Edgar Filing: FLAG FINANCIAL CORP

Flag Financial Corporation 10-Q 09-30-2005

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2005

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _____ to ______

Commission file number 0-24532
Flag Financial Corporation Logo

FLAG FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

	Georgia		58-2094179
	(State of incorporation)		(I.R.S. Employer Identification No.)

3475 Piedmont Road N.E. Suite 550

Atlanta, Georgia 30305

(Address of principal executive offices)

(404) 760-7700

(Registrant’s telephone number)

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Common stock, par value $1 per share: 8,546,086 shares outstanding as of November 2, 2005

Flag Financial Corporation and Subsidiary

Table of Contents

			Page
PART I.	Financial Information

Item 1.	Financial Statements

		Consolidated Balance Sheets at September 30, 2005 (unaudited) and December 31, 2004 (audited) and September 30, 2004 (unaudited)	3

		Consolidated Statements of Earnings for the Quarters and Nine Months Ended September 30, 2005 and 2004 (unaudited)	4

		Consolidated Statements of Comprehensive Income for the Quarters and Nine Months Ended September 30, 2005 and 2004 (unaudited)	5

		Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004 (unaudited)	6

		Notes to Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition And Results of Operations		11

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		30

Item 4.	Controls and Procedures		30

PART II.	Other Information

Item 1.	Legal Proceedings		31

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		31

Item 3.	Defaults Upon Senior Securities		31

Item 4.	Submission of Matters to a Vote of Security Holders		31

Item 5.	Other Information		31

Item 6.	Exhibits		31

SIGNATURES			32

Table of Contents

Part I.

Financial Information

Item 1.

Financial Statements

FLAG FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)
	September 30, 2005			December 31, 2004			September 30, 2004
	*(unaudited)*			(audited)			(unaudited)
Assets

Cash and due from banks	$	16,101		$	13,345		$	13,721
Other interest-bearing deposits in banks		5,946			13,397			15,852
Federal funds sold		24,578			13,574			18,826
Total cash and cash equivalents		46,625			40,316			48,399
Other interest-bearing deposits in banks		4,000			5,473			1,626
Investment securities available-for-sale		99,878			111,390			94,607
Other investments		12,332			13,161			13,211
Mortgage loans held-for-sale		10,401			10,688			6,666
Loans, net of allowance for loan losses of $9,511, $8,602 and $8,328, respectively		691,488			596,101			582,046
Premises and equipment, net		13,458			14,458			14,284
Intangible assets		20,986			20,919			16,246
Other assets		19,957			15,831			15,953
Total assets	$	919,125		$	828,337		$	793,038

Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing deposits	$	57,372		$	48,812		$	42,679
Interest-bearing demand deposits		347,971			347,940			320,777
Savings		20,697			20,940			21,863
Time		358,766			289,155			277,998
Total deposits		784,806			706,847			663,317
Advances from Federal Home Loan Bank		25,000			25,000			40,000
Federal funds purchased and repurchase agreements		1,420			2,295			4,144
Other borrowings		-			4,300			-
Junior subordinated debentures		24,743			14,433			14,433
Other liabilities		8,504			6,260			6,106
Total liabilities		844,473			759,135			728,000

Preferred stock, 10,000,000 shares authorized, none issued and outstanding		-			-			-
Common stock , $1 par value, 20,000,000 shares authorized, 10,097,272, 10,053,572 and 9,810,849 shares issued and outstanding at September 30, 2005, December 31, 2004 and September 30, 2004, respectively		10,097			10,054			9,811
Additional paid-in capital		28,296			27,954			24,799
Retained earnings		49,875			44,642			43,460
Accumulated other comprehensive (loss) income		(112	)		56			472
Less: Treasury stock at cost; 1,551,186 shares at September 30, 2005, December 31, 2004 and September 30, 2004		(13,504	)		(13,504	)		(13,504	)
Total stockholders' equity		74,652			69,202			65,038
Total liabilities and stockholders' equity	$	919,125		$	828,337		$	793,038

See accompanying notes to unaudited consolidated financial statements.

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FLAG FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share data)
	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004

	(unaudited)
Interest income:
Interest and fees on loans	$	14,279	$	9,515	$	38,120	$	26,313
Interest on investment securities		1,339		1,177		3,719		3,925
Interest on federal funds sold and other interest-bearing deposits in banks		315		121		945		320
Total interest income		15,933		10,813		42,784		30,558
Interest expense:
Interest on deposits:
Demand		2,339		1,343		5,963		3,576
Savings		35		32		98		99
Time		2,857		1,436		7,369		3,857
Interest on other borrowings		586		354		1,412		887
Total interest expense		5,817		3,165		14,842		8,419
Net interest income before provision for loan losses		10,116		7,648		27,942		22,139
Provision for loan losses		375		375		750		1,470
Net interest income after provision for loan losses		9,741		7,273		27,192		20,669
Noninterest income:
Service charges on deposit accounts		855		946		2,428		2,796
Mortgage banking activities		890		744		2,157		1,869
Fees on payroll services		542		-		1,622		-
Insurance commissions and brokerage fees		66		162		198		438
Gain on sale of branch		-		-		-		3,000
Gain on sales of other real estate owned		336		78		558		113
Gain on sales of investment securities available-for-sale		-		7		129		700
Other		345		317		1,136		621
Total noninterest income		3,034		2,254		8,228		9,537
Noninterest expense:
Salaries and employee benefits		5,539		4,480		15,759		13,347
Occupancy		977		974		2,915		2,747
Professional fees		429		235		1,462		817
Postage, printing and supplies		257		244		734		693
Communications		539		556		1,648		1,670
Other		1,114		808		2,876		2,744
Total noninterest expense		8,855		7,297		25,394		22,018
Earnings before provision for income taxes		3,920		2,230		10,026		8,188
Provision for income taxes		1,283		571		3,256		2,512
Net earnings	$	2,637	$	1,659	$	6,770	$	5,676

Basic earnings per share	$	0.31	$	0.20	$	0.79	$	0.67

Diluted earnings per share	$	0.28	$	0.19	$	0.73	$	0.63

See accompanying notes to unaudited consolidated financial statements.

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FLAG FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)
	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
	(unaudited)

Net earnings	$	2,637		$	1,659		$	6,770		$	5,676
Other comprehensive income, net of tax:
Unrealized gains (losses) on investment securities available-for-sale:
Unrealized gains (losses) arising during the period, net of income tax (benefit) of $165, $271, $7 and $(187), respectively		270			441			11			(306	)
Reclassification adjustment for gains included in net earnings, net of income tax of $0, $3, $49 and $267, respectively		-			(4	)		(80	)		(433	)
Unrealized losses on cash flow hedges, net of income tax (benefit) of $(80), $0, $(61) and $0, respectively		(131	)		-			(99	)		-
Other comprehensive income (loss)		139			437			(168	)		(739	)
Comprehensive income	$	2,776		$	2,096		$	6,602		$	4,937

See accompanying notes to unaudited consolidated financial statements.

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FLAG FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
	Nine Months Ended September 30,
	2005			2004

Cash flows from operating activities:
Net earnings	$	6,770		$	5,676
Adjustment to reconcile net earnings to net cash provided by operating activities:
Depreciation, amortization and accretion		1,484			2,322
Provision for loan losses		750			1,470
Gain on sale of branch office		-			(3,000	)
Gain on sales of investment securities available-for-sale		(129	)		(700	)
Gain on sales of loans		(1,249	)		(1,028	)
(Gain) loss on disposals of premises and equipment		(23	)		56
Gain on sales of other real estate owned		(558	)		(113	)
Change in:
Mortgage loans held-for-sale		1,536			(1,404	)
Other assets and liabilities		(2,162	)		(3,084	)
Net cash provided by operating activities		6,419			195

Cash flows from investing activities:
Cash paid in branch sale		-			(14,141	)
Net change in other interest-bearing deposits in banks		1,473			1,049
Proceeds from sales, calls and maturities of investment securities available-for-sale		81,449			65,603
Purchases of investment securities available-for-sale		(70,118	)		(39,649	)
Purchases of other investments		(242	)		(750	)
Proceeds from sales of other investments		1,071			3,160
Net change in loans		(98,629	)		(123,110	)
Proceeds from sale of other real estate owned		3,277			1,650
Proceeds from sale of premises and equipment		871			183
Purchases of premises and equipment		(1,013	)		(1,136	)
Purchases of cash surrender value life insurance		(186	)		(115	)
Net cash used in investing activities		(82,047	)		(107,256	)

Cash flows from financing activities:
Net change in deposits		77,959			128,502
Change in federal funds purchased and repurchase agreements		(875	)		(2,453	)
Change in other borrowings		(4,300	)		1,400
Proceeds from FHLB advances		-			15,000
Payments of FHLB advances		-			(33,000	)
Proceeds from issuance of junior subordinated debt		10,310			14,433
Purchase of treasury stock		-			(3,927	)
Proceeds from exercise of stock options		385			278
Cash dividends paid		(1,542	)		(1,510	)
Net cash provided by financing activities		81,937			118,723

Net change in cash and cash equivalents		6,309			11,662
Cash and cash equivalents at beginning of period		40,316			36,737

Cash and cash equivalents at end of period	$	46,625		$	48,399

See accompanying notes to unaudited consolidated financial statements.

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Flag Financial Corporation and Subsidiary

Notes to Consolidated Financial Statements

The accompanying consolidated financial statements have not been audited. The results of operations are not necessarily indicative of the results of operations for the full year or any other interim periods.

Note 1.

Basis of Presentation

The consolidated financial statements include the accounts of Flag Financial Corporation (“Flag” or the “Company”) and its wholly owned subsidiary, Flag Bank (the “Bank”). All significant intercompany accounts and transactions have been eliminated in consolidation.

The consolidated financial information furnished herein represents all adjustments that are, in the opinion of management, necessary to present a fair statement of the results of operations, changes in cash flows and financial position for the periods covered herein and are normal and recurring in nature. For further information, refer to the consolidated financial statements and related notes included in Flag’s annual report on Form 10-K for the year ended December 31, 2004.

Note 2.

Mergers and Acquisitions

On May 26, 2005, Flag and First Capital Bancshares, Inc. (“First Capital”) entered into a definitive agreement for Flag to acquire First Capital. First Capital, a bank holding company, is headquartered in Norcross, Georgia and is the parent company of First Capital Bank, which operates five banking offices in the north metro Atlanta market. The acquisition of First Capital will significantly accelerate Flag’s growth strategy, more than doubling its presence in the metro Atlanta market. As of September 30, 2005, First Capital has approximately $675 million in assets. The consideration will be a combination of cash and stock with the transaction valued at approximately $123.0 million. Intangible assets of $86.3 million will result from the merger. The agreement has been approved by the board of directors and the shareholders of each company and is subject to regulatory approvals. The merger is expected to close in the fourth quarter of 2005.

To finance the First Capital merger, Flag anticipates it will issue an additional $15.0 million in trust preferred securities and plans to raise additional capital of up to $8.3 million through the exercise of the outstanding warrants to purchase up to 1.25 million shares of common stock. Flag issued the warrants during 2002, 2003 and 2004 in connection with a series of private placements of Flag common stock. The warrants were issued and sold at a price of $1.00 per warrant and have an original term of 10 years. In consideration for the selling shareholders’ agreement to forfeit the remaining term of the warrants and exercise them in connection with the merger, Flag has agreed to adjust the exercise prices of the warrants. Related parties hold 840,000 of the outstanding warrants with an original weighted exercise price of $9.10 per share and an adjusted weighted average exercise price of $6.51 per share.

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Flag Financial Corporation and Subsidiary

Notes to Consolidated Financial Statements

Note 3.

Recent Accounting Pronouncements

As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, Flag currently accounts for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and, as such, generally recognizes no compensation expense for employee stock options. The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No.123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income earnings per share in Note 5 to our consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in the periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized in prior periods for such excess tax deductions were insignificant. On April 14, 2005, the Securities and Exchange Commission (the “SEC”) announced a new rule that amends the compliance dates for SFAS No. 123(R). The SEC’s new rule allows companies to implement SFAS No. 123(R) at the beginning of their next fiscal year, instead of the next reporting period that begins after June 15, 2005; consequently; Flag will adopt the standard in the first quarter of 2006.

Note 4.

Net Earnings Per Common Share

Net earnings per common share are based on the weighted average number of common shares outstanding during each period. The calculation of basic and diluted earnings per share is as follows (in thousands, except per share amounts):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004
Basic earnings per share:
Net earnings	$	2,637	$	1,659	$	6,770	$	5,676

Weighted average common shares outstanding		8,546		8,263		8,533		8,416

Basic earnings per share	$	0.31	$	0.20	$	0.79	$	0.67

Diluted earnings per share:
Net earnings	$	2,637	$	1,659	$	6,770	$	5,676

Weighted average common shares outstanding		8,546		8,263		8,533		8,416
Effect of stock options and warrants		729		593		710		562
Total weighted average common shares and common stock equivalents		9,275		8,856		9,243		8,978

Diluted earnings per share	$	0.28	$	0.19	$	0.73	$	0.63

Note 5.

Stock-based Compensation

Flag currently accounts for stock-based compensation to employees and non-employee members of the Board under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net earnings, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

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Flag Financial Corporation and Subsidiary

Notes to Consolidated Financial Statements

Note 5.

Stock-based Compensation (continued)

The following table illustrates the effect on net earnings and earnings per share if Flag had applied the fair value recognition provisions of SFAS No.123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts):

	Three months ended September 30,						Nine months ended September 30,
	2005			2004			2005			2004
Net earnings as reported	$	2,637		$	1,659		$	6,770		$	5,676
Compensation expense determined by fair value method		(45	)		(49	)		(135	)		(104	)
Pro forma net earnings	$	2,592		$	1,610		$	6,635		$	5,572

Basic earnings per share:
As reported	$	0.31		$	0.20		$	0.79		$	0.67
Pro forma	$	0.30		$	0.19		$	0.78		$	0.66

Diluted earnings per share:
As reported	$	0.28		$	0.19		$	0.73		$	0.63
Pro forma	$	0.28		$	0.18		$	0.72		$	0.62

During the nine months ended September 30, 2005, Flag issued 81,500 options with a weighted average grant date fair value of $3.93 each. The fair value of each option was estimated on the date of grant using the Black-Scholes options-pricing model with the following assumptions: dividend yield ranged from 1.72% to 1.80%, volatility ranged from .2185 to .2225, risk free interest rate ranged from 4.24% to 4.36%, and an expected life of seven years.

Note 6.

Loans

Flag engages in a full complement of lending activities, including permanent residential mortgage loans, permanent residential construction loans, commercial mortgage loans, commercial business loans, financial loans, agricultural loans and consumer installment loans. Flag generally concentrates lending efforts on real estate related loans. As of September 30, 2005, Flag’s loan portfolio consisted of 53.8% real estate mortgage loans, including 1-4 family residential loans, multi-family loans and commercial real estate loans, 30.7% real estate construction loans, 13.2% commercial, financial and agricultural loans, and 2.3% consumer installment loans. While risk of loss is primarily tied to the credit quality of the various borrowers, risk of loss may also increase due to factors beyond Flag’s control, such as local, regional and/or national economic downturns. General conditions in the real estate market may also impact the relative risk in the real estate portfolio. Of the target areas of lending activities, commercial and financial loans are generally considered to have a greater risk of loss than real estate loans or consumer installment loans.

Loans are reported at outstanding unpaid balances and unamortized premiums or discounts on purchased loans. Balances within the major loans receivable categories are represented in the following table (in thousands):

	September 30, 2005		% of Total Loans			December 31, 2004		% of Total Loans			September 30, 2004		% of Total Loans

Commercial/financial/agricultural	$	92,457		13.2	%	$	57,231		9.5	%	$	64,603		10.9	%
Real estate - Construction		215,501		30.7	%		176,111		29.1	%		159,308		27.0	%
Real estate - Mortgage		376,877		53.8	%		355,575		58.8	%		351,669		59.6	%
Consumer installment loans		16,160		2.3	%		15,644		2.6	%		14,620		2.5	%
Lease financing		4		-			142		-			174		-
Total loans		700,999		100.0	%		604,703		100.0	%		590,374		100.0	%
Less: Allowance for loan losses		9,511					8,602					8,328
Total net loans	$	691,488				$	596,101				$	582,046

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Flag Financial Corporation and Subsidiary

Notes to Consolidated Financial Statements

Note 7.

Stock Repurchase Program

In March 2004, Flag’s Board of Directors authorized a stock repurchase program covering an amount equal to 10% of the outstanding shares of Flag’s common stock. As of September 30, 2005, the Company has repurchased approximately 304,000 shares of the approximately 853,000 shares authorized to be purchased, at an average price of $12.91.

Note 8.

Trust Preferred Securities

On July 18, 2005, the Company closed a private offering of 10,000 floating rate Preferred Securities offered and sold by Flag Financial Corporation Statutory Trust II (“Trust II”) having a liquidation amount of $1,000 each. The proceeds from such issuances, together with the proceeds of the related issuance of common securities of Trust II purchased by the Company in the amount of $310,000, were invested in floating rate Junior Subordinated Debentures (the “July 2005 Debentures”) of the Company totaling $10.3 million. The July 2005 Debentures are due September 30, 2035 and may be redeemed after five years, and sooner in certain specific events, including in the event that certain circumstances render them ineligible for treatment as Tier 1 capital, subject to prior approval by the Federal Reserve Board, if then required. Such debentures presently qualify as Tier 1 capital for regulatory reporting. The sole assets of Trust II are the July 2005 Debentures. The July 2005 Debentures are unsecured and rank junior to all senior debt of the Company and on par with the debentures issued in connection with the Company’s other trust preferred securities. The Company owns all of the common securities of Trust II. For the quarter ended September 30, 2005, the floating rate securities had a 6.17% interest rate, which will reset quarterly at the three-month LIBOR rate plus 1.50%. Flag intends to use the capital for the merger with First Capital and for other general corporate purposes. Flag anticipates it will issue additional trust preferred securities prior to the close of the First Capital transaction.

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Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

The following discussion and comments contain "forward-looking statements" relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of our management, as well as assumptions made by and information currently available to our management. The words “expect”, “estimate”, “anticipate”, and “believe”, as well as similar expressions, are intended to identify forward-looking statements. Our actual results may differ materially from the results discussed in the forward-looking statements, and our operating performance each quarter is subject to various risks and uncertainties. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, (i) the strength of the U.S. economy as well as the strength of the local economies in which operations are conducted; (ii) the effects of changing interest rates, which could lower margins; (iii) unanticipated inflation, interest rate, market and monetary fluctuations; (iv) unanticipated regulatory proceedings or legal actions, or changes in accounting policies and practices as adopted by the Financial Accounting Standards Board; (v) issues involved in the integration of acquisitions, including but not limited to our pending First Capital acquisition; and (vi) the timely development of products and services that position Flag to succeed in an increasingly competitive industry. If we are unsuccessful in managing the risks relating to these factors, together with other risks incident to the operation of our business, our financial condition, results of operations and cash flows could be adversely affected. Forward-looking statements speak only as of the date on which they are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made to reflect the occurrence of unanticipated events.

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with accounting principles generally accepted in the United States and with general practices within the banking industry. In connection with the application of those principles, we have made judgments, estimates and assumptions which, in the case of estimating our allowance for loan losses (ALL), have been critical to the determination of our financial position and results of operations. Management assesses the adequacy of the ALL regularly during the year, and formally prior to the end of each calendar quarter. This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance.

This estimation process can affect our estimated loan loss expense for a given period. Generally, the allowance for loan losses increases as the outstanding balance of loans or the level of classified or impaired loans increases. Loans or portions of loans that are deemed uncollectible are charged against and reduce the allowance. The allowance is replenished by means of a provision for loan losses that is charged as an expense. As a result, our estimate of the allowance for loan losses affects our earnings directly.

The ALL consists of two portions (1) allocated amounts representing the potential exposures on specifically identified credits and other exposures readily predictable by historical or comparative experience; and (2) an unallocated amount representative of inherent loss which is not readily identifiable. Even though the ALL is composed of two components, the entire ALL is available to absorb any credit losses. Allocated amounts are used on loans where management has determined that there is an increased probability or severity of loss than on the loan portfolio as a whole. We base the allocation for these unique loans primarily on risk rating grades assigned to each of these loans as a result of our loan management and review processes. We then assign each risk-rating grade a loss ratio, which is determined based on the experience of management, discussions with banking regulators and our independent loan review process. We estimate losses on impaired loans based on estimated cash flows discounted at the loan's original effective interest rate or based on the underlying collateral value. To the extent that management does not believe that a certain loan's risk is appropriately represented by the risk rating grades, a specific review of the credit is performed which would result in a specific allocation for that particular loan.

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Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Unallocated amounts are particularly subjective and do not lend themselves to exact mathematical calculation. The unallocated amount represents estimated inherent credit losses which may exist, but have not yet been identified, as of the balance sheet date. In estimating the unallocated amount, we consider such matters as changes in the local or national economy, the depth or experience in the lending staff, any concentrations of credit in any particular industry group, and new banking laws or regulations. After we assess applicable factors, we evaluate the aggregate unallocated amount based on our management's experience. We then evaluate the resulting ALL balance by comparing the balance in the ALL to historical trends and peer information. Our management then evaluates the result of the procedures performed, including the result of our testing, and concludes on the appropriateness of the balance of the ALL in its entirety.

The audit committee of our board of directors reviews the assessment prior to the filing of quarterly and annual financial information. In assessing the adequacy of the ALL, we also rely on an ongoing independent loan review process. We undertake this process both to ascertain whether there are loans in the portfolio whose credit quality has weakened over time and to assist in our overall evaluation of the risk characteristics of the entire loan portfolio. Our loan review process includes the judgment of management, input from our independent loan reviewer, and reviews that may have been conducted by bank regulatory agencies as part of their usual examination process.

See "Provision and Allowance for Loan Losses" for additional information.

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Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

The Company’s net income for the quarter ended September 30, 2005, was $2.6 million, or $0.28 per diluted share, compared to net income of $1.7 million, or $0.19 per diluted share, for the September 30, 2004 quarter. Net income for the nine months ended September 30, 2005, was $6.8 million, or $0.73 per diluted share, compared to $5.7 million, or $0.63 per diluted share for the nine months ended September 30, 2004.

Net interest income grew 32.3% and 26.2% to $10.1 million and $27.9 million for the quarter and nine months ended September 30, 2005, respectively. Net interest income for the quarter and nine months ended September 30, 2004 was $7.6 million and $22.1 million, respectively. The improvement in net interest income resulted from an increase in average loans outstanding as well as an increase in the yield on loans of 175 basis points and 123 basis points to 8.39% and 7.98% for the quarter and nine months ended September 30, 2005, respectively. This compares to 6.64% and 6.75% for the same periods last year. Average loans outstanding grew $111.8 million and $117.8 million for the quarter and nine months ended September 30, 2005. Average interest-bearing deposits also increased by $121.0 million and $128.2 million, respectively, during the same periods. While the increase in average interest-bearing deposits was greater than the increase in average loans outstanding, the increase in the cost of interest-bearing deposits for the quarter and nine months ended September 30, 2005, was 103 basis points and 82 basis points, respectively.

Return on average assets for the quarter and nine months ended September 30, 2005, was 1.18% and 1.05%, respectively, compared to 0.87% and 1.04%, respectively, for the same periods in 2004. Return on average equity for the quarter and nine months ended September 30, 2005, was 14.46% and 12.67%, respectively, compared to 10.21% and 11.50%, respectively, for the same periods in 2004.

During the nine months ended September 30, 2005, Flag’s total assets increased by $90.8 million to $919.1 million from $828.3 million at December 31, 2004. Gross loans outstanding and total deposits have increased $96.3 million and $78.0 million, respectively, from December 31, 2004. Gross loans outstanding and total deposits in the metro Atlanta region grew $76.6 million and $99.3 million, respectively, during the same time period.

Nonperforming assets declined during the quarter ended September 30, 2005. Nonperforming assets were 0.49% of total assets at September 30, 2005, compared to 0.64% and 0.74% at December 31, 2004 and September 30, 2004, respectively. Net recoveries to average loans were 0.13% and 0.05% for the quarters ended September 30, 2005 and 2004, respectively. Net recoveries for the nine months ended September 2005 were 0.03% compared to net charge-offs of 0.06% for the nine months ended September 30, 2004. The allowance for loan losses at September 30, 2005, was 1.36% of gross loans outstanding compared to 1.42% at December 31, 2004 and 1.41% at September 30, 2004. The ratio of the allowance for loan losses to nonperforming loans was 2.75, 2.00 and 1.82 times at September 30, 2005, December 31, 2004 and September 30, 2004, respectively.

Mergers and Acquisitions

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Summary Financial Data

The following table presents summary financial data for the previous five quarters (in thousands, except per share data).

	2005									2004
(unaudited)	Third Quarter			Second Quarter			First Quarter			Fourth Quarter			Third Quarter
INCOME SUMMARY
Interest income	$	15,933		$	14,064		$	12,787		$	12,063		$	10,813
Interest expense		5,817			4,817			4,208			3,639			3,165
Net interest income		10,116			9,247			8,579			8,424			7,648
Provision for loan losses		375			-			375			375			375
Noninterest income		3,034			2,592			2,602			1,931			2,254
Noninterest expense		8,855			8,422			8,117			7,490			7,297
Earnings before taxes		3,920			3,417			2,689			2,490			2,230
Income taxes		1,283			1,111			862			798			571
Net earnings	$	2,637		$	2,306		$	1,827		$	1,692		$	1,659

PERFORMANCE RATIOS
Earnings per common share:
Basic	$	0.31		$	0.27		$	0.21		$	0.20		$	0.20
Diluted		0.28			0.25			0.20			0.19			0.19
Cash dividends declared		0.06			0.06			0.06			0.06			0.06
Book value per share		8.74			8.47			8.24			8.14			7.87

Return on average equity		14.46	%		12.96	%		10.49	%		10.25	%		10.21	%
Return on average assets		1.18	%		1.09	%		0.88	%		0.86	%		0.87	%
Net interest margin		4.83	%		4.74	%		4.63	%		4.62	%		4.33	%
Yield on interest-earning assets		7.59	%		7.19	%		6.84	%		6.59	%		6.11	%
Cost of interest-bearing liabilities		3.05	%		2.71	%		2.44	%		2.16	%		1.94	%
Efficiency ratio		67.76	%		70.99	%		71.83	%		72.66	%		74.00	%
Net overhead ratio		2.60	%		2.76	%		2.66	%		2.83	%		2.64	%
Dividend payout ratio		19.45	%		22.16	%		27.97	%		30.14	%		29.90	%

ASSET QUALITY
Allowance for loan losses	$	9,511		$	8,915		$	8,862		$	8,602		$	8,328
Nonperforming assets		4,507			4,925			6,740			5,310			5,907
Allowance for loan losses to loans		1.36	%		1.38	%		1.44	%		1.42	%		1.41	%
Nonperforming assets to total assets		0.49	%		0.57	%		0.80	%		0.64	%		0.74	%
Net (recoveries) charge-offs to average loans		(0.13	)%		(0.03	)%		0.08	%		0.07	%		(0.05	)%

AVERAGE BALANCES
Gross loans outstanding	$	672,860		$	619,511		$	603,412		$	590,355		$	566,691
Mortgage loans held-for-sale		11,846			7,153			6,780			6,156			6,240
Interest-earning assets		838,482			789,448			772,409			733,709			710,765
Total assets		895,843			845,847			830,013			786,976			762,679
Deposits		765,055			725,350			707,934			670,725			629,221
Stockholders’ equity		72,921			71,183			69,657			66,016			65,003
Common shares outstanding:
Basic		8,546			8,537			8,515			8,337			8,263
Diluted		9,275			9,231			9,268			8,993			8,856

AT PERIOD END
Gross loans outstanding	$	700,999		$	647,862		$	615,115		$	604,703		$	590,374
Mortgage loans held-for-sale		10,401			9,106			7,271			10,688			6,666
Interest-earning assets		858,134			805,442			780,756			772,387			741,162
Total assets		919,125			862,509			840,415			828,337			793,038
Deposits		784,806			740,803			713,360			706,847			663,317
Stockholders’ equity		74,652			72,389			70,297			69,202			65,038
Common shares outstanding		8,546			8,546			8,528			8,503			8,260

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview of Financial Condition

Total assets were $919.1 million at September 30, 2005, an increase of $90.8 million or 11.0% from $828.3 million at December 31, 2004. Interest-earning assets (consisting of loans, investment securities, other interest-bearing deposits in banks and short-term investments) totaled $858.1 million or 93.4% of total assets at September 30, 2005, compared to $772.4 million or 93.2% of total assets at December 31, 2004. During the same period, stockholders’ equity increased $5.5 million or 7.9% to $74.7 million at September 30, 2005, compared to $69.2 million at December 31, 2004.

Loans

Gross loans outstanding (excluding mortgage loans held-for-sale) at September 30, 2005, totaled $701.0 million, an increase of $96.3 million or 15.9% from $604.7 million at December 31, 2004. The increase is primarily attributable to the Company’s continued growth in the metro Atlanta area. Loans in the metro Atlanta region grew to $456.0 million at September 30, 2005, compared to $379.4 million at December 31, 2004. As of September 30, 2005, loans in metro Atlanta represented 65.0% of gross loans outstanding. Mortgage loans held-for-sale totaled $10.4 million compared to $10.7 million at December 31, 2004. Flag concentrates its lending activities in several areas that management believes provides adequate diversification with acceptable yield and risk levels. These areas include, but are not limited to construction, commercial real estate, agricultural and correspondent lending (lending services to other community banks). For more information see Note 6 to the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations - Provision and Allowance for Loan Losses.

Investment Securities

The composition of the investment securities portfolio reflects management’s strategy of maintaining an appropriate combination of liquidity, interest-rate risk and yield. Flag seeks to maintain an investment portfolio with minimal credit risk, investing mostly in obligations of the United States Treasury or other state and federal governmental agencies. Investment securities at September 30, 2005, totaled $112.2 million, a decrease of $12.3 million or 9.9% from $124.6 million at December 31, 2004. Investment securities comprised 13.1% and 16.1% of interest-earning assets at September 30, 2005 and December 31, 2004, respectively.

Federal Funds Sold and Other Interest-bearing Deposits in Banks

Short-term investments (federal funds sold and other interest-bearing deposits in banks) totaled $30.5 million at September 30, 2005, a decrease of $3.6 million or 13.2% from $27.0 million at December 31, 2004. Short-term investments amounted to 3.6% of interest-earning assets at September 30, 2005 and 3.5% of interest-earning assets at December 31, 2004.

Premises and Equipment

Premises and equipment at September 30, 2005, totaled $13.5 million compared to $14.5 million at December 31, 2004. In the first quarter of 2005, Flag sold one of its banking centers with a net book value of $828,000 and recognized a pre-tax gain of $36,000. Flag maintains a branch location in the center under a lease agreement with the buyer.

Deposits and Other Funding

Total deposits at September 30, 2005, were $784.8 million, an increase of $78.0 million or 11.0% from $706.8 million at December 31, 2004. Core deposits offer the Bank a lower cost source of funds. Core deposits (noninterest-bearing demand deposits, interest-bearing demand deposits, and savings) were $426.0 million at September 30, 2005, compared to $417.7 million at December 31, 2004. Core deposits comprise 54.3% of the total deposit base at September 30, 2005 versus 59.1% at December 31, 2004. Total time deposits amounted to $358.8 million at September 30, 2005, compared to $289.2 million at December 31, 2004. Customer deposits represented 93.9% of total funding at September 30, 2005 and December 31, 2004. Total deposits in the Company’s metro Atlanta region increased $99.3 million or 27.3% to $463.0 million at September 30, 2005, compared to $363.7 million at December 31, 2004. Core deposits in the same region increased $46.6 million to $237.9 million at September 30, 2005, from $191.3 million at December 31, 2004. During the current quarter, Flag repaid the outstanding balance on a line of credit and has no outstanding other borrowings at September 30, 2005, compared to $4.3 million from December 30, 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Advances from the Federal Home Loan Bank

Advances from the Federal Home Loan Bank (“FHLB”) remained unchanged at $25.0 million at September 30, 2005 and December 31, 2004. Borrowings from the FHLB decreased during the past 12 months as a result of Flag’s successful implementation of its deposit sales program.

Junior Subordinated Debentures

Junior subordinated debentures increased $10.3 million to $24.7 million at September 30, 2005, compared to $14.4 million at December 31, 2004. On July 18, 2005, the Company closed a private offering of 10,000 floating rate Preferred Securities offered and sold by Flag Financial Corporation Statutory Trust II (“Trust II”) having a liquidation amount of $1,000 each. The proceeds from such issuances, together with the proceeds of the related issuance of common securities of Trust II purchased by the Company in the amount of $310,000, were invested in floating rate Junior Subordinated Debentures of the Company totaling $10.3 million. Flag intends to use the capital for the merger with First Capital and for other general corporate purposes. For more information see Note 8 to the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital.

Liquidity Management and Funding Sources

Liquidity management involves Flag’s ability to maintain adequate short-term assets to meet the cash flow expectations of depositors and other lending institutions and to provide funds for the growth in interest-earning assets on a timely and cost effective basis. Liquidity is managed daily by understanding the cash flow expectations of depositors and other lending institutions and maintaining enough liquid assets to meet these expectations.

Liquid assets (assets that can be easily converted to cash) at September 30, 2005, totaled $113.0 million and included cash and due from banks, federal funds sold and other interest-bearing deposits, unpledged investment securities available-for-sale and mortgage loans held-for-sale.

Deposits provide a significant portion of the Company’s cash flow needs and continue to provide a relatively stable, low cost source of funds. As of September 30, 2005, Flag had $405.3 million of deposits due on demand, $20.7 million in savings deposits and $277.9 million of time deposits and other borrowings due within one year. Other funding sources readily available to the Company are purchased funds, including wholesale funding sources. Wholesale funding sources include advances from the Federal Home Loan Bank, federal funds purchased and securities sold under agreements to repurchase. Flag maintains available lines of credit with other financial institutions. These include federal funds and other lines of credit totaling $72 million and a line of credit with the FHLB totaling $49 million. Flag also maintains a line of credit with the Federal Reserve Bank of Atlanta totaling $136 million. At September 30, 2005, $25.0 million of the available $257 million in total lines was advanced to Flag.

Cash flows from operations are also a source of liquidity. Net cash from operations results primarily from net income adjusted for certain items such as depreciation and amortization, provision for loan losses, gains on the sale of investments in real estate and timing differences from the sale of loans held for sale versus originations of loans held for sale.

Off-Balance Sheet Arrangements

Flag is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are written conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. A commitment involves, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. Flag’s exposure to credit loss in the event of non-performance by the other party to the instrument is represented by the contractual notional amount of the instrument.

Since certain commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Flag uses the same credit policies in making commitments to extend credit as they do for on-balance sheet instruments. Collateral held for commitments to extend credit varies but may include accounts receivable, inventory, property, plant, equipment, and income-producing commercial properties.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following table summarizes Flag’s off-balance sheet financial instruments whose contract amounts represent credit risk as of September 30, 2005 and December 31, 2004 (in thousands):

	2005		2004
Commitments to extend credit	$	239,535	$	142,036
Standby letters of credit	$	10,165	$	3,650

Market Risk Sensitivity

Market rate sensitivity is the tendency for changes in the interest rate environment to be reflected in Flag’s net interest income and results of operations. Flag, through its asset and liability management program, seeks to balance maturities and rates on interest-earning assets and the corresponding funding such that interest rate fluctuations have a minimal impact on earnings and the value of Flag’s equity.

Historically, the average term to maturity or repricing (rate changes) of assets (primarily loans and investment securities) has exceeded the average repricing period of liabilities (primarily deposits and borrowings). Flag’s primary source of funding has been demand deposits (interest-bearing and noninterest-bearing) instead of time deposits and wholesale borrowings with longer maturities. This method of funding interest-earning assets has issues concerning interest rate risk, liquidity and profitability, all of which were contemplated and measured by the Company. Flag concluded that this strategy is the most profitable method of funding growth in interest-earning assets of the Company for the foreseeable future and has committed significant sales, marketing and training resources at being successful in this effort. Where interest rate risk is concerned, Flag considered factors such as account size, relationship strength and historical rate levels needed to remain competitive. Generally speaking, it is the opinion of management that these deposits are less sensitive to rate movements than the interest-earning assets they are funding. Flag uses an interest rate simulation model that uses management assumptions and theories regarding rate movements and the impact each movement will have on individual components of the balance sheet. As of September 30, 2005, Flag’s simulation model shows that Flag’s balance sheet is asset-sensitive, meaning a rising rate environment would have a positive impact on Flag’s net interest income. The Company uses three standard scenarios — rates unchanged, rising rates, and declining rates — in analyzing interest rate sensitivity. At September 30, 2005, Flag’s simulation model indicated that a 100 basis points increase or decrease over the next twelve months would increase net interest income approximately 5.23%, and decrease net interest income approximately 7.71% in the rising and declining rate scenarios, respectively, versus the projection under unchanged rates. Management expects that the Federal Reserve will continue to raise interest rates in 2005.

Management carefully measures and monitors market rate sensitivity and believes that its operating strategies offer protection against interest rate risk. As required by various regulatory authorities, Flag’s Board of Directors established an interest rate risk policy, which sets specific limits on interest rate risk exposure. Adherence to this policy is reviewed by Flag's executive committee and presented at least annually to the Board of Directors.

Flag’s management from time to time uses certain derivative instruments in an effort to add stability to the Company’s net interest income and manage exposure to changing interest rates. All derivatives are classified as either fair value hedges (those designed to hedge the fair market value of asset or liabilities affected by changing interest rates) or cash flow hedges (those designed to mitigate exposure to variability in expected future cash flows due to changing interest rates).

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

At September 30, 2005, the Company had interest rate swaps and interest rate floors designated as cash flow hedges. No fair value hedges were outstanding. The following table summarizes the outstanding derivative instruments (dollars in thousands):

Interest Rate Swaps

Type	Transaction Date		Term Date		Notional		Receive Rate			Pay Rate			Current Spread			Fair Value
Receive Fixed, Pay LIBOR Swap		June 2004		Dec 2005	$	5,000		2.68	%		3.8375	%		(1.1575	)%	$	(17	)

Receive Fixed, Pay LIBOR Swap		June 2004		June 2006		15,000		3.00	%		3.8375	%		(0.8375	)%		(154	)

Receive Fixed, Pay LIBOR Swap		June 2004		Dec 2006		5,000		3.27	%		3.8375	%		(0.5675	)%		(76	)

Total Received Fixed Swaps					$	25,000		2.99	%		3.8375	%		(0.8475	)%	$	(247	)


Interest Rate Floors

Type		Transaction Date		Term Date		Notional		Strike Rate			Current Rate			Current Spread			Fair Value
Prime Based Floor		May 2005		May 2008	$	50,000		5.50	%		6.75	%		(1.25	)%	$	9

Prime Based Floor		May 2005		May 2010		50,000		5.50	%		6.75	%		(1.25	)%		77

Total Interest Rate Floors					$	100,000		5.50	%		6.75	%		(1.25	)%	$	86

As of September 30, 2005, the change in net unrealized losses of $160,000, pretax, for derivatives designated as cash flow hedges is separately disclosed in comprehensive income. No hedging ineffectiveness on cash flow hedges was recognized during the nine months ended September 30, 2005.

Capital

At September 30, 2005, the capital ratios of Flag and the Bank were adequate compared to the minimum regulatory capital requirements. Minimum regulatory capital levels for banks and holding companies require Tier 1 capital (core capital accounts less intangible assets) to risk-weighted assets of at least 4%, total capital (Tier 1 capital plus a portion of the allowance for loan losses) to risk-weighted assets of 8%, and Tier 1 capital to average assets of at least 4%.

On April 15, 2004, the Company closed a private offering of 14,000 floating rate Capital Securities offered and sold by Flag Financial Corporation Statutory Trust (the “Trust”) having a liquidation amount of $1,000 each. The proceeds from such issuances, together with the proceeds of the related issuance of common securities of the Trust purchased by the Company in the amount of $433,000, were invested in floating rate Junior Subordinated Debentures (the “2004 Debentures”) of the Company totaling $14.4 million. The 2004 Debentures are due April 15, 2034 and may be redeemed after five years, and sooner in certain specific events, including in the event that the certain circumstances render them ineligible for treatment as Tier 1 capital, subject to prior approval by the Federal Reserve Board, if then required. Such debentures presently qualify as Tier 1 capital for regulatory reporting. The sole assets of the Trust are the 2004 Debentures. The 2004 Debentures are unsecured and rank junior to all senior debt of the Company and on par with the debentures issued in connection with the Company’s other trust preferred securities. The Company owns all of the common securities of the Trust. For the quarter ended September 30, 2005, the floating rate securities had a 6.32% interest rate, which will reset quarterly at the three-month LIBOR rate plus 2.75%.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

On July 18, 2005, the Company closed a private offering of 10,000 floating rate Preferred Securities offered and sold by Flag Financial Corporation Statutory Trust II (“Trust II”) having a liquidation amount of $1,000 each. The proceeds from such issuances, together with the proceeds of the related issuance of common securities of Trust II purchased by the Company in the amount of $310,000, were invested in floating rate Junior Subordinated Debentures (the “July 2005 Debentures”) of the Company totaling $10.3 million. The July 2005 Debentures are due September 30, 2035 and may be redeemed after five years, and sooner in certain specific events, including in the event that certain circumstances render them ineligible for treatment as Tier 1 capital, subject to prior approval by the Federal Reserve Board, if then required. Such debentures presently qualify as Tier 1 capital for regulatory reporting. The sole assets of Trust II are the July 2005 Debentures. The July 2005 Debentures are unsecured and rank junior to all senior debt of the Company and on par with the debentures issued in connection with the Company’s other trust preferred securities. The Company owns all of the common securities of Trust II. For the quarter ended September 30, 2005, the floating rate securities had a 6.17% interest rate, which will reset quarterly at the three-month LIBOR rate plus 1.50%. Flag intends to use the capital for the merger with First Capital and for other general operating purposes. Flag anticipates it will issue additional trust preferred securities prior to the close of the First Capital transaction. For more information see Management’s Discussion and Analysis of Financial Condition and Results of Operations - Mergers and Acquisitions.

The following table reflects Flag’s capital position with respect to the regulatory minimums as of September 30, 2005 (in thousands):


	Actual Amount		%		Required Amount		%		Excess Amount		%

Total Capital (to Risk Weighted Assets)	$	86,819		11.96%	$	58,089		8.00%	$	28,730		3.96%
Tier 1 Capital (to Risk Weighted Assets)	$	77,726		10.70%	$	29,044		4.00%	$	48,682		6.70%
Tier 1 Capital (to Average Assets)	$	77,726		8.88%	$	34,994		4.00%	$	42,732		4.88%

Provision and Allowance for Loan Losses

Flag’s overall credit quality improved in the quarter ended September 30, 2005. Net recoveries to average loans were 0.13% and 0.05% for the quarters ended September 30, 2005 and 2004, respectively. Net recoveries for the nine months ended September 2005 were 0.03% compared to net charge-offs of 0.06% for the nine months ended September 30, 2004. Loan loss provision for each of the quarters ended September 30, 2005 and 2004 totaled $375,000. For the nine months ended September 30, 2005, loan loss provision totaled $750,000 compared to $1.5 million in the same period in 2004. Flag’s provision for the nine months ended September 30, 2004 included a $345,000 charge for specific credits taken in the first quarter of 2004.

The allowance for loan losses is established through provisions for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collection of the principal is unlikely. The allowance is an amount which, in management's judgment, will be adequate to absorb losses on existing loans that may become uncollectible.

The allowance for loan losses totaled $9.5 million at September 30, 2005, compared to $8.6 million and $8.3 million at December 31, 2004 and September 30, 2004, respectively. The allowance for loan losses to gross loans outstanding decreased slightly to 1.36% at September 30, 2005, compared to 1.42% at December 31, 2004 and 1.41% at September 30, 2004. The ratio of the allowance for loan losses to nonperforming loans improved to 2.75 times at September 30, 2005, from 2.00 times and 1.82 times at December 31, 2004 and September 30, 2004, respectively. Management considered the level of charge-offs and nonperforming loans, as well as the mix of nonperforming loans, in determining the level of allowance for loan losses.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

An allocation of the allowance for loan losses has been made according to the respective amounts deemed necessary to provide for the probability of incurred losses within the various loan categories. Although other relevant factors are considered, management believes that the level of loan loss allowance at September 30, 2005, was adequate based primarily on previous charge-off experience, adjusted for risk characteristics associated with changes in the composition and growth in the loan portfolio, the specific circumstances of the concentrations in the nonaccrual loans and loans past due 90 days and still accruing, including the market value of collateral and economic conditions that may affect the borrowers’ ability to repay and such other factors which, in management’s judgment, deserve recognition under existing economic conditions.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review Flag's allowance for loan losses. Such agencies may require Flag to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. For more information see Note 6 to the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operation - Nonperforming Assets.

The following table presents an analysis of the allowance for loan losses for the three and nine month periods ended (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Balance of allowance for loan losses at beginning of period	$	8,915		$	7,489		$	8,602		$	6,685
Allowance for loan losses added for acquisition		-			400			-			400
Provision charged to operating expense		375			375			750			1,470
Charge-offs:
Commercial		-			(78	)		(266	)		(90	)
Real estate - mortgage		(39	)		(9	)		(46	)		(402	)
Consumer installment loans		(24	)		(8	)		(55	)		(155	)
Lease financing		(1	)		-			(1	)		-
Total charge-offs		(64	)		(95	)		(368	)		(647	)
Recoveries:
Commercial		38			65			163			202
Real estate - mortgage		238			68			328			136
Consumer installment loans		9			26			36			82
Total recoveries		285			159			527			420
Net recoveries (charge-offs)		221			64			159			(227	)
Balance of allowance for loan losses at end of period	$	9,511		$	8,328		$	9,511		$	8,328

See “Critical Accounting Policies” for an explanation of our methodology for determining the appropriate level for the allowance and its effect on our results of operations.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Nonperforming Assets

Nonperforming assets (nonaccrual loans, loans past due 90 days and still accruing, other real estate owned and repossessions) totaled $4.5 million at September 30, 2005, compared to $5.3 million at December 2004 and $5.9 million at September 30, 2004. Nonperforming assets to total assets were 0.49% at September 30, 2005, compared to 0.64% and 0.74% at December 31, 2004 and September 30, 2004, respectively. Nonaccrual loans decreased $813,000 to $3.4 million at September 30, 2005, from $4.2 million at December 31, 2004. Loans past due 90 days and still accruing and other real estate owned and repossessions totaled $1.1 million at September 30, 2005 and December 31, 2004.

Flag has a loan review function that continually monitors selected accruing loans for which general economic conditions or changes within a particular industry could cause the borrowers financial difficulties. The loan review function also identifies loans with high degrees of credit or other risks. The focus of loan review is to maintain a low level of nonperforming assets and to return current nonperforming assets to earning status.

Flag’s credit quality has improved significantly over the past few years. This is due to several factors including a stricter credit culture that focuses more heavily on the quality of the borrower’s financial condition and collateral values. In addition, Flag’s expansion into lending in metro Atlanta presents more credit opportunities than in the Company’s past, allowing the Company to be more selective in the credit approval process without hindering or slowing the growth in loans outstanding.

The following table summarizes the nonperforming assets for the periods presented (in thousands):

	September 30, 2005			December 31, 2004			September 30, 2004

Loans on nonaccrual	$	3,411		$	4,224		$	4,557
Loans past due 90 days and still accruing		49			74			15
Other real estate owned and repossessions		1,047			1,012			1,335
Total nonperforming assets	$	4,507		$	5,310		$	5,907
Total nonperforming assets as a percentage of total assets		0.49	%		0.64	%		0.74	%

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations for the Three Month Periods Ended September 30, 2005 and 2004

Net income - Net income for the quarter ended September 30, 2005, was $2.6 million or $0.28 per diluted share, compared to $1.7 million or $0.19 per diluted share for the same quarter in 2004. Return on average assets was 1.18% and 0.87% for the quarter ended September 30, 2005 and 2004, respectively, while return on average equity was 14.46% and 10.21% for the same quarters.

Net interest income - Net interest income for the quarter ended September 30, 2005, was $10.1million, an increase of $2.5 million or 32.3% from $7.6 million for the third quarter of 2004. Flag’s net interest margin (net interest income on a taxable-equivalent basis divided by average interest-earning assets) increased 50 basis points to 4.83% from 4.33% on average interest-earning assets of $838.5 million and $710.8 million for the quarters ended September 30, 2005 and September 30, 2004, respectively. In 2004, in anticipation of rising interest rates, Flag began to reposition its balance sheet to a more asset-sensitive position. A balance sheet is considered asset sensitive when its assets (loans and securities) reprice faster or to a greater extent than liabilities (deposits and borrowings). An asset-sensitive balance sheet will produce more net interest income when interest rates rise and less net interest income when interest rates decline. The Federal Reserve has increased the discount rate eight times since September 30, 2004, increasing the rate from 1.75% to 3.75%. For more information on Flag’s asset and liability management program see Management’s Discussion and Analysis of Financial Condition and Results of Operation - Market Risk Sensitivity.

Interest income - Interest income for the quarter ended September 30, 2005, was $15.9 million, an increase of $5.1 million or 47.4% compared to $10.8 million in the same quarter in 2004. The increase is primarily due to a higher level of average loans coupled with an increase in the yield on loans.

Interest income and fees on loans increased $4.8 million or 50.1% to $14.3 million for the quarter ended September 30, 2005, compared to $9.5 million in the same quarter last year. Average loans outstanding, including mortgage loans held-for-sale, during the quarter ended September 30, 2005, were $684.7 million compared to $572.9 million for the same quarter in 2004. The yield on loans in the quarter ended September 30, 2005, was 8.39%, an increase of 175 basis points from 6.64% in the same quarter last year. The increase in yield is primarily attributable to re-pricing of the adjustable rate loan portfolio as a result of the rising rate environment.

Interest income on investment securities increased $162,000 or 13.8% to $1.3 million for the quarter ended September 30, 2005, from $1.2 million in the same quarter in 2004. The average balance of investment securities increased to $116.2 million in the quarter ended September 30, 2005, from $110.1 million in the third quarter of 2004. The yield on investment securities increased 32 basis points to 4.76% in the quarter ended September 30, 2005, from 4.44% in the same quarter in 2004.

Interest on federal funds sold and other interest-bearing deposits in banks increased $194,000 or 160.3% in the quarter ended September 30, 2005, to $315,000 from $121,000 in the third quarter of 2004. Interest on federal funds sold and other interest-bearing deposits in banks increased primarily as a result of an increase in the average balance of federal funds sold and an increase in the yields. The yield on federal funds sold and other interest-bearing deposits increased to 3.32% from 1.73% during the quarter ended September 30, 2005, compared to 2004. The increase in yield reflects the impact of the rise in the discount rate over the past 12 months.

Interest expense - Interest expense for the quarter ended September 30, 2005, was $5.8 million, an increase of $2.7 million or 83.8% from $3.2 million in the same quarter in 2004. The increase is due to higher levels of average interest-bearing liabilities coupled with a rising interest rate environment. In the quarter ended September 30, 2005, average interest-bearing liabilities increased $107.8 million or 16.6% to $757.6 million from $649.8 million in the third quarter of 2004. Flag’s total cost of interest-bearing liabilities increased 111 basis points to 3.05% from 1.94% over the same period last year.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Interest expense on deposits increased $2.4 million or 86.1% to $5.2 million in the quarter ended September 30, 2005, from $2.8 million in the third quarter of 2004. The increase is due to both an increase in the average balance and cost of interest-bearing deposits. Average interest-bearing demand deposits in the quarter ended September 30, 2005, were $367.3 million, an increase of $22.6 million or 6.5%, from $344.8 million in the third quarter of 2004. Average time deposits in the quarter ended September 30, 2005, were $341.1 million, an increase of $98.4 million or 40.5% from $242.7 million in the third quarter of 2004. The weighted average interest rate for interest-bearing demand deposits was 2.56% and 1.59% in the quarters ended September 30, 2005 and 2004, respectively. The weighted average interest rate for time deposits was 3.32% and 2.35% in the quarters ended September 30, 2005 and 2004, respectively. The increase in the weighted average interest rate is primarily attributable to increased pricing of Flag’s deposit products as a result of the rising rate environment.

Interest expense on FHLB advances and other borrowings for the quarter ended September 30, 2005, was $237,000, an increase of $75,000 or 46.3%, from $162,000 for the same quarter of 2004. Average FHLB advances and other borrowings in the quarter ended September 30, 2005, were $26.4 million, a decrease of $14.1 million or 34.8%, from $40.5 million in the same quarter of 2004. The increase in the weighted average rate to 3.56% in the quarter ended September 30, 2005, from 1.59% in the same period last year, offset the decrease in average other borrowings.

Interest expense on junior subordinated debt was $338,000 for the quarter ended September 30, 2005, an increase of $167,000 or 97.7% from $171,000 for the same quarter of 2004. The weighted average balance increased $6.9 million or 48.1% to $21.4 million for the quarter ended September 30, 2005, from $14.4 million in the same quarter last year. The weighted average interest rate was 6.27% for the quarter ended September 30, 2005, compared to 4.71% for the same period of 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following tables reflect the average balances, the interest income or expense and the average yield and cost of the Company’s interest-earning assets and interest-bearing liabilities during the three month periods presented (dollars in thousands):

Consolidated Average Balance Sheets

	Three Months Ended September 30,
			2005							2004
	Average Balance		Interest Income/ Expense		Weighted Average Rate			Average Balance		Interest Income/ Expense		Weighted Average Rate

Assets:
Loans⁽¹⁾	$	684,706	$	14,326		8.39	%	$	572,931	$	9,559		6.64	%
Taxable investment securities		108,547		1,252		4.58	%		102,537		1,094		4.24	%
Tax-exempt investment securities		7,630		141		7.33	%		7,527		134		7.11	%
Other interest-bearing deposits in banks		18,322		153		3.31	%		17,360		87		1.99	%
Federal funds sold		19,277		162		3.33	%		10,410		34		1.30	%
Total interest-earning assets		838,482	$	16,034		7.59	%		710,765	$	10,908		6.11	%
Noninterest-earning assets		57,361							51,914

Total assets	$	895,843						$	762,679

Liabilities and stockholders’ equity:
Interest-bearing demand deposits	$	346,211	$	2,339		2.68	%	$	322,561	$	1,343		1.66	%
Savings deposits		21,120		35		0.66	%		22,189		32		0.57	%
Time deposits		341,115		2,857		3.32	%		242,723		1,436		2.35	%
Total interest-bearing deposits		708,446		5,231		2.93	%		587,473		2,811		1.90	%
FHLB advances and other borrowings		26,391		237		3.56	%		40,452		162		1.59	%
Federal funds purchased and repurchase agreements		1,392		11		3.14	%		7,415		21		1.13	%
Junior subordinated debentures		21,381		338		6.27	%		14,433		171		4.71	%
Total interest-bearing liabilities		757,610	$	5,817		3.05	%		649,773	$	3,165		1.94	%
Noninterest-bearing demand deposits		56,609							41,748
Noninterest-bearing liabilities		8,703							6,155
Stockholders’ equity		72,921							65,003
Total liabilities and stockholders’ equity	$	895,843						$	762,679

Net interest rate spread			$	10,217		4.54	%			$	7,743		4.17	%
Taxable-equivalent adjustment				101							95
Net interest income, actual			$	10,116						$	7,648

Net interest-earning assets/net interest margin	$	80,872				4.83	%	$	60,992				4.33	%
Interest-earning assets as a percentage of interest-bearing liabilities						110.67	%						109.39	%

⁽¹⁾	Nonaccrual loans are included in average balances and income on such loans, if recognized, is recognized on a cash basis.

Noninterest income - Noninterest income for the quarter ended September 30, 2005, increased $780,000 or 34.6% to $3.0 million compared to $2.3 million in the third quarter of 2004. Traditionally service charges on deposit accounts and revenues from mortgage banking activities have been the largest components of noninterest income. Service charges on deposit accounts decreased to $855,000 for the quarter ended September 30, 2005, a decrease of $91,000 or 9.6%, from $946,000 in the third quarter of 2004. While Flag maintained strong growth in deposits during the past year, much of the growth came from higher-balance money market and interest-bearing checking balances where customers carry balances sufficient to qualify for reduced or eliminated fees. Mortgage banking activities includes origination fees, service release premiums and the gain on the sales of mortgage loans held-for-sale. Mortgage banking activities totaled $890,000 for the quarter ended September 30, 2005, an increase of $146,000 or 19.6%, compared to $744,000 in the third quarter of 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Payroll Solutions generated fee income of $542,000 in the quarter ended September 30, 2005. Flag acquired Payroll Solutions, a leading provider of payroll services, in the fourth quarter of 2004..

Gains on sales of other real estate owned increased $258,000 to $336,000 in the quarter ended September 30, 2005, from $78,000 in the third quarter of 2004. In the quarter ended September 30, 2005, Flag recognized a $317,000 gain on the sale of 29.5 acres of land.

Other income increased $28,000 or 8.8% to $345,000 in the quarter ended September 30, 2005, compared to $317,000 in the same quarter last year.

Noninterest expense - Noninterest expense for the quarter ended September 30, 2005, totaled $8.9 million, an increase of $1.6 million or 21.4%, compared to $7.3 million in the same quarter of 2004.

Salaries and employee benefits totaled $5.5 million, an increase of $1.1 million or 23.6%, from $4.5 million in the third quarter of 2004. The increase in salaries and benefits relates primarily to increases in production personnel in the metro Atlanta region and the addition of Payroll Solutions personnel totaling $266,000. In the quarter ended September 30, 2005, salaries and employee benefits increased $843,000 million in metro Atlanta, excluding Payroll Solutions, and decreased $50,000 in the Company’s Central and West regions.

Occupancy expense for the quarters ended September 30, 2005 and 2004, totaled $977,000 and 974,000, respectively.

Professional fees were $429,000 in the quarter ended September 30, 2005, an increase of $194,000 or 82.6%, compared to $235,000 in the same quarter of 2004. This increase is in part due to additional expenses related to continued compliance with the Sarbanes-Oxley Act.

Other noninterest expense totaled $1.1 million for the quarter ended September 30, 2005, an increase of $306,000 or 37.9%, compared to $808,000 in the same quarter of 2004. Marketing expense totaled $250,000, an increase of $68,000 or 37.4%, from $182,000 in the third quarter of 2004. The increase in marketing expense is primarily attributable to advertising costs associated with building Flag’s metro Atlanta franchise. Similarly, travel and entertainment increased to $135,000 in the quarter ended September 30, 2005, an increase of $43,000 or 46.7% from $92,000 in the quarter ended September 30, 2004. Other outside service fees totaled $155,000 in the quarter ended September 30, 2005, an increase of $49,000 or 46.2% from $106,000 in the third quarter of 2004.

Income taxes - Income tax expense for the quarter ended September 30, 2005, totaled $1.3 million compared to $571,000 million for the same quarter of 2004. Flag’s effective tax rate increased to 32.7% in the quarter ended September 30, 2005, compared to 25.6% in the same quarter of 2004. Flag’s lower effective tax rate in the quarter ended September 30, 2004 relates to certain state income tax credits taken during the third quarter of 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations for the Nine Month Periods Ended September 30, 2005 and 2004

Net income - Net income for the nine months ended September 30, 2005, was $6.8 million or $0.73 per diluted share compared to net income of $5.7 million or $0.63 per diluted share for the same period in 2004. Return on average assets was 1.05% and 1.04% for the nine months ended September 30, 2005 and 2004, respectively, while return on average equity was 12.67% and 11.50% for the same periods. Included in the 2004 earnings is an after-tax gain on the sale of its Thomaston, Georgia branch of approximately $1.47 million. In addition to the one-time gain, Flag had other charges to earnings of 2004, including credit related charges of approximately $376,000 after-tax and a charge relating to its benefit plans of approximately $234,000 after-tax. Excluding the effects of the one-time gain and other charges, earnings for the first nine months of 2004 were approximately $4.8 million.

Net interest income - Net interest income for the nine months ended September 30, 2005, was $27.9 million, an increase of $5.8 million or 26.2% from $22.1 million for the first nine months of 2004. Flag’s net interest margin (net interest income on a taxable-equivalent basis divided by average interest-earning assets) increased 27 basis points to 4.71% from 4.44% on average interest-earning assets of $800.4 million and $675.6 million for the nine months ended September 30, 2005 and 2004, respectively. In 2004, in anticipation of rising interest rates, Flag began to reposition its balance sheet to a more asset-sensitive position. A balance sheet is considered asset sensitive when its assets (loans and securities) reprice faster or to a greater extent than liabilities (deposits and borrowings). An asset-sensitive balance sheet will produce more net interest income when interest rates rise and less net interest income when interest rates decline. The Federal Reserve has increased the discount rate eight times since September 30, 2004, increasing the rate from 1.75% to 3.75%. For more information on Flag’s asset and liability management program see Management’s Discussion and Analysis of Financial Condition and Results of Operation - Market Risk Sensitivity.

Interest income - Interest income for the nine months ended September 30, 2005, was $42.8 million, an increase of $12.2 million or 40.0% compared to $30.6 million in the same period in 2004. The increase is primarily due to a higher level of average loans coupled with an increase in the yield on loans.

Interest income and fees on loans increased $11.8 million or 44.9% to $38.1 million for the nine months ended September 30, 2005, compared to $26.3 million in the same period last year. Average loans outstanding, including mortgage loans held-for-sale, during the nine months ended September 30, 2005, were $640.8 million compared to $523.0 million for the first nine months of 2004. The yield on loans in the nine months ended September 30, 2005, was 7.98% an increase of 123 basis points from 6.75% in the same period last year. The increase in yield is primarily attributable to re-pricing of the adjustable rate loan portfolio as a result of the rising rate environment.

Interest income on investment securities decreased $206,000 or 5.3% to $3.7 million for the nine months ended September 30, 2005, from $3.9 million for the same period in 2004. The decrease is the result of a decline in the average balance of investment securities. The average balance of investment securities decreased to $116.6 million in the nine months ended September 30, 2005, from $123.5 million in the first nine months of 2004. The yield on investment securities in the nine months ended September 30, 2005, was 4.44% compared to 4.43% in the same period in 2004.

Interest on federal funds sold and other interest-bearing deposits in banks increased $625,000 or 195.3% in the nine months ended September 30, 2005, to $945,000 from $320,000 in the first nine months of 2004. Interest on federal funds sold and other interest-bearing deposits increased primarily as a result of a higher average balance of federal funds sold and an increase in the yields. The yield on federal funds sold and other interest-bearing deposits in banks increased to 2.94% from 1.47% during the nine months ended September 30, 2005, compared to 2004. The increase in yield reflects the impact of the rise in the discount rate over the past 12 months.

Interest expense - Interest expense for the nine months ended September 30, 2005, was $14.8 million, an increase of $6.4 million or 76.3% from $8.4 million in the same period in 2004. The increase is due to higher levels of average interest-bearing liabilities coupled with a rising interest rate environment. In the nine months ended September 30, 2005, average interest-bearing liabilities increased $110.2 million or 18.0% to $723.6 million from $613.4 million in the first nine months of 2004. Flag’s total cost of interest-bearing liabilities increased 91 basis points to 2.74% from 1.83% over the same period last year.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Interest expense on deposits increased $5.9 million or 78.3% to $13.4 million in the nine months ended September 30, 2005, from $7.5 million in the same period in 2004. The increase is due to both an increase in the average balance and cost of interest-bearing deposits. Average interest-bearing demand deposits in the nine months ended September 30, 2005, were $359.5 million, an increase of $33.7 million or 10.3%, from $325.8 million in the first nine months of 2004. Average time deposits in the nine months ended September 30, 2005, were $318.3 million, an increase of $94.5 million or 42.2% from $223.8 million in the first nine months of 2004. The weighted average interest rate for interest-bearing demand deposits was 2.25% and 1.51% in the nine months ended September 30, 2005 and 2004, respectively. The weighted average interest rate for time deposits was 3.10% and 2.30% during the nine months ended September 30, 2005 and 2004, respectively. The increase in the weighted average interest rate is primarily attributable to increased pricing of Flag’s deposit products as a result of the rising rate environment.

Interest expense on FHLB advances and other borrowings for the nine months ended September 30, 2005, was $639,000, an increase of $91,000 or 16.6%, from $548,000 for the same period of 2004. Average FHLB advances and other borrowings in the nine months ended September 30, 2005, were $26.8 million, a decrease of $22.8 million or 46.0%, from $49.6 million in the same period of 2004. An increase in the weighted average rate, offset the decrease in average other borrowings, increasing to 3.19% compared to 1.47% in the first nine months of 2005 and 2004, respectively.

Interest expense on junior subordinated debt was $743,000 for the nine months ended September 30, 2005, an increase of $454,000 from $289,000 for the same period of 2004. The weighted average balance increased $8.1 million or 92.8% to $16.8 million for the nine months ended September 30, 2005, from $8.7 million in the same period last year. The weighted average interest rate was 5.92% for the nine months ended September 30, 2005, compared to 4.44% for the same period of 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following tables reflect the average balances, the interest income or expense and the average yield and cost of the Company’s interest-earning assets and interest-bearing liabilities during the nine month periods presented (dollars in thousands):

Consolidated Average Balance Sheets

	Nine Months Ended September 30,
			2005							2004
	Average Balance		Interest Income/ Expense		Weighted Average Rate			Average Balance		Interest Income/ Expense		Weighted Average Rate

Assets:
Loans⁽¹⁾	$	640,793	$	38,247		7.98	%	$	523,032	$	26,443		6.75	%
Taxable investment securities		109,530		3,473		4.24	%		115,434		3,652		4.23	%
Tax-exempt investment securities		7,092		399		7.51	%		8,029		442		7.36	%
Other interest-bearing deposits in banks		18,718		426		3.04	%		15,748		216		1.83	%
Federal funds sold		24,221		519		2.86	%		13,331		104		1.04	%
Total interest-earning assets		800,354	$	43,064		7.19	%		675,574	$	30,857		6.10	%
Noninterest-earning assets		57,122							52,770
Total assets	$	857,476						$	728,344

Liabilities and stockholders’ equity:
Interest-bearing demand deposits	$	337,999	$	5,963		2.36	%	$	302,789	$	3,576		1.58	%
Savings deposits		21,548		98		0.61	%		23,043		99		0.57	%
Time deposits		318,300		7,369		3.10	%		223,782		3,857		2.30	%
Total interest-bearing deposits		677,847		13,430		2.65	%		549,614		7,532		1.83	%
FHLB advances and other borrowings		26,807		639		3.19	%		49,632		548		1.47	%
Federal funds purchased and repurchase agreements		2,212		30		1.81	%		5,481		50		1.22	%
Junior subordinated debentures		16,774		743		5.92	%		8,702		289		4.44	%
Total interest-bearing liabilities		723,640	$	14,842		2.74	%		613,429	$	8,419		1.83	%
Noninterest-bearing demand deposits		55,142							43,619
Noninterest-bearing liabilities		7,428							5,497
Stockholders’ equity		71,266							65,799
Total liabilities and stockholders’ equity	$	857,476						$	728,344

Net interest rate spread			$	28,222		4.45	%			$	22,438		4.27	%
Taxable-equivalent adjustment				280							299
Net interest income, actual			$	27,942						$	22,139

Net interest-earning assets/net interest margin	$	76,714				4.71	%	$	62,145				4.44	%
Interest-earning assets as a percentage of interest-bearing liabilities						110.60	%						110.13	%

⁽¹⁾	Nonaccrual loans are included in average balances and income on such loans, if recognized, is recognized on a cash basis.

Noninterest income - Noninterest income for the nine months ended September 30, 2005, decreased $1.3 million or 13.7% to $8.2 million from $9.5 million in the first nine months of 2004. In the first nine months of 2004, noninterest income includes a $3.0 million pre-tax gain on the sale of Flag’s Thomaston, Georgia branch.

Traditionally service charges on deposit accounts and revenues from mortgage banking activities have been the largest components of noninterest income. Service charges on deposit accounts decreased to $2.4 million for the nine months ended September 30, 2005, a decrease of $368,000 or 13.2%, from $2.8 million in the first nine months of 2004. While Flag maintained strong growth in deposits during the past year, much of the growth came from higher-balance money market and interest-bearing checking balances where customers carry balances sufficient to qualify for reduced or eliminated fees. Mortgage banking activities includes origination fees, service release premiums and the gains on sales of mortgage loans held-for-sale. Mortgage banking activities totaled $2.2 million, an increase of $288,000 or 15.4%, compared to $1.9 million in the first nine months of 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Payroll Solutions generated $1.6 million in fee income in the nine months ended September 30, 2005. Flag acquired Payroll Solutions, a leading provider of payroll services, in the fourth quarter of 2004.

In the nine months ended September 30, 2005, gains on sales of securities were $129,000, a decrease of $571,000, compared to $700,000 in the same period last year. Gains on sales of other real estate owned increased $445,000 to $558,000 in the nine months ended September 30, 2005, from $113,000 in the first nine months of 2004. In the quarter ended September 30, 2005, Flag recognized a $317,000 gain on the sale of 29.5 acres of land.

Other income increased $515,000 or 82.9% to $1.1 million in the nine months ended September 30, 2005, compared to $621,000 in the same period last year. Other miscellaneous income on loans, which are included in other income, increased $230,000 or 100.9% to $458,000 in the nine months ended September 30, 2005, compared to $228,000 in the first nine months of 2004. The rise in other miscellaneous income on loans is primarily due to increased loan activity generated by Flag’s correspondent and structured lending groups.

Noninterest expense - Noninterest expense for the nine months ended September 30, 2005, totaled $25.4 million, an increase of $3.4 million or 15.3%, compared to $22.0 million in the same period of 2004.

Salaries and employee benefits totaled $15.8 million in the nine months ended September 30, 2005, an increase of $2.4 million or 18.1%, from $13.3 million in the first nine months of 2004. The increase in salaries and benefits relates primarily to increases in production personnel in metro Atlanta and the addition of Payroll Solutions personnel totaling $789,000. In the nine months ended September 30, 2005, salaries and employee benefits increased $1.9 million in metro Atlanta, excluding Payroll Solutions, and decreased $276,000 in the Company’s Central and West regions. In the first nine months of 2004, salaries and employee benefits included a $376,000 charge related to deferred compensation plans.

Occupancy expense for the nine months ended September 30, 2005, totaled $2.9 million, an increase of $168,000 or 6.1% from $2.7 million in the first nine months of 2004.

Professional fees were $1.5 million in the nine months ended September 30, 2005, an increase of $645,000 or 79.0%, compared to $817,000 in the same period of 2004. This increase is in part due to additional expenses related to continued compliance with the Sarbanes-Oxley Act.

Other noninterest expense totaled $2.9 million for the nine months ended September 30, 2005, a decrease of $132,000 or 4.8%, compared to $2.7 million in the same period of 2004. Included in other noninterest expense in 2004, were real estate write-downs totaling $262,000, compared to $61,000 in the nine months ended September 30, 2005, a decrease of $201,000 or 229.5%. Marketing expense totaled $563,000, an increase of $200,000 or 55.1%, from $363,000 in the first nine months of 2004. The increase in marketing expense is primarily attributable to advertising costs associated with building Flag’s metro Atlanta franchise.

Income taxes - Income tax expense for the nine months ended September 30, 2005, totaled $3.3 million compared to $2.5 million for the same period of 2004. Flag’s effective tax rate increased to 32.5% in the nine months ended September 30, 2005, compared to 30.7% in the same period of 2004. Flag’s higher effective tax rate relates to certain state income tax credits taken in the nine months ended September 30, 2004.

Table of Contents

Flag Financial Corporation and Subsidiary

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

As of September 30, 2005, there were no substantial changes in the composition of Flag’s market-sensitive assets and liabilities or their related market values from those reported as of December 31, 2004. The foregoing disclosures related to the market risk of Flag should be read in conjunction with Flag’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2004, included in Flag’s 2004 Annual Report on Form 10-K.

Item 4.

Controls and Procedures

As of the end of the period covered by this report, Flag carried out an evaluation, under the supervision and with the participation of Flag’s management, including Flag’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Flag’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, Flag’s Chief Executive Officer and Chief Financial Officer concluded that Flag’s disclosure controls and procedures are effective in timely alerting them to material information relating to Flag (including its consolidated subsidiary) that is required to be included in Flag’s periodic filings with the Securities and Exchange Commission. There have been no significant changes in Flag’s internal controls or, to Flag’s knowledge, in other factors that could significantly affect those internal controls subsequent to the date Flag carried out its evaluation, and there have been no corrective actions with respect to significant deficiencies or material weaknesses.

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PART II.

Other Information

Flag Financial Corporation and Subsidiary

Item 1.

Legal Proceedings - None

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth information regarding the Company’s purchases of its common stock on a monthly basis during the quarter ended September 30, 2005 (in thousands):

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part Of Publicly Announced Plans Or Programs ⁽¹⁾		Maximum Number Of Shares that May Yet Be Purchased Under the Plans or Programs

July 1 through July 31, 2005		-		-		1,551		549

August 1 through August 31, 2005		-		-		1,551		549

September 1 through September 30,2005		-		-		1,551		549

Total						1,551		549

⁽¹⁾ On March 19, 2004, Flag Financial Corporation announced a stock repurchase plan. The Company’s Board of Directors authorized the repurchase of up to 10% of the Company’s outstanding shares of common stock. No expiration date was specified, and no shares were repurchased under or outside of the plan during the quarter ended September 30, 2005. As of September 30, 2005, the Company has repurchased 304,000 shares at an aggregate cost of $3.9 million.

Item 3.

Defaults upon Senior Securities - None

Item 4.

Submission of Matters to a Vote of Security Holders - None

Item 5.

Other Information - None

Item 6.

Exhibits

31.1	Section 302 Certification by Chief Executive Officer
31.2	Section 302 Certification by Chief Financial Officer
32.1	Section 906 Certification by Chief Executive Officer and Chief Financial Officer

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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.

	Flag Financial Corporation


	/s/ Joseph W Evans
	Joseph W. Evans
	Chief Executive Officer

	November 08, 2005

	/s/ J. Daniel Speight
	J. Daniel Speight
	Chief Financial Officer

	November 08, 2005