**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K**





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





For
      the
      fiscal year ended December 31, 2006





OR





**o
      TRANSITIONAL REPORT
      UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**





For
      the
      transition period from _______ to _______.





COMMISSION
      FILE NUMBER 000-32951





**CRESCENT
      FINANCIAL CORPORATION**


(Exact
      name of registrant as specified in its charter)





NORTH
                CAROLINA
            
            56-2259050(State
                or Other Jurisdiction of
            
            (I.R.S.
                EmployerIncorporation
                or Organization)
            
            Identification
                No.)





1005
      High House Road, Cary, North Carolina


27513


(Address
      of Principal Executive Offices)


(Zip
      Code)





Registrant’s
      Telephone number, including area code: (919) 460-7770





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





**NONE**





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





**COMMON
      STOCK, PAR VALUE $1.00 PER SHARE**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


o
      Yes x No





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act.


o
      Yes x No





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





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





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of "accelerated
      filer and large accelerated filer" in Rule 12b-2 of the Exchange Act Rule.





Large
                accelerated filer o
            Accelerated
                filer o
            Non-accelerated
                filer x





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).


o
      Yes x No




State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      last sold, or the average bid and asked price of such common equity, as of
      the
      last business day of the registrant's most recently completed second fiscal
      quarter: $68,324,358.





Indicate
      the number of shares outstanding of each of the registrant’s classes of Common
      Stock as of the latest practicable date: 8,298,296 shares of Common Stock
      outstanding as of March 15, 2007.





**Documents
      Incorporated by Reference.**


None.










**PART
                I**
            
            **FORM
                10-K**
            
            **PROXY**
              **STATEMENT**
            
            **ANNUAL**
              **REPORT****Item
                1 - Business**
            
            **X****Item
                1A - Risk Factors**
            
            **X****Item
                1B - Unresolved Staff Comments**
            
            **X****Item
                2 - Properties**
            
            **X****Item
                3 - Legal Proceedings**
            
            **X****Item
                4 - Submission of Matters to a Vote**
              **of
                Security Holders**
            
            **X****PART
                II****Item
                5 - Market for Registrant’s**
              **Common
                Equity, Related**
              **Stockholder
                Matters and Issuer**
              **Purchases
                of Equity Securities**
            
            **X****Item
                6 - Selected Financial Data**
            
            **X****Item
                7 - Management’s Discussion and**
              **Analysis
                of Financial Condition**
              **and
                Results of Operation**
            
            **X****Item
                7A - Quantitative and Qualitative**
              **Disclosures
                About Market**
              **Risk******
            
            **X****Item
                8 - Financial Statements and**
              **Supplementary
                Data**
            
            **X****Item
                9 -  Changes in and Disagreements**
              **with
                Accountants on**
              **Accounting
                and Financial**
              **Disclosure**
            
            **X****Item
                9A - Controls and Procedures**
            
            **X****Item
                9B - Other Information**
            
            **X****PART
                III****Item
                10 - Directors and Executive**
              **Officers
                of the Registrant**
            
            **X**
            
            **X****Item
                11 - Executive Compensation**
            
            
            
            **X****Item
                12 - Security Ownership of Certain**
              **Beneficial
                Owners and**
              **Management
                and Related**
              **Stockholder
                Matters**
            
            **X**
            
            **X****Item
                13 - Certain Relationships and**
              **Related
                Transactions**
            
            
            
            **X****Item
                14 - Principal Accounting Fees and**
              **Services**
            
            
            
            **X****PART
                IV****Item
                15 - Exhibits, Financial Statement**
              **Schedules**
            
            **X**





2




**PART
      I**





**ITEM
      1 - BUSINESS**





**General**





Crescent
      Financial Corporation (referred to as the “Registrant,” the “Company” or by the
      use of “we,” “our” or “us”) was incorporated under the laws of the State of
      North Carolina on April 27, 2001, at the direction of the Board of Directors
      of
      Crescent State Bank (“CSB”), for the purpose of serving as the bank holding
      company for CSB and became the holding company for CSB on June 30, 2001. To
      become CSB’s holding company, Registrant received approval of the Federal
      Reserve Board as well as CSB’s shareholders. Upon receiving such approval, each
      share of $5.00 par value common stock of CSB was exchanged on a one-for-one
      basis for the $1.00 par value common stock of the Registrant. On August 31,
      2006, the Registrant acquired Port City Capital Bank for cash and stock valued
      at $40.2 million. The Company now serves as a multi-bank holding
      company.





CSB
      was
      incorporated on December 22, 1998 as a North Carolina-chartered commercial
      bank
      and opened for business on December 31, 1998. Including its main office, CSB
      operates ten (10) full service branch offices in Cary (2), Apex, Clayton, Holly
      Springs, Pinehurst, Raleigh, Southern Pines, Sanford and Garner, North Carolina
      and one loan production office in Raleigh, North Carolina. The Southern Pines
      and Pinehurst offices were acquired through a merger with Centennial Bank of
      Southern Pines in August, 2003.





Port
      City
      Capital Bank (“PCCB”) was organized and incorporated under the laws of the State
      of North Carolina on June 13, 2002 and commenced operations on July 1, 2002.
      PCCB currently serves New Hanover County, North Carolina and surrounding areas
      through one banking office. As a state chartered bank that is not a member
      of
      the Federal Reserve, PCCB is subject to regulation by the State of North
      Carolina Banking Commission and the Federal Deposit Insurance
      Corporation.





The
      Registrant operates for the primary purpose of serving as the holding company
      for the two banks. The Registrant’s headquarters are located at 1005 High House
      Road, Cary, North Carolina 27513.





The
      banks
      operate for the primary purpose of serving the banking needs of individuals,
      and
      small- to medium-sized businesses in their market area. The banks offer a range
      of banking services including checking and savings accounts, commercial,
      consumer and personal loans, and mortgage services and other associated
      financial services.





**Lending
      Activities**





*General.* We
      provide a wide range of short- to medium-term commercial, mortgage, construction
      and personal loans, both secured and unsecured. We also make real estate
      mortgage and construction loans and Small Business Administration guaranteed
      loans. Many of our commercial loans are collateralized with real estate in
      our
      market but such collateral is mainly a secondary, and not primary, source of
      repayment. We have maintained a balance between variable and fixed rate loans
      within our portfolio. Variable rate loans accounted for 55% of the loan balances
      outstanding at December 31, 2006 while fixed rate loans accounted for 45% of
      the
      balances.





Our
      loan
      policies and procedures establish the basic guidelines governing our lending
      operations. Generally, the guidelines address the types of loans that we seek,
      target markets, underwriting and collateral requirements, terms, interest rate
      and yield considerations and compliance with laws and regulations. All loans
      or
      credit lines are subject to approval procedures and amount limitations. These
      limitations apply to the borrower’s total outstanding indebtedness to us,
      including the indebtedness of any guarantor. The policies are reviewed and
      approved at least annually by the board of directors of the bank. We supplement
      our own supervision of the loan underwriting and approval process with periodic
      loan audits by internal loan examiners and outside professionals experienced
      in
      loan review work.




*Commercial
      Mortgage Loans.* We
      originate and maintain a significant amount of commercial real estate loans.
      This lending involves loans secured principally by commercial office buildings,
      both investment and owner occupied. We require the personal guaranty of
      principals and a demonstrated cash flow capability sufficient to service the
      debt. The real estate collateral is a secondary source of repayment. Loans
      secured by commercial real estate may be in greater amount and involve a greater
      degree of risk than one to four family residential mortgage loans. Payments
      on
      such loans are often dependent on successful operation or management of the
      properties. We also make loans secured by commercial/investment properties
      provided the subject property is either pre-leased or pre-sold before the bank
      commits to finance its construction.





3


*Construction
      Loans.* Another
      of our primary lending focuses is construction/development lending. We originate
      one to four family residential construction loans for the construction of custom
      homes (where the home buyer is the borrower) and provide financing to builders
      and consumers for the construction of homes. We finance “starter” homes as well
      as “high-end” homes. We generally receive a pre-arranged permanent financing
      commitment from an outside banking entity prior to financing the construction
      of
      pre-sold homes. The bank is active in the construction market and makes
      construction loans to builders of homes that are not pre-sold, but limits the
      number of such loans to any one builder. This type of lending is only done
      with
      local, well-established builders and not with large or national tract builders.
      We lend to builders in our market who have demonstrated a favorable record
      of
      performance and profitable operations. We limit the number of unsold homes
      for
      each builder but there is no limit for pre-sold homes. We will also finance
      small tract developments and sub-divisions; however, we seek to be only one
      of a
      number of financial institutions making construction loans in any one tract
      or
      sub-division. We endeavor to further limit our construction lending risk through
      adherence to established underwriting procedures and the requirement of
      documentation of all draw requests. We require personal guarantees of the
      principals and demonstrated secondary sources of repayment on construction
      loans.





*Commercial
      Loans.* Commercial business lending is another focus of our lending activities.
      Commercial loans include secured loans for working capital, expansion and other
      business purposes. Short-term working capital loans generally are secured by
      accounts receivable, inventory and/or equipment. Lending decisions are based
      on
      an evaluation of the financial strength, cash flow, management and credit
      history of the borrower, and the quality of the collateral securing the loan.
      With few exceptions, we require personal guarantees of the principals and
      secondary sources of repayment, primarily a deed of trust on local real estate.
      Commercial loans generally provide greater yields and reprice more frequently
      than other types of loans, such as commercial mortgage loans. More frequent
      repricing means that yields on our commercial loans adjust more quickly with
      changes in interest rates.





*Loans
      to Individuals, Home Equity Lines of Credit and Residential Real Estate Loans.* Loans
      to
      individuals (consumer loans) include automobile loans, boat and recreational
      vehicle financing, home equity and home improvement loans and miscellaneous
      secured and unsecured personal loans. Consumer loans generally can carry
      significantly greater risks than other loans, even if secured, if the collateral
      consists of rapidly depreciating assets such as automobiles and equipment.
      Repossessed collateral securing a defaulted consumer loan may not provide an
      adequate secondary source of repayment of the loan. Consumer loan collections
      are sensitive to job loss, illness and other personal factors. We attempt to
      manage the risks inherent in consumer lending by following established credit
      guidelines and underwriting practices designed to minimize risk of loss.





Residential
      real estate loans are made for purchasing and refinancing one to four family
      properties. We offer fixed and variable rate options, but generally limit the
      maximum fixed rate term to five years. We provide customers access to long-term
      conventional real estate loans through our mortgage loan department, which
      originates loans and brokers them for sale in the secondary market. Such loans
      are closed by mortgage brokers and are not funded by us. We anticipate that
      we
      will continue to be an active originator of mortgage loans and only hold for
      our
      own account a small number of well-collateralized, non-conforming residential
      loans.





4


The
      following table describes our loan portfolio composition by category:


At
                  December 31,2006
              
              2005
              
              2004%
                  of Total
              
              
              
              %
                  of Total
              
              
              
              %
                  of TotalAmount
              
              Loans
              
              Amount
              
              Loans
              
              Amount
              
              Loans(Dollars
                  in thousands)Real
                  estate - commercial
              
              $
              304,823
              
              
              55.36
              %
              $
              174,039
              
              
              52.92
              %
              
              121,825
              
              
              47.24
              %Real
                  estate - residential
              
              
              20,224
              
              
              3.67
              %
              
              14,914
              
              
              4.54
              %
              
              11,604
              
              
              4.50
              %Construction
                  loans
              
              
              110,033
              
              
              19.99
              %
              
              46,607
              
              
              14.17
              %
              
              38,916
              
              
              15.09
              %Commercial
                  and industrial loans
              
              
              67,822
              
              
              12.32
              %
              
              52,708
              
              
              16.03
              %
              
              48,757
              
              
              18.90
              %Home
                  equity loans and lines of credit
              
              
              42,704
              
              
              7.76
              %
              
              34,921
              
              
              10.62
              %
              
              30,960
              
              
              12.00
              %Loans
                  to individuals
              
              
              4,977
              
              
              0.90
              %
              
              5,670
              
              
              1.72
              %
              
              5,846
              
              
              2.27
              %Total
                  loans
              
              
              550,583
              
              
              100.00
              %
              
              328,859
              
              
              100.00
              %
              
              257,908
              
              
              100.00
              %Less:
                  Net deferred loan fees
              
              
              (764
              )
              
              
              
              
              (537
              )
              
              
              
              
              (447
              )Total
                  loans, net
              
              $
              549,819
              
              
              
              
              $
              328,322
              
              
              
              
              $
              257,461




At
                  December 31,2003
              
              2002%
                  of Total
              
              
              
              %
                  of TotalAmount
              
              Loans
              
              Amount
              
              Loans(Dollars
                  in thousands)Real
                  estate - commercial
              
              $
              101,316
              
              
              46.66
              %
              $
              52,361
              
              
              41.59
              %Real
                  estate - residential
              
              
              14,765
              
              
              6.80
              %
              
              2,319
              
              
              1.84
              %Construction
                  loans
              
              
              31,612
              
              
              14.56
              %
              
              27,503
              
              
              21.84
              %Commercial
                  and industrial loans
              
              
              38,237
              
              
              17.61
              %
              
              24,682
              
              
              19.60
              %Home
                  equity loans and lines of credit
              
              
              22,985
              
              
              10.59
              %
              
              16,051
              
              
              12.75
              %Loans
                  to individuals
              
              
              8,213
              
              
              3.78
              %
              
              3,002
              
              
              2.38
              %Total
                  loans
              
              
              217,128
              
              
              100.00
              %
              
              125,917
              
              
              100.00
              %Less:
                  Net deferred loan fees
              
              
              (382
              )
              
              
              
              
              (244
              )Total
                  loans, net
              
              $
              216,746
              
              
              
              
              $
              125,673


The
      following table presents at December 31, 2006 (i) the aggregate maturities
      of
      loans in the named categories of our loan portfolio and (ii) the aggregate
      amounts of such loans, by variable and fixed rates that mature after one
      year:


Within
              
              1-5
              
              After
                  51
                  Year
              
              Years
              
              Years
              
              Total(In
                  thousands)Commercial
                  mortgage
              
              $
              101,268
              
              $
              196,840
              
              $
              6,715
              
              $
              304,823Residential
                  mortgage
              
              
              9,425
              
              
              10,623
              
              
              176
              
              
              20,224Construction
                  loans
              
              
              78,101
              
              
              29,085
              
              
              2,847
              
              
              110,033Commercial
                  and industrial
              
              
              47,266
              
              
              20,420
              
              
              136
              
              
              67,822Home
                  equity lines and loans
              
              
              4,320
              
              
              12,569
              
              
              25,815
              
              
              42,704Individuals
              
              
              2,534
              
              
              2,124
              
              
              319
              
              
              4,977Total
              
              $
              242,914
              
              $
              271,661
              
              $
              36,008
              
              $
              550,583Fixed
                  rate loans
              
              
              
              
              
              
              
              
              
              
              $
              190,301Variable
                  rate loans
              
              
              
              
              
              
              
              
              
              
              
              117,368$
              307,669




5




*Loan
      Approvals.* Our
      loan
      policies and procedures establish the basic guidelines governing lending
      operations. Generally, the guidelines address the type of loans that we seek,
      target markets, underwriting and collateral requirements, terms, interest rate
      and yield considerations and compliance with laws and regulations. All loans
      and
      credit lines are subject to approval procedures and amount limitations.
      Depending upon the loan requested, approval may be granted by the individual
      loan officer, our officers’ loan committee or, for the largest relationships,
      the directors’ loan committee. The Company’s full board is required to approve
      any single transaction of $2.5 million or more. These amount limitations apply
      to the borrower’s total outstanding indebtedness to us, including the
      indebtedness of any guarantor. The policies are reviewed and approved at least
      annually by the board of directors.





Responsibility
      for loan review, underwriting, compliance and document monitoring resides with
      the senior credit officer. He is responsible for loan processing and approval.
      On an annual basis, the board of directors of the bank determines the
      president’s lending authority, who then delegates lending authorities to the
      senior credit officer and other lending officers of the bank. Delegated
      authorities may include loans, letters of credit, overdrafts, uncollected funds
      and such other authorities as determined by the board of directors or the
      president within his delegated authority.





*Credit
      Cards.* We
      offer
      a credit card on an agency basis as an accommodation to our customers. We assume
      none of the underwriting risk.





*Loan
      Participations.* From
      time
      to time we purchase and sell loan participations to or from other banks within
      and outside our market area. All loan participations purchased have been
      underwritten using our standard and customary underwriting criteria.





**Commitments
      and Contingent Liabilities**





In
      the
      ordinary course of business, we enter into various types of transactions that
      include commitments to extend credit. We apply the same credit standards to
      these commitments as we use in all of our lending activities and have included
      these commitments in our lending risk evaluations. Our exposure to credit loss
      under commitments to extend credit is represented by the amount of these
      commitments. See Note M of the “Notes to Consolidated Financial Statements.”





**Asset
      Quality**





We
      consider asset quality to be of primary importance, and employ a third party
      loan reviewer to ensure adherence to the lending policy as approved by our
      board
      of directors. It is the responsibility of each lending officer to assign an
      appropriate risk grade to every loan originated. Credit administration, through
      the loan review process, validates the accuracy of the initial risk grade
      assessment. In addition, as a given loan’s credit quality improves or
      deteriorates, it is credit administration’s responsibility to change the
      borrower’s risk grade accordingly. At least annually we undergo loan review by
      an outside third party who reviews compliance with our underwriting standards
      and risk grading and provides a report detailing the conclusions of that review
      to our board of directors and senior management. The banks’ boards requires
      management to address any criticisms raised during the loan review and to take
      appropriate actions where warranted.





**Investment
      Activities**





Our
      investment portfolio plays a major role in management of liquidity and interest
      rate sensitivity and, therefore, is managed in the context of the overall
      balance sheet. The securities portfolio generates a nominal percentage of our
      interest income and serves as a necessary source of liquidity. Debt and equity
      securities that will be held for indeterminate periods of time, including
      securities that we may sell in response to changes in market interest or
      prepayment rates, needs for liquidity and changes in the availability of and
      the
      yield of alternative investments, are classified as available for sale. We
      carry
      these investments at market value, which we generally determine using published
      quotes or a pricing matrix obtained at the end of each month. Unrealized gains
      and losses are excluded from our earnings and are reported, net of applicable
      income tax, as a component of accumulated other comprehensive income in
      stockholders’ equity until realized.





6


**Deposit
      Activities**





We
      provide a range of deposit services, including non-interest bearing checking
      accounts, interest bearing checking and savings accounts, money market accounts
      and certificates of deposit. These accounts generally earn interest at rates
      established by management based on competitive market factors and management’s
      desire to increase or decrease certain types or maturities of deposits. We
      use
      brokered deposits to supplement our funding sources. However, we strive to
      establish customer relations to attract core deposits in non-interest bearing
      transactional accounts and thus reduce our cost of funds.





The
      following table sets forth for the years indicated the average balances
      outstanding and average interest rates for each major category of
      deposits:


For
                  the Year Ended December 31,2006
              
              2005
              
              2004(Dollars
                  in thousands)Average
              
              
              Average
              
              
              Average
              
              
              Average
              
              
              Average
              
              
              AverageBalance
              
              
              Rate
              
              
              Balance
              
              
              Rate
              
              
              Balance
              
              
              RateNon-interest
                  bearing deposits
              
              $
              56,376
              
              
              -
              
              $
              42,641
              
              
              -
              
              $
              37,898
              
              
              -Interest
                  bearing demand deposits
              
              
              37,876
              
              
              1.46
              %
              
              39,609
              
              
              1.05
              %
              
              40,931
              
              
              0.79
              %Money
                  market deposits
              
              
              51,926
              
              
              3.52
              %
              
              41,548
              
              
              2.16
              %
              
              31,537
              
              
              1.29
              %Savings
                  deposits
              
              
              40,694
              
              
              4.51
              %
              
              4,952
              
              
              1.79
              %
              
              2,758
              
              
              0.36
              %Time
                  deposits over $100,000
              
              
              154,538
              
              
              4.82
              %
              
              110,312
              
              
              3.30
              %
              
              85,961
              
              
              2.57
              %Time
                  deposits under $100,000
              
              
              72,440
              
              
              3.51
              %
              
              58,787
              
              
              3.13
              %
              
              56,445
              
              
              2.68
              %Total
                  interest bearing deposits
              
              
              357,474
              
              
              3.97
              %
              
              255,208
              
              
              2.70
              %
              
              217,632
              
              
              2.04
              %Total
                  average deposits
              
              $
              413,850
              
              
              3.43
              %
              $
              297,849
              
              
              2.31
              %
              $
              255,530
              
              
              1.73
              %




For
                  the Year Ended December 31,2003
              
              2002(Dollars
                  in thousands)Average
              
              Average
              
              Average
              
              AverageBalance
              
              Rate
              
              Balance
              
              RateNon-interest
                  bearing deposits
              
              $
              34,977
              
              
              -
              
              $
              24,086
              
              
              -Interest
                  bearing demand deposits
              
              
              31,340
              
              
              0.94
              %
              
              19,668
              
              
              1.61
              %Money
                  market deposits
              
              
              22,589
              
              
              1.37
              %
              
              21,144
              
              
              1.90
              %Savings
                  deposits
              
              
              1,544
              
              
              0.40
              %
              
              1,154
              
              
              0.69
              %Time
                  deposits over $100,000
              
              
              41,644
              
              
              3.15
              %
              
              30,627
              
              
              3.65
              %Time
                  deposits under $100,000
              
              
              41,566
              
              
              2.95
              %
              
              28,218
              
              
              3.76
              %Total
                  interest bearing deposits
              
              
              138,683
              
              
              2.21
              %
              
              100,811
              
              
              2.85
              %Total
                  average deposits
              
              $
              173,660
              
              
              1.77
              %
              $
              124,897
              
              
              2.30
              %





The
      following table sets forth the amounts and maturities of certificates of deposit
      with balances of $100,000 or more at December 31, 2006:


Remaining
                  maturity:
              
              (in
                  thousands)Three
                  months or less
              
              $
              55,900Over
                  three months through one year
              
              
              93,602Over
                  one year through three years
              
              
              66,766Over
                  three years through five years
              
              
              13,498Total
              
              $
              229,766





7


**Borrowings**





As
      additional sources of funding, we use advances from the Federal Home Loan Bank
      of Atlanta under a line of credit equal to 20% of the CSB’s total assets ($101.5
      million at December 31, 2006). Outstanding advances at December 31, 2006 were
      $55.0 million. Pursuant to collateral agreements with the Federal Home Loan
      Bank, at December
      31, 2006 advances were secured by investment securities available for sale
      with
      a fair value of $9.8 million and by loans with a carrying amount of $116.1
      million, which approximates market value. PCCB does not utilize the FHLB as
      a
      funding source.





We
      may
      purchase federal funds through five unsecured federal funds lines of credit
      aggregating $44.2 million. These lines are intended for short-term borrowings
      and are subject to restrictions limiting the frequency and terms of the
      advances. These lines of credit are payable on demand and bear interest based
      upon the daily federal funds rate (5.63% at December 31, 2006). Short-term
      borrowings may also consist of securities sold under a repurchase agreement.
      Securities sold under repurchase agreements generally mature within one to
      four
      days from the transaction date. There were $6.5 million in federal funds
      purchased at December 31, 2006.





**Junior
      Subordinated Debt**





In
      August
      of 2003, $8.0 million in trust preferred securities were placed through Crescent
      Financial Capital Trust I. The trust has invested the total proceeds from the
      sale of its trust preferred securities in junior subordinated deferrable
      interest debentures issued by us. The trust preferred securities pay cumulative
      cash distributions quarterly at an annual rate, reset quarterly, equal to
      three-month LIBOR plus 310 basis points. The dividends paid to holders of the
      trust preferred securities, which are recorded as interest expense, are
      deductible by us for income tax purposes. The trust preferred securities are
      redeemable on or after October 7, 2008. We have fully and unconditionally
      guaranteed the trust preferred securities through the combined operation of
      the
      debentures and other related documents. Our obligation under the guarantee
      is
      unsecured and subordinate to senior and subordinated indebtedness. The principal
      reason for issuing trust preferred securities is that the proceeds from their
      sale qualify as Tier 1 capital for regulatory capital purposes (subject to
      certain limitations), thereby enabling us to enhance our regulatory capital
      positions without diluting the ownership of our stockholders.





**Investment
      Services**





Crescent
      State Bank has entered into a revenue sharing agreement with Capital Investment
      Group, Raleigh, North Carolina, under which it receives revenue for securities
      and annuity sales generated by brokers located in our offices. We offer this
      investment service under the name “Crescent Investment Services.”





Port
      City
      Capital Bank has entered into a revenue sharing agreement with Fountain
      Financial Associates, Wilmington, North Carolina, under which it receives
      revenue for securities and annuity sales generated by brokers located in its
      office.





**Courier
      Services**





We
      offer courier services to our customers free-of-charge as a
      convenience and a demonstration of our commitment to superior
      customer-service.  Our couriers travel to the customer’s
      location, pick-up non-cash deposits from the customer and deliver those deposits
      to the bank.  We feel our couriers serve as ambassadors for our bank and
      enhance our presence in the communities we serve.





**Banking
      Technology**




Because
      of the level of sophistication of our markets, we commenced operations with
      a
      full array of technology available for our customers. Our customers have the
      ability to perform on-line banking and bill paying, access on-line check images,
      make transfers, initiate wire transfer requests and stop payment orders of
      checks. We provide our customers with imaged check statements, thereby
      eliminating the cost of returning checks to customers and eliminating the
      clutter of canceled checks. Through branch image capture technology, both CSB
      and PCCB offer same day credit for deposits made prior to 5:00 pm.




8


**Strategy**





Our
      strategy is three-fold: we are committed to achieving growth and performance
      through exceptional customer service and sound asset quality; we provide a
      comprehensive array of products and services; and we are able to adapt to a
      rapidly changing banking environment. We place the highest priority on providing
      professional, highly personalized service - it’s the driving force behind our
      business. Our de novo expansion strategy is to identify growth markets and
      expand into them, but only when we are able to retain the services of an
      experienced banker with  extensive
      personal knowledge of that market.





**Primary
      Market Area**





CSB’s
      market area includes the four contiguous counties of Wake, Johnston, Lee and
      Moore Counties. This area includes the State Capitol of Raleigh as well as
      the
      area known as Research Triangle Park, one of the nation’s leading technology
      centers. Our market area is home to several universities and institutions of
      higher learning, including North Carolina State University. The four counties
      comprising our market area have a diverse economy centered on state government,
      the academic community, the technology industry, the medical and pharmaceuticals
      sectors and the many small businesses that support these enterprises as well
      as
      the people that live and work in this area. According to the U.S. Census Bureau,
      the Raleigh-Durham-Cary Metropolitan Statistical Area, which includes the Town
      of Cary, had a population of approximately 1.5 million people in 2005. Lee
      and
      Moore Counties are located to the south of Raleigh in the region referred to
      as
      the Sandhills area, which is home to the towns of Pinehurst, Sanford and
      Southern Pines. The region’s economy benefits from an emphasis on the golf
      industry due to the many world class golf courses located in the vicinity and
      also from a growing retiree population drawn to the mild climate and
      recreational activities afforded by the Sandhills area.





Cary,
      the
      second largest city in Wake County and the seventh largest in North Carolina,
      has an estimated population of 117,000 as of October 2006. The area has a very
      strong and diversified economy. The total population of Wake County is over
      748,000 as of June 2005. The total population of Johnston County is over
      146,000, Moore County has an estimated population of over 80,000 and Lee County
      has an estimated population of over 55,000 as of June 2005. Our market area
      is
      served by several major highways, Interstates 40, 440 and 540, US 1, US 64,
      and
      NC 55. International, national, and regional airlines offer service from the
      Raleigh-Durham International Airport, which is less than five miles from
      Cary.





The
      population of our market area is relatively diverse, young and highly educated.
      As of 2000, over 60% of Cary’s population 25 years or older had at least a
      bachelor’s degree. This educational level is due to the number of higher
      education institutions located in our market area as well as the Research
      Triangle Park’s high technology employee base.





The
      economic strength of the area is also reflected by the per capita income, which
      as of the year 2003 for the Raleigh-Durham-Cary metropolitan statistical area
      was $33,627 compared to $28,071 for North Carolina. The median family income
      in
      the Raleigh-Durham-Cary metropolitan statistical area in 2005 was $69,800
      compared to $56,712 for the State of North Carolina. Cary is home to the world’s
      largest privately held software company, SAS Institute, and it has attracted
      other world-class businesses including MCI, RH Donnelly, Siemens, American
      Airlines, Oxford University Press and Austin Foods. The Research Triangle Park
      houses major facilities of IBM, GlaxoSmithKline, Nortel, the U.S. Environmental
      Protection Agency, Quintiles and numerous other technology and bio-medical
      firms.





PCCB’s
      market area includes New Hanover County which is home to Wilmington, North
      Carolina as well as the University of North Carolina at Wilmington. Wilmington
      has an estimated population of 100,000 while New Hanover County has a population
      of approximately 180,000. Wilmington is the ninth largest city in North
      Carolina. The median family income for Wilmington was $54,200 and per capita
      income was $21,500. Wilmington has a sizable seaport and is the most eastern
      point in the United States of Interstate 40. The area has become an important
      destination for the entertainment industry as over 200 movies or television
      shows have been produced in Wilmington. The population is culturally diverse
      and
      the median age is 34 years old.





9


**Competition**





Commercial
      banking in North Carolina is extremely competitive in large part due to early
      adoption of statewide branching. We compete in our market area with large
      regional and national banking organizations, other federally and state chartered
      financial institutions such as savings and loan institutions and credit unions,
      consumer finance companies, mortgage companies and other lenders engaged in
      the
      business of extending credit. Many of our competitors have broader geographic
      markets and higher lending limits than we do and are also able to provide more
      services and make greater use of media advertising. All markets in which we
      have
      a banking office are also served by branches of the largest banks in North
      Carolina





For
      example, as of June 30, 2006 there were 218 offices of 24 different commercial
      banks in Wake County, 30 offices of 9 different commercial banks in Johnston
      County, 37 offices of 11 different commercial banks in Moore County, 19 offices
      of 8 different commercial banks in Lee County and 70 offices of 15 different
      commercial banks in New Hanover County. While we typically do not compete
      directly for loans with larger banks, they do influence our deposit products.
      We
      do compete more directly with mid-size and small community banks that have
      offices in our market areas. There are also a number of new community banks
      in
      Wake and Durham Counties that have a direct competitive effect as borrowers
      tend
      to “shop” the terms of their loans and deposits.





The
      enactment of legislation authorizing interstate banking has led to increases
      in
      the size and financial resources of some of our competitors. In addition, as
      a
      result of interstate banking, out-of-state commercial banks have acquired North
      Carolina banks and heightened the competition among banks in North Carolina.
      For
      example, SunTrust Bank, Atlanta, Georgia, a large multi-state financial
      institution, has branches throughout North Carolina, including Wake County.





Despite
      the competition in our market areas, we believe that we have certain competitive
      advantages that distinguish us from our competition. We offer customers modern
      banking services without forsaking prompt, personal service and friendliness.
      We
      also have established a local advisory board in each of our communities to
      help
      us better understand their needs and to be “ambassadors” of the bank. It is our
      intention to further develop advisory boards as we expand into additional
      communities in our market area. We offer many personalized services and attract
      customers by being responsive and sensitive to their individualized needs.
      We
      believe our approach to business builds goodwill among our customers,
      stockholders, and the communities we serve that results in referrals from
      stockholders and satisfied customers. We also rely on traditional marketing
      to
      attract new customers. To enhance a positive image in the community, we support
      and participate in local events and our officers and directors serve on boards
      of local civic and charitable organizations.





**Employees**





At
      December 31, 2006, the Registrant employed 113 full-time and 16 part-time
      employees. None of the Registrant’s employees are covered by a collective
      bargaining agreement. The Registrant believes its relations with its employees
      to be good.





**REGULATION**





**Regulation
      of the Banks**





The
      banks
      are extensively regulated under both federal and state law. Generally, these
      laws and regulations are intended to protect depositors and borrowers, not
      shareholders. To the extent that the following information describes statutory
      and regulatory provisions, it is qualified in its entirety by reference to
      the
      particular statutory and regulatory provisions. Any change in applicable law
      or
      regulation may have a material effect on the business of the Registrant and
      the
      banks.





State
      Law .
      The
      banks are subject to extensive supervision and regulation by the North Carolina
      Commissioner of Banks (the “Commissioner”). The Commissioner oversees state laws
      that set specific requirements for bank capital and regulate deposits in, and
      loans and investments by, banks, including the amounts, types, and in some
      cases, rates. The Commissioner supervises and performs periodic examinations
      of
      North Carolina-chartered banks to assure compliance with state banking statutes
      and regulations, and the banks are required to make regular reports to the
      Commissioner describing in detail the resources, assets, liabilities and
      financial condition of the banks. Among other things, the Commissioner regulates
      mergers and consolidations of state-chartered banks, the payment of dividends,
      loans to officers and directors, record keeping, types and amounts of loans
      and
      investments, and the establishment of branches.





10




Deposit
      Insurance . The
      banks’ deposits are insured up to applicable limits by the Deposit Insurance
      Fund, or DIF, of the FDIC. The DIF is the successor to the Bank Insurance Fund
      and the Savings Association Insurance Fund, which were merged in 2006. The
      banks’ deposits, therefore, are subject to FDIC deposit insurance assessment.




The
      FDIC recently amended its risk-based deposit assessment system for 2007 to
      implement authority granted by the Federal Deposit Insurance Reform Act of
      2005,
      or the Reform Act. Under the revised system, insured institutions are assigned
      to one of four risk categories based on supervisory evaluations, regulatory
      capital levels and certain other factors. An institution’s assessment rate
      depends upon the category to which it is assigned. Risk Category I, which
      contains the least risky depository institutions, is expected to include more
      than 90% of all institutions. Unlike the other categories, Risk Category I
      contains further risk differentiation based on the FDIC’s analysis of financial
      ratios, examination component ratings and other information. Assessment rates
      are determined by the FDIC and currently range from five to seven basis points
      for the healthiest institutions (Risk Category I) to 43 basis points of
      assessable deposits for the riskiest (Risk Category IV). The FDIC may adjust
      rates uniformly from one quarter to the next, except that no single adjustment
      can exceed three basis points.




The
      FDIC is authorized to set the reserve ratio for the DIF annually at between
      1.15% and 1.5% of estimated insured deposits, in contrast to the statutorily
      fixed ratio of 1.25% under the old system. The ratio, which is viewed by the
      FDIC as the level that the funds should achieve, was established by the agency
      at 1.25% for 2007. The Reform Act also provided for the possibility that the
      FDIC may pay dividends to insured institutions once the DIF reserve ratio equals
      or exceeds 1.35% of estimated insured deposits. The Reform Act also provided
      for
      a one-time credit for eligible institutions based on their assessment base
      as of
      December 1996. Subject to certain limitations with respect to institutions
      that
      are exhibiting weaknesses, credits can be used to offset future assessments
      until exhausted.





Capital
      Requirements .
      The
      federal banking regulators have adopted certain risk-based capital guidelines
      to
      assist in the assessment of the capital adequacy of a banking organization’s
      operations for both transactions reported on the balance sheet as assets and
      transactions, such as letters of credit, and recourse arrangements, which are
      recorded as off balance sheet items. Under these guidelines, nominal dollar
      amounts of assets and credit equivalent amounts of off balance sheet items
      are
      multiplied by one of several risk adjustment percentages which range from 0%
      for
      assets with low credit risk, such as certain U.S. Treasury securities, to 100%
      for assets with relatively high credit risk, such as business
      loans.





A
      banking
      organization’s risk-based capital ratios are obtained by dividing its qualifying
      capital by its total risk- adjusted assets. The regulators measure risk-adjusted
      assets, which include off balance sheet items, against both total qualifying
      capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
      Tier 1 capital. “Tier 1,” or core capital, includes common equity, qualifying
      noncumulative perpetual preferred stock and minority interests in equity
      accounts of consolidated subsidiaries, less goodwill and other intangibles,
      subject to certain exceptions. “Tier 2,” or supplementary capital, includes
      among other things, limited-life preferred stock, hybrid capital instruments,
      mandatory convertible securities, qualifying subordinated debt, and the
      allowance for loan and lease losses, subject to certain limitations and less
      required deductions. The inclusion of elements of Tier 2 capital is subject
      to
      certain other requirements and limitations of the federal banking agencies.
      Banks and bank holding companies subject to the risk-based capital guidelines
      are required to maintain a ratio of Tier 1 capital to risk-weighted assets
      of at
      least 4% and a ratio of total capital to risk-weighted assets of at least 8%.
      The appropriate regulatory authority may set higher capital requirements when
      particular circumstances warrant. As of December 31, 2006, CSB was classified
      as
“well-capitalized” with Tier 1 and Total Risk-Based Capital of 9.12% and 10.26%,
      respectively. As of December 31, 2006, PCCB was classified as “well-capitalized”
with Tier 1 and Total Risk-Based Capital of 9.50% and 10.69%,
      respectively.





The
      federal banking agencies have adopted regulations specifying that they will
      include, in their evaluations of a bank’s capital adequacy, an assessment of the
      bank’s interest rate risk exposure. The standards for measuring the adequacy and
      effectiveness of a banking organization’s interest rate risk management include
      a measurement of board of directors and senior management oversight, and a
      determination of whether a banking organization’s procedures for comprehensive
      risk management are appropriate for the circumstances of the specific banking
      organization.




11




Failure
      to meet applicable capital guidelines could subject a banking organization
      to a
      variety of enforcement actions, including limitations on its ability to pay
      dividends, the issuance by the applicable regulatory authority of a capital
      directive to increase capital and, in the case of depository institutions,
      the
      termination of deposit insurance by the FDIC, as well as the measures described
      under the “Federal Deposit Insurance Corporation Improvement Act of 1991” below,
      as applicable to undercapitalized institutions. In addition, future changes
      in
      regulations or practices could further reduce the amount of capital recognized
      for purposes of capital adequacy. Such a change could affect the ability of
      the
      banks to grow and could restrict the amount of profits, if any, available for
      the payment of dividends to the shareholders.





Federal
      Deposit Insurance Corporation Improvement Act of 1991 .
      In
      December 1991, Congress enacted the Federal Deposit Insurance Corporation
      Improvement Act of 1991 (the “FDIC Improvement Act”), which substantially
      revised the bank regulatory and funding provisions of the Federal Deposit
      Insurance Act and made significant revisions to several other federal banking
      statutes. The FDIC Improvement Act provides for, among other things:




·
            publicly
                available annual financial condition and management reports for certain
                financial institutions, including audits by independent
                accountants,


·
              the
                  establishment of uniform accounting standards by federal banking
                  agencies,


·
            the
                establishment of a “prompt corrective action” system of regulatory
                supervision and intervention, based on capitalization levels, with
                greater
                scrutiny and restrictions placed on depository institutions with
                lower
                levels of capital,





·
            additional
                grounds for the appointment of a conservator or receiver, and





·
            restrictions
                or prohibitions on accepting brokered deposits, except for institutions
                which significantly exceed minimum capital
                requirements.





The
      FDIC
      Improvement Act also provides for increased funding of the FDIC insurance funds
      and the implementation of risk-based premiums.





A
      central
      feature of the FDIC Improvement Act is the requirement that the federal banking
      agencies take “prompt corrective action” with respect to depository institutions
      that do not meet minimum capital requirements. Pursuant to the FDIC Improvement
      Act, the federal bank regulatory authorities have adopted regulations setting
      forth a five-tiered system for measuring the capital adequacy of the depository
      institutions that they supervise. Under these regulations, a depository
      institution is classified in one of the following capital categories: “well
      capitalized,” “adequately capitalized,” “undercapitalized,” “significantly
      undercapitalized” and “critically undercapitalized.” An institution may be
      deemed by the regulators to be in a capitalization category that is lower than
      is indicated by its actual capital position if, among other things, it receives
      an unsatisfactory examination rating with respect to asset quality, management,
      earnings or liquidity.





The
      FDIC
      Improvement Act provides the federal banking agencies with significantly
      expanded powers to take enforcement action against institutions which fail
      to
      comply with capital or other standards. Such action may include the termination
      of deposit insurance by the FDIC or the appointment of a receiver or conservator
      for the institution. The FDIC Improvement Act also limits the circumstances
      under which the FDIC is permitted to provide financial assistance to an insured
      institution before appointment of a conservator or receiver.





International
      Money Laundering Abatement and Financial Anti-Terrorism Act of
      2001 .
      On
      October 26, 2001, the USA Patriot Act of 2001 was enacted. This act contains
      the
      International Money Laundering Abatement and Financial Anti-Terrorism Act of
      2001, which sets forth anti-money laundering measures affecting insured
      depository institutions, broker-dealers and other financial institutions. The
      Act requires U.S. financial institutions to adopt new policies and procedures
      to
      combat money laundering and grants the Secretary of the Treasury broad authority
      to establish regulations and to impose requirements and restrictions on the
      operations of financial institutions.





12


Miscellaneous .
      The
      dividends that may be paid by each bank are subject to legal limitations. In
      accordance with North Carolina banking law, dividends may not be paid unless
      a
      bank’s capital surplus is at least 50% of its paid-in capital.




The
      earnings of the banks will be affected significantly by the policies of the
      Federal Reserve Board, which is responsible for regulating the United States
      money supply in order to mitigate recessionary and inflationary pressures.
      Among
      the techniques used to implement these objectives are open market transactions
      in United States government securities, changes in the rate paid by banks on
      bank borrowings, and changes in reserve requirements against bank deposits.
      These techniques are used in varying combinations to influence overall growth
      and distribution of bank loans, investments, and deposits, and their use may
      also affect interest rates charged on loans or paid for deposits.





The
      monetary policies of the Federal Reserve Board have had a significant effect
      on
      the operating results of commercial banks in the past and are expected to
      continue to do so in the future. In view of changing conditions in the national
      economy and money markets, as well as the effect of actions by monetary and
      fiscal authorities, no prediction can be made as to possible future changes
      in
      interest rates, deposit levels, loan demand or the business and earnings of
      the
      banks.





We
      cannot
      predict what legislation might be enacted or what regulations might be adopted,
      or if enacted or adopted, the effect thereof on the banks’
operations.





**Regulation
      of the Registrant**





Federal
      Regulation .
      The
      Registrant is subject to examination, regulation and periodic reporting under
      the Bank Holding Company Act of 1956, as administered by the Federal Reserve
      Board. The Federal Reserve Board has adopted capital adequacy guidelines for
      bank holding companies on a consolidated basis.





The
      Registrant is required to obtain the prior approval of the Federal Reserve
      Board
      to acquire all, or substantially all, of the assets of any bank or bank holding
      company. Prior Federal Reserve Board approval is required for the Registrant
      to
      acquire direct or indirect ownership or control of any voting securities of
      any
      bank or bank holding company if, after giving effect to such acquisition, it
      would, directly or indirectly, own or control more than five percent of any
      class of voting shares of such bank or bank holding company.





The
      merger or consolidation of the banks with each other or with another bank,
      or
      the acquisition by the Registrant of assets of another bank, or the assumption
      of liability by the Registrant to pay any deposits in another bank, will require
      the prior written approval of the primary federal bank regulatory agency of
      the
      acquiring or surviving bank under the federal Bank Merger Act. The decision
      is
      based upon a consideration of statutory factors similar to those outlined above
      with respect to the Bank Holding Company Act. In addition, in certain such
      cases
      an application to, and the prior approval of, the Federal Reserve Board under
      the Bank Holding Company Act and/or the North Carolina Banking Commission may
      be
      required.





The
      Registrant is required to give the Federal Reserve Board prior written notice
      of
      any purchase or redemption of its outstanding equity securities if the gross
      consideration for the purchase or redemption, when combined with the net
      consideration paid for all such purchases or redemptions during the preceding
      12
      months, is equal to 10% or more of the Registrant’s consolidated net worth. The
      Federal Reserve Board may disapprove such a purchase or redemption if it
      determines that the proposal would constitute an unsafe and unsound practice,
      or
      would violate any law, regulation, Federal Reserve Board order or directive,
      or
      any condition imposed by, or written agreement with, the Federal Reserve Board.
      Such notice and approval is not required for a bank holding company that would
      be treated as “well capitalized” under applicable regulations of the Federal
      Reserve Board, that has received a composite “1” or “2” rating at its most
      recent bank holding company inspection by the Federal Reserve Board, and that
      is
      not the subject of any unresolved supervisory issues.





13


The
      status of the Registrant as a registered bank holding company under the Bank
      Holding Company Act does not exempt it from certain federal and state laws
      and
      regulations applicable to corporations generally, including, without limitation,
      certain provisions of the federal securities laws.





In
      addition, a bank holding company is prohibited generally from engaging in,
      or
      acquiring five percent or more of any class of voting securities of any company
      engaged in, non-banking activities. One of the principal exceptions to this
      prohibition is for activities found by the Federal Reserve Board to be so
      closely related to banking or managing or controlling banks as to be a proper
      incident thereto. Some of the principal activities that the Federal Reserve
      Board has determined by regulation to be so closely related to banking as to
      be
      a proper incident thereto are:


·
              making
                  or servicing loans;
 ·
                performing
                    certain data processing services;
 ·
              providing
                  discount brokerage services;
 
 ·
              acting
                  as fiduciary, investment or financial
                  advisor;
 
 ·
              leasing
                  personal or real property;
 ·
                making
                    investments in corporations or projects designed primarily to
                    promote
                    community welfare; and
 
 ·
                acquiring
                    a savings and loan
                    association.





In
      evaluating a written notice of such an acquisition, the Federal Reserve Board
      will consider various factors, including among others the financial and
      managerial resources of the notifying bank holding company and the relative
      public benefits and adverse effects which may be expected to result from the
      performance of the activity by an affiliate of such company. The Federal Reserve
      Board may apply different standards to activities proposed to be commenced de  novo and
      activities commenced by acquisition, in whole or in part, of a going concern.
      The required notice period may be extended by the Federal Reserve Board under
      certain circumstances, including a notice for acquisition of a company engaged
      in activities not previously approved by regulation of the Federal Reserve
      Board. If such a proposed acquisition is not disapproved or subjected to
      conditions by the Federal Reserve Board within the applicable notice period,
      it
      is deemed approved by the Federal Reserve Board.





However,
      with the passage of the Gramm-Leach-Bliley Financial Services Modernization
      Act
      of 1999, which became effective on March 11, 2000, the types of activities
      in
      which a bank holding company may engage were significantly expanded. Subject
      to
      various limitations, the Modernization Act generally permits a bank holding
      company to elect to become a “financial holding company.” A financial holding
      company may affiliate with securities firms and insurance companies and engage
      in other activities that are “financial in nature.” Among the activities that
      are deemed “financial in nature” are, in addition to traditional lending
      activities, securities underwriting, dealing in or making a market in
      securities, sponsoring mutual funds and investment companies, insurance
      underwriting and agency activities, certain merchant banking activities and
      activities that the Federal Reserve Board considers to be closely related to
      banking.





A
      bank
      holding company may become a financial holding company under the Modernization
      Act if each of its subsidiary banks is “well capitalized” under the Federal
      Deposit Insurance Corporation Improvement Act prompt corrective action
      provisions, is well managed and has at least a satisfactory rating under the
      Community Reinvestment Act. In addition, the bank holding company must file
      a
      declaration with the Federal Reserve Board that the bank holding company wishes
      to become a financial holding company. A bank holding company that falls out
      of
      compliance with these requirements may be required to cease engaging in some
      of
      its activities. The Registrant has not yet elected to become a financial holding
      company.





Under
      the
      Modernization Act, the Federal Reserve Board serves as the primary “umbrella”
regulator of financial holding companies, with supervisory authority over each
      parent company and limited authority over its subsidiaries. Expanded financial
      activities of financial holding companies generally will be regulated according
      to the type of such financial activity: banking activities by banking
      regulators, securities activities by securities regulators and insurance
      activities by insurance regulators. The Modernization Act also imposes
      additional restrictions and heightened disclosure requirements regarding private
      information collected by financial institutions.





Sarbanes-Oxley
      Act of 2002. On July
      30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some
      of
      the most sweeping federal legislation addressing accounting, corporate
      governance and disclosure issues. The impact of the Sarbanes-Oxley Act is
      wide-ranging as it applies to all public companies and imposes significant
      new
      requirements for public company governance and disclosure requirements.




14


In
      general, the Sarbanes-Oxley Act mandates important new corporate governance
      and
      financial reporting requirements intended to enhance the accuracy and
      transparency of public companies’ reported financial results. It establishes new
      responsibilities for corporate chief executive officers, chief financial
      officers and audit committees in the financial reporting process and creates
      a
      new regulatory body to oversee auditors of public companies. It backs these
      requirements with new SEC enforcement tools, increases criminal penalties for
      federal mail, wire and securities fraud, and creates new criminal penalties
      for
      document and record destruction in connection with federal investigations.
      It
      also increases the opportunity for more private litigation by lengthening the
      statute of limitations for securities fraud claims and providing new federal
      corporate whistleblower protection.




The
      economic and operational effects of this new legislation on public companies,
      including us, is significant in terms of the time, resources and costs
      associated with complying with the new law. Because the Sarbanes-Oxley Act,
      for
      the most part, applies equally to larger and smaller public companies, we are
      presented with additional challenges as a smaller, community-oriented financial
      institution seeking to compete with larger financial institutions in our market.





Capital
      Requirements .
      The
      Federal Reserve Board uses capital adequacy guidelines in its examination and
      regulation of bank holding companies. If capital falls below minimum guidelines,
      a bank holding company may, among other things, be denied approval to acquire
      or
      establish additional banks or non-bank businesses.





The
      Federal Reserve Board’s capital guidelines establish the following minimum
      regulatory capital requirements for bank holding companies:


·
              a
                  leverage capital requirement expressed as a percentage of adjusted
                  total
                  assets;
 ·
                a
                    risk-based requirement expressed as a percentage of total risk-weighted
                    assets; and
 
 ·
                a
                    Tier 1 leverage requirement expressed as a percentage of adjusted
                    total
                    assets.





The
      leverage capital requirement consists of a minimum ratio of total capital to
      total assets of 4%, with an expressed expectation that banking organizations
      generally should operate above such minimum level. The risk-based requirement
      consists of a minimum ratio of total capital to total risk-weighted assets
      of
      8%, of which at least one-half must be Tier 1 capital (which consists
      principally of shareholders’ equity). The Tier 1 leverage requirement consists
      of a minimum ratio of Tier 1 capital to total assets of 3% for the most
      highly-rated companies, with minimum requirements of 4% to 5% for all others.
      As
      of December 31, 2006, the Registrant was classified as “well-capitalized” with
      Tier 1 and Total Risk-Based Capital of 9.88% and 11.03%,
      respectively.





The
      risk-based and leverage standards presently used by the Federal Reserve Board
      are minimum requirements, and higher capital levels will be required if
      warranted by the particular circumstances or risk profiles of individual banking
      organizations. Further, any banking organization experiencing or anticipating
      significant growth would be expected to maintain capital ratios, including
      tangible capital positions (i.e., Tier 1 capital less all intangible
      assets),


well
      above the minimum levels.





Source
      of Strength for Subsidiaries .
      Bank
      holding companies are required to serve as a source of financial strength for
      their depository institution subsidiaries, and, if their depository institution
      subsidiaries become undercapitalized, bank holding companies may be required
      to
      guarantee the subsidiaries’ compliance with capital restoration plans filed with
      their bank regulators, subject to certain limits.





Dividends .
      As a
      bank holding company that does not, as an entity, currently engage in separate
      business activities of a material nature, the Registrant’s ability to pay cash
      dividends depends upon the cash dividends the Registrant receives from the
      Bank.
      At present, the Registrant’s only source of income is dividends paid by the Bank
      and interest earned on any investment securities the Registrant holds. The
      Registrant must pay all of its operating expenses from funds it receives from
      the Bank. Therefore, shareholders may receive dividends from the Registrant
      only
      to the extent that funds are available after payment of our operating expenses
      and the board decides to declare a dividend. In addition, the Federal Reserve
      Board generally prohibits bank holding companies from paying dividends except
      out of operating earnings, and the prospective rate of earnings retention
      appears consistent with the bank holding company’s capital needs, asset quality
      and overall financial condition. We expect that, for the foreseeable future,
      any
      dividends paid by the Bank to us will likely be limited to amounts needed to
      pay
      any separate expenses of the Registrant and/or to make required payments on
      our
      debt obligations, including the interest payments on our junior subordinated
      debt.





15


The
      FDIC
      Improvement Act requires the federal bank regulatory agencies biennially to
      review risk-based capital standards to ensure that they adequately address
      interest rate risk, concentration of credit risk and risks from non-traditional
      activities and, since adoption of the Riegle Community Development and
      Regulatory Improvement Act of 1994, to do so taking into account the size and
      activities of depository institutions and the avoidance of undue reporting
      burdens. In 1995, the agencies adopted regulations requiring as part of the
      assessment of an institution’s capital adequacy the consideration of (a)
      identified concentrations of credit risks, (b) the exposure of the institution
      to a decline in the value of its capital due to changes in interest rates and
      (c) the application of revised conversion factors and netting rules on the
      institution’s potential future exposure from derivative
      transactions.





In
      addition, the agencies in September 1996 adopted amendments to their respective
      risk-based capital standards to require banks and bank holding companies having
      significant exposure to market risk arising from, among other things, trading
      of
      debt instruments, (1) to measure that risk using an internal value-at-risk
      model
      conforming to the parameters established in the agencies’ standards and (2) to
      maintain a commensurate amount of additional capital to reflect such risk.
      The
      new rules were adopted effective January 1, 1997, with compliance mandatory
      from
      and after January 1, 1998.





Under
      the
      Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”),
      depository institutions are liable to the FDIC for losses suffered or
      anticipated by the FDIC in connection with the default of a commonly controlled
      depository institution or any assistance provided by the FDIC to such an
      institution in danger of default. This law is applicable to the Registrant
      because it currently maintains separate subsidiary depository institutions,
      CSB
      and PCCB.





Subsidiary
      banks of a bank holding company are subject to certain quantitative and
      qualitative restrictions imposed by the Federal Reserve Act on any extension
      of
      credit to, or purchase of assets from, or letter of credit on behalf of, the
      bank holding company or its subsidiaries, and on the investment in or acceptance
      of stocks or securities of such holding company or its subsidiaries as
      collateral for loans. In addition, provisions of the Federal Reserve Act and
      Federal Reserve Board regulations limit the amounts of, and establish required
      procedures and credit standards with respect to, loans and other extensions
      of
      credit to officers, directors and principal shareholders of the Bank, the
      Registrant, and any subsidiary of the Registrant and related interests of such
      persons. Moreover, subsidiaries of bank holding companies are prohibited from
      engaging in certain tie-in arrangements (with the holding company or any of
      its
      subsidiaries) in connection with any extension of credit, lease or sale of
      property or furnishing of services.





Any
      loans
      by a bank holding company to a subsidiary bank are subordinate in right of
      payment to deposits and to certain other indebtedness of the subsidiary bank.
      In
      the event of a bank holding company’s bankruptcy, any commitment by the bank
      holding company to a federal bank regulatory agency to maintain the capital
      of a
      subsidiary bank would be assumed by the bankruptcy trustee and entitled to
      a
      priority of payment. This priority would also apply to guarantees of capital
      plans under the FDIC Improvement Act.





**Interstate
      Branching**





Under
      the
      Riegle-Neal Interstate Banking and Branching Act (the “Riegle-Neal Act”), the
      Federal Reserve Board may approve bank holding company acquisitions of banks
      in
      other states, subject to certain aging and deposit concentration limits. As
      of
      June 1, 1997, banks in one state may merge with banks in another state, unless
      the other state has chosen not to implement this section of the Riegle-Neal
      Act.
      These mergers are also subject to similar aging and deposit concentration
      limits.





North
      Carolina “opted-in” to the provisions of the Riegle-Neal Act. Since July 1,
      1995, an out-of-state bank that did not already maintain a branch in North
      Carolina was permitted to establish and maintain a de  novo branch
      in North Carolina, or acquire a branch in North Carolina, if the laws of the
      home state of the out-of-state bank permit North Carolina banks to engage in
      the
      same activities in that state under substantially the same terms as permitted
      by
      North Carolina. Also, North Carolina banks may merge with out-of-state banks,
      and an out-of-state bank resulting from such an interstate merger transaction
      may maintain and operate the branches in North Carolina of a merged North
      Carolina bank, if the laws of the home state of the out-of-state bank involved
      in the interstate merger transaction permit interstate merger.





16


We
      cannot
      predict what legislation might be enacted or what regulations might be adopted,
      or if enacted or adopted, the effect thereof on our operations.





**ITEM
        1A - RISK FACTORS**





**Risks
      Associated with our Continued Operations**





**We
      may not be able to maintain and manage our growth, which may adversely affect
      our results of operations and financial condition and the value of our common
      stock.**





Our
      strategy has been to increase the size of our company by opening new offices
      and
      aggressively pursuing business development opportunities. We have grown rapidly
      since we commenced operations. We can provide no assurance that we will continue
      to be successful in increasing the volume of loans and deposits at acceptable
      risk levels and upon acceptable terms while managing the costs and
      implementation risks associated with our growth strategy. There can be no
      assurance that our further expansion will be profitable or that we will continue
      to be able to sustain our historical rate of growth, either through internal
      growth or through successful expansion of our markets, or that we will be able
      to maintain capital sufficient to support our continued growth. If we grow
      too
      quickly, however, and are not able to control costs and maintain asset quality,
      rapid growth also could adversely affect our financial performance. We may
      acquire other banks as a means to expand into new markets or to capture
      additional market share. We are unable to predict whether or when any
      prospective acquisitions will occur or the likelihood of completing an
      acquisition on favorable terms and conditions. Any acquisition involves certain
      risks including, but not limited to:





·
            difficulties
                assimilating acquired operations and
                personnel;




·
            potential
                disruptions of our ongoing
                business;




·
            the
                diversion of resources and management
                time;




·
            the
                possibility that uniform standards, controls, procedures and policies
                may
                not be maintained;




·
            risks
                associated with entering new markets in which we have little or no
                experience;




·
            the
                potential impairment of relationships with employees or customers
                as a
                result of changes in management;




·
            difficulties
                in evaluating the historical or future financial performance of the
                acquired business; and




·
            brand
                awareness issues related to the acquired assets or
                customers.





If
      we
      decide to make an acquisition, there can be no assurance that the acquired
      bank
      would perform as expected.





**Our
      recent operating results may not be indicative of our future operating results.**





We
      may
      not be able to sustain our historical rate of growth. Because of our relatively
      small size and shorter operating history, it will be difficult for us to
      replicate our historical earnings growth as we continue to expand. Consequently,
      our historical results of operations will not necessarily be indicative of
      our
      future operations. Various factors, such as economic conditions, regulatory
      and
      legislative considerations, and competition, may also impede our ability to
      expand our market presence. If we experience a significant decrease in our
      historical rate of growth, our results of operations and financial condition
      may
      be adversely affected because a high percentage of our operating costs are
      fixed
      expenses.





**A
      decrease in interest rates could adversely impact our
      profitability.**





Our
      results of operations may be significantly affected by the monetary and fiscal
      policies of the federal government and the regulatory policies of government
      authorities. A significant component of our earnings is our net interest income.
      Net interest income is the difference between income from interest-earning
      assets, such as loans, and the expense of interest-bearing liabilities, such
      as
      deposits and our borrowings. Like many financial institutions, we are subject
      to
      the risk of fluctuations in interest rates. A significant decrease in interest
      rates could have a material adverse effect on our net income as we would expect
      the yields on our earning assets to decrease more quickly than the cost of
      our
      interest-bearing deposits and borrowings.





17


**Our
      profitability depends significantly on economic conditions in our market
      area.**





Our
      success depends to a large degree on the general economic conditions in Wake,
      Johnston, Moore, Lee, and New Hanover Counties and adjoining markets. The local
      economic conditions in these areas have a significant impact on the amount
      of
      loans that we make to our borrowers, the ability of our borrowers to repay
      these
      loans and the value of the collateral securing these loans. A significant
      decline in general economic condition caused by inflation, recession,
      unemployment or other factors beyond our control would impact these local
      economic conditions and could negatively affect our financial condition and
      performance.





**The
      lack of seasoning of our loan portfolio makes it difficult to assess the
      adequacy of our loan loss reserves accurately.**





We
      attempt to maintain an appropriate allowance for loan losses to provide for
      potential losses in our loan portfolio. We periodically determine the amount
      of
      the allowance based on consideration of several factors, including:




·
            
            an
                ongoing review of the quality, mix, and size of our overall loan
                portfolio;




·
            
            our
                historical loan loss experience;




·
            
            evaluation
                of economic conditions;




·
            
            regular
                reviews of loan delinquencies and loan portfolio quality; and




·
            
            the
                amount and quality of collateral, including guarantees, securing
                the
                loans.




However,
      there is no precise method of predicting credit losses, since any estimate
      of
      loan losses is necessarily subjective and the accuracy depends on the outcome
      of
      future events. In addition, due to our rapid growth over the past several years
      and our limited operating history, a large portion of the loans in our loan
      portfolio was originated recently. In general, loans do not begin to show signs
      of credit deterioration or default until they have been outstanding for some
      period of time, a process referred to as “seasoning.” As a result, a portfolio
      of older loans will usually perform more predictably than a newer portfolio.
      Because our loan portfolio is relatively new, the current level of delinquencies
      and defaults may not be representative of the level that will prevail when
      the
      portfolio becomes more seasoned, which may be higher than current levels. If
      charge-offs in future periods increase, we may be required to increase our
      provision for loan losses, which would decrease our net income and possibly
      our
      capital.





**If
      we experience greater loan losses than anticipated, it will have an adverse
      effect on our net income.**





While
      the
      risk of nonpayment of loans is inherent in banking, if we experience greater
      nonpayment levels than we anticipate, our earnings and overall financial
      condition, as well as the value of our common stock, could be adversely
      affected.





We
      cannot
      assure you that our monitoring procedures and policies will reduce certain
      lending risks or that our allowance for loan losses will be adequate to cover
      actual losses. In addition, as a result of the rapid growth in our loan
      portfolio, loan losses may be greater than management’s estimates of the
      appropriate level for the allowance. Loan losses can cause insolvency and
      failure of a financial institution and, in such an event, our shareholders
      could
      lose their entire investment. In addition, future provisions for loan losses
      could materially and adversely affect our profitability. Any loan losses will
      reduce the loan loss allowance. A reduction in the loan loss allowance will
      be
      restored by an increase in our provision for loan losses. This would reduce
      our
      earnings which could have an adverse effect on our stock price.





18


**Liquidity
      is essential to our business and we rely, in part, on external sources to
      finance a significant portion of our operations.**





Liquidity
      is essential to our business. Our liquidity could be substantially negatively
      affected by our inability to access secured lending markets, brokered deposit
      markets or raise funding in the long-term or short-term capital markets. Factors
      that we cannot control, such as disruption of the financial markets or negative
      views about the financial services industry generally, could impair our ability
      to raise funding. In addition, our ability to raise funding could be impaired
      if
      the Federal Home Loan Bank (FHLB) or deposit brokers develop a negative
      perception of our long-term or short-term financial prospects. Such negative
      perceptions could be developed if we suffer a decline in the level of our
      business activity, regulatory authorities take significant action against us,
      or
      we discover employee misconduct or illegal activity, among other things. If
      we
      were unable to raise funds using the methods described above, we would likely
      need to liquidate unencumbered assets, such as our investment and loan
      portfolios, to meet maturing liabilities. We may be unable to sell some of
      our
      assets, or we may have to sell assets at a discount from market value, either
      of
      which could adversely affect our operations.





**We
      rely heavily on the services of key personnel.**





Michael
      G. Carlton, our president and chief executive officer, has substantial
      experience with our operations and has contributed significantly to our growth
      since our founding. The loss of the services of Mr. Carlton or of one or
      more of the key members of our executive management team may have a material
      adverse effect on our operations. If Mr. Carlton or other members of our
      executive management team were no longer employed by us, our ability to
      implement our growth strategy could be impaired.





**Our
      ability to retain and attract qualified employees is critical to the success
      of
      our business and the failure to do so may materially adversely affect our
      performance.**





Our
      people are our most important resource and competition for qualified employees
      is intense. In order to attract and retain qualified employees, we must
      compensate such employees at market levels. Those levels have caused employee
      compensation to be our greatest expense as compensation is highly variable
      and
      moves with performance. If we are unable to continue to attract and retain
      qualified employees, or if compensation costs required to attract and retain
      employees become more expensive, our performance, including our competitive
      position, could be materially adversely affected.





**The
      success of our growth strategy depends on our ability to identify and retain
      individuals with experience and relationships in the markets in which we intend
      to expand.**





We
      may
      expand our banking network over the next several years, not just in our existing
      core market area, but also in other community markets throughout central North
      Carolina and other contiguous markets. To expand into new markets successfully,
      we must identify and retain experienced key management members with local
      expertise and relationships in these markets. We expect that competition for
      qualified management in the markets in which we may expand will be intense
      and
      that there will be a limited number of qualified persons with knowledge of
      and
      experience in the community banking industry in these markets. Even if we
      identify individuals that we believe could assist us in establishing a presence
      in a new market, we may be unable to recruit these individuals away from more
      established banks. In addition, the process of identifying and recruiting
      individuals with the combination of skills and attributes required to carry
      out
      our strategy is often lengthy. Our inability to identify, recruit, and retain
      talented personnel to manage new offices effectively would limit our growth
      and
      could materially adversely affect our business, financial condition, and results
      of operations.





**New
      or acquired bank office facilities and other facilities may not be
      profitable.**





We
      may
      not be able to identify profitable locations for new bank offices and the costs
      to start up new bank office facilities or to acquire existing bank offices,
      and
      the additional costs to operate these facilities, may increase our noninterest
      expense and decrease earnings in the short term. If offices of other banks
      become available for sale, we may acquire those offices. It may be difficult
      to
      adequately and profitably manage our growth through the establishment or
      purchase of bank offices. In addition, we can provide no assurance that any
      such
      offices will successfully attract enough deposits to offset the expenses of
      their operation.





19


**We
      are subject to operational risk and an operational failure could materially
      adversely affect our businesses.**




Operational
      risk refers to the risk of loss arising from inadequate or failed internal
      processes, people and/or systems. Operational risk also refers to the risk
      that
      external events, such as external changes (e.g., natural disasters, terrorist
      attacks and/or health epidemics), failures or frauds, will result in losses
      to
      our businesses.




Our
      business is highly dependent on our ability to process, on a daily basis, a
      large number of transactions and the transactions we process have become
      increasingly complex. We perform the functions required to operate our business
      either by ourselves or through agreements with third parties. We rely on the
      ability of our employees, our internal systems and systems at technology centers
      operated by third parties to process high numbers of transactions. In the event
      of a breakdown or improper operation of our or third-party’s systems or improper
      action by third parties or employees, we could suffer financial loss, an
      impairment to our liquidity, a disruption of our businesses, regulatory
      sanctions and damage to our reputation.





**In
      order to be profitable, we must compete successfully with other financial
      institutions which have greater resources and capabilities than we
      do.**




The
      banking business in North Carolina in general, and in the Triangle area in
      particular, which is part of our market area, is extremely competitive. Most
      of
      our competitors are larger and have greater resources than we do and have been
      in existence a longer period of time. We will have to overcome historical
      bank-customer relationships to attract customers away from our competition.
      We
      compete with the following types of institutions:


·   other
                    commercial banks
              ·securities
                  brokerage firms·savings
                    banks
              ·mortgage
                  brokers·thrifts
              ·insurance
                  companies·credit
                    unions
              ·mutual
                  funds·consumer
                    finance companies
              ·trust
                  companies




Some
      of
      our competitors are not regulated as extensively as we are and, therefore,
      may
      have greater flexibility in competing for business. Some of these competitors
      are subject to similar regulation but have the advantages of larger established
      customer bases, higher lending limits, extensive branch networks, numerous
      automated teller machines, greater advertising-marketing budgets or other
      factors.




Our
      legal
      lending limit is determined by law. The size of the loans which we offer to
      our
      customers may be less than the size of the loans that larger competitors are
      able to offer. This limit may affect to some degree our success in establishing
      relationships with the larger businesses in our market.





**We
      are subject to extensive regulation that could limit or restrict our activities.**





We
      operate in a highly regulated industry and are subject to examination,
      supervision, and comprehensive regulation by the North Carolina Office of the
      Commissioner of Banks, the FDIC, and the Federal Reserve Board. Our compliance
      with these regulations is costly and restricts certain of our activities,
      including payment of dividends, mergers and acquisitions, investments, loans
      and
      interest rates charged, interest rates paid on deposits, and locations of
      offices. We must also meet regulatory capital requirements. If we fail to meet
      these capital and other regulatory requirements, our financial condition,
      liquidity, and results of operations would be materially and adversely affected.
      Our failure to remain “well capitalized” and “well managed” for regulatory
      purposes could affect customer confidence, our ability to grow, our cost of
      funds and FDIC insurance, our ability to pay dividends on common stock, and
      our
      ability to make acquisitions.





The
      laws
      and regulations applicable to the banking industry could change at any time,
      and
      we cannot predict the effects of these changes on our business and
      profitability. For example, new legislation or regulation could limit the manner
      in which we may conduct our business, including our ability to obtain financing,
      attract deposits, and make loans. Many of these regulations are intended to
      protect depositors, the public, and the FDIC, not shareholders. In addition,
      the
      burden imposed by these regulations may place us at a competitive disadvantage
      compared to competitors who are less regulated. The laws, regulations,
      interpretations, and enforcement policies that apply to us have been subject
      to
      significant change in recent years, sometimes retroactively applied, and may
      change significantly in the future. Our cost of compliance could adversely
      affect our ability to operate profitably.





20


**Our
      growth may require us to raise additional capital that may not be available
      when
      it is needed, or at all.**





We
      are
      required by regulatory authorities to maintain adequate levels of capital to
      support our operations. We anticipate that our capital resources will satisfy
      our capital requirements for the foreseeable future. We may at some point,
      however, need to raise additional capital to support our continued growth.
      Our
      ability to raise additional capital, if needed, will depend in part on
      conditions in the capital markets at that time, which are outside our control,
      and on our financial performance. Accordingly, we may be unable to raise
      additional capital, if and when needed, on terms acceptable to us, or at all.
      If
      we cannot raise additional capital when needed, our ability to further expand
      our operations through internal growth and acquisitions could be materially
      impaired. In addition, if we issue additional equity capital, the interests
      of
      existing shareholders would be diluted.





**Efforts
      to comply with the Sarbanes-Oxley Act will involve significant expenditures,
      and
      non-compliance with the Sarbanes-Oxley Act may adversely affect us.**





The
      Sarbanes-Oxley Act of 2002, and the related rules and regulations promulgated
      by
      the Securities and Exchange Commission that are now applicable to us, have
      increased the scope, complexity, and cost of corporate governance, reporting,
      and disclosure practices. We have experienced, and we expect to continue to
      experience, greater compliance costs, including costs related to internal
      controls, as a result of the Sarbanes-Oxley Act. We expect these new rules
      and
      regulations to continue to increase our accounting, legal, and other costs,
      and
      to make some activities more difficult, time consuming, and costly. In the
      event
      that we are unable to achieve or maintain compliance with the Sarbanes-Oxley
      Act
      and related rules, we may be adversely affected.





We
      are
      evaluating our internal control systems in order to allow management to report
      on, and our independent registered public accounting firm to attest to, our
      internal control over financial reporting, as required by Section 404 of
      the Sarbanes-Oxley Act. If we identify significant deficiencies or material
      weaknesses in our internal control over financial reporting that we cannot
      remediate in a timely manner, or if we are unable to receive a positive
      attestation from our independent registered public accounting firm with respect
      to our internal control over financial reporting, the trading price of our
      common stock could decline, our ability to obtain any necessary equity or debt
      financing could suffer, and, if accepted for listing, our common stock could
      ultimately be delisted from the NASDAQ Global Market. In this event, the
      liquidity of our common stock would be severely limited and the market price
      of
      our common stock would likely decline significantly.





In
      addition, the new rules adopted as a result of the Sarbanes-Oxley Act could
      make
      it more difficult or more costly for us to obtain certain types of insurance,
      including directors’ and officers’ liability insurance, which could make it more
      difficult for us to attract and retain qualified persons to serve on our board
      of directors or as executive officers.





**Risks
      Related to an Investment in our Common Stock**





**Our
      securities are not FDIC insured.**





Our
      common stock is not a savings or deposit account or other obligation of the
      bank, and is not insured by the Federal Deposit Insurance Corporation or any
      other governmental agency and is subject to investment risk, including the
      possible loss of principal.





**We
      do not plan to pay cash dividends for the foreseeable future.**





We
      do not
      expect to pay cash dividends on our common stock in the foreseeable future,
      as
      we intend to retain earnings to provide the capital necessary to fund our growth
      strategy. You should not buy shares in this offering if you need dividend income
      from this investment. Our ability to declare and pay cash dividends will be
      dependent upon, among other things, restrictions imposed by the reserve and
      capital requirements of North Carolina and federal banking regulations, our
      income and financial condition, tax considerations, and general business
      conditions. Therefore, investors should not purchase shares with a view for
      a
      current return on their investment in the form of cash dividends.





21


**We
      have implemented anti-takeover devices that could make it more difficult for
      another company to acquire us, even though such an acquisition may increase
      shareholder value.**





In
      some
      cases, shareholders would receive a premium for their shares if we were acquired
      by another company. However, state and federal law and our articles of
      incorporation and bylaws make it difficult for anyone to acquire us without
      approval of our board of directors. For example, our articles of incorporation
      require a supermajority vote of two-thirds of our outstanding common stock
      in
      order to effect a sale or merger of the company in certain circumstances. Our
      bylaws also divide the board of directors into three classes of directors
      serving staggered three-year terms with approximately one-third of the board
      of
      directors elected at each annual meeting of shareholders. The classification
      of
      directors makes it more difficult for shareholders to change the composition
      of
      the board of directors. As a result, at least two annual meetings of
      shareholders would be required for the shareholders to change a majority of
      the
      directors, whether or not a change in the board of directors would be beneficial
      and whether or not a majority of shareholders believe that such a change would
      be desirable. Consequently, a takeover attempt may prove difficult, and
      shareholders may not realize the highest possible price for their securities.





**The
      holder of our junior subordinated debenture has rights that are senior to those
      of our common shareholders.**





We
      have
      supported our continued growth through the issuance of trust preferred
      securities from a special purpose trust and an accompanying sale of an $8.2
      million junior subordinated debenture to this trust. Payments of the principal
      and interest on the trust preferred securities of this trust are conditionally
      guaranteed by us. Further, the accompanying junior subordinated debenture that
      we issued to the trust is senior to our shares of common stock. As a result,
      we
      must make payments on the junior subordinated debenture before any dividends
      can
      be paid on our common stock and, in the event of our bankruptcy, dissolution
      or
      liquidation, the holder of the junior subordinated debenture must be satisfied
      before any distributions can be made on our common stock. We have the right
      to
      defer distributions on the junior subordinated debenture (and the related trust
      preferred securities) for up to five years, during which time no dividends
      may
      be paid on our common stock.





**ITEM
      1B - UNRESOLVED STAFF COMMENTS**





Not
      applicable.




**ITEM
        2 - PROPERTIES**
  The
        following table sets forth the location of the Registrant’s main office and
        branch offices, as well as certain information relating to these offices
        to
        date.





**Office
                Locations**
            
            **Year****Opened**
            
            **Approximate**
              **Square
                Footage**
            
            **Owned
                or Leased**Main
                Office
              1005
                High House Road
              Cary,
                NC
            
            
            2000
            
            
            8,100
            
            
            LeasedCary
                Office
              1155
                Kildaire Farm Road
              Cary,
                NC
            
            
            1998
            
            
            2,960
            
            
            LeasedApex
                Office
              303
                South Salem Street
              Apex,
                NC
            
            
            1999
            
            
            3,500
            
            
            Leased




22




Clayton
                Office
              315
                East Main Street
              Clayton,
                NC
            
            
            2000
            
            
            2,990
            
            
            LeasedHolly
                Springs Office
              700
                Holly Springs Road
              Holly
                Springs, NC
            
            
            2003
            
            
            3,500
            
            
            OwnedPinehurst
                Office
              211-M
                Central Park Avenue
              Pinehurst,
                NC
            
            
            2003
            
            
            2,850
            
            
            LeasedSouthern
                Pines Office
              185
                Morganton Road
              Southern
                Pines, NC
            
            
            2003
            
            
            3,500
            
            
            LeasedSanford
                Office
              870
                Spring Lane
              Sanford,
                NC
            
            
            2004
            
            
            3,500
            
            
            Structure
                owned with ground leaseGarner
                Office
              574
                Village Court
              Garner,
                NC
            
            
            2005
            
            
            1,960
            
            
            LeasedRaleigh
                Loan Production Office
              4601
                Six Forks Road
              Raleigh,
                NC
            
            
            2005
            
            
            2,439
            
            
            LeasedFalls
                of Neuse Office
              6408
                Falls of Neuse Road
              Raleigh,
                NC
            
            
            2006
            
            
            2,442
            
            
            OwnedPort
                City Capital Bank
              1508
                Military Cutoff Road
              Wilmington,
                NC 28403
            
            
            2006
            
            
            6,634
            
            
            Leased




**Operations
                Locations**
            
            **Year****Opened**
            
            **Approximate**
              **Square
                Footage**
            
            **Owned
                or Leased**206
                High House Road
              Cary,
                NC
            
            
            2005
            
            
            12,535
            
            
            Leased





The
      total
      net book value of the Company’s real property used for business purposes,
      furniture, fixtures, and equipment on December 31, 2006 was $5,907,664. All
      properties are considered by Company management to be in good condition and
      adequately covered by insurance.





**ITEM
      3 - LEGAL PROCEEDINGS**





There
      are
      no pending legal proceedings to which the Registrant is a party, or of which
      any
      of its property is the subject other than routine litigation that is incidental
      to its business.





**ITEM
      4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





No
      matters were submitted to a vote of shareholders in the fourth quarter of
      2006.





23


**PART
      II**





**ITEM
      5 - MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
      OF EQUITY SECURITIES**





The
      Registrant’s stock is listed on the NASDAQ Global Market under the symbol
“CRFN.” There were 8,265,136 shares outstanding at December 31, 2006 owned by
      approximately 2,900 shareholders. The table below lists the high and low prices
      at which trades were completed during each quarter for the last two years.
      The
      Company’s stock is considered thinly traded with less than ten thousand shares
      traded, on average, per day. Our ability to pay cash dividends depends on the
      cash dividends we receive from the banks. However, the banks are restricted
      in
      the amount of dividends they may pay. See the section entitled Regulation in
      Item 1 for further disclosure regarding cash dividend payments. Moreover, we
      do
      not expect to pay cash dividends on our common stock in the foreseeable future,
      as we intend to retain earnings in order to provide the capital necessary to
      fund our growth strategy.





Low
                (1)
            
            High
                (1)January
                1, 2005 to March 31, 2005
            
            
            11.05
            
            
            12.82April
                1, 2005 to June 30, 2005
            
            
            12.71
            
            
            15.00July
                1, 2005 to September 30, 2005
            
            
            13.57
            
            
            14.83October
                1, 2005 to December 31, 2005
            
            
            12.83
            
            
            14.78January
                1, 2006 to March 31, 2006
            
            
            13.09
            
            
            13.57April
                1, 2006 to June 30, 2006
            
            
            12.91
            
            
            15.04July
                1, 2006 to September 30, 2006
            
            
            12.80
            
            
            14.30October
                1, 2006 to December 31, 2006
            
            
            12.38
            
            
            13.50





(1)
            The
                2005 prices quoted above have been adjusted to reflect the 15% stock
                split
                effected as a stock dividend paid in 2006 and a 15% stock distribution
                in
                2005.





See
      Item
      12 of this Report for disclosure regarding securities authorized for issuance
      under equity compensation plans.




24


**ITEM**




At
                or for the Years EndedDecember
                31,**2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**(Dollars
                in thousands, except share and per share data)**Summary
                of Operations**Interest
                income
            
            $
            36,707
            
            $
            22,827
            
            $
            15,896
            
            $
            10,950
            
            $
            8,556Interest
                expense
            
            
            17,257
            
            
            8,872
            
            
            5,466
            
            
            3,749
            
            
            3,189Net
                interest income
            
            
            19,450
            
            
            13,955
            
            
            10,430
            
            
            7,201
            
            
            5,367Provision
                for loan losses
            
            
            991
            
            
            807
            
            
            736
            
            
            551
            
            
            689Net
                interest income after the provision
              for
                loan losses
            
            
            18,459
            
            
            13,148
            
            
            9,694
            
            
            6,650
            
            
            4,678Non-interest
                income
            
            
            2,612
            
            
            2,417
            
            
            2,342
            
            
            1,645
            
            
            768Non-interest
                expense
            
            
            13,387
            
            
            10,762
            
            
            8,531
            
            
            5,767
            
            
            4,124Income
                before income taxes
            
            
            7,684
            
            
            4,803
            
            
            3,505
            
            
            2,528
            
            
            1,322Income
                taxes
            
            
            2,780
            
            
            1,659
            
            
            1,172
            
            
            873
            
            
            94Net
                income
            
            
            4,904
            
            
            3,144
            
            
            2,333
            
            
            1,655
            
            
            1,228**Per
                Share and Shares Outstanding****(1)**Net
                income, basic(2)
            
            $
            0.74
            
            $
            0.64
            
            $
            0.50
            
            $
            0.40
            
            $
            0.39Net
                income, diluted(2)
            
            $
            0.71
            
            $
            0.61
            
            $
            0.47
            
            $
            0.38
            
            $
            0.38Book
                value at end of period
            
            $
            10.05
            
            $
            7.17
            
            $
            5.68
            
            $
            5.20
            
            $
            4.53Tangible
                book value
            
            $
            6.24
            
            $
            6.52
            
            $
            4.88
            
            $
            4.38
            
            $
            4.53Weighted
                average shares outstanding:Basic
            
            
            6,619,105
            
            
            4,911,264
            
            
            4,678,604
            
            
            4,143,766
            
            
            3,111,805Diluted
            
            
            6,922,552
            
            
            5,165,861
            
            
            4,925,264
            
            
            4,295,142
            
            
            3,201,626Shares
                outstanding at period end
            
            
            8,265,136
            
            
            5,780,353
            
            
            4,717,210
            
            
            4,641,069
            
            
            3,911,536**Balance
                Sheet Data**Total
                assets
            
            $
            697,909
            
            $
            410,788
            
            $
            331,227
            
            $
            273,714
            
            $
            182,005Total
                investments(3)
            
            
            85,578
            
            
            57,752
            
            
            54,935
            
            
            38,383
            
            
            45,559Total
                loans, net
            
            
            542,874
            
            
            323,971
            
            
            253,793
            
            
            213,442
            
            
            123,962Total
                deposits
            
            
            541,881
            
            
            322,081
            
            
            273,649
            
            
            218,615
            
            
            153,105Borrowings
            
            
            69,699
            
            
            45,212
            
            
            29,555
            
            
            29,003
            
            
            10,000Stockholders’
                equity
            
            
            83,034
            
            
            41,457
            
            
            26,777
            
            
            24,150
            
            
            17,732**Selected
                Performance Ratios**Return
                on average assets
            
            
            0.93
            %
            
            0.84
            %
            
            0.76
            %
            
            0.79
            %
            
            0.85
            %Return
                on average stockholders’ equity
            
            
            8.72
            %
            
            10.34
            %
            
            9.14
            %
            
            8.25
            %
            
            9.31
            %Net
                interest spread(4)
            
            
            3.29
            %
            
            3.51
            %
            
            3.26
            %
            
            3.09
            %
            
            3.18
            %Net
                interest margin(5)
            
            
            3.95
            %
            
            3.94
            %
            
            3.61
            %
            
            3.64
            %
            
            3.87
            %Non-interest
                income as a percentage of
              total
                revenue(6)
            
            
            11.84
            %
            
            14.76
            %
            
            18.34
            %
            
            18.60
            %
            
            12.52
            %Non-interest
                income as a percentage of
              average
                assets
            
            
            0.49
            %
            
            0.64
            %
            
            0.76
            %
            
            0.78
            %
            
            0.53
            %Non-interest
                expense to average
              assets
            
            
            2.53
            %
            
            2.86
            %
            
            2.76
            %
            
            2.75
            %
            
            2.85
            %Efficiency
                ratio(7)
            
            
            60.68
            %
            
            65.73
            %
            
            66.79
            %
            
            65.19
            %
            
            67.22
            %Average
                stockholders’ equity to
              average
                total assets
            
            
            10.64
            %
            
            8.08
            %
            
            8.27
            %
            
            9.55
            %
            
            9.13
            %**Asset
                Quality Ratios**Net
                charge-offs to average loans
              outstanding
            
            
            0.02
            %
            
            0.04
            %
            
            0.15
            %
            
            0.05
            %
            
            0.09
            %Allowance
                for loan losses to period end
              loans
            
            
            1.26
            %
            
            1.33
            %
            
            1.42
            %
            
            1.52
            %
            
            1.36
            %Allowance
                for loan losses to non-
              performing
                loans
            
            
            5,145
            %
            
            16,960
            %
            
            73,360
            %
            
            2,078
            %
            
            NMNon-performing
                loans to period end
              loans
            
            
            0.02
            %
            
            0.01
            %
            
            0.00
            %
            
            0.07
            %
            
            0.00
            %Non-performing
                assets to total assets(8)
            
            
            0.03
            %
            
            0.01
            %
            
            0.09
            %
            
            0.06
            %
            
            0.00
            %**Capital
                Ratios**Total
                risk-based capital ratio
            
            
            11.03
            %
            
            13.68
            %
            
            11.61
            %
            
            12.95
            %
            
            13.23
            %Tier
                1 risk-based capital ratio
            
            
            9.88
            %
            
            12.51
            %
            
            10.38
            %
            
            11.70
            %
            
            12.04
            %Leverage
                ratio
            
            
            9.13
            %
            
            11.51
            %
            
            9.49
            %
            
            10.63
            %
            
            10.08
            %Equity
                to assets ratio
            
            
            11.90
            %
            
            10.09
            %
            
            8.08
            %
            
            8.82
            %
            
            9.74
            %**Other
                Data**Number
                of full-service banking offices
            
            
            11
            
            
            9
            
            
            8
            
            
            7
            
            
            5Number
                of full-time equivalent
              employees
            
            
            122
            
            
            90
            
            
            78
            
            
            64
            
            
            37


(1)
              Adjusted
                  to reflect the stock splits effected in the form of a 15% stock
                  dividend
                  in each of 2006 and 2005, a 20% stock distribution in 2004, a 15%
                  stock
                  distribution in 2003 and a 12.5% stock distribution in 2002.


25





(2)
            Computed
                based on the weighted average number of shares outstanding during
                each
                period.




(3)
            Consists
                of interest-earning deposits, federal funds sold, investment securities
                and FHLB stock.




(4)
            Net
                interest spread is the difference between the average yield on
                interest-earning assets and the average cost of interest-bearing
                liabilities.





(5)
            Net
                interest margin is net interest income divided by average interest-earning
                assets.




(6)
            Total
                revenue consists of net interest income and non-interest
                income.




(7)
            Efficiency
                ratio is non-interest expense divided by the sum of net interest
                income
                and non-interest income.




(8)
                Non-performing
                    assets consist of non-accrual loans, restructured loans, and
                    foreclosed
                    assets, where
                    applicable.




26


**ITEM
        7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
        OPERATIONS**





Management’s
      discussion and analysis is intended to assist readers in the understanding
      and
      evaluation of the financial condition and consolidated results of operations
      of
      Crescent Financial Corporation (“Crescent” or the “Company”). The analysis
      includes detailed discussions for each of the factors affecting Crescent
      Financial Corporation’s operating results and financial condition for the years
      ended December 31, 2006 and 2005. It should be read in conjunction with the
      audited consolidated financial statements and accompanying notes included in
      this report and the supplemental financial data appearing throughout this
      discussion and analysis.





The
      following discussion and analysis contains the consolidated financial results
      for the Company, Crescent State Bank and Port City Capital Bank for the years
      ended December 31, 2006 and 2005. The Company had previously discontinued the
      consolidation of Crescent Financial Capital Trust I and began reporting the
      junior subordinated debentures that the Company issued in exchange for the
      proceeds that resulted from the issuance of the trust preferred securities.
      The
      trust preferred securities are classified as long-term debt obligations. Except
      for the accounting treatment, the relationship between the Company and Crescent
      Financial Capital Trust I has not changed. Crescent Financial Capital Trust
      I
      continues to be a wholly owned subsidiary of the Company and the full and
      unconditional guarantee of the Company for the repayment of the trust preferred
      securities remains in effect. The financial statements presented contain the
      consolidation of Crescent Financial Corporation and the Banks only. The Company
      and its consolidated subsidiaries are collectively referred to herein as the
      Company unless otherwise noted.





**COMPARISON
      OF FINANCIAL CONDITION AT DECEMBER 31, 2006 AND 2005**





The
      Company reported total assets of $697.9 million at December 31, 2006, reflecting
      a $287.1 million or 70% increase over total assets of $410.8 at December 31,
      2005. At December 31, 2006 total earning assets increased by 66% or $252.9
      million growing to $639.0 million from $386.1 million at December 31, 2005.
      Earning assets at December 31, 2006 consisted of $549.8 million in gross loans,
      $88.3 million in investment securities and Federal Home Loan Bank (FHLB) stock
      and $855,000 in overnight investments and interest bearing deposits. Total
      liabilities increased by 66% or $245.5 million from $369.3 million at December
      31, 2005 to $614.9 million at year-end 2006. Due to the completion of the
      acquisition of Port City Capital Bank in the third quarter, the exercise of
      vested stock options and net income for the twelve-month period, total
      stockholders’ equity increased 100% or $41.6 million from $41.5 million to $83.0
      million.




Loans
      comprise the largest portion of our earning assets and experienced significant
      growth during the year. Gross loans increased by $221.5 million or 67% growing
      from $328.3 million at December 31, 2005 to $549.8 million at December 31,
      2006.
      Most loan categories experienced net growth during the twelve-month period.
      The
      commercial mortgage loan category experienced the most significant net growth
      in
      terms of dollars growing $130.7 million or 75% from $173.7 million to $304.4
      million. Net growth in other loan categories, presented in order of dollar
      growth, were as follows: construction loans increased by $63.4 million or 136%
      from $46.4 million to $109.8 million, commercial and industrial loans increased
      by $15.1 million or 29% from $52.7 million to $67.8 million, home equity lines
      and loans increased by $7.8 million or 22% from $34.9 million to $42.7 million
      and residential mortgage loans increased by $5.3 million or 36% from $14.9
      million to $20.2 million. The consumer loan portfolio declined by 12% or $0.7
      million during the year to close at $5.0 million.





The
      acquisition of Port City Capital Bank on August 31, 2006 added $128.5 million
      of
      the total $221.5 million increase in gross loans. Loans acquired by category
      include $115.2 million of commercial mortgage loans, $9.5 million of commercial
      loans, $2.3 million home equity lines, $1.2 million residential real estate
      mortgage loans, and $300,000 in the consumer loan category.





The
      composition of the loan portfolio, by category, as of December 31, 2006 is
      as
      follows: 55% commercial mortgage loans, 20% construction loans, 12% commercial
      and industrial loans, 8% home equity loans and lines of credit, 4% residential
      mortgage loans and 1% consumer loans. The composition of the loan portfolio,
      by
      category, as of December 31, 2005 was as follows: 53% commercial mortgage loans,
      16% commercial and industrial loans, 14% construction loans, 11% home equity
      loans and lines of credit, 4% residential mortgage loans and 2% consumer loans.
      The changes in loan composition are primarily due to the composition of the
      loan
      portfolio acquired in the PCCB transaction. As of the merger date, August 31,
      2006, the composition of PCCB’s portfolio was as follows: 62% commercial
      mortgage loans, 28% construction, 7% commercial and industrial, 2% home equity
      lines and loans and 1% residential mortgage loans. Consumer loans comprised
      less
      than one half of 1%.





27


We
      track
      each loan we originate using the North American Industry Classification System
      (NAICS) code. Through the use of this code, we can monitor those industries
      for
      which we have a significant concentration of exposure. At December 31, 2006,
      there were two industry codes for which our concentration exposure exceeded
      10%
      of the total loan portfolio. Loans to investors who lease non-residential
      buildings other than miniwarehouses comprised 21% of our loan portfolio and
      loans to builders for land subdivision comprised 11% of the loan
      portfolio.





The
      allowance for loan losses was $6.9 million or 1.26% of total outstanding loans
      at December 31, 2006 compared with $4.4 million or 1.33% of total
      outstanding loans at December 31, 2005. The
      acquisition of PCCB added $1.7 million of the total $2.5 million increase in
      the
      loan loss allowance. The
      credit quality of the Company’s loan portfolio remains high. At December 31,
      2006, there were two loans totaling approximately $135,000 in non-accrual
      status. The percentage of non-performing loans to total loans at December 31,
      2006 was 0.02%. There were eight loans aggregating $554,000 that were 30 days
      or
      more past due. There were no loans past due 90 days or more and still accruing
      interest at December 31, 2006. At December 31, 2005, there were three loans
      totaling approximately $26,000 in non-accrual status. Non-performing loans
      to
      total loans, expressed as a percentage, at December 31, 2005 was 0.01%. In
      addition to the three loans in non-accrual status, there were seven loans
      totaling approximately $404,000 that were 30 days or more past due. There were
      no loans 90 days or more past due and still accruing interest. See the section
      entitled “Non Performing Assets” for more details.





The
      amortized cost and fair market value of the Company’s investment securities
      portfolio at December 31, 2006 were $85.5 million and $84.7 million,
      respectively. All investments are accounted for as available for sale under
      Financial Accounting Standards Board ("FASB") No. 115 and are presented at
      their
      fair market value. The portfolio experienced a net increase of $29.2 million
      or
      53% compared with $55.5 million at December 31, 2005. The Company’s investment
      in debt securities at December 31, 2006, consisted of U.S. Government agency
      securities, collateralized mortgage obligations (CMOs), mortgage-backed
      securities (MBSs), municipal bonds, a trust preferred stock issue and common
      stock of a publicly traded financial institution. Increases in the portfolio
      during 2006 were attributed to purchases of $25.2 million, acquisition of $16.4
      million securities from PCCB, a $0.3 million increase in the fair market value
      of the portfolio, as well as net premium accretion of $20,000. Activities
      resulting in portfolio decreases included $6.6 million in principal re-payments
      on CMOs and MBSs, and $6.1 million in sales of securities available for sale.
      The Company also owned $3.6 million of Federal Home Loan Bank stock at
      December 31, 2006 compared with $2.1 million at December 31, 2005.





Interest-earning
      deposits held at correspondent banks increased by $695,000 from $68,000 at
      December 31, 2005 to $763,000 at December 31, 2006. Funds held in
      interest-earning deposit accounts result primarily from the receipt of principal
      and interest from the investment portfolio. As funds accumulate, they are
      reinvested in investment securities.





Non-interest
      earning assets totaled $65.9 million at December 31, 2006 increasing by $36.8
      million or 127% compared with $29.1 million at the prior year end. The largest
      increase was in goodwill which grew by $26.6 million from $3.6 million to $30.2
      million due to the acquisition of PCCB in August, 2006. Goodwill was not
      impaired at December 31, 2006. Cash and due from banks grew by $4.9 million
      from
      $9.4 million to $14.3 million. Cash and due from banks includes cash on hand
      in
      branches and amounts represented by checks in the process of being collected
      through the Federal Reserve payment system. These checks were not yet collected
      and therefore could not be invested overnight. For more details regarding the
      increase in cash and cash equivalents, see the Consolidated Statements of Cash
      Flows. Other assets increased by $1.8 million primarily due to the acquisition
      of PCCB, who had $1.5 million of other assets at December 31, 2006 which
      included their core deposit intangible of $1.1 million. Accrued interest
      receivable increased by $1.3 million due to the higher volume of earning assets.
      Total premises and equipment at December 31, 2006 was $5.9 million compared
      with
      $4.8 million the prior year. The $1.1 million net increase resulted from $1.7
      million in new purchases, and $85,000 from the acquisition, less $699,000 of
      depreciation. Deferred tax assets increased by $828,000 mainly due to the
      acquisition of PCCB. The cash surrender value of bank owned life insurance
      increased by $200,000 from $5.5 million to $5.7 million.





Between
      December 31, 2005 and December 31, 2006, total deposits increased by $219.8
      million or 68%. Time deposits increased the most growing by $117.5 million
      from
      $178.2 million to $295.7 million. Increases in other deposit categories included
      $69.0 million in savings account balances growing to $78.4 million from $9.4
      million, $23.6 million in non-interest bearing demand growing to $70.4 million
      from $46.8 million, and $13.7 million in money market balances growing from
      $45.8 million to $59.5 million. Interest bearing demand declined by $4.1 million
      from $41.9 million to $37.8 million.




28


We
      have
      historically offered a relationship-based interest-bearing checking account
      that
      paid an above average market rate. Prior to July 2004 when interest rates were
      declining, the rate of interest on the relationship-based interest bearing
      account was higher than the money market and savings rates. As a result,
      customers shifted funds out of money market accounts into the interest-bearing
      checking account. During 2006, the Company introduced a high-yielding statement
      savings account. At its highest balance tier, the new product pays a rate of
      interest higher than either the money market or the relationship-based interest
      bearing checking accounts. While the account was very successful in attracting
      new deposits, there was some shifting of funds from our premium interest-bearing
      checking account into the new savings product.




The
      acquisition of Port City Capital Bank on August 31, 2006 added approximately
      $144.2 million in deposits to the Company’s balance sheet. The total increase
      included $95.3 million in time deposits, $28.5 million in money market, $14.8
      million in non interest bearing demand, $5.6 million in interest bearing demand,
      and $76,000 in savings accounts.





The
      Banks
      maintain a number of deposit relationships with real estate settlement
      attorneys. Balances in these escrow accounts can fluctuate significantly based
      on the amount of mortgage loan activity. At December 31, 2006, the aggregate
      balance in the real estate settlement accounts was $13.1 million compared to
      $13.7 million at December 31, 2005.





The
      composition of the deposit base, by category, at December 31, 2006 was as
      follows: 55% in time deposits, 14% in savings deposits, 13% in non
      interest-bearing demand deposits, 11% in money market deposits, and 7% in
      interest-bearing demand deposits. The composition of the deposit base, by
      category, at December 31, 2005 was as follows: 55% in time deposits, 15% in
      non
      interest-bearing demand deposits, 14% in money market deposits, 13% in
      interest-bearing demand deposits, and 3% in savings deposits. As was the case
      with the loan portfolio, the acquisition of PCCB in August 2006 impacted deposit
      composition. The composition of the PCCB deposit base at August 31, 2006 was
      as
      follows: 66% in time deposits, 20% in money market, 10% in non-interest bearing
      and 4% in interest bearing demand and less than 1% in savings accounts. Prior
      to
      the acquisition and through the development of the new high-interest yielding
      statement savings account mentioned above, CSB was able to significantly
      increase its core deposit base while reducing its reliance on time deposits
      (brokered funds). Prior to August 2006, time deposits as a percentage of total
      deposits had fallen to 52%.





At
      December 31, 2006 the Company had $229.8 million in time deposits of $100,000
      or
      more compared to $118.5 million at December 31, 2005. The
      acquisition of PCCB brought $88.8 million of time deposits greater than
      $100,000. The
      Company uses brokered certificates of deposit as an alternative funding source.
      Brokered deposits represent a source of fixed rate funds that do not need to
      be
      collateralized like Federal Home Loan Bank borrowings. The Company expects
      to
      utilize the brokered deposit market in the future. Brokered deposits at December
      31, 2006 were $141.7 million compared to $68.0 million at December 31, 2005.





Total
      borrowings increased by 54% from $45.2 million at December 31, 2005 to $69.7
      million at December 31, 2006. Borrowings at December 31, 2006 consisted of
      $37.0
      million in long-term FHLB advances, $18.0 million in short-term FHLB advances,
      $8.2 million in junior subordinated debt issued to an unconsolidated subsidiary,
      and $6.5 million in Federal funds purchased from a correspondent bank. The
      adoption of FASB Interpretation Number (FIN) 46, *Consolidation
      of Variable Interest Equities,* resulted
      in the deconsolidation of the trust subsidiary, Crescent Financial Capital
      Trust
      I (“Trust”), formed for the purpose of issuing trust preferred securities. As a
      result, the subordinated debt issued to the Trust for the proceeds of the trust
      preferred securities is included in long-term debt. At December 31, 2005, the
      Company had $22.0 million in long-term FHLB advances, $10.0 million in
      short-term FHLB advances, $8.2 million in junior subordinated debt issued to
      an
      unconsolidated subsidiary, $4.8 million in Federal funds purchased from a
      correspondent bank and $185,000 in securities sold under a repurchase agreement.
      Securities sold under repurchase agreements generally mature within one to
      four
      days from the transaction date. PCCB had no FHLB borrowings at the time of
      merger.





29


Accrued
      expenses and other liabilities increased by $1.3 million to $3.3 million at
      December 31, 2006 compared with $2.0 million at December 31, 2005. The increase
      is due to higher levels of accrued interest and accrued operating expenses.





Total
      stockholders’ equity increased by $41.6 million between December 31, 2005 and
      December 31, 2006. The increase was the net result of $36.0 million due to
      the
      issuance of common stock pursuant to the merger transaction, net income for
      the
      year of $4.9 million, plus $301,000 ($256,000 in cash proceeds and $45,000
      in
      tax benefits) in additional capital from the exercise of stock options, $196,000
      in stock based compensation expense and a $181,000 increase in the after-tax
      value of investment securities.





**COMPARISON
      OF RESULTS OF OPERATIONS FOR THE YEARS ENDED**


**DECEMBER
      31, 2006 AND 2005**





Net
      Income. For the year ended December 31, 2006, the Company reported an increase
      in net income of 56% to $4.9 million compared to $3.1 million for the year
      ended
      December 31, 2005. Net income per diluted share increased 17% to $0.71 compared
      to $0.61 for the prior year period. The percentage increase in earnings per
      share did not mirror that of the increase in net income primarily due to the
      addition of 2.4 million shares from the acquisition of PCCB. Per share data
      for
      2005 data has been adjusted for the 15% stock split effected as a stock dividend
      payable on May 31, 2006 to shareholders of record on May 18, 2006. Returns
      on
      average assets and average equity were 0.93% and 8.72%, respectively, for the
      year ended December 31, 2006 compared to 0.84% and 10.34% for the prior year
      period.





Net
      Interest Income. Net interest income was $19.4 million for the current year
      compared to $14.0 million for the prior year. The 39% increase in net interest
      income was due primarily to significant growth in average earning
      assets.





Net
      interest margin is interest income earned on loans, securities and other earning
      assets, less interest expense paid on deposits and borrowings, expressed as
      a
      percentage of total average earning assets. The net interest margin for the
      year
      ended December 31, 2006 was 3.95% compared to 3.94% for the prior year. The
      average yield on earning assets for the current period was 7.46% compared to
      6.45% from the year ended December 31, 2005 and the average cost of
      interest-bearing funds was 4.17% compared to 2.94%. The decline in interest
      rate
      spread from 3.51% to 3.29% was partially offset by an improvement in the ratio
      of average interest-earning assets to average interest-bearing liabilities
      which
      increased from 117.14% at December 31, 2005 to 118.88% at December 31,
      2006.





Between
      July 1, 2004 and July 5, 2006, the Federal Reserve (the “Fed”) increased
      short-term interest rates sixteen times for a total of 400 basis points.
      Interest rates stabilized over the last five months of 2006. While several
      factors influence the level of intermediate and long-term interest rates,
      increases in short-term interest rates would generally result in a parallel
      shift in the entire yield curve across all investment horizons. The current
      rate
      increases did not impact intermediate and long-term rates in the typical manner,
      as those rates continued to trade in very tight ranges to levels seen prior
      to
      July 2004. The result has been a flat to inverted yield curve across investment
      terms. In other words, where historically interest rates for ten year terms
      were
      higher than overnight and other short-term investments, the current rate
      environment has short-term interest rates at higher levels than ten year rates.





Approximately
      55% of the Company’s loan portfolio carry variable rate pricing based on the
      Prime lending rate or LIBOR (London Inter Bank Offering Rate). As short-term
      rates have risen, variable rate loans have repriced higher resulting in a higher
      yield on average earning assets. While the yield on the variable portion of
      existing loans was rising with rate increases, rates on new loans were trending
      lower based on competition and new loan mix. Of the $93.0 million in organic
      loan growth, $51.5 million was in the commercial mortgage loan category. Due
      to
      the nature of the collateral and the competitive marketplace, this type of
      loan
      typically receives very favorable fixed-rate pricing based on the intermediate
      to long end of the yield curve. The volume of new loan originations outpaced
      the
      generation of lower cost core deposits causing the Company to rely more heavily
      on savings and brokered certificates of deposit resulting in a higher cost
      of
      funds than we would have anticipated. The Company expects to experience some
      net
      interest margin compression in the current stable rate environment. In rising
      or
      falling interest rate environments, the Company would expect moderate expansion
      or contraction of margin, respectively.





Total
      average interest earning assets were $491.8 million for the year ended December
      31, 2006, increasing by $137.9 million or 39% when compared to an average of
      $353.9 million for the year ended December 31, 2005. Increases in average
      balances by earning asset category are as follows: average loans increased
      by
      $117.6 million or 40% from $297.0 million for 2005 to $414.6 million for 2006,
      investment securities grew by $15.9 million or 29% from $55.3 million for 2005
      to $71.2 million for 2006 and Federal funds sold and other earning assets
      increased from $1.5 million in 2005 to $6.0 million for 2006. Total average
      interest-bearing liabilities increased by $111.6 million with interest-bearing
      deposits increasing by $102.2 million or 40% and borrowings increasing by $9.4
      million.





30


Total
      interest income for 2006 increased by $13.9 million to $36.7 million compared
      to
      $22.8 million for the prior year. The increase was the result of a $10.0 million
      improvement from increased earning asset levels and a $3.9 million increase
      due
      to the rising interest rate environment. Total interest expense grew by $8.4
      million attributed to a $4.1 million increase from higher interest bearing
      liability volumes and $4.3 million due to higher interest rates.





Provision
      for Loan Losses. The Company’s provision for loan losses for 2006 was $991,000
      compared to $807,000 recorded in the prior year. The increase in the loan loss
      provision was due to the increase in net loan growth. Organic loan growth was
      $93.0 million ($221.5 million total less $128.5 million acquired through PCCB)
      during 2006 compared to $70.9 million in 2005 and net charge-offs for 2006
      were
      $84,000 compared to $124,000 during the prior year. Provisions for loan losses
      are charged to income to bring the allowance for loan losses to a level deemed
      appropriate by management. While net growth in the loan portfolio is the primary
      driver in determining the loan loss provision, there are other factors which
      are
      more fully discussed under the section entitled “Analysis of Allowance for Loan
      Losses.”





Non-Interest
      Income. Non-interest income increased by $195,000 or 8% to $2.6 million for
      2006
      compared to $2.4 million for the prior year period. The largest components
      of
      non-interest income in 2006 were $1,090,000 in customer service fees, $642,000
      in mortgage loan origination fees, $229,000 in earnings on cash value of bank
      owned life insurance and $197,000 in service charges and fees on deposit
      accounts. For the year ended December 31, 2005, the largest components of
      non-interest income included $870,000 in customer service fees, $755,000 in
      mortgage loan origination fees, $226,000 in earnings on cash value of bank
      owned
      life insurance and $175,000 in service charges and fees on deposit accounts.
      The
      Company recognized $16,000 in losses on the disposition of available for sale
      investment securities in 2005.





Non-Interest
      Expenses. Non-interest expenses were $13.4 million for year ended December
      31,
      2006 compared to $10.8 million for the prior year period. The $2.6 million
      or
      24% increase reflects the continuing efforts to expand the Company’s
      infrastructure and branch network. Of the $2.6 million increase, $1.9 million
      was in personnel, occupancy and data processing which are the areas most
      impacted by the branch network and infrastructure improvements.





Total
      compensation for the year ended December 31, 2006 was $7.3 million reflecting
      a
      24% increase when compared to $5.9 million for the year ended December 31,
      2005.
      As of December 31, 2006, the Company employs 122 full-time equivalent employees
      in eleven full-service branch offices, one loan production office and various
      administrative support departments. In comparison, a t
      December 31, 2005, the Company employed 90 full-time equivalent employees in
      nine full-service branch offices and various administrative support departments.





Occupancy
      expenses were $2.0 million for 2006 compared to $1.7 million in 2005 increasing
      by $290,000 or 17%. During 2006, the Company opened one new full-service office
      as well as acquired PCCB in August. During 2005, the Company opened an
      operations facility, one new full-service office, one loan production office
      and
      converted one office from a temporary branch location into a permanent building.
      Additional expansion opportunities will be explored as we identify the bankers
      of choice in other communities.





Data
      processing expenses were $834,000 for 2006 compared to $648,000 for the prior
      year. The 29% increase was due to growth in account volumes, contractual
      increases in data processing costs and the additional data line expenses for
      the
      new offices. Because data processing expense is tied closely to transaction
      and
      account volumes, these expenses should increase as the Company continues to
      grow.





Professional
      fees and services totaled $899,000 in 2006, up $187,000 or 26% over the $712,000
      for 2005. The largest components of professional fees and services were
      directors’ fees, legal expenses, and accounting and audit expenses. In
      anticipation of needing to comply with the provisions of Sarbanes-Oxley Section
      404, the Company spent approximately $80,000 documenting and sample testing
      various major control processes related to financial reporting. The parameters
      and timing to implement Sarbanes-Oxley Section 404 have changed several times
      and the Company was not required, as of December 31, 2006, to provide
      management’s written assessment of the adequacy of its internal controls over
      financial reporting. The Company will need to comply with Section 404 at
      December 31, 2007. The amount budgeted in 2007 for Sarbanes-Oxley compliance
      is
      approximately $100,000.





31


The
      total
      of all other non-interest expenses for the year ended December 31, 2006 was
      $2.3
      million compared to $1.8 million for the prior year. The increase was primarily
      the result of the Company’s continued growth. The largest components of other
      non-interest expenses include office supplies and printing, advertising, and
      loan related fees. Management expects that as the Company continues to expand,
      expenses associated with these categories will increase.





Provision
      for Income Taxes. For 2006, the Company’s provision for income taxes was $2.8
      million compared to $1.7 million for the prior year. The effective tax rates
      for
      2006 and 2005 were 36.2% and 34.5%, respectively. The effective tax rate
      increased because the percentage of total income attributable to tax exempt
      sources declined as compared with the prior year period as well as the non-tax
      deductibility of the expensing of the fair value of stock options pursuant
      to
      FASB 123R.





**COMPARISON
      OF RESULTS OF OPERATIONS FOR THE YEARS ENDED**


**DECEMBER
      31, 2005 AND 2004**





Net
      Income. For the year ended December 31, 2005, the Company reported an increase
      in net income of 35% to $3.1 million compared to $2.3 million for the year
      ended
      December 31, 2004. Net income per diluted share increased 30% to $0.61 compared
      to $0.47 for the prior year period. The percentage increase in earnings per
      share did not mirror that of the increase in net income primarily due to the
      sale of 848,000 additional shares of stock during the fourth quarter of 2005.
      The 2005 and 2004 per share data have been adjusted for the 15% stock split
      effected as a stock dividend payable on May 31, 2006 to shareholders of record
      on May 18, 2006. Returns on average assets and average equity were 0.84% and
      10.34%, respectively, for the year ended December 31, 2005 compared to 0.76%
      and
      9.14% for the prior year period.





Net
      Interest Income. Net interest income was $14.0 million for the current year
      compared to $10.4 million for the prior year. The 34% increase in net interest
      income was due primarily to significant growth in average earning assets and
      the
      rising interest rate environment.





Net
      interest margin is interest income earned on loans, securities and other earning
      assets, less interest expense paid on deposits and borrowings, expressed as
      a
      percentage of total average earning assets. The net interest margin for the
      year
      ended December 31, 2005 was 3.94% compared to 3.61% for the prior year. The
      average yield on earning assets for the current period was 6.45% compared to
      5.51% from the year ended December 31, 2004, and the average cost of
      interest-bearing funds was 2.94% compared to 2.24%. Although the interest rate
      spread widened from 3.26% to 3.51%, we became more reliant on interest-bearing
      funds as the ratio of average interest-earning assets to average
      interest-bearing liabilities declined from 118.42% at December 31, 2004 to
      117.15% at December 31, 2005.





Between
      July 1, 2004 and December 31, 2005, the Federal Reserve (the “Fed”) increased
      short-term interest rates thirteen times for a total of 325 basis points.
      Initially the increases were designed to achieve a more neutral monetary policy
      than had existed during the thirty months prior to June 30, 2004, and more
      recent increases were aimed at controlling certain perceived inflationary
      pressures in the economy. Approximately 61% of the Company’s loan portfolio
      carries variable rate pricing based on the Prime lending rate or LIBOR (London
      Inter Bank Offering Rate). While the current rate environment has resulted
      in an
      increase in the net interest margin, the magnitude of the increase has been
      less
      than we would have anticipated. Despite the sharp increase in the short-term
      interest rates, intermediate and long-term rates have not risen to the same
      extent. This has resulted in a flattening of the interest rate yield curve.
      Of
      the $70.9 million increase in net loan growth since December 31, 2004, $52.2
      million has come in the commercial real estate category. Due to the nature
      of
      the collateral and the competitive marketplace, this type of loan typically
      receives very favorable fixed-rate pricing based on the intermediate to long
      end
      of the yield curve. Therefore, interest rates on new commercial real estate
      loans are not 325 basis points higher, but rather only slightly higher than
      loans made a year ago. The volume of new loan originations has outpaced the
      generation of lower cost core deposits causing the Company to rely more heavily
      on borrowed funds and brokered certificates of deposit resulting in the cost
      of
      funds to increase at a higher rate than we would have anticipated. The Company
      should continue to experience marginal benefit from a moderately rising rate
      environment. If rates stabilize or begin to trend downward, other things being
      equal, we will begin to experience some margin compression.





32


Total
      average interest earning assets were $353.9 million for the year ended December
      31, 2005, increasing by $65.2 million or 23% when compared to an average of
      $288.7 million for the year ended December 31, 2004. Increases in average
      balances by earning asset category are as follows: average loans increased
      by
      $56.7 million or 24% from $240.3 million for 2004 to $297.0 million for 2005,
      investment securities grew by $10.8 million or 24% from $44.5 million for 2004
      to $55.3 million for 2005 and Federal funds sold and other earning assets
      declined from $3.9 million in 2004 to $1.5 million for 2005. Total average
      interest-bearing liabilities increased by $58.3 million with interest-bearing
      deposits increasing by $37.6 million or 17% and borrowings increasing by $45.8
      million.





Total
      interest income for 2005 increased by $6.9 million to $22.8 million compared
      to
      $15.9 million for the prior year. The increase was the result of a $4.1 million
      improvement from increased earning asset levels and a $2.8 million increase
      due
      to the rising interest rate environment. Total interest expense grew by $3.4
      million attributed to a $1.8 million increase from higher interest bearing
      liability volumes and $1.6 million due to higher interest rates.





Provision
      for Loan Losses. The Company’s provision for loan losses for 2005 was $807,000
      compared to $736,000 recorded in the prior year. The increase in the loan loss
      provision was due to the increase in net loan growth. The loan portfolio grew
      by
      $70.9 million during 2005 compared with $40.7 million in 2004 and net
      charge-offs for 2005 were $124,000 compared to $372,000 during the prior year.
      Provisions for loan losses are charged to income to bring the allowance for
      loan
      losses to a level deemed appropriate by management. While net growth in the
      loan
      portfolio is the primary driver in determining the loan loss provision, there
      are other factors which are more fully discussed under the section entitled
      “Analysis of Allowance for Loan Losses.”





Non-Interest
      Income. Non-interest income increased by $193,000 or 9% to $2.4 million for
      2005
      compared to $2.3 million for the prior year period. The largest components
      of
      non-interest income in 2005 were $870,000 in customer service fees, $755,000
      in
      mortgage loan origination, $226,000 in earnings on cash value of bank owned
      life
      insurance and $175,000 in service charges and fees on deposit accounts. For
      the
      year ended December 31, 2004, the largest components of non-interest income
      included $689,000 in customer service fees, $643,000 in mortgage loan
      origination, $235,000 in earnings on cash value of life insurance and $187,000
      in service charges and fees on deposit accounts. During 2004, the Company had
      a
      membership interest in a mortgage loan origination company and received $287,000
      in income distributions. Additionally, when the membership interest was sold
      during the fourth quarter of 2004, a $118,000 gain on investment was recognized.
      Earnings on cash value of life insurance fell slightly due to a deceased
      crediting rate and service charges declined because of the increase in the
      earnings credit applied to commercial account balances to offset hard service
      charges. The Company recognized $16,000 in losses on the disposition of
      available for sale investment securities in 2005.





Non-Interest
      Expenses. Non-interest expenses were $10.8 million for year ended December
      31,
      2005 compared to $8.5 million for the prior year period. The $2.2 million or
      26%
      increase reflects the continuing efforts to expand the Company’s infrastructure
      and branch network. Of the $2.2 million increase, $1.8 million was in personnel,
      occupancy and data processing which are the areas most impacted by the branch
      network and infrastructure improvements.





Total
      compensation for the year ended December 31, 2005 was $5.9 million reflecting
      a
      34% increase when compared to $4.4 million for the year ended December 31,
      2004.
      As of December 31, 2005, the Company employs 90 full-time equivalent employees
      (81 full-time and 18 part-time) in nine full-service branch offices, one loan
      production office and various administrative support departments. In comparison,
      a t
      December 31, 2004, the Company employed 76 full-time equivalent employees (68
      full-time and 15 part-time) in eight full-service branch offices and various
      administrative support departments.





Occupancy
      expenses were $1.7 million for 2005 compared to $1.5 million in 2004 increasing
      by $212,000 or 14%. During 2005, the Company opened an operations facility,
      one
      new full-service office, one loan production office and converted one office
      from a temporary branch location into a permanent building. In 2004, the Company
      operated seven full-service branch locations for the entire year and one branch
      for the final two months. The Company expects to open a full-service branch
      office in Raleigh, North Carolina during the second quarter of 2006. Additional
      expansion opportunities will be explored as we identify the bankers of choice
      in
      other communities.





Data
      processing expenses were $648,000 for 2005 compared to $549,000 for the prior
      year. The 18% increase was due to growth in account volumes, contractual
      increases in data processing costs and the additional data line expenses for
      the
      new offices. Because data processing expense is tied closely to transaction
      and
      account volumes, these expenses should increase as the Company continues to
      grow.





33


Professional
      fees and services totaled $712,000 in 2005, up $146,000 or 26% over the $566,000
      for 2004. The largest components of professional fees and services were
      directors’ fees, legal expenses, and accounting and audit expenses. In
      anticipation of needing to comply with the provisions of Sarbanes-Oxley Section
      404, the Company spent approximately $80,000 documenting and sample testing
      various major control processes related to financial reporting. The parameters
      and timing to implement Sarbanes-Oxley Section 404 have changed several times
      and the Company was not required, as of December 31, 2005, to provide
      management’s written assessment of the adequacy of its internal controls over
      financial reporting. Although the final rules of the legislation have not yet
      been released, the Company is proceeding as though we will need to be compliant
      at December 31, 2007. The amount budgeted for Sarbanes-Oxley compliance is
      approximately $120,000.





The
      total
      of all other non-interest expenses for the year ended December 31, 2005 was
      $1.8
      million compared to $1.5 million for the prior year. The increase was primarily
      the result of the Company’s continued growth. The largest components of other
      non-interest expenses include office supplies and printing, advertising, and
      loan related fees. Management expects that as the Company continues to expand,
      expenses associated with these categories will increase.





Provision
      for Income Taxes. For 2005, the Company’s provision for income taxes was $1.7
      million compared to $1.2 million for the prior year. The effective tax rates
      for
      2005 and 2004 were 34.5% and 33.4%, respectively. The effective tax rate
      increased because the percentage of total income attributable to tax exempt
      sources declined as compared with the prior year period.





34




**NET
      INTEREST INCOME**





Net
      interest income represents the difference between income derived from
      interest-earning assets and interest expense incurred on interest-bearing
      liabilities. Net interest income is affected by both (1) the difference between
      the rates of interest earned on interest-earning assets and the rates paid
      on
      interest-bearing liabilities (“interest rate spread”) and (2) the relative
      amounts of interest-earning assets and interest-bearing liabilities (“net
      interest-earning balance”). The following table sets forth information relating
      to average balances of the Company's assets and liabilities for the years ended
      December 31, 2006, 2005 and 2004. The table reflects the average yield on
      interest-earning assets and the average cost of interest-bearing liabilities
      (derived by dividing income or expense by the daily average balance of
      interest-earning assets or interest-bearing liabilities, respectively) as well
      as the net interest margin. In preparing the table, non-accrual loans are
      included in the average loan balance.


For
                    the Years Ended December 31,2006
              
              2005
              
              2004Average
              
              
              
              Average
              
              Average
              
              
              
              Average
              
              Average
              
              
              
              Averagebalance
              
              Interest
              
              rate
              
              balance
              
              Interest
              
              rate
              
              balance
              
              Interest
              
              rate(Dollars
                    in thousands)Interest-earning
                  assets:Loan
                  portfolio
              
              $
              414,644
              
              $
              33,093
              
              
              7.98
              %
              $
              297,045
              
              $
              20,456
              
              
              6.89
              %
              $
              240,346
              
              $
              14,024
              
              
              5.83
              %Investment
                  securities
              
              
              71,151
              
              
              3,303
              
              
              4.64
              %
              
              55,285
              
              
              2,323
              
              
              4.20
              %
              
              44,469
              
              
              1,825
              
              
              4.10
              %Federal
                  funds and otherinterest-earning
                  assets
              
              
              5,996
              
              
              310
              
              
              5.17
              %
              
              1,531
              
              
              47
              
              
              3.07
              %
              
              3,862
              
              
              47
              
              
              1.22
              %Total
                  interest-earning assets
              
              
              491,791
              
              
              36,706
              
              
              7.46
              %
              
              353,861
              
              
              22,826
              
              
              6.45
              %
              
              288,677
              
              
              15,896
              
              
              5.51
              %Non-interest-earning
                  assets
              
              
              36,654
              
              
              
              
              
              
              
              
              22,465
              
              
              
              
              
              
              
              
              19,890Total
                  assets
              
              $
              528,445
              
              
              
              
              
              
              
              $
              376,326
              
              
              
              
              
              
              
              $
              308,567Interest-bearing
                  liabilities:Deposits:Interest-bearing
                  NOW
              
              $
              37,876
              
              
              553
              
              
              1.46
              %
              $
              39,609
              
              
              416
              
              
              1.05
              %
              $
              40,931
              
              
              323
              
              
              0.79
              %Money
                  market and savings
              
              
              92,620
              
              
              3,664
              
              
              3.96
              %
              
              46,500
              
              
              985
              
              
              2.12
              %
              
              34,295
              
              
              392
              
              
              1.14
              %Time
                  deposits
              
              
              226,978
              
              
              9,990
              
              
              4.40
              %
              
              169,099
              
              
              5,483
              
              
              3.24
              %
              
              142,406
              
              
              3,716
              
              
              2.61
              %Short-term
                  borrowings
              
              
              16,318
              
              
              844
              
              
              5.17
              %
              
              12,239
              
              
              475
              
              
              3.88
              %
              
              1,318
              
              
              48
              
              
              3.64
              %Long-term
                  debt
              
              
              39,906
              
              
              2,206
              
              
              5.53
              %
              
              34,626
              
              
              1,513
              
              
              4.37
              %
              
              24,824
              
              
              987
              
              
              3.98
              %Total
                  interest-bearingliabilities
              
              
              413,698
              
              
              17,257
              
              
              4.17
              %
              
              302,073
              
              
              8,872
              
              
              2.94
              %
              
              243,774
              
              
              5,466
              
              
              2.24
              %Other
                  liabilities
              
              
              58,542
              
              
              
              
              
              
              
              
              43,843
              
              
              
              
              
              
              
              
              39,279Total
                  liabilities
              
              
              472,240
              
              
              
              
              
              
              
              
              345,916
              
              
              
              
              
              
              
              
              283,053Stockholders’
                  equity
              
              
              56,205
              
              
              
              
              
              
              
              
              30,410
              
              
              
              
              
              
              
              
              25,514Total
                  liabilities andstockholders’
                  equity
              
              $
              528,445
              
              
              
              
              
              
              
              $
              376,326
              
              
              
              
              
              
              
              $
              308,567Net
                  interest income andinterest
                  rate spread
              
              
              
              
              $
              19,449
              
              
              3.29
              %
              
              
              
              $
              13,954
              
              
              3.51
              %
              
              
              
              $
              10,430
              
              
              3.26
              %Net
                  interest margin
              
              
              
              
              
              
              
              
              3.95
              %
              
              
              
              
              
              
              
              3.94
              %
              
              
              
              
              
              
              
              3.61
              %Ratio
                  of average interest-earning
                  assets to averageinterest-bearing
                  liabilities
              
              
              118.88
              %
              
              
              
              
              
              
              
              117.14
              %
              
              
              
              
              
              
              
              118.42
              %




35




**VOLUME/RATE
      VARIANCE ANALYSIS**





The
      following table analyzes the dollar amount of changes in interest income and
      interest expense for major components of interest-earning assets and
      interest-bearing liabilities. The table distinguishes between (i) changes
      attributable to volume (changes in volume multiplied by the prior period’s
      rate), (ii) changes attributable to rate (changes in rate multiplied by the
      prior period’s volume), and (iii) net change (the sum of the previous columns).
      The change attributable to both rate and volume (changes in rate multiplied
      by
      changes in volume) has been allocated proportionately to both the changes
      attributable to volume and the changes attributable to rate.


Year
                  Ended
              
              Year
                  EndedDecember
                  31, 2006 vs. 2005
              
              December
                  31, 2005 vs. 2004Increase
                  (Decrease) Due to
              
              Increase
                  (Decrease) Due toVolume
              
              Rate
              
              Total
              
              Volume
              
              Rate
              
              Total(Dollars
                  in thousands)Interest
                  income:Loan
                  portfolio
              
              $
              9,017
              
              $
              3,620
              
              $
              12,637
              
              $
              3,646
              
              $
              2,786
              
              $
              6,432Investment
                  securities
              
              
              718
              
              
              262
              
              
              980
              
              
              453
              
              
              45
              
              
              498Federal
                  funds and otherinterest-earning
                  assets
              
              
              213
              
              
              50
              
              
              263
              
              
              -
              
              
              -
              
              
              -Total
                  interest income
              
              
              9,948
              
              
              3,932
              
              
              13,880
              
              
              4,099
              
              
              2,831
              
              
              6,930Interest
                  expense:Deposits:Interest-bearing
                  NOW
              
              
              (17
              )
              
              154
              
              
              137
              
              
              (10
              )
              
              103
              
              
              93Money
                  market and savings
              
              
              1,429
              
              
              1,250
              
              
              2,679
              
              
              175
              
              
              418
              
              
              593Time
                  deposits
              
              
              2,205
              
              
              2,302
              
              
              4,507
              
              
              770
              
              
              996
              
              
              1,767Short-term
                  borrowings
              
              
              184
              
              
              185
              
              
              369
              
              
              424
              
              
              3
              
              
              427Long-term
                  debt
              
              
              253
              
              
              440
              
              
              693
              
              
              420
              
              
              106
              
              
              526Total
                  interest expense
              
              
              4,054
              
              
              4,331
              
              
              8,385
              
              
              1,780
              
              
              1,626
              
              
              3,406Net
                  interest income increase(decrease)
              
              $
              5,894
              
              $
              (399
              )
              $
              5,495
              
              $
              2,319
              
              $
              1,205
              
              $
              3,524




**NONPERFORMING
      ASSETS**





Our
      financial statements are prepared on the accrual basis of accounting, including
      the recognition of interest income on loans, unless we place a loan in
      nonaccrual status. We account for loans on a nonaccrual basis when we have
      serious doubts about the collectibility of principal or interest. Generally,
      our
      policy is to place a loan on nonaccrual status when the loan becomes past due
      90
      days. We also place loans on nonaccrual status in cases where we are uncertain
      whether the borrower can satisfy the contractual terms of the loan agreement.
      Amounts received on nonaccrual loans generally are applied first to principal
      and then to interest only after all principal has been collected. Restructured
      loans are those for which concessions, including the reduction of interest
      rates
      below a rate otherwise available to that borrower or the deferral of interest
      or
      principal have been granted due to the borrower’s weakened financial condition.
      We accrue interest on restructured loans at the restructured rates when we
      anticipate that no loss of original principal will occur. Potential problem
      loans are loans which are currently performing and are not included as
      nonaccrual or restructured loans above, but about which we have serious doubts
      as to the borrower’s ability to comply with present repayment terms. These loans
      are likely to be included later in nonaccrual, past due or restructured loans,
      so they are considered by our management in assessing the adequacy of our
      allowance for loan losses. At December 31, 2006, we identified six loans in
      the
      aggregate amount of $857,000 as potential problem loans. The loans possess
      certain unfavorable characteristics which cause management some concern. These
      loans will continue to be closely monitored. At December 31, 2005 there were
      four loans totaling $263,000 as potential problem loans.





36


At
      December 31, 2006, there were four foreclosed properties valued at $98,000
      and
      two nonaccrual loans totaling $135,000. Foreclosed property is valued at the
      lower of appraised value or the outstanding loan balance. Interest foregone
      on
      nonaccrual loans for the year ended December 31, 2006 was approximately $9,900.
      At December 31, 2005 there was one foreclosed property valued at $22,000 and
      three loans in nonaccrual status totaling $26,000. The foreclosed property
      held
      at December 31, 2005 was still held at December 31, 2006. Interest foregone
      on
      nonaccrual loans for the prior year period was approximately $5,300. There
      were
      no loans at December 31, 2006 or 2005 that were 90 days or more past due and
      still accruing interest. There were no repossessed assets at December 31, 2006
      or 2005.





The
      table
      sets forth, for the period indicated, information about our nonaccrual loans,
      loans past due 90 days or more and still accruing interest, total nonperforming
      loans (nonaccrual loans plus loans past due 90 days or more and still accruing
      interest), and total nonperforming assets.


At
                  December 31,2006
              
              2005
              
              2004
              
              2003
              
              2002(Dollars
                  in thousands)Nonaccrual
                    loans
              
              $
              135
              
              $
              26
              
              $
              5
              
              $
              159
              
              $
              -Restructured
                  loans
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
                  nonperforming loans
              
              
              135
              
              
              26
              
              
              5
              
              
              159
              
              
              -Real
                    estate owned
              
              
              98
              
              
              22
              
              
              245
              
              
              -
              
              
              -Repossessed
                  assets
              
              
              -
              
              
              -
              
              
              48
              
              
              -
              
              
              -Total
                  nonperforming assets
              
              $
              233
              
              $
              48
              
              $
              298
              
              $
              159
              
              $
              -Accruing
                  loans past due90
                    days or more
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              647
              
              $
              -Allowance
                    for loan losses
              
              
              6,945
              
              
              4,351
              
              
              3,668
              
              
              3,304
              
              
              1,711Nonperforming
                  loans toperiod
                    end loans
              
              
              0.02
              %
              
              0.01
              %
              
              0.00
              %
              
              0.07
              %
              
              0.00
              %Nonperforming
                  loans and loanspast
                  due 90 days or more toperiod
                    end loans
              
              
              0.02
              %
              
              0.01
              %
              
              0.00
              %
              
              0.37
              %
              
              0.00
              %Allowance
                  for loan losses toperiod
                    end loans
              
              
              1.26
              %
              
              1.33
              %
              
              1.42
              %
              
              1.52
              %
              
              1.36
              %Allowance
                  for loan losses tononperforming
                  loans
              
              
              5,144.96
              %
              
              16,960.60
              %
              
              73,360.00
              %
              
              2,077.99
              %
              
              NMAllowance
                  for loan losses tononperforming
                  loans and loanspast
                    due 90 days or more
              
              
              5,144.96
              %
              
              16,960.60
              %
              
              73,360.00
              %
              
              409.93
              %
              
              NMNonperforming
                  assets to total assets
              
              
              0.03
              %
              
              0.01
              %
              
              0.09
              %
              
              0.06
              %
              
              0.00
              %Nonperforming
                  assets and loanspast
                  due 90 days or more tototal
                    assets
              
              
              0.03
              %
              
              0.01
              %
              
              0.09
              %
              
              0.29
              %
              
              0.00
              %





37




**ANALYSIS
      OF ALLOWANCE FOR LOAN LOSSES**





The
      allowance for loan losses is established through periodic charges to earnings
      in
      the form of a provision for loan losses. Increases to the allowance for loan
      losses occur as a result of provisions charged to operations and recoveries
      of
      amounts previously charged-off, and decreases to the allowance occur when loans
      are charged-off. Management evaluates the adequacy of our allowance for loan
      losses on a monthly basis. The evaluation of the adequacy of the allowance
      for
      loan losses involves the consideration of loan growth, loan portfolio
      composition and industry diversification, historical loan loss experience,
      current delinquency levels, adverse conditions that might affect a borrower’s
      ability to repay the loan, estimated value of underlying collateral, prevailing
      economic conditions and all other relevant factors derived from our history
      of
      operations. Additionally, as an important component of their periodic
      examination process, regulatory agencies review our allowance for loan losses
      and may require additional provisions for estimated losses based on judgments
      that differ from those of management.





We
      use an
      internal grading system to assign the degree of inherent risk on each individual
      loan. The grade is initially assigned by the lending officer and reviewed by
      the
      loan administration function. The internal grading system is reviewed and tested
      periodically by an independent third party credit review firm. The testing
      process involves the evaluation of a sample of new loans, loans having been
      identified as possessing potential weakness in credit quality, past due loans
      and nonaccrual loans to determine the ongoing effectiveness of the internal
      grading system. The loan grading system is used to assess the adequacy of the
      allowance for loan losses.





Management
      has developed a model for evaluating the adequacy of the allowance for loan
      losses. The model distinguishes between loans that will be evaluated as a group
      by loan category and those loans to be evaluated individually. Management has
      assigned a range of predetermined allowance percentages for each major loan
      category. Loans that exhibit an acceptable level of risk per the internal loan
      grading system are grouped by loan category and multiplied by the associated
      allowance percentage to determine an adequate level of allowance for loan
      losses.





Based
      on
      the loan grading system, management maintains an internally classified watch
      list. Loans classified as watch list credits, and those loans that are not
      watch
      list credits but possess other characteristics which in the opinion of
      management suggest a higher degree of inherent risk, are evaluated individually,
      by loan category, using higher allowance percentages. Using the data gathered
      during the monthly evaluation process, the model calculates an acceptable range
      for allowance for loan losses. Management and the board of directors are
      responsible for determining the appropriate level of the allowance for loan
      losses within that range.





The
      primary reason for increases to the allowance for loan losses has been growth
      in
      total outstanding loans, however, there were other factors influencing the
      provision. Other factors influencing the level of the allowance of loan losses
      included the volume of net charge-offs experienced through the year and the
      current level of nonperforming loans. At or for the year ended December 31,
      2006, there were $84,000 in net loan charge-offs and $135,000 in nonaccrual
      loans compared with $124,000 in net loan charge-offs and $26,000 in nonaccrual
      loans at or for the year ended December 31, 2005. The allowance for loan losses
      at December 31, 2006 was $6.9 million, which represents 1.26% of total
      outstanding loans compared to $4.4 million and 1.33% for the prior year. The
      allowance for loan losses as a percentage of total outstanding loans declined
      from the prior year primarily due to improvement in the asset quality of the
      portfolio.





The
      allowance for loan losses represents management’s estimate of an amount adequate
      to provide for known and inherent losses in the loan portfolio in the normal
      course of business. While management believes the methodology used to establish
      the allowance for loan losses incorporates the best information available at
      the
      time, future adjustments to the level of the allowance may be necessary and
      the
      results of operations could be adversely affected should circumstances differ
      substantially from the assumptions initially used. We believe that the allowance
      for loan losses was established in conformity with generally accepted accounting
      principles; however, there can be no assurances that the regulatory agencies,
      after reviewing the loan portfolio, will not require management to increase
      the
      level of the allowance. Likewise, there can be no assurance that the existing
      allowance for loan losses is adequate should there be deterioration in the
      quality of any loans or changes in any of the factors discussed above. Any
      increases in the provision for loan losses resulting from such deterioration
      or
      change in condition could adversely affect our financial condition and results
      of operations.





38


The
      following table describes the allocation of the allowance for loan losses among
      various categories of loans for the dates indicated:




At
                  December 31,2006
              
              2005
              
              2004%
                  of Total
              
              
              
              %
                  of Total
              
              
              
              %
                  of TotalAmount
              
              Loans
                  (1)
              
              Amount
              
              Loans
                  (1)
              
              Amount
              
              Loans
                  (1)(Dollars
                  in thousands)Real
                  estate - commercial
              
              $
              3,920
              
              
              55.36
              %
              $
              1,876
              
              
              52.92
              %
              $
              1,290
              
              
              47.24
              %Real
                  estate - residential
              
              
              121
              
              
              3.67
              %
              
              90
              
              
              4.54
              %
              
              44
              
              
              4.50
              %Construction
                  loans
              
              
              1,379
              
              
              19.99
              %
              
              735
              
              
              14.17
              %
              
              718
              
              
              15.09
              %Commercial
                  and industrial loans
              
              
              1,161
              
              
              12.32
              %
              
              1,138
              
              
              16.03
              %
              
              1,105
              
              
              18.90
              %Home
                  equity loans and lines of credit
              
              
              269
              
              
              7.76
              %
              
              201
              
              
              10.62
              %
              
              173
              
              
              12.00
              %Loans
                  to individuals
              
              
              95
              
              
              0.90
              %
              
              311
              
              
              1.72
              %
              
              338
              
              
              2.27
              %Total
                  allowance
              
              $
              6,945
              
              
              100.00
              %
              $
              4,351
              
              
              100.00
              %
              $
              3,668
              
              
              100.00
              %
  At
                  December 31,2003
              
              2002%
                  of Total
              
              
              
              %
                  of TotalAmount
              
              Loans
                  (1)
              
              Amount
              
              Loans
                  (1)(Dollars
                  in thousands)Real
                  estate - commercial
              
              $
              1,330
              
              
              46.66
              %
              $
              584
              
              
              41.59
              %Real
                  estate - residential
              
              
              54
              
              
              6.80
              %
              
              9
              
              
              1.84
              %Construction
                  loans
              
              
              778
              
              
              14.56
              %
              
              435
              
              
              21.84
              %Commercial
                  and industrial loans
              
              
              841
              
              
              17.61
              %
              
              518
              
              
              19.60
              %Home
                  equity loans and lines of credit
              
              
              115
              
              
              10.59
              %
              
              88
              
              
              12.75
              %Loans
                  to individuals
              
              
              186
              
              
              3.78
              %
              
              77
              
              
              2.38
              %Total
                  allowance
              
              $
              3,304
              
              
              100.00
              %
              $
              1,711
              
              
              100.00
              %





(1)
            Represents
                total of all outstanding loans in each category as a percent of total
                loans outstanding.





39




The
      following table presents information regarding changes in the allowance for
      loan
      losses for the years indicated:


At
                    or for the Year Ended December 31,2006
                
                2005
                
                2004
                
                2003
                
                2002(Dollars
                    in thousands)Balance
                    at beginning of period
                
                $
                4,351
                
                $
                3,668
                
                $
                3,304
                
                $
                1,711
                
                $
                1,116Charge-offs:Construction
                    loans
                
                
                -
                
                
                -
                
                
                15
                
                
                27
                
                
                -Commercial
                    real estate
                
                
                -
                
                
                34
                
                
                21
                
                
                -
                
                
                -Commercial
                    and industrial loans
                
                
                14
                
                
                140
                
                
                345
                
                
                59
                
                
                21Residential
                    real estate
                
                
                64
                
                
                -
                
                
                34
                
                
                -
                
                
                -Loans
                    to individuals
                
                
                8
                
                
                9
                
                
                16
                
                
                13
                
                
                74Total
                    charge-offs
                
                
                86
                
                
                183
                
                
                431
                
                
                99
                
                
                95Recoveries:Commercial
                    and industrial loans
                
                
                1
                
                
                22
                
                
                57
                
                
                4
                
                
                1Construction
                    loans
                
                
                -
                
                
                27
                
                
                -
                
                
                -
                
                
                -Loans
                    to individuals
                
                
                1
                
                
                10
                
                
                2
                
                
                8
                
                
                -Total
                    recoveries
                
                
                2
                
                
                59
                
                
                59
                
                
                12
                
                
                1Net
                    charge-offs
                
                
                84
                
                
                124
                
                
                372
                
                
                87
                
                
                94Allowance
                    acquired from Port CityCapital
                    Bank merger
                
                
                1,687
                
                
                -
                
                
                -
                
                
                -
                
                
                -Allowance
                    acquired from CentennialBank
                    merger
                
                
                -
                
                
                -
                
                
                -
                
                
                1,129
                
                
                -Provision
                    for loan losses
                
                
                991
                
                
                807
                
                
                736
                
                
                551
                
                
                689Balance
                    at the end of the year
                
                $
                6,945
                
                $
                4,351
                
                $
                3,668
                
                $
                3,304
                
                $
                1,711Total
                    loans outstanding at year-end
                
                $
                549,819
                
                $
                328,322
                
                $
                257,908
                
                $
                217,128
                
                $
                125,917Average
                    loans outstanding for the year
                
                $
                414,644
                
                $
                297,045
                
                $
                240,346
                
                $
                160,134
                
                $
                104,519Allowance
                    for loan losses toloans
                    outstanding
                
                
                1.26
                %
                
                1.33
                %
                
                1.42
                %
                
                1.52
                %
                
                1.36
                %Ratio
                    of net loan charge-offs toaverage
                    loans outstanding
                
                
                0.02
                %
                
                0.04
                
                
                0.15
                %
                
                0.05
                %
                
                0.09
                %


**INVESTMENT
      ACTIVITIES**





The
      Company’s investment portfolio plays a major role in management of liquidity and
      interest rate sensitivity and, therefore, is managed in the context of the
      overall balance sheet. The securities portfolio generates a nominal percentage
      of our interest income and serves as a necessary source of liquidity. We account
      for investment securities as follows:





*Available
      for sale.* Debt and
      equity securities that will be held for indeterminate periods of time, including
      securities that we may sell in response to changes in market interest or
      prepayment rates, needs for liquidity and changes in the availability of and
      the
      yield of alternative investments are classified as available for sale. The
      Company carries these investments at market value, which we generally determine
      using published quotes as of the close of business. Unrealized gains and losses
      are excluded from our earnings and are reported, net of applicable income tax,
      as a component of accumulated other comprehensive income in stockholders’ equity
      until realized.





40


The
      following table summarizes the amortized costs and market value of available
      for
      sale securities at the dates indicated:


At
                  December 31, 2006
              
              At
                  December 31, 2005
              
              At
                  December 31, 2004Amortized
              
              Fair
              
              Amortized
              
              Fair
              
              Amortized
              
              Faircost
              
              value
              
              cost
              
              value
              
              cost
              
              value(In
                  thousands)Securities
                  available for sale:U.S.
                  government securitiesand
                  obligations of U.S.government
                  agencies
              
              $
              7,493
              
              $
              7,385
              
              $
              5,945
              
              $
              5,793
              
              $
              2,943
              
              $
              2,932Mortgage-backed
                  securities
              
              
              54,949
              
              
              54,274
              
              
              35,042
              
              
              34,147
              
              
              37,326
              
              
              37,308Municipal
              
              
              22,321
              
              
              22,182
              
              
              15,173
              
              
              15,110
              
              
              12,685
              
              
              12,704Other
              
              
              779
              
              
              882
              
              
              500
              
              
              500
              
              
              500
              
              
              500Total
                  securities availablefor
                  sale
              
              $
              85,542
              
              $
              84,723
              
              $
              56,660
              
              $
              55,550
              
              $
              53,454
              
              $
              53,444




**LIQUIDITY
      AND CAPITAL RESOURCES**





Maintaining
      adequate liquidity while managing interest rate risk is the primary goal of
      the
      Company’s asset and liability management strategy. Liquidity is the ability to
      fund the needs of the Company’s borrowers and depositors, pay operating
      expenses, and meet regulatory liquidity requirements. Maturing investments,
      loan
      and mortgage-backed securities principal repayments, deposit growth, the
      brokered deposit market, and borrowings from the Federal Home Loan Bank are
      presently the main sources of the Company’s liquidity. The Company’s primary
      uses of liquidity are to fund loans and to make investments.





At
      December 31, 2006, liquid assets (cash and due from banks, interest-earning
      deposits with banks, federal funds sold and investment securities available
      for
      sale) were approximately $103.5 million, which represents 15% of total assets
      and 19% of total deposits. Supplementing this liquidity, the Company has
      available lines of credit from various correspondent banks of approximately
      $145.7 million of which $61.5 million was outstanding. At December 31, 2006,
      outstanding commitments for undisbursed lines of credit and letters of credit
      amounted to $179.0 million. Management believes that the combined aggregate
      liquidity position of the Company is sufficient to meet the funding requirements
      of loan demand and deposit maturities and withdrawals in the near term.
      Certificates of deposit represented 55% of the Company’s total deposits at
      December 31, 2006. The Company’s growth strategy will include efforts focused at
      increasing the relative volume of transaction deposit accounts. Certificates
      of
      deposit of $100,000 or more represented 42% of the Company’s total deposits at
      year-end. While these deposits are generally considered rate sensitive and
      the
      Company will need to pay competitive rates to retain these deposits at maturity,
      there are other subjective factors that will determine the Company’s continued
      retention of those deposits.





Under
      federal capital regulations, the Company must satisfy certain minimum leverage
      ratio requirements and risk-based capital requirements. At December 31, 2006,
      the Company’s equity to asset ratio was 10.64%. All capital ratios place the
      subsidiaries in excess of the minimum required to be deemed well-capitalized
      banks by regulatory measures. CSB’s ratio of Tier 1 capital to
      risk-weighted assets at December 31, 2006 was 9.12% while PCCB’s was
      9.50%.





**ASSET/LIABILITY
      MANAGEMENT**





The
      primary objective of asset and liability management is to provide sustainable
      and growing net interest income under varying economic environments, while
      protecting the economic values of our balance sheet assets and liabilities
      from
      the adverse effects of changes in interest rates. Our overall interest-rate
      risk
      position is maintained within a series of policies approved by the Board and
      guidelines established and monitored by ALCO.





41


Because
      no one individual measure can accurately assess all of our risks to changes
      in
      rates, we use several quantitative measures in our assessment of current and
      potential future exposures to changes in interest rates and their impact on
      net
      interest income and balance sheet values. Net interest income simulation is
      the
      primary tool used in our evaluation of the potential range of possible net
      interest income results that could occur under a variety of interest-rate
      environments. We also use market valuation and duration analysis to assess
      changes in the economic value of balance sheet assets and liabilities caused
      by
      assumed changes in interest rates. Finally, gap analysis — the difference
      between the amount of balance sheet assets and liabilities repricing within
      a
      specified time period — is used as a measurement of our interest-rate risk
      position.





To
      measure, monitor, and report on our interest-rate risk position, we begin with
      two models: (1) net interest income at risk which measures the impact on net
      interest income over the next twelve months to immediate, or “rate shock,” and
      slow, or “rate ramp,” changes in market interest rates; and (2) net economic
      value of equity that measures the impact on the present value of all net
      interest income-related principal and interest cash flows of an immediate change
      in interest rates. Net interest income at risk is designed to measure the
      potential impact of changes in market interest rates on net interest revenue
      in
      the short term. Net economic value of equity, on the other hand, is a long-term
      view of interest-rate risk, but with a liquidation view of the Company. Both
      of
      these models are subject to ALCO-established guidelines, and are monitored
      regularly.





In
      calculating our net interest income at risk, we start with a base amount of
      net
      interest revenue that is projected over the next twelve months, assuming that
      the then-current yield curve remains unchanged over the period. Our existing
      balance sheet assets and liabilities are adjusted by the amount and timing
      of
      transactions that are forecasted to occur over the next twelve months. That
      yield curve is then “shocked,” or moved immediately, ±200 basis points in a
      parallel fashion, or at all points along the yield curve. Two new twelve-month
      net interest income projections are then developed using the same balance sheet
      and forecasted transactions, but with the new yield curves, and compared to
      the
      base scenario. We also perform the calculations using interest rate ramps,
      which
      are ±100, ±200 and ±300 basis point changes in interest rates that are assumed
      to occur gradually over the next twelve-month period, rather than immediately
      as
      we do with interest-rate shocks.





Net
      economic value of equity is based on the change in the present value of all
      net
      interest income-related principal and interest cash flows for changes in market
      rates of interest. The present value of existing cash flows with a then-current
      yield curve serves as the base case. We then apply an immediate parallel shock
      to that yield curve of ±100 and ±200 basis points and recalculate the cash flows
      and related present values.





Key
      assumptions used in the models described above include the timing of cash flows;
      the maturity and repricing of balance sheet assets and liabilities, especially
      option-embedded financial instruments like mortgage-backed securities and FHLB
      advances; changes in market conditions; and interest-rate sensitivities of
      our
      customer liabilities with respect to the interest rates paid and the level
      of
      balances. These assumptions are inherently uncertain and, as a result, the
      models cannot precisely calculate future net interest income or predict the
      impact of changes in interest rates on net interest income and economic value.
      Actual results could differ from simulated results due to the timing, magnitude
      and frequency of changes in interest rates and market conditions, changes in
      spreads and management strategies, among other factors. Projections of potential
      future streams of net interest income are assessed as part of our forecasting
      process.





**Net
      Interest Income at Risk Analysis.** The
      following table presents the estimated exposure of net interest income for
      the
      next twelve months, calculated as of December 31, 2006 and 2005, due to an
      immediate and gradual ± 200 basis point shift in then-current interest rates.
      Estimated incremental exposures set forth below are dependent on management’s
      assumptions about asset and liability sensitivities under various interest-rate
      scenarios, such as those previously discussed, and do not reflect any actions
      management may undertake in order to mitigate some of the adverse effects of
      interest-rate changes on the Company’s financial performance.





42





Net
                  Interest Income at Risk(dollars
                  in thousands)
              
              Estimated
                  Exposure toNet
                  Interest IncomeRate
                  change
              
              2006
              
              2005+200
                  basis points shock
              
              $
              1,925
              
              $
              1,535-200
                  basis point shock
              
              
              (1,285
              )
              
              (1,983
              )+200
                  basis point ramp
              
              
              1,320
              
              
              963-200
                  basis point ramp
              
              
              (741
              )
              
              (1,056
              )




**Net
      Economic Value of Equity Analysis.** The
      following table presents estimated EVE exposures, calculated as of December
      31,
      2006 and 2005, assuming an immediate and prolonged shift in interest rates,
      the
      impact of which would be spread over a number of years.


Net
                  Economic Value of Equity
              
              Estimated
                  Exposure to(dollars
                  in thousands)
              
              Net
                  Economic Value of EquityRate
                  Change
              
              2006
              
              2005+100
                  basis point shock
              
              $
              (1,949
              )
              $
              (649
              )-100
                  basis point shock
              
              
              473
              
              
              (104
              )+200
                  basis point shock
              
              
              (4,219
              )
              
              (1,122
              )-200
                  basis point shock
              
              
              (973
              )
              
              (1,245
              )




While
      the
      measures presented in the tables above are not a prediction of future net
      interest income or valuations, they do suggest that if all other variables
      remained constant, in the short term, falling interest rates would lead to
      net
      interest income that is lower than it would otherwise have been, and rising
      rates would lead to higher net interest income. Other important factors that
      impact the levels of net interest income are balance sheet size and mix;
      interest-rate spreads; the slope, how quickly or slowly market interest rates
      change and management actions taken in response to the preceding
      conditions.





**Interest
      Rate Gap Analysis.** As
      a part
      of its interest rate risk management policy, the Company calculates an interest
      rate “gap.” Interest rate “gap” analysis is a common, though imperfect, measure
      of interest rate risk, which measures the relative dollar amounts of
      interest-earning assets and interest-bearing liabilities which reprice within
      a
      specific time period, either through maturity or rate adjustment. The “gap” is
      the difference between the amounts of such assets and liabilities that are
      subject to repricing. A “positive” gap for a given period means that the amount
      of interest-earning assets maturing or otherwise repricing within that period
      exceeds the amount of interest-bearing liabilities maturing or otherwise
      repricing within the same period. Accordingly, in a declining interest rate
      environment, an institution with a positive gap would generally be expected,
      absent the effects of other factors, to experience a decrease in the yield
      on
      its assets greater than the decrease in the cost of its liabilities and its
      net
      interest income should be negatively affected. Conversely, the yield on its
      assets for an institution with a positive gap would generally be expected to
      increase more quickly than the cost of funds in a rising interest rate
      environment, and such institution’s net interest income generally would be
      expected to be positively affected by rising interest rates. Changes in interest
      rates generally have the opposite effect on an institution with a “negative
      gap.”





The
      table
      below sets forth the amounts of interest-earning assets and interest-bearing
      liabilities outstanding at December 31, 2006 that are projected to reprice
      or mature in each of the future time periods shown. Except as stated below,
      the
      amounts of assets and liabilities shown which reprice or mature within a
      particular period were determined in accordance with the contractual terms
      of
      the assets or liabilities. Loans with adjustable rates are shown as being due
      at
      the end of the next upcoming adjustment period. Money market deposit accounts
      and negotiable order of withdrawal or other transaction accounts are assumed
      to
      be subject to immediate repricing and depositor availability and have been
      placed in the shortest period. In making the gap computations, none of the
      assumptions sometimes made regarding prepayment rates and deposit decay rates
      have been used for any interest-earning assets or interest-bearing liabilities.
      In addition, the table does not reflect scheduled principal payments that will
      be received throughout the lives of the loans or investments. The interest
      rate
      sensitivity of the Company’s assets and liabilities illustrated in the following
      table would vary substantially if different assumptions were used or if actual
      experience differs from that indicated by such assumptions.




43


Terms
                  to Repricing at December 31, 2006More
                  Than
              
              More
                  Than1
                  Year
              
              1
                  Year to
              
              3
                  Years to
              
              More
                  Thanor
                  Less
              
              3
                  Years
              
              5
                  Years
              
              5
                  Years
              
              Total(Dollars
                  in thousands)INTEREST-EARNING
                  ASSETS:Loans
                  receivable:Commercial
                  mortgage loans
              
              $
              152,110
              
              $
              69,077
              
              $
              77,774
              
              $
              5,862
              
              $
              304,823Residential
                  mortgage loans
              
              
              10,629
              
              
              7,216
              
              
              2,339
              
              
              40
              
              
              20,224Construction
                  and development
              
              
              94,650
              
              
              6,800
              
              
              7,191
              
              
              1,392
              
              
              110,033Commercial
                  and industrial loans
              
              
              54,120
              
              
              9,703
              
              
              3,968
              
              
              31
              
              
              67,822Home
                  equity lines and loans
              
              
              41,809
              
              
              580
              
              
              285
              
              
              30
              
              
              42,704Loans
                  to individuals
              
              
              3,369
              
              
              1,267
              
              
              330
              
              
              11
              
              
              4,977Interest-earning
                  deposits with banks
              
              
              763
              
              
              -
              
              
              -
              
              
              -
              
              
              763Fed
                  funds sold
              
              
              92
              
              
              -
              
              
              -
              
              
              -
              
              
              92Investment
                  securities available for sale
              
              
              13,737
              
              
              16,293
              
              
              15,377
              
              
              39,316
              
              
              84,723Federal
                  Home Loan Bank stock
              
              
              3,583
              
              
              -
              
              
              -
              
              
              -
              
              
              3,583Total
                  interest-earning assets
              
              $
              374,862
              
              $
              110,936
              
              $
              107,264
              
              $
              46,682
              
              $
              639,744INTEREST-BEARING
                  LIABILITIES:Deposits:Money
                  market, NOW and savings
              
              $
              175,723
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              175,723Time
              
              
              202,070
              
              
              79,015
              
              
              14,653
              
              
              -
              
              
              295,738Short-term
                  borrowings
              
              
              24,451
              
              
              -
              
              
              -
              
              
              -
              
              
              24,451Long-term
                  borrowings
              
              
              40,248
              
              
              -
              
              
              -
              
              
              5,000
              
              
              45,248Total
                  interest-bearing liabilities
              
              $
              442,492
              
              $
              79,015
              
              $
              14,653
              
              $
              5,000
              
              $
              541,160INTEREST
                  SENSITIVITY GAP PERPERIOD
              
              $
              (67,630
              )
              $
              31,921
              
              $
              92,611
              
              $
              41,682
              
              $
              98,584CUMULATIVE
                  INTEREST SENSITIVITYGAP
              
              $
              (67,630
              )
              $
              (35,709
              )
              $
              56,902
              
              $
              98,584
              
              $
              98,584CUMULATIVE
                  GAP AS A PERCENTAGEOF
                  TOTAL INTEREST-EARNING ASSETS
              
              
              (10.57
              %)
              
              (5.58
              %)
              
              8.89
              %
              
              15,41
              %
              
              15.41
              %CUMULATIVE
                  INTEREST-EARNINGASSETS
                  AS A PERCENTAGE OFCUMULATIVE
                  INTEREST-BEARINGLIABILITIES
              
              
              84.72
              %
              
              93.15
              %
              
              110.61
              %
              
              118.22
              %
              
              118.22
              %
 44




**CRITICAL
      ACCOUNTING POLICY**





The
      Company's most significant critical accounting policy is the determination
      of
      its allowance for loan losses. A critical accounting policy is one that is
      both
      very important to the portrayal of the Company's financial condition and
      results, and requires management's most difficult, subjective or complex
      judgments. What makes these judgments difficult, subjective and/or complex
      is
      the need to make estimates about the effects of matters that are inherently
      uncertain. Refer to the discussion within Analysis of Allowance for Loan Losses
      and Note B to the consolidated financial statements for comprehensive discussion
      regarding this accounting policy.





**QUARTERLY
      FINANCIAL INFORMATION**




The
      following table sets forth, for the periods indicated, certain of our
      consolidated quarterly financial information. This information is derived from
      our unaudited financial statements, which include, in the opinion of management,
      all normal recurring adjustments which management considers necessary for a
      fair
      presentation of the results for such periods. This information should be read
      in
      conjunction with our consolidated financial statements included elsewhere in
      this report. The results for any quarter are not necessarily indicative of
      results for any future period.




Quarterly
        Financial Data (dollars
          in thousands, except per share data)
  Year
                  Ended December 31, 2006
              
              Year
                  Ended December 31, 2005Fourth
              
              Third
              
              Second
              
              First
              
              Fourth
              
              Third
              
              Second
              
              FirstQuarter
              
              Quarter
              
              Quarter
              
              Quarter
              
              Quarter
              
              Quarter
              
              Quarter
              
              QuarterOperating
                  Data:Total
                  interest income
              
              $
              12,288
              
              $
              9,522
              
              $
              7,794
              
              $
              7,101
              
              $
              6,609
              
              $
              6,059
              
              $
              5,394
              
              $
              4,764Total
                  interest expense
              
              
              6,044
              
              
              4,608
              
              
              3,578
              
              
              3,027
              
              
              2,671
              
              
              2,411
              
              
              2,069
              
              
              1,720Net
                  interest income
              
              
              6,244
              
              
              4,914
              
              
              4,216
              
              
              4,074
              
              
              3,938
              
              
              3,648
              
              
              3,325
              
              
              3,044Provision
                  for loan losses
              
              
              374
              
              
              182
              
              
              164
              
              
              270
              
              
              60
              
              
              240
              
              
              303
              
              
              204Net
                  interest income after provision
              
              
              5,870
              
              
              4,732
              
              
              4,052
              
              
              3,804
              
              
              3,878
              
              
              3,408
              
              
              3,022
              
              
              2,840Non-interest
                  income
              
              
              701
              
              
              695
              
              
              619
              
              
              596
              
              
              675
              
              
              614
              
              
              583
              
              
              544Non-interest
                  expense
              
              
              3,979
              
              
              3,432
              
              
              3,104
              
              
              2,871
              
              
              3,006
              
              
              2,718
              
              
              2,614
              
              
              2,423Income
                  before income taxes
              
              
              2,592
              
              
              1,995
              
              
              1,567
              
              
              1,529
              
              
              1,547
              
              
              1,304
              
              
              991
              
              
              961Provision
                  for income taxes
              
              
              949
              
              
              721
              
              
              564
              
              
              547
              
              
              542
              
              
              459
              
              
              338
              
              
              320Net
                  income
              
              $
              1,643
              
              $
              1,274
              
              $
              1,003
              
              $
              982
              
              $
              1,005
              
              $
              845
              
              $
              653
              
              $
              641Securities
                  gains/(losses)
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              (17
              )
              $
              1
              
              $
              -Per
                  Share Data:Earnings
                  per share- basic
              
              $
              0.20
              
              $
              0.19
              
              $
              0.17
              
              $
              0.17
              
              $
              0.19
              
              $
              0.17
              
              $
              0.14
              
              $
              0.14Earnings
                  per share - diluted
              
              
              0.19
              
              
              0.18
              
              
              0.17
              
              
              0.16
              
              
              0.18
              
              
              0.17
              
              
              0.13
              
              
              0.13




**RECENT
      ACCOUNTING PRONOUNCEMENTS**





For
      recently issued accounting pronouncements that may affect the Company, see
      Note
      B of Notes to Consolidated Financial Statements.





**OFF-BALANCE
      SHEET ARRANGEMENTS**





The
      Company has various financial instruments (outstanding commitments) with
      off-balance sheet risk that are issued in the normal course of business to
      the
      meet the financing needs of its customers. See Note N to the consolidated
      financial statements for more information regarding these commitments and
      contingent liabilities.





45




**FORWARD-LOOKING
      INFORMATION**





This
      annual report may contain, in addition to historical information, certain
“forward-looking statements” that represent management’s judgment concerning the
      future and are subject to risks and uncertainties that could cause the Company’s
      actual operating results and financial position to differ materially from those
      projected in the forward-looking statements. Such forward-looking statements
      can
      be identified by the use of forward-looking terminology such as “may,” “will,”
“expect,” “anticipate,” “estimate” or “continue” or the negative thereof or
      other variations thereof or comparable terminology. Factors that could influence
      the estimates include changes in national, regional and local market conditions,
      legislative and regulatory conditions, and the interest rate
      environment.





**ITEM
      7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





Market
      risk reflects the risk of economic loss resulting from adverse changes in market
      price and interest rates. This risk of loss can be reflected in diminished
      current market values and/or reduced potential net interest income in future
      periods. Our market risk arises primarily from interest rate risk inherent
      in
      our lending and deposit-taking activities. The structure of our loan and deposit
      portfolios is such that a significant decline in interest rates may adversely
      impact net market values and net interest income. We do not maintain a trading
      account nor are we subject to currency exchange risk or commodity price risk.
      Interest rate risk is monitored as part of the bank’s asset/liability management
      function.





See
      the
      section entitled Asset/Liability Management in Item 7 for a more detailed
      discussion of market risk.





46




**ITEM
      8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**





***CRESCENT
      FINANCIAL CORPORATION AND SUBSIDIARY***




***CONSOLIDATED
      FINANCIAL STATEMENTS***





***Years
      Ended December 31, 2006, 2005 and 2004***




47




CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES
 INDEX
        TO THE CONSOLIDATED FINANCIAL ST ATEMENTS


Page
                  No.Report
                  of Independent Registered Public Accounting Firm
              49Consolidated
                  Balance Sheetsas
                  of December 31, 2006 and 2005
              50Consolidated
                  Statements of Operationsfor
                  the years ended December 31, 2006, 2005 and 2004
              51Consolidated
                  Statements of Changes in Stockholders’ Equityfor
                  the years ended December 31, 2006, 2005 and 2004
              52Consolidated
                  Statements of Cash Flowsfor
                  the years ended December 31, 2006, 2005 and 2004
              53Notes
                  to Consolidated Financial Statements
              54




48











***REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM***





To
      the
      Stockholders and the Board of Directors


Crescent
      Financial Corporation


Cary,
      North Carolina





We
      have
      audited the accompanying consolidated balance sheets of Crescent Financial
      Corporation and subsidiaries as of December 31, 2006 and 2005, and the related
      consolidated statements of operations, changes in stockholders’ equity and cash
      flows for each of the years in the three-year period ended December 31, 2006.
      These consolidated financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these consolidated
      financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. We were not engaged to perform
      an
      audit of the Company’s internal control over financial reporting. Our audit
      included consideration of internal control over financial reporting as a basis
      for designing audit procedures that are appropriate in the circumstances, but
      not for the purpose of expressing an opinion on the effectiveness of the
      Company’s internal control over financial reporting. Accordingly, we express no
      such opinion. An audit also includes examining, on a test basis, evidence
      supporting the amounts and disclosures in the financial statements, assessing
      the accounting principles used and significant estimates made by management,
      and
      evaluating the overall financial statement presentation. We believe that our
      audits provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Crescent Financial
      Corporation and subsidiaries at December 31, 2006 and 2005 and the results
      of
      their operations and their cash flows for each of the years in the three-year
      period ended December 31, 2006 in conformity with accounting principles
      generally accepted in the United States of America.







*Raleigh,
      North Carolina*


*March
      16, 2007*




49




***CRESCENT
      FINANCIAL CORPORATION AND SUBSIDIARY***


***CONSOLIDATED
      BALANCE SHEETS***


***December
      31, 2006 and 2005***





2006
              
              2005**ASSETS**Cash
                  and due from banks
              
              $
              14,295,053
              
              $
              9,402,960Interest-earning
                  deposits with banks
              
              
              763,057
              
              
              68,547Federal
                  funds sold
              
              
              92,000
              
              
              -Investment
                  securities available for sale, at fair value (Note C)
              
              
              84,722,892
              
              
              55,550,261Loans
                  (Note D)
              
              
              549,818,548
              
              
              328,321,640Allowance
                  for loan losses (Note D)
              
              
              (6,945,000
              )
              
              (4,351,000
              )NET
                  LOANS
              
              
              542,873,548
              
              
              323,970,640Accrued
                  interest receivable
              
              
              3,045,840
              
              
              1,768,029Federal
                  Home Loan Bank stock, at cost
              
              
              3,582,800
              
              
              2,133,400Bank
                  premises and equipment (Note E)
              
              
              5,907,664
              
              
              4,844,056Investment
                  in life insurance
              
              
              5,683,493
              
              
              5,483,313Goodwill
              
              
              30,225,549
              
              
              3,600,298Other
                  assets
              
              
              6,717,324
              
              
              3,966,671TOTAL
                  ASSETS
              
              $
              697,909,220
              
              $
              410,788,175**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**Deposits:Demand
              
              $
              70,420,392
              
              $
              46,829,792Savings
              
              
              78,379,431
              
              
              9,364,575Money
                  market and NOW
              
              
              97,343,128
              
              
              87,695,273Time
                  (Note F)
              
              
              295,738,729
              
              
              178,191,148TOTAL
                  DEPOSITS
              
              
              541,881,680
              
              
              322,080,788Short-term
                  borrowings (Note G)
              
              
              24,451,000
              
              
              14,964,153Long-term
                  debt (Note G)
              
              
              45,248,000
              
              
              30,248,000Accrued
                  expenses and other liabilities
              
              
              3,294,562
              
              
              2,038,020TOTAL
                  LIABILITIES
              
              
              614,875,242
              
              
              369,330,961Commitments
                  (Notes D, H and N)Stockholders’
                  Equity (Note P)Common
                  stock, $1 par value, 20,000,000shares
                  authorized; 8,265,136 shares and 5,026,394shares
                  issued and outstanding at December 31, 2006and
                  2005, respectively
              
              
              8,265,136
              
              
              5,026,394Additional
                  paid-in capital
              
              
              62,659,201
              
              
              29,405,559Retained
                  earnings
              
              
              12,610,588
              
              
              7,707,054Accumulated
                  other comprehensive loss
              
              
              (500,947
              )
              
              (681,793
              )TOTAL
                  STOCKHOLDERS’ EQUITY
              
              
              83,033,978
              
              
              41,457,214TOTAL
                  LIABILITIES ANDSTOCKHOLDERS’
                  EQUITY
              
              $
              697,909,220
              
              $
              410,788,175




*See
      accompanying notes.*




50




***CRESCENT
      FINANCIAL CORPORATION AND SUBSIDIARY***


***CONSOLIDATED
      STATEMENTS OF OPERATIONS***


***Years
      Ended December 31, 2006, 2005 and 2004***


2006
              
              2005
              
              2004INTEREST
                  AND FEE INCOMELoans
              
              $
              33,093,487
              
              $
              20,456,115
              
              $
              14,023,925Investment
                  securities available for sale
              
              
              3,302,639
              
              
              2,323,232
              
              
              1,824,596Interest-earning
                  deposits with banks
              
              
              23,837
              
              
              15,298
              
              
              5,440Federal
                  funds sold
              
              
              286,473
              
              
              31,948
              
              
              42,366TOTAL
                  INTEREST AND FEE INCOME
              
              
              36,706,436
              
              
              22,826,593
              
              
              15,896,327INTEREST
                  EXPENSEMoney
                  market, NOW and savings deposits
              
              
              4,216,641
              
              
              1,401,267
              
              
              715,554Time
                  deposits
              
              
              9,989,995
              
              
              5,483,116
              
              
              3,715,626Short-term
                  borrowings
              
              
              843,995
              
              
              474,665
              
              
              48,089Long-term
                  debt
              
              
              2,206,229
              
              
              1,513,180
              
              
              986,700TOTAL
                  INTEREST EXPENSE
              
              
              17,256,860
              
              
              8,872,228
              
              
              5,465,969NET
                  INTEREST INCOME
              
              
              19,449,576
              
              
              13,954,365
              
              
              10,430,358PROVISION
                  FOR LOAN LOSSES (Note D)
              
              
              990,786
              
              
              806,796
              
              
              736,070NET
                  INTEREST INCOME AFTERPROVISION
                  FOR LOAN LOSSES
              
              
              18,458,790
              
              
              13,147,569
              
              
              9,694,288NON-INTEREST
                  INCOMEMortgage
                  origination revenue
              
              
              642,188
              
              
              755,300
              
              
              643,287Fees
                  on deposit accounts
              
              
              1,287,476
              
              
              1,044,771
              
              
              876,207Earnings
                  on life insurance
              
              
              228,573
              
              
              226,156
              
              
              234,950Gain
                  (loss) on sale of securities
              
              
              -
              
              
              (16,422
              )
              
              57Gain
                  (loss) on sale or disposal of assets
              
              
              2,782
              
              
              (13,000
              )
              
              5,636Other
                  (Note J)
              
              
              450,873
              
              
              420,407
              
              
              581,837TOTAL
                  NON-INTEREST INCOME
              
              
              2,611,892
              
              
              2,417,212
              
              
              2,341,974NON-INTEREST
                  EXPENSESalaries
                  and employee benefits
              
              
              7,307,183
              
              
              5,904,586
              
              
              4,421,135Occupancy
                  and equipment
              
              
              2,018,079
              
              
              1,728,366
              
              
              1,515,868Data
                  processing
              
              
              833,923
              
              
              647,685
              
              
              549,397Other
                  (Note J)
              
              
              3,227,363
              
              
              2,480,871
              
              
              2,044,965TOTAL
                  NON-INTEREST EXPENSE
              
              
              13,386,548
              
              
              10,761,508
              
              
              8,531,365INCOME
                  BEFORE INCOME TAXES
              
              
              7,684,134
              
              
              4,803,273
              
              
              3,504,897INCOME
                  TAXES (Note I)
              
              
              2,780,600
              
              
              1,658,900
              
              
              1,172,200NET
                  INCOME
              
              $
              4,903,534
              
              $
              3,144,373
              
              $
              2,332,697NET
                  INCOME PER COMMON SHAREBasic
              
              $
              0.74
              
              $
              0.64
              
              $
              0.50Diluted
              
              $
              0.71
              
              $
              0.61
              
              $
              0.47WEIGHTED
                  AVERAGE COMMONSHARES
                  OUTSTANDINGBasic
              
              
              6,619,105
              
              
              4,911,264
              
              
              4,678,604Diluted
              
              
              6,922,552
              
              
              5,165,861
              
              
              4,925,264
  See accompanying notes.


51


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARY***
 ***CONSOLIDATED
        STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY***
 ***Years
        Ended December 31, 2006, 2005 and 2004*** ******
 Common
                    stock
                
                Additional
                        paid-in
                
                Retained
                
                Accumulated
                      other
                        comprehensive
                        income
                
                TotalShares
                
                Amount
                
                capital
                
                earnings
                
                (loss)
                
                equityBalance
                    at December 31, 2003
                
                
                2,924,429
                
                $
                2,924,429
                
                $
                18,884,505
                
                $
                2,229,984
                
                $
                110,982
                
                $
                24,149,900Comprehensive
                    income:Net
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                2,332,697
                
                
                -
                
                
                2,332,697Net
                    unrealized holding loss onavailable
                    for sale securities
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (117,630
                )
                
                (117,630
                )Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                2,215,067Common
                    stock issued pursuant to:Stock
                    options exercised
                
                
                57,231
                
                
                57,231
                
                
                291,717
                
                
                -
                
                
                -
                
                
                348,948Stock
                    option related tax benefits
                
                
                -
                
                
                -
                
                
                61,709
                
                
                -
                
                
                -
                
                
                61,709Stock
                    split effected in the form ofa
                    twenty percent stock dividendwith
                    net cash received forfractional
                    shares
                
                
                585,229
                
                
                585,229
                
                
                (583,439
                )
                
                -
                
                
                -
                
                
                1,790Balance
                    at December 31, 2004
                
                
                3,566,889
                
                
                3,566,889
                
                
                18,654,492
                
                
                4,562,681
                
                
                (6,648
                )
                
                26,777,414Comprehensive
                    income:Net
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                3,144,373
                
                
                -
                
                
                3,144,373Net
                    unrealized holding loss onavailable
                    for sale securities
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (675,145
                )
                
                (675,145
                )Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                2,469,228Common
                    stock issued pursuant to:Stock
                    options exercised
                
                
                75,539
                
                
                75,539
                
                
                317,373
                
                
                -
                
                
                -
                
                
                392,912Stock
                    option related tax benefits
                
                
                -
                
                
                -
                
                
                199,800
                
                
                -
                
                
                -
                
                
                199,800Issuance
                    of new stock
                
                
                848,000
                
                
                848,000
                
                
                10,769,858
                
                
                -
                
                
                -
                
                
                11,617,858Stock
                    split effected in the form ofa
                    fifteen percent stock dividendwith
                    net cash received forfractional
                    shares
                
                
                535,966
                
                
                535,966
                
                
                (535,964
                )
                
                -
                
                
                -
                
                
                2Balance
                    at December 31, 2005
                
                
                5,026,394
                
                
                5,026,394
                
                
                29,405,559
                
                
                7,707,054
                
                
                (681,793
                )
                
                41,457,214Comprehensive
                    income:Net
                    income
                
                
                -
                
                
                -
                
                
                -
                
                
                4,903,534
                
                
                -
                
                
                4,903,534Net
                    unrealized holding gain onavailable
                    for sale securities
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                180,846
                
                
                180,846Total
                    comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                5,084,380Common
                    stock issued pursuant to:Stock
                    options exercised
                
                
                44,029
                
                
                44,029
                
                
                211,768
                
                
                -
                
                
                -
                
                
                255,797Stock
                    option related tax benefits
                
                
                -
                
                
                -
                
                
                45,401
                
                
                -
                
                
                -
                
                
                45,401Expense
                      recognized in connection withstock options
                
                
                -
                
                
                -
                
                
                195,578
                
                
                -
                
                
                -
                
                
                195,578Issuance
                    of restricted stock, net ofdeferred
                    compensation
                
                
                7,387
                
                
                7,387
                
                
                (719
                )
                
                -
                
                
                -
                
                
                6,668Shares
                    issued in connection withbusiness
                    combination
                
                
                2,432,374
                
                
                2,432,374
                
                
                33,566,001
                
                
                -
                
                
                -
                
                
                35,998,375Stock
                    split effected in the form ofa
                    fifteen percent stock dividendwith
                    net cash paid forfractional
                    shares
                
                
                754,952
                
                
                754,952
                
                
                (764,387
                )
                
                -
                
                
                -
                
                
                (9,435
                )Balance
                    at December 31, 2006
                
                
                8,265,136
                
                $
                8,265,136
                
                $
                62,659,201
                
                $
                12,610,588
                
                $
                (500,947
                )
                $
                83,033,978
  See accompanying notes.


52




***CRESCENT
      FINANCIAL CORPORATION AND SUBSIDIARY***


***CONSOLIDATED
      STATEMENTS OF CASH FLOWS***


***Years
      Ended December 31, 2006, 2005 and 2004***





2006
            
            2005
            
            2004CASH
                FLOWS FROM OPERATING ACTIVITIESNet
                income
            
            $
            4,903,534
            
            $
            3,144,373
            
            $
            2,332,697Adjustments
                to reconcile net income to net cashprovided
                by operating activities:Depreciation
            
            
            698,754
            
            
            613,388
            
            
            542,570Provision
                for loan losses
            
            
            990,786
            
            
            806,796
            
            
            736,070Amortization
                of core deposit intangible
            
            
            58,384
            
            
            20,901
            
            
            20,901Deferred
                income taxes
            
            
            (210,710
            )
            
            (11,549
            )
            
            160,602(Gain)
                loss on disposition of assets
            
            
            (2,782
            )
            
            13,000
            
            
            (5,636
            )(Gain)
                loss on sale of securities
            
            
            -
            
            
            16,422
            
            
            (57
            )Net
                (accretion) amortization of premiums on securities
            
            
            (20,023
            )
            
            82,702
            
            
            100,458Gain
                on sale of membership interest in mortgage company
            
            
            -
            
            
            -
            
            
            (118,048
            )Net
                increase in cash surrender value life insurance
            
            
            (200,180
            )
            
            (200,050
            )
            
            (210,575
            )Stock
                based compensation
            
            
            202,246
            
            
            -
            
            
            -Change
                in assets and liabilities:Increase
                in accrued interest receivable
            
            
            (592,718
            )
            
            (549,457
            )
            
            (254,196
            )(Increase)
                decrease in other assets
            
            
            (579,977
            )
            
            (116,897
            )
            
            (1,416,879
            )Increase
                in accrued interest payable
            
            
            136,282
            
            
            309,284
            
            
            25,663Increase
                (decrease) in accrued expensesand
                other liabilities
            
            
            269,732
            
            
            482,878
            
            
            (726,882
            )NET
                CASH PROVIDED BYOPERATING
                ACTIVITIES
            
            
            5,653,328
            
            
            4,611,791
            
            
            1,186,688CASH
                FLOWS FROM INVESTING ACTIVITIESPurchase
                of investment securitiesavailable
                for sale
            
            
            (25,248,980
            )
            
            (13,524,336
            )
            
            (28,835,075
            )Proceeds
                from maturities and repaymentsof
                investment securities available for sale
            
            
            6,646,100
            
            
            6,374,682
            
            
            7,782,416Proceeds
                from sale of securities available for sale
            
            
            6,106,354
            
            
            3,845,157
            
            
            4,312,157Proceeds
                from sale of membership interestin
                mortgage company
            
            
            -
            
            
            -
            
            
            580,548Loan
                originations and principal collections, net
            
            
            (93,377,653
            )
            
            (70,984,109
            )
            
            (41,087,890
            )Purchases
                of premises and equipment
            
            
            (1,679,226
            )
            
            (2,440,261
            )
            
            (876,310
            )Proceeds
                from disposals of premises and equipment
            
            
            800
            
            
            -
            
            
            1,851Proceeds
                from sales of foreclosed assets
            
            
            127,450
            
            
            297,978
            
            
            60,006Purchases
                of Federal Home Loan Bank stock
            
            
            (1,163,300
            )
            
            (686,200
            )
            
            (497,200
            )Net
                cash acquired in business combination
            
            
            8,221,923
            
            
            -
            
            
            -NET
                CASH USED BYINVESTING
                ACTIVITIES
            
            
            (100,366,532
            )
            
            (77,117,089
            )
            
            (58,559,497
            )CASH
                FLOWS FROM FINANCING ACTIVITIESNet
                increase in deposits accounts
            
            
            75,613,197
            
            
            48,431,967
            
            
            55,033,864Net
                increase (decrease) in short-term borrowings
            
            
            9,486,847
            
            
            13,657,048
            
            
            (7,695,441
            )Net
                increase in long-term debt
            
            
            15,000,000
            
            
            2,000,000
            
            
            8,248,000Proceeds
                from sale of common stock, net
            
            
            -
            
            
            11,617,858
            
            
            -Proceeds
                from stock options exercised
            
            
            255,797
            
            
            392,912
            
            
            348,948Net
                cash received for fractional shares
            
            
            (9,435
            )
            
            2
            
            
            1,790Excess
                tax benefits from stock options exercised
            
            
            45,401
            
            
            199,800
            
            
            61,709NET
                CASH PROVIDED BYFINANCING
                ACTIVITIES
            
            
            100,391,807
            
            
            76,299,587
            
            
            55,998,870NET
                INCERASE (DECREASE) INCASH
                AND CASH EQUIVALENTS
            
            
            5,678,603
            
            
            3,794,289
            
            
            (1,373,939
            )CASH
                AND CASH EQUIVALENTS, BEGINNING
            
            
            9,471,507
            
            
            5,677,218
            
            
            7,051,157CASH
                AND CASH EQUIVALENTS, ENDING
            
            $
            15,150,110
            
            $
            9,471,507
            
            $
            5,677,218




See
      accompanying notes.




53


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


NOTE
      A - ORGANIZATION AND
      OPERATIONS


On
      June
      29, 2001, Crescent Financial Corporation (the “Company”) was formed as a holding
      company for Crescent State Bank (“CSB”). Upon formation, one share of the
      Company’s $1 par value common stock was exchanged for each of the outstanding
      shares of CSB’s $5 par value common stock. The Company acquired Port City
      Capital Bank (“PCCB”) on August 31, 2006.





CSB
      was
      incorporated December 22, 1998 and began banking operations on December 31,
      1998. CSB is engaged in general commercial and retail banking in Wake, Johnston,
      Lee and Moore Counties, North Carolina, operating under the banking laws of
      North Carolina and the rules and regulations of the Federal Deposit Insurance
      Corporation and the North Carolina Commissioner of Banks. CSB undergoes periodic
      examinations by those regulatory authorities.





Port
      City
      Capital Bank was organized and incorporated under the laws of the State of
      North
      Carolina on June 13, 2002 and commenced operations on July 1, 2002. PCCB
      currently serves New Hanover County, North Carolina and surrounding areas
      through one banking office. As a state chartered bank that is not a member
      of
      the Federal Reserve, PCCB is subject to regulation by the State of North
      Carolina Banking commission and the Federal Deposit Insurance Corporation.





The
      Company formed Crescent Financial Capital Trust I during 2003 in order to
      facilitate the issuance of trust preferred securities. The Trust is a statutory
      business trust formed under the laws of the state of Delaware, of which all
      common securities are owned by the Company. Under Financial Accounting Standards
      Board (“FASB”) Interpretation No. (“FIN”) 46, *Consolidation
      of Variable Interest Entities* ,
      Crescent Financial Capital Trust I is not included in the Company’s consolidated
      financial statements. The junior subordinated debentures issued by the Company
      to the trust are included in long-term debt and the Company’s equity interest in
      the trust is included in other assets.





The
      trust
      preferred securities presently qualify as Tier 1 regulatory capital and are
      reported in Federal Reserve regulatory reports as a minority interest in a
      consolidated subsidiary. The junior subordinated debentures do not qualify
      as
      Tier 1 regulatory capital. On March 1, 2005, the Board of Governors of the
      Federal Reserve issued the final rule that would retain the inclusion of trust
      preferred securities in Tier 1 capital of bank holding companies, but with
      stricter quantitative limits and clearer qualitative standards. Under the new
      rule, after a three-year transition period, the aggregate amount of trust
      preferred securities and certain other capital elements would be limited to
      25
      percent of Tier 1 capital elements, net of goodwill less any associated deferred
      tax liability. The amount of trust preferred securities and certain other
      elements in excess of the limit could be included in Tier 2 capital, subject
      to
      restrictions. The Company believes that the Bank will remain "well capitalized"
      under the new Federal Reserve Board guidelines (or the Company would still
      exceed the regulatory required minimums for capital adequacy
      purposes).





**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





***Basis
      of Presentation***





The
      accompanying consolidated financial statements include the accounts and
      transactions of Crescent Financial Corporation and its wholly-owned subsidiaries
      Crescent State Bank and Port City Capital Bank. All significant intercompany
      transactions and balances have been eliminated in consolidation. Crescent
      Financial Corporation and its subsidiaries are collectively referred to herein
      as the “Company.”





***Use
      of Estimates***





The
      preparation of consolidated financial statements in conformity with accounting
      principles generally accepted in the United States of America requires
      management to make estimates and assumptions that affect the reported amounts
      of
      assets and liabilities and the disclosure of contingent assets and liabilities
      at the date of the financial statements and the reported amounts of revenues
      and
      expenses during the reporting period. Actual results could differ from those
      estimates. Material estimates that are particularly susceptible to significant
      change relate to the determination of the allowance for loan
      losses.





54




***CRESCENT
          FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
          to Consolidated Financial Statements***
 ***December
          31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Cash
      and Cash Equivalents***





For
      purposes of the consolidated statements of cash flows, cash and cash equivalents
      include cash and due from banks, interest-earning deposits with banks and
      federal funds sold.





***Securities
      Available for Sale***





Available
      for sale securities are carried at fair value and consist of bonds, notes,
      and
      marketable equity securities not classified as trading securities or as held
      to
      maturity securities. Unrealized holding gains and losses on available for sale
      securities are reported as a net amount in other comprehensive income, net
      of
      related tax effects. Gains and losses on the sale of available for sale
      securities are determined using the specific-identification method. Declines
      in
      the fair value of individual held to maturity and available for sale securities
      below their cost that are other than temporary would result in write-downs
      of
      the individual securities to their fair value. Such write-downs would be
      included in earnings as realized losses. Premiums and discounts are recognized
      in interest income using the interest method over the period to
      maturity.





***Loans***





Loans
      that management has the intent and ability to hold for the foreseeable future,
      or until maturity, are reported at their outstanding principal adjusted for
      any
      charge-offs, the allowance for loan losses, and any deferred fees or costs
      on
      originated loans and unamortized premiums or discounts on purchased or acquired
      loans. Loan origination fees and certain direct origination costs are
      capitalized and recognized as an adjustment of the yield of the related loan.
      Interest on loans is recorded based on the principal amount outstanding. The
      accrual of interest on impaired loans is discontinued when, in management’s
      opinion, the borrower may be unable to meet payments as they become due.
      Generally, loans are placed on nonaccrual when they are past due 90 days. While
      a loan is classified as nonaccrual and the future collectibility of the recorded
      loan balance is doubtful, collections of interest and principal are generally
      applied as a reduction to the principal outstanding. When the future
      collectibility of the recorded loan balance is not in doubt, interest income
      may
      be recognized on a cash basis. When a loan is charged-off, all unpaid accrued
      interest is reversed.





***Allowance
      for Loan Losses***





The
      allowance for loan losses is established as losses are estimated to have
      occurred through a provision for loan losses charged to earnings. The provision
      for loan losses is based upon management’s best estimate of the amount needed to
      maintain the allowance for loan losses at an adequate level. Loan losses are
      charged against the allowance when management believes the uncollectibility
      of a
      loan balance is confirmed. Subsequent recoveries, if any, are credited to the
      allowance.





The
      allowance for loan losses is evaluated on a regular basis by management and
      is
      based upon management’s periodic review of the collectibility of the loans in
      light of the current status of the portfolio, historical experience, the nature
      and volume of the loan portfolio, adverse situations that may affect the
      borrower’s ability to repay, estimated value of any underlying collateral, and
      prevailing economic conditions. Management segments the loan portfolio by loan
      type in considering each of the aforementioned factors and their impact upon
      the
      level of the allowance for loan losses.





A
      loan is
      considered impaired when, based on current information and events, it is
      probable that the Company will be unable to collect the scheduled payments
      of
      principal or interest when due according to the contractual terms of the loan
      agreement. Factors considered by management in determining impairment include
      payment status, collateral value, and the probability of collecting scheduled
      principal and interest payments when due. Loans that experience insignificant
      payment delays and payment shortfalls generally are not classified as
      impaired.





55




***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Allowance
      for Loan Losses (Continued)***





Management
      determines the significance of payment delays and payment shortfalls on a
      case-by-case basis, taking into consideration all of the circumstances
      surrounding the loan and the borrower, including the length of the delay, the
      reasons for the delay, the borrower’s prior payment record, and the amount of
      the shortfall in relation to the principal and interest owed. Impairment is
      measured on a loan by loan basis by either the present value of expected future
      cash flows discounted at the loan’s effective interest rate, the loan’s
      obtainable market price, or the fair value of the collateral if the loan is
      collateral dependent.





***Premises
      and Equipment***





Land
      is
      carried at cost. Other components of premises and equipment are stated at cost
      less accumulated depreciation. Depreciation is calculated on the straight-line
      method over the estimated useful lives of the assets which are 37 - 40 years
      for
      buildings and 3 - 10 years for furniture and equipment. Leasehold improvements
      are amortized over the terms of the respective leases or the estimated useful
      lives of the improvements, whichever is shorter. Repairs and maintenance costs
      are charged to operations as incurred, and additions and improvements to
      premises and equipment are capitalized. Upon sale or retirement, the cost and
      related accumulated depreciation are removed from the accounts and any gains
      or
      losses are reflected in current operations.





***Foreclosed
      Assets***





Assets
      acquired through, or in lieu of, loan foreclosure are held for sale and are
      initially recorded at fair value at the date of foreclosure, establishing a
      new
      cost basis. Subsequent to foreclosure, valuations are periodically performed
      by
      management and the assets are carried at the lower of carrying amount or fair
      value less cost to sell. Revenue and expenses from operations and changes in
      the
      valuation allowance are included in net expenses from foreclosed
      assets.





***Stock
      in Federal Home Loan Bank of Atlanta***





As
      a
      requirement for membership, the Company invests in stock of the Federal Home
      Loan Bank of Atlanta (“FHLB”). This investment is carried at cost. Due to the
      redemption provisions of the FHLB, the Company estimated that fair value equals
      cost and that this investment was not impaired at December 31,
      2006.





***Income
      Taxes***





Deferred
      tax assets and liabilities are recognized for the estimated future tax
      consequences attributable to differences between the tax bases of assets and
      liabilities and their carrying amounts for financial reporting purposes.
      Deferred tax assets are also recognized for operating loss carryforwards.
      Deferred tax assets and liabilities are measured using enacted tax rates in
      effect for the year in which the temporary differences are expected to be
      recovered or settled. Deferred tax assets are reduced by a valuation allowance
      if it is more likely than not that the tax benefits will not be
      realized.





***Goodwill***





Goodwill
      of $26,625,251 arose from the 2006 purchase of Port City Capital Bank. Goodwill
      of $3,600,298 arose from the 2003 purchase of Centennial Bank. Pursuant to
      Statement of Financial Accounting Standards (“SFAS”) No. 142, *Goodwill
      and Other Intangible Assets,* goodwill
      acquired will not be amortized but will be subject to an annual impairment
      test.
      Goodwill recorded by the Company amounted to $30,225,549 and $3,600,298 at


December
      31, 2006 and 2005, respectively. There were no impairment charges recorded
      in
      2006 or 2005 as a result of the goodwill testing.





56




***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Other
      Intangible Assets***





Other
      intangible assets were acquired in conjunction with the 2006 purchase of Port
      City Capital Bank and the 2003 purchase of Centennial Bank. Subject to the
      provisions of SFAS No. 142, such other intangible assets, which consist solely
      of the deposit base premiums acquired through the purchase of these banks,
      are
      amortized over the approximate estimated lives of the related acquired deposit
      relationships. In accordance with the Company's estimate of the approximate
      lives of the acquired deposit relationships, a 10 year straight-line
      amortization schedule has been established for these intangible assets. The
      Company will continue to evaluate the amortization period and such amortization
      period could be revised downwards (but not upwards) in the future if
      circumstances warrant. The initial deposit premium related to the purchase
      of
      Port City Capital Bank was $1,124,481 and the premium related to the purchase
      of
      Centennial Bank was $209,012. The balance of the unamortized deposit premiums
      was $1,226,339 and $160,242 at December 31, 2006 and 2005, respectively.
      Amortization of the deposit premium amounted to $58,384, $20,901, and $20,901
      for the years ended December 31, 2006, 2005 and 2004, respectively. Amortization
      of the core deposit intangible is estimated to be $133,349 per year for each
      of
      the next six years, $126,383 in year seven, and $112,448 annually thereafter
      until fully amortized.





***Stock
      Compensation Plans***





Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), *Share-Based
      Payment* ("SFAS
      No. 123R"), which was issued by the FASB in December 2004. SFAS No. 123R revises
      SFAS No. 123 *Accounting
      for Stock Based Compensation* ,
      and
      supersedes Accounting Principles Board Opinion (“APB”) No. 25, *Accounting
      for Stock Issued to Employees* ,
      and its
      related interpretations. SFAS No. 123R requires recognition of the cost of
      employee services received in exchange for an award of equity instruments in
      the
      financial statements over the period the employee is required to perform the
      services in exchange for the award (usually the vesting period). SFAS No. 123R
      also requires measurement of the cost of employee services received in exchange
      for an award based on the grant-date fair value of the award. SFAS No. 123R
      also
      amends SFAS No. 95, *Statement
      of Cash Flows* ,
      to
      require that excess tax benefits be reported as financing cash inflows, rather
      than as a reduction of taxes paid, which is included within operating cash
      flows.





The
      Company adopted SFAS No. 123R using the modified prospective application as
      permitted under SFAS No. 123R. Accordingly, prior period amounts have not been
      restated. Under this application, the Company is required to record compensation
      expense for all awards granted after the date of adoption and for the unvested
      portion of previously granted awards that remain outstanding at the date of
      adoption. Prior to the adoption of SFAS No. 123R, the Company used the intrinsic
      value method as prescribed by APB No. 25 and thus recognized no compensation
      expense for options granted with exercise prices equal to the fair market value
      of the Company's common stock on the date of grant.





The
      impact of the adoption of SFAS 123(R) is as follows:


For
                  the year endedDecember
                  31, 2006Income
                  before income tax expense
              
              $
              (202,000
              )Net
                  income
              
              $
              (202,000
              )Cash
                  flow from operating activities
              
              $
              (45,000
              )Cash
                  flow provided by financing activities
              
              $
              45,000Basic
                  earnings per share
              
              $
              (0.03
              )Diluted
                  earnings per share
              
              $
              (0.03
              )




57




***CRESCENT
          FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
          to Consolidated Financial Statements***
 ***December
          31, 2006, 2005 and 2004***





**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Stock
      Compensation Plans (Continued)***





The
      following table illustrates the effect on net income and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS 123R
      to
      options granted under the Company’s stock option plans for the years ended
      December 31, 2005 and 2004. For purposes of this pro forma disclosure, the
      value
      of the options is estimated using the Black-Scholes option-pricing model and
      amortized to expense over the options’ vesting periods.


2005
              
              2004(Dollars
                  in thousands)Net
                income:As
                  reported
              
              $
              3,144
              
              $
              2,333Deduct:
                  Total stock-based employee compensationexpense
                  determined under fair value method for allawards,
                  net of related tax effects
              
              
              (135
              )
              
              (69
              )Pro
                  forma
              
              $
              3,009
              
              $
              2,264Basic
                  earnings per share:As
                  reported
              
              $
              .64
              
              $
              .50Pro
                  forma
              
              
              .61
              
              
              .48Diluted
                  earnings per share:As
                  reported
              
              $
              .61
              
              $
              .47Pro
                  forma
              
              
              .58
              
              
              .46
  ***Per
        Share Results***





During
      2006, 2005 and 2004, the Company effected stock splits in the form of 15%,
      15%
      and 20% stock dividends, respectively. Basic and diluted net income per common
      share have been computed by dividing net income for each period by the weighted
      average number of shares of common stock outstanding during each period after
      retroactively adjusting for these stock splits. All references herein to net
      income per share and weighted average shares outstanding have been adjusted
      to
      give effect to these stock splits.





Basic
      earnings per share represents income available to common stockholders divided
      by
      the weighted-average number of common shares outstanding during the period.
      Diluted earnings per share reflect additional common shares that would have
      been
      outstanding if dilutive potential common shares had been issued, as well as
      any
      adjustment to income that would result from the assumed issuance. Potential
      common shares that may be issued by


the
      Company relate to outstanding stock options and restricted stock and are
      determined using the treasury stock method. For the years ended December 31,
      2006, 2005 and 2004, there were 37,083, 9,000 and 24,725 outstanding stock
      options, respectively, which were not included in the computation of diluted
      earnings per share because they had no dilutive effect.





***Comprehensive
      Income***





The
      Company reports as comprehensive income all changes in stockholders’ equity
      during the year from sources other than shareholders. Other comprehensive income
      refers to all components (revenues, expenses, gains, and losses) of
      comprehensive income that are excluded from net income. The Company’s only
      component of other comprehensive income is unrealized gains and losses on
      investment securities available for sale.





58


***CRESCENT
          FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
          to Consolidated Financial Statements***
 ***December
          31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Comprehensive
      Income (Continued)***





The
      components of other comprehensive income and related tax effects are as
      follows:


2006
              
              2005
              
              2004Change
                  in unrealized holding gains (losses)on
                  available for sale securities
              
              $
              289,891
              
              $
              (1,115,858
              )
              $
              (170,495
              )Realized
                  (gain) loss on sale of availablefor
                  sale securities
              
              
              -
              
              
              16,422
              
              
              (57
              )Tax
                  effect
              
              
              (109,045
              )
              
              424,291
              
              
              52,922180,846
              
              
              (675,145
              )
              
              (117,630
              )Net
                  of tax amount
              
              $
              180,846
              
              $
              (675,145
              )
              $
              (117,630
              )


***Mortgage
      Loan Origination and Other Fees***





Mortgage
      loan origination fees represent fees received for the origination of loans
      for
      sale in the secondary market through the Company’s relationship with various
      mortgage brokers. These fees are recognized in income as they are earned upon
      the closing of each loan. A membership interest in Sidus (a mortgage broker)
      was
      sold during 2004, and although the Company no longer receives dividend
      distributions from Sidus, we will continue to originate loans for and collect
      mortgage loan origination fees from Sidus.





Fees
      derived from leasing and investment transactions with Technology Capital
      Partners and the Capital Investment


Group,
      Inc., respectively, are recognized in income as these transactions are
      consummated.





***Segment
      Reporting***





SFAS
      No.
      131, *Disclosure
      about Segments of an Enterprise and Related Information* ,
      requires that public entities disclose information about products and services
      provided by operating segments, geographic areas and major customers,
      differences between the measurements used in reporting segment information
      and
      those used in the entity’s general-purpose financial statements, and changes in
      the measurement of segment amounts from period to period.





Operating
      segments are components of an enterprise with separate financial information
      available for use by the chief operating decision maker to allocate resources
      and to assess performance. The Company has determined that it has one
      significant operating segment, the providing of financial services, including
      commercial and retail banking, mortgage, and investment services, to customers
      located in its market areas. The various products are those generally offered
      by
      community banks, and the allocation of resources is based on the overall
      performance of the Company, rather than the performance of individual branches
      or products.




***New
      Accounting Standards***





SFAS No. 155, *Accounting
      for Certain Hybrid Financial Instruments — an amendment of
      SFAS No. 133 and 140* provides
      entities relief from the requirement to separately determine the fair value
      of
      an embedded derivative that would otherwise be bifurcated from the host contract
      under SFAS 133. This statement allows an irrevocable election on an
      instrument-by-instrument basis to measure such a hybrid financial instrument
      at
      fair value. This statement is effective for all financial instruments acquired
      or issued after the beginning of the fiscal years beginning after
      September 15, 2006. The Company has evaluated this statement and does not
      believe it will have a material effect
      on the Company’s financial position, results of operations and cash flows.





59


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***New
      Accounting Standards (Continued)***





SFAS
      No.
      158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement
      Plans* .
      This
      statement requires recognition on the balance sheet of a plan’s overfunded or
      underfunded status with an offset to comprehensive income. This statement also
      requires, with limited exceptions, that the funded status of the plan be
      determined as of the employer’s fiscal year end. The balance sheet recognition
      provisions of SFAS 158 are effective for entities with publicly traded equity
      securities for years ending after December 15, 2006 and for all other entities
      for years ending after June 15, 2007. The Company does not anticipate that
      this
      statement will have an impact on the Company’s financial position, results of
      operations and cash flows.





In
      July
      2006, the FASB issued FIN. 48, *Accounting
      for Uncertainty in Income Taxes-an interpretation of FASB Statement
      No. 109* ,
      which
      is a change in accounting for income taxes. FIN 48 specifies how tax benefits
      for uncertain tax positions are to be recognized, measured, and derecognized
      in
      financial statements; requires certain disclosures of uncertain tax matters;
      specifies how reserves for uncertain tax positions should be classified on
      the
      balance sheet; and provides transition and interim period guidance, among other
      provisions. FIN 48 is effective for fiscal years beginning after
      December 15, 2006 and as a result, is effective for the Company in the
      first quarter of fiscal 2008. The Company is currently evaluating the impact
      of
      FIN 48 on its Consolidated Financial Statements.





In
      September 2006, the SEC staff issued Staff Accounting Bulletin
      (“SAB”) No. 108, ****** *Considering
      the Effects of Prior Year Misstatements When Quantifying Misstatements in the
      Current Year Financial Statements* .
      SAB No. 108 addresses the diversity in practice by registrants when
      quantifying the effect of an error on the financial statements.
      SAB No. 108 provides guidance on the consideration of the effects of
      prior year misstatements in quantifying current year misstatements and is
      effective for annual periods ending after November 15, 2006. The Company adopted
      the provisions of SAB No. 108 effective December 31, 2006.
      The adoption of SAB No. 108 did not have a material financial impact
      on the Company’s consolidated financial statements.





The
      Emerging Issues Task Force (“EITF”) reached a consensus at its September 2006
      meeting regarding EITF 06-4, *Accounting
      for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
      Split-Dollar Life Insurance Arrangements.* The
      scope of EITF 06-4 is limited to the recognition of a liability and related
      compensation costs for endorsement split-dollar life insurance policies that
      provide a benefit to an employee that extends to postretirement periods.
      Therefore, this EITF would not apply to a split-dollar life insurance
      arrangement that provides a specified benefit to an employee that is limited
      to
      the employee’s active service period with an employer. This EITF 06-4 is
      effective for fiscal years beginning after December 15, 2007, with earlier application permitted. The effects of this EITF have not yet been evaluated.





The
      EITF
      reached a consensus at its September 2006 meeting regarding EITF 06-5, *Accounting
      for Purchases of Life Insurance Determining the Amount That Could be Realized
      in
      Accordance with FASB Technical Bulletin No. 85-5* .
      The
      scope of EITF 06-5 is limited to the determination of net cash surrender value
      of a life insurance contract in accordance with Technical Bulletin 85-4. This
      EITF outlines when contractual limitations of the policy should be considered
      when determining the net realizable value of the contract. EITF 06-5 is
      effective for fiscal years beginning after December 15, 2006, with earlier application permitted. The Company has evaluated the effects of this EITF and concluded
      that
      it will not have a material effect on our consolidated financial
      statements.





From
      time
      to time the FASB issues exposure drafts for proposed statements of financial
      accounting standards. Such exposure drafts are subject to comment from the
      public, to revisions by the FASB and to final issuance by the FASB as statements
      of financial accounting standards. Management considers the effect of the
      proposed statements on the consolidated financial statements of the Company
      and
      monitors the status of changes to and proposed effective dates of exposure
      drafts.





60




***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)**





***Reclassifications***





Certain
      amounts in the 2005 and 2004 consolidated financial statements have been
      reclassified to conform to the 2006 presentation. The reclassifications had
      no
      effect on net income or stockholders’ equity as previously
      reported.





**NOTE
      C - INVESTMENT SECURITIES**





The
      following is a summary of the securities portfolios by major
      classification:


December
                  31, 2006Amortizedcost
              
              Gross
                      unrealized
                      gains
              
              Gross
                        unrealized
                        gains
              
              FairvalueSecurities
                  available for sale:U.S.
                  government securitiesand
                  obligations of U.S.government
                  agencies
              
              $
              7,493,079
              
              $
              5,790
              
              $
              113,998
              
              $
              7,384,871Mortgage-backed
              
              
              54,949,049
              
              
              154,157
              
              
              828,909
              
              
              54,274,297Municipals
              
              
              22,320,984
              
              
              67,266
              
              
              206,104
              
              
              22,182,146Other
              
              
              779,398
              
              
              102,180
              
              
              -
              
              
              881,578$
              85,542,510
              
              $
              329,393
              
              $
              1,149,011
              
              $
              84,722,892
  December
                  31, 2005Amortizedcost
              
              Gross
                        unrealized
                        gains
              
              Gross
                        unrealized
                        gains
              
              FairvalueSecurities
                  available for sale:U.S.
                  government securitiesand
                  obligations of U.S.government
                  agencies
              
              $
              5,944,426
              
              $
              -
              
              $
              151,481
              
              $
              5,792,945Mortgage-backed
              
              
              35,042,315
              
              
              -
              
              
              895,212
              
              
              34,147,103Municipals
              
              
              15,173,028
              
              
              88,274
              
              
              151,089
              
              
              15,110,213Other
              
              
              500,000
              
              
              -
              
              
              -
              
              
              500,000$
              56,659,769
              
              $
              88,274
              
              $
              1,197,782
              
              $
              55,550,261




There
      were no security gains or losses in 2006. There were gross gains from sales
      of
      securities of $538 and gross losses of $16,960 in 2005. In 2004 there were
      gross
      securities gains of $57 and no security losses from sales of securities.





The
      following tables show investments’ gross unrealized losses and fair values,
      aggregated by investment category and length of time that the individual
      securities have been in a continuous unrealized loss position, at December
      31,
      2006 and 2005. The 2006 unrealized losses on investment securities relate to
      nine U.S. Government agency securities, fifty-seven mortgage-backed securities,
      and thirty municipal securities. The 2005 unrealized losses on investment
      securities relate to nine U.S. Government agency security, fifty-one
      mortgage-backed securities, and fifteen municipal securities. The unrealized
      losses relate to debt securities that have incurred fair value reductions due
      to
      higher market interest rates since the securities were purchased. The unrealized
      losses will reverse at maturity or prior to maturity if market interest rates
      decline to levels that existed when the securities were purchased. Since none
      of
      the unrealized losses relate to the marketability of the securities or the
      issuer’s ability to honor redemption obligations, none of the securities are
      deemed to be other than temporarily impaired.





61


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      C - INVESTMENT SECURITIES (Continued)**


December
                  31, 2006Less
                  Than 12 Months
              
              12
                  Months or More
              
              TotalFairvalue
              
              Unrealized
                losses
              
              Fairvalue
              
              Unrealized
                losses
              
              Fairvalue
              
              UnrealizedlossesSecurities
                  available for sale:U.S.
                  government securitiesand
                  obligations of U.S.government
                  agencies
              
              $
              -
              
              $
              -
              
              $
              5,350,947
              
              $
              113,998
              
              $
              5,350,947
              
              $
              113,998Mortgage-backed
              
              
              6,823,616
              
              
              32,598
              
              
              27,048,461
              
              
              796,311
              
              
              33,872,077
              
              
              828,909Municipals
              
              
              11,531,302
              
              
              79,878
              
              
              4,255,378
              
              
              126,226
              
              
              15,786,680
              
              
              206,104Total
                  temporarily impaired securities
              
              $
              18,354,918
              
              $
              112,476
              
              $
              36,654,786
              
              $
              1,036,535
              
              $
              55,009,704
              
              $
              1,149,011
  December
                  31, 2005Less
                  Than 12 Months
              
              12
                  Months or More
              
              TotalFair
                value
              
              Unrealized
                losses
              
              Fairvalue
              
              Unrealized
                losses
              
              Fairvalue
              
              UnrealizedlossesSecurities
                  available for sale:U.S.
                  government securitiesand
                  obligations of U.S.government
                  agencies
              
              $
              4,357,371
              
              $
              98,615
              
              $
              1,435,574
              
              $
              52,866
              
              $
              5,792,945
              
              $
              151,481Mortgage-backed
                  securities
              
              
              15,763,472
              
              
              278,572
              
              
              17,319,426
              
              
              616,640
              
              
              33,082,898
              
              
              895,212Municipals
              
              
              4,715,660
              
              
              71,011
              
              
              2,778,200
              
              
              80,078
              
              
              7,493,860
              
              
              151,089Total
                  temporarily impaired securities
              
              $
              24,836,503
              
              $
              448,198
              
              $
              21,533,200
              
              $
              749,584
              
              $
              46,369,703
              
              $
              1,197,782
  At
        December 31, 2006 and 2005, investment securities with a carrying value of
        $12,146,961 and $17,765,148, respectively, were pledged to secure public
        deposits, borrowings and for other purposes required or permitted by law.
  The
        amortized cost and fair values of securities available for sale at December
        31,
        2006 by expected maturity are shown below. Expected maturities will differ
        from
        contractual maturities because borrowers may have the right to call or prepay
        obligations with or without call or prepayment penalties.


Amortized
              
              Faircost
              
              valueDue
                  within one year
              
              $
              9,233,636
              
              $
              9,209,363Due
                  after one year through five years
              
              
              39,262,431
              
              
              38,713,193Due
                  after five years through ten years
              
              
              24,606,755
              
              
              24,390,330Due
                  after ten years
              
              
              12,439,688
              
              
              12,410,006$
              85,542,510
              
              $
              84,722,892


62


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      C - INVESTMENT SECURITIES (Continued)**





The
      following table presents the carrying values, intervals of maturities or
      repricings, and weighted average yields of our investment portfolio at December
      31, 2006:




Repricing
                  or MaturingLess
                  than
                one
                  year
              
              One
                  to
                five
                  years
              
              Five
                  to
                ten
                  years
              
              Over
                  ten
                years
              
              Total(Dollars
                  in thousands)Securities
                  available for sale:U.
                  S. government agenciesBalance
              
              $
              -
              
              $
              5,196
              
              $
              2,189
              
              $
              -
              
              $
              7,385Weighted
                  average yield
              
              
              -
              
              
              4.62
              %
              
              4.77
              %
              
              -
              
              
              4.66
              %Mortgage-backed
                  securitiesBalance
              
              $
              7,715
              
              $
              29,333
              
              $
              12,273
              
              $
              4,953
              
              $
              54,274Weighted
                  average yield
              
              
              4.84
              %
              
              4.88
              %
              
              5.10
              %
              
              5.24
              %
              
              4.95
              %Municipal
                  securitiesBalance
              
              $
              1,113
              
              $
              4,184
              
              $
              9,928
              
              $
              6,957
              
              $
              22,182Weighted
                  average yield
              
              
              3.66
              %
              
              3.47
              %
              
              4.04
              %
              
              4.17
              %
              
              3.95
              %OtherBalance
              
              $
              382
              
              $
              -
              
              $
              -
              
              $
              500
              
              $
              882Weighted
                  average yield
              
              
              -
              
              
              -
              
              
              -
              
              
              9.00
              %
              
              5.77
              %TotalBalance
              
              $
              9,210
              
              $
              38,713
              
              $
              24,390
              
              $
              12,410
              
              $
              84,723Weighted
                  average yield
              
              
              4.55
              %
              
              4.69
              %
              
              4.64
              %
              
              4.79
              %
              
              4.68
              %




**NOTE
      D - LOANS**





Following
      is a summary of loans at December 31, 2006 and 2005.


2006
              
              
              2005Real
                  estate - commercial
              
              $
              304,822,939
              
              $
              174,038,866Real
                  estate - residential
              
              
              20,223,856
              
              
              14,914,096Construction
                  loans
              
              
              110,032,772
              
              
              46,607,263Commercial
                  and industrial loans
              
              
              67,822,285
              
              
              52,707,715Home
                  equity loans and lines of credit
              
              
              42,704,279
              
              
              34,920,770Loans
                  to individuals
              
              
              4,976,566
              
              
              5,670,103Total
                  loans
              
              
              550,582,697
              
              
              328,858,813Less:Deferred
                  loan fees
              
              
              (764,149
              )
              
              (537,173
              )Allowance
                  for loan losses
              
              
              (6,945,000
              )
              
              (4,351,000
              )Total
              
              $
              542,873,548
              
              $
              323,970,640


Loans
      are
      primarily made in the Company’s market area of North Carolina, principally Wake,
      Johnston, Lee, Moore, and New Hanover counties. Real estate loans can be
      affected by the condition of the local real estate market. Commercial and
      consumer and other loans can be affected by the local economic
      conditions.





63


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      D - LOANS (Continued)**





No
      loans
      have been restructured during 2006 or 2005. Loans totaling $135,000 and $26,000
      were considered impaired as of December 31, 2006 and 2005, respectively.
      Impaired loans at December 31, 2006 of $135,000, which represented all of the
      Company’s non-accruing loans on that date, had a corresponding valuation
      allowance of $20,000. Impaired loans at December 31, 2005 of $26,000, which
      represented all of the Company’s non-accruing loans on that date, had a
      corresponding valuation allowance of $10,000. The average recorded investment
      in
      impaired loans during the years ended December 31, 2006 and 2005 was $148,000
      and $94,000, respectively. For the years ended December 31, 2006 and 2005,
      the
      interest income the Company recognized from impaired loans during the portion
      of
      the year that they were impaired was not material.





The
      Company has granted loans to certain directors and executive officers of the
      Company and their related interests. Such loans are made on substantially the
      same terms, including interest rates and collateral, as those prevailing at
      the
      time for comparable transactions with other borrowers and, in management’s
      opinion, do not involve more than the normal risk of collectibility. All loans
      to directors and executive officers or their related interests are submitted
      to
      the Board of Directors for approval. A summary of loans to directors, executive
      officers and their interests follows:


Loans
                  to directors and officers as a group at December 31, 2005
              
              $
              15,990,828Loans
                  acquired from Port City Capital Bank
              
              
              13,680,599Net
                  payments during year ended December 31, 2006
              
              
              1,421,719Loans
                  to directors and officers as a group at December 31, 2006
              
              $
              28,249,708




At
      December 31, 2006, the Company had pre-approved but unused lines of credit
      totaling $3,737,609 to executive officers, directors and their related
      interests. No additional funds are committed to be advanced at December 31,
      2006.





An
      analysis of the allowance for loan losses follows:


2006
              
              2005
              
              2004Balance
                  at beginning of year
              
              $
              4,351,000
              
              $
              3,668,000
              
              $
              3,304,250Provision
                  for loan losses
              
              
              990,786
              
              
              806,796
              
              
              736,070Charge-offs
              
              
              (85,571
              )
              
              (182,973
              )
              
              (431,318
              )Recoveries
              
              
              2,168
              
              
              59,177
              
              
              58,998Net
                  charge-offs
              
              
              (83,403
              )
              
              (123,796
              )
              
              (372,320
              )Allowance
                  recorded related to loans acquired in acquisition of Port City
                  Capital
                  Bank
              
              
              1,686,617
              
              
              -
              
              
              -Balance
                  at end of year
              
              $
              6,945,000
              
              $
              4,351,000
              
              $
              3,668,000





64


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      E - PREMISES AND EQUIPMENT**





Following
      is a summary of premises and equipment at December 31, 2006 and
      2005:


2006
              
              2005Land
              
              $
              2,102,283
              
              $
              1,293,923Buildings
                  and leasehold improvements
              
              
              3,298,026
              
              
              3,015,307Furniture
                  and equipment
              
              
              3,081,514
              
              
              2,540,053Less
                  accumulated depreciation
              
              
              (2,574,159
              )
              
              (2,005,227
              )Total
              
              $
              5,907,664
              
              $
              4,844,056




Depreciation
      and amortization amounting to $698,754 in 2006, $613,388 in 2005, and $542,570
      in 2004 is included in occupancy and equipment expense.





**NOTE
      F - DEPOSITS**





The
      weighted average cost of time deposits was 4.40% and 3.24% at December 31,
      2006
      and 2005, respectively.





At
      December 31, 2006, the scheduled maturities of certificates of deposit are
      as
      follows:


Less
                  than
              
              $100,000$100,000
              
              or
                  more
              
              TotalThree
                  months or less
              
              $
              14,748,573
              
              $
              55,899,672
              
              $
              70,648,245Over
                  three months through one year
              
              
              37,569,053
              
              
              93,601,775
              
              
              131,170,828Over
                  one year through three years
              
              
              12,500,400
              
              
              66,766,075
              
              
              79,266,475Over
                  three years to five years
              
              
              1,154,885
              
              
              13,498,296
              
              
              14,653,181Total
              
              $
              65,972,911
              
              $
              229,765,818
              
              $
              295,738,729




**NOTE
      G - BORROWINGS**





Borrowings
      are comprised of the following at December 31, 2006 and 2005:


2006
              
              2005Short-term
                  borrowings:Federal
                  funds purchased
              
              $
              6,451,000
              
              $
              4,779,000Repurchase
                  agreements
              
              
              -
              
              
              185,153Federal
                  Home Loan Bank advances maturing within one year
              
              
              18,000,000
              
              
              10,000,000Total
                  short-term borrowings
              
              $
              24,451,000
              
              $
              14,964,153Long-term
                  debt:Federal
                  Home Loan Bank advances maturing beyond one year
              
              $
              37,000,000
              
              $
              22,000,000Junior
                  subordinated debentures
              
              
              8,248,000
              
              
              8,248,000Total
                  long-term debt
              
              $
              45,248,000
              
              $
              30,248,000


65


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      G - BORROWINGS (Continued)**





***Short-term
      Borrowings***





The
      Company may purchase federal funds through unsecured federal funds guidance
      lines of credit totaling $44.2 million at December 31, 2006. These lines are
      intended for short-term borrowings and are subject to restrictions limiting
      the
      frequency and terms of advances. These lines of credit are payable on demand
      and
      bear interest based upon the daily federal funds rate. The Company had
      $6,451,000 outstanding balance on the lines of credit as of December 31, 2006
      compared to $4,779,000 at December 31, 2005.





Also
      included in short-term borrowings are repurchase agreements with outstanding
      balances of $185,153 at December 31, 2005. There were no outstanding
      balances in repurchase agreements at December 31, 2006. Securities sold under
      agreements to repurchase generally mature within one day from the transaction
      date and are collateralized by U.S. Government Agency obligations.





A
      summary
      of selected data related to short-term borrowed funds follows:


For
                  the Year Ended December 31,2006
              
              2005(Dollars
                  in thousands)Short-term
                  borrowings:Repurchase
                  agreements and federal fundspurchased:Balance
                  outstanding at end of year
              
              $
              6,451
              
              $
              4,964Maximum
                  amount outstanding at any monthend
                  during the year
              
              
              7,603
              
              
              5,809Average
                  balance outstanding during the year
              
              
              3,258
              
              
              2,393Weighted-average
                  interest rate during the year
              
              
              5.33
              %
              
              3.60
              %Weighted-average
                  interest rate at end of year
              
              
              5.63
              %
              
              4.34
              %




***Federal
      Home Loan Bank Advances***





The
      Company has a $101.5 million credit line available with the Federal Home Loan
      Bank for advances. These advances are secured by a blanket floating lien on
      qualifying commercial real estate, first mortgage loans and pledged investment
      securities with a market value of $9.8 million.





At
      December 31, 2006, the Company had the following advances outstanding from
      the
      Federal Home Loan Bank of Atlanta:


Maturity
              
              Interest
                  Rate
              
              Rate
                  Type
              
              2006
              
              2005May
                  10, 2006
              
              
              4.56
              %
              
              Fixed
              
              $
              -
              
              $
              2,000,000July
                  6, 2011
              
              
              4.44
              %
              
              Convertible
              
              
              -
              
              
              5,000,000July
                  20, 2006
              
              
              4.19
              %
              
              Adjustable
              
              
              -
              
              
              8,000,000July
                  16, 2012
              
              
              3.84
              %
              
              Convertible
              
              
              5,000,000
              
              
              5,000,000May
                  18, 2007
              
              
              5.44
              %
              
              Prime
                  Based
              
              
              8,000,000
              
              
              -December
                  31, 2007
              
              
              5.09
              %
              
              Convertible
              
              
              10,000,000
              
              
              -July
                  28, 2008
              
              
              5.40
              %
              
              Prime
                  Based
              
              
              10,000,000
              
              
              -March
                  25, 2019
              
              
              4.87
              %
              
              Convertible
              
              
              10,000,000
              
              
              -January
                  28, 2019
              
              
              4.93
              %
              
              Convertible
              
              
              12,000,000
              
              
              12,000,000$
              55,000,000
              
              $
              32,000,000


66


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      G - BORROWINGS (Continued)**





***Federal
      Home Loan Bank Advances (Continued)***





At
      December 31, 2006 and 2005, the weighted average interest rates on the above
      advances were 5.01% and 4.12%, respectively. The advance maturing on July 16,
      2012 and bearing interest at 3.84%, is continuously convertible every three
      months to a variable rate at the three month London Inter- Bank Offering Rate
      (“LIBOR”) if this rate is equal to or exceeds 7%. The advance maturing on May
      18, 2007 bears interest at Prime less 2.85%. The advance maturing December
      31,
      2007 bears a fixed interest rate of 5.09% and is convertible every three months
      to a variable rate based on LIBOR. The advance maturing on July 28, 2008 bears
      interest at Prime less 2.81%. The advance maturing on March 25, 2019 bears
      interest at the three month LIBOR minus 50 basis points until March 25, 2009
      and
      then will bear interest at 4.26%, at which time it becomes subject to conversion
      to a variable rate at the three month LIBOR. The advance maturing on January
      28,
      2019 bears interest at the 1 month LIBOR minus 42.5 basis points until January
      27, 2009 and then bears interest at 3.90%, at which time it becomes subject
      to
      conversion to a variable rate at the three month LIBOR.





At
      December 31, 2006, two notes with maturities of less than one year were
      classified as short-term borrowings, totaling $18,000,000. At December 31,
      2005,
      two notes with maturities of less than one year were classified as short-term
      borrowings, totaling $10,000,000.





***Junior
      Subordinated Debentures***





In
      2003,
      the Company issued $8,248,000 of junior subordinated debentures to Crescent
      Financial Capital Trust I (the “Trust”) in exchange for the proceeds of trust
      preferred securities issued by the Trust. The junior subordinated debentures
      are
      included in long-term debt and the Company’s equity interest in the trust is
      included in other assets.





The
      junior subordinated debentures pay interest quarterly at an annual rate, reset
      quarterly, equal to LIBOR plus 3.10%. The debentures are redeemable on October
      7, 2008 or afterwards, in whole or in part, on any January 7, April 7, July
      7,
      or October 7. Redemption is mandatory at October 7, 2033. The Company guarantees
      the trust preferred securities through the combined operation of the junior
      subordinated debentures and other related documents. The Company’s obligation
      under the guarantee is unsecured and subordinate to senior and subordinated
      indebtedness of the Company.





The
      trust
      preferred securities presently qualify as Tier 1 regulatory capital and are
      reported in Federal Reserve regulatory reports as a minority interest in a
      consolidated subsidiary. The junior subordinated debentures do not qualify
      as
      Tier 1 regulatory capital. On March 1, 2005, the Board of Governors of the
      Federal Reserve issued a final rule stating that trust preferred securities
      will
      continue to be included in Tier 1 capital, subject to stricter quantitative
      and
      qualitative standards. For Bank Holding Companies, trust preferred securities
      will continue to be included in Tier 1 capital up to 25% of core capital
      elements (including trust preferred securities) net of goodwill less any
      associate deferred tax liability.




**NOTE
      H - LEASES**





The
      Company has entered into eleven non-cancelable operating leases for its main
      office, operations center, and branch facilities. Future minimum lease payments
      under these leases for the years ending December 31 are as
      follows:


2007
              
              $
              948,4722008
              
              
              887,7782009
              
              
              816,6122010
              
              
              427,5922011
              
              
              320,284Thereafter
              
              
              2,359,118Total
              
              $
              5,759,856


67


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      H - LEASES (Continued)**





The
      leases contain renewal options for various additional terms after the expiration
      of the initial term of each lease. The cost of such rentals is not included
      above. Total rent expense for the years ended December 31, 2006, 2005 and 2004
      amounted to $892,734, $743,095, and $539,240, respectively.





**NOTE
      I - INCOME TAXES**





The
      significant components of the provision for income taxes for the years ended
      December 31, 2006, 2005 and 2004 are as follows:


2006
              
              2005
              
              2004Current
                  tax provision:Federal
              
              $
              2,422,394
              
              $
              1,366,832
              
              $
              809,768State
              
              
              568,916
              
              
              303,617
              
              
              201,8302,991,310
              
              
              1,670,449
              
              
              1,011,598Deferred
                  tax provision (benefit):Federal
              
              
              (153,224
              )
              
              (34,424
              )
              
              117,839State
              
              
              (57,486
              )
              
              22,875
              
              
              42,763(210,710
              )
              
              (11,549
              )
              
              160,602Provision
                  for income taxes
              
              $
              2,780,600
              
              $
              1,658,900
              
              $
              1,172,200





The
      difference between the provision for income taxes and the amounts computed
      by
      applying the statutory federal income tax rate of 34% to income before income
      taxes is summarized below:


2006
              
              2005
              
              2004Tax
                  computed at statutory rate of 34%
              
              $
              2,612,868
              
              $
              1,633,113
              
              $
              1,191,665Effect
                  of state income taxes
              
              
              337,544
              
              
              235,976
              
              
              173,645Non-taxable
                  income
              
              
              (217,265
              )
              
              (158,773
              )
              
              (114,271
              )Non-taxable
                  Bank Owned Life Insurance
              
              
              (77,169
              )
              
              (77,119
              )
              
              (90,573
              )Other
              
              
              124,622
              
              
              25,703
              
              
              11,734$
              2,780,600
              
              $
              1,658,900
              
              $
              1,172,200


Significant
      components of deferred taxes at December 31, 2006 and 2005 are as
      follows:


2006
              
              2005Deferred
                  tax assets:Allowance
                  for loan losses
              
              $
              2,540,149
              
              $
              1,539,907Net
                  operating loss carryforwards
              
              
              76,390
              
              
              215,279Premises
                  and equipment
              
              
              147,092
              
              
              109,702Rent
                  abatement
              
              
              11,807
              
              
              15,856Unrealized
                  loss on securities
              
              
              318,671
              
              
              427,715Fair
                  value adjustments
              
              
              305,377
              
              
              -Deferred
                  compensation
              
              
              260,443
              
              
              -Other
              
              
              86,833
              
              
              96,866Net
                  deferred tax assets
              
              
              3,746,762
              
              
              2,405,325Deferred
                  tax liabilities:Intangible
                  assets
              
              
              (472,803
              )
              
              (61,780
              )Deferred
                  loan costs
              
              
              (30,062
              )
              
              (62,881
              )Prepaid
                  expenses
              
              
              (107,316
              )
              
              (64,421
              )Net
                  deferred tax liabilities
              
              
              (610,181
              )
              
              (189,082
              )Net
                  deferred tax asset included in other assets
              
              $
              3,136,581
              
              $
              2,216,243




68


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      I - INCOME TAXES (Continued)**





It
      is
      management’s opinion that realization of the net deferred tax asset is more
      likely than not based on the Company’s history of taxable income and estimates
      of future taxable income.





The
      Company has net operating loss carryforwards for federal tax purposes of
      approximately $225,000, which were acquired in the merger of Centennial Bank
      and
      which expire beginning in 2020.





**NOTE
      J - NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE**





The
      major
      components of non-interest income for the years ended December 31, 2006, 2005
      and 2004 are as follows:


2006
              
              2005
              
              2004Distribution
                  from mortgage company
              
              
              46,099
              
              
              38,152
              
              
              286,646Brokerage
                  referral fees
              
              
              78,510
              
              
              203,168
              
              
              138,237Gain
                  on sale of membership interest in mortgage company
              
              
              -
              
              
              -
              
              
              118,048Other
              
              
              326,264
              
              
              179,087
              
              
              38,906Total
              
              $
              450,873
              
              $
              420,407
              
              $
              581,837


The
      major
      components of other non-interest expense for the years ended December 31, 2006,
      2005 and 2004 are as follows:


2006
              
              2005
              
              2004Postage,
                  printing and office supplies
              
              $
              472,542
              
              $
              411,673
              
              $
              335,961Advertising
                  and promotions
              
              
              517,015
              
              
              396,772
              
              
              318,901Professional
                  fees and services
              
              
              899,389
              
              
              711,805
              
              
              566,171Other
              
              
              1,338,417
              
              
              960,621
              
              
              823,932Total
              
              $
              3,227,363
              
              $
              2,480,871
              
              $
              2,044,965





**NOTE
      K - RESERVE REQUIREMENTS**





The
      aggregate net reserve balance maintained under the requirements of the Federal
      Reserve, which is non-interest bearing, was approximately $4,950,000 at December
      31, 2006.





**NOTE
      L - REGULATORY MATTERS**





The
      Company (on a consolidated basis) and the Banks are subject to various
      regulatory capital requirements administered by the federal banking agencies.
      Failure to meet minimum capital requirements can initiate certain mandatory
      and
      possibly additional discretionary actions by regulators that, if undertaken,
      could have a direct material effect on the Company’s and Bank’s financial
      statements. Under capital adequacy guidelines and the regulatory framework
      for
      prompt corrective action, the Company and the Banks must meet specific capital
      guidelines that involve quantitative measures of their assets, liabilities
      and
      certain off-balance sheet items as calculated
      under regulatory accounting practices. The capital amounts and classification
      are also subject to qualitative judgments by the regulators about components,
      risk weightings, and other factors. Prompt corrective action provisions are
      not
      applicable to bank holding companies.




69


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      L - REGULATORY MATTERS (Continued)**





The
      Banks, as North Carolina banking corporations, may pay dividends to the Company
      only out of undivided profits as determined pursuant to North Carolina General
      Statutes Section 53-87. However, regulatory authorities may limit payment of
      dividends by any bank when it is determined that such a limitation is in the
      public interest and is necessary to ensure the financial soundness of the
      bank.





Quantitative
      measures established by regulation to ensure capital adequacy require the
      Company and the Banks to maintain minimum amounts and ratios (set forth in
      the
      following table) of total and Tier I capital (as defined) to average assets
      (as
      defined). Management believes, as of December 31, 2006 and 2005, that the
      Company and the Banks met all capital adequacy requirements to which they are
      subject.





As
      of
      December 31, 2006, the most recent notification from the Federal Deposit
      Insurance Corporation categorized both Crescent State Bank and Port City Capital
      Bank as well capitalized under the regulatory framework for prompt corrective
      action. To be categorized as well capitalized, an institution must maintain
      minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set
      forth in the following tables. There are no conditions or events since the
      notification that management believes have changed either Bank’s category. The
      Bank’s actual capital amounts and ratios as of December 31, 2006 and 2005 are
      presented in the table below.


Actual
              
              Minimum
                  for capital
                adequacy
                  purposes
              
              Minimum
                  to be well
                capitalized
                  under prompt
                corrective
                  action provisionsAmount
              
              Ratio
              
              Amount
              
              Ratio
              
              Amount
              
              Ratio(Dollars
                  in thousands)Crescent
                  State BankAs
                  of December 31, 2006:Total
                  Capital (to Risk-Weighted Assets)
              
              $
              46,980
              
              
              10.26
              %
              $
              36,640
              
              
              8.00
              %
              $
              45,800
              
              
              10.00
              %Tier
                  I Capital (to Risk-Weighted Assets)
              
              
              41,774
              
              
              9.12
              %
              
              18,320
              
              
              4.00
              %
              
              27,480
              
              
              6.00
              %Tier
                  I Capital (to Average Assets)
              
              
              41,774
              
              
              8.47
              %
              
              19,717
              
              
              4.00
              %
              
              24,646
              
              
              5.00
              %As
                  of December 31, 2005:Total
                  Capital (to Risk-Weighted Assets)
              
              $
              38,275
              
              
              10.33
              %
              $
              29,643
              
              
              8.00
              %
              $
              37,053
              
              
              10.00
              %Tier
                  I Capital (to Risk-Weighted Assets)
              
              
              33,924
              
              
              9.16
              %
              
              14,821
              
              
              4.00
              %
              
              22,232
              
              
              6.00
              %Tier
                  I Capital (to Average Assets)
              
              
              33,924
              
              
              8.42
              %
              
              16,123
              
              
              4.00
              %
              
              20,155
              
              
              5.00
              %Port
                  City Capital BankAs
                  of December 31, 2006:Total
                  Capital (to Risk-Weighted Assets)
              
              $
              16,002
              
              
              10.69
              %
              $
              11,971
              
              
              8.00
              %
              $
              14,964
              
              
              10.00
              %Tier
                  I Capital (to Risk-Weighted Assets)
              
              
              14,217
              
              
              9.50
              %
              
              5,985
              
              
              4.00
              %
              
              8,978
              
              
              6.00
              %Tier
                  I Capital (to Average Assets)
              
              
              14,217
              
              
              8.64
              %
              
              6,585
              
              
              4.00
              %
              
              8,232
              
              
              5.00
              %


The
      Company is also subject to these requirements. At December 31, 2006, the
      Company’s total capital to risk-weighted assets, Tier I capital to risk-weighted
      assets and Tier I capital to average assets were 11.03%, 9.88% and 9.13%,
      respectively. At December 31, 2005, the Company’s total capital to risk-weighted
      assets, Tier I capital to risk-weighted assets and Tier I capital to average
      assets were 13.68%, 12.51% and 11.51%, respectively.




70


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      M - BUSINESS COMBINATION**





On
      April
      6, 2006, the Company entered into a definitive agreement to acquire Port City
      Capital Bank in Wilmington, North Carolina. The acquisition was approved at
      the
      annual shareholders’ meeting on July 11, 2006 and the transaction took place
      effective with the close of business on August 31, 2006. Port City Capital
      Bank
      is now a wholly-owned banking subsidiary of Crescent Financial Corporation
      operating under its current name and with its current board of directors and
      management. Port City Capital Bank shareholders received $3.30 in cash for
      each
      share of Port City Capital Bank stock they owned, and exchanged each share
      of
      Port City Capital Bank stock for 2.262 shares of Crescent Financial Corporation
      common stock. As a result of the acquisition, the Company paid $3.6 million
      in
      cash and has issued 2,432,374 additional shares of stock. The acquisition was
      accounted for using the purchase method of accounting, with the operating
      results of Port City Capital Bank subsequent to August 31, 2006 included in
      the
      Company’s financial statements **.**





The
      following table reflects the unaudited proforma combined results of operations
      for the years ended December
      31, 2006 and 2005, assuming the acquisition had occurred at the beginning of
      fiscal year 2005.


2006
              
              2005Net
                  interest income
              
              $
              26,250,692
              
              $
              18,802,822Net
                  income
              
              
              6,833,502
              
              
              4,960,512Net
                  income per share:Basic
              
              $
              0.75
              
              $
              0.68Diluted
              
              
              0.72
              
              
              0.65





The
      proforma net income for the year ended December 31, 2006 does not reflect
      approximately $1,575,000 in merger related costs incurred by Port City Capital
      Bank. In management’s opinion, these unaudited results are not necessarily
      indicative of what actual combined results of operations might have been if
      the
      acquisition had been effective at the beginning of fiscal 2005.





A
      summary
      of the total purchase price of the transaction is as follows:


Fair
                  value of common stock issued
              
              $
              31,669,470Fair
                  value of common stock options issued
              
              
              4,328,905Cash
                  paid for shares
              
              
              3,550,620Transaction
                  costs paid in cash
              
              
              609,505Total
                  purchase price
              
              $
              40,158,500




A
      summary
      of the fair value of assets acquired and liabilities assumed is as
      follows:


Cash
                  and cash equivalents
              
              $
              12,382,048Investment
                  securities available for sale
              
              
              16,366,192Stock
                  in FHLB of Atlanta
              
              
              286,100Loans
                  receivable, net
              
              
              126,715,970Premises
                  and equipment
              
              
              84,775Deferred
                  tax asset
              
              
              817,430Goodwill
              
              
              26,625,251Core
                  deposit intangible
              
              
              1,124,481Other
                  assets
              
              
              794,477Deposits
              
              
              (144,187,695
              )Other
                  liabilities
              
              
              (850,529
              )Net
                  assets acquired
              
              $
              40,158,500




71


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      N - OFF-BALANCE SHEET RISK**





The
      Company 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 include commitments to extend credit and standby letters
      of credit. Those instruments involve, to varying degrees, elements of credit
      and
      interest rate risk in excess of the amount recognized in the balance sheet.
      The
      contract or notional amounts of those instruments reflect the extent of
      involvement the Company has in particular classes of financial instruments.
      The
      Company uses the same credit policies in making commitments and conditional
      obligations as it does for on-balance sheet instruments.





Commitments
      to extend credit are agreements to lend to a customer as long as there is no
      violation of conditions established in the contract. Commitments generally
      have
      fixed expiration dates or other termination clauses and may require payment
      of a
      fee. Since some of the commitments are expected to expire without being drawn
      upon, the total commitment amounts do not necessarily represent future cash
      requirements. The Company evaluates each customer’s creditworthiness on a
      case-by-case basis. The amount of collateral obtained, if deemed necessary
      by
      the Bank, upon extension of credit is based on management’s credit evaluation of
      the borrower. Collateral obtained varies but may include real estate, stocks,
      bonds, and certificates of deposit.





A
      summary
      of the contract amount of the Company’s exposure to off-balance sheet credit
      risk as of December 31, 2006 is as follows (amounts in
      thousands):


Financial
                  instruments whose contract amounts represent credit risk:Commitments
                  to extend credit
              
              $
              128,299Undisbursed
                  equity lines of credit
              
              
              40,346Financial
                  standby letters of credit
              
              
              10,336Commitment
                  to invest in Small Business Investment Corporation
              
              
              63





**NOTE
      O - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS**





Financial
      instruments include cash and due from banks, interest-earning deposits with
      banks, federal funds sold, investment securities, loans, Federal Home Loan
      Bank
      stock, investment in life insurance, accrued interest receivable, accrued
      interest payable, deposit accounts, and borrowings. Fair value estimates are
      made at a specific moment in time, based on relevant market information and
      information about the financial instrument. These estimates do not reflect
      any
      premium or discount that could result from offering for sale at one time the
      Company’s entire holdings of a particular financial instrument. Because no
      active market readily exists for a portion of the Company’s financial
      instruments, fair value estimates are based on judgments regarding future
      expected loss experience, current economic conditions, risk characteristics
      of
      various financial instruments, and other factors. These estimates are subjective
      in nature and involve uncertainties and matters of significant judgment and,
      therefore, cannot be determined with precision. Changes in assumptions could
      significantly affect the estimates.





The
      following methods and assumptions were used to estimate the fair value of each
      class of financial instruments for which it is practicable to estimate that
      value:





***Cash
      and Cash Equivalents***





The
      carrying amounts for cash and cash equivalents approximate fair value because
      of
      the short maturities of those instruments.





***Investment
      Securities***





Fair
      value for investment securities equals quoted market price if such information
      is available. If a quoted market price is not available, fair value is estimated
      using quoted market prices for similar securities.





72


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      O - DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
      (Continued)**





***Loans***





For
      certain homogenous categories of loans, such as residential mortgages, fair
      value is estimated using the quoted market prices for securities backed by
      similar loans, adjusted for differences in loan characteristics. The fair value
      of other types of loans is estimated by discounting the future cash flows using
      the current rates at which similar loans would be made to borrowers with similar
      credit ratings and for the same remaining maturities.





***Federal
      Home Loan Bank Stock***





The
      carrying value of Federal Home Loan Bank stock approximates fair value based
      on
      the redemption provisions of the Federal Home Loan Bank.





***Investment
      in Life Insurance***





The
      carrying value of life insurance approximates fair value because this investment
      is carried at cash surrender value, as determined by the insurers.





***Deposits***





The
      fair
      value of demand deposits, savings, money market and NOW accounts is the amount
      payable on demand at the reporting date. The fair value of time deposits is
      estimated using the rates currently offered for instruments of similar remaining
      maturities.





***Short-term
      Borrowings and Long-term Debt***





The
      fair
      value of short-term borrowings and long-term debt are based upon the discounted
      value when using current rates at which borrowings of similar maturity could
      be
      obtained.





***Accrued
      Interest Receivable and Accrued Interest Payable***





The
      carrying amounts of accrued interest receivable and payable approximate fair
      value, because of the short maturities of these instruments.





The
      carrying amounts and estimated fair values of the Company’s financial
      instruments, none of which are held for trading purposes, are as follows at
      December 31, 2006 and 2005:


2006
              
              2005Carrying
              
              Estimated
              
              Carrying
              
              Estimatedamount
              
              fair
                  value
              
              amount
              
              fair
                  valueFinancial
                  assets:Cash
                  and cash equivalents
              
              $
              15,150,110
              
              $
              15,150,110
              
              $
              9,471,507
              
              $
              9,471,507Investment
                  securities
              
              
              84,722,892
              
              
              84,722,892
              
              
              55,550,261
              
              
              55,550,261Federal
                  Home Loan Bank stock
              
              
              3,582,800
              
              
              3,582,800
              
              
              2,133,400
              
              
              2,133,400Loans,
                  net
              
              
              542,873,548
              
              
              538,653,000
              
              
              323,790,640
              
              
              321,215,000Investment
                  in life insurance
              
              
              5,683,493
              
              
              5,683,493
              
              
              5,483,313
              
              
              5,483,313Accrued
                  interest receivable
              
              
              3,045,840
              
              
              3,045,840
              
              
              1,768,029
              
              
              1,768,029Financial
                  liabilities:Deposits
              
              
              541,881,680
              
              
              523,783,000
              
              
              322,080,788
              
              
              310,537,800Short-term
                  borrowings
              
              
              24,451,000
              
              
              24,451,000
              
              
              14,964,153
              
              
              14,964,153Long-term
                  borrowings
              
              
              45,248,000
              
              
              38,620,000
              
              
              30,248,000
              
              
              29,856,000Accrued
                  interest payable
              
              
              1,237,808
              
              
              1,237,808
              
              
              801,571
              
              
              801,571


73


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      P - EMPLOYEE AND DIRECTOR BENEFIT PLANS**





All
      information presented under this caption has been adjusted for the effects
      of
      the stock splits effected in the form of stock dividends discussed in Note
      B
      under the caption ***Per
      Share Results*** .
      During
      1999 the Company adopted, with shareholder approval, an Employee Stock Option
      Plan (the “Employee Plan”) and a Director Stock Option Plan (the “Director
      Plan”). During 2002 and 2005, with shareholder approval, the Company amended the
      Employee plan to increase the number of shares available under the plan.
      In
      2003, in conjunction with the merger between Crescent and Centennial Bank of
      Southern Pines, stock options approved under Centennial’s Plan were acquired by
      Crescent.  Certain
      of the options granted under the Director Plan vested immediately at the time
      of
      grant. All other options granted vested twenty-five percent at the grant date,
      with the remainder vesting over a three-year period. All unexercised options
      expire ten years after the date of grant.





At
      the
      time of the PCCB merger, PCCB had two stock option plans, the 2002 Incentive
      Stock Option Plan and the 2002 Nonstatutory Stock Option Plans, whose options
      were converted to options to purchase Crescent Financial Corporation stock
      at an
      exchange rate of 2.5133. There were 225,954 incentive stock options and 228,459
      non-statutory stock options converted. Since all options authorized under the
      PCCB plans had been granted, there will be no more options granted under either
      of these plans.





At
      the
      Company’s annual meeting on July 11, 2006, the shareholders approved the 2006
      Omnibus Stock Ownership and Long Term Incentive Plan (the “Omnibus Plan”) to
      replace the previous plans. This plan authorizes 335,000 shares of the common
      stock of Crescent to be issued in the form of incentive stock option grants,
      non-statutory stock option grants, restricted stock grants, long term incentive
      compensation units, or stock appreciation rights. In the event that the number
      of shares of common stock that remain available for future issuance under the
      Plan as of December 31, 2006 and as of the last day of each calendar year
      commencing thereafter, is less than 1.5% of the total number of shares of common
      stock issued and outstanding as of such date (the “Replacement Amount”), then
      the Plan Pool shall be increased as of such date by a number of shares of common
      stock equal to the Replacement Amount. At December 31, 2006, there were 313,163
      unissued shares in this plan.





The
      share-based awards granted under the aforementioned plans have similar
      characteristics, except that some awards have been granted in options and
      certain awards have been granted in restricted stock. Therefore, the following
      disclosures have been disaggregated for the stock option and restricted stock
      awards of the plans due to their dissimilar characteristics. The Company funds
      the option shares and restricted stock from unauthorized but un-issued
      shares.





***Stock
      Option Plans***





A
      summary
      of the Company’s option plans as of and for the years ended December 31, 2006,
      2005 and 2004, adjusted for the stock split effected in the form of a 15% stock
      dividend distributed in May 2006, is as follows:


2006
              
              2005
              
              2004Number
              
              Weighted
                Average
                Option Price
              
              Number
              
              Weighted
                    Average
                    Option
                    Price
              
              Number
              
              Weighted
                      Average
                      Option
                      PriceOptions
                  outstanding, beginning of year
              
              
              550,102
              
              $
              5.84
              
              
              618,265
                  $
              
              
              5.31
              
              
              655,706
              
              $
              4.92Granted
              
              
              14,450
              
              
              13.17
              
              
              32,258
              
              
              13.35
              
              
              46,684
              
              
              9.92Exercised
              
              
              (45,655
              )
              
              5.60
              
              
              (87,939
              )
              
              8.89
              
              
              (75,955
              )
              
              4.59Forfeited
              
              
              (12,065
              )
              
              12.87
              
              
              (12,482
              )
              
              8.89
              
              
              (8,170
              )
              
              7.41Converted
                  from PCCB plans
              
              
              454,413
              
              
              4.81
              
              
              -
              
              
              -
              
              
              -
              
              
              -Options
                  outstanding, end of year
              
              
              961,245
              
              $
              5.39
              
              
              550,102
                  $
              
              
              5.84
              
              
              618,265
              
              $
              5.31




74


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***





**NOTE
      P - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)**





***Stock
      Option Plans (continued)***





The
      following table provides the range of exercise prices for options outstanding
      at
      December 31, 2006:





Range
                of ExercisePrices
            
            Stock
                OptionsOutstanding
            
            Weighted
                AverageExercise
                Price
            
            Weighted
                Average RemainingContractual
                Life$4.33
                  -$6.74
            
            
            869,287
            
            $
            4.84
            
            
            62
                months$6.75
                  -$9.15
            
            
            40,650
            
            $
            8.10
            
            
            83
                months$9.16
                  -$11.56
            
            
            13,225
            
            $
            10.78
            
            
            93
                months$11.57
                  -$13.98
            
            
            38,083
            
            $
            13.13
            
            
            110
                months961,245
            
            $
            5.39
            
            
            65
                months





The
      fair
      market value of each option award is estimated on the date of grant using the
      Black-Scholes option pricing model. The risk-free interest rate is based upon
      a
      U.S. Treasury instrument with a life that is similar to the expected life of
      the
      option grant. Expected volatility is based upon the historical volatility of
      the
      Company’s stock price based upon the previous 3 years trading history. The
      expected term of the options is based upon the average life of previously issued
      stock options.





The
      assumptions used in estimating fair values, together with the estimated per
      share value of options granted are displayed below:


2006
              
              2005
              
              2004Assumptions
                  in estimating option values:Risk-free
                  interest rate
              
              
              4.58
              %
              
              4.36
              %
              
              3.66
              %Dividend
                  yield
              
              
              -
              %
              
              -
              %
              
              -
              %Volatility
              
              
              34.24
              %
              
              36.50
              %
              
              39.29
              %Expected
                  life
              
              
              7
                  years
              
              
              7
                  years
              
              
              7
                  yearsThe weighted
                average
                grant date fair value of options
              
              $
              6.03
              
              $
              6.25
              
              $
              2.29




Compensation
      cost charged to income was approximately $202,000 for the year end December
      31,
      2006 as a result of the implementation of SFAS No. 123R. Cash received from
      option exercise under all share-based payment arrangements for the year ended
      December 31, 2006 was $256,000. The actual tax benefit in stockholders equity
      realized for the tax deductions from option exercise of the share-based payment
      arrangements totaled $45,000 for the year ended December 31, 2006.





The
      total
      intrinsic value of options exercised during the years ended December 31, 2006
      was $351,000. The aggregate intrinsic value of options outstanding and options
      exercisable at December 31, 2006 was $7,102. As of December 31, 2006, there
      was
      $133,000 of unrecognized compensation cost related to the nonvested stock option
      plans. That cost is expected to be recognized as follows: $79,000 in 2007,
      $48,000 in 2008 and $5,000 in 2009.





***Stock
      Award Plans***





A
      summary
      of the status of the Company’s non-vested stock awards as of December 31, 2006,
      and changes during the year then ended is presented  below:


Weightedaveragegrant
                  dateShares
              
              fair
                  valueNon-vested
                  - December 31, 2005
              
              
              -
              
              $
              -Granted
              
              
              7,387
              
              
              13.54Vested
              
              
              -
              
              
              -Forfeited
              
              
              -
              
              
              -Non-vested
                  - December 31, 2006
              
              
              7,387
              
              $
              13.54


75


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      P - EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued)**





***Stock
      Award Plans (Continued)***





The
      total
      fair value of restricted stock grants issued during the year ended December
      31,
      2006 was $100,020. There were no restricted stock grants vested during the
      period.





As
      of
      December 31, 2006, there was $93,352 of unrecognized compensation cost related
      to the nonvested stock award plan. That cost is expected to be recognized over
      a
      weighted average period of 4.6 years.





***Supplemental
      Retirement***





During
      2003, the Company adopted a Supplemental Executive Retirement Plan (SERP) for
      its senior executives. The Company has purchased life insurance policies in
      order to provide future funding of benefit payments. Plan benefits will accrue
      and vest during the period of employment and will be paid in monthly benefit
      payments over the officer’s remaining life commencing with the officer’s
      retirement at any time after attainment of age sixty-five. Expenses attributable
      to the matching contributions for the years ended December 31, 2006, 2005 and
      2004 were $87,657, $80,022, and $77,963, respectively. The accrued liability
      of
      the plan at December 31, 2006 and 2005 was $263,884 and $176,227,
      respectively.





***Defined
      Contribution Plan***





The
      Company sponsors a contributory profit-sharing plan which provide for
      participation by substantially all employees. Participants may make voluntary
      contributions resulting in salary deferrals in accordance with Section 401(k)
      of
      the Internal Revenue Code. The plans provide for employee contributions up
      to
      $15,000 of the participant's annual salary and an employer contribution of
      100%
      matching of the first 6% of pre-tax salary contributed by each participant.
      The
      Company may make additional discretionary profit sharing contributions to the
      plan on behalf of all participants; in 2005 the Company declared an $80,000
      discretionary contribution. There were no discretionary contributions for 2006
      or 2004. Amounts deferred above the first 6% of salary are not matched by the
      Company. Expenses related to these plans for the years ended December 31, 2006,
      2005 and 2004 were $269,058, $172,450, and $111,442, respectively.





***Employment
      Agreements***





The
      Company has entered into employment agreements with certain of its executive
      officers to ensure a stable and competent management base. The agreements
      provide for benefits as spelled out in the contracts and cannot be terminated
      by
      the Board of Directors, except for cause, without prejudicing the officers’
rights to receive certain vested rights, including compensation. In the event
      of
      a change in control of the Company, as outlined in the agreements, the acquirer
      will be bound to the terms of the contracts.




76


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***


**NOTE
      Q - PARENT COMPANY FINANCIAL DATA**





Condensed
      statements of financial condition as of December 31, 2006 and 2005, and its
      related condensed statements of operations and cash flows for each of the years
      in the three-year period ended December 31, 2006 are as follows:


**Condensed
        Balance Sheets**
 **December
        31, 2006 and 2005**
  2006
              
              2005ASSETSCash
                  and due from banks
              
              $
              4,218,479
              
              $
              12,535,544Investment
                  in subsidiaries
              
              
              87,188,534
              
              
              37,249,786Other
                  assets
              
              
              73,694
              
              
              112,162TOTAL
                  ASSETS
              
              $
              91,480,707
              
              $
              49,897,492LIABILITIES
                  AND STOCKHOLDERS' EQUITYLiabilities:Accrued
                  interest payable
              
              $
              166,963
              
              $
              142,851Due
                  to former Centennial Shareholders
              
              
              27,113
              
              
              33,974Accrued
                  expenses and other liabilities
              
              
              4,653
              
              
              15,453Subordinated
                  debentures
              
              
              8,248,000
              
              
              8,248,000TOTAL
                  LIABILITIES
              
              
              8,446,729
              
              
              8,440,278Stockholders'
                  equity:Common
                  stock
              
              
              8,265,136
              
              
              5,026,394Additional
                  paid-in capital
              
              
              62,659,201
              
              
              29,405,559Retained
                  earnings
              
              
              12,610,588
              
              
              7,707,054Accumulated
                  other comprehensive loss
              
              
              (500,947
              )
              
              (681,793
              )TOTAL
                  STOCKHOLDERS’ EQUITY
              
              
              83,033,978
              
              
              41,457,214TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY
              
              $
              91,480,707
              
              $
              49,897,492




**Condensed
        Statements of Operations**
 **Years
        Ended December 31, 2006, 2005 and 2004**




2006
              
              2005
              
              2004Equity
                  in earnings of subsidiaries
              
              $
              4,988,649
              
              $
              3,397,675
              
              $
              2,539,365Interest
                  income
              
              
              630,505
              
              
              233,179
              
              
              144,117Dividend
                  income
              
              
              20,669
              
              
              16,238
              
              
              11,520Other
                  miscellaneous income
              
              
              23,286
              
              
              803
              
              
              -Interest
                  expense
              
              
              (720,822
              )
              
              (573,438
              )
              
              (416,547
              )Other
                  operating expenses
              
              
              (81,853
              )
              
              (59,784
              )
              
              (50,558
              )Income
                  tax benefit (expense)
              
              
              43,100
              
              
              129,700
              
              
              104,800Net
                  income
              
              $
              4,903,534
              
              $
              3,144,373
              
              $
              2,332,697




77


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***
 
 NOTE
        Q - PARENT COMPANY FINANCIAL
        DATA
  **Condensed
        Statements of Cash
        Flows**


**Years
      Ended December 31, 2006, 2005 and 2004**


2006
              
              2005
              
              2004Cash
                  flows from operating activities:Net
                  income
              
              $
              4,903,534
              
              $
              3,144,373
              
              $
              2,332,697Adjustments
                  to reconcile net income to net cashprovided
                  (used) by operating activities:Amortization
              
              
              33,400
              
              
              33,400
              
              
              33,400Stock
                  based compensation
              
              
              202,246
              
              
              -
              
              
              -Equity
                  in earnings of Crescent State Bank
              
              
              (4,194,284
              )
              
              (3,397,675
              )
              
              (2,539,365
              )Equity
                  in earnings of Port City Capital Bank
              
              
              (794,365
              )
              
              -
              
              
              -Changes
                  in assets and liabilities:Increase
                  in other assets
              
              
              5,068
              
              
              (10,765
              )
              
              (18,235
              )Increase
                  (decrease) in accrued interest payable
              
              
              24,112
              
              
              40,983
              
              
              (21,504
              )Increase
                  (decrease) in accrued expensesand
                  other liabilities
              
              
              (10,799
              )
              
              25,353
              
              
              (2,200
              )Net
                  cash provided (used) by operating activities
              
              
              168,912
              
              
              (164,331
              )
              
              (215,207
              )Cash
                  flows from investing activities:Investment
                  in Subsidiaries
              
              
              (8,770,879
              )
              
              (1,750,000
              )
              
              -Net
                  cash used by investing activities
              
              
              (8,770,879
              )
              
              (1,750,000
              )
              
              -Cash
                  flows from financing activities:Net
                  proceeds from issuance of common stock
              
              
              -
              
              
              11,617,858
              
              
              -Proceeds
                  from exercise of stock options
              
              
              255,797
              
              
              392,912
              
              
              348,948Excess
                  tax benefits from stock options exercised
              
              
              45,401
              
              
              199,800
              
              
              61,709Payments
                  to former Centennial Shareholders
              
              
              (6,861
              )
              
              (101,820
              )
              
              (748,816
              )Cash
                  (paid) received in lieu of fractional shares
              
              
              (9,435
              )
              
              2
              
              
              1,790Net
                  cash provided (used) by financing activities
              
              
              284,902
              
              
              12,108,752
              
              
              (336,371
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              (8,317,065
              )
              
              10,194,421
              
              
              (551,578
              )Cash
                  and cash equivalents, beginning
              
              
              12,535,544
              
              
              2,341,123
              
              
              2,892,701Cash
                  and cash equivalents, ending
              
              $
              4,218,479
              
              $
              12,535,544
              
              $
              2,341,123


78


***CRESCENT
        FINANCIAL CORPORATION AND SUBSIDIARIES***
 ***Notes
        to Consolidated Financial Statements***
 ***December
        31, 2006, 2005 and 2004***





**NOTE
      R - SUPPLEMENTAL DISCLOSURE FOR STATEMENT OF CASH FLOWS**


2006
              
              2005
              
              2004Supplemental
                  Disclosure of Cash Flow Information:Cash
                  paid during the year for:Interest
              
              $
              17,120,578
              
              $
              8,562,944
              
              $
              5,440,306Income
                  taxes
              
              $
              2,655,001
              
              $
              1,330,000
              
              $
              1,031,500Supplemental
                  Disclosure of Noncash Investingand
                  Financing Activities:Transfer
                  of loans to foreclosed assets
              
              $
              199,900
              
              $
              48,300
              
              $
              375,400Increase
                  (decrease) in fair value of securitiesavailable
                  for sale, net of tax
              
              
              180,846
              
              
              (675,145
              )
              
              (117,630
              )





The
      fair
      value of assets acquired and liabilities assumed in the PCCB merger are
      presented in Note M.





**NOTE
      S -** **SALE
      OF COMMON STOCK**





The
      Company completed the sale of 848,000 shares of its common stock at $15.00
      per
      share on November 2, 2005. Expenses associated with the sale amounted to
      $1,102,142 resulting in net proceeds from the offering of
      $11,617,858.





79




**ITEM
      9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





Not
      applicable.





**ITEM
      9A - CONTROLS AND PROCEDURES**





The
      Registrant’s Chief Executive Officer and Chief Financial Officer have conducted
      an evaluation of the Registrant’s disclosure controls and procedures as of
      December 31, 2006. Based on their evaluation, the Registrant’s Chief Executive
      Officer and Chief Financial Officer have concluded that the Registrant’s
      disclosure controls and procedures are effective to ensure that information
      required to be disclosed by the Registrant in reports that it files or submits
      under the Securities Exchange Act of 1934 is recorded, processed, summarized
      and
      reported within the time periods specified in the applicable Securities and
      Exchange Commission rules and forms. There were no changes in the Registrant’s
      internal controls or in other factors that could materially affect these
      controls subsequent to the date of the most recent evaluation of these controls
      by the Registrant’s Chief Executive Officer and Chief Financial Officer,
      including any corrective actions with regard to deficiencies and
      weaknesses.





**ITEM
      9B - OTHER INFORMATION**





Not
      applicable.





**PART
      III**





**ITEM
      10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**





Incorporated
      by reference from the discussion under the headings “Proposal 1: Election of
      Directors,” “Executive Compensation - Executive Officers,” “Director
      Relationships,” “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Meetings and Committees of the Board of Directors - Audit Committee” in the
      Registrant’s Proxy Statement for the 2007 Annual Meeting of Shareholders to be
      filed with the SEC.





The
      Registrant has adopted a Code of Ethics that applies, among others, to its
      principal executive officer and principal financial officer. The Registrant’s
      Code of Ethics is available at www.crescentstatebank.com .





**ITEM
      11 - EXECUTIVE COMPENSATION**





Incorporated
      by reference from the discussion under the heading “Executive Compensation,”
“Director Compensation,” “Compensation Committee Interlocks and Insider
      Participation” and “Compensation Committee Report” in the Registrant’s Proxy
      Statement for the 2007 Annual Meeting of Shareholders to be filed with the
      SEC.





**ITEM
      12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS**





Incorporated
      by reference from the discussion under the heading “Beneficial Ownership of
      Voting Securities” in the Registrant’s Proxy Statement for the 2007 Annual
      Meeting of Shareholders to be filed with the SEC.





**Stock
      Option Plans**





Set
      forth
      below is certain information regarding the Registrant’s various stock option
      plans.




80


**EQUITY
        COMPENSATION PLAN INFORMATION**


Plan
                Category
            
            Number
                of securities to be issued upon exercise of outstanding options,
                warrants,
                and rights
              (a)
            
            Weighted-average
                exercise price of outstanding options, warrants, and rights
              (b)
            
            Number
                of securities remaining available for future issuance under equity
                compensation plans (excluding securities reflected in column
                (a))
              (c)Equity
                compensation plans approved by security holders
            
            
            961,245
            
            $
            5.39
            
            
            313.163Equity
                compensation plans not approved by security holders
            
            
            None
            
            
            None
            
            
            NoneTotal
            
            
            961,245
            
            $
            5.39
            
            
            313,163





See
      additional information in Note P under the heading "Employee and Director
      Benefit Plans - Stock Option Plans" in Item 8 of this report.





**ITEM
      13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**





Incorporated
      by reference from the discussion under the headings “Director Independence” and
“Indebtedness of and Transactions with Management” in the Registrant’s Proxy
      Statement for the 2007 Annual Meeting of Shareholders to be filed with the
      SEC.





**ITEM
      14 - PRINCIPAL ACCOUNTING FEES AND SERVICES**





Incorporated
      by reference from pages the discussion under the heading “Proposal 2:
      Ratification of Independent Public Accountants” and “Audit Committee Report” in
      the Registrant’s Proxy Statement for the 2007 Annual Meeting of Shareholders to
      be filed with the SEC.





**ITEM
      15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES**





**(a)**  **Exhibits**





**3(i)**  Articles
      of Incorporation of Registrant (Incorporated by reference from the Annual Report
      on Form 10-KSB of the Registrant for the fiscal year ended December 31, 2001,
      as
      filed with the Securities and Exchange Commission on March 27,
      2002)





**3(ii)**  Bylaws
      of
      Registrant (Incorporated by reference from the Annual Report on Form 10-KSB
      of
      the Registrant for the fiscal year ended December 31, 2001, as filed with the
      Securities and Exchange Commission on March 27, 2002)





**4**  Form
      of
      Stock Certificate (Incorporated by reference from the Annual Report on Form
      10-KSB of the Registrant for the fiscal year ended December 31, 2001, as filed
      with the Securities and Exchange Commission on March 27, 2002)





**10(i)**  1999
      Incentive Stock Option Plan, approved by shareholders on April 27, 1999
      (Incorporated by reference from Registrant’s Registration Statement on Form S-8
      as filed with the SEC on September 5, 2001)





**10(ii)**  1999
      Nonqualified Stock Option Plan for Directors, approved by shareholders on April
      27, 1999 (Incorporated by reference from Registrant’s Registration Statement on
      Form S-8 as filed with the SEC on September 5, 2001)





**10(iii)**   Employment
      Agreement between the Registrant and Michael G. Carlton (Incorporated by
      reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on
      March 30, 2004)





**10(iv)**  Employment
      Agreement between the Registrant and Bruce W. Elder **** (Incorporated
      by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC
      on March 30, 2004)




81




**10(v)**  Employment
      Agreement between the Registrant and Thomas E. Holder, Jr. **** (Incorporated
      by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC
      on March 30, 2004)





**10(vi)** Amended
      and Restated Trust Agreement of Crescent Financial Capital Trust I (Incorporated
      by reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC
      on March 30, 2004)





**10(vii)** Indenture
      (Incorporated by reference from Registrant’s Annual Report on Form 10-KSB filed
      with the SEC on March 30, 2004)





**10(viii)** Junior
      Subordinated Debenture (Incorporated by reference from Registrant’s Annual
      Report on Form 10-KSB filed with the SEC on March 30, 2004)





**10(ix)** Guarantee
      Agreement (Incorporated by reference from Registrant’s Annual Report on Form
      10-KSB filed with the SEC on March 30, 2004)





**10(x)**  Salary
      Continuation Agreement with Michael G. Carlton (Incorporated by reference from
      Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 30,
      2004)





**10(xi)** Salary
      Continuation Agreement with Bruce W. Elder (Incorporated by reference from
      Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 30,
      2004)





**10(xii)** Salary
      Continuation Agreement with Thomas E. Holder, Jr. (Incorporated by reference
      from Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 30,
      2004)





**10(xiii)** Endorsement Split Dollar Agreement with Michael G. Carlton (Incorporated by
      reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on
      March 30, 2004)





**10(xiv)**   Endorsement
      Split Dollar Agreement with Bruce W. Elder (Incorporated by reference from
      Registrant’s Annual Report on Form 10-KSB filed with the SEC on March 30,
      2004)





**10(xv)** Endorsement Split Dollar Agreement with Thomas E. Holder, Jr. (Incorporated
      by
      reference from Registrant’s Annual Report on Form 10-KSB filed with the SEC on
      March 30, 2004)





**10(xvi)**  Crescent
      State Bank Directors’ Compensation Plan (Incorporated by reference from
      Registrant’s Annual Report on Form 10-K filed with the SEC on March 28,
      2006)





**10(xvii)**  Employment
      Agreement with Ray D. Vaughn (Incorporated by reference from Registrant’s Annual
      Report on Form 10-K filed with the SEC on March 28, 2006)





**10(xviii)** 2006
      Omnibus Stock Ownership and Long Term Incentive Plan, approved by shareholders
      on July 11, 2006 (incorporated by reference from Registrant’s Registration
      Statement on Form S-8 filed with the SEC on August 11, 2006)





**21**
            Subsidiaries
                (Filed herewith)





**31(i)**
            Certification
                of Principal Executive Officer Pursuant to Section 302 of the Sarbanes
                Oxley Act (Filed herewith)





**31(ii)**
            Certification
                of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes
                Oxley Act (Filed herewith)





**32(i)**
            Certification
                of Principal Executive Officer Pursuant to Section 906 of the Sarbanes
                Oxley Act (Filed herewith)





**32(ii)**
            Certification
                of Principal Accounting Officer Pursuant to Section 906 of the Sarbanes
                Oxley Act (Filed herewith)


**99(i)**
              Registrant’s
                  Proxy Statement for the 2007 Annual Meeting of Shareholders (Filed
                  with the Securities and Exchange Commission pursuant to Rule
                  14a-6)


82





**SIGNATURES**





In
      accordance with the requirements of Section 13 of the Securities Exchange Act
      of
      1934, the Registrant has duly caused this Report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.


**CRESCENT
                FINANCIAL CORPORATION**
              RegistrantBy:
            /s/ Michael
              G. CarltonDate:
              March
              27, 2007
            Michael G. Carlton
              President
                and Chief Executive Officer




In
      accordance with the Securities Exchange Act of 1934, this Report has been signed
      below by the following persons on behalf of the Registrant and in the capacities
      and on the dates indicated.





/s/
              Michael G. Carlton
            
            March
                27, 2007Michael
                G. Carlton, President andChief
              Executive Officer, Director/s/
              Bruce W. Elder
            
            March
                27, 2007Bruce
                W. Elder, Vice President(Principal
              Accounting Officer)/s/
                Brent D. Barringer
            
            March
                27, 2007Brent
              D. Barringer, Director/s/
                William H. Cameron
            
            March
                27, 2007William
              H. Cameron, Director/s/
                Bruce I. Howell
            
            March
                27, 2007Bruce
              I. Howell, Director/s/
              James A. Lucas
            
            March
                27, 2007James
                A. Lucas, Director/s/
              Kenneth A. Lucas
            
            March
                27, 2007Kenneth
                A. Lucas, Director/s/
              Sheila Hale Ogle
            
            March
                27, 2007Sheila
                Hale Ogle, Director/s/
              Charles A. Paul
            
            March
                27, 2007Charles
                A. Paul, Director/s/
              Francis R. Quis, Jr.
            
            March
                27, 2007Francis
                R. Quis, Jr., Director/s/
              Jon S. Rufty
            
            March
                27, 2007Jon
                S. Rufty, Director/s/
              Jon T. Vincent
            
            March
                27, 2007Jon
                T. Vincent, Director/s/
              Stephen K. Zaytoun
            
            March
                27, 2007Stephen
                K. Zaytoun, Director





83




**EXHIBIT
      INDEX**




**Exhibit********Number**
            
            **Exhibit**3(i)
            
            Articles
                of Incorporation.
            
            *3(ii)
            
            Bylaws
            
            *4
            
            Form
                of Stock Certificate
            
            *10(i)
            
            1999
                Incentive Stock Option Plan
            
            **10(ii)
            
            1999
                Nonqualified Stock Option Plan
            
            **10(iii)
            
            Employment
                Agreement Michael G. Carlton
            
            ***10(iv)
            
            Employment
                Agreement of Bruce W. Elder
            
            ***10(v)
            
            Employment
                Agreement of Thomas E. Holder, Jr.
            
            ***10(vi)
            
            Amended
                and Restated Trust Agreement of Crescent Financial Capital Trust
                I
            
            ***10(vii)
            
            Indenture
            
            ***10(viii)
            
            Junior
                Subordinated Debenture
            
            ***10(ix)
            
            Guarantee
                Agreement
            
            ***10(x)
            
            Salary
                Continuation Agreement with Michael G. Carlton
            
            ***10(xi)
            
            Salary
                Continuation Agreement with Bruce W. Elder
            
            ***10(xii)
            
            Salary
                Continuation Agreement with Thomas E. Holder, Jr.
            
            ***10(xiii)
            
            Endorsement
                Split Dollar Agreement with Michael G. Carlton
            
            ***10(xiv)
            
            Endorsement
                Split Dollar Agreement with Bruce W. Elder
            
            ***10(xv)
            
            Endorsement
                Split Dollar Agreement with Thomas E. Holder, Jr.
            
            ***10(xvi)
            
            Crescent
                State Bank Directors’ Compensation Plan
            
            ****10(xvii)
            
            Employment
                Agreement with Ray D. Vaughn
            
            ****21
            
            Subsidiaries
            
            Filed
                herewith23
            
            Consent
                of Dixon Hughes PLLC31(i)
            
            Certification
                of Principal Executive Officer Pursuant to Section 302 of the Sarbanes
                Oxley Act
            
            Filed
                herewith31(ii)
            
            Certification
                of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes
                Oxley Act
            
            Filed
                herewith32(i)
            
            Certification
                of Principal Executive Officer Pursuant to Section 906 of the Sarbanes
                Oxley Act
            
            Filed
                herewith




84




32(ii)
            
            Certification
                of Principal Accounting Officer Pursuant to Section 906 of the Sarbanes
                Oxley Act
            
            Filed
                herewith99(i)
            
            Registrant’s
                Proxy Statement for the 2007 Annual Meeting of
                Shareholders
            
            *****





*  Incorporated
      by reference to the Registrant’s 10-KSB for the year ended December 31, 2001, as
      filed with the SEC on March 27, 2002.





**  Incorporated
      by reference to the Registrant’s Registration Statement on Form S-8 as filed
      with the SEC on September 5, 2001.





***  Incorporated
      by reference from Annual Report on Form 10-KSB filed with the SEC on March
      30,
      2004.





****  Incorporated
      by reference from Annual Report on Form 10-K filed with the SEC on March 28,
      2006.





*****  Filed
      with the Securities and Exchange Commission pursuant to Rule
      14a-6.




85