loans, leasing options, commercial overdraft protection and corporate

2

credit cards. We strive to do business in the areas served by our branches, and
all of our marketing and the vast majority of our loan customers are located
within our existing market areas. The only significant exceptions to this local
lending philosophy are loans made with an undertaking from the Small Business
Administration that may from time to time come to us because of our reputation
and expertise as an SBA lender. Prior to making a loan, we obtain detailed loan
applications to determine the borrower's ability to repay, and the more
significant items on these applications are verified through the use of credit
reports, financial statements and confirmations. The following is a discussion
of each of our major types of lending:

Commercial Real Estate Lending

Permanent. Commercial real estate lending includes loans for permanent
financing and construction. Commercial real estate lending typically involves
higher loan principal amounts and the repayment of loans is dependent, in large
part, on sufficient income from the properties securing the loans to cover
operating expenses and debt service. As a general practice, we require our
commercial real estate loans to be secured by well-managed income producing
property with adequate margins and to be guaranteed by responsible parties. We
look for opportunities where cash flow from the collateral provides adequate
debt service coverage and the guarantor's net worth is centered on assets other
than the project we finance. It has been our experience that borrowers whose
assets consist entirely of real estate, especially development projects, are
particularly sensitive to real estate market cycles. In the event of a slowdown
in the real estate market, real estate projects generally come under pressure at
the same time and liquidity of the borrower may be strained. As of December 31,
2001, our commercial real estate loans for permanent financing totaled $185.4
million.

Our underwriting guidelines for commercial real estate loans reflect
all relevant credit factors, including, among other things, the income generated
from the underlying property to adequately service the debt, the availability of
secondary sources of repayment and the overall creditworthiness of the borrower.
In addition, we look to the value of the collateral, while maintaining the level
of equity invested by the borrower.

All valuations on property that will secure loans are performed by
independent outside appraisers who are reviewed by our Executive Vice President
of Risk Management and reported annually to our Credit Committee. We retain a
valid lien on real estate and obtain a title insurance policy that insures the
property is free of encumbrances.

Construction. We recognize that commercial, multifamily and other
nonresidential properties can involve market risk due to the length of time it
may take to bring a finished real estate product to market. As a result, we will
only make these types of loans when pre-leasing or pre-sales and or other credit
factors suggest that the borrower can carry the debt if the anticipated market
and property cash flow projections change during the construction phase. At
December 31, 2001, we had $13.3 million commercial construction loans.

Income producing property loans are supported by evidence of the
borrower's capacity to service the debt. The principals or general partners
guarantee all of our commercial construction loans. Any interest reserves
established on conventional construction loans are not funded with the proceeds
of the loan.

Construction loan borrowers are generally pre-qualified for the
permanent loan by us. We obtain a copy of the contract with the general
contractor who must be acceptable to us. All plans, specifications and surveys
must include proposed improvements. We review feasibility studies and
sensitivity and risk analysis showing sensitivity of the project to variables
such as interest rates, vacancy rates, lease rates and operating expenses for
income producing properties and copies of any previous environment site
assessments if applicable.

Commercial Business Lending

These loans consist of lines of credit, revolving credit facilities,
demand loans, term loans, equipment loans, SBA loans, stand-by letters of credit
and unsecured loans. Commercial business loans are generally secured by accounts
receivable, equipment and other collateral, such as readily marketable stocks
and bonds with adequate margins, cash value in life insurance policies and
savings and time deposits at the Bank. At December 31, 2001, our commercial
business loans totaled $133.3 million, including $37.2 million of corporate
obligations.

In general, commercial business loans involve more credit risk than
residential mortgage loans and real estate-backed commercial loans and,
therefore, usually yield a higher return to us. The increased risk for
commercial business loans is due to the type of collateral securing these loans.
The increased risk also derives from the expectation that commercial loans
generally will be serviced principally from the operations of the business, and
those operations may not be successful. Historical trends have shown these types
of loans to have higher delinquencies than mortgage loans. Because of this, we
often utilize the SBA 7(a) program to reduce the inherent risk associated with
commercial business lending.

Another way that we reduce risk in the commercial loan portfolio is by
taking accounts receivable as collateral. Our accounts receivable financing
facilities, which provide a relatively high yield with considerable collateral
control, are lines of credit under which a company can borrow up to the amount
of a borrowing base which covers all of the company's receivables. From our
customer's point of view, accounts receivable financing is an efficient way to
finance expanding operations because borrowing capacity expands as sales
increase. Customers can borrow from 75% to 90% of qualified receivables placed
in our system less accounts over 60 days past due. In most cases, the borrower's
customers pay us directly. For borrowers with a good track record for earnings
and quality receivables, we will consider pricing based on the prime rate for
transactions in which we lend up to a percentage of qualified outstanding
receivables based on reported agings of the receivables portfolio.

3

We also actively pursue for our customers, equipment lease financing
opportunities other than cars, trucks and other on-road rolling stock. We
provide financing and use a third party to service the leases. Payback is
derived from the cash flow of the borrower, so credit quality may not be any
lower than it would be in the case of an unsecured loan for a similar amount and
term.

SBA Lending

We have developed an expertise in the federally guaranteed SBA program.
The SBA program is an economic development program that finances the expansion
of small businesses. We are a Preferred Lender in the Richmond District and a
Certified Lender in the Washington D. C. District of the SBA. As an SBA
Preferred and Certified Lender, our preapproved status allows us to quickly
respond to customers' needs. Under the SBA program, we originate and fund SBA
7(a) loans that qualify for guarantees up to 85% of principal and accrued
interest. We also originate 504 chapter loans in which we generally provide 50%
of the financing in the form of a first lien. Prior to the second quarter of
2001, we sold the guaranteed portion of our SBA loans into the secondary market.
However, due to a combination of newly implemented prepayment penalties, which
should lower the risk of prepayments, and the relatively high yields associated
with these loans, we intend to hold these loans for the foreseeable future. At
December 31, 2001, our total SBA loans were $71.1 million, which consisted of
$33.6 million of 7(a) program loans and $37.5 million of 504 chapter loans.

We provide SBA loans to potential borrowers who are proposing a
business venture, often with existing cash flow and a reasonable chance of
success. We do not treat the SBA guarantee as a substitute for a borrower
meeting our credit standards, and except for minimum capital levels or maximum
loan terms, the borrower must meet our other credit standards as applicable to
loans outside the SBA process.

Residential Mortgage Lending

Permanent. Residential mortgage loans are secured by single-family
homes. We make fixed and adjustable rate first mortgage loans on residential
properties with terms up to 30 years. We offer second mortgages in conjunction
with our own first mortgages or those of other lenders. In the case of
conventional loans, we typically lend up to 80% of the appraised value of
single-family residences and require private mortgage insurance for loans
exceeding this amount. At December 31, 2001, we had $61.7 million of permanent
residential mortgage loans.

We retain a valid lien on real estate and obtain a title insurance
policy that insures that the property is free of encumbrances. We also require
hazard insurance and flood insurance for all loans secured by real property if
the property is in a flood plain as designated by the Department of Housing and
Urban Development. We also require most borrowers to advance funds on a monthly
basis from which we make disbursements for items such as real estate taxes,
private mortgage insurance and hazard insurance.

Construction. We typically make one to four family residential
construction loans to individuals building their personal residence contracted
through a licensed general contractor, or where the borrower has requested to
act as contractor. Construction loans generally have interest rates of prime
plus one to two percent and fees of one to three points, loan-to-value ratios of
80% or less based on current appraisals and terms of generally nine months or
less. At December 31, 2001, we had $15.7 million of residential construction
loans.

Individual construction loan borrowers are generally pre-qualified for
the permanent loan by another reputable lender. In virtually all cases, when we
make a residential construction loan to a builder, the residence is pre-sold. We
obtain a copy of the contract with the general contractor who must be acceptable
to us. All plans, specifications and surveys must include proposed improvements.
Borrowers must evidence the capacity to service the debt until settlement or in
the event the contract is voided.

Consumer Lending

We offer various types of secured and unsecured consumer loans. We make
consumer loans primarily for personal, family or household purposes as a
convenience to our customer base since these loans are not the focus of our
lending activities. As a general guideline, a consumer's total debt service
should not exceed 40% of his gross income or 45% of net income. For purposes of
this calculation, debt includes house payment or rent, fixed installment
payments, the estimated payment for the loan being requested and the minimum
required payment on any revolving debt. At December 31, 2001, we had $9.3
million of consumer loans.

4

Loan Portfolio Composition

The following table summarizes the composition of our loan portfolio as of
the dates indicated:

2001 2000 1999 1998 1997
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
--------------------------------------------------------------------------------------------------
(amounts in thousands)

Construction and land development
Residential $ 15,711 4% $ 17,816 6% $ 7,853 3% $ 6,949 3% $ 9,470 5%
Commercial 13,349 3% 10,491 3% 8,270 3% 11,214 6% 13,160 6%
Other 1,735 0% 2,535 1% 1,616 1% 2,010 1% 3,655 2%
Mortgage
Residential 61,741 15% 53,165 17% 48,604 20% 54,822 26% 61,328 29%
Commercial 185,367 44% 127,736 40% 108,255 46% 83,114 39% 70,450 34%
Commercial and industrial 133,258 32% 101,002 31% 54,175 23% 40,814 20% 36,578 18%
Consumer 9,272 2% 7,617 2% 9,995 4% 11,559 5% 13,524 6%
-------------------------------------------------------------------------------------------------

Total loans receivable 420,433 100% 320,362 100% 238,768 100% 210,482 100% 208,165 100%

Less:
Deferred loan fees, net 2,106 1,670 1,230 1,065 862
Allowance for loan losses 7,354 4,921 3,452 3,062 2,743
--------- --------- -------- -------- ---------

Loans receivable, net $410,973 $313,771 $234,086 $206,355 $204,560
========= ========= ======== ======== =========

The following table sets forth the contractual maturity ranges of the
commercial and industrial loans and construction loans and the amount of those
loans with predetermined and floating interest rates in each maturity range as
of December 31, 2001:

Over 1 Year
Through 5 Years Over 5 years
One Year Fixed Floating Fixed Floating
or Less Rate Rate Rate Rate Total
------------ ------------ ----------- ------------ ------------ ------------
(amounts in thousands)

Construction:
Residential $ 14,691 $ - $ 1,020 $ - $ - $ 15,711
Commercial 11,547 1,022 780 13,349
Other 876 352 264 43 200 1,735
Commercial and Industrial 48,626 22,643 12,672 28,642 20,675 133,258
------------ ------------ ----------- ------------ ------------ ------------

Total $ 75,740 $ 22,995 $ 14,978 $ 28,685 $ 21,655 $ 164,053
============ ============ =========== ============ ============ ============

Credit Approval and Collection Policies

Because long-term credit performance is so closely associated with a
bank's underwriting policy, we have instituted what management believes is a
stringent loan underwriting policy. Our underwriting guidelines are tailored for
particular credit types, including lines of credit, revolving credit facilities,
demand loans, term loans, equipment loans, real estate loans, SBA loans,
stand-by letters of credit and unsecured loans. We will make extensions of
credit based on, among other factors, the potential borrower's creditworthiness,
likelihood of repayment and proximity to market areas served.

We have a standing Credit Committee comprised of certain of our
officers, each of whom has a defined lending authority as an individual and in
combination with other officers. These individual lending authorities are
determined by our Chief Executive Officer and certain directors and are based on
the individual's technical ability and experience. These authorities must be
approved by our board of directors and the Credit Committee. Our Credit
Committee is comprised of four levels of members: junior, regular, senior and
executive, based on experience. Our executive members are our Chief Executive
Officer, our President and our Executive Vice President. Under our loan approval
process, the sponsoring loan officer's approval is required on all credit
submissions. This approval must be included in or added to the individual and
joining authorities outlined below. The sponsoring loan officer is

5

primarily responsible for the customer's relationship with us, including, among
other things, obtaining and maintaining adequate credit file information. We
require each loan officer to maintain loan files in an order and detail that
would enable a disinterested third party to review the file and determine the
current status and quality of the credit.

In addition to approval of the sponsoring loan officer, we require
approvals from one or more members of the Credit Committee on all loans. The
approvals required differ based on the size of the borrowing relationship. At
least one senior or one executive member must approve all loans in the amount of
$100,000 or more. All three of the executive members of the Committee must
approve all loans of $1 million or more. Regardless of the number of approvals
needed, we encourage each member to treat his or her approval as if it were the
only approval necessary to approve the loan. Our legal lending limit to one
borrower is limited to 15% of our unimpaired capital and surplus. As of December
31, 2001, our lending limit was approximately $9.7 million, although we had no
loans to one borrower that approached our legal lending limit at that date.

The following collection actions are the minimal procedures which
management believes are necessary to properly monitor past due loans and leases.
When a borrower fails to make a payment, we contact the borrower in person, in
writing and by telephone. At a minimum, all borrowers are notified by mail when
payments of principal and/or interest are five days past due and when payments
are 10 days past due. In addition, consumer loan borrowers are assessed a late
charge when payments are 10 days past due. Real estate and commercial loan
borrowers are assessed a late charge when payments are 15 days past due.
Customers are contacted by a loan officer before the loan becomes 60 days
delinquent. After 90 days, if the loan has not been brought current or an
acceptable arrangement is not worked out with the borrower, we will institute
measures to remedy the default, including commencing foreclosure action with
respect to mortgage loans and repossessions of collateral in the case of
consumer loans.

If foreclosure is effected, the property is sold at a public auction in
which we may participate as a bidder. If we are the successful bidder, we
include the acquired real estate property in our real estate owned account until
it is sold. These assets are carried at the lower of cost or fair value net of
estimated selling costs. To the extent there is a decline in value, that amount
is charged to operating expense.

Past Due Loans and Nonperforming Assets

Nonperforming assets were $1.5 million at December 31, 2001 compared
with $1.9 million at December 31, 2000 reflecting continued strong asset
quality. Our ratio of nonperforming assets to total loans and other real estate
owned was 0.35% at December 31, 2001 and 0.61% at December 31, 2000.

Nonperforming assets were $1.9 million at December 31, 2000 compared
with $2.9 million at December 31, 1999, a decrease of $1.0 million. The ratio of
nonperforming assets to total loans and other real estate owned was 0.61% at
December 31, 2000 and 1.20% at December 31, 1999.

We generally place a loan on nonaccrual status when it becomes 90 days
past due. Loans are also placed on nonaccrual status in cases where we are
uncertain whether the borrower can satisfy the contractual terms of the loan
agreement. Cash payments received while a loan is categorized as nonaccrual are
recorded as a reduction of principal as long as doubt exists as to future
collections.

We maintain appraisals on loans secured by real estate, particularly
those categorized as nonperforming loans and potential problem loans. In
instances where appraisals reflect reduced collateral values, we make an
evaluation of the borrower's overall financial condition to determine the need,
if any, for possible writedowns to their net realizable values. We record other
real estate owned at the lower of our recorded investment in the loan or fair
value less our estimated costs to sell.

6

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

At December 31,
2001 2000 1999 1998 1997
------------- ------------- -------------- ------------- -------------
(amounts in thousands)

Accruing loans 90 days or more delinquent (1):
Mortgage-commercial $ - $ - $ - $ 372 $ -
Commercial and industrial - 1 226 283 71
Consumer - 8 9 231 6
------------- ------------- ------------- ------------- -------------
Total - 9 235 886 77
============= ============= ============= ============= =============

Nonperforming loans:
Construction-residential - 56 - - -
Mortgage-residential 343 499 413 291 443
Mortgage-commercial 1,130 1,317 109 1,033 1,002
Commercial and industrial - - - 1,576 889
Consumer - - - 6 74
------------- ------------- ------------- ------------- -------------
Subtotal 1,473 1,872 522 2,906 2,408
------------- ------------- ------------- ------------- -------------
Troubled debt restructuring:
Mortgage-commercial - 49 68 - -
------------- ------------- ------------- ------------- -------------
Other real estate owned:
Mortgage-residential - 17 - - -
Mortgage-commercial - - 2,296 498 722
------------- ------------- ------------- ------------- -------------
Subtotal - 17 2,296 498 722
------------- ------------- ------------- ------------- -------------
Total nonperforming assets $ 1,473 $ 1,938 $ 2,886 $ 3,404 $ 3,130
============= ============= ============= ============= =============

Nonperforming assets to total assets 0.19% 0.32% 0.71% 0.84% 0.88%
Nonperforming assets to total loans and
other real estate owned 0.35% 0.61% 1.20% 1.62% 1.50%

- --------------------------------------

(1) Accruing loans 90 days or more delinquent includes portions guaranteed by
the Small Business Administration.

Our loss and delinquency experience on our residential real estate loan
portfolio has been limited by a number of factors, including our underwriting
standards. Whether our loss and delinquency experience in this area of our
portfolio will increase significantly depends upon the value of the real estate
securing loans and economic factors such as increases in unemployment as well as
the overall economy of the region. Management believes that the allowance for
loan losses at December 31, 2001 is a reasonable estimate of known and inherent
losses in the loan portfolio at that date.

At December 31, 2001, loans totaling $7.1 million were considered
potential problem loans and are not reported in the table above. These loans are
subject to management attention and their classification is reviewed on a
quarterly basis.

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Allowance for Loan Losses

The following table summarizes activity in our allowance for loan
losses during the periods indicated:

As of and for the Years Ended December 31,
--------------------------------------------------------------------------
2001 2000 1999 1998 1997
----------- ----------- ---------- ---------- -----------
(dollars in thousands)

Total loans at end of period, net of deferred fees $ 418,328 $ 318,692 $ 237,539 $ 209,417 $ 207,538
=========== =========== ========== ========== ===========

Average loans outstanding $ 353,147 $ 267,186 $ 219,286 $ 205,208 $ 193,094
=========== =========== ========== ========== ===========

Allowance at beginning of period $ 4,921 $ 3,452 $ 3,062 $ 2,743 $ 2,374
Provision for losses 4,470 1,335 2,130 1,301 1,265
Allowance acquired from First Savings Bank - 594 - - -
Charge-offs:
Construction and land development
Residential - - - (81) -
Commercial - - - (261) -
Mortgage
Residential (25) (232) (775) (140) (65)
Commercial (105) (100) (480) - (200)
Commercial and industrial (2,175) (488) (736) (514) (256)
Consumer (113) (54) (55) (9) (413)
----------- ----------- ---------- ---------- -----------
Total charge-offs $ (2,418) (874) (2,046) (1,005) (934)
----------- ----------- ---------- ---------- -----------
Recoveries 381 414 306 23 38
----------- ----------- ---------- ---------- ------------
Net charge-offs (2,037) (460) (1,740) (982) (896)
----------- ----------- ---------- ---------- -----------
Allowance at end of period $ 7,354 $ 4,921 $ 3,452 $ 3,062 $ 2,743
=========== =========== ========== ========== ===========

Ratio of allowance to end of period loans 1.76% 1.54% 1.45% 1.46% 1.32%

Ratio of net charge-offs to average loans outstanding 0.58% 0.17% 0.79% 0.48% 0.46%

Our allowance for loan losses is established through charges to
earnings in the form of a provision for loan losses. Management evaluates the
allowance at least quarterly. In addition, on a quarterly basis our board of
directors reviews our loan portfolio, conducts an evaluation of the credit
quality and reviews the loan loss provision, recommending changes as may be
required. In evaluating the allowance, management considers the growth,
composition and industry diversification of the portfolio, historical loan loss
experience, current delinquency levels and general economic conditions.

The allowance for loan losses represents management's estimate of an
amount appropriate to provide for known and inherent losses in the loan
portfolio in the normal course of business. We make specific allowances for each
loan based on its type and classification as discussed below. However, there are
additional factors contributing to losses that cannot be quantified precisely or
attributed to particular loans or categories of loans, including general
economic and business conditions and credit quality trends. We have established
an unallocated portion of the allowance based on our evaluation of these
factors, which management believes is prudent and consistent with regulatory
requirements. 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. The allowance is also subject to regulatory examinations
and determination by the regulatory agencies as to the appropriate level of the
allowance.

We follow a loan review program designed to evaluate the credit risk in
our loan portfolio. Through this loan review process, we maintain an internally
classified watch list that helps management assess the overall quality of the
loan portfolio and the level of the allowance for loan losses. In establishing
the appropriate classification for specific assets, management considers, among
other factors, the estimated value of the underlying collateral, the borrower's
ability to repay, the borrower's payment history and the current delinquent
status. As a result of this process, loans are categorized as substandard,
doubtful, loss or special mention and reserves are allocated based on
management's judgement and historical experience.

Loans classified as "substandard" are those loans with clear and
defined weaknesses such as a highly-leveraged position, unfavorable financial
ratios, uncertain repayment sources or poor financial condition which may
jeopardize the liquidation of the debt. They are characterized by the distinct
possibility that we will sustain some losses if the deficiencies are not
corrected. A reserve of 15% is generally allocated to these loans.

Loans classified as "doubtful" are those loans which have
characteristics similar to substandard loans but with an increased risk that
collection or liquidation in full is highly questionable and improbable. A
reserve of 50% is generally allocated to loans classified as doubtful.

8

Loans classified as "loss" are considered uncollectible and of such little
value that their continuance as bankable assets is not warranted. This
classification does not mean that the loan has absolutely no recovery or salvage
value but rather it is not practical or desirable to defer a loss on this asset
even though partial recovery may be effected in the future. A reserve of 100% is
allocated to loans classified as loss.

In addition to the above classification categories, we also categorize
certain loans as "special mention." While special mention loans do not have all
the characteristics of a substandard or doubtful loan, they have one or more
deficiencies which warrant special attention and which corrective management
action, such as accelerated collection practices, may remedy. A reserve of 7% is
generally allocated to special mention loans.

During the evaluation of the loan portfolio, any loans that are not
classified or rated special mention are referred to as "passing loans." We also
assign a reserve allocation to these loans.

The following table describes the allocation of the allowance for loan
losses among various categories of loans and certain other information for the
dates indicated. The allocation is made for analytical purposes only and is not
necessarily indicative of the categories in which future losses may occur. With
respect to investment securities underwritten as loans, the allowance is not
available to cover any impairment that is other than temporary. Because of this,
in the event of other than temporary impairment of an investment security
underwritten as a loan, such impairment must be charged to earnings in the same
manner as an investment security which is not underwritten as a loan.

At December 31,
2001 2000 1999 1998
Percent Percent Percent Percent
of Loans of Loans of Loans of Loans
in Each in Each in Each in Each
Category Category Category Category
to Total to Total to Total to Total
Amount Loans Amount Loans Amount Loans Amount Loans
----------------------- --------------------- -------------------- --------------------
(amounts in thousands)

Construction and land
development
Residential $ 536 4% $ 55 6% $ 32 3% $ 21 3%
Commercial 452 3% 65 3% 34 3% 46 6%
Other 66 0% 10 1% 22 1% 32 1%
Mortgage
Residential 306 15% 219 17% 256 20% 361 26%
Commercial 3,281 44% 1,184 40% 1,021 46% 881 39%
Commercial and industrial 2,019 32% 2,377 31% 921 23% 752 20%
Consumer 304 2% 116 2% 151 4% 151 5%
Unallocated 390 NA 895 NA 1,015 NA 818 NA
------- ---- ------- ---- ------- ---- ------- ----

Allowance for loan losses $ 7,354 100% $ 4,921 100% $ 3,452 100% $ 3,062 100%
======= ==== ======= ==== ======= ==== ======= ====

1997
Percent
of Loans
in Each
Category
to Total
Amount Loans
------------------

Construction and land
development
Residential $ 55 5%
Commercial 43 6%
Other 175 2%
Mortgage
Residential 199 29%
Commercial 1,141 34%
Commercial and industrial 524 18%
Consumer 75 6%
Unallocated 531 NA
------- ----

Allowance for loan losses $ 2,743 100%
======= ====

We have allocated the allowance according to the amount deemed to be
reasonably necessary to provide for losses being incurred within each of the
above categories of loans. These figures are based on gross loans. The increase
in the allowance for loan losses allocated to commercial mortgage loans and
nonmortgage business loans is primarily a result of the increase in the balance
of such loans and a refinement in our methodology of estimating our allowance
for loan losses during 2001.

9

Investment Activities

Our securities portfolio is managed by our President and our Senior Vice
President/Treasurer, both of whom have significant experience in this area, with
the concurrence of our Asset/Liability Committee. In addition to our President
(chairman) and our Senior Vice President/Treasurer, this committee is comprised
of our Chief Executive Officer and three outside directors. Investment
management is performed in accordance with our investment policy, which is
approved annually by the Asset/Liability Committee and the board of directors.
Our investment policy addresses our investment strategies, approval process,
approved securities dealers and authorized investments. At December 31, 2001,
all of our investment securities were classified as available-for-sale and may
be sold as part of our asset/liability management strategy in response to
changes in interest rates and liquidity needs.

Our investment policy authorizes us to invest in:

. GNMA, FNMA and FHLMC mortgage-backed securities (MBS)
. Private-label residential MBS, as long as they carry
investment-grade ratings
. Private-label commercial MBS, as long as they carry
investment-grade ratings
. Collateralized mortgage obligations
. Municipal securities
. Corporate obligations
. Interest-only mortgage-backed strips
. Treasury securities
. Agency securities
. Asset-backed securities
. Interest-rate caps
. Interest-rate swaps

Mortgage-backed securities are securities that have been developed by
pooling a number of real estate mortgages and which are principally issued by
federal agencies such as the Government National Mortgage Association (GNMA),
Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage
Corporation (FHLMC). These securities are deemed to have high credit ratings,
and minimum regular monthly cash flows of principal and interest are guaranteed
by the issuing agencies.

Unlike U.S. Treasury and U.S. government agency securities, which have a
lump sum payment at maturity, mortgage-backed securities provide cash flows from
regular principal and interest payments and principal prepayments throughout the
lives of the securities. Mortgage-backed securities which are purchased at a
premium will generally suffer decreasing net yields as interest rates drop
because homeowners tend to refinance their mortgages. Thus, the premium paid
must be amortized over a shorter period. Conversely, mortgage-backed securities
purchased at a discount will obtain higher net yields in a decreasing interest
rate environment. As interest rates rise, the opposite will generally be true.
During a period of increasing interest rates, fixed rate mortgage-backed
securities do not tend to experience heavy prepayments of principal, and
consequently the average life of these securities will be lengthened. If
interest rates begin to fall, prepayments will increase.

Collateralized mortgage obligations (CMOs) are bonds that are backed by
pools of mortgages. The pools can be GNMA, FNMA or FHLMC pools or they can be
private-label pools. The CMOs are designed so that the mortgage collateral will
generate a cash flow sufficient to provide for the timely repayment of the
bonds. The mortgage collateral pool can be structured to accommodate various
desired bond repayment schedules, provided that the collateral cash flow is
adequate to meet scheduled bond payments. This is accomplished by dividing the
bonds into classes to which payments on the underlying mortgage pools are
allocated. The bond's cash flow, for example, can be dedicated to one class of
bondholders at a time, thereby increasing call protection to bondholders. In
private-label CMOs, losses on underlying mortgages are directed to the most
junior of all classes and then to the classes above in order of increasing
seniority, which means that the senior classes have enough credit protection to
be given the highest credit rating by the rating agencies.

10

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

December 31, December 31, December 31,
2001 2000 1999
----------------- ---------------- -----------------

(amounts in thousands)
Available-for-sale securities (at fair value):
FHLMC mortgage-backed securities $ 11,305 $ 32,128 $ 16,369
GNMA mortgage-backed securities 4,603 13,576 2,589
FNMA mortgage-backed securities 26,429 67,539 25,678
Collateralized mortgage obligations 238,075 95,764 47,798
Obligations of counties and municipalities 859 6,118 3,572
Corporate obligations 19,737 12,416 945
U.S. Treasury and other Government agency obligations 515 2,482 770
FHLB stock 3,375 2,700 1,725
Federal Reserve Bank stock 1,230 615 293
Other equity securities 484 69 69
--------- --------- --------

Total classified as investment securities 306,612 233,407 99,808
Corporate obligations classified as loans 37,213 32,418 -
--------- --------- --------

$ 343,825 $ 265,825 $ 99,808
========= ========= ========

Held-to-maturity securities (at amortized cost):
FHLMC mortgage-backed securities $ - $ - $ 3,837
GNMA mortgage-backed securities - - 17,177
FNMA mortgage-backed securities - - 6,764
Collateralized mortgage obligations - - 6,938
Obligations of counties and municipalities - - 2,395
--------- --------- --------

$ - $ - $ 37,111
========= ========= ========

In December 2000, we transferred investment securities classified as
held-to-maturity with an amortized cost of $48.3 million to the
available-for-sale classification in order to provide us with more flexibility
in managing the interest-rate risk in the investment security portfolio. These
investment securities had gross unrealized gains of $563 thousand and gross
unrealized losses of $228 thousand. Subsequent to the transfer, we sold
investment securities with an amortized cost of $9.6 million, and recognized a
loss of $159 thousand in the fourth quarter of 2000. Because of the transfer, we
will be unable to classify investment securities as held-to-maturity in the
foreseeable future.

11

The following table summarizes the contractual maturity of investment
securities and their weighted average yields as of December 31, 2001:

Available-for-sale

Weighted
Estimated Amortized Average
Fair Value Cost Yield
---------------------------------------------------------------------------------------

Debt obligations:
One year or less $ 25,000 $ 25,000 8.00%
After one through five years 2,513,222 2,485,504 6.90%
After five through ten years 6,144,956 6,197,140 7.73%
After ten years 12,428,557 13,201,243 4.50%
---------------------------
Total 21,111,735 21,908,887 5.68%
---------------------------
Mortgage-backed securities 42,336,121 41,493,040 6.25%
Collateralized mortgage obligations 238,074,675 235,061,328 7.43%
Equity securities 5,089,029 5,089,029 5.60%
---------------------------
Total classified as investment securities 306,611,560 303,552,284 7.11%
---------------------------

Debt obligations classified as loans:
After one through five years 6,093,640 5,954,476 7.53%
After five through ten years 4,081,040 4,103,586 9.10%
After ten years 27,038,675 26,534,248 7.91%
---------------------------
Total classified as loans 37,213,355 36,592,310 7.98%
---------------------------

$343,824,915 $340,144,594 7.20%
===========================

Contractual maturity of mortgage-backed securities and collateralized
mortgage obligations is not a reliable indicator of their expected life because
borrowers have the right to prepay their obligations at any time.

Deposits

Deposits, which represent 89% of our interest-rate sensitive
liabilities as of December 31, 2001, have historically been the primary source
of funding our asset growth. In addition to deposits, we obtain funds from loan
repayments, maturing investments, loan sales, cash flows generated from
operations, capital trust borrowings and Federal Home Loan Bank advances.
Borrowings may be used as an alternative source of lower cost funds or to fund
the origination of certain assets.

The following table sets forth the average balances and weighted
average rates paid, presented on a daily average basis, for our deposits for the
periods indicated:

Year Ended December 31,
2001 2000 1999
--------------------- --------------------- ---------------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
--------- --------- --------- --------- --------- ---------
(amounts in thousands)

Demand $ 66,305 0.00% $ 58,188 0.00% $ 50,501 0.00%
Interest checking 31,398 1.22% 27,124 0.68% 33,993 0.96%
Money market and savings 84,410 2.97% 68,605 3.91% 59,743 3.22%
Certificates of deposit (1) 377,680 4.96% 242,706 6.00% 209,993 5.39%
--------- --------- ---------

$ 559,793 $ 396,623 $ 354,230
========= ========= =========

Weighted average rate 3.86% 4.39% 3.83%
====== ====== ======

- ---------------------------
(1) Includes institutional CD's, some of which are callable and are tied to
interest rate swaps. At December 31, 2001, we had $267.2 million in
institutional CD's, $145.0 million of which are callable and tied to
interest rate swaps.

12

The following table sets forth by time remaining until maturity our
certificates of deposit of $100,000 or more at December 31, 2001:

Time Deposits of
Maturity Period $100,000 or More
--------------------------------------- ----------------------
(amounts in thousands)

Three months or less $ 79,179
Over three months through twelve months 79,794
Over twelve months 149,104
---------------------

Total $ 308,077
=====================

Borrowings

Borrowings consist of short-term and long-term advances from the
Federal Home Loan Bank of Atlanta and capital trust borrowings. Long-term
borrowings totaled $15.0 million at December 31, 2001 and are comprised of three
$5.0 million advances from the Federal Home Loan Bank of Atlanta. These advances
carry an average cost of 6.07% and have call dates ranging from September 2002
to 2004, with maturity dates ranging from September 2009 through 2010. The
following table sets forth information regarding our short-term borrowings at
and for the periods indicated:

Year Ended
December 31,
2001 2000 1999
--------------------------------
(Dollars in thousands)

Ending Balance $ 40,500 $ 19,000 $ -
Average Balance for the Period 81,098 21,088 11,874
Maximum Month-end Balance
During the Period 148,501 47,000 25,000
Average Interest Rate for the Period 4.29% 6.58% 5.23%
Weighted Average Interest Rate at
the End of the Period 2.27% 6.35% -%

In May of 2000, we formed a wholly-owned statutory business trust,
Southern Financial Capital Trust I, which issued $5.0 million in trust preferred
securities and in September of 2000, we formed a second wholly-owned statutory
business trust, Southern Financial Statutory Trust I, which issued $8.0 million
in trust preferred securities. Each trust invested the proceeds in an equivalent
amount of our junior subordinated debentures bearing an interest rate equal to
the distribution rate on the respective issue of trust preferred securities.
Both issuances of debentures will mature in 2030, which date may be shortened to
a date not earlier than 2005 if certain conditions are met, including prior
approval of the Federal Reserve. These debentures, which are the only assets of
each trust, are subordinate and junior in right of payment to all of our present
and future senior indebtedness. We have fully and unconditionally guaranteed
each trust's obligations under the trust preferred securities.

The debentures issued to Capital Trust I accrue interest at an annual
rate of 11.0% of the aggregate liquidation amount, payable quarterly, and the
debentures issued to Statutory Trust I accrue interest at an annual rate of
10.60% of the liquidation preference, payable quarterly. The quarterly
distributions on each issuance of trust preferred securities are paid at the
same rate that interest is paid on the corresponding debentures. Distributions
to the holders of the trust preferred securities are included in interest
expense, within the category entitled borrowings. Under the provisions of each
issue of the debentures, we have the right to defer payment of interest on the
debentures at any time, or from time to time, for periods not exceeding five
years. If interest payments on either issue of the debentures are deferred, the
distributions on the applicable trust preferred securities will also be
deferred.

For financial reporting purposes, the trusts are treated as our
subsidiaries and consolidated in our financial statements. The trust preferred
securities are presented as a separate category of long-term debt on the balance
sheet. Although the trust preferred securities are not included as a component
of stockholders' equity in the balance sheet, for regulatory purposes the
Federal Reserve Board treats a portion of the trust preferred securities as Tier
1 capital. The treatment of the trust preferred securities as Tier 1 or Tier 2
capital, in addition to the ability to deduct the expense of the junior
subordinated debentures for federal income tax purposes, provided us with a
cost-effective method of raising capital to support the bank.

13

Taking the underwriting discount into account, the aggregate amount of the
trust preferred securities have a pretax interest cost to us of 11.05% per
annum. To mitigate the negative impact of this interest cost on our consolidated
net income, we invested the proceeds of the issuance of debentures in investment
securities.

Supervision and Regulation

General

We are a bank holding company within the meaning of the Bank Holding
Company Act of 1956, as amended, and therefore are supervised and examined by
the Board of Governors of the Federal Reserve System. We are also subject to
Virginia laws that regulate banks and bank holding companies that are
administered by the Bureau of Financial Institutions of the State Corporation
Commission of Virginia. Because of the insurance on our deposits, we are also
affected by rules and regulations of the Federal Deposit Insurance Corporation.
We are a member of the Federal Reserve System and the Federal Home Loan Bank of
Atlanta.

The supervision, regulation and examination of us and the bank are intended
primarily for the protection of depositors rather than holders of our
securities.

Bank Holding Company Regulation

We are required to file periodic reports and any additional information
with the Federal Reserve. The Federal Reserve examines us and may examine our
subsidiaries. The State Corporation Commission also may examine us.

The Bank Holding Company Act requires prior Federal Reserve approval for,
among other things, the acquisition of direct or indirect ownership or control
of more than 5% of the voting shares or substantially all of the assets of any
bank, or a merger or consolidation of a bank holding company with another bank
holding company. A bank holding company may acquire direct or indirect ownership
or control of voting shares of any company that is engaged directly or
indirectly in banking or managing or controlling banks or performing services
for its authorized subsidiaries. A bank holding company also may engage in or
acquire an interest in a company that engages in activities which the Federal
Reserve has determined by regulation or order to be so closely related to
banking as to be a proper incident thereto.

The activities permissible to bank holding companies and their affiliates
were substantially expanded by the Gramm-Leach-Bliley Act which became effective
on March 11, 2000. The Gramm-Leach-Bliley Act authorizes affiliations between
commercial banks, investment banks and insurance companies and allows bank
holding companies and state banks, if permitted by state law, to engage in a
variety of new activities. Under the Gramm-Leach-Bliley, a bank holding company
can elect to be treated as a financial holding company. A financial holding
company may engage in any activity and acquire and retain any company that the
Federal Reserve determines to be financial in nature. A financial holding
company also may engage in any activity that is complementary to a financial
activity and does not pose a substantial risk to the safety and soundness of
depository institutions or the financial system generally. The Federal Reserve
must consult with the Secretary of the Treasury in determining whether an
activity is financial in nature or incidental to a financial activity.

We are a legal entity separate and distinct from the bank and transactions
between the bank and any of its nonbanking subsidiaries, including us, and any
of our nonbanking subsidiaries, are subject to Section 23A of the Federal
Reserve Act. Section 23A of the Federal Reserve Act imposes limits on such
transactions. Section 23A defines "covered transactions," which include loans,
and limits a bank's covered transactions with any affiliate to 10% of the bank's
capital and surplus. It also requires that all of a bank's loans to an affiliate
be secured by acceptable collateral, generally United States government or
agency securities.

We and the bank also are subject to Section 23B of the Federal Reserve Act,
which requires that transactions between the bank and any of its affiliates be
on terms and under circumstances, including credit standards, that are
substantially the same or at least as favorable to the bank as those prevailing
at the time for transactions with unaffiliated companies.

Federal Reserve policy requires a bank holding company to act as a source
of financial strength and to take measures to preserve and protect bank
subsidiaries in situations where additional investments in a troubled bank may
not otherwise be warranted. As a result, a bank holding company may be required
to lend money to its subsidiaries in the form of capital notes or other
instruments that qualify as capital under regulatory rules. Any loans from the
holding company to such subsidiary banks likely will be unsecured and
subordinated to such bank's depositors and perhaps to other creditors of its
bank subsidiaries.

Bank Supervision

As a Virginia bank that is a member of the Federal Reserve System, the bank
is regulated and examined by the State Corporation Commission and by its primary
federal regulator, the Federal Reserve. The State Corporation Commission and the
Federal Reserve regulate and monitor all of the bank's operations, including
reserves, loans, mortgages, payments of dividends and the establishment of
branches.

Various statutes limit the ability of the bank to pay dividends, extend
credit or otherwise supply funds to usi and our nonbanking subsidiaries.
Dividends from the bank are expected to constitute our major source of funds.

14

Regulatory Capital Requirements

All banks and bank holding companies are required to maintain minimum
levels of regulatory capital. The federal bank regulatory agencies have
established substantially similar risked based and leverage capital standards
for banks that they regulate. These regulatory agencies also may impose capital
requirements in excess of these standards on a case-by-case basis for various
reasons, including financial condition or actual or anticipated growth. Under
the risk-based capital requirements of these regulatory agencies, we and the
bank are required to maintain a minimum ratio of total capital to risk-weighted
assets of at least 8%. At least half of the total capital is required to be tier
1 capital, which consists principally of common and certain qualifying preferred
shareholders' equity, less certain intangibles and other adjustments. The
remainder, tier 2 capital, consists of a limited amount of subordinated and
other qualifying debt and a limited amount of the general loan loss allowance.
Based upon the applicable Federal Reserve regulations, at December 31, 2001, the
bank was considered to be "well capitalized."

In addition, the federal regulatory agencies have established a minimum
leverage capital ratio, Tier 1 capital divided by tangible assets. These
guidelines provide for a minimum leverage capital ratio of 3% for banks and
their respective holding companies that meet certain specified criteria,
including that they have the highest regulatory examination rating and are not
contemplating significant growth or expansion. All other institutions are
expected to maintain a leverage ratio above that minimum. The guidelines also
provide that banking organizations experiencing internal growth or making
acquisitions will be expected to maintain strong capital positions substantially
above the minimum supervisory levels, without significant reliance on intangible
assets.

Limits on Dividends and Other Payments

Virginia law restricts distributions of dividends to our shareholders. Our
shareholders are entitled to receive dividends as declared by our board of
directors. However, no distribution to our shareholders may be made if, after
giving effect to the distribution, we would not be able to pay our debts as they
become due in the usual course of business or our total assets would be less
than our total liabilities. There are similar restrictions on stock repurchases
and redemptions.

Banks have limits on all capital distributions, including cash dividends,
payments to repurchase or otherwise acquire shares, payments to shareholders of
another institution in a cash-out merger, and other distributions charged
against capital.

The bank may not make a capital distribution, including the payment of a
dividend, if, after the distribution, it would become undercapitalized. The
prior approval of the Federal Reserve is required if the total of all dividends
declared by the bank in any calendar year will exceed the sum of the bank's net
profits for that year and its retained net profits for the preceding two
calendar years. The Federal Reserve also may limit the payment of dividends by
any state member bank if it considers the payment an unsafe or unsound practice.
In addition, under Virginia law no dividend may be declared or paid that would
impair a Virginia chartered bank's paid-in capital. The State Corporation
Commission has general authority to prohibit payment of dividends by a Virginia
chartered bank if it determines that the limit is in the public interest and is
necessary to ensure the bank's financial soundness.

FDIC Regulations

The Federal Deposit Insurance Corporation Improvement Act of 1991 required
each federal banking agency to revise its risk-based capital standards to ensure
that those standards take adequate account of interest rate risk, concentration
of credit risk and the risks of non-traditional activities. Each federal banking
agency has issued regulations, specifying the levels at which a financial
institution would be considered "well capitalized," "adequately capitalized,"
"undercapitalized," "significantly undercapitalized," or "critically
undercapitalized," and to take certain mandatory and discretionary supervisory
actions based on the capital level of the institution. Those supervisory actions
become increasingly severe for banks that are undercapitalized or worse.

Under the Federal Reserve's regulations implementing the prompt corrective
action provisions, an institution is considered well capitalized if it has total
risk-based capital of 10% or more, has a Tier I risk-based capital ratio of 6%
or more, has a leverage capital ratio of 5% or more and is not subject to any
order or final capital directive to meet and maintain a specific capital level
for any capital measure.

An adequately capitalized institution has a total risk-based capital ratio
of 8% or more, a Tier I risk-based ratio of 4% or more and a leverage capital
ratio of 4% or more (3% under certain circumstances) and does not meet the
definition of well capitalized.

An undercapitalized institution has a total risk-based capital ratio that
is less than 8%, a Tier I risk-based capital ratio that is less than 4% or a
leverage capital ratio that is less than 4% (3% in certain circumstances).
Undercapitalized banks are subject to growth limits and are required to submit a
capital restoration plan for approval. For a capital restoration plan to be
acceptable, the bank's parent holding company must guarantee that the bank will
comply with the capital restoration plan. The aggregate liability of the parent
holding company is limited to the lesser of 5% of the bank's total assets at the
time it became undercapitalized and the amount necessary to bring the
institution into compliance with applicable capital standards. If a bank fails
to submit an acceptable plan, it is treated as if it is significantly
undercapitalized. If the controlling holding company fails to fulfill its
obligations and files (or has filed against it) a petition under the federal
Bankruptcy Code, the claim would be entitled to a priority in such bankruptcy
proceeding over third-party creditors.

A significantly undercapitalized institution has a total risk-based capital
ratio that is less than 6%, a Tier I risk-based capital ratio that is less than
3% or a leverage capital ratio that is less than 3%. Significantly
undercapitalized depository institutions may be subject to a number of
requirements and restrictions, including orders to sell sufficient voting stock
to become adequately capitalized, requirements to reduce total assets, and
cessation of receipt of deposits from correspondent banks.

15

A critically undercapitalized institution has a ratio of tangible equity to
total assets that is equal to or less than 2%. A critically undercapitalized
bank is likely to be put in receivership and liquidated.

In addition, under certain circumstances, a federal banking agency may
reclassify a well capitalized institution as adequately capitalized and may
require an adequately capitalized institution or an undercapitalized institution
to comply with supervisory actions as if it were in the next lower category.

The Federal Deposit Insurance Corporation Improvement Act also required
federal banking regulators to draft standards in a number of other important
areas to assure bank safety and soundness, including internal controls,
information systems and internal audit systems, credit underwriting, asset
growth, compensation, loan documentation and interest rate exposure. The Federal
Deposit Insurance Corporation Improvement Act also required the regulators to
establish maximum ratios of classified assets to capital, and minimum earnings
sufficient to absorb losses without impairing capital. The legislation also
contained other provisions which restricted the activities of state-chartered
banks, amended various consumer banking laws, limited the ability of
undercapitalized banks to borrow from the Federal Reserve's discount window and
required federal banking regulators to perform annual onsite bank examinations.

Brokered Deposit Restrictions

Institutions that are only "adequately capitalized" (as defined for
purposes of the prompt corrective action rules described above) cannot accept,
renew or roll over brokered deposits except with a waiver from the FDIC, and are
subject to restrictions on the interest rates that can be paid on such deposits.
Undercapitalized institutions may not accept, renew, or roll over brokered
deposits.

Deposit Insurance Assessments

The bank's deposits are currently insured to a maximum of $100,000 per
depositor, subject to certain aggregation rules. The FDIC has implemented a
risk-related assessment system for deposit insurance premiums. All depository
institutions have been assigned to one of nine risk assessment classifications
based on certain capital and supervisory measures. The bank's deposits are
subject to the rates of the Savings Associations Insurance Fund since it
converted to a commercial bank from a federal savings bank on December 1, 1995.
Based on its current risk classifications, the bank pays the minimum Savings
Associations Insurance Fund assessment and Bank Insurance Fund assessments.

Community Reinvestment Act

The Community Reinvestment Act of 1977, as amended, ("CRA") encourages
banks consistent with their safe and sound operation, to help meet the credit
needs for their entire communities, including low and moderate-income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions, nor does it limit an institution's
discretion to develop the types of products and services that it believes are
best suited to its particular community consistent with the CRA.

A depository institution's primary federal regulator, in connection with
its examination of the institution, must assess the institution's record in
assessing and meeting the credit needs of the community served by that
institution, including low and moderate-income neighborhoods. The regulatory
agency's assessment of the institution's record is made available to the public.
Further, such assessment is required of any institution which has applied to
charter a national bank, obtain deposit insurance coverage for a newly chartered
institution, establish a new branch office that accepts deposits, relocate an
office or merge or consolidate with, or acquire the assets or assume the
liabilities of, a federally regulated financial institution. If a bank holding
company applies for approval to acquire a bank or other bank holding company,
the Federal Reserve will assess the records of each subsidiary depository
institution of the applicant bank holding company, and such records may be the
basis for denying the application.

Fiscal and Monetary Policy

Banking is a business which depends on interest rate differentials. In
general, the difference between the interest paid by a bank on its deposits and
its other borrowings, and the interest received by a bank on its loans and
securities holdings, constitutes the major portion of a bank's earnings. Thus,
our earnings and growth and the earnings and growth of the bank will be subject
to the influence of economic conditions generally, both domestic and foreign,
and also to the monetary and fiscal policies of the United States and its
agencies, particularly the Federal Reserve. The Federal Reserve regulates the
supply of money through various means, including open market dealings in United
States government securities, the discount rate at which banks may borrow from
the Federal Reserve, and the reserve requirements on deposits. We cannot predict
the ultimate effect of the nature and timing of any changes in such policies
will have on our business or on the business of our subsidiaries.

Federal Home Loan Bank System

We are a member of the Federal Home Loan Bank System, which consists of 12
district Federal Home Loan Banks with each subject to supervision and regulation
by the Federal Housing Finance Board. The Federal Home Loan Banks provide a
central credit facility for member institutions. The bank, as a member of the
Federal Home Loan Bank of Atlanta, is required to acquire and hold shares of
capital stock in that Federal Home Loan Bank in an amount equal to at least 1%
of the aggregate principal amount of their unpaid residential mortgage loans,
home purchase contracts and similar obligations at the beginning of each year,
or 5% of their borrowings from the Federal Home Loan Bank of Atlanta, whichever
is greater. At December 31, 2001, we had an investment of $3.4 million in the
stock of the Federal Home Loan Bank of Atlanta and were in compliance with these
requirements.

16

Competition

The banking business is highly competitive, and our profitability depends
principally on our ability to compete in the market areas in which our banking
operations are located. We experience substantial competition in attracting and
retaining savings deposits and in lending funds. The primary factors we
encounter in competing for savings deposits are convenient office locations and
rates offered. Direct competition for savings deposits comes from other
commercial bank and thrift institutions, money market mutual funds and corporate
and government securities which may offer more attractive rates than insured
depository institutions are willing to pay. The primary factors we encounter in
competing for loans include, among others, interest rate and loan origination
fees and the range of services offered. Competition for origination of real
estate loans normally comes from other commercial banks, thrift institutions,
mortgage bankers, mortgage brokers and insurance companies. We have been able to
compete effectively with other financial institutions by emphasizing customer
service and technology; by establishing long-term customer relationships and
building customer loyalty; and by providing products and services designed to
address the specific needs of our customers.

Employees

At December 31, 2001, we had 182 full-time employees, six of whom were
executive officers. Management considers its relations with its employees to be
good. Neither we nor the bank are a party to any collective bargaining
agreement.

17

Item 2. Properties
- --------------------

Offices and Other Material Properties

We conduct business from our main office in Warrenton, Virginia and at
20 branch offices. Our headquarters are located at 37 E. Main Street, Warrenton,
Virginia in an office building we lease. All of our leases are for terms of five
years or more and the expiration dates range from June 2002 to September 2016,
not including any optional renewal periods which may be available.

The following table sets forth the date opened or acquired, ownership
status and the total deposits, not including institutional deposits, for each of
our banking locations:

Date Opened Deposits at
Office Location or Acquired Owned or Leased December 31, 2001
-----------------------------------------------------------------------------------------

Home Office:

37 E. Main Street February Leased $ 24,987
Warrenton, VA 1989

Branch Offices:

362 Elden Street April Leased 23,421
Herndon, VA 1986

101 W. Washington Street November Leased 14,965
Middleburg, VA 1987

33 W. Piccadilly Street November Owned 11,625
Winchester, VA 1990

526 E. Market Street March Leased 29,562
Leesburg, VA 1992

4021 University Drive September Owned 16,134
Fairfax, VA 1993

322 Lee Highway August Leased 29,696
Warrenton, VA 1994

5245 Old Centreville Road April Leased 7,459
Herndon, VA 1995

13542 Minnieville Road April Leased 10,646
Woodbridge, VA 1995

1095 Millwood Pike July Owned 6,051
Winchester, VA 1996

46910 Community Plaza April Leased 3,767
Sterling, VA 1998

18

Date Opened Deposits at
Office Location or Acquired Owned or Leased December 31, 2001
- -------------------------------------------------------------------------------------------

2062 Plank Road January Leased 5,273
Fredericksburg, VA 1999

10175 Hastings Drive March Leased 6,645
Manassas, VA 1999

7857 Heritage Drive (1) October Leased 5,860
Annandale, VA 1999

9720 Lee Highway (1) October Leased 49,920
Fairfax, VA 1999

527 Maple Avenue (1) October Leased 17,547
Vienna, VA 1999

8414 Lee Highway (1) October Owned 45,588
Merrifield, VA 1999

10693 Courthouse Road (2) September Leased 23,863
Fredericksburg, VA 2000

6354 Walker Lane (2) September Leased 20,827
Alexandria, VA 2000

1055 Thomas Jefferson St., NW August Leased 14,296
Washington, DC 2001

300 E. Market Street January Leased 361
Charlottesville, VA 2002

(1) Acquired from the Horizon Bank of Virginia

(2) Acquired from First Savings Bank of Virginia

19

Item 3. Legal Proceedings
- --------------------------

We and the bank from time to time are involved in legal proceedings
arising in the normal course of business. 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 4. Submission of Matters to Vote of Security Holders
- ----------------------------------------------------------

None.

PART II.
- -------

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
- ------------------------------------------------------------------------------

The information required herein is incorporated by reference from page
40 of the Annual Report.

Item 6. Selected Financial Data
- --------------------------------

The information required herein is incorporated by reference from pages
2 and 3 of the Annual Report.

Item 7. Management's Discussion and Analysis
- ---------------------------------------------

The information required herein is incorporated by reference from pages
8 through 16 of the Annual Report.

Item 7a. Quantitative and Qualitative Disclosure about Market Risk
- ------------------------------------------------------------------

The information required herein is incorporated by reference from pages
13 through 15 of the Annual Report.

Item 8. Financial Statements
- -----------------------------

The information required herein is incorporated by reference from pages
17 through 37 of the Annual Report.

Item 9. Changes in and Disagreements With Accountants on Accounting and
- ------------------------------------------------------------------------
Financial Disclosure
- --------------------

None.

PART III.
- --------

Item 10. Directors, Executive Officers, Promoters and Control Persons;
- ----------------------------------------------------------------------
Compliance with Section 16(a) of the Exchange Act
- -------------------------------------------------

The information required herein is incorporated by reference from pages
6 through 10 of the definitive proxy statement of Southern Financial Bancorp,
Inc. filed on March 22, 2002 ("Definitive Proxy Statement").

Item 11. Executive Compensation
- -------------------------------

The information required herein is incorporated by reference from pages
11 through 12 of the Definitive Proxy Statement.

Item 12. Security Ownership of Certain Beneficial Owners and Management
- -----------------------------------------------------------------------

The information required herein is incorporated by reference from pages
8 through 10 of the Definitive Proxy Statement.

Item 13. Certain Relationships and Related Transactions
- -------------------------------------------------------

The information required herein is incorporated by reference from page
7 of the Definitive Proxy Statement.

20

PART IV.
- --------

Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K
- ---------------------------------------------------------------------------

(a) Documents filed as a part of the report:

(1) The following is an index to the financial statements of the
Registrant included in the Annual Report to Stockholders for the year
ended December 31, 2001, and incorporated herein by reference in Item
8. The remaining information appearing in the Annual Report to
Stockholders is not deemed to be filed as part of this Report, except
as expressly provided herein.

Page(s) in
Annual Report
-------------

Independent Auditors' Report 17
Consolidated Balance Sheets:
December 31, 2001 and December 31, 2000 18
Consolidated Statements of Income:
Years Ended December 31, 2001, 2000 and 1999 19
Consolidated Statements of Comprehensive Income:

Years Ended December 31, 2001, 2000 and 1999 20
Consolidated Statements of Changes in Stockholders'
Equity:

Years Ended December 31, 2001, 2000 and 1999 21
Consolidated Statements of Cash Flows:
Years Ended December 31, 2001, 2000 and 1999 22
Notes to Consolidated Financial Statements 23 - 37

(2) All other schedules have been omitted as the required information is
either inapplicable or included in the Notes to Consolidated Financial
Statements.

(3) Exhibits (listed numbers correspond to item 601 of Regulation S-K)

(3) Articles of Incorporation of Southern Financial Bancorp, Inc., by
reference to the Form S-4 Registration Statement filed with the
Securities and Exchange Commission on August 4, 1995, and
By-Laws, by reference to Form S-4 Registration Statement filed
with the Securities and Exchange Commission on August 4, 1995

(4) Instruments Defining the Rights of Security Holders, Including
Indentures--Reference is made to Exhibit (3) above

(9) Voting Trust Agreement--Not applicable

(11) Statement re Computation of Per Share Earnings--Reference is made
to Note 1 and Note 15 to Financial Statements, Page 25 and Page
37, respectively, in Annual Report

(12) Statement re Computation of Ratios--Not applicable

(13) Pages 17-37 of the Annual Report to Stockholders for the Year
Ended December 31, 2001

(18) Letter re Change in Accounting Principles--Not applicable

(21) Subsidiaries of the registrant:

Percentage of Voting
Jurisdiction of Securities Owned by
Name Incorporation the Parent
---- ------------- --------------------

Southern Financial Bank Virginia 100%
Southern WebTech.com, Inc. Virginia 100%
Southern Financial Capital Trust I Delaware 100%
Southern Financial Statutory Trust I Delaware 100%

21

(22) Published Report Regarding Matters Submitted to Vote of
Security Holders--Not applicable

(23) (a) Consent of KPMG LLP

(24) Power of Attorney - Not applicable

(28) Information from Reports Furnished to State Insurance
Regulatory Authorities - Not applicable

(b) No reports on Form 8-K were filed during the quarter ended December 31,
2001.

22

SIGNATURES

Pursuant to the requirement of Section 13 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.

By: /s/Georgia S. Derrico
----------------------------------------
Georgia S. Derrico
Chairman of the Board and Chief
Executive Officer

Dated: March 29, 2002
-----------------

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below on the dates indicated.

Name Title Date
- ----------------------------------- ------------------------------- -----------------

/s/Georgia S. Derrico Director and Chairman of March 29, 2002
- ----------------------------------- -----------------
Georgia S. Derrico the Board and Chief
Executive Officer

/s/R. Roderick Porter Director and President and March 29, 2002
- ----------------------------------- -----------------
R. Roderick Porter Chief Operating Officer

/s/David de Give Director and Senior Vice March 29, 2002
- ----------------------------------- -----------------
David de Give President/Treasurer

/s/Patricia A. Ferrick Senior Vice President and March 29, 2002
- ----------------------------------- -----------------
Patricia A. Ferrick Chief Financial Officer

/s/William H. Lagos Senior Vice President/Controller March 29, 2002
- ----------------------------------- -----------------
William H. Lagos (Principal Accounting Officer)

/s/Virginia Jenkins Director March 29, 2002
- ----------------------------------- -----------------
Virginia Jenkins

/s/Neil J. Call Director March 29, 2002
- ----------------------------------- -----------------
Neil J. Call

/s/Michael P. Rucker Director March 29, 2002
- ----------------------------------- -----------------
Michael P. Rucker

/s/Alfonso G. Finocchiaro Director March 29, 2002
- ----------------------------------- -----------------
Alfonso G. Finocchiaro

23

/s/Robert P. Warhurst Director March 29, 2002
- ----------------------------------- -----------------
Robert P. Warhurst

/s/John C. Belotti Director March 29, 2002
- ----------------------------------- -----------------
John C. Belotti

/s/Fred L. Bollerer Director March 29, 2002
- ----------------------------------- -----------------
Fred L. Bollerer

/s/Richard E. Smith Director March 29, 2002
- ----------------------------------- -----------------
Richard E. Smith

/s/Barbara J. Fried Director March 29, 2002
- ----------------------------------- -----------------
Barbara J. Fried

24

INDEX TO EXHIBITS

Number and Descriptions

13 Southern Financial Bancorp, Inc.
December 31, 2001 Annual Report to Stockholders

23 (a) Consent of KPMG LLP

25